NOTES TO FINANCIAL STATEMENTS
Three Months Ended March 31, 2013
(Unaudited)
NOTE 1 – DESCRIPTION OF BUSINESS
AND SUMMARY OF ACCOUNTING POLICIES
Description of Business
On May 16, 2011, the Company transferred,
through a spin-off to its then wholly owned subsidiary, Worlds Online Inc., the majority of its operations and related operational
assets. The Company retained its patent portfolio which it intends to continue to increase and to more aggressively enforce against
alleged infringers. The Company also entered into a License Agreement with Worlds Online Inc. to sublicense its patented technologies.
Basis of Presentation
The accompanying financial statements
have been prepared in conformity with accounting principles generally accepted in the United States of America ("US GAAP"),
which contemplates continuation of the Company as a going concern. The Company has always been considered a developmental stage
business, has incurred significant losses since its inception and has had minimal revenues from operations. The Company will require
substantial additional funds for development and enforcement of its patent portfolio. There can be no assurance that the Company
will be able to obtain the substantial additional capital resources to pursue its business plan or that any assumptions relating
to its business plan will prove to be accurate. The Company has not been able to generate sufficient revenue or obtain sufficient
financing which has had a material adverse effect on the Company, including requiring the Company to reduce operations. These factors
raise substantial doubt about the Company's ability to continue as a going concern. For the past year the Company has been operating
at a significantly reduced capacity, with only one full time employee, performing primarily consulting services and licensing software
and using consultants to perform any additional work that may be required.
Use of Estimates
The preparation of financial statements
in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could differ from these estimates.
Cash and Cash Equivalents
Cash and cash equivalents are comprised of highly liquid
money market instruments, which have original maturities of three months or less at the time of purchase.
Due from Related Party
Due from related party is comprised
of cash payments made by Worlds Inc. on behalf of Worlds Online Inc. for shared operating expenses.
Revenue Recognition
Effective for the second quarter of
2011, the Company spun off its online businesses to Worlds Online Inc. The Companys sources of revenue after the spin off
will be from sublicenses of the patented technology by Worlds Online and any revenue that may be generated from enforcing its patents.
Prior to the spin-off, the Company had the following sources of revenue: (1) consulting/licensing revenue from the performance
of development work performed on behalf of the Company and licensing revenue or from the sale of certain software to third parties;
and (2) VIP subscriptions to our Worlds Ultimate 3-D Chat service. Following the spin-off we expect to receive revenue from royalties
on licenses of our IP and from litigation settlements from infringers of our IP. The Company recognizes revenue when all of the
following criteria are met: evidence of an arrangement exists such as a signed contract, delivery has occurred, the price is fixed
or determinable, and collectibility is reasonable assured. This will usually be in the form of a receipt of a customers acceptance
indicating the product has been completed to their satisfaction except for development work and service revenue which is recognized
when the services have been performed. Deferred revenue represents cash payments received in advance to be recorded as revenue
when earned. The corresponding cost associated with those contracts is also deferred as deferred costs until the revenue is ultimately
recognized.
Research and Development Costs
Research and development costs are charged
to operations as incurred.
Property and Equipment
Property and equipment are stated at
cost. Depreciation is provided on a straight line basis over the estimated useful lives of the assets ranging from three to five
years. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting
gains or losses are included in income. Maintenance and repairs are charged to expense in the period incurred.
Impairment of Long Lived Assets
The Company evaluates the recoverability
of its fixed assets and other assets in accordance with section 360-10-15 of the FASB Accounting Standards Codification for disclosures
about Impairment or Disposal of Long-Lived Assets. Disclosure requires recognition of impairment of long-lived assets in the event
the net book value of such assets exceeds its expected cash flows. If so, it is considered to be impaired and is written down to
fair value, which is determined based on either discounted future cash flows or appraised values. The Company adopted the statement
on inception. No impairments of these types of assets were recognized during the three months ended March 31, 2013 and 2012.
Stock-Based Compensation
The Company accounts for stock-based
compensation using the fair value method following the guidance set forth in section 718-10 of the FASB Accounting Standards Codification
for disclosure about Stock-Based Compensation. This section requires a public entity to measure the cost of employee services received
in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That
cost will be recognized over the period during which an employee is required to provide service in exchange for the award- the
requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees
do not render the requisite service.
Income Taxes
The Company accounts for income taxes
under Section 740-10-30 of the FASB Accounting Standards Codification. Deferred income tax assets and liabilities are determined
based upon differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted
tax rates and laws that will be in effect when the differences are expected to reverse. Deferred tax assets are reduced by a valuation
allowance to the extent management concludes it is more likely than not that the assets will not be realized. Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates
is recognized in the consolidated statements of operations in the period that includes the enactment date.
ASC 740 prescribes a comprehensive model
for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken
or expected to be taken on a tax return. Under ASC 740, tax positions must initially be recognized in the financial statements
when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions must
initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized
upon ultimate settlement with the tax authority assuming full knowledge of the position and relevant facts.
Notes Payable
The Company has $773,279 in short term
notes outstanding at March 31, 2013.
Deferred Revenue
As part of a debt refinancing in 2000,
$631,950 of debt was renegotiated to deferred revenue representing future services to be provided by the Company. $355,000 has
been amortized into income since then. The balance was transferred over to Worlds Online Inc. and no longer appears on the Company’s
balance sheet.
Call Option Agreements
The Company has entered into call option
agreements with 13 of its major shareholders. The call options give the Company the right to purchase up to 4,150,000 shares of
stock back at prices ranging from $0.15 per share up to $0.40 per share. The Company issued an aggregate of 680,000 shares of stock
to these shareholders as an inducement to enter into these call option agreements. The call option agreements have expiration dates
of 1 and 2 years. In 2011, 12 of the call options were extended for 1 year. The Company issued 315,000 additional shares as an
inducement to enter into the 1 year extensions. At December 31, 2012 all call options have expired
Comprehensive Income (Loss)
The Company reports comprehensive income
and its components following guidance set forth by section 220-10 of the FASB Accounting Standards Codification which establishes
standards for the reporting and display of comprehensive income and its components in the consolidated financial statements. There
were no items of comprehensive income (loss) applicable to the Company during the period covered in the consolidated financial
statements.
Loss Per Share
Net loss per common share is computed
pursuant to section 260-10-45 of the FASB Accounting Standards Codification. Basic net loss per share is computed by dividing net
loss by the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed
by dividing net loss by the weighted average number of shares of common stock and potentially outstanding shares of common stock
during each period. There were no potentially dilutive shares outstanding as of March 31, 2013 and 2012.
Commitments and Contingencies
The Company follows subtopic 450-20
of the FASB Accounting Standards Codification to report accounting for contingencies. Certain conditions may exist as of the date
the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more
future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves
an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted
claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or unasserted claims
as well as the perceived merits of the amount of relief sought or expected to be sought therein.
If the assessment of a contingency indicates
that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated
liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material
loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent
liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.
Loss contingencies considered remote
are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not
believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s
financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and
adversely affect the Company’s business, financial position, and results of operations or cash flows.
During 2000 the Company was involved
in a lawsuit relating to unpaid consulting services. In April, 2001 a judgment against the Company was rendered for approximately
$205,000. As of December 31, 2012, and 2011 the Company recorded a reserve of $205,000 for this lawsuit, which is included in accrued
expenses in the accompanying balance sheets.
Risk and Uncertainties
The Company is subject to risks common
to companies in the technology industries, including, but not limited to, litigation, development of new technological innovations
and dependence on key personnel.
Off Balance Sheet Arrangements
The Company does not have any off-balance sheet arrangements.
Uncertain Tax Positions
The Company did not take any uncertain
tax positions and had no adjustments to unrecognized income tax liabilities or benefits pursuant to the provisions of Section 740-10-25
for the years ended December 31, 2012 or 2011.
Recent Accounting Pronouncements
The Company has reviewed all
recently issued, but not yet effective, accounting pronouncements and do not believe the future adoption of any such pronouncements
may be expected to cause a material impact on its financial condition or the results of its operations.
In May 2011, FASB issued Accounting
Standards Update No. 2011-04, “Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and
Disclosure Requirements in U.S. GAAP and IFRSs” (“ASU 2011-04”). ASU 2011-04 changes the wording used to
describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements
to ensure consistency between U.S. GAAP and IFRS. ASU 2011-04 also expands the disclosures for fair value measurements that are
estimated using significant unobservable (Level 3) inputs. This new guidance is to be applied prospectively. The Company
anticipates that the adoption of this standard will not materially expand its financial statement note disclosures.
In June 2011, FASB issued ASU
No. 2011-05, “Comprehensive Income (ASC Topic 220): Presentation of Comprehensive Income” (“ASU 2011-05”),
which amends current comprehensive income guidance. This accounting update eliminates the option to present the components
of other comprehensive income as part of the statement of shareholders’ equity. Instead, the Company must report comprehensive
income in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive
income, or in two separate but consecutive statements. ASU 2011-05 will be effective for public companies during the interim
and annual periods beginning after December 15, 2011, with early adoption permitted. The Company is reviewing ASU 2011-05
to ascertain its impact on the Company’s financial position, results of operations or cash flows as it only requires a change
in the format of the current presentation.
In September 2011, the FASB issued
ASU 2011-08, “Testing Goodwill for Impairment”, which allows, but does not require, an entity when performing its annual
goodwill impairment test the option to first do an initial assessment of qualitative factors to determine whether it is more likely
than not that the fair value of a reporting unit is less than its carrying amount for purposes of determining whether it is even
necessary to perform the first step of the two-step goodwill impairment test. Accordingly, based on the option created in ASU 2011-08,
the calculation of a reporting unit’s fair value is not required unless, as a result of the qualitative assessment, it is
more likely than not that fair value of the reporting unit is less than its carrying amount. If it is less, the quantitative impairment
test is then required. ASU 2011-08 also provides for new qualitative indicators to replace those currently used. Prior to ASU 2011-08,
entities were required to test goodwill for impairment on at least an annual basis, by first comparing the fair value of a reporting
unit with its carrying amount. If the fair value of a reporting unit is less than its carrying amount, then the second step of
the test is performed to measure the amount of impairment loss, if any. ASU 2011-08 is effective for annual and interim goodwill
impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company adopted
ASU 2011-08 during the first quarter of fiscal 2013. The adoption of ASU 2011-08 did not impact the Company’s results of
operations or financial condition.
In December 2011, FASB issued
Accounting Standards Update 2011-11, “Balance Sheet - Disclosures about Offsetting Assets and Liabilities” to enhance
disclosure requirements relating to the offsetting of assets and liabilities on an entity's balance sheet. The update requires
enhanced disclosures regarding assets and liabilities that are presented net or gross in the statement of financial position when
the right of offset exists, or that are subject to an enforceable master netting arrangement. The new disclosure requirements relating
to this update are retrospective and effective for annual and interim periods beginning on or after January 1, 2013. The update
only requires additional disclosures, as such, the Company does not expect that the adoption of this standard will have a material
impact on its results of operations, cash flows or financial condition.
In July 2012, the FASB issued
ASU No. 2012-02, “Testing Indefinite-Lived Intangible Assets for Impairment”. The guidance allows companies to perform
a “qualitative” assessment to determine whether further impairment testing of indefinite-lived intangible assets is
necessary, similar in approach to the goodwill impairment test. ASU 2012-02 allows companies the option to first assess qualitatively
whether it is more likely than not that an indefinite-lived intangible asset is impaired, before determining whether it is necessary
to perform the quantitative impairment test. An entity is not required to calculate the fair value of an indefinite-lived intangible
asset and perform the quantitative impairment test unless the entity determines that it is more likely than not that the asset
is impaired. Companies can choose to perform the qualitative assessment on none, some, or all of its indefinite-lived intangible
assets or choose to only perform the quantitative impairment test for any indefinite-lived intangible in any period.ASU 2012-02
is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early
adoption permitted. The Company is in the process of evaluating the guidance and the impact ASU 2012-02 will have on its financial
statements.
NOTE 2 - GOING CONCERN
The accompanying financial statements
have been prepared assuming that the Company will continue as a going concern. Since its inception, the Company has had periods
where it had only minimal revenues from operations. There can be no assurance that the Company will be able to obtain the additional
capital resources to fully implement its business plan or that any assumptions relating to its business plan will prove to be accurate.
The Company is pursuing sources of additional financing and there can be no assurance that any such financing will be available
to the Company on commercially reasonable terms, or at all. Any inability to obtain additional financing will likely have a material
adverse effect on the Company, including possibly requiring the Company to reduce and/or cease operations.
These factors raise substantial doubt
about the ability of the Company to continue as a going concern. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
NOTE 3 - PRIVATE PLACEMENTS OF EQUITY
During the three months ended
March 31, 2013, the Company sold 875,000 common shares for a cash investment of $87,500. The company received $10,000 for
stock issued in 2012 and recorded as subscription receivable.
During the three months ended March
31, 2013, the Company raised $78,500 with the exercise of warrants covering 523,333 shares of its common stock at a price of $0.15
per share.
During the three months ended March
31, 2013, the Company issued an aggregate of 1,050,000 shares of common stock as payment for services rendered with an aggregate
value of $281,800, $232,037 of which was recorded as deferred compensation as of March 31, 2013.
During the three months
ended March 31, 2013, the Company issued 1,500,000 common shares for a cash investment of $150,000 which was received in
2012. The shares were not issued as of December 31, 2012, and were recorded as common stock subscribed but not yet issued at
December 31, 2012.
During the three months ended March
31, 2012, the Company sold 1,000,000 common shares for a cash investment of $250,000.
During the three months ended March
31, 2012, the Company issued an aggregate of 417,952 shares of common stock and will issue 637,276 shares of common stock as payment
for services rendered with an aggregate value of $207,035.
NOTE 4 - NOTES PAYABLE
We
issued an aggregate of $2.4 million face amount of Senior Secured Convertible Notes (the “Notes”). The Notes
are divided into Series A, Series B and Series C with the Series A and B Notes aggregating to $1.95 million and the Series
C Notes aggregating to $450,000. All of the Notes carry a 14% annual interest rate upon default and are payable on March 13,
2016.
The Company has determined that the conversion feature of the Notes represent an embedded derivative since the
Notes are convertible into a variable number of shares upon conversion. These Notes are classified as a derivative liability
and not a note payable, see Note 11 below.
Notes payable at March 31, 2013 consist
of the following:
|
|
|
|
|
|
Unsecured note payable to a shareholder bearing 8% interest.
|
Entire balance of principal and unpaid interest due on demand
|
|
$
|
124,230
|
|
|
|
|
|
|
Unsecured note payable to a shareholder bearing 10% interest
|
|
|
|
|
Entire balance of principal and unpaid interest due on demand
|
|
$
|
649,049
|
|
|
|
|
|
|
Total current
|
|
$
|
773,279
|
|
|
|
|
|
|
2013
|
|
$
|
773,279
|
|
2014
|
|
$
|
-0-
|
|
2015
|
|
$
|
-0-
|
|
2016
|
|
$
|
-0-
|
|
2017
|
|
$
|
-0-
|
|
|
|
$
|
773,279
|
|
NOTE 5- PROPERTY AND EQUIPMENT
The detail composition of property and equipment at March
31, 2013 and December 31, 2012 is as follows:
|
|
|
31-Mar
|
|
|
|
31-Dec
|
|
|
|
|
2013
|
|
|
|
2012
|
|
Computer equipment
|
|
$
|
10,891
|
|
|
$
|
10,891
|
|
Less: accumulated depreciation
|
|
|
10,891
|
|
|
|
10,891
|
|
|
|
$
|
0
|
|
|
$
|
0
|
|
Depreciation expense recorded for the three months ended
March 31, 2013 and 2012 was $0 and $0, respectively.
NOTE 6 – STOCK OPTIONS
During the three months ended March
31, 2013, the Company issued 4,535,714 warrants as part of the senior secured
convertible notes. No stock options were issued. During the three months ended March 31, 2013, 523,333 stock options were exercised
for cash proceeds of $78,500.
During the three months ended March
31, 2012, no stock options or warrants were exercised.
Stock Warrants and Options
|
Stock warrants/options outstanding and
exercisable on March 31, 2013 are as follows:
|
|
|
|
Exercise Price per Share
|
Shares Under Option/warrant
|
Remaining Life in Years
|
|
|
|
|
|
|
|
|
|
|
Outstanding
|
|
|
|
|
|
|
|
$
|
0.50
|
|
|
4,535,714
|
|
|
4.96
|
|
$
|
0.35
|
|
|
212,500
|
|
|
0.75
|
|
$
|
0.20
|
|
|
300,000
|
|
|
0.75
|
|
$
|
0.15
|
|
|
1,014,167
|
|
|
1.75
|
|
$
|
0.115
|
|
|
500,000
|
|
|
4.58
|
|
$
|
0.11
|
|
|
150,000
|
|
|
2.05
|
|
$
|
0.11
|
|
|
300,000
|
|
|
.05
|
|
$
|
0.076
|
|
|
7,500,000
|
|
|
1.00
|
|
$
|
0.05
|
|
|
600,000
|
|
|
.60
|
|
|
Exercisable
|
|
|
|
|
|
|
|
$
|
0.50
|
|
|
4,535,714
|
|
|
4.96
|
|
$
|
0.35
|
|
|
212,500
|
|
|
0.75
|
|
$
|
0.20
|
|
|
300,000
|
|
|
0.75
|
|
$
|
0.15
|
|
|
1,014,167
|
|
|
1.75
|
|
$
|
0.11
|
|
|
150,000
|
|
|
2.05
|
|
$
|
0.11
|
|
|
300,000
|
|
|
.05
|
|
$
|
0.076
|
|
|
7,500,000
|
|
|
1.00
|
|
$
|
0.05
|
|
|
600,000
|
|
|
.60
|
|
NOTE 7 - INCOME TAXES
At
March 31, 2013, the Company had federal and state net operating loss carry forwards of approximately $41,400,000
that
expire in various years through the year 2026.
Due to operating losses, there is no
provision for current federal or state income taxes for the three months ended March 31, 2013 and 2012.
Deferred income taxes reflect the net
tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and
the amount used for federal and state income tax purposes.
The Company’s deferred tax asset
at March 31, 2013 consists of net operating loss carry forwards calculated using federal and state effective tax rates equating
to approximately $16,146,000 less a valuation allowance in the amount of approximately $16,146,000. Because of the Company’s
lack of earnings history, the deferred tax asset has been fully offset by a valuation allowance. The valuation allowance increased
by approximately $86,000 and $38,000 for the three months ended March 31, 2013 and 2012, respectively.
The Company’s total deferred tax
asset as of March 31, 2013 is as follows:
Net operating loss carry forwards
|
|
$
|
16,146,000
|
|
Valuation allowance
|
|
|
(16,146,000)
|
|
|
|
|
|
|
Net deferred tax asset
|
|
$
|
—
|
|
The reconciliation of income taxes computed at
the federal and state statutory income tax rate to total income taxes for the three months ended March 31, 2013 and 2012
is as follows:
Income tax computed at the federal statutory rate
|
34%
|
Income tax computed at the state statutory rate
|
5%
|
Valuation allowance
|
(39%)
|
Total deferred tax asset
|
0%
|
NOTE 8 - COMMITMENTS AND CONTINGENCIES
The Company is committed to an employment
agreement with its President and CEO, Thom Kidrin.
The agreement, dated as of August 30, 2012, is for
five years with a one-year renewal option held by Mr. Kidrin. The agreement provides for a base salary of $175,000, which
increases 10% on September 1 of each year; a monthly car allowance of $500; an annual bonus equal to 2.5% of Pre-Tax Income (as
defined in the agreement); an additional bonus as follows: $75,000, if Pre-Tax Income for the year is between 150% and 200% of
the prior fiscal year’s Pre-Tax Income or (B) $100,000, if Pre-Tax Income for the year is between 201% and 250% of the prior
fiscal year’s Pre-Tax Income or (C) $200,000, if Pre-Tax Income for the year is 251% or greater than the prior fiscal year’s
Pre-Tax Income, but in no event shall this additional bonus exceed five (5%) percent of Pre-Tax Income for such year; payment of
up to $10,000 in life insurance premiums; options to purchase 7.5 million shares of Worlds Inc. common stock at an exercise price
of $0.076 per share, all of which vested on August 30, 2012; a death benefit of at least $2 million dollars; and a payment
equal to 2.99 times his base amount (as defined in the agreement) in the event of a Change of Control (as defined in the agreement).
The agreement also provides that Mr. Kidrin can be terminated for cause (as defined in the agreement) and that he is subject to
restrictive covenants for 12 months after termination
.
The Company is committed to a consulting agreement
with an unrelated business consultant. The contract is dated January 1, 2012, calls for monthly payments in the amounts of $5,000
for the 24 month term of the contract and expires on January 1, 2014
NOTE 9 -
RELATED PARTY TRANSACTIONS
On May 16, 2011, the Company transferred,
through a spin-off to its then wholly owned subsidiary, Worlds Online Inc., the majority of its operations and related operational
assets. The Company retained its patent portfolio which it intends to continue to increase and to more aggressively enforce against
alleged infringers. The Company also entered into a License Agreement with Worlds Online Inc. to sublicense its patented technologies.
Due from related party is comprised of cash
payments made by Worlds Inc. on behalf of Worlds Online Inc. for shared operating expenses. The balance due at March 31, 2013 is
$236,774.
NOTE 10 - PATENTS
Worlds Inc. currently has seven
patents, 6,219,045 - 7,181,690 - 7,493,558 – 7,945,856, - 8,082,501, 8,145,998 and 8,161,383. On March 30, 2012, the Company
filed a patent infringement lawsuit against Activision Bizzard Inc., Blizzard Entertainment Inc. and Activision Publishing Inc.
in the United States District Court for the District of Massachusetts. Susman Godfrey LLP is lead counsel for the Company. The
costs to prosecute those parties that the Company and our legal counsel believe to be infringing on said patents were capitalized
under patents until a resolution is reached.
There can be no assurance that
the Company will be successful in its ability to prosecute its IP portfolio or that we will be able to acquire additional patents.
NOTE 11 – DERIVATIVE LIABILITIES
On March 20, 2013 the Company entered
into strategic financing agreements with several institutional investors that could provide the Company with up to $2.3 million
of debt financing based upon the amount of conversions and redemptions. The transaction documents provide, among other things,
that (i) the investors will receive five year warrants in an amount equal to 100% of the number of shares of our common stock
the investors would receive if the Notes (defined below) were converted on March 13, 2013, at an exercise price of $0.50 per share,
(ii) $1.950 million of the funds will deposited in one of our bank accounts but will be subject to a control account agreement
which will provide that the Company can only withdraw funds from the account as the investors convert or redeem the Notes, (iii)
the investors have demand and piggy-back registration rights for the shares of common stock underlying the warrants and Notes,
(iv) the Notes will be secured by a first priority security interest in all of our assets, other than its patents, (v) each investor
may not convert any Note or exercise any warrants if doing so will cause the investor to own more than 4.99% of our outstanding
common stock at any time, although under certain circumstances they can each own up to 9.99% of our outstanding common stock,
(vi) we paid $40,000 of the investors’ legal fees incurred with respect to this transaction, and (vii) for the next three
years the investors have a right to participate in up to 50% of any of our future financings. The warrants and Notes contain standard
anti-dilution provisions and the Securities Purchase Agreements contains standard covenants for a financing of this nature. In
the event the Company acquires any subsidiaries while the Notes are outstanding, such subsidiaries will be obligated to guaranty
the Notes and any other obligations we owe to the investors pursuant to the transaction documents.
The Company has determined that the
conversion feature of the Notes represent an embedded derivative since the Notes are convertible into a variable number of shares
upon conversion. Accordingly, the Notes are not considered to be conventional debt under EITF 00-19 and the embedded conversion
feature must be bifurcated from the debt host and accounted for as a derivative liability. Accordingly, the fair value of this
derivative instrument has been recorded as a liability on the balance sheet with the corresponding amount recorded as a discount
to the Notes. Such discount will be accreted from the grant date to the maturity date of the Notes. The change in the fair value
of the derivative liability will be recorded in other income or expenses in the statement of operations at the end of each period,
with the offset to the derivative liability on the balance sheet. The beneficial conversion feature included in the Notes resulted
in an initial debt discount of $2,400,000 and an initial loss on the valuation of derivative liabilities of $512,637 based on the
initial fair value of the derivative liability of $2,912,637. The fair value of the embedded derivative liability was calculated
at grant date utilizing the following assumptions:
Grant Date
|
Fair Value
|
Term
(Years)
|
Assumed Conversion Price
|
Market Price on Grant Date
|
Volatility Percentage
|
Risk-free
Rate
|
3/20/13
|
$2,912,637
|
3.0
|
$0.326
|
$0.465
|
238%
|
0.0038
|
At March 31, 2013,
the Company revalued the embedded derivative liability. For the period from the grant date to March 31, 2013, the Company decreased
the derivative liability of $2,912,637 by $567,016 resulting in a derivative liability of $2,345,621 at March 31, 2013.
The fair value of the embedded derivative
liability was calculated at March 31, 2013 utilizing the following assumptions:
Fair Value
|
Term
(Years)
|
Assumed Conversion
Price
|
Volatility Percentage
|
Risk-free
Rate
|
$2,345,621
|
2.97
|
$0.352
|
234%
|
0.0036
|
The carrying value
of the Notes was $2,345,621 as of March 31, 2013. The Company recorded interest expense related to this note of $5,600 and amortization
of the debt discount in the amount of $21,198 during the period ended March 31, 2013.