Note 6 – Private Placement

 

Senior Secured Convertible Notes

 

On May 16, 2013, the Company entered into a securities purchase agreement (the “Securities Purchase Agreement”) with accredited investors (the “Investors”), pursuant to which the Company sold an aggregate of (i) $5,500,009 principal amount of senior secured convertible notes (the “Convertible Notes”). In connection with the sale of the Convertible Notes (the “Bridge Financing”), the Company entered into a registration rights agreement (the “Registration Rights Agreement”) and a security agreement (the “Security Agreement”) with the Investors. The closing of the Bridge Financing was completed on May 16, 2013. The Convertible Notes bear interest at 6% per annum and would have matured on August 16, 2014.

 

The principal and interest of the Convertible Notes are convertible into the Company’s common stock at a conversion price between $2.07 and $4.15 per share depending on the facts and circumstances at the time of the conversion (see below). Upon issuance, the Convertible Notes bear simple interest at 6% per annum, and upon the occurrence of any specified event of default, the Convertible Notes would have borne interest at 12% per annum. The Convertible Notes are required to be converted upon the IPO, if any, in which case the conversion price is equal to 50% of the price to the public in such offering (but not more than $4.15 or less than $2.07 per share) (See Note 10 – Subsequent Events - Conversion of Convertible Notes).

 

The aggregate amount of accrued interest on the Convertible Notes was $285,699 and $207,945 as of March 31, 2014 and December 31, 2013, respectively. As of March 31, 2014, the principal and accrued interest on the Convertible Notes were convertible into 1,833,336 and 95,233 shares of the Company’s common stock, assuming a conversion price of $3.00 per share (or, fifty percent of the IPO per share price of $6.00 per share).

 

Pursuant to the terms of the Convertible Notes, the conversion price is subject to adjustment in the event of an IPO, other financing and upon certain other events. The embedded conversion feature was not clearly and closely related to the host instrument and was bifurcated from the host Convertible Notes as a derivative, principally because the instrument’s variable exercise price terms would not qualify as being indexed to the Company’s own common stock. Accordingly, this conversion feature instrument has been classified as a derivative liability in the accompanying condensed balance sheet as of March 31, 2014.  Derivative liabilities are initially recorded at fair value and are then re-valued at each reporting date, with changes in fair value recognized in earnings during the reporting period.

 

The Company determined that the initial fair value of the embedded conversion option was $5,376,000.  From the gross proceeds upon the issuance of the Convertible Notes of $5,500,009, the Company deducted in full the fair value of the embedded conversion feature of $5,376,000 as a debt discount, as shown below. The debt discount is being amortized under the effective interest method over the term of the Convertible Notes. 

 

Face value of the Convertible Notes		$	5,500,009
Discount-fair value of embedded conversion feature			(5,376,000)
Proceeds attributable to the Convertible Notes		$	124,009

 

The Company calculated the fair value of the embedded conversion feature of the Convertible Notes using a Monte Carlo simulation, with the observable assumptions as provided in the table below. The significant unobservable inputs used in the fair value measurement of the reporting entity’s embedded conversion feature are expected stock prices, levels of trading and liquidity of the Company stock. Significant increases in the expected stock prices and expected liquidity would result in a significantly higher fair value measurement.  Significant increases in either the probability or severity of default of the host instrument would result in a significantly lower fair value measurement. 

 

		As of March 31, 2014				As of December 31, 2013
Stock price on valuation date		$	14.75			$	1.68
Conversion price		$	3.00			$	2.07
Term (years)			0.10				.26
Expected volatility			60	%			60	%
Dividend yield			0	%			0	%
Weighted average risk-free interest rate			1.32	%			1.75	%
Trials			20,000				20,000
Aggregate fair value		$	28,459,000			$	5,573,000

 

The amortization of debt discount related to the Convertible Notes was $920,739, $0 and $1,626,028, respectively, for the three months ended March 31, 2014 and 2013 and for the period October 30, 2012 (inception) through March 31, 2014, respectively. As of March 31, 2014, the debt discount will be amortized over a remaining period of 0.4 years. The derivative liability related to the embedded conversion feature is revalued at each reporting period.  During the three months ended March 31, 2014 and 2013 and for the period October 30, 2012 (inception) through March 31, 2014, the Company recorded an increase of $22,886,000, $0 and $23,083,000, respectively, in the fair value of the derivative liability for the conversion feature of the Convertible Notes, which was recorded as a change in the fair value of derivative liabilities within the condensed statement of operations.

 

Placement Agent Agreement

 

On January 23, 2013, the Company entered into an agreement (the “Placement Agent Agreement”) with MDB Capital Group, Inc. (“MDB”), pursuant to which the Company appointed MDB to act as the Company’s placement agent in connection with the sale of the Company’s securities (“Offering or Offerings”). Specifically, MDB was the placement agent in connection with the sale of its Convertible Notes.

 

In connection with the sale of the Convertible Notes, the Company paid MDB a cash fee of $538,393 and sold to MDB for $1,000 in cash, a warrant issued on May 16, 2013 (the “Financing Warrant”) to purchase shares of the Company’s common stock. The Financing Warrant was fully vested upon issuance, has a term of five years and may not be exercised until six months after the consummation of a qualifying firm commitment underwritten initial public offering. Pursuant to the terms of the Financing Warrant, the aggregate exercise price is fixed at $550,000, with the per share exercise price determined based upon 120% of the conversion price of the Convertible Notes upon the consummation of the IPO, or upon other events under which the Convertible Notes may convert. As of March 31, 2014, the Financing Warrant was exercisable into 152,778 shares of the Company’s common stock, assuming an exercise price of $3.60 per share (or 120% of the Convertible Notes conversion price of $3.00 per share)

 

In addition, in the event of a non-liquid exit transaction, as defined in the Financing Warrant agreement, the holder of the Financing Warrant may put the Financing Warrant back to the Company for a cash settlement at a fair value amount to be determined by appraisal and agreed to by both parties.

 

MDB shall have certain registration rights with respect to the common stock issued upon exercise of the Financing Warrant, including a one-time demand registration right with respect to such common stock.

 

Consulting Agreement

 

On January 23, 2013, the Company entered into a consulting agreement with MDB (the “Consulting Agreement”), pursuant to which MDB agreed to provide financial, strategic and intellectual property advisory services. The Consulting Agreement had an initial term of 180 days, and was renewed automatically upon the expiration of its initial term, after which it will continue in effect until it is terminated by either party with 30 days written notice to the other party.

 

As consideration for services provided under the Consulting Agreement prior to May 16, 2013, the Company sold to MDB for $1,500 in cash, a warrant (the “Consulting Warrant”) for the purchase of an aggregate of 278,228 shares of the Company’s common stock. The Consulting Warrant was fully vested upon issuance, has a term of five years, an exercise price of $0.04 per share and may not be exercised until six months after the consummation of the IPO. The Consulting Warrant may be exercised on a cashless basis. In addition, in the event of a non-liquid exit transaction, as defined in the Consulting Warrant, the holder of the Consulting Warrant may put the Consulting Warrant back to the Company for a cash settlement at a fair value amount to be determined by appraisal and agreed to by both parties.

 

MDB shall have certain registration rights with respect to the common stock issued upon exercise of the Consulting Warrant, including a one-time demand registration right with respect to such common stock.

 

Accounting for the Financing Warrant and the Consulting Warrant

 

The Company determined that due to their cash settlement features both the Financing Warrant and the Consulting Warrant qualified as derivative instruments.  Accordingly, these instruments have been classified as derivative liabilities in the accompanying balance sheet as of March 31, 2014.  Derivative liabilities are initially recorded at fair value and are then re-valued at each reporting date, with changes in fair value recognized in earnings during the reporting period.

 

The Company calculated the fair value of the Financing Warrant and the Consulting Warrant using a Monte Carlo simulation, with the observable assumptions as provided in the table below.   The significant unobservable inputs used in the fair value measurement of the reporting entity’s Financing Warrant and the Consulting Warrant are expected stock prices, levels of trading and liquidity of the Company’s common stock. Significant increases in the expected stock prices and expected liquidity would result in a significantly higher fair value measurement.  Significant increases in either the probability or severity of default of the host instrument would result in a significantly lower fair value measurement. 

 

Provided below are the principal assumptions used in the measurement of the fair values of the Financing Warrant and the Consulting Warrant as of March 31, 2014 and December 31, 2013.

 

		As of March 31, 2014								As of December 31, 2013
		Financing Warrant				Consulting Warrant				Financing Warrant				Consulting Warrant
Stock price on valuation date		$	14.75			$	14.75			$	1.68			$	1.68
Exercise price		$	3.60			$	0.04			$	2.49			$	0.04
Term (years)			4.13				4.13				4.38				4.38
Expected volatility			60	%			60	%			60	%			60	%
Dividend yield			0	%			0	%			0	%			0	%
Weighted average risk-free interest rate			1.32	%			1.32	%			1.75	%			1.75	%
Number of warrants			152,778				278,228				220,905				278,228
Number of trials			20,000				20,000				20,000				20,000
Aggregate fair value		$	1,764,000			$	4,045,000			$	175,000			$	529,000

 

The initial fair value of the Financing Warrant was $186,500 and was accounted for as derivative issuance expense and along with the other derivative issuance expenses (see below), was expensed upon the issuance of the Convertible Notes. The initial fair value of the Consulting Warrant was $537,500, and was expensed immediately as a consulting fee and was recorded within general and administrative expenses in the condensed statement of operations for the year ended December 31, 2013. During the three months ended March 31, 2014, the Company recorded an aggregate increase of $5,105,000 in the fair value of the derivative liability for the Financing Warrant and the Consulting Warrant, which was recorded as a change in the fair value of derivative liabilities within the condensed statement of operations.

 

Patent Assignment

 

On May 16, 2013, the Company entered into a patent assignment and Security Agreement with the Investors, in order to grant a continuing security interest in the patents included as collateral pledged in connection with the Convertible Notes. The security interest in the Company’s patents terminated on April 2, 2014, in connection with the conversion of the Convertible Notes.