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EX-32.1 - EXHIBIT 32.1 - PROSPER MARKETPLACE, INCexhibi32d19d30d2011.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
 (Mark One)
     
þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2011

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: 333-147019

PROSPER MARKETPLACE, INC.
(Exact name of registrant as specified in its charter)

Delaware
 
6199
 
73-1733867
(State or other jurisdiction of
 
(Primary Standard Industrial
 
(I.R.S. Employer
incorporation or organization)
 
Classification Code Number
 
Identification Number)

111 Sutter Street, 22nd Floor
San Francisco, CA  94104
(415) 593-5400
(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)
 
    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 þ 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ  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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
Accelerated filer o
Non-accelerated filer o(Do not check if a smaller reporting company)
Smaller reporting company þ
 
    Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of October 28, 2011, there were 4,669,249 shares of the registrant’s common stock outstanding.




 
 

 

TABLE OF CONTENTS
 
 
Page No.
i
 
 
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41
41
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41
42
43
   
   

 
 

 


FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements include all statements that do not relate solely to historical or current facts, and can generally be identified by the use of words such as “may,” “believe,” “will,” “expect,” “project,” “estimate,” “intend,” “anticipate,” “plan,” “continue” or similar expressions.   In particular, information appearing under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” includes forward-looking statements. Forward-looking statements inherently involve many risks and uncertainties that could cause actual results to differ materially from those projected in these statements.

 
Where, in any forward-looking statement, we express an expectation or belief as to future results or events, such expectation or belief is based on the current plans and expectations of our management and expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the expectation or belief will result or be achieved or accomplished. More information on factors that could cause actual results or events to differ materially from those anticipated is included from time to time in our reports filed with the Securities and Exchange Commission (the “SEC”), including our Annual Report on Form 10-K for the year ended December 31, 2010, particularly under the caption “Risk Factors.”

 
All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q and are expressly qualified in their entirety by the cautionary statements included in this Quarterly Report on Form 10-Q or our Annual Report on Form 10-K for the year ended December 31, 2010, particularly under the caption “Risk Factors.” We undertake no obligation to update or revise forward-looking statements that may be made to reflect events or circumstances that arise after the date made or to reflect the occurrence of unanticipated events, other than as required by law.

 
 
WHERE YOU CAN FIND MORE INFORMATION
 
We file annual, quarterly and current reports and other information with the SEC. You can inspect, read and copy these reports and other information at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You can obtain information regarding the operation of the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that makes available reports, proxy statements and other information regarding issuers that file electronically.



Item 1. Financial Statements
 
Prosper Marketplace, Inc.
 Balance Sheets
   
September 30,
   
December 31,
 
   
2011
   
2010
 
   
(Unaudited)
   
(Note 2)
 
ASSETS
           
   Cash and cash equivalents
  $ 13,558,911     $ 4,284,228  
   Restricted cash
    3,834,100       2,566,631  
   Servicing rights
    -       2,986  
   Receivables
    16,379       6,306  
   Loans held for investment at fair value
    146,748       -  
   Borrower Loans Receivable at fair value
    56,900,829       23,689,950  
   Property and equipment, net
    1,246,396       765,210  
   Prepaid and other assets
    269,979       174,805  
   Intangible assets, net
    -       50,306  
Total assets
  $ 75,973,342     $ 31,540,422  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
   Accounts payable
  $ 984,566     $ 554,347  
   Accrued liabilities
    1,590,681       1,219,239  
   Borrower Payment Dependent Notes at fair value
    56,333,232       23,478,046  
   Repurchase obligation
    22,168       71,001  
   Notes payable
    -       288,594  
                 
Total liabilities
    58,930,647       25,611,227  
                 
   Commitments and contingencies (see Note 12)
               
                 
   Stockholders' Equity
               
   Convertible preferred stock – Series A ($0.001 par value; 4,023,999 shares authorized, issued and outstanding as of September 30, 2011 and December 31, 2010)
    4,024       4,024  
   Convertible preferred stock – Series B ($0.001 par value; 3,310,382 shares authorized, issued and outstanding as of September 30, 2011 and December 31, 2010)
    3,310       3,310  
   Convertible preferred stock – Series C ($0.001 par value; 2,063,558 shares authorized, issued and outstanding as of September 30, 2011 and December 31, 2010)
    2,064       2,064  
   Convertible preferred stock – Series D ($0.001 par value; 20,543,819 shares authorized; 20,340,705 issued and outstanding as of September 30, 2011 and December 31, 2010)
    20,341       20,341  
   Convertible preferred stock – Series D-1 ($0.001 par value; none authorized, issued and outstanding as of September 30, 2011, and 3,110,188 shares authorized, issued and outstanding at December 31, 2010)
    -       3,110  
   Convertible preferred stock – Series E ($0.001 par value; 23,222,747 shares authorized; 23,222,747 issued and outstanding as of September 30, 2011)
    23,223       -  
   Convertible preferred stock – Series E-1 ($0.001 par value; 10,000,000 shares authorized; 10,000,000 issued and outstanding as of September 30, 2011)
    10,000       -  
   Common stock ($0.001 par value; 71,417,830 shares authorized; 4,669,249 shares and 4,478,667 shares issued and outstanding as of September 30, 2011 and December 31, 2010, respectively)
    4,670       4,480    
   Additional paid-in capital
    73,684,140       56,659,849  
   Accumulated deficit
    (56,709,077 )     (50,767,983 )
   Total stockholders' equity
    17,042,695       5,929,195  
                 
Total liabilities and stockholders' equity
  $ 75,973,342     $ 31,540,422  
                 
The accompanying notes are an integral part of these financial statements.
 
 
 
Prosper Marketplace, Inc.
 
Statements of Operations
 
(Unaudited)
 
                           
   
Three Months Ended September 30,
     
Nine Months Ended September 30,
 
   
2011
   
2010
     
2011
   
2010
 
Revenues
                         
   Origination fees
  $ 762,000     $ 191,831       $ 1,753,852     $ 512,101  
   Loan servicing fees
    3,236       42,250         22,800       142,870  
   Interest income on Borrower Loans and Payment Dependent Notes, net     
    153,900       123,720         338,614       178,020  
   Rebates and promotions
    (314,320 )     3,251         (759,284 )     (16,617 )
Revenues
    604,816       361,052         1,355,982       816,374  
                                   
Cost of revenues
                                 
   Cost of services
    (302,999 )     (265,485 )       (898,975 )     (668,708 )
   Reversal of (Provision for) loan and Note repurchases
    (7,148 )     813         50,644       (26,817 )
Net revenues
    294,669       96,380         507,651       120,849  
                                   
Operating expenses
                                 
   Compensation and benefits
    1,746,136       1,177,175         4,907,562       3,430,904  
   Marketing and advertising
    375,219       103,036         1,225,589       487,337  
   Depreciation and amortization
    114,501       143,044         347,771       421,208  
General and administrative
                                 
   Professional services
    489,207       702,540         1,630,130       2,111,524  
   Facilities and maintenance
    197,010       159,097         522,963       478,709  
   Other
    209,886       215,705         645,763       1,130,345  
Total expenses
    3,131,959       2,500,597         9,279,778       8,060,027  
Loss before other income
    (2,837,290 )     (2,404,217 )       (8,772,127 )     (7,939,178 )
                                   
Other income
                                 
   Interest income
    846       4,782         3,443       9,111  
   Change in fair value on Borrower Loans, Loans Held for Investment and  Payment Dependent Notes, net
    390,469       163,836         865,993       397,644  
   Insurance recoveries
    -       -         1,896,844       -  
   Loss on impairment of fixed assets
    -       -         (1,714 )     (3,179 )
   Other income
    25,438       12,583         66,467       41,300  
Total other income, net
    416,753       181,201         2,831,033       444,876  
                                   
Loss before income taxes
    (2,420,537 )     (2,223,016 )       (5,941,094 )     (7,494,302 )
Provision for income taxes
    -       -         -       -  
Net loss
  $ (2,420,537 )   $ (2,223,016 )     $ (5,941,094 )   $ (7,494,302 )
                                   
                                   
 Net loss per share – basic and diluted
  $ (0.52 )   $ (0.50 )     $ (1.30 )   $ (1.68 )
 Weighted average shares - basic and diluted net loss per share
    4,669,249       4,478,667         4,583,997       4,470,953  
                                   
The accompanying notes are an integral part of these financial statements.


 
 
Prosper Marketplace, Inc.
Statements of Stockholders' Equity
                                           
   
Preferred Stock
   
Common Stock
   
Additional Paid-In
   
Accumulated
       
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
Deficit
   
Total
 
Balance as of January 1, 2010 (Audited)
    9,397,939     $ 9,398       4,460,667     $ 4,462     $ 41,406,457     $ (40,625,261 )   $ 795,056  
                                                         
   Issuance of convertible preferred stock, Series D
    20,340,705       20,341                       14,998,161               15,018,502  
                                                         
   Issuance of convertible preferred stock, Series D-1
    3,110,188     $ 3,110                                       3,110  
                                                         
   Offering costs on preferred stock
                                    (275,903 )             (275,903 )
                                                         
   Exercise of stock options
                    18,000       18       6,482               6,500  
                                                         
   Issuance of common stock warrants
                                    96,625               96,625  
                                                         
   Compensation expense
                                    214,340               214,340  
                                                         
   Net loss
                                            (7,494,302 )     (7,494,302 )
                                                         
Balance as of September 30, 2010 (Unaudited)
    32,848,832     $ 32,849       4,478,667     $ 4,480     $ 56,446,162     $ (48,119,563 )   $ 8,363,928  
                                                         
Balance as of January 1, 2011 (Audited)
    32,848,832     $ 32,849       4,478,667     $ 4,480     $ 56,659,849     $ (50,767,983 )   $ 5,929,195  
                                                         
   Issuance of convertible preferred stock, Series E
    23,222,747       23,223                       17,116,777               17,140,000  
                                                         
   Issuance of convertible preferred stock, Series E-1
    10,000,000       10,000                                       10,000  
                                                         
   Conversion of convertible preferred stock, Series D-1
    (3,110,188 )     (3,110 )     1       -       3,110               (0 )
                                                         
   Offering costs on preferred stock
                                    (454,336 )             (454,336 )
                                                         
   Exercise of stock options
                    100,416       100       20,983               21,083  
                                                         
   Exercise of common stock warrants
                    90,165       90       17,943               18,033  
                                                         
   Issuance of common stock warrants
                                    78,884               78,884  
                                                         
   Compensation expense
                                    240,930               240,930  
                                                         
   Net loss
                                            (5,941,094 )     (5,941,094 )
                                                         
Balance as of September 30, 2011 (Unaudited)
    62,961,391     $ 62,962       4,669,249     $ 4,670     $ 73,684,140     $ (56,709,077 )   $ 17,042,695  
                                                         
The accompanying notes are an integral part of these financial statements.
 

Prosper Marketplace, Inc.
Statements of Cash Flows
(Unaudited)
   
Nine Months Ended September 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
  $ (5,941,094 )   $ (7,494,302 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
     Depreciation and amortization
    347,771       421,208  
     Loss on impairment of fixed assets
    1,714       3,179  
     Change in fair value of loans held for investment
    46        
     Change in fair value of Borrower Loans
    (2,161,235 )     1,671,980  
     Change in fair value of Borrower Payment Dependent Notes
    1,295,196       (2,069,624 )
     Stock-based compensation expense
    240,930       214,340  
     Expenses paid with warrants
    78,884        
     Provision for (Reversal of) loan and Note repurchases
    (50,644 )     26,817  
     Change in fair value of servicing rights
    2,986       17,599  
     Amortization of discount on long-term debt
    11,406       147,764  
     Premium on early conversion of convertible note
          300,000  
Changes in operating assets and liabilities:
               
     Restricted cash
    (1,267,469 )     (253,142 )
     Receivables
    (10,073 )     6,550  
     Prepaid and other assets
    (95,174 )     29,886  
     Accounts payable and accrued liabilities
    801,661       (283,602 )
     Loan and Note repurchases
    1,811       4,183  
Net cash used in operating activities
    (6,743,284 )     (7,257,164 )
                 
Cash flows from investing activities:
               
Origination of loans held for investment at fair value
    (146,794 )      
Origination of Borrower Loans held at fair value
    (47,927,629 )     (18,559,333 )
Repayment of Borrower Loans held at fair value
    16,877,985       5,633,104  
Purchases of property and equipment
    (780,364 )     (324,436 )
Net cash used in investing activities
    (31,976,802 )     (13,250,665 )
                 
Cash flows from financing activities:
               
Proceeds from issuance of convertible preferred stock
    17,149,999       11,344,728  
Offering costs - convertible preferred stock
    (454,336 )     (275,903 )
Proceeds from issuance of Notes held at fair value
    47,927,629       18,559,333  
Payment of Notes held at fair value
    (16,367,639 )     (5,413,651 )
Proceeds from the issuance of notes payable
          2,550,000  
Principal repayment of notes payable
    (300,000 )     (323,575 )
Proceeds from issuance of common stock
    39,116       6,500  
Net cash provided by financing activities
    47,994,769       26,447,432  
                 
Net increase in cash and cash equivalents
    9,274,683       5,939,603  
Cash and cash equivalents at beginning of the period
    4,284,228       616,089  
Cash and cash equivalents at end of the period
  $ 13,558,911     $ 6,555,692  
                 
                 
The accompanying notes are an integral part of these financial statements.
 
 
 
 
PROSPER MARKETPLACE, INC.
 
Notes to Financial Statements
(Unaudited)
 
1. Operations and Business
 
Prosper Marketplace, Inc. (“Prosper,” the “Company,” “we,” “us,” “our”) was incorporated in the state of Delaware on March 22, 2005. Prosper is an online marketplace for peer-to-peer lending. Prosper’s website provides an online marketplace for loans where people list and bid on loans with interest rates of return determined by Prosper.   Lender members access our platform and bid the amount they are willing to commit to the purchase of a Note that is dependent for payment on the corresponding borrower loan, at interest rates set by Prosper.  Loan terms are subject to minimum and maximum loan amounts determined by the borrower’s credit bureau score and Prosper score, at interest rates set by Prosper.  Prosper facilitates the lending and borrowing activities and acts as an agent to the lender by maintaining its online marketplace. Prosper also handles all ongoing loan administration tasks, including loan servicing and collections on behalf of the lenders. Prosper generates revenue by collecting one-time fees from borrowers on funded loans and from loan servicing fees paid by lender members.
 
All loans requested and obtained by Prosper borrower members through our platform are unsecured obligations of individual borrower members with a fixed interest rate and a loan term set at one, three or five years as of September 30, 2011.  All loans are funded by WebBank, an FDIC-insured, Utah-chartered industrial loan company.  After funding a loan, WebBank assigns the loan to Prosper, without recourse to WebBank, in exchange for the principal amount of the borrower loan.  WebBank does not have any obligation to purchasers of the Notes.

On July 13, 2009, we implemented a new operating structure and began issuing Borrower Payment Dependent Notes (“Notes”).  The post registration operating structure resulted in Prosper purchasing loans from WebBank, and holding the loans until maturity.  Prosper issues new securities, the Notes, to the winning lenders.  Prosper’s obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan owned by Prosper.  As a result of these changes, borrower loans and the Notes originated on or after July 13, 2009 are carried on Prosper’s balance sheet as assets and liabilities, respectively.  Prosper has elected to carry the borrower loans and the Notes on its balance sheet at fair value.
 
As reflected in the accompanying financial statements, Prosper has incurred net losses and negative cash flows from operations since inception, and has an accumulated deficit of approximately $56.7 million as of September 30, 2011.  For the three and nine months ended September 30, 2011, the Company incurred a net loss of $2.4 million and $5.9 million, respectively and the Company had negative cash flows from operations of $6.7 million for the nine months ended September 30, 2011.  Since its inception, Prosper has financed its operations primarily through equity financing from various sources.  In June 2011 the Company raised $17.2 million through the issuance of our Series E Preferred Stock to certain new investors and certain of Prosper’s existing investors.  Please see Note 9, “Shareholders’ Equity” for further discussion of our Preferred Stock.  In November 2011, the Company raised $9.0 million through the issuance of our Series F Preferred Stock to certain new investors.  Please see Note 15 “Subsequent Events – Preferred Stock” for a further discussion of our Series F Preferred Stock issuance.

 
2. Summary of Significant Accounting Policies
 
Basis of Presentation
 
The Company’s unaudited interim financial statements have been prepared in accordance with U.S. generally accepted accounting principles (US GAAP) and disclosure requirements for interim financial information and the requirements of Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements.  The unaudited interim financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2010, as filed with the SEC on Form 8-K on August 5, 2011.  The balance sheet at December 31, 2010 has been derived from the audited financial statements at that date. Management believes these unaudited interim financial statements reflect all adjustments, including those of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

Use of Estimates
 
The preparation of financial statements in conformity with US GAAP requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the related disclosures at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. These estimates, judgments and assumptions include but are not limited to the following: valuation of borrower loans receivable and associated member payment dependent notes, valuation of loans held for investment, valuation allowance on deferred tax assets, valuation and amortization periods of intangible assets, repurchase obligation, stock-based compensation expense, and contingent liabilities. Prosper bases its estimates on historical experience and on various other assumptions that Prosper believes to be reasonable under the circumstances. Actual results could differ from those estimates.

Certain Risks and Concentrations

In the normal course of its business, Prosper encounters two significant types of risk: credit and regulatory. Financial instruments that potentially subject Prosper to significant concentrations of credit risk consist primarily of cash, cash equivalents and restricted cash. The Company places cash, cash equivalents and restricted cash with high-quality financial institutions. Prosper is exposed to credit risk in the event of default by these institutions to the extent the amount recorded on the balance sheet exceeds FDIC insured amounts. Prosper performs periodic evaluations of the relative credit standing of these financial institutions and has not sustained any credit losses from instruments held at these financial institutions.

As previously described, beginning on July 13, 2009, loans originated by Prosper are carried on our balance sheet.  The loans are funded by the Notes and repayment of any Note is wholly dependent on the repayment of the loan associated with that Note.  As a result, Prosper does not bear the risk associated with the repayment of principal on loans carried on its balance sheet.  A decrease in the value of a borrower loan carried on Prosper’s balance sheet associated with increased credit risk is directly offset by a reduction in the value of the Notes Prosper issued in association with the loan. However, Prosper charges a servicing fee that is deducted from loan payments.  To the extent that loan payments are not made, Prosper’s servicing income will be reduced.  

Prosper is subject to various regulatory requirements. The failure to appropriately identify and address these regulatory requirements could result in certain discretionary actions by regulators that could have a material effect on Prosper’s financial position and results of operations (See Note 12 — Commitments and Contingencies — Securities Law Compliance).

 
 
Cash and Cash Equivalents
 
Prosper invests its excess cash primarily in money market funds and in highly liquid debt instruments of U.S. municipalities, and the U.S. government and its agencies. All highly liquid investments with stated maturities of three months or less from date of purchase are classified as cash equivalents. Cash equivalents are recorded at cost, which approximates fair value. Such deposits periodically exceed amounts insured by the FDIC.
 
Restricted Cash
 
Restricted cash consists primarily of cash deposits required to support an irrevocable letter of credit held by a financial institution in connection with the Company’s office lease and the Company’s Automated Clearing House and loan origination activities, and secured corporate credit cards.
  
Fair Value of Borrower Loans, Borrower Payment Dependent Notes and Loans Held for Investment

The Company accounts for its borrower loans and loans held for investment as assets and accounts for its borrower payment dependent notes as liabilities and carries these instruments at fair value.

Borrower Loans and Borrower Payment Dependent Notes

As of July 13, 2009, the Company implemented its new operating structure and began issuing Notes and purchasing loans from WebBank, and holding the loans until maturity.  Prosper’s obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan owned by Prosper.   As a result of these changes, borrower loans and the Notes are carried on our balance sheet as assets and liabilities, respectively, and are carried at fair value.
 
Loans Held for Investment

From time to time, Prosper will fund all or a portion of a borrower loan.  At September 30, 2011 Prosper had funded an aggregate total of $146,794 in principal amount of borrower loans to borrower members.  There were no loans purchased by Prosper and held for investment during 2010.  These loans are classified as loans held for investment based on management’s intent to hold these loans for the foreseeable future or to maturity.
 
For our borrower loans, borrower payment dependent notes and loans held for investment, we adopted the provisions of Accounting Standards Codification (ASC) Topic 825, Financial Instruments.  ASC Topic 825 permits companies to choose to measure certain financial instruments and certain other items at fair value on an instrument-by-instrument basis with unrealized gains and losses on items for which the fair value option has been elected reported in earnings.  The fair value election, with respect to an item, may not be revoked once an election is made.  In applying the provisions of ASC Topic 825, we recorded assets and liabilities measured using the fair value option in a way that separates these reported fair values from the carrying values of similar assets and liabilities measured with a different measurement attribute.  We do not record a specific allowance account related to the borrower loans, loans held for investment and Notes in which we have elected the fair value option, but rather estimate the fair value of the borrower loans, loans held for investment and Notes using discounted cash flow methodologies adjusted for Prosper’s historical loss and recovery rates.  We have reported the aggregate fair value of the borrower loans, loans held for investment and Notes as separate line items in the assets and liabilities sections of the balance sheet using the methods described in ASC Topic 820, Fair Value Measurements and Disclosures– See Fair Value Measurement.
 

Property and Equipment
 
Property and equipment consists of computer equipment, office furniture and equipment, and software purchased or developed for internal use. Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method based on the estimated useful lives of the assets, which range from three to seven years. Prosper capitalizes expenditures for replacements and betterments and expenses amounts for maintenance and repairs as they are incurred.  Depreciation and amortization commences once the asset is placed in service.
 
Internal Use Software and Website Development

Prosper accounts for internal use software costs, including website development costs, in accordance with ASC Topic 350-40, Internal Use Software and ASC Topic 350-50, Website Development Costs. In accordance with ASC Topics 350-40 and 350-50, the costs to develop software for Prosper’s website and other internal uses are capitalized when management has authorized and committed project funding, preliminary development efforts are successfully completed, and it is probable that the project will be completed and the software will be used as intended. Capitalized software development costs primarily include software licenses acquired, fees paid to outside consultants, and salaries for employees directly involved in the development efforts.
 
Costs incurred prior to meeting these criteria, together with costs incurred for training and maintenance, are expensed. Costs incurred for upgrades and enhancements that are considered to be probable to result in additional functionality are capitalized. Capitalized costs are included in Property and Equipment and amortized using the straight-line method over their expected lives. The Company evaluates its software assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.  Recoverability of software assets to be held and used is measured by a comparison of the carrying amount of the asset to the future net undiscounted cash flows expected to be generated by the asset.  If such software assets are considered to be impaired, the impairment to be recognized is the excess of the carrying amount over the fair value of the software asset.
 
Intangible Assets
 
Prosper records the purchase of intangible assets not purchased in a business combination in accordance with ASC Topic 350. Prosper has an intangible asset resulting from the purchase of the “Prosper.com” domain name.  The intangible asset is amortized on a straight-line basis over five years, which was fully amortized as of September 30, 2011.
 
Impairment of Long-Lived Assets Including Acquired Intangible Assets
 
In accordance with ASC Topic 360, Property Plant and Equipment, Prosper reviews property and equipment and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying values of those assets may not be recoverable.  Recoverability of assets to be held and used is measured by comparing the carrying value of the asset to future net undiscounted cash flows that the assets are expected to generate. If an asset is considered to be impaired, the impairment to be recognized equals the amount by which the asset’s carrying value exceeds its fair value. Fair value is estimated using discounted net cash flows.
 
Repurchase Obligation
 
Prosper is obligated to indemnify lenders and repurchase certain Notes sold to lenders in the event of Prosper’s violation of applicable federal, state, or local lending laws, or verifiable identify theft. The amount of the Note repurchase obligation is estimated based on historical experience. Prosper accrues a provision for the repurchase obligation when the loans are funded. Repurchased Notes and loans  associated with violations of federal, state, or local lending laws, or verifiable identity thefts are written off at the time of repurchase.


Revenue Recognition
 
Prosper recognizes revenue in accordance with ASC Topic 605, Revenue Recognition.  Under ASC Topic 605, Prosper recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price of the services is fixed and determinable and collectability is reasonably assured.
 
Origination Fees

Origination fees are a percentage of the amount borrowed varying by Prosper Rating and are recognized when the loan is funded to the borrower. Effective July 26, 2010, we instituted the following schedule of origination fees: borrowers with a Prosper Rating of AA were charged an origination fee of 0.5% of the aggregate principal balance of the loan with no minimum fee, borrowers with a Prosper Rating of A through B were charged an origination fee of 3% of the aggregate principal balance of the loan or $75 whichever was greater and borrowers with a Prosper Rating of C through HR were charged an origination fee of 4.5% of the aggregate principal balance of the loan or $75,  whichever was greater.  As of December 20, 2010, we modified this fee schedule to eliminate the $75 minimum fee as well as increasing the minimum loan amount to $2,000. Prior to July 26, 2010, borrowers with a Prosper Rating of AA were charged an origination  fee of 0.5% of the aggregate principal balance of the loan with no minimum fee, borrowers with a Prosper Rating of A through HR were charged an origination fee of 3% of the aggregate principal balance of the loan or $50 whichever was greater.
 
Loan servicing fees

Loan servicing revenue includes monthly loan servicing fees and non-sufficient funds (NSF) fees on loans originated prior to October 16, 2008. Loan servicing fees are accrued daily based on the current outstanding loan principal balance of the borrower loan but are not recognized until payment is received due to the uncertainty of collection of borrower loan payments. Our servicing fee is equal to 1.0% of the outstanding principal balance of the corresponding borrower loan.  Prosper charges a NSF fee to borrowers for the first failed payment of each billing period.  NSF fees are charged to the borrower and collected and recognized immediately.

Interest income (expense) on Borrower Loans receivable and Payment Dependent Notes

We recognize interest income on our borrower loan receivable using the accrual method based on the stated interest rate to the extent that we believe it to be collectable.  We record interest expense on the corresponding Payment Dependent Note based on the contractual interest rate. Gross interest income earned and gross interest expense incurred was $2,670,067 and $2,516,166, and $945,830 and $822,110 for the three months ended September 30, 2011 and 2010, respectively.  Gross interest income earned and gross interest expense incurred was $6,089,978 and $5,751,364, and $2,033,703 and $1,855,684 for the nine months ended September 30, 2011 and 2010, respectively.

Advertising and Promotional Expenses
 
Under the provisions of ASC Topic 720, Other Expenses, the costs of advertising are expensed as incurred. Advertising costs were approximately $375,200 and $103,000 for the three months ended September 30, 2011 and 2010, respectively and approximately $1,125,600 and $487,300 for the nine months ended September 30, 2011 and 2010, respectively.
 
Stock-Based Compensation
 
The Company accounts for its stock-based compensation for employees using fair-value-based accounting in accordance with ASC Topic 718, Stock Compensation.  ASC Topic 718 requires companies to estimate the fair value of stock-based awards on the date of grant using an option-pricing model. The stock-based compensation related to an award that is expected to vest is amortized using the straight line method over the vesting term of the award, which is generally four years. Expected forfeitures of unvested options are estimated at the time of grant and reduce the recognized stock-based compensation expense. The forfeitures were estimated based on historical experience. The Company estimated its annual forfeiture rate to be 23.6% and 23.2% for the nine months ended September 30, 2011 and 2010, respectively.
 

Prosper has granted options to purchase shares of common stock to nonemployees in exchange for services performed. Prosper accounts for stock options and restricted stock issued to nonemployees in accordance with the provisions of ASC Topic 505-50, Equity-Based Payments to Non-Employees, which requires that equity awards be recorded at their fair value.  Under ASC Topics 718 and 505-50, Prosper uses the Black-Scholes model to estimate the value of options granted to nonemployees at each vesting date to determine the appropriate charge to stock-based compensation. The volatility of common stock was based on comparative company volatility.
 
The fair value of stock option awards for the nine months ended September 30, 2011 and 2010 was estimated as of  the respective grant dates using the Black-Scholes model with the following average assumptions:

   
Three Months Ended
 
Nine Months Ended
 
September 30,
September 30,
   
2011
 
2010
 
2011
 
2010
Volatility of common stock
 
79.38%
 
67.70%
 
77.59%
 
67.68%
Risk-free interest rate
 
0.74%
 
1.48%
 
0.87%
 
1.79%
Expected life*
 
4.5 years
 
4.4 years
 
4.5 years
 
4.3 years
Dividend yield
 
0%
 
0%
 
0%
 
0%
Weighted-average fair value of grants
 
$0.12
 
$0.20
  
$0.13
  
$0.20

 
*For nonemployee stock option awards, the expected life is the contractual term of the award, which is generally ten years.

The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility. Because Prosper’s equity awards have characteristics significantly different from those of traded options, the changes in the subjective input assumptions can materially affect the fair value estimate.
 
Total stock-based compensation expense for employee and non-employee stock-option awards reflected in the statements of operations for the nine months ended September 30, 2011 and 2010 was approximately $240,930 and $214,340, respectively and $74,188 and $88,215 for the three months ended September 30, 2011 and 2010, respectively.  As of September 30, 2011, the unamortized stock-based compensation expense related to unvested stock-based awards was approximately $428,210 which will be recognized over the remaining vesting period of approximately 3.0 years.
 
Net Loss Per Share
 
Prosper computes net loss per share in accordance with ASC Topic 260 Earnings Per Share. Under ASC Topic 260, basic net loss per share is computed by dividing net loss per share available to common stockholders by the weighted average number of common shares outstanding for the period and excludes the effects of any potentially dilutive securities. Diluted earnings per share, if presented, would include the dilution that would occur upon the exercise or conversion of all potentially dilutive securities into common stock using the “treasury stock” and/or “if converted” methods as applicable. At September 30, 2011, there were outstanding convertible preferred stock, warrants and options convertible into 62,961,391, 1,343,589 and 11,963,780 common shares, respectively, which may dilute future earnings per share. Due to the Company reporting a net loss for the three and nine months ended September 30, 2011 and 2010, there is no calculation of fully-diluted earnings per share as all common stock equivalents are anti-dilutive.



Income Taxes
 
Prosper uses the liability method to account for income taxes. Under this method, deferred income tax assets and liabilities are based on the differences between the financial statements and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.  Under ASC Topic 740, Income Taxes, our policy to include interest and penalties related to gross unrecognized tax benefits within our provision for income taxes did not change.

Fair Value Measurement

Prosper adopted ASC Topic 820 on January 1, 2008. ASC Topic 820 provides a framework for measuring the fair value of assets and liabilities.  ASC Topic 820 also provides guidance regarding a fair value hierarchy, which prioritizes information used to measure fair value and the effect of fair value measurements on earnings and provides for enhanced disclosures determined by the level within the hierarchy of information used in the valuation.  ASC Topic 820 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances.

ASC Topic 820 defines fair value in terms of the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The price used to measure the fair value is not adjusted for transaction costs while the cost basis of certain financial instruments may include initial transaction costs. Under ASC Topic 820, the fair value measurement also assumes that the transaction to sell an asset occurs in the principal market for the asset or, in the absence of a principal market, the most advantageous market for the asset. The principal market is the market in which the reporting entity would sell or transfer the asset with the greatest volume and level of activity for the asset. In determining the principal market for an asset or liability under ASC Topic 820, it is assumed that the reporting entity has access to the market as of the measurement date. If no market for the asset exists or if the reporting entity does not have access to the principal market, the reporting entity should use a hypothetical market.
 
Under ASC Topic 820, assets and liabilities carried at fair value in the balance sheets are classified among three levels based on the observability of the inputs used to determine fair value:

 
Level 1 — The valuation is based on quoted prices in active markets for identical instruments.
 
Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
 
Level 3 — The valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques, which incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument or valuations that require significant management judgment or estimation.

Prosper determines the fair values of its financial instruments based on the fair value hierarchy established in that standard, which requires an entity to maximize the use of quoted prices and observable inputs and to minimize the use of unobservable inputs when measuring fair value. Various valuation techniques are utilized, depending on the nature of the financial instrument, including the use of market prices for identical or similar instruments, or discounted cash flow models.  When possible, active and observable market data for identical or similar financial instruments are utilized. Alternatively, fair value is determined using assumptions that management believes a market participant would use in pricing the asset or liability.

The Company’s financial instruments consist principally of cash and cash equivalents, restricted cash, receivables, loans held for investment, borrower loans, accounts payable and accrued liabilities, and borrower payment dependent notes.  The estimated fair values of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities approximate their carrying values because of their short term nature.
 


The following tables present the assets and liabilities measured at fair value on a recurring basis as of September 30, 2011 and December 31, 2010:

September 30, 2011
 
Level 1 Inputs
 
Level 2 Inputs
 
Level 3 Inputs
 
Fair Value
Assets
                       
    Borrower Loans receivable
   
   
 
$
56,900,829
 
$
56,900,829
    Loans held for investment
             
 
146,748
 
 
146,748
                         
Liabilities
                       
    Borrower Payment Dependent Notes
   
   
 
$
56,333,232
 
$
56,333,232
                 
                 
December 31, 2010
 
Level 1 Inputs
 
Level 2 Inputs
 
Level 3 Inputs
 
Fair Value
Assets
                       
Servicing rights
   
   
 
$
2,986
 
$
2,986
    Borrower Loans receivable
   
   
   
23,689,950
   
23,689,950
                         
Liabilities
                       
    Borrower Payment Dependent Notes
   
   
 
$
23,478,046 
 
$
23,478,046 

As observable market prices are not available for the borrower loans, Notes and loans held for investment, or for similar assets and liabilities, we believe that these assets and liabilities should be considered Level 3 financial instruments under ASC Topic 820.  In a hypothetical transaction as of the measurement date, the Company believes that differences in the principal marketplace in which the loans are originated and the principal marketplace in which the Company might offer those loans may result in differences between the originated amount of the loans and their fair value as of the transaction date.  For borrower loans and loans held for investment, the fair value is estimated using discounted cash flow methodologies based upon valuation assumptions including prepayment speeds, roll rates, recovery rates and discount rates based on the perceived credit risk within each credit grade.

 Our obligation to pay principal and interest on any Note is equal to the loan payments, if any, we receive on the corresponding borrower loan, net of our 1.0% servicing fee.  As such, the fair value of the Note is approximately equal to the fair value of the borrower loans, adjusted for the 1.0% servicing fee.  Any unrealized gains or losses on the borrower loans, loans held for investment and Notes for which the fair value option has been elected is recorded as a separate line item in the statement of operations.  The effective interest rate associated with the Notes will be less than the interest rate earned on the borrower loans due to the 1.0% servicing fee.  See Notes 3 and 4 for a further discussion of the significant assumptions used to value borrower loans, Notes and loans held for investment.



The changes in Level 3 assets measured at fair value on a recurring basis are as follows:
 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
Servicing Rights
 
Borrower Loans
 
Borrower Payment Dependent Notes
 
Loans Held for Investment
 
Total
Balance at January 1, 2011
$
2,986
 
$
23,689,950
 
$
(23,478,046)
 
$
 
$
214,890
Originations
 
   
47,927,629
   
(47,927,629)
   
146,794
   
146,794
Principal repayments
 
   
(16,877,985)
   
16,367,639
 
   
(510,346)
Change in fair value on borrower loans and Payment Dependent Notes
 
   
2,161,235
   
(1,295,196)
 
   
866,039
Change in fair value of servicing rights
 
(2,986)
   
   
 
   
(2,986)
Change in fair value of loans held for investment
                 
(46)
   
(46)
Balance at September 30, 2011
$
 
$
56,900,829
 
$
(56,333,232)
 
$
146,748
 
$
714,345


Balance at January 1, 2010
$
24,319
 
$
7,020,363
 
$
(6,903,173)
 
$
 
$
141,509
Originations
 
 
18,559,333
 
(18,559,333)
 
   
Principal repayments
 
 
(5,633,104)
 
5,413,651
 
   
(219,453)
Change in fair value on borrower loans and Payment Dependent Notes
 
 
(1,671,980)
 
2,069,624
 
   
397,644
Change in fair value of servicing rights
 
(17,599)
 
 
 
   
(17,599)
Balance at September 30, 2010
$
6,720
 
$
18,274,612
 
$
(17,979,231)
 
$
 
$
302,101

3. Loans Held for Investment
 
As of September 30, 2011, we funded and retained a total of approximately $147,000 of borrower loans originated through our platform. When a borrower member loan has been funded in whole, or in part, by us, we retain the portion of the borrower’s monthly loan payment that corresponds to the percentage of the loan that we have funded. In these cases, we record interest income on these borrower loans.

Origination fees earned from borrower loans funded by Prosper are initially deferred and subsequently amortized ratably over the term of the borrower loan and are reported in the statement of operations as Origination fees.

Prosper estimates the fair value of the loans held for investment using discounted cash flow methodologies based upon a set of valuation assumptions similar to those of Borrower Loans, which are set forth in Note 4, as they have similar characteristics and we expect these loans to behave in a comparable manner.  The valuation assumptions the Company used to value these loans include prepayment rates, default rates and recovery rates derived from historical loan performance data and discount rates based on credit grade applied to each loan.

The fair value adjustment on these loans held for investment was $46, which is included in earnings for the three and nine months ended September 30, 2011.  No principal repayments were made on these loans during the current quarter as no loan had reached its first billing cycle as of September 30, 2011.  As of September 30, 2011, there were no loans held for investment that were greater than 90 days delinquent.  Due to the recent origination of these loans, the fair value approximates the carrying value of these loans and the change in fair value attributable to instrument-specific credit risk is immaterial.



4. Borrower Loans and Borrower Payment Notes Held at Fair Value

Prosper estimates the fair value of the borrower loans and Notes using discounted cash flow methodologies based upon a set of valuation assumptions. The main assumptions Prosper used to value the borrower loans and Notes include prepayment rates derived from historical prepayment rates for each credit score, default rates derived from historical performance, recovery rates and discount rates applied to each credit tranche based on the perceived credit risk of each credit grade. Our obligation to pay principal and interest on any Note is equal to the loan payments, if any, we receive on the corresponding borrower loan, net of our 1.0% servicing fee.  As such, the fair value of the Note is approximately equal to the fair value of the borrower loans, adjusted for the 1.0% servicing fee.  The effective interest rate associated with the Notes will be less than the interest rate earned on the borrower loans due to the 1.0% servicing fee.
 
For borrower loans originated and Notes issued after July 13, 2009, we used the following average assumptions to determine the fair value as of September 30, 2011:
 
Monthly prepayment rate speed
1.58%
Recovery rate
5.12%
Discount rate *
8.99%
Weighted average default rate
10.87%
* This is the average discount rate among all of Prosper’s credit grades  


The following table presents additional information about borrower loans and Notes measured at fair value on a recurring basis for the nine months ended September 30, 2011:
 
   
Borrower Loans
   
Notes
 
Fair value at January 1, 2011
 
$
23,689,950
   
$
23,478,046
 
  Originations
   
47,927,629
     
47,927,629
 
  Principal repayments
   
(15,529,097)
     
(15,018,751)
 
Borrower Loans and Notes charged-off during the period
   
(1,348,888)
     
(1,348,888)
 
  Realized and unrealized losses included in earnings
   
2,161,235
     
 
  Realized and unrealized gains included in earnings
   
     
1,295,196
 
Fair value at September 30, 2011
 
$
56,900,829
   
$
55,333,232
 

Due to the recent origination of the borrower loans and Notes, the change in fair value attributable to instrument-specific credit risk is immaterial.  The Company had no originations of borrower loans or issuances of Notes prior to July 13, 2009. Of the loans originated from July 13, 2009 to September 30, 2011, the Company had 627 loans which were 90 days or more delinquent for an aggregate principal amount of $2,256,948 and a fair value of $145,753 as of September 30, 2011.

5. Notes Payable

In 2006, we entered into a non-interest bearing promissory note in the amount of $380,000 for the purchase of the “Prosper.com” domain name. The note was discounted by $109,583 for a net payable of $270,417. The promissory note includes both principal and interest and is payable in annual installments of $20,000 due on the first, second, third, and fourth anniversary of the note and $300,000 due on the fifth anniversary of the note. In June 2011, the promissory note was paid in full. Interest on the note was imputed at an 8% annual rate and is amortized to interest expense over the five year life of the loan.  We recorded amortized interest expense of $11,406 and $16,543 for the nine months ended September 30, 2011 and 2010, respectively.



6. Accrued Liabilities
 
As of September 30, 2011 and December 31, 2010, accrued liabilities consist of the following:

   
September 30,
   
December 31,
 
   
2011
   
2010
 
Legal accruals and fees
  $ 396,199     $ 373,572  
Audit, tax and accounting
    375,696       411,256  
Payroll and benefits
    206,293       161,732  
Loan servicing costs
    350,171       115,364  
Other
    262,322       157,315  
    $ 1,590,681     $ 1,219,239  

 7. Repurchase Obligation
 
Changes in the repurchase obligation are summarized below:

Balance at January 1, 2011
     
$
71,001
 
      Reversal of provision for Loan and Note repurchases
       
(50,644)
 
      Repurchased Loan and Note recoveries during the period
       
1,811
 
Balance at September 30, 2011
     
$
22,168
 
 
 8. Net Loss Per Share
As mentioned in Note 2, the Company computes net loss per share in accordance with ASC Topic 260. Under ASC Topic 260, basic net loss per share is computed by dividing net loss per share available to common stockholders by the weighted average number of common shares outstanding for the period and excludes the effects of any potentially dilutive securities. Diluted earnings per share, if presented, would include the dilution that would occur upon the exercise or conversion of all potentially dilutive securities into common stock using the “treasury stock” and/or “if converted” methods as applicable.

Basic and diluted loss per share was calculated as follows:

   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
   
2011
 
2010
 
2011
 
2010
Numerator:
               
Net loss
 
$
(2,420,537)
 
$
(2,223,016)
 
$
(5,941,094)
 
$
(7,494,302)
Denominator:
               
Weighted average shares used in computing basic and diluted net loss per share
 
4,669,249
 
4,478,667
 
4,583,997
 
4,470,953
Basic and diluted net loss per share
 
$
(0.52)
 
$
(0.50)
 
$
(1.30)
 
$
(1.68)



Due to losses attributable to common stockholders for each of the periods below, the following potentially dilutive shares are excluded from the diluted net loss per share calculation because they were anti-dilutive under the treasury stock method, in accordance with ASC Topic 260:
 
 
September 30,
 
2011
   
2010
Excluded Securities:
       
  Convertible preferred stock issued and outstanding
62,961,391
     
29,738,647
  Stock options issued and outstanding
11,963,780
     
6,419,844
 Warrants issued and outstanding
1,343,589
     
-
Total common stock equivalents excluded from diluted net loss per common share computation
76,268,760
     
36,158,491

9. Stockholders’ Equity
 
Preferred Stock
 
Under Prosper’s certificate of incorporation, preferred stock is issuable in series, and the Board of Directors is authorized to determine the rights, preferences, and terms of each series.
 
In April 2010, Prosper issued and sold 20,340,705 shares of Series D (Series D) and 3,110,188 shares of Series D-1 (Series D-1) convertible preferred stock in a private placement for $14,595,709, which is net of issuance costs of $125,903.  In June 2011, Prosper issued and sold 23,222,747 shares of Series E (Series E) convertible preferred stock in a private placement for $16,702,396, which is net of issuance costs of approximately $447,603.  In connection with that sale, we issued 10,000,000 shares of the Company’s Series E-1 Preferred Stock to certain holders of our Series A, B and C Preferred Stock who participated in the Series E financing.  The E-1 shares were allocated among these stockholders in proportion to their relative participation in the Series E financing.  Upon issuance of our Series E and E-1 preferred stock all shares of our Series D-1 preferred stock were converted to common shares.

Dividends
 
The holders of Series D and Series E Preferred Stock are entitled to receive an annual dividend per share in an amount equal to 8% times the Liquidation Preference for such share, payable in preference and priority to any declaration or payment of any distribution on Common Stock of the Company in such calendar year. Such dividends shall be payable only when, as, and if declared by the Board of Directors. To date, no dividends have been declared, and there are no dividends in arrears at September 30, 2011. The accrued but unpaid cumulative dividends on shares of Series E Preferred Stock shall be paid in preference and priority to the payment of the accrued but unpaid cumulative dividends on shares of Series D Preferred Stock.  The right to receive dividends on shares of Series D Preferred Stock and Series E Preferred Stock are cumulative from and after the date of issuance of such shares.

Conversion

Each share of preferred stock shall automatically be converted into fully-paid, non-assessable shares of common stock at the conversion rate for such share (i) immediately prior to the closing of an underwritten initial public offering at a price per share (prior to underwriting commissions and expenses) that values the Company at least $200,000,000 in an offering with aggregate proceeds to Prosper of at least $40,000,000 (before  deducting underwriters commissions and expenses), pursuant to an effective registration statement filed under the Securities Act of 1933, as amended (the “Securities Act”), covering the offer and sale of Prosper’s common stock, or (ii) upon the receipt of a written request for such conversion from the holders of more than sixty percent (60%) of the voting power of all then outstanding shares of preferred stock, or, if later, the effective date for conversion specified in such requests, provided that shares of Series D shall not be automatically converted pursuant to clause (ii) unless the holders of eighty-two percent (82%) of the outstanding shares of Series D approve such conversion, and shares of Series E shall not be automatically converted pursuant to clause (ii) unless the holders of eighty-two percent (82%) of the outstanding shares of Series E approve such conversion.  In addition, if when a liquidation event occurs, any of a holder’s shares of Series A, Series B or Series C Preferred Stock have been converted into Common Stock, then all shares of Series E-1 Preferred Stock held by such holder shall automatically be converted into fully-paid, non-assessable shares of Common Stock at the then effective conversion rate for such shares immediately prior to such liquidation event. 
 


Liquidation Rights
 
In the event of any sale liquidation, dissolution, or winding up of Prosper, whether voluntary or involuntary, the holders of Series E Preferred Stock shall be entitled to receive, prior and in preference to any distribution of the proceeds to the holders of Series A, Series B, Series C, Series D, Series E-1or Common Stock by reason of their ownership of such stock, an amount per share for each share of Series E Preferred Stock held by them equal to the sum of $0.7385 (as adjusted for any stock dividends, combinations, or splits), plus all declared but unpaid dividends (if any) on such share of Series E Preferred Stock.  If upon such liquidation event, the assets of the Company legally available for distribution to the holders of the Series E Preferred Stock are insufficient to pay the preferential amount specified above, then the entire assets of the Company legally available for distribution shall be distributed with equal priority and pro rata among the holders of the Series E Preferred Stock.

After the payment or setting aside for payment to the holders of Series E Preferred Stock of the preferential amount specified above, the holders of Series D Preferred Stock shall be entitled to receive prior and in preference to any distribution of proceeds to the holders of Series A, Series B, Series C, Series E-1 or Common Stock by reason of their ownership of such stock, an amount per share for each share of Series D Preferred Stock held by them equal to the sum of $0.7385 (as adjusted for any stock dividends, combinations, or splits), plus all declared but unpaid dividends (if any) on such share of Series D Preferred Stock.   After the payment of or settling aside for payment to the of holders of Series E and Series D Preferred Stock of the full amounts specified above, the holders of Series E-1 preferred stock shall be entitled to receive prior and in preference to any distribution of proceeds to the holders of Series A, Series B, Series C or Common Stock by reason of their ownership of such stock an amount per share for each share of Series E-1 Preferred Stock held by them equal to $1.00.

After the payment or setting aside for payment to the holders of Series E, Series D and Series E-1 Preferred Stock specified above, the entire remaining proceeds legally available for distribution shall be distributed pro rata to the holders of Series E Preferred Stock, Series D Preferred Stock and Common Stock in proportion to the number of shares of common stock held by them, assuming for purposes of the calculation that all outstanding shares of Series E and Series D Preferred Stock were converted into Common Stock at the conversion rate then in effect, provided, however, that the maximum aggregate amount per share that may be paid to a holder of Series E or Series D Preferred Stock in connection with a liquidation event will be three times the original issue price for such share.

Voting
 
Holders of preferred stock are entitled to vote on all matters on which holders of Common Stock are entitled to vote.  Each holder of preferred stock is entitled to the number of votes equal to the number of shares of common stock into which such holder’s preferred shares could be converted.  Holders of preferred stock, are entitled to notice of any stockholders’ meeting in accordance with the Bylaws of Prosper. The holders of the preferred stock vote as one class with the holders of common stock, except with respect to certain matters that require separate votes.



Common Stock
 
Prosper is authorized to issue up to 71,417,830 shares of common stock, $0.001 par value, of which 4,669,249 and 4,478,667 shares were issued and outstanding as of September 30, 2011, and December 31, 2010, respectively.  Each holder of common stock shall be entitled to one vote for each share of common stock held.
 
Common Stock Issued upon Exercise of Stock Options

For the nine months ended September 30, 2011 and 2010, the Company issued 100,416 and 18,000 shares of common stock, respectively, upon the exercise of options for cash proceeds of $21,083 and $6,500, respectively.
 
Common Stock Issued upon Exercise of Warrants

For the nine months ended September 30, 2011, the Company issued 90,165 shares of common stock upon the exercise of warrants for cash proceeds of $18,033.  No common stock was issued upon exercise of warrants during the nine months ended September 30, 2010

10. Stock Option Plan and Other Stock Compensation
 
In 2005, Prosper’s Board of Directors, which at such time was comprised of the Company’s sole stockholders, approved the adoption of the 2005 Stock Option Plan (the “Plan”). Under the Plan, options to purchase up to 1,879,468 shares of common stock were reserved for grants to employees, directors, and consultants by the Board of Directors to promote the success of Prosper’s business. On January 31, 2008, the Board of Directors increased the total number of options under the Plan by 500,000 for a total of 2,379,468 options available for grant. On October 6, 2009, the Board of Directors increased the total number of options under the Plan by an additional 500,000 for a total of 2,879,468 options available for grant. On April 15, 2010, the Board of Directors increased the total number of options under the Plan by an additional 6,109,321 for a total of 8,988,789 options available to grant. On June 3, 2011, the Board of Directors increased the total number of options under the Plan by an additional 3,550,875 for a total of 12,539,664 options available to grant.

Incentive stock options are granted to employees at an exercise price not less than 100% of the fair market value of Prosper’s common stock on the date of grant. Nonstatutory stock options are granted to consultants and directors at an exercise price not less than 100% of the fair market value of Prosper’s common stock on the date of grant. If options are granted to a stockholder who hold 10% or more of the combined voting power of all classes of Prosper’s stock on the option grant date, then the exercise price shall not be less than 110% of the fair market value of Prosper’s common stock on the date of grant. The fair market value is based on a good faith estimate by the Board of Directors at the time of each grant. As there is no active trading market for these options, such estimates may ultimately differ from valuations completed by an independent party. The options generally vest over four years, which is the same as the performance period. In no event are options exercisable more than ten years after the date of grant.



Option activity under the Option Plan is summarized as follows for the periods below:

 
Options Issued and Outstanding
 
Weighted-Average Exercise Price
Balance as of January 1, 2010
1,897,126
 
$0.96
     Options granted (weighted average fair value of $0.20)
5,265,897
 
$0.20
     Options exercised
(18,000)
 
$0.36
     Options canceled
(725,179)
 
$0.82
Balance as of September 30, 2010
6,419,844
 
$0.35
       
Balance as of January 1, 2011
5,766,859
 
$0.30
     Options granted (weighted average fair value of $0.13)
6,854,008
 
$0.13
     Options exercised
(100,416)
 
$0.21
     Options canceled
(556,671)
 
$0.25
Balance as of September 30, 2011
11,963,780
 
$0.37
       
Options outstanding and exercisable at September 30, 2011
2,720,766
 
$0.21

Other Information Regarding Stock Options

Additional information regarding common stock options outstanding as of September 30, 2011 is as follows:
 
     
Options Outstanding
   
Options Exercisable
 
Range of Exercise Prices
   
Number Outstanding
   
Weighted Avg. Remaining Life
   
Weighted Avg. Exercise Price
   
Intrinsic Value
   
Number Exercisable
   
Weighted Avg. Exercise Price
   
Intrinsic Value
 
$0.12 - $0.12       5,741,030       9.94     $ 0.12             25,000     $ 0.12        
$0.20 - $0.20       5,349,164       8.83       0.20             1,995,912       0.20        
$0.25 - $0.25       34,158       3.93       0.25             34,158       0.25        
$0.50 - $0.50       304,117       5.12       0.50             304,117       0.50        
$0.56 - $0.56       365,000       7.84       0.56             200,311       0.56        
$1.94 - $1.94       125,311       7.26       1.94             121,373       1.94        
$2.17 - $2.17       45,000       6.44       2.17             39,895       2.17        
          11,963,780       9.20     $ 0.37     $       2,720,766     $ 0.21     $  
 
The intrinsic value is calculated as the difference between the value of Prosper's common stock at September 30, 2011, which was $0.12 per share, and the exercise price of the options.
 
No compensation expense is recognized for unvested shares that are forfeited upon termination of service, and the stock-based compensation expense for the nine months ended September 30, 2011 and 2010 reflect the expenses that Prosper expects to recognize after the consideration of estimated forfeitures.

11. Income Taxes
 
As part of the process of preparing the Company’s financial statements, the Company is required to estimate its income taxes in each of the jurisdictions in which it operates. This process involves determining the Company’s income tax expense (benefit) together with calculating the deferred income tax expense (benefit) related to temporary differences resulting from differing treatment of items, such as deferred revenue or deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the accompanying balance sheet. The Company must then assess the likelihood that the deferred tax assets will be recovered through the generation of future taxable income.
 


Due to the book and tax net losses incurred during the nine months ended September 30, 2011 and 2010, Prosper has not incurred any income tax expense during those periods.  In addition, Prosper has maintained a full valuation allowance against its net deferred tax assets because the realization of those deferred tax assets is dependent upon future earnings, and the amount and timing of those earnings, if any is uncertain.
 
12. Commitments and Contingencies
 
Future minimum lease payments and other commitments
 
Prosper leases its corporate office and co-location facility under noncancelable operating leases that expire in July 2013 and August 2014, respectively. Prosper’s corporate office lease has the option to renew for an additional two years.  Future minimum rental payments under these leases as of September 30, 2011 are as follows:

Remaining three months ended December 31, 2011
 
$
103,896
 
Years ended December 31:
       
2012
   
416,808
 
2013
   
298,357
 
2014
   
86,569
 
Total future operating lease obligations
 
$
905,630
 

Rental expense under premises-operating lease arrangements was approximately $106,248 and $324,852 for the three and nine months ended September 30, 2011, and $108,539 and $322,562 for the corresponding periods during 2010, respectively.

On April 14, 2008, the Company entered into an agreement with a WebBank, Utah-chartered loan company, whereby all loans originated through the Prosper marketplace resulting from listings posted on or after April 15, 2008 are made by WebBank. The arrangement allows for loans to be offered to borrowers at uniform nationwide terms. The Company is required to pay WebBank the greater of a monthly minimum fee or a fee calculated based on a certain percentage of monthly loan origination volume.

On March 3, 2009, the Company entered into an agreement with a third party broker-dealer in which the third party agreed to operate and maintain Prosper’s Note Trader Platform on which lender members may offer their Notes for sale to other lender members.  The Company is required to pay the third party broker-dealer an agreed upon monthly fee which equals the difference between the minimum monthly fee and the transaction fees collected by the third party provider during that month.

Securities Law Compliance

From inception through October 16, 2008, the Company sold approximately $178.1 million of loans to unaffiliated lender members, and $1.0 million of loans to affiliated lender members through the Prosper platform whereby the Company assigned promissory notes directly to lender members. The Company did not register the offer and sale of the promissory notes offered and sold through the Prosper platform under the Securities Act of 1933 or under the registration or qualification provisions of any state securities laws. The Company’s management believes that the question of whether or not the operation of the Prosper platform involved an offer or sale of a “security” involved a complicated factual and legal analysis and was uncertain. If the sales of promissory notes offered through the Company’s platform were viewed as a securities offering, the Company would have failed to comply with the registration and qualification requirements of federal and state laws and lender members who hold these promissory notes may be entitled to rescission of unpaid principal, plus statutory interest. Generally, the federal statute of limitations
for noncompliance with the requirement to register securities under the Securities Act of 1933 is one year from the violation.
 


The Company’s decision to restructure its operations and cease sales of promissory notes offered through the platform effective October 16, 2008 limited this contingent liability to the period covering Prosper's activities prior to October 16, 2008.

The Company has not recorded an accrued loss contingency in connection with the sale of promissory notes to lender members. Accounting for loss contingencies involves the existence of a condition, situation or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future event(s) occur or fail to occur. An estimated loss in connection with a loss contingency shall be recorded by a charge to current operations if both of the following conditions are met: first, the amount can be reasonably estimated; and second, the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements.
 
The Company has assessed the contingent liability related to prior sales of loans on the platform and has determined that the occurrence of the contingency is reasonably possible but not probable and that contingent liability ranges from $0 in the event the Company prevails to a maximum of approximately $45.6 million which represents the remaining outstanding principal amount of $68.3 thousand and loans charged off of approximately $45.5 million as of September 30, 2011.

On November 26, 2008, the Company and the North American Securities Administrators Association (“NASAA”) executed a settlement term sheet relating to Prosper’s alleged unregistered offer and sale of securities through its prior platform.  The term sheet set forth the material terms of a consent order between the Company and the states in which the Company offered loan notes for sale prior to November 2008. On April 21, 2009, the Company and NASAA reached agreement on the final terms of this consent order.  The consent order involves payment by the Company of up to an aggregate of $1.0 million in penalties, which have been allocated among the states based on Prosper’s loan sale transaction volume in each state prior to November 2008. A state that enters into a consent order receives its portion of the $1 million in exchange for its agreement to terminate, or refrain from initiating, any investigation of Prosper’s note sale activities prior to November 2008.  Penalties are paid promptly after a state enters into a consent order. NASAA has recommended that each state enter into a consent order.  However, no state is obliged to do so, and there is no deadline by which a state must make its decision. Prosper is not required to pay any portion of the penalty to those states that do not elect to enter into a consent order. If a state does not enter into a consent order, it is free to pursue its own remedies against the Company, subject to any applicable statute of limitations. As of September 30, 2011, the Company has entered into consent orders with 33 states and has paid an aggregate of $436,717 in penalties to those states.

As of September 30, 2011 and December 31, 2010, the Company had accrued approximately $277,000 and $284,000, respectively, in connection with the contingent liability associated with the states that have not entered into consent orders, in accordance with ASC Topic 450, Contingencies. The methodology applied to estimate the accrual was to divide the $1,000,000 maximum fee pro-rata by state using the Company’s originations from inception through November 2008. A weighting was then applied by state to each state that has not entered into a consent order, assign a likelihood that the penalty will be claimed. In estimating the probability of a claim being made by a state, we considered factors such as the standard terms of the consent orders, whether the state ever gave any indication of concern regarding the sale of promissory notes through our prior platform; the probability of a state electing not to enter into a consent order in order to pursue their own litigation against the Company; whether the penalty is sufficient to compensate a state for the cost of processing the settlement consent order; and finally the impact that current economic conditions have had on state governments. The Company will continue to evaluate this accrual and related assumptions as new information becomes known.

On November 26, 2008, plaintiffs, Christian Hellum, William Barnwell and David Booth, individually and on behalf of all other plaintiffs similarly situated, filed a class action lawsuit against us, certain of our executive officers and our directors in the Superior Court of California, County of San Francisco, California.  The suit was brought on behalf of all loan note purchasers on our online lending platform from January 1, 2006 through October 14, 2008.  The lawsuit alleges that Prosper offered and sold unqualified and unregistered securities in violation of the California and federal securities laws.  The lawsuit seeks class certification, damages and the right of rescission against Prosper and the other named defendants, as well as treble damages against Prosper and the award of attorneys’ fees, experts’ fees and costs, and pre-judgment and post-judgment interest.


Some of the individual defendants filed a demurrer to the First Amended Complaint, which was heard on June 11, 2009 and sustained by the court with leave to amend until July 10, 2009.  The plaintiffs filed a Second Amended Complaint on July 10, 2009, to which the same individual defendants demurred.  On September 15, 2009, this demurrer was sustained by the court without leave to amend.  On February 25, 2011, the plaintiffs filed a Third Amended Complaint, which removed David Booth as a plaintiff and added Brian Russom and Michael Del Greco as plaintiffs.  The new plaintiffs are representing the same putative class and prosecuting the same claims as the previously named plaintiffs. On April 29, 2011, the California Court of Appeal reversed the trial court’s decision sustaining the individual defendants’ demurrer to the Second Amended Complaint. On June 9, 2011, the individual defendants filed a petition before the California Supreme Court seeking review of the Court of Appeal’s opinion.  On July 20, 2011, the California Supreme Court denied that petition.

Prosper’s insurance carrier with respect to the class action lawsuit, Greenwich Insurance Company (“Greenwich”), has denied coverage.  On August 21, 2009, Prosper filed suit against Greenwich in the Superior Court of California, County of San Francisco, California.  The lawsuit sought a declaration that Prosper was entitled to coverage under its policy with Greenwich for losses arising out of the class action lawsuit as well as damages and the award of attorneys’ fees and pre-judgment and post-judgment interest.

On January 26, 2011, the court issued a final statement of decision finding that Greenwich has a duty to defend the class action lawsuit, and requiring that Greenwich pay Prosper's past and future defense costs in the class action suit up to $2 million.  As of September 30, 2011, Greenwich had made payments to Prosper in the amount of $1,896,844 to reimburse Prosper for the defense costs it had already incurred in the class action suit. This reimbursement is reflected in Other Income in our Statement of Operations. Greenwich is required to reimburse Prosper for up to an additional $103,156 in defense costs for the class action suit going forward.  Each such reimbursement will be due within a reasonable period following Prosper incurring any such costs and presenting the applicable invoice to Greenwich.  When a final judgment has been entered on the suit, Greenwich will also be required to pay Prosper pre-judgment interest on the defense costs incurred by Prosper in the class action suit prior to the Court’s decision.  The amount of this pre-judgment interest is $142,584. 

On July 1, 2011, Prosper and Greenwich entered into a Stipulated Order of Judgment pursuant to which Prosper agreed to dismiss its remaining claims against Greenwich.  On August 12, 2011, Greenwich filed a notice of appeal of the court's decision regarding Greenwich’s duty to defend up to $2 million.

We intend to vigorously defend the class action lawsuit.  We cannot, however, presently determine or estimate the final outcome of the lawsuit, and there can be no assurance that it will be finally resolved in our favor.  If the class action lawsuit is not resolved in our favor, we might be obliged to pay damages, and might be subject to such equitable relief as a court may determine.  

As of September 30, 2011, the class action lawsuit is in its preliminary stages and its probable outcome cannot presently be determined, nor can the amount of damages or other costs that might be borne by Prosper be estimated.           



13. Related Parties

Prosper’s executive officers, directors and certain affiliates participate on the Company’s lending platform by placing bids and purchasing Notes originated on the platform.  The aggregate amount of loans purchased and the income earned by these related parties as of September 30, 2011 and 2010 are summarized below:

    Aggregate Amount of Loans Purchased    
Interest Earned on Loans for the Nine Months Ended,
     September 30,   September 30,     September 30,     September 30,
Related Party    2011   2010     2011   2010
Executive officers & management
 
$
1,521,268
 
$
 555,994
 
$
61,987
 
$
9,698
Directors
   
652,789
   
653,487
   
13,511
   
12,200
Affiliates
   
1,139,597
   
167,259
   
60,446
   
383
   
$
3,313,654
 
$
1,376,740
 
$
135,944
 
$
22,281

The Notes purchased by officers, directors and certain affiliates were obtained on the same terms and conditions as those obtained by other Note purchasers.  Of the total aggregate amount of Notes purchased by officers, directors and certain affiliates since inception approximately $178,617 or 5% and $167,417 or 12% of principal has been charged off through September 30, 2011 and 2010, respectively. Prosper earned approximately $6,193 and $1,307 of servicing fees revenue related to these Notes for the nine months ended September 30, 2011 and 2010, respectively.

14. Postretirement Benefit Plans
 
Prosper has a 401(k) plan that covers all employees meeting certain eligibility requirements. The 401(k) plan is designed to provide tax-deferred retirement benefits in accordance with the provisions of Section 401(k) of the Internal Revenue Code. Eligible employees may defer up to 90% of eligible compensation up to the annual maximum as determined by the Internal Revenue Service. Prosper’s contributions to the plan are discretionary. Prosper has not made any contributions to the plan to date.

15. Subsequent Events

Stock Option Plan and Other Stock Compensation

On September 20, 2011, the Compensation Committee of the Board of Directors increased the total number of options under the Plan by an additional 1,000,000 for a total of 13,539,664 options available for grant.  This increase was approved by the Company’s stockholders on October 17, 2011.

Common Stock

On November 2, 2011, Prosper and John Witchel, one of Prosper’s co-founders, entered into a stock repurchase agreement pursuant to which Prosper repurchased from Mr. Witchel 1,800,000 shares of the company’s common stock at a purchase price of $0.16 per share for an aggregate purchase price of $288,000.  The repurchased shares will remain part of the Company’s common stock and be available for future issuance by the Company.

Preferred Stock

On November 3, 2011, Prosper entered into a stock purchase agreement  with certain new investors (the “Share Purchasers”), pursuant to which, Prosper issued and sold to such Share Purchasers  8,996,739 shares of the Company’s Series F Preferred Stock (the “Shares”) for an aggregate purchase price of $9.0 million.  The Share Purchasers included certain investment funds that are affiliated with IDG Capital Partners and Accel Partners. James W. Breyer, who is a member of Prosper’s Board of Directors, is a partner of Accel Partners.

Commitments and Contingencies

On November 3, 2011, Greenwich Insurance Company (“Greenwich”) made a payment to Prosper in the amount of $103,156 to reimburse Prosper for defense costs it had incurred for the Hellum class action lawsuit.  This payment brought the total amount of such payments made by Greenwich to $2 million.  This means that Greenwich has now satisfied its obligations with respect to Prosper’s defense costs for the Hellum suit, with the exception of $142,584 in pre-judgment interest that Greenwich will be required to pay to Prosper when a final judgment has been entered in Prosper’s suit against Greenwich.  Please see Note 12, “Commitments and Contingencies — Securities Law Compliance” for a further discussion of these suits.



 
Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION

This management’s discussion and analysis of financial condition and results of operations, or MD&A, contains forward-looking statements that involve risks and uncertainties. Please see “Forward-Looking Statements” in this Quarterly Report on Form 10-Q for a discussion of the uncertainties, risks and assumptions associated with these statements. This discussion should be read in conjunction with our historical financial statements and related notes thereto and the other disclosures contained elsewhere in this Quarterly Report on Form 10-Q. The results of operations for the periods reflected herein are not necessarily indicative of results that may be expected for future periods, and our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including but not limited to those included elsewhere in this Quarterly Report on Form 10-Q and those included in the “Risk Factors” section and elsewhere in our Annual Report on Form 10-K.
 
Overview

We provide a peer-to-peer online credit marketplace that permits our borrow members to apply for loans and lender members to purchase Notes issued by Prosper, the proceeds of which facilitate the funding of specific loans to borrowers.  Our platform enables our borrower members to request and obtain personal, unsecured loans by posting anonymous “listings” on the platform indicating the principal amount of the desired loan.  Loan terms are subject to minimum and maximum loan amounts determined by the borrower’s credit bureau score and Prosper score, at interest rates set by Prosper.  We assign a Prosper Rating consisting of letter credit grades, based in part on the borrower’s credit score, to each borrower who requests a borrower loan.  Prosper borrower members’ Prosper Rating, credit score range, debt-to-income ratios and other credit data are displayed with their listings and are available for viewing by lender members on an anonymous basis.  Lender members access our platform and “bid” the amount they are willing to commit to the purchase of a Note that is dependent for payment on the corresponding borrower loan, at interest rates set by Prosper.  By making a bid on a listing, a lender member is committing to purchase from Prosper a Note in the principal amount of the lender’s winning bid.  Lender members who purchase the Notes will designate that the sale proceeds be applied to facilitate the funding of the corresponding borrower loan.  Loans originated to borrower members are made by WebBank, an FDIC-insured, Utah-chartered industrial loan company, and sold and assigned to Prosper.
 
All loans requested and obtained by Prosper borrower members through our platform are unsecured obligations of individual borrower members with a fixed interest rate and a loan term currently set at one, three or five years.  With respect to loans resulting from listings posted by Prosper borrower members prior to April 15, 2008 Prosper is the originating lender for licensing and regulatory purposes.  All borrower loans resulting from listings posted on or after April 15, 2008 are funded by WebBank.  After funding a loan, WebBank assigns the loan to Prosper, without recourse to WebBank, in exchange for the principal amount of the borrower loan.  WebBank does not have any obligation to purchasers of the Notes.  We verify the identity of 100%  our borrowers using a variety of methods including credit bureau data, other electronic data sources and offline documentary procedures.  We verify income and or employment on a subset of borrowers based on a proprietary algorithm.  The intention of the algorithm is to verify income or employment in cases where the self reported income of the borrower is highly determinative of the borrowers risk rating.

We derive our operating revenue by charging a transaction fee or origination fee equal to a specified percentage of the principal amount of the borrower loan paid by the borrower upon funding of the loan. The transaction fee is paid to WebBank, and WebBank, in turn, pays Prosper amounts equal to the transaction fees as compensation for its loan origination activities. We also charge lender members a servicing fee equal to an annualized rate set at a percentage of the outstanding principal balance of the corresponding borrower loan, which we deduct from each lender member’s share of the borrower loan payments.
 
 

Our Operating History

We incorporated in Delaware in March 2005 and launched our public website, www.prosper.com on February 13, 2006.  As of September 30, 2011, our platform has facilitated 44,014 borrower loans since its launch totaling an aggregate principal amount of approximately $262,892,000.

We made significant changes to the operation of our lending platform on July 13, 2009.  Prior to October 16, 2008, we purchased loans from WebBank and then sold and assigned the loans to the lender members who bid on the listings for those loans.  From October 16, 2008 through July 12, 2009, we ceased originating loans on our platform while we waited for the Securities and Exchange Commission to declare our registration statement on Form S-1 covering our origination activity effective.  Since July 13, 2009, we retain the loans and issue new securities, the Notes, to the winning lenders.  Our obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan.  We expect to generate increased revenue from borrower origination fees and non-sufficient funds fees and lender members’ servicing fees as our transaction volume increases.  Over time, we expect that the number of borrowers and lender members and the volume of borrower loans originated through our platform will increase.

We have a limited operating history and have incurred net losses since our inception.  Our net loss was $2,420,537 and $2,223,016 for the three months ended September 30, 2011 and 2010, respectively and $5,941,094 and $7,494,302 for the nine months ended September 30, 2011 and 2010, respectively.  We earn revenues primarily from borrower origination fees, non-sufficient funds fees and lender member service fees. At this stage of our development, we have funded our operations primarily with proceeds from equity financings, which are described below under “Liquidity and Capital Resources.”

Our operating plan calls for a continuation of the current strategy of increasing transaction volume to increase revenue until we reach profitability and become cash-flow positive.  In addition, our 2011 operating plan calls for continued investment in the development of our website, loan servicing platform, loan scoring and marketing efforts before we reach profitability.

Our historical financial results and this discussion reflect the structure of our lending platform and our operations both prior to and after July 13, 2009.  For a discussion of the effect of our new structure on our financial statements, see “Borrower Loans and Payment Dependent Notes” under “Critical Accounting Policies and Estimates” below.

Trends and Uncertainties

The peer-to-peer lending industry remains a very innovative and unique industry, and the application of federal and state laws in areas such as securities and consumer finance to our business is still evolving.  We will continue to monitor this evolution actively in order to identify and respond quickly to any legislative or regulatory developments that may impact our platform.

Through the first nine months of 2011, we have increased our origination volume consistently month over month in terms of both units and total dollar amounts.  We hope to continue this trend of growth as our borrower and lender bases continue to strengthen, and become more familiar with our platform.  Over time we expect our lender base to grow as we gain more exposure to potential lenders, and establish our Notes as a viable investment alternative.

As discussed in the notes to our financial statements located elsewhere in this report, we issued and sold 23,222,747 shares of our Series E convertible preferred stock in June 2011 in a private placement for an aggregate of $17.2 million.  We also issued and sold 8,996,739 shares of our Series F convertible preferred stock in November 2011 in a private placement for an aggregate of $9.0 million.  In July 2011 we launched Quick Invest, our loan search tool, to allow lender members to better identify Notes that meet their investment criteria and simplify their user experience in deploying funds on our site.  We continue to invest in software, hardware and website development in order to improve our operating platform and to maintain and enhance our website attractiveness and ease of use.  We have increased headcount across our critical business groups in response to our strategic growth plan while still retaining a flexible and scalable platform to leverage in the future.

 
Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which we have prepared in accordance with U.S. generally accepted accounting principles.  The preparation of financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and the related disclosures.  Prosper bases its estimates on historical experience and on various other assumptions that Prosper believes to be reasonable under the circumstances.  Actual results could differ from those estimates.  Our significant accounting policies which include repurchase obligation, revenue recognition, stock-based compensation, and income taxes are more fully described in Note 2 to our financial statements included elsewhere in this quarterly report.

Critical accounting policies are those policies that we believe present the most complex or subjective measurements and have the most potential to impact our financial position and operating results.  While all
decisions regarding accounting policies are important, we believe that the following policies could be considered critical.

Fair Value Measurement

Under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 820 Fair Value Measurements and Disclosures, which we adopted on January 1, 2008, we determine the fair values of our financial instruments based on the fair value hierarchy established in that standard, which requires an entity to maximize the use of quoted prices and observable inputs and to minimize the use of unobservable inputs when measuring fair value. We use various valuation techniques depending on the nature of the financial instrument, including the use of market prices for identical or similar instruments, or discounted cash flow models.  When possible, active and observable market data for identical or similar financial instruments are utilized. Alternatively, we determine fair value using assumptions that we believe a market participant would use in pricing the asset or liability.

The Company’s financial instruments consist principally of cash and cash equivalents, restricted cash, receivables, loans held for investment, borrower loans, accounts payable and accrued liabilities and borrower payment dependent notes.  The estimated fair values of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities approximate their carrying values because of their short term nature.

We account for our loans held for investment, borrower loans, and borrower payment dependent notes on a fair value basis. We believe, however, that borrower loans and payment dependent notes represent a pertinent element of our current quarter financial statement.  For additional information and discussion regarding our significant accounting policies surrounding fair value measurement, see Note 2, Note 3 and Note 4 to the financial statements included elsewhere in this report.

Borrower Loans and Payment Dependent Notes

On July 13, 2009, we implemented our new operating structure and began issuing Notes.  This operating structure resulted in Prosper purchasing loans from WebBank and holding the loans until maturity.  Prosper issues new securities, the Notes, to the winning lenders.  Prosper’s obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan owned by Prosper.  As a result of these changes, Prosper carries the borrower loans and the Notes on its balance sheet as assets and liabilities, respectively.
 


In conjunction with our new operating structure, we adopted the provisions of ASC Topic 825, Financial Instruments.  ASC Topic 825 permits companies to choose to measure certain financial instruments and certain other items at fair value.  The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings.  We applied the provisions of ASC Topic 825 to the borrower loans and Notes issued subsequent to July 13, 2009 on an instrument by instrument basis.  We did not apply the provisions of ASC Topic 825 to loans issued prior to July 13, 2009.  The aggregate fair value of the borrower loans and Notes are reported as separate line items in the assets and liabilities sections of the  balance sheet using the methods described in ASC Topic 820.

We determine the fair value of the borrower loans and Notes in accordance with the fair value hierarchy established in ASC Topic 820, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  As observable market prices are not available for the borrower loans and Notes we hold or for similar assets and liabilities, we believe the borrower loans and Notes should be considered Level 3 financial instruments under ASC Topic 820.  ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  

In a hypothetical transaction as of the measurement date, we believe that differences in the principal marketplace in which the loans are originated and the principal marketplace in which we might offer those loans may result in differences between the originated amount of the loans and their fair value as of the transaction date. Changes in the fair value of borrower loans and Notes subject to the provisions of ASC Topic 820 are recognized in earnings; fees and costs associated with the origination or acquisition of borrower loans are recognized as incurred.  Prosper estimates the fair value of the borrower loans and Notes using a discounted cash flow methodology based upon a set of valuation assumptions Prosper believes market participants would use for similar assets and liabilities. The main assumptions used to value the borrower loans and Notes include default rates, discount rates applied to each credit tranche/grade, prepayment rates, and recovery rates.

For borrower loans and Notes issued after July 13, 2009, we used the following average assumptions to determine the fair value as of September 30, 2011:
 
Monthly prepayment rate speed
1.58%
Recovery rate
5.12%
Discount rate *
8.99%
Weighted Average Default Rate
10.87%
* This is the weighted average discount rate among all of Prosper’s credit grades



Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at September 30, 2011 for borrower loans and Notes are presented in the following table:
  
         
Payment
 
   
Borrower
   
Dependent
 
   
Loans
   
Notes
 
    Discount rate assumption:      
8.99
%
   
8.99
%
Decrease in fair value and income (loss) to earnings from:
               
100 basis point increase
 
$
(500,600
)
 
$
496,300
 
200 basis point increase
   
(991,200
)
   
982,700
 
                 
Increase in fair value and income (loss) to earnings from:
               
100 basis point decrease
 
$
510,800
   
$
(506,500
)
200 basis point decrease
   
1,032,100
     
(1,023,400
)
                 
                 
    Default rate assumption:
     
10.87
%
   
10.87
%
Decrease in fair value and income (loss) to earnings from:
               
10% higher default rates
 
$
(718,900
)
 
$
712,400
 
20% higher default rates
   
(1,430,800
)
   
1,417,900
 
                 
Increase in fair value  and income (loss) to earnings from:
               
10% lower default rates
 
$
726,000
   
$
(719,500
)
20% lower default rates
   
1,459,000
     
(1,446,000
)
 
Overall, if the fair value of the borrower loans decrease or increase due to any changes in our assumptions, there will also be a corresponding decrease or increase in the fair value of the linked Notes. As a result, the effect on Prosper’s earnings of adverse changes in key assumptions is mitigated. However, the impact of these changes in fair value could have a material adverse impact on lender members’ investments in the Notes.  

As we receive scheduled payments of principal and interest on the borrower loans we will in turn make principal and interest payments on the Notes.  These principal payments will reduce the carrying value of the borrower loans and Notes.  If we do not receive payments on the borrower loans, we are not obligated to and will not make payments on the Notes.  The fair value of a Note is approximately equal to the fair value of the corresponding borrower loan, less the 1.0% service fee.  If the fair value of the borrower loan decreases due to our expectation regarding both the likelihood of default of the loan and the amount of loss in the event of default, there will also be a corresponding decrease in the fair value of the Note (an unrealized gain related to the Note and an unrealized loss related to the borrower loan).

For additional information and discussion, see Note 2 and Note 4 to the financial statements included elsewhere in this report.



Results of Operations
 
Prosper Marketplace, Inc.
Statement of Operations
(Unaudited)
 
   
Three Months Ended September 30,
     
Nine Months Ended September 30,
 
    2011     2010     Change from prior period       2011     2010     Change from prior period  
          As % of Sales          As % of Sales     $ Increase/(Decrease)     %            As % of Sales         As % of Sales            As % of Sales  
Revenues
                                                                 
   Origination fees
  $ 762,000         $ 191,831         $ 570,169       297 %     $ 1,753,852         $ 512,101         $ 1,241,751       242 %
   Loan servicing fees
    3,236           42,250           (39,014 )     (92 %)       22,800           142,870           (120,070 )     (84 %)
   Interest income on Borrower Loans and    Borrower Payment Dependent Notes, net
    153,900           123,720           30,180       24 %       338,614           178,020           160,594       90 %
   Rebates and promotions
    (314,320 )         3,251           (317,571 )     (9768 %)       (759,284 )         (16,617 )         (742,667 )     4469 %
Revenues
    604,816           361,052           243,764       68 %       1,355,982           816,374           539,608       66 %
                                                                                   
Cost of Revenues
                                                                                 
   Cost of services
    (302,999 )   (50 %)     (265,485 )   (74 %)     (37,514 )     14 %       (898,975 )   (66 %)     (668,708 )   (82 %)     (230,267 )     34 %
   Reversal of (Provision for) loan and Note repurchases
    (7,148 )   (1 %)     813     0 %     (7,961 )     (979 %)       50,644     4 %     (26,817 )   (3 %)     77,461       (289 %)
 Net Revenues
    294,669             96,380