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, 2018. 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 stockholders approved an increase in the authorized shares of common stock to 100,000,000. At the commitment date, which occurred upon such stockholder 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. As of May 31, 2018 the undeclared, accrued dividends were approximately $199,000 or 387,000 shares of common stock.

 

AVCP Convertible Notes

During the year ended May 31, 2015, the Company issued a two-year term unsecured convertible promissory note (the “AVCP Two-Year Note”) in the aggregate principal amount of $2,000,000 to Alpha Venture Capital Partners, L.P. (“AVCP”), an affiliate of one of the Company’s directors as described under Note 15 below. As described in greater detail below, along with the AVCP Bridge Note, the AVCP Two-Year Note has subsequently been 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. 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 below. 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 AVCP. 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 into shares of the Company’s common stock 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). 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.

As a result of the private placement of approximately $4.0 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 Short Term 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 ASC 480 and ASC 815. The debt discounts associated with the notes were amortized over the term of the notes and the Company recognized approximately $94,000 in non-cash amortization expense for the period ended May 31, 2016. ASC 815 generally requires embedded terms and features that have characteristics of derivatives to be evaluated for bifurcation and separate accounting in instances where their economic risks and characteristics are not clearly and closely related to the risks of the host contract. The embedded derivative features consisted of the conversion price being subject to (i) adjustment for stock splits and similar corporate events and (ii) reduction to a conversion price per share that is 10% below the lowest sale price that is below $0.9444 per share for common stock sold or deemed sold in future securities offerings, subject to certain exempt transactions. The note conversion round down (or anti-dilution) provision terms were not consistent with the definition for financial instruments indexed to the Company’s stock. As such, the conversion option and conversion reset price protection in the AVCP Convertible Notes required bifurcation as a derivative liability. 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				Warrants issued on
		September 26, 2014				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, the Company recognized a loss on extinguishment of the AVCP Convertible Notes of $584,177, 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	)		$	—			$	—

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 Notes”) and related warrants to investors for cash. Each 2015 Note was originally convertible, at the election of the holder, at any time into common shares at a $0.75 per share. The 2015 Notes bore interest of 7% per annum, payable in cash upon maturity. In connection with the issuance of the 2015 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 year
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 2015 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 215 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 Notes, and a corresponding increase to additional paid-in capital. The debt discounts were amortized over the life of the 2015 Notes. The Company recognized approximately $ 1,784,000 as interest expense related to the amortization of the debt during the year ended May 31, 2016. There were no 2015 Notes outstanding at May 31, 2016. The unamortized discounts were fully amortized upon conversion of the 2015 Notes before maturity. During the year ended May 31, 2016, the Company tendered an offer to settle the balances of the 2015 Notes. The Company offered to exchange the 2015 Notes for (i) the issuance of restricted shares of common stock, for the settlement of the balance of the 2015 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 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 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 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 of approximately $789,000 on the 2015 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 Notes for fiscal year ended May 31, 2016 was as follows:

 

		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 (the “2017 Notes”), with a maturity date of January 31, 2018, and related warrants to investors for cash. The principal amount of the 2017 Notes, including any accrued but unpaid interest thereon, was 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 bore simple interest at the annual rate of 7%. Principal and accrued interest, to the extent not previously paid or converted, was due and payable on the maturity date.

On June 14, 2017, the Company’s Board of Directors approved a modification in the warrant terms issued in connection with the 2017 Notes. The warrant coverage was increased from 25% to 50% and the exercise price of the warrant was reduced from $1.35 to $1.00 per share. On June 19, 2017, in connection with the new terms, the Company issued an incremental 383,333 warrant shares to these previous 2017 Note holders.

During the year May 31, 2018, the Company issued approximately $4.89 million in aggregate principal of additional 2017 Notes and related warrants, as described above. At the commitment dates, the Company determined that the conversion feature related to these 2017 Notes to be 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 on the commitment dates and the effective conversion price after discounting the 2017 Notes for the fair value of the related warrants.

In connection with the sale of the 2017 Notes for the years ended May 31, 2018 and May 31, 2017, detachable common stock warrants to purchase a total of 4,025,656 common shares, with an exercise price of $1.00 per share and a five-year term were issued to the 2017 Note holders. 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.

 

		2018		2017
Expected dividend yield		0%		0%
Stock price volatility		69.8%		69%
Expected term		5 year		5 year
Risk-free interest rate		1.77-1.93%		1.75%
Grant-date fair value		$0.30-$0.39		$0.24

 

The fair value of the warrants, coupled with the beneficial conversion features, were recorded as a debt discount to the 2017 Notes and a corresponding increase to additional paid-in capital was amortized over the term of the 2017 Notes. The Company incurred debt discount of approximately $1.5 million and $92,000 during the years ended May 31, 2018 and May 31, 2017, respectively, related to the beneficial conversion feature and detachable warrants issued with the 2017 Notes. Accordingly, the Company recognized approximately $1.6 million and $-0- of non-cash debt discount during the year ended May 31, 2018 and May 31, 2017, respectively. In connection with the 2017 Notes, the Company incurred direct issuance costs of approximately $0.4 million during the year ended May 31, 2018. The issuance costs were amortized over the term of the 2017 Notes and accordingly, the Company recognized approximately $0.4 million of debt issuance costs during the year ended May 31, 2018.

On January 31, 2018, in connection with a registered direct equity offering, as fully described in Note 11, the 2017 Notes in an aggregate principal amount of $5,788,500, plus accrued unpaid interest of approximately $243,000 were sold for 12,062,728 shares of common stock. The 2017 Note investors also received warrants to purchase 7,718,010 shares of common stock. The securities were sold at a combined purchase price of $0.50 per share of common stock and related warrants, for aggregate gross proceeds to the Company of approximately $6.0 million. The Company repaid one 2017 Note, including accrued interest in the aggregate of approximately $259,000.

Activity related to the 2017 Notes was as follows:    

 

		For the year ended May 31,
		2018				2017
Face amount of Notes		$	6,038,500			$	1,150,000
Unamortized discount			—				(92,000	)
Registered direct equity offering			(5,788,500	)			—
Note repayment			(250,000	)			—
Carrying value of Notes, net		$	—			$	1,058,000