Beam11 or YJ, please comment in layman's terms on the huge gain on derivative financial instruments. Some relevant information is copied and pasted below. Without this Neomedia would have had a huge net loss more indicative of the loss on operations reported.
Thanks in advance,
SS9173
Fair Value of Derivatives
The Company generally does not use derivative financial instruments to hedge exposures to cash-flow risks or market-risks that may affect the fair values of its financial instruments. However, certain other financial instruments, such as warrants and embedded conversion features that are indexed to the Company’s common stock, are classified as liabilities when either (a) the holder possesses rights to net-cash settlement or (b) physical or net-share settlement is not within the control of the Company. In such instances, net-cash settlement is assumed for financial accounting and reporting, even when the terms of the underlying contracts do not provide for net-cash settlement. Such financial instruments are initially recorded at fair value and subsequently adjusted to fair value at the close of each reporting period.
The caption “Derivative Financial Instruments” consists of (i) the fair values associated with derivative features embedded in the Series C convertible preferred stock, (ii) the fair values of the detachable warrants that were issued in connection with the preferred stock financing arrangement, and (iii) the fair value of detachable warrants that were outstanding prior to the issuance of the Series C Preferred Shares.
Derivative income for the six months ended June 30, 2006 and 2005 associated with adjustments recorded to reflect the aforementioned derivatives at fair value amounted to $15,794,000 and $0, respectively, and is reported as “Gain on Derivative Financial Instruments” in the accompanying condensed consolidated statement of operations.
Fair value considerations for derivative financial instruments:
Freestanding derivative instruments, consisting of warrants that arose from the Cornell financing and those reclassified as described above are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions included in this model as of June 30, 2006 are as follows:
Holder Cornell Capital Partners Other
Instrument Warrants Warrants
Exercise price $0.35 - $0.50 $0.01 - $3.45
Term (years) 5.0 1.0 - 5.0
Volatility 70.80% 52.56% -70.80%
Risk-free rate 3.65% 3.65%
Embedded derivative financial instruments, arising from the Series C convertible preferred stock, consist of multiple individual features that were embedded in the instrument. The Company evaluated all significant features of the hybrid instruments and, where required under current accounting standards, bifurcated features for separate report classification. These features were aggregated into one compound derivative financial instrument for financial reporting purposes. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.
Assumptions included exercise estimates/behaviors and the following other significant estimates:
Instrument Features
Conversion prices $0.95 - $1.29
Remaining terms (years) 1 - 5
Equivalent volatility 52.56% - 56.47%
Equivalent interest-risk adjusted rate 8.17% - 8.58%
Equivalent credit-risk adjusted yield rate 14.50%
Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. The assumptions included in the Monte Carlo Simulation calculation are highly subjective and subject to interpretation.
Accounting Treatment of Series C Convertible Preferred Stock
In connection with the accounting treatment of the Series C convertible preferred stock sale, NeoMedia recognized a gain on derivative financial instruments of $11,025,000 and $15,794,000 during the three and six month periods ended June 30, 2006, respectively. The gain is due to the change in fair value of derivative financial instruments resulting from a decrease in NeoMedia’s stock price from $0.389 per share on the date of the Series C convertible preferred stock sale (February 17, 2006) to $0.231 per share on June 30, 2006. The fair value of the derivative financial instruments at each measurement date correlates to NeoMedia’s stock price at the same date. As a result, NeoMedia’s net income varies significantly from its cash flow from operations during the three and isx months ended June 30, 2006. In future periods, NeoMedia’s earnings could fluctuate dramatically from quarter to quarter if its stock price is significantly different from the stock price at the end of the previous measurement period. Because NeoMedia cannot guarantee that it has enough authorized shares to net share settle the Series C convertible preferred stock, the change in fair value of derivative instruments will be recorded to NeoMedia’s statement of operations each reporting period until the Series C convertible preferred stock is fully converted.
