NOTE 4 – CONVERTIBLE DEBT

On December 2, 2011, the Company and HEP Investments, LLC, a Michigan limited liability company (“Lender”), entered into a loan arrangement (the “Loan”) pursuant to which the parties executed the following documents, effective as of December 1, 2011: (i) a loan agreement under which the Lender has agreed to advance up to $2,000,000 to the Company, subject to certain conditions (the “Loan Agreement”), (ii) a Convertible Secured Promissory Note in the initial principal amount of $600,000 (the “Note”) and (iii) (a) a Security Agreement, under which the Company granted the Lender a security interest in all of its assets and (b) an IP security agreement under which the Company and its subsidiaries granted the Lender a security interest in all their respective intellectual properties, including patents, in each case order to secure their respective obligations to the Lender under the Note and related documents.  In addition, the Company’s subsidiaries have guaranteed the Company’s obligations under the Note.

As of December 5, 2011, the Lender has advanced the Company $600,000, consisting of $500,000 in cash and $100,000 previously advanced by the Lender in connection with a transaction previously disclosed in a Current Report on Form 8-K dated September 12, 2011.   The Lender has agreed to advance the remaining $1,400,000 in $250,000 increments (final increment of $150,000) upon request of the Company’s CEO, subject to satisfaction of certain conditions.  In addition, the Company has agreed to (i) issue the Lender warrants to purchase 1,666,667 shares of common stock at an exercise price of $.12 per share (including a cashless exercise provision), expiring September 30, 2016 and (ii) enter into a Registration Rights Agreement with respect to all the shares of common stock issuable to the Lender in connection with the Loan transaction, in each case subject to completion of funding of the full $2,000,000 called for by the Loan Agreement.

Amounts advanced under the Note (i) are secured by all the Company’s assets, (ii) are convertible into the Company’s restricted common stock at the lesser of $.12 per share or a 25% discount off of the ten day trailing quoted price of the common stock in the over the counter (OTC) market, and (iii) must bear interest at the rate of 11% per annum.  Additionally, those amounts are subject to the following requirements:  (x) accrued interest must be paid on the first and second anniversary of the Note, and (y) unpaid principal not previously converted into common stock must be repaid on the second anniversary of the Note December 1, 2013. The Company has also agreed to a specified use of proceeds.  The Note may be prepaid upon sixty days written notice, provided that the Company shall be required to pay a prepayment premium equal to 5% of the amount repaid.

The Company has made certain agreements with the Lender which shall remain in effect as long as any amount is outstanding under the Loan.  Such agreements include an agreement not to make any change in the Company’s senior management, without the prior written consent of the Lender. Two representatives of the Lender will have the right to attend Board of Director meetings as non-voting observers.

The Company recorded a debt discount of $500,000 against this Loan.  In addition, the Company recorded a derivative liability of $552,988.  This represents the future value of the stock to be issued under the terms of the convertible debt.  We valued this stock utilizing the Black-Scholes method of valuation relying on the following assumptions:  volatility 151.45%, annual rate of dividends 0% and a risk free interest rate of .27%.  In addition, the Company has recognized other income of $24,422 representing the change in fair value of this derivative liability.  We marked this derivative liability to fair value at December 31, 2011 utilizing the Black-Scholes method of valuation relying on the following assumptions:  volatility 151.49%, annual rate of dividends 0%, and a risk free rate of .25%.    

During the first quarter of 2012, the Company and The Venture Group, LLC, a Maryland limited liability company (“Venture Group”, “Lender”, or “Noteholder”), entered into the following agreements, effective as of January 26, 2012: (i) a Subscription Agreement under which the Lender has agreed to advance $500,000 to the Company, as follows:  $332,000 on January 26, 2012, which advance has been made, and $168,000 by February 3, 2012 (of which $57,000 has been advanced as of June 30, 2012), (ii) a Subordinated Convertible Promissory Note in the principal amount of $332,000 (“2012 Note”); (iii) (a) a Security Agreement, under which the Company granted the Lender a subordinated security interest in all of its assets and (b) an IP security agreement under which the Company granted the Lender a subordinated security interest in all its intellectual properties, including patents, to secure its obligations to the Lender under the Note and related documents; (iv) a Termination and Mutual Release Agreement under which the Company and Venture Group terminated their prior agreements and released each other from any liability, including liabilities related to the financing agreements they previously executed; and (v) a Termination and Release Agreement under which the Company and Oxford Holdings, LLC terminated their prior agreement and Oxford Holdings released the Company from any liability, including liabilities related to the agreement they previously executed.  The Company also acknowledged an intercreditor agreement between Venture Group and HEP Investments, LLC, the Company’s senior secured lender.   

In addition, the Company has agreed to issue the Lender warrants to purchase an aggregate of 833,333 shares of common stock at an exercise price of $.12 per share, for a term of three years (assuming funding of the full $500,000).  The Warrants are issuable to the Lender pro rata based on the amount invested in relation to the total investment amount (about 166,667 warrants per $100,000 invested). Amounts advanced under the 2012 Note are (i) secured on a subordinated basis by all the Company’s assets, (ii) convertible into the Company’s restricted common stock at $.12 per share, (iii) bear interest at the rate of 11% per annum (payable on the first and second anniversary of the 2012 Note (unless earlier paid off), in cash or stock, at the Company’s option), and unpaid principal not previously converted into common stock must be repaid on the second anniversary of the 2012 Note (January 2, 2014). The 2012 Note may be prepaid upon thirty days written notice, but not before August 31, 2012, provided that in the event of prepayment, the Company must pay the Lender an additional 5% of the outstanding principal amount. The Company has agreed to pay the following aggregate fees to Oxford Holdings, LLC in connection with the Loan transaction (assuming funding of the full $500,000): (i) finder’s fees of approximately $27,600 in cash, (ii) warrants to purchase 200,000 shares of common stock at an exercise price of $.15 per share for a term of two years, and (iii) a $15,000 non-accountable expense allowance.  In addition, the Company has paid Venture Group $10,000 for payment of the Venture Group’s legal fees.

The Company recorded a deferred debt discount in the amount of $332,000, to reflect the beneficial conversion feature of the convertible debt and fair value of the warrants in accordance with ASC standards. The Company valued the beneficial conversion feature and recorded the amount of $130,264 as a reduction to the carrying amount of the convertible debt and as an addition to paid-in capital. Additionally, the relative fair value of the warrants ($201,736) was calculated and recorded as a further reduction to the carrying amount of the convertible debt and an addition to additional paid-in capital. We valued this transaction utilizing the Black-Scholes method of valuation relying on the following assumptions:  volatility - 154.35%, annual rate of dividends 0% and a risk free interest rate of .22%.  In connection with the $332,000 in convertible notes, the Company recorded non-cash finance charges of $293,282 during the three months ended March 31, 2012.

During the three months ended March 31, 2012, 1% Convertible Debentures in the amount of $47,500 matured and were extended by a noteholder and significant shareholder of the Company. Under the terms of the extension agreement the notes will all be extended by two years from their original maturity date. The extensions were requested by the noteholder for no consideration. These modifications were not considered significant under ASC standards.

On March 12, 2012, HEP Investments advanced the Company an additional $100,000 pursuant to its previously disclosed agreement to invest up to $2,000,000 in convertible notes.

During the second quarter of 2012, HEP Investments advanced the Company an additional $325,000 pursuant to its previously disclosed agreement to invest up to $2,000,000 in convertible notes.  The Company recorded a deferred debt discount in the amount of $500,000, to reflect the beneficial conversion feature of the convertible debt and fair value of the warrants in accordance with ASC standards (the debt discount calculation was inclusive of investments made in the fourth quarter of 2011 and the first quarter of 2012). The Company valued the beneficial conversion feature and recorded the amount of $445,147 as a reduction to the carrying amount of the convertible debt and as an addition to paid-in capital. Additionally, the relative fair value of the warrants ($54,853) was calculated and recorded as a further reduction to the carrying amount of the convertible debt and an addition to additional paid-in capital. We valued these transactions utilizing the Black-Scholes method of valuation relying on the following assumptions:  volatility of 140.93%-143.36%, annual rate of dividends 0% and a risk free interest rate of .25%. In connection with the $325,000 in convertible notes, the Company recorded non-cash finance charges of $16,575 during the three months ended June 30, 2012.

Amortization of the debt discount on the remaining notes was $545,659 for the six months ended June 30, 2012.

During the three months ended June 30, 2012, 1% Convertible Debentures in the amount of $37,600 that matured, as well as $70,000 in 1% Convertible Debentures that were due to mature in the third quarter were extended by a noteholder and significant shareholder of the Company.  Under the terms of the extension agreement the notes will all be extended by two years from their original maturity date. The extensions were requested by the noteholder for no consideration. These modifications were not considered significant under ASC standards.