Annual report pursuant to Section 13 and 15(d)

Convertible Instruments

v3.7.0.1
Convertible Instruments
12 Months Ended
May 31, 2017
Convertible Instruments

Note 4 – Convertible Instruments

Series B Convertible Preferred Stock

During fiscal 2010, the Company issued 400,000 shares of Series B, $0.001 par value Convertible Preferred Stock (“Series B”) at $5.00 per share for cash proceeds totaling $2,009,000, of which 92,100 shares remain outstanding at May 31, 2017. Each share of the Series B is convertible into ten shares of the Company’s $0.001 par value common stock, including any accrued dividends, with an effective fixed conversion price of $0.50 per share. The holders of the Series B can only convert their shares to common shares provided the Company has sufficient authorized common shares at the time of conversion. Accordingly, the conversion option was contingent upon the Company increasing its authorized common shares, which occurred in April 2010, when the Company’s shareholders approved an increase in the authorized shares of common stock to 100,000,000. At the commitment date, which occurred upon such shareholder approval, the conversion option related to the Series B was beneficial. The intrinsic value of the conversion option at the commitment date resulted in a constructive dividend to the Series B holders of approximately $6,000,000. The constructive dividend increased and decreased additional paid-in capital by identical amounts. The Series B has liquidation preferences over the common shares at $5.00 per share plus any accrued dividends. Dividends are payable to the Series B holders when declared by the board of directors at the rate of $0.25 per share per annum. Such dividends are cumulative and accrue whether or not declared and whether or not there are any profits, surplus or other funds or assets of the Company legally available. The Series B holders have no voting rights.

2013 Convertible Notes

During the year ended May 31, 2013, the Company issued $6,588,250 in aggregate original principal amount of unsecured convertible notes (the “2013 Convertible Notes”) to investors for cash. Each outstanding 2013 Convertible Note was convertible at the election of the holder at any time into common shares at a fixed conversion price. At issuance, total principal of $6,208,250 was convertible at $0.75 per share, and $380,000 was convertible at $0.65 per share. The 2013 Convertible Notes were payable in full between November 30, 2013 and March 6, 2016, and bore interest at rates ranging from 5% to 10% per year, payable in cash semi-annually in arrears beginning on April 1, 2013. At May 31, 2017 and May 31, 2016, there were no convertible notes outstanding related to this offering.

 

In connection with the initial sale of the 2013 Convertible Notes, detachable common stock warrants to purchase a total of 8,527,984 common shares with a two-year term at exercise prices ranging from $0.75 to $2.00 per share were issued to the investors. The Company determined the fair value of the warrants at issuance using the Black-Scholes option pricing model utilizing certain weighted average assumptions, such as expected stock price volatility, term of the warrants, risk-free interest rates and expected dividend yield at the grant date.

Additionally, at the commitment date, the Company determined that the conversion feature related to the 2013 Convertible Notes was beneficial to the investors. As a result, the Company determined the intrinsic value of the conversion feature utilizing the fair value of the underlying common stock at the commitment date and the effective conversion price after discounting the 2013 Convertible Notes for the fair value of the warrants. The fair value of the warrants and the intrinsic value of the beneficial conversion feature were recorded as a debt discount to the 2013 Convertible Notes, with a corresponding increase to additional paid-in capital. The debt discount was amortized over the life of the 2013 Convertible Notes. During the years ended May 31, 2017 and May 31, 2016, the Company recognized approximately $ -0- and $7,000, respectively, as interest expense related to amortization of the debt discount. The unamortized discount was fully amortized upon any conversion of the 2013 Convertible Notes before maturity. Activity related to the 2013 Convertible Notes for the year ended May 31, 2017 and May 31, 2016 was as follows:

 

     May 31, 2017      May 31, 2016  

Face amount of Notes

   $ —        $ 50,000  
  

 

 

    

 

 

 

Unamortized discount

     —          —    

Conversions

     —          (50,000
  

 

 

    

 

 

 

Total carrying value of Notes

   $ —        $ —    
  

 

 

    

 

 

 

The Company determined the fair value of the extended warrants described below, as follows:

 

     2016    2017

Expected dividend yield

   0%    0%

Stock price volatility

   64.56% - 69.30%    4.00%

Expected term

   1 year    1 month

Risk-free interest rate

   0.33%    77.00%

Grant-date fair value

   $0.15-$0.18    $0.11

During each of the fiscal years ended May 31, 2015 and 2016, the board approved a one-year extension of expiration dates on the aforementioned detachable common stock warrants, which had an original term of two years, covering approximately 6.3 million shares of common stock, with an exercise price of $1.00 per share. The first extension of expiration dates ranged from October 2015 through January 2016 and the second extension deferred the expiration dates to October 2016 through January 2017. The extensions were effective upon the receipt of certain executed documentation from the warrantholders. Pursuant to U.S. GAAP, the Company recognized non-cash interest expense in fiscal years ended May 31, 2017 and 2016 of approximately $72,000 and $867,000, respectively, in connection with these extensions, which represented the incremental increase in the fair value of the modified warrants.

As fully disclosed in Note 6 below, these warrants were granted an additional and final extension with all extended expirations dates being May 31, 2017, subsequently extended until June 30, 2017. The Company determined the fair value of the new warrants using the Black-Scholes option pricing model utilizing certain weighted-average assumptions, such as expected stock price volatility, term of the warrants, risk-free rate and expected dividend yield at the commitment date.

AVCP Convertible Notes

During the year ended May 31, 2015, the Company issued a three-month unsecured convertible promissory note (the “AVCP Bridge Note” and together with the AVCP Two-Year Note, the “AVCP Convertible Notes”) in the aggregate principal amount of $1,500,000 to Alpha Venture Capital Partners, L.P. (“AVCP”), an affiliate of one of the Company’s directors. As described in greater detail below, the AVCP Bridge Note, along with the AVCP Two-Year Note, were subsequently converted in a transaction occurring during the year ended May 31, 2016. The principal amount of the AVCP Bridge Note plus unpaid accrued interest was convertible at the election of the holder into shares of the Company’s common stock at any time prior to maturity at an initial conversion price of $1.00 per share. The AVCP Bridge Note bore simple interest of 1.2% per month, payable at maturity on May 5, 2015, and monthly thereafter, upon the Company’s election to exercise a one-time option to extend the maturity by an additional three months, which the Company exercised on April 1, 2015 (extending the maturity date to August 5, 2015). Prepayment was permitted without penalty subject to the Company’s obligation to pay at least three months’ interest on the principal amount. The conversion price was subject to (i) adjustment for stock splits and similar corporate events and (ii) reduction to a price per share that is 10% below the lowest sale price that is below $.9444 per share, for shares of common stock sold or deemed sold in future securities offerings, including sales to AVCP and its designees subject to certain exempt transactions. Without AVCP’s prior written consent, the Company was not permitted to incur additional indebtedness for borrowed money, other than up to an additional $6.0 million in convertible promissory notes that may be issued to AVCP or related parties, unless such indebtedness was subordinated in right of payment to the Company’s obligations under the AVCP Bridge Note and any additional notes issued to AVCP or related parties.

During the year ended May 31, 2015, the Company issued an additional two-year term unsecured convertible promissory note (the “AVCP Two-Year Note”) in the aggregate principal amount of $2,000,000 to AVCP, an affiliate of one of the Company’s directors. As described in greater detail below, along with the AVCP Bridge Note, the AVCP Two-Year Note was subsequently converted in a transaction occurring during the year ended May 31, 2016. The AVCP Two-Year Note bore simple interest at the annual rate of 5%, payable quarterly. The principal balance of the AVCP Two-Year Note was due and payable in full on September 26, 2016, subject to acceleration of payment in the event of default. Prepayment was permitted without penalty. The AVCP Two-Year Note included events of default for nonpayment of principal or interest when due or other breaches of the AVCP Two-Year Note, as well as for breach of any term of the AVCP Two-Year Note and related warrant agreement. The principal amount of the AVCP Two-Year Note plus unpaid accrued interest was convertible at the election of the holder into shares of the Company’s common stock at any time prior to maturity at an initial conversion price of $1.00 per share. The conversion price was subject to adjustment on the same terms, and contained similar consent rights to the issuance of additional indebtedness, as the AVCP Bridge Note above.

As a result of the private placement of approximately $4 million in convertible notes during the fourth quarter of fiscal year ended May 31, 2015, as described below, the conversion price of the AVCP Convertible Notes was reduced to $0.675 per share of common stock, which was 90% of the weighted-average price of the deemed issued shares of $0.75 related to the approximately $4 million offering of 2015 Convertible Notes described below. The decrease in the conversion price caused the number of shares of common stock issuable upon conversion of the AVCP Convertible Notes to increase from 3,500,000 to 5,185,185 shares of common stock.

The Company accounted for the AVCP Convertible Notes and related warrants, fully described below, as a financing transaction, wherein proceeds were allocated to the financial instruments issued. Prior to making the accounting allocation, the AVCP Convertible Notes and warrants were evaluated for proper classification under FASB ASC 480 “Distinguishing Liabilities from Equity” and ASC 815. The debt discounts associated with the notes were amortized over the term of the notes and the Company recognized approximately $ -0- and $94,000 in non-cash amortization expense for the years ended May 31, 2017 and May 31, 2016, respectively.

In connection with the original issuance of the two AVCP Convertible Notes, the Company issued warrants to AVCP covering 250,000 and 75,000 shares of the Company’s common stock exercisable at a price of $0.50 per share on September 26, 2014 and February 6, 2015, respectively. The warrants are currently exercisable in full, include a cashless exercise feature, and will expire on December 31, 2019 and February 29, 2020, respectively. The aforementioned warrants have a term of five years from inception and an exercise price of $0.50 per share and meet the conditions for equity classification per ASC 815. The fair value of the warrants was determined using a Black-Scholes option model using the following assumptions:

 

     Warrants issued on
September 26, 2014
   Warrants issued on
February 6, 2015

Risk free interest rate

   1.82%    1.48%

Expected life

   5 years    5 years

Expected volatility

   136%    119%

Dividend yield

   0.00%    0.00%

Based on the previous conclusions, the Company allocated the cash proceeds first to the derivative liability at its fair value and then to the warrants at their relative fair value, with the residual allocated to the host AVCP Convertible Notes as presented below.

On June 23, 2015, the Company, Alpha Venture Capital Management, LLC and AVCP entered into a Debt Conversion and Termination Agreement pursuant to which (i) AVCP agreed to convert the $3,535,627 in aggregate indebtedness as of June 23, 2015 under the AVCP Convertible Notes in exchange for 5,237,966 shares of the Company’s common stock; (ii) subject to the conversion of the two AVCP Convertible Notes, the Company agreed to issue AVCP an additional five-year warrant covering 1,000,000 shares of common stock at an exercise price of $0.675 per share and (iii) subject to the AVCP’s receipt of the common shares and warrant, the parties agreed to (a) terminate the subscription agreements; and (b) release and discharge each other party from all claims and obligations arising under the two AVCP Convertible Notes and subscription agreements. As a result of the debt conversion, during the year ended May 31, 2016, the Company recognized a loss on extinguishment of the AVCP Convertible Notes of approximately $584,000, a non-cash gain on the change in the fair value of the derivative liability of approximately $647,000 and non-cash inducement interest expense of approximately $758,000 arising from the aforementioned warrant.

 

            Year Ended May 31, 2016        
     May 31, 2015      Debt Discount      Fair Value     Conversion     May 31, 2016  

AVCP Convertible notes payable

   $ 2,637,618      $ 94,344      $ —       $ (2,731,962   $ —    

Compound embedded derivative

     2,008,907        —          (646,505     (1,362,402     —    

Warrants (equity allocation)

     215,732        —          —         —         —    

Accrued interest on notes payable

     —          —          —         (35,627     —    

Fair Value of Common Stock Issued

     —          —          —         4,714,168       —    

Loss on Conversion

     —          —          —         (584,177     —    
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 
   $ 4,862,257      $ 94,344      $ (646,505   $ —       $ —    
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

The following table summarizes the fair value of the derivative liability and linked common shares of the AVCP Notes, as of the derivative liability inception dates (September 26, 2014 and February 6, 2015) and fiscal year end May 31, 2016.    

 

     Total      Total  
     Shares Indexed      Derivative Liability  

Derivative Liability May 31, 2014

     —        $ —    

September 26, 2014

     2,000,000        767,038  

February 6, 2015

     1,500,000        403,226  

Change in fair value 2015

     1,685,185        838,643  
  

 

 

    

 

 

 

Balance May 31, 2015

     5,185,185      $ 2,008,907  

Change in fair value 2016

     —          (646,505

Conversion of notes payable June 24, 2015

     (5,185,185      (1,362,402
  

 

 

    

 

 

 

Balance May 31, 2016

     —        $ —    
  

 

 

    

 

 

 

Changes in the fair value of the derivative liability, carried at fair value, are reported as “Change in fair value of derivative liability” in the Consolidated Statements of Operations. During the year ended May 31, 2017 and May 31, 2016, the Company recognized a non-cash gain of approximately of $-0- and $647,000, due to the change in derivative liability related to the fundamental transaction feature in the registered direct warrants and embedded derivative in the AVCP Notes.

ASC 815 does not permit an issuer to account separately for individual derivative terms and features embedded in hybrid financial instruments that require bifurcation and liability classification as derivative financial instruments. Rather, such terms and features must be combined together and fair valued as a single, compound embedded derivative. The Company selected a Binomial Lattice Model (“Lattice”) to value the compound embedded derivative because it believes this technique is reflective of all significant assumptions that market participants would likely consider in negotiating the transfer of this convertible note. Such assumptions include, among other inputs, stock price volatility, risk-free rates, credit risk assumptions, early redemption and conversion assumptions, and the potential for future adjustment of the conversion price due to a future dilutive financing.

 

Significant inputs and assumptions used in the Lattice for the derivative liability related to the AVCP notes payable are as follows:

 

     September 26,
2014
    February 6,
2015
    May 31,
2015
    June 23,
2015
 

Quoted market price on valuation date

   $ 0.79     $ 0.96     $ 0.99     $ 0.90  

Contractual conversion rate

   $ 1.00     $ 1.00     $ 1.00     $ 1.00  

Adjusted conversion price (a)

   $ 0.9759     $ 1.0000     $ 0.675     $ 0.675  

Contractual term to maturity (years)

     2.00       0.49       0.18-1.33       0.12  

Expected volatility

     123     124     90%-114     48

Contractual interest rate

     5     2     1.5%-5.0     1.2

Risk-free rate

     0.59     0.045     0.041%-0.48     0.001

Risk adjusted rate

     2.69     2.78     2.80     2.80

Probability of event of default

     5.00     5.00     5.00     5.00

 

(a) The adjusted conversion price input used in the Binomial Lattice Model considers both (i) the reduction of the conversion price to $0.675 on April 30, 2015, as result of a private placement offering in which Common Stock was sold for a weighted average price of $0.75 and (ii) potential adjustment to the stated conversion price due to a future dilutive issuance. This input was calculated using a probability-weighted approach which considered the likelihood of various scenarios occurring including (i) potential success or failure of various phases for PRO 140, (ii) the probability the Company will enter into a future financing and (iii) and the potential price of a future financing.

The fair value of the derivative liability is significantly influenced by the Company’s trading market price, stock price volatility, changes in interest, assumptions regarding the adjusted conversion price and early redemption or conversion of the AVCP Notes.

2015 Short-Term Convertible Notes

During the year ended May 31, 2015, the Company issued approximately $4.0 million of six-month unsecured convertible promissory notes (the “2015 Short-Term Convertible Notes”) and related warrants to investors for cash. Each 2015 Short-Term Convertible Note was originally convertible, at the election of the holder, at any time into common shares at a $0.75 per share. The 2015 Short-Term Convertible Notes bore interest of 7% per annum, payable in cash upon maturity. In connection with the issuance of the 2015 Short-Term Convertible Notes, the Company also issued warrants with a five-year term to purchase a total of 1,061,586 shares of common stock at an exercise price of $0.75. The Company determined the fair value of the warrants using the Black-Scholes option pricing model utilizing certain weighted-average assumptions, such as expected stock price volatility, term of the warrants, risk-free interest rate and expected dividend yield at the commitment date.

The Company utilized the following weighted-average assumptions to value the above investor warrants:

 

     2015

Expected dividend yield

   0%

Stock price volatility

   88.79%

Expected term

   5 years

Risk-free interest rate

   1.46%-1.58%

Grant-date fair value

   $0.52-$0.76

Additionally, at the commitment date, the Company determined that the conversion feature related to the Short-Term Convertible Notes was beneficial to the investors. As a result, the Company determined the intrinsic value of the beneficial conversion feature utilizing the fair value of the underlying common stock at the commitment date and the effective conversion price after discounting the Short-Term Convertible Notes for the fair value of the warrants. The fair value of the warrants and the intrinsic value of the conversion feature were recorded as a debt discounts to the 2015 Short-Term Convertible Notes, and a corresponding increase to additional paid-in capital. The debt discounts are amortized over the life of the 2015 Short-Term Convertible Notes. The Company recognized approximately $-0- and $1,784,000 as interest expense related to the amortization of the debt during the year ended May 31, 2017 and 2016, respectively. There were no 2015 Short-Term Convertible Notes outstanding at May 31, 2017 or May 31, 2016. The unamortized discounts were fully amortized upon any conversion of the 2015 Short-Term Convertible Notes before maturity.

During the year ended May 31, 2016, the Company tendered an offer to settle the balances of the 2015 Short-Term Convertible Notes. The Company offered to exchange the 2015 Short-Term Convertible Notes for (i) the issuance of restricted shares of common stock, for the settlement of the balance of the 2015 Short-Term Convertible Notes, principal and accrued but unpaid interest as of September 21, 2015, which was the commitment date, at a conversion price of $0.675 per share, and (ii) the amendment of the related warrants to reduce the exercise price to $0.675 per share. The offer represented a 10.0% discount to $0.75, which was the current conversion price of the 2015 Short-Term Convertible Notes and current exercise price of the related warrants. On September 21, 2015, the offering period and withdrawal rights for the exchange offer expired, and the Company completed the exchange offer for approximately $2.7 million in aggregate original principal amount of 2015 Short-Term Convertible Notes.

Following the consummation of the exchange offer described above, an aggregate principal amount of $525,000 and accrued but unpaid interest of $17,830 converted into 723,773 shares of common stock. The principal and interest for 2015 Short-Term Convertible Notes that were not exchanged in the exchange offer, or that are not otherwise converted pursuant to their terms, became due and payable between October 30, 2015 and November 15, 2015, six months from their issuance. The Company repaid the remaining aggregate principal and interest on such Convertible Notes of approximately $789,000 Short-Term Convertible Notes on their respective maturity dates. Related to the tender offer conversions, the Company recognized approximately $330,000 in non-cash interest expense and approximately $108,000 commission expense to assist the Company in conversion of the debt at the commitment date.

Activity related to the 2015 Short-Term Convertible Notes for fiscal year ended May 31, 2017 and May 31, 2016 was as follows:

 

    May 31, 2017     May 31, 2016  

Face amount of Notes

  $ —       $ 3,981,050  
 

 

 

   

 

 

 

Unamortized discount

    —         —    

Tender offer conversions

    —         (2,693,800

Conversions

    —         (525,000

Payments upon maturity

    —         (762,250
 

 

 

   

 

 

 

Total carrying value of Notes

  $ —       $ —    
 

 

 

   

 

 

 

2017 Short-Term Convertible Notes

During the year ended May 31, 2017, the Company issued $1.15 million of unsecured convertible promissory notes, with a maturity date of January 31, 2018, (the “2017 Notes”) and related warrants to investors for cash. The principal amount of the 2017 Notes, including any accrued but unpaid interest thereon, is convertible at the election of the holder at any time into shares of common shares at any time prior to maturity at a conversion price of $0.75 per share. The 2017 Notes bear simple interest at the annual rate of 7%. Principal and accrued interest, to the extent not previously paid or converted, is due and payable on the maturity date. At the commitment date, the conversion price was greater than the fair value of the common stock. Accordingly, no beneficial conversion feature was recorded. The Company incurred approximately $92,000 of debt discount related to the detachable warrants issued with the 2017 Notes, which will be amortized over the term of the notes.

In connection with the sale of the 2017 Notes, detachable common stock warrants to purchase a total of 383,333 common shares, with an exercise price of $1.35 per share and a five-year term were issued to the investors. The Company determined the fair value of the warrants at issuance using the Black-Scholes option pricing model utilizing certain weighted average assumptions, such as expected stock price volatility, expected term of the warrants, risk-free interest rates and expected dividend yield at the grant date.

 

     2017

Expected dividend yield

   0%

Stock price volatility

   69.00%

Expected term

   5 year

Risk-free interest rate

   1.75%

Grant-date fair value

   $0.24

The fair value of the warrants were recorded as a debt discount to the 2017 Notes and a corresponding increase to additional paid-in capital. The non-cash debt discount, of approximately $92,000 will be amortized over the term of the 2017 Notes.