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 November 30, 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 November 30, 2018 and May 31, 2018, the undeclared, accrued dividends were approximately $205,000 and $199,000, respectively, or 410,000 and 387,000 shares of common stock, respectively.

Short-term Convertible Notes

During the fiscal year ended May 31, 2018, the Company issued approximately $4.89 million in aggregate principal of short-term Convertible Notes, with a maturity date of January 31, 2018, and related warrants to investors for cash. The principal amount of the short-term Convertible 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 short-term Convertible Notes bore 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 Company determined that the conversion feature related to these short-term Convertible 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 short-term Convertible Notes for the fair value of the related warrants.

In connection with the sale of the short-term Convertible Notes, 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 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.

 

		2018
Expected dividend yield		0%
Stock price volatility		69.80%
Expected term		5 year
Risk-free interest rate		1.77-1.93%
Grant-date fair value		$0.30-$0.39

The fair value of the warrants, coupled with the beneficial conversion features, were recorded as a debt discount to the short-term Convertible Notes and a corresponding increase to additional paid-in capital was amortized over the term of the short-term Convertible Notes. The Company incurred debt discount of approximately $1.5 million related to the beneficial conversion feature and detachable warrants issued with the short-term Convertible Notes during the year ended May 31, 2018. Accordingly, the Company recognized approximately $-0- and $1.2 million of non-cash debt discount during the six months ended November 30, 2018 and November 30, 2017. In connection with the short-term Convertible 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 short-term Convertible Notes and accordingly, the Company recognized approximately $-0- and $0.3 million of debt issuance costs during the six months ended November 30, 2018 and November 30, 2017, respectively.

On January 31, 2018, in connection with a registered direct equity offering, as fully described in Note 11, the short-term Convertible 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 short-term Convertible 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 short-term Convertible Note, including accrued interest in the aggregate of approximately $259,000. During the six months ended November 30, 2018 and November 30, 2017, the Company recognized approximately $-0- and $75,000, of interest expense related to the short-term Convertible Notes.

 

Activity related to the short-term Convertible Notes was as follows:

 

		November 30, 2018				May 31, 2018
Face amount of short-term Convertible Notes		$	—			$	6,038,500
Unamortized discount			—				—
Registered direct equity offering			—				(5,788,500	)
Note repayment			—				(250,000	)
Carrying value of short-term Convertible Notes		$	—			$	—

Long-term Convertible Note

On June 26, 2018, the Company entered into a securities purchase agreement, pursuant to which the Company issued a convertible promissory note (the “Note”) with a two-year term to an institutional accredited investor in the initial principal amount of $5.7 million. The investor gave consideration of $5.0 million to the Company. The Note bears interest of 10% and is convertible into common stock, at $0.55 per share. The Note is convertible in total, or in part, of the outstanding balance, at any time after six months from the issue date upon five trading days’ notice, subject to certain adjustments and ownership limitations specified in the Note. The Investor may redeem any portion of the Note, at any time after six months from the issue date upon five trading days’ notice, subject to a maximum monthly redemption amount of $350,000. The securities purchase agreement requires the Company to reserve shares for future conversions or redemptions by dividing the outstanding principal balance plus accrued interest by the conversion price of $0.55 per share times 1.5.

In connection with the Note, the Company recorded debt discount of $0.6 million and debt issuance costs of $0.1 million. The discount and issuance costs will be amortized over the life of the Note, and accordingly, the Company recognized approximately $20,000 and $-0- amortization of debt issuance costs for the six months ended November 30, 2018 and November 30, 2017, respectively and approximately $118,000 and $-0- of amortization of debt discount for the six months ended November 30, 2018 and November 30, 2017, respectively.

Effective November 15, 2018, the Note was amended to allow the Investor to redeem the monthly redemption amount of $350,000 in cash or stock, at the lesser of (i) $0.55, or (ii) the lowest closing bid price of the Company’s common stock during the 20 days prior to the conversion, multiplied by a conversion factor of 85%. The variable rate redemption provision meets the definition of a derivative instrument and subsequent to the amendment, it no longer meets the criteria to be considered indexed to the Company’s own stock. As of November 15, 2018, the redemption provision requires bifurcation as a derivative liability at fair value under the guidance in ASC Topic No. 815, “Derivatives and Hedging.”

The amendment of the Note was also evaluated under ASC Topic 470-50-40, “Debt Modifications and Extinguishments.” Based on the guidance, the instruments were determined to be substantially different, and debt extinguishment accounting was applied. We recorded approximately $1.5 million as an extinguishment loss, which was the difference in the net carrying value of the Note prior to the amendment of approximately $5.4 million, and the fair value of the Note and embedded derivatives after the amendment of approximately $6.9 million. The extinguishment loss includes a write-off of unamortized debt issuance costs and the debt discount associated with the original Note. During the six months ended November 30, 2018 and November 30, 2017, the Company recognized approximately $248,000 and $-0-, of interest expense related to the Notes.

Activity related to the Note was as follows:

 

		November 30, 2018
		Short term				Long term				Total				May 31, 2018
Face amount of convertible promissory note		$	—			$	—			$	—			$	—
June 26, 2018 convertible promissory note			2,100,000				3,600,000				5,700,000				—
Monthly redemption			700,000				(700,000	)			—				—
Unamortized discount at August 31, 2018			(344,614	)			(281,628	)			(626,242	)			—
Carrying value of convertible notes at August 31, 2018		$	2,455,386			$	2,618,372			$	5,073,758			$	—
Carrying value of convertible notes at November 30, 2018		$	4,200,000			$	1,396,974			$	5,596,974			$	—