VIVEVE MEDICAL, INC. - Quarter Report: 2012 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x                QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the quarterly period ended September 30, 2012.

 

OR

 

o                   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the transition period from                  to                  

 

Commission File Number: 1-11388

 

PLC SYSTEMS INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code: (508) 541-8800

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)  Yes o  No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

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PLC SYSTEMS INC.

 

Index

 

Part I.	Financial Information:
	Item 1.	Financial Statements
		Condensed Consolidated Balance Sheets (unaudited)	3
		Condensed Consolidated Statements of Operations (unaudited)	4
		Condensed Consolidated Statements of Comprehensive Loss (unaudited)	5
		Condensed Consolidated Statements of Cash Flows (unaudited)	6
		Notes to Condensed Consolidated Financial Statements (unaudited)	7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	30
	Item 4.	Controls and Procedures	31
Part II.	Other Information:
	Item 1A.	Risk Factors	31
	Item 5.	Other Matters	31
	Item 6.	Exhibits	31

 

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Part I.                        Financial Information

 

Item 1.                     Financial Statements

 

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

		September 30, 2012			December 31, 2011
ASSETS
Current assets:
Cash and cash equivalents		$	723		$	2,585
Accounts receivable, net of allowance of $2 at September 30, 2012 and December 31, 2011, respectively		525			453
Inventories		235			238
Prepaid expenses and other current assets		224			233
Total current assets		1,707			3,509
Equipment, furniture and leasehold improvements, net		79			36
Other assets		4			4
Total assets		$	1,790		$	3,549
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable		$	231		$	149
Accrued compensation		35			63
Accrued other		314			221
Deferred revenue		394			277
Total current liabilities		974			710
Convertible notes		10,176			5,327
Warrant liabilities		5,700			1,600
Commitments and Contingencies (Note 12)
Stockholders’ deficit:
Common stock, no par value, unlimited shares authorized, 31,809 shares issued and outstanding as of September 30, 2012 and 30,351 shares issued and outstanding as of December 31, 2011		93,893			93,893
Additional paid in capital		1,429			996
Accumulated deficit		(110,115		)	(98,727		)
Accumulated other comprehensive loss		(267		)	(250		)
Total stockholders’ deficit		(15,060		)	(4,088		)
Total liabilities and stockholders’ deficit		$	1,790		$	3,549

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

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PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011
Revenues		$	212		$	27		$	595		$	482
Cost of revenues		84			17			308			355
Gross profit		128			10			287			127
Operating expenses:
Selling, general and administrative		674			591			1,899			1,850
Research and development		549			312			1,618			759
Total operating expenses		1,223			903			3,517			2,609
Gain on the sale of assets		—			—			—			(40		)
Loss from continuing operations		(1,095		)	(893		)	(3,230		)	(2,442		)
Other income (expense):
Interest expense		(137		)	(116		)	(369		)	(277		)
Foreign currency transaction gain		17			—			2			—
Financing costs associated with convertible notes		(80		)	—			(80		)	(530		)
Change in fair value of warrant liabilities		(1,117		)	232			(3,517		)	(872		)
Change in fair value of convertible notes		(757		)	376			(4,218		)	(1,840		)
Other income		4			—			24			—
Total other (expense) income		(2,070		)	492			(8,158		)	(3,519		)
Net loss from continuing operations before income taxes		(3,165		)	(401		)	(11,388		)	(5,961		)
Benefit for income taxes from continuing operations		—			—			—			492
Net loss from continuing operations, net of income taxes		(3,165		)	(401		)	(11,388		)	(5,469		)
Discontinued operations:
Income from discontinued operations, net of income taxes		—			—			—			53
Gain on sale of discontinued operations, net of provision for income taxes of $492		—			—			—			687
Net income from discontinued operations, net of income taxes		—			—			—			740
Net loss		$	(3,165	)	$	(401	)	$	(11,388	)	$	(4,729	)
Net loss per weighted average share, basic and diluted:
From loss on continuing operations attributable to common stockholders		$	(0.10	)	$	(0.01	)	$	(0.37	)	$	(0.18	)
From income on discontinued operations		—			—			—			0.00
From gain on sale of discontinued operations		—			—			—			0.02
Net loss attributable to common stockholders per weighted average share, basic and diluted		$	(0.10	)	$	(0.01	)	$	(0.37	)	$	(0.16	)
Weighted average shares outstanding:
Basic and diluted		30,397			30,351			30,912			30,351

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

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PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(In thousands)

(Unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011
Net loss		$	(3,165	)	$	(401	)	$	(11,388	)	$	(4,729	)
Other comprehensive (loss) income:
Foreign currency translation adjustments		2			(14		)	(17		)	3
Other comprehensive (loss) income		2			(14		)	(17		)	3
Comprehensive loss		$	(3,163	)	$	(415	)	$	(11,405	)	$	(4,726	)

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

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PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

		Nine Months Ended September 30,
		2012			2011
Cash flows from operating activities:
Net loss		$	(11,388	)	$	(4,729	)
Income from discontinued operations		—			(53		)
Gain on sale of discontinued operations, net of taxes		—			(687		)
Depreciation and amortization		31			3
Stock-based compensation expense		433			123
Change in fair value of warrant liabilities		3,517			872
Change in fair value of convertible notes		4,218			1,840
Financing costs associated with convertible notes		80			530
Non-cash interest expense		215			158
Deferred income taxes		—			(492		)
Change in assets and liabilities:
Accounts receivable		59			(122		)
Inventory		3			108
Prepaid expenses and other assets		12			(86		)
Accounts payable		82			(298		)
Deferred revenue		109			(98		)
Accrued liabilities		65			(41		)
Net cash flows used in operating activities		(2,564		)	(2,972		)
Cash flows used for investing activities:
Purchase of property and equipment		(74		)	4
Net cash used for investing activities		(74		)	4
Cash flows from financing activities:
Net proceeds from issuance of convertible notes and warrants		920			3,605
Net cash provided by financing activities		920			3,605
Discontinued operations:
Net cash provided by operating activities		—			210
Net cash provided by investing activities		—			1,000
Net cash provided by discontinued operations		—			1,210
Effect of exchange rate changes on cash and cash equivalents		(144		)	3
Net (decrease) increase in cash and cash equivalents		(1,862		)	1,850
Cash and cash equivalents at beginning of period		2,585			1,324
Cash and cash equivalents at end of period		$	723		$	3,174
Supplemental disclosure of cash flow information:
Cash paid for interest		$	154		$	122

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

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PLC SYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

September 30, 2012

 

1.                                      Business and Liquidity

 

PLC Systems Inc. (“PLC” or the “Company”) is a medical device company specializing in innovative technologies for the cardiac and vascular markets.  Over the past four years, the Company has begun commercialization outside the United States (the “U.S.”) of its newest product, RenalGuard®, which currently represents the Company’s key strategic growth initiative and primary business focus.  The RenalGuard System consists of a proprietary console and accompanying single-use sets and is designed to reduce the potentially toxic effects that contrast media can have on the kidneys when it is administered to patients during certain medical imaging procedures. The Company conducts business operations as one operating segment.

 

For the nine months ended September 30, 2012, the Company incurred a loss from continuing operations of approximately $3,230,000, and used cash in operations of $2,564,000.  At September 30, 2012, the Company had an accumulated deficit of $110,115,000.  Management expects that quarterly losses and negative cash flows will continue during 2012 and beyond. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying unaudited condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

 

Based upon the current financial condition of the Company and the expectation of continued quarterly losses during 2012, management is currently investigating ways to raise additional capital that can be completed in the next few months. Subsequent to December 31, 2011, the Company reported that it had engaged a financial advisor to assist the Company in this effort. The Company was able to raise an additional $1,000,000 in capital before issuance costs on July 2, 2012, through the completion of additional financing by the closing on the second tranche of convertible notes with GCP IV LLC (the “Investors” or “Holders”) (see Note 11).  The Company will also continue to review its other expense areas to determine whether additional reductions in discretionary spending can be achieved.

 

The Company also believes that the publication of positive clinical results from two independent investigator-sponsored clinical trials in Italy, which show RenalGuard to be both a safe and effective product for reducing the incidence of Contrast-Induced Nephropathy (“CIN”) in at-risk patients, presents a substantial opportunity for it to increase its sales and achieve profitable results in the next few years, provided, among other factors, the Company is able to raise the additional capital it needs in the near term to sustain its operations and expand its RenalGuard sales and marketing programs and obtain approval by the U.S. Food and Drug Administration (“FDA”) to market RenalGuard in the United States.

 

2.                                      Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.  These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

 

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The preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure 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 those estimates.

 

In the first quarter of 2011, the Company sold the assets related to its TMR business to Novadaq Corp., a subsidiary of Novadaq Technologies Inc., the Company’s then exclusive distributor of TMR in the U.S., for $1,000,000 plus the relief of approximately $614,000 in service contract obligations (see Note 10), and issued $4,000,000 in secured convertible debt (see Note 11).

 

As a result of its sale in the first quarter of 2011, the operating results of the Company’s TMR business, including those related to the prior periods, have been reclassified from continuing operations to discontinued operations in the accompanying unaudited condensed consolidated financial statements (see Note 9).

 

3.                                      Inventories

 

Inventories are stated at the lower of cost (computed on a first-in, first-out method) or market value and include allocations of labor and overhead.  As of September 30, 2012 and December 31, 2011, inventories consisted of the following (in thousands):

 

		September 30, 2012			December 31, 2011
Raw materials		$	227		$	157
Finished goods		8			81
		$	235		$	238

 

4.                                      Stock-Based Compensation

 

Stock Option Plans and Restricted Share Issuance

 

In May 2005, the Company’s shareholders approved the 2005 Stock Incentive Plan (the “2005 Plan”).  Incentive stock options are issuable only to employees of the Company, while non-qualified stock options may be issued to non-employee directors, consultants and others, as well as to employees.  Under the 2005 Plan, the per share exercise price of incentive stock options may not be less than the fair market value of the common stock on the date the option is granted.  The 2005 Plan provides that the Company may not grant non-qualified stock options at an exercise price less than 85% of the fair market value of the Company’s common stock.

 

The Company grants stock options to its non-employee directors.  New non-employee directors receive an initial grant of an option to purchase 45,000 shares of the Company’s common stock that generally vest in quarterly installments over three years.  Once the initial grant has fully vested, non-employee directors (other than the Chairman of the Board) receive an annual grant of an option to purchase 22,500 shares of the Company’s common stock that generally will vest in four equal quarterly installments. The Chairman of the Board receives an annual grant of an option to purchase 45,000 shares of the Company’s common stock that generally vests in four equal quarterly installments. All such options have an exercise price equal to the fair market value of the Company’s common stock on the date of grant.

 

During the three months ended September 30, 2012, the Company didn’t grant any options to employees or non-employee directors.

 

During the three months ended June 30, 2012, the Company granted options to employees to purchase 355,000 shares of the Company’s common stock, which vest ratably over a three year period and granted options to

 

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purchase 112,500 shares of the Company’s common stock to non-employee directors that vest quarterly over one year.

 

As a result of employee terminations in the first quarter of 2011, options held by terminated employees to purchase a total of 173,000 shares of common stock with an exercise price of $0.24 per share were cancelled, but were replaced by the Company with new options, all of which were immediately vested, to purchase 173,000 shares of common stock at an exercise price of $0.24 per share.  The Company recorded an additional $2,000 in stock compensation expense related to these grants during the three months ended March 31, 2011.

 

During the year ended December 31, 2011, the Company granted options to purchase 565,000 shares of the Company’s common stock to employees with performance-based vesting.  Management determined that as of June 30, 2012, it was probable that the performance conditions associated with the performance-based vesting were to be met in July 2012 with the closing of the second tranche convertible notes. Therefore, the related expense was recorded in the six months ending June 30, 2012.

 

During the nine months ended September 30, 2012, the Company issued an aggregate of 1,458,336 shares of restricted common stock (625,000 shares as of the three months ended March 31, 2012, 208,334 shares as of the three months ended June 30, 2012 and 625,002 as of the three months ended September 30, 2012) to Garden State Securities, Inc. and JFS Investments, Inc., respectively, in exchange for certain investor relations and related consulting services to the Company.  These shares vest immediately but are restricted from being sold for a period of six months from the date of issuance.  The issuance of these shares resulted in $123,000 and $368,000 of compensation expense in the three and nine months ended September 30, 2012.

 

As of September 30, 2012, there were 674,156 shares of common stock available to be granted under the 2005 Plan.

 

The following is a summary of option activity under all plans (in thousands, except per option data):

 

		Number of Options		Weighted Average Exercise Price			Average Remaining Contractual Life (Years)		Aggregate Intrinsic Value
Outstanding, December 31, 2011		5,602		$	0.21
Granted		468		0.17
Exercised		—		—
Expired		(3	)	0.55
Forfeited		(475	)	0.24
Outstanding, September 30, 2012		5,592		0.21			3.42		158,700
Exercisable, September 30, 2012		4,870		0.21			2.54		111,065

 

Stock-Based Compensation Expense

 

The Company recorded compensation expense related to stock options of $12,000 and $65,000 in the three and nine months ended September 30, 2012, respectively, as compared to $29,000 and $123,000 in the three and nine months ended September 30, 2011, respectively.  The Company also recorded compensation expense of $123,000 and $368,000 related to the issuance of restricted common shares during the three and nine months ended September 30, 2012, respectively.  As of September 30, 2012, the Company had $76,000 of total unrecognized compensation cost related to its unvested options, which is expected to be recognized over a weighted average period of 1.94 years.

 

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The weighted average fair value of options issued, as estimated using the Black-Scholes model, was $0.16 and $0.11 during the nine months ended September 30, 2012 and 2011, respectively. The assumptions used were as follows:

 

		Grants Issued in:
		2012		2011
Expected life (years)		5.00-6.00		1.00–6.00
Risk free rate		0.19-0.69%		0.27–2.65%
Volatility		204.1-216.2%		107.2-132.1%
Expected dividend yield		None		None
Value of options granted		$0.12-0.17		$0.01–0.13

 

The expected life was calculated using the simplified method. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant for the expected term.  Expected volatility is based exclusively on historical volatility data of the Company’s common stock.  The Company estimates an expected forfeiture rate by analyzing historical forfeiture activity and considering how future forfeitures are expected to differ from historical forfeitures.  The Company expects that all outstanding options at September 30, 2012 will fully vest over their requisite service period.  Actual results, and future changes in estimates, may differ substantially from the Company’s current estimates.

 

Stock Purchase Plan

 

The Company has a 2000 Employee Stock Purchase Plan (the “Purchase Plan”) for all eligible employees whereby shares of the Company’s common stock may be purchased at six-month intervals at 95% of the average of the closing bid and ask prices of the Company’s common stock on the last business day of the relevant plan period.  Employees may purchase shares having a value not exceeding 10% of their gross compensation during an offering period, subject to certain additional limitations.  There was no activity during the three and nine months ended September 30, 2012 or 2011.  At September 30, 2012, 294,461 shares were reserved for future issuance under the Purchase Plan.

 

5.                                      Revenue Recognition

 

The Company recognizes revenue when the following basic revenue recognition criteria have been met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the price to the buyer charged for products delivered or services rendered and collectability of the sales price. The Company assesses credit worthiness of customers based upon prior history with the customer and assessment of financial condition. The Company’s shipping terms are customarily Free On Board (“FOB”) shipping point. The Company records revenue at the time of shipment if all other revenue recognition criteria have been met. As of September 30, 2012 and December 31, 2011, the Company had deferred revenue of $394,000 and $277,000, respectively of revenues related to shipments to its distributor in Italy, Artech, because not all revenue recognition criteria were met.  During the three and nine months ended September 30, 2012, the Company recognized $65,000 and $126,000, respectively, in revenue of previously deferred revenue upon the receipt of cash from the customer.

 

6.                                      Loss per Share

 

In the three and nine months ended September 30, 2012 and 2011, basic and diluted loss per share have been computed using only the weighted average number of common shares outstanding during the period without giving effect to any potential future issuances of common stock related to stock option programs, investor warrants

 

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or convertible notes, since their inclusion would be anti-dilutive.

 

For the three and nine months ended September 30, 2012, 50,047,785 and 47,096,392 shares attributable to outstanding warrants, convertible notes and stock options, and for the three and nine months ended September 30, 2011, 46,102,000 shares attributable to outstanding warrants, convertible notes and stock options were excluded from the calculation of diluted earnings per share because the effect would have been anti-dilutive.

 

7.                                      Total Comprehensive Loss

 

Total comprehensive loss for the three and nine months ended September 30, 2012 was $3,163,000 and $11,405,000 as compared to $415,000 and $4,726,000 in the three and nine months ended September 30, 2011, respectively.  Comprehensive loss is comprised of the net loss plus the increase or decrease in currency translation adjustment.

 

8.                                      Warranty and Preventative Maintenance Costs

 

The Company warranties its products against manufacturing defects under normal use and service during the warranty period.  The Company evaluates the estimated future unrecoverable costs of warranty and preventative maintenance services for its installed base of products on a quarterly basis and adjusts its warranty reserve accordingly.  The Company considers all available evidence, including historical experience and information obtained from supplier audits.  There was no warranty liability recorded at September 30, 2012 or December 31, 2011.

 

9.                                      Sale of Assets

 

In May 2010, the Company sold to a newly-formed corporation affiliated with its principal OEM customer certain of its OEM surgical tube assets, comprised principally of inventory, equipment, intellectual property and certain other intangible assets, as well as all necessary manufacturing documentation needed to perform contract assembly services for general purpose CO2 lasers. The total sale price for these assets was $225,000, of which approximately $154,000 was paid at the time of closing, with the balance in a note receivable totaling $71,000.  At the closing of the transaction and as of December 31, 2010, the note receivable was fully reserved.  Following the sale, Dr. Robert I. Rudko, who was a director and a stockholder of the Company at the time, acquired a minority interest in the corporation that purchased the OEM assets. In conjunction with this transaction, in the year ended December 31, 2010, the Company recorded an initial gain on sale of assets of $98,000.  In March 2011, Dr. Rudko resigned from the Company’s Board of Directors.  Also in March 2011, the Company reached an agreement with the acquiring company to settle the note receivable at a reduced amount of $40,000.  This amount was collected in April 2011, and was recorded as a gain when cash was received during the second quarter of 2011.

 

10.                               Sale of TMR Business to Novadaq/Discontinued Operations

 

On November 5, 2010, the Company entered into an agreement to sell its TMR business to Novadaq. This transaction was approved by the Company’s shareholders at a special meeting on January 31, 2011 and the transaction closed on February 1, 2011.

 

Under terms of the agreement, Novadaq acquired substantially all of the Company’s assets that were used in the TMR business including all manufacturing rights, substantially all product inventories, and all equipment, intellectual property, regulatory approvals, clinical data and documentation related to TMR, for a purchase price of $1 million in cash and the assumption of all the Company’s obligations under service contracts as of the closing date totaling $614,000.  The total carrying value of the assets sold as of the transaction date was $385,000.  In addition, the Company incurred transaction costs of $50,000.  The Company has recorded a gain on sale of discontinued operations before income taxes of $1,179,000 in the statement of operations.

 

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The operating results of these operations, including those related to the prior periods, have been reclassified from continuing operations to discontinued operations in the accompanying condensed consolidated financial statements.

 

Revenues and net income attributable to discontinued operations for the nine months ended September 30, 2011 are as follows:

 

		Nine months ended September 30, (In thousands)
		2011
Revenues:
Product sales		$	455
Service fees		68
Total		523
Income from discontinued operations		$	53

 

11.                               Convertible Notes and Warrant Liabilities

 

Features of the Convertible Notes and Investor Warrants

 

On February 22, 2011 (the “Original Issue Date”), the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) and a 5% Senior Secured Convertible Debenture Agreement (the “Note Agreement”) with GCP IV LLC (the “Investors” or “Holders”) pursuant to which the Company agreed to issue and sell in a private placement to the Investors an aggregate principal amount of $4,000,000 of convertible notes due February 22, 2014 (the “Convertible Notes”) and warrants to purchase up to 40,000,000 shares of common stock, which expire February 22, 2016 (the “Investor Warrants”).  Under the terms of the Purchase Agreement, the Company had the opportunity to raise up to an additional $2 million from the Holders of the Convertible Notes in two separate $1 million tranches, based upon meeting certain operational milestones within certain periods of time.  The deadline for achieving the operational milestones for the first $1 million tranche expired in February 2012 without the Company achieving such milestones; however, as discussed below, the Investors agreed to waive both the deadline and the achievement of these milestones as a condition for the investment of the first additional $1 million tranche (“Second Tranche”) which was completed on July 2, 2012.  The second additional $1 million tranche is due to the Company upon achievement of the applicable operational milestones at any time prior to February 22, 2014.

 

Convertible Notes

 

The Convertible Notes require payment of interest on the outstanding principal amount, in cash, at the rate of 5% per annum, payable quarterly on January 1, April 1, July 1, and October 1, beginning on the first such date following the Original Issue Date, on each conversion date (for the principal amount then being converted), on each optional redemption date (for the principal amount then being redeemed) and on the maturity date. Interest is calculated on the basis of a 360-day year and accrues daily commencing on the Original Issue Date until payment in full of the outstanding principal, together with all accrued and unpaid interest, liquidated damages and other amounts that may become due in connection with the Convertible Notes, has been made.

 

The Holders may convert the outstanding principal amount of the Convertible Notes into shares of the Company’s common stock at the conversion price of $0.10 per share (“Conversion Price”). The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

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At any time after February 2012, and upon entering into a change of control transaction or Fundamental Transaction, as defined in the Debenture Agreement, the Company may deliver a notice to the Holders of its irrevocable election to redeem all of the then outstanding principal of the Convertible Notes for cash in an amount equal to the sum of (a) the greater of (i) the outstanding amount of the Convertible Notes divided by the Conversion Price on the date of the mandatory default amount, as defined in the Purchase Agreement, is either (A) demanded or (B) paid in full, whichever has a lower conversion price, multiplied by the Volume Weighted Average Price (“VWAP”) of the date of the mandatory default amount is either (x) demanded or otherwise due or (y) paid in full, whichever has higher VWAP, plus all accrued and unpaid interest, or (ii) 130% of the outstanding principal amount of the Notes, plus 100% of accrued and unpaid interest, and (b) all other amounts, costs, expenses and liquidated damages due under the various agreements covering issuance of the Convertible Notes. Such amount would include the liquidated damages due under the default provision of the Purchase Agreement.  As of September 30, 2012, the Company has elected to not deliver such notice.

 

The Company is required to repay, in cash, any outstanding principal amount of the Convertible Notes on February 22, 2014 and is not permitted, except upon entering into a change of control transaction or fundamental transaction as noted above, to prepay any portion of the principal amount without prior written consent of the Holders.

 

Investor Warrants

 

On February 22, 2011, the Company issued warrants for the purchase of up to 40,000,000 shares of common stock at the exercise price of $0.15 per share and with an expiration date of February 22, 2016 (the “Warrants”). The following is a summary of the Warrants outstanding for the nine months ending September 30, 2012:

 

		Warrants		Exercise Price
Beginning balance		40,000,000		$	0.15
Add: Adjustments (pursuant to warrants agreement)		—		n/a
Less: Exercised		—		n/a
Ending balance		40,000,000		$	0.15

 

The Warrants are exercisable in cash to purchase shares of the Company’s common stock (the “Warrant Shares”). The Exercise Price may be paid pursuant to a cashless exercise provision if the Warrant Shares have not been registered within six months after the Warrants are issued. The Exercise Price of the Warrants shall be adjusted in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Exercise Price.

 

In connection with a Fundamental Transaction, as defined in the Purchase Agreement, that is an all-cash transaction, the Company shall have the right to purchase from the Holders all, but not less than all, of the unexercised portion of the Warrants by paying in cash to the Holders an amount equal to 30% of the Exercise Price multiplied by the number of shares of Common Stock for which the Warrants are exercisable immediately prior to such change of control transaction.

 

Features of the 2012 Second Tranche Amendment

 

On July 2, 2012, the Company entered into an Amendment and Waiver to Securities Purchase Agreement (the “Amendment and Waiver”) to amend our Purchase Agreement with the Investors.  Under the Amendment and Waiver agreement the Company has agreed to issue and sell in a private placement to the Investors an aggregate

 

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principle amount of $1,000,000 (the “Second Tranche”) of 5% Senior Secured Convertible Debentures of the Company (the “Second Convertible Notes”), warrants to purchase up to 10,000,000 shares of common stock at an initial exercise price of $0.15 per share (the “$0.15 Warrants”) and warrants to purchase up to 10,000,000 shares of common stock at an initial exercise price of $0.25 per share (the “$0.25 Warrants” and together with the $0.15 Warrants, the “2012 Warrants”).

 

The Second Convertible Notes

 

The Second Convertible Notes contain the same terms as the original Convertible Notes and requires payment of interest at the rate of 5% per annum, payable quarterly and mature on July 2, 2015.  The Second Convertible Notes provide the Investors the option at any time prior to the repayment of the notes to convert any portion of the outstanding Second Tranche balance into fully-paid and non-assessable restricted shares of common stock of the Company at an initial conversion price of $0.10 per share (the “Conversion Price”).

 

The Convertible Notes include an adjustment close providing that if the Company issues additional shares of common stock prior to the repayment of the Second Tranche at a price per share less than the effective conversion price of the Second Convertible Notes, the conversion price will, subject to certain exceptions, be reduced to an amount equal to the price per share paid or payable for the common stock of the Company in such subsequent issuance or deemed subsequent issuance.  The Conversion price is subject to adjustments in the event of (a) stock splits, stock dividends, combinations, dividends, rights offerings and mergers or sales of assets or similar events and (b) dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

The Second Convertible Notes and the Purchase Agreement covering both are secured by a security interest in all assets of the Company and its subsidiaries and all such obligations are guaranteed jointly and severally by the Company’s subsidiaries. The Second Convertible Notes also contain non-financial covenants which limit the Company and its subsidiaries from incurring subsequent indebtedness, incurring liens, amending organizational documents, repurchasing or repaying other debt, paying cash dividends and entering into affiliate transactions.

 

The Second Convertible Notes may be redeemed at the option of the Company only in connection with a change of control or other fundamental transaction of the Company and subject to the satisfaction of other conditions including, without limitation, that the shares issuable upon conversion of the debentures are freely tradable and that there is no event of default.

 

The 2012 Warrants

 

On July 2, 2012, the Company issued warrants for the purchase of up to 20,000,000 shares of common stock with five year terms.  The warrants were issued to allow the Investors to purchase up to 10,000,000 shares of common stock at an initial purchase price of $0.15 per share and the remaining 10,000,000 shares of common stock at an initial purchase price of $0.25 per share. The terms of the 2012 Warrants are identical to those of the Warrants, except that the 2012 Warrants are exercisable for a period of five years from the date of issuance and contain different exercise prices. The following is a summary of the 2012 Warrants outstanding for the nine months ending September 30, 2012:

 

$0.15 Warrants		Warrants		Exercise Price
Beginning balance at December 31, 2011		—		$	—
Add: Second Tranche Agreement		10,000,000		0.15
Add: Adjustments (pursuant to warrants agreement)		—		n/a
Less: Exercised		—		n/a
Ending balance at September 30, 2012		10,000,000		$	0.15

 

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$0.25 Warrants		Warrants		Exercise Price
Beginning balance at December 31, 2011		—		$	—
Add: Second Tranche Agreement		10,000,000		0.25
Add: Adjustments (pursuant to warrants agreement)		—		n/a
Less: Exercised		—		n/a
Ending balance at September 30, 2012		10,000,000		$	0.25

 

The 2012 Warrants are exercisable in cash to purchase shares of the Company’s common stock.  The exercise price may be paid pursuant to a cashless exercise provision if the 2012 Warrants have no effective registration statement registering the shares underlying the warrants by surrendering warrant shares having a value equal to the exercise price of the portion of the warrants being exercised.  The exercise price of the 2012 Warrants shall be adjusted in the event of (a) stock splits, stock dividends, combinations, rights offerings, mergers or sales of assets or similar events, and (b) dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the exercise price.

 

The 2012 Warrants provide that the 2012 Warrants may be purchased at the option of the Company only in connection with a change in control of the Company that is an all-cash transaction.  The purchase price is 30% of the then effective exercise price of the warrants multiplied by the number of common shares for which the 2012 Warrants are then exercisable.  All but not less than all of the 2012 Warrants outstanding are required to be repurchased at such a time.

 

Fair Value Measurements

 

The Company measures and reports fair value in accordance with Accounting Standards Codifications (“ASC”) 820 — Fair Value Measurements and Disclosures (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value investments.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, principal (or most advantageous) markets, and an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.

 

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques may require significant judgment and are primarily dependent upon the characteristics of the asset or liability, and the quality and availability of inputs. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and resulting measurement as follows:

 

Level 1

 

Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;

 

Level 2

 

Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data for substantially the

 

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full term of the assets or liabilities; and

 

Level 3

 

Unobservable inputs for the asset or liability that are supported by little or no market activity and that are significant to the fair values.

 

Fair value measurements are required to be disclosed by the Level within the fair value hierarchy in which the fair value measurements in their entirety fall. Fair value measurements using significant unobservable inputs (in Level 3 measurements) are subject to expanded disclosure requirements including a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following: (i) total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings, and a description of where those gains or losses included in earning are reported in the statement of income.

 

The following summarizes the Company’s assets and liabilities measured at fair value as of September 30, 2012:

 

					Fair Value Measurements at Reporting Date Using:
					Quoted Prices
					in Active			Significant
					Markets for			Other			Significant
		Balance as of			Identical			Observable			Unobservable
		September 30,			Assets			Inputs			Inputs
Description		2012			(Level 1)			(Level 2)			(Level 3)
Liabilities
Convertible notes		$	10,176,000		$	—		$	—		$	10,176,000
Warrant liabilities		$	5,700,000		$	—		$	—		$	5,700,000
Total Liabilities		$	15,876,000		$	—		$	—		$	15,876,000

 

Accounting for the Convertible Notes, Second Convertible Notes, Investor Warrants and 2012 Warrants

 

Investor Warrants and 2012 Warrants

 

In June 2008, the FASB issued ASC 815-40-15 (formerly EITF 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock), which was effective for the Company in 2009. This issued guidance requires that derivative instruments be evaluated for certain contingencies and anti-dilution provisions that would affect their equity classification as a derivative under ASC 815, Derivatives and Hedging (ASC 815) and requires the instruments to be classified as liabilities and reported at fair value.

 

Upon issuance, the Investor Warrants and 2012 Warrants were not considered indexed to the Company’s own stock and therefore are required to be accounted for as freestanding derivative instruments and classified as a liability. As a result, the Investor Warrants and 2012 Warrants are recorded as a liability at fair value as of September 30, 2012 with changes in fair value recorded in the consolidated statement of operations.

 

Convertible Notes and Second Tranche Convertible Notes

 

The Company has determined that the Convertible Notes and the Second Convertible Notes constitute a hybrid instrument that has the characteristics of a debt host contract containing several embedded derivative features that would require bifurcation and separate accounting as a derivative instrument pursuant to the provisions

 

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of ASC 815. The Company has identified all of the derivatives associated with the February 22, 2011 financing and the July 2, 2012 additional financing.  As permitted under ASC 825-10-10 — Financial Instruments, as it relates to the fair value option, the Company has elected, as of February 22, 2011 and including the July 2, 2012 financing, to measure the Convertible Notes in their entirety at fair value with changes in fair value recognized in the Condensed Consolidated Statement of Operations as either a gain or loss until the notes are settled. As such, the Company has appropriately valued the embedded derivatives as a single hybrid contract together with the Convertible Notes and the Second Convertible Notes. This election was made by the Company after determining the aggregate fair value of the Convertible Notes and the Second Convertible Notes to be more meaningful in the context of the Company’s financial statements than if separate fair values were assigned to each of the multiple embedded instruments contained in the Convertible Notes and the Second Convertible Notes.

 

Convertible Notes

 

Upon issuance of the Convertible Notes, the Company allocated the proceeds received to the Convertible Notes and Investor Warrants on a relative fair value basis. As a result of such allocation, the Company determined the initial carrying value of the Notes to be $3,208,000. The Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $3,680,000. As of September 30, 2012, the Convertible Notes have been marked to fair value resulting in a derivative liability of $8,240,000. The net charge to other income (expense) was a gain of $747,000 in the three months ended September 30, 2012 and a loss of $2,715,000 in the nine months ended September 30, 2012. The debt discount in the amount of $792,000 (resulting from the allocation of proceeds) is being amortized to interest expense using the effective interest method over the expected term of the Convertible Notes. The Company amortized $67,000 and $198,000 for the three and nine months ended September 30, 2012, respectively which is a component of interest expense.

 

Upon issuance, the Company allocated $792,000 of the initial proceeds to the Investor Warrants and immediately marked them to fair value resulting in a derivative liability of $908,000. As of September 30, 2012, the Investor Warrants have been marked to fair value resulting in a derivative liability of $3,200,000. The charge to other income (expense) for the three and nine months ended September 30, 2012 was income of $800,000 and expense of $1,600,000, respectively.

 

Second Convertible Notes

 

Upon issuance of the Second Convertible Notes, the Company allocated the proceeds received to the Second Convertible Notes and 2012 Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Second Convertible Notes to be $417,000.  The Second Convertible Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $2,073,000.  As of September 30, 2012, the Second Convertible Notes have been marked to fair value resulting in a derivative liability of $1,936,000.  The net charge to other income (expense) was a loss of $1,503,000 in the three and nine months ended September 30, 2012, respectively.  The debt discount in the amount of $583,000 (resulting from the allocation of proceeds) is being amortized to interest expense using the effective interest method over the expected term of the Second Convertible Notes. The Company amortized $17,000 for the three and nine months ended September 30, 2012, respectively which is a component of interest expense.

 

Upon issuance of the 2012 Warrants, the Company allocated $583,000 of the initial proceeds to the 2012 Warrants and immediately marked them to fair value resulting in a derivative liability of $2,900,000.  As of September 30, 2012, the 2012 Investor Warrants have been marked to fair value resulting in a derivative liability of $2,500,000. The charge to other income (expense) for the three and nine months ended September 30, 2012 was expense of $1,917,000, respectively.

 

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A summary of changes in the Convertible Notes and Investor Warrants is as follows:

 

		Fair Value of Convertible Notes			Fair Value of Warrant Liabilities			Fair Value of Second Convertible Notes			Fair Value of 2012 Warrant Liabilities			Total
Allocation of initial proceeds		$	3,208,000		$	792,000		$	—		$	—		$	4,000,000
Initial fair value adjustment		$	469,000		$	116,000		$	—		$	—		$	585,000
February 22, 2011		$	3,677,000		$	908,000		$	—		$	—		$	4,585,000
Amortization of debt discount		$	158,000		$	—		$	—		$	—		$	158,000
Fair value adjustment		$	1,371,000		$	756,000		$	—		$	—		$	2,127,000
Balance September 30, 2011		$	5,206,000		$	1,664,000		$	—		$	—		$	6,870,000
Balance December 31, 2011		$	5,327,000		$	1,600,000		$	—		$	—		$	6,927,000
Allocation of initial proceeds		$	—		$	—		$	417,000		$	583,000		$	1,000,000
Initial fair value adjustment		$	—		$	—		$	1,656,000		$	2,317,000		$	3,973,000
July 2, 2012		$	5,327,000		$	1,600,000		$	2,073,000		$	2,900,000		$	11,900,000
Amortization of debt discount		$	198,000		$	—		$	17,000		$	—		$	215,000
Fair value adjustment		$	2,715,000		$	1,600,000		$	(154,000	)	$	(400,000	)	$	3,761,000
Balance September 30, 2012		$	8,240,000		$	3,200,000		$	1,936,000		$	2,500,000		$	15,876,000

 

The Company records the fair value of Convertible Notes, Second Convertible Notes, Investor Warrants and 2012 Warrants as a long term liability.

 

Financing Costs

 

Financing costs include costs associated with obtaining the February 22, 2011 financing.  Financing costs totaling $530,000 were recorded in other income (expense) in the nine months ending September 30, 2011, $135,000 of which were recorded in prepaid expenses and other current assets at December 31, 2010 and expensed upon closing of the transaction.

 

The Company incurred financing costs associated with obtaining the July 2, 2012 financing which totaled $80,000 and were recorded in other income (expense) in the three and nine months ending September 30, 2012.

 

Valuation — Methodology and Significant Inputs Assumptions

 

Fair values for the Company’s derivatives and financial instruments are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates. Such amounts and the recognition of such amounts are subject to significant estimates that may change in the future. The methods and significant inputs and assumptions utilized in estimating the fair value of the Warrant Liabilities, 2012 Warrant Liabilities, Convertible Notes and Second Convertible Notes are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.

 

Warrant Liabilities

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was utilized to estimate the fair value of the Warrant Liabilities as of February 22, 2011, September 30, 2011, December 31, 2011 and September 30, 2012. This model is widely used in estimating value of European options dependent upon a non dividend-paying stock and fixed inputs. This model is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:

 

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Input		February 22, 2011			September 30, 2011			December 31, 2011			September 30, 2012
Stock Price		$	0.0755		$	0.12		$	0.1075		$	0.19
Exercise Price		$	0.15		$	0.15		$	0.15		$	0.15
Expected Life (in years)		5.00			4.40			4.15			3.40
Stock Volatility		90		%	95		%	95		%	100		%
Risk-Free Rate		2.16		%	0.80		%	0.63		%	0.37		%
Dividend Rate		0		%	0		%	0		%	0		%
Outstanding Shares of Common Stock		30,351,092			30,351,092			30,351,092			31,809,428

 

2012 Warrant Liabilities

 

$0.15 Warrants

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was utilized to estimate the fair value of the $0.15 Warrants as of July, 2, 2012 and September 30, 2012.  This model is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:

 

Input		July 2, 2012			September 30, 2012
Stock Price		$	0.20		$	0.19
Exercise Price		$	0.15		$	0.15
Expected Life (in years)		5.00			4.76
Stock Volatility		110.00		%	100.00		%
Risk-Free Rate		0.67		%	0.58		%
Dividend Rate		0		%	0		%
Outstanding Shares of Common Stock		30,976,092			31,809,428

 

$0.25 Warrants

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was utilized to estimate the fair value of the $0.25 Warrants as of July, 2, 2012 and September 2012.  This model is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:

 

Input		July 2, 2012			September 30, 2012
Stock Price		$	0.20		$	0.19
Exercise Price		$	0.25		$	0.25
Expected Life (in years)		5.00			4.76
Stock Volatility		110.00		%	100.00		%
Risk-Free Rate		0.67		%	0.58		%
Dividend Rate		0		%	0		%
Outstanding Shares of Common Stock		30,976,092			31,809,428

 

Convertible Notes

 

A binomial lattice model was utilized to estimate the fair value of the Convertible Notes. The binomial model considers the key features of the Convertible Notes, as noted above, and is subject to the significant assumptions discussed below. First, a discrete simulation of the Company’s stock price, without effects of dilution due to the conversion feature, was conducted at each node and throughout the expected life of the instrument. Second, a discrete simulation of the Company’s stock price, with effects of dilution due to the conversion feature, was conducted at each node and throughout the expected life of the instrument. Third, based upon the simulated

 

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stock price with dilution effect, an analysis of the higher position of a conversion position, redemption position, or holding position (i.e. fair value of the respective future nodes value discounted using the applicable discount rate) was conducted relative to each node until a final fair value of the instrument is conducted at the node representing the measurement date. This model requires the following key inputs with respect to the Company and/or instrument:

 

Input		February 22, 2011			September 30, 2011			December 31, 2011			September 30, 2012
Stock Price		$	0.0755		$	0.1200		$	0.1075		$	0.19
Exercise Price		$	0.10		$	0.10		$	0.10		$	0.10
Expected remaining term (in years)		3.00			2.40			2.15			1.40
Stock Volatility		95		%	100		%	100		%	105		%
Risk-Free Rate		1.22		%	0.32		%	0.27		%	0.19		%
Dividend Rate		0		%	0		%	0		%	0		%
Outstanding Shares of Common Stock		30,351,092			30,351,092			30,351,092			31,809,428
Effective discount rate		20.3		%	16.4		%	13.2		%	9.90		%
Probability of forced redemption		20		%	20		%	20		%	20		%

 

Second Tranche Convertible Notes

 

A binomial lattice model was utilized to estimate the fair value of the Second Tranche Convertible Notes. The binomial model considers the key features of the Second Tranche Convertible Notes, as noted above, and is subject to the significant assumptions discussed below. First, a discrete simulation of the Company’s stock price, without effects of dilution due to the conversion feature, was conducted at each node and throughout the expected life of the instrument. Second, a discrete simulation of the Company’s stock price, with effects of dilution due to the conversion feature, was conducted at each node and throughout the expected life of the instrument. Third, based upon the simulated stock price with dilution effect, an analysis of the higher position of a conversion position, redemption position, or holding position (i.e. fair value of the respective future nodes value discounted using the applicable discount rate) was conducted relative to each node until a final fair value of the instrument is conducted at the node representing the measurement date. This model requires the following key inputs with respect to the Company and/or instrument:

 

Input		July 2, 2012			September 30, 2012
Stock Price		$	0.20		$	0.19
Exercise Price		$	0.10		$	0.10
Expected remaining term (in years)		3.00			2.75
Stock Volatility		100		%	95		%
Risk-Free Rate		0.39		%	0.29		%
Dividend Rate		0		%	0		%
Outstanding Shares of Common Stock		30,976,092			31,809,428
Effective discount rate		10.00		%	10.00		%
Probability of forced redemption		20.00		%	20.00		%

 

The following are significant assumptions utilized in developing the inputs of both the Convertible Notes and the Second Convertible Notes:

 

·                  The Company’s common stock shares are traded on the OTC Bulletin Board and, accordingly, the stock price input is based upon bid prices as of the valuation dates due to the extremely thin trading volume, broker-driven market (vs. exchange market) and the wide bid/ask spread as of the valuation

 

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date;

 

·                  The expected future stock prices of the Company’s stock were modeled to include the effect of dilution upon conversion of the instruments to shares of common stock;

 

·                  Stock volatility was estimated by considering (i) the annualized monthly volatility of the Company’s stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instruments (monthly data set is more relevant given the extremely thin trading volume of the Company’s common stock) and (ii) the annualized daily volatility of comparable companies’ stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instrument. Historic prices of the Company and comparable companies’ common stock were used to estimate volatility as the Company did not have traded options as of the valuation dates;

 

·                  Based upon the Company’s historical operations and management’s expectations for the foreseeable future, the Company’s stock was assumed to be a non-dividend-paying stock;

 

·                  The risk-free interest rate is based on the U.S. Treasury Yield curve in effect as on the valuation date for the expected term;

 

·                  With respect to the Convertible Notes and the Second Convertible Notes, the Company is expected to pay all accrued interest due to the Holders on each Interest Payment Date;

 

·                  With respect to the Convertible Notes and Second Convertible Notes, based upon management’s expectations for a change of control or fundamental transaction to occur prior to the maturity date of the Convertible Notes and the Second Convertible Notes, a low probability of a forced redemption;

 

·                  Upon a change of control redemption, the change of control redemption amount shall equal to the sum of:

 

I.                the greater of:

 

(i)                                     the outstanding amount of the debt divided by the Conversion Price on the date of the mandatory default amount is either (A) demanded or (B) paid in full, whichever has a lower conversion price, multiplied by the VWAP of the date of the mandatory default amount is either (x) demanded or otherwise due or (y) paid in full, whichever has higher VWAP, plus all accrued and unpaid interest, or

 

(ii)                                  130% of the outstanding principal amount of the debt, plus 100% of accrued and unpaid interest, and

 

II.           all other amounts, costs, expenses and liquidated damages due under the various agreements covering issuance of the debt.

 

Additionally, it is assumed that no amounts are due pursuant to clause (II) above in any period and that the stock price at each respective node represents a reasonable approximation of the VWAP requirements.

 

The changes in fair value between reporting periods are related to the changes in the price of the Company’s common stock as of the measurement dates, the volatility of the Company’s common stock during the remaining term of the instrument, changes in the conversion price and effective discount rate.

 

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12.                               Commitments

 

Lease Commitments

 

In June 2011, the Company entered into a three year facility lease for office space at a new location in Milford, Massachusetts, beginning August 2011.  In addition to the minimum lease payments, the new lease agreement requires payment of the Company’s pro-rata share of property taxes and building operating expenses.

 

Under the new lease, future minimum lease payments are estimated to be as follows (in thousands):

 

Year		Future Minimum Lease Payments
2012		10
2013		41
2014		30
Total		$	81

 

The Company manufactures its RenalGuard consoles and sterile disposable kits using two separate outside contract manufacturers. The contracts with these manufacturers do not contain minimum purchase requirements or any future commitments. Purchases are made upon request to the manufacturer.

 

During the year ended December 31, 2011, the Company hired a clinical research organization (“CRO”) to assist with managing its clinical trial. The contract with the CRO does not contain minimum purchase requirements or any future commitments, and payments are made once services are provided.

 

13.                               Subsequent Event

 

The Company has evaluated all events or transactions through the date of this filing.  During this period, the Company did not have any material subsequent events that impacted its condensed consolidated financial statements or disclosures.

 

Item 2.                     Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

We are a medical device company specializing in innovative technologies for the cardiac and vascular markets. Our key strategic growth initiative is RenalGuard.

 

RenalGuard is designed to reduce the potentially toxic effects that contrast media can have on the kidneys when administered to at-risk patients during certain medical imaging procedures. It is believed that allowing contrast media to dwell in the kidneys of certain higher risk patients can lead to contrast induced nephropathy (CIN), a potentially deadly form of acute kidney injury. By inducing and maintaining a high urine flow rate before, during and after these medical imaging procedures, we believe the incidence rates of CIN in at-risk patients can be reduced. RenalGuard facilitates this increased urine clearance automatically, enabling the body to more rapidly void the contrast media, thereby reducing its overall resident time and potential toxic effects in the kidney. RenalGuard may have additional applications in ancillary therapeutic areas, such as chemotherapy, where protecting the kidneys from toxic agents is beneficial, but PLC is primarily focusing on CIN prevention currently.

 

The RenalGuard System consists of a proprietary console and accompanying single-use sets. RenalGuard operates by first collecting and measuring patient urine outputs and then in real-time precisely matching these urine outputs with a prescribed replacement fluid by means of intravenous infusion. With its automated matched fluid replacement capability, RenalGuard is intended to promote and maintain high urine outputs and minimize the risk

 

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