LAPOLLA INDUSTRIES, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED-CONTINUED)
Note 10. Derivatives and Fair Value.
The Company has evaluated the application of GAAP with respect to the embedded conversion feature associated with the ComVest Convertible Term Note and associated Warrants to purchase common stock and determined these instruments were required to be accounted for as derivatives as of January 1, 2009 due to the down round protection feature on the conversion price and the exercise price. The Company records the fair value of these derivatives on its balance sheet at fair value with changes in the values of these derivatives reflected in the statements of operations as “Gain (Loss) on Derivative Liabilities.” These derivative instruments are not designated as hedging instruments under GAAP and are disclosed on the balance sheet under “Derivative Liabilities”. At March 31, 2010, all of the Company’s derivative liabilities were categorized as Level 3 fair value assets.
Level 3 Valuation Techniques
Financial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial liabilities consist of the embedded conversion feature and freestanding warrants that contain down round provisions for which there is no current market for these securities such that the determination of fair value requires significant judgment or estimation. We have valued the embedded conversion feature and the freestanding warrants using a lattice model, with the assistance of a valuation consultant, for which management understands the methodologies. This model incorporates transaction details such as the Company’s stock price, contractual terms, maturity, risk free rates, as well as assumptions about future financings, volatility, and holder behavior as of January 1, 2010 and March 31, 2010. The primary assumptions include projected annual volatility of 142% and holder exercise targets at 135% of the conversion price for the Convertible Term Note and 150% of exercise price for the warrants, decreasing as the warrants approach maturity. The fair value of the derivatives as of January 1, 2009 upon implementation of EITF 07-05 was estimated by management to be $890,289. Amounts previously recorded to paid-in capital associated with these derivatives of $1,555,420 were reversed and the remaining $665,131 was recorded as a cumulative adjustment to accumulated deficit. The fair value of the derivatives as of March 31, 2010 was estimated to be $414,743. The foregoing assumptions are reviewed quarterly and subject to change based primarily on management’s assessment of the probability of the events described occurring. Accordingly, changes to these assessments could materially affect the valuation.
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis
Financial assets and liabilities measured at fair value on a recurring basis are summarized below and disclosed on the balance sheet under derivative liabilities:
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As of March 31, 2010
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|
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|
|
|
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Fair Value Measurements Using
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|
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Carrying Value
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Level 1
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Level 2
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Level 3
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Total
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|
|
Derivative Liabilities
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|
$ |
414,743 |
|
|
|
— |
|
|
|
— |
|
|
$ |
414,743 |
|
|
$ |
414,743 |
|
|
Total Derivative Liabilities
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|
$ |
414,743 |
|
|
|
— |
|
|
|
— |
|
|
$ |
414,743 |
|
|
$ |
414,743 |
|
The table below provides a summary of the changes in fair value, including net transfers in and/or out, of all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at March 31, 2010:
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Fair Value Measurements Using Level 3 Inputs
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|
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Derivative Liabilities
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Totals
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Beginning Balance as of January 1, 2010
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|
$ |
571,864 |
|
|
$ |
571,864 |
|
|
Total (Gains) or Losses (realized/unrealized)included in Net Income (Loss)
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|
|
(157,121 |
) |
|
|
(157,121 |
) |
|
Purchases, Issuances and Settlements
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|
— |
|
|
|
— |
|
|
Transfers in and/or out of Level 3
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|
|
— |
|
|
|
— |
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Ending Balance at March 31, 2010
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|
$ |
414,743 |
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|
$ |
414,743 |
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