In April 2008, the FASB issued a pronouncement that provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in the pronouncement on accounting for derivatives. This pronouncement was effective for financial statements issued for fiscal years beginning after December 15, 2008. The adoption of these requirements can affect the accounting for warrants and many convertible instruments with provisions that protect holders from a decline in the stock price (or “down-round” provisions). For example, warrants with such provisions will no longer be recorded in equity. Down-round provisions reduce the exercise price of a warrant or convertible instrument if a company either issues equity shares for a price that is lower than the exercise price of those instruments or issues new warrants or convertible instruments that have a lower exercise price.

The Company evaluated whether convertible debt and warrants to acquire stock of the Company contain provisions that protect holders from declines in the stock price or otherwise could result in modification of the exercise price under the respective convertible debt and warrant agreements. The Company determined that the notes and the conversion notes of certain notes contained such provisions and recorded such instruments as derivative liabilities upon issuance. In addition, in periods prior to July 1, 2012, the Company did not have enough authorized shares to issue common shares resulting in the potential exercise or conversion of its issued and outstanding options, warrants or convertible notes. Accordingly, these instruments were reflected as derivative liabilities as of June 30, 2012 and prior. In July 2012, the Company was successful in increasing the number of authorized shares in the corporate treasury effectively eliminating the majority of the derivative liability. 

Derivative liabilities were valued using the weighted-average Black-Scholes-Merton option pricing model, which approximates the Monte Carlo and other binomial valuation techniques, with the following assumptions:

The risk-free interest rate was based on rates established by the Federal Reserve Bank. The Company based the expected volatility assumption on a volatility index of peer companies as the Company did not have sufficient market information to estimate the volatility of its own stock, and the expected life of the instruments is determined by the expiration date of the instrument. The expected dividend yield was based on the fact that the Company has not paid dividends to common stockholders in the past and does not expect to pay dividends to common stockholders in the future.

The Company determined the fair value of the derivative liabilities related to debt instruments to be $3,679,746 as of December 31, 2011. During the year ended December 31, 2012, the Company recorded a gain for the change in fair value of derivative liabilities of $1,936,878 which is recorded in the accompanying statement of operations for the year then ended. Also in 2012, the completion of the increase in the number of authorized shares resulted in the extinguishment of the derivatives of $1,578,405 pertaining to warrants and options. As the warrants and options are related to equity instruments, the extinguishment of derivative liabilities was recorded as an increase in additional paid in capital. The fair value of the derivative liabilities was determined to be $199,027 at December 31, 2012.