Note 5 – Convertible Preferred Stock
On February 14, 2011, we completed a public offering of 1,667 shares of our convertible preferred stock at a price of $1,000 per share, with an original issue discount of 4%, for gross proceeds of $1.6 million. The convertible preferred stock was convertible into 16,670,000 shares of common stock at a conversion price of $0.10 per share. The conversion price was also subject to adjustment if the Company issued equity securities (other than certain excluded securities) at a price per share less than the conversion price, such that the conversion price would equal the price per share of such equity securities. The convertible preferred stock was subject to automatic conversion, subject to the satisfaction of certain customary equity conditions, in four equal monthly installments commencing with March 17, 2011. The conversion price on each automatic conversion date was equal to the lower of (i) the conversion price then in effect or (ii) 85% of the average of the three lowest closing bid prices of the Company’s common stock during the 20 trading day period prior to automatic conversion date. The Company could elect, at its option but subject to the satisfaction of certain conditions, to redeem the shares of convertible preferred stock in lieu of an automatic conversion occurring.
The estimated fair value of the convertible preferred stock and related conversion feature at issuance was $3,250,000. In accordance with FASB ASC 815 Derivatives and Hedging, the original fair value of the embedded conversion feature of $1,579,000 has been recorded as conversion feature liability. The original fair value was computed using the Black-Scholes model under the following assumptions: (1) expected life of .33 years; (2) volatility of 116%; (3) risk free interest of 2.26%, and (4) dividend rate of 0%. In addition, the Company is required to report the conversion liability at fair value and record the fluctuation to the fair value of the conversion feature liability to current operations.
As convertible preferred stock converted into common stock, the Company reduces the fair value of the conversion feature attributable to the convertible preferred shares converted and records the value as additional paid in capital. During the three months ended June 30, 2011, the Company derecognized the remaining $962,000 of the conversion feature liability in connection with the remaining shares that were converted.
The change in the fair value of the conversion feature liability resulted in losses of $794,000 for the three month period ended June 30, 2011 and a gain of $27,000 for the six month period ended June 30, 2011. The fair value of conversion feature outstanding at June 30, 2011 was $0 since all of the remaining shares were converted during the three month period ended June 30, 2011.
The investors also received Series PA Warrants, with a 5 year term from its initial exercise date, to purchase up to 16,670,000 shares of common stock at an exercise price of $0.15 per share; Series PB Warrants, with a 1 year term, to purchase up to 16,670,000 shares of common stock at an exercise price of $0.10 per share; and Series PC Warrants, with a 5 year term from its initial exercise date, to purchase up to 16,670,000 shares of common stock at an exercise price of $0.15 per share. The Series PC Warrants may be exercised by the investors only to the extent and in the same percentage that the investors exercise its Series PB Warrants. The Series PB Warrants are immediately exercisable, while the other warrants are only exercisable after June 8, 2012. As discussed in Note 6, the Company estimated the fair value of the Series PA, PB and PC Warrants on the grant date of February 14, 2011 to be $7,087,000.
The original fair value of the embedded conversion feature of $1,579,000, the original fair value of the warrants of $7,087,000 and the original issue discount of $67,000 were recorded as discounts to the convertible preferred stock. As a result, the value of the convertible preferred stock liability was reduced to zero. Discounts exceeding the fair value of the convertible preferred stock of $7,066,000 were recorded as interest expense. The discounts to the convertible preferred stock are accreted to interest expense as the convertible preferred stock is converted into common shares. The discount accreted to interest expense for the three month and six month periods ended June 30, 2011 was $701,000 and $1,667,000, respectively.