UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM
10-Q


(Mark
One)




x
            Quarterly
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934




For the
quarterly period ended December 31, 2010




 ̈
            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 0-26285




CNS
RESPONSE, INC.


(Exact
name of registrant as specified in its charter)




Delaware
                
                87-0419387(State
      or other jurisdiction of
                
                (I.R.S.
      Employerincorporation
      or organization)
                
                Identification
      No.)





85
Enterprise, Suite 410


Aliso
Viejo, CA 92656


(Address
of principal executive offices) (Zip Code)




(949)
420-4400


(Registrant’s
telephone number, including area code)




(Former
name, former address, former fiscal year, if changed since last
report)




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 x                                  No   ̈




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).


Yes  ̈                                  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 the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





Large
      accelerated filer
               ̈
              
              Accelerated
      filer  ̈Non-accelerated
      filer
               ̈
              (Do
      not check if smaller reporting company)
              Smaller
      reporting company x




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).


Yes  ̈                                  No  x




As of
February 11, 2011, the issuer had 56,023,921 shares of common stock, par value
$.001 per share, issued and outstanding.





CNS
RESPONSE, INC.





INDEX
TO FORM 10-Q




PagePART
      I
                
                FINANCIAL
      INFORMATION
                
                3Item
      1.
                
                Financial
      Statements
                
                3Unaudited
      Condensed Consolidated Statements of Operations for the three months ended
      December 31, 2010 and 2009
                
                3Condensed
      Consolidated Balance Sheetsas of December 31, 2010 (unaudited) and
      September 30, 2010
                
                4Unaudited
      Condensed Consolidated Statements of Cash Flows for the three months ended
      December 31, 2010 and 2009
                
                5Unaudited
      Condensed Consolidated Statements of Stockholders’ Equity
      (Deficit)  for the three months ended December 31, 2010 and
      2009
                
                6Notes
      to Unaudited Condensed Consolidated Financial Statements
                
                7Item
      2.
                
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                21Item
      3.
                
                Quantitative
      and Qualitative Disclosures About Market Risk
                
                31Item
      4.
                
                Controls
      and Procedures
                
                31PART
      II
                
                OTHER
      INFORMATION
                
                33Item
      1A.
                
                Risk
      Factors
                
                33Item
      2.
                
                Unregistered
      Sales of Equity Security and Use of Proceeds.
                
                33Item
      5.
                
                Other
      Information
                
                37Item
      6.
                
                Exhibits
                
                37




2


PART
I


FINANCIAL
INFORMATION




Item
      1.
            Financial
      Statements




CNS
RESPONSE, INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS





For the three months ended
                    December 31,2010
                  
                  
                  2009REVENUESNeurometric
      Information Services
                  
                  $
                  27,300
                  
                  
                  $
                  22,400Clinical
      Services
                  
                  
                  120,600
                  
                  
                  
                  121,100147,900
                  
                  
                  
                  143,500OPERATING
      EXPENSESCost
      of neurometric services revenues
                  
                  
                  36,100
                  
                  
                  
                  29,600Research
      and development
                  
                  
                  355,400
                  
                  
                  
                  222,600Sales
      and marketing
                  
                  
                  246,700
                  
                  
                  
                  200,400General
      and administrative
                  
                  
                  1,053,800
                  
                  
                  
                  1,547,700Total
      operating expenses
                  
                  
                  1,692,000
                  
                  
                  
                  2,000,300OPERATING
      LOSS
                  
                  
                  (1,544,100
                  )
                  
                  
                  (1,856,800
                  )OTHER
      INCOME (EXPENSE)Interest
      income (expense), net
                  
                  
                  (2,627,100
                  )
                  
                  
                  (1,600
                  )Financing
      fees
                  
                  
                  (142,700
                  )
                  
                  
                  -Gain
      on derivative liabilities
                  
                  
                  4,217,500
                  
                  
                  
                  -Total
      other income
                  
                  
                  1,447,700
                  
                  
                  
                  ( 1,600
                  )LOSS
      BEFORE  INCOME TAXES
                  
                  
                  (96,400
                  )
                  
                  
                  (1,858,400
                  )Income
      taxes
                  
                  
                  1,300
                  
                  
                  
                  800NET
      LOSS
                  
                  $
                  (97,700
                  )
                  
                  $
                  (1,859,200
                  )NET
      LOSS PER SHARE:Basic
                  
                  $
                  (0.00
                  )
                  
                  $
                  (0.04
                  )Diluted
                  
                  $
                  (0.00
                  )
                  
                  $
                  (0.04
                  )WEIGHTED
      AVERAGE SHARES OUTSTANDING:Basic
                  
                  
                  56,023,921
                  
                  
                  
                  42,584,297Diluted
                  
                  
                  56,023,921
                  
                  
                  
                  42,584,297





See
accompanying Notes to Condensed Consolidated Financial
Statements.


3


CNS
RESPONSE, INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS





(Unaudited) Asat
                      December 31,
                    
                    
                    As at
                      September 30,2010
                    
                    
                    2010ASSETSCURRENT
      ASSETS:Cash
                    
                    $
                    697,800
                    
                    
                    $
                    62,000Accounts
      receivable (net of allowance for doubtful accounts of $20,400 and $10,400
      as of December 31 and September 30, 2010 respectively)
                    
                    
                    51,100
                    
                    
                    
                    48,900Prepaids
      and other
                    
                    
                    45,400
                    
                    
                    
                    84,900Total
      current assets
                    
                    
                    794,300
                    
                    
                    
                    195,800Furniture
      & equipment
                    
                    
                    36,200
                    
                    
                    
                    23,000Other
      assets
                    
                    
                    18,700
                    
                    
                    
                    18,700TOTAL
      ASSETS
                    
                    $
                    849,200
                    
                    
                    $
                    237,500LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts
      payable (including $95,900 and $60,800 to related parties as of December
      31 and September 30, 2010 respectively)
                    
                    $
                    1,239,800
                    
                    
                    $
                    1,383,700Accrued
      liabilities
                    
                    
                    440,600
                    
                    
                    
                    380,700Other
      payable – related party
                    
                    
                    -
                    
                    
                    
                    100,000Deferred
      compensation (including $118,700 and $81,200 to related parties as of
      December 31 and September 30, 2010, respectively)
                    
                    
                    243,300
                    
                    
                    
                    263,600Accrued
      patient costs
                    
                    
                    135,000
                    
                    
                    
                    135,000Accrued
      consulting fees (including $27,000 and $27,000 to related parties as of
      December 31 and September 30, 2010, respectively)
                    
                    
                    86,600
                    
                    
                    
                    86,600Accrued
      interest
                    
                    
                    62,600
                    
                    
                    
                    -Derivative
      liability
                    
                    
                    1,888,300
                    
                    
                    
                    2,061,900Secured
      convertible promissory notes-related party (net of discounts $2,423,700
      and  $1,023,900 as of December 31 and September 30, 2010,
      respectively)
                    
                    
                    600,300
                    
                    
                    
                    -Current
      portion of long-term debt
                    
                    
                    5,600
                    
                    
                    
                    26,900Total
      current liabilities
                    
                    
                    4,702,100
                    
                    
                    
                    4,438,400LONG-TERM
      LIABILITIESCapital
      lease
                    
                    
                    14,900
                    
                    
                    
                    3,400Total
      long-term liabilities
                    
                    
                    14,900
                    
                    
                    
                    3,400TOTAL
      LIABILITIES
                    
                    
                    4,717,000
                    
                    
                    
                    4,441,800COMMITMENTS
      AND CONTINGENCIES
                    
                    
                    -
                    
                    
                    
                    -STOCKHOLDERS'
      EQUITY:Common
      stock, $0.001 par value; authorized 750,000,000 shares; 56,023,921
      shares outstanding as of December 31 and September 30,
2010
                    
                    
                    56,000
                    
                    
                    
                    56,000Additional
      paid-in capital
                    
                    
                    29,543,800
                    
                    
                    
                    29,109,600Accumulated
      deficit
                    
                    
                    (33,467,600
                    )
                    
                    
                    (33,369,900
                    )Total
      stockholders' equity
                    
                    
                    (3,867,800
                    )
                    
                    
                    (4,204,300
                    )TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                    
                    $
                    849,200
                    
                    
                    $
                    237,500





See
accompanying Notes to Condensed Consolidated Financial
Statements.


4


CNS
RESPONSE, INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS





For the three months ended
                                December 31,2010
                              
                              
                              2009CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      loss
                              
                              $
                              (97,700
                              )
                              
                              $
                              (1,859,200
                              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and Amortization
                              
                              
                              2,700
                              
                              
                              
                              2,400Amortization
      of discount on bridge notes issued
                              
                              
                              600,300
                              
                              
                              
                              -Stock-based
      compensation
                              
                              
                              434,200
                              
                              
                              
                              183,800Issuance
      of warrants for financing services
                              
                              
                              82,700
                              
                              
                              
                              -Gain
      on derivative liability valuation
                              
                              
                              (4,217,500
                              )
                              
                              
                              -Non-cash
      interest expense
                              
                              
                              2,021,200
                              
                              
                              
                              -Doubtful
      debt write-off
                              
                              
                              -
                              
                              
                              
                              5,800Changes
      in operating assets and liabilitiesAccounts
      receivable
                              
                              
                              (2,200
                              )
                              
                              
                              (1,500
                              )Prepaids
      and other current assets
                              
                              
                              39,500
                              
                              
                              
                              43,200Accounts
      payable
                              
                              
                              (143,900
                              )
                              
                              
                              (197,800
                              )Accrued
      liabilities
                              
                              
                              122,500
                              
                              
                              
                              (2,000
                              )Deferred
      compensation
                              
                              
                              (20,300
                              )
                              
                              
                              6,800Accrued
      consulting fees
                              
                              
                              -
                              
                              
                              
                              (20,000
                              )Accrued
      patient costs
                              
                              
                              -
                              
                              
                              
                              (107,200
                              )Security
      deposit on new lease
                              
                              
                              -
                              
                              
                              
                              (16,600
                              )Net
      cash used in operating activities
                              
                              
                              (1,178,500
                              )
                              
                              
                              (1,962,300
                              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Acquisition
      of Furniture & Equipment
                              
                              
                              (15,900
                              )
                              
                              
                              -Net
      cash used in operating activities
                              
                              
                              (15,900
                              )
                              
                              
                              -CASH
      FLOWS FROM FINANCING ACTIVITIESRepayment
      of note
                              
                              
                              (24,700
                              )
                              
                              
                              (22,900
                              )Repayment
      of leases
                              
                              
                              (1,000
                              )
                              
                              
                              (500
                              )New
      equipment lease
                              
                              
                              15,900
                              
                              
                              
                              -Net
      proceeds from bridge notes
                              
                              
                              1,840,000
                              
                              
                              
                              -Proceeds
      from sale of common stock, net of  offering
costs
                              
                              
                              -
                              
                              
                              
                              2,922,600Net
      cash provided by financing activities
                              
                              
                              1,830,200
                              
                              
                              
                              2,899,200Net
      increase in cash
                              
                              
                              635,800
                              
                              
                              
                              936,900Cash,
      beginning of period
                              
                              
                              62,000
                              
                              
                              
                              988,100Cash,
      end of period
                              
                              $
                              697,800
                              
                              
                              $
                              1,925,000SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATIONCash  paid
      during the period for:Interest
                              
                              $
                              1,000
                              
                              
                              $
                              1600Income
      taxes
                              
                              $
                              1,300
                              
                              
                              $
                              800





See
accompanying Notes to Condensed Consolidated Financial
Statements.


5


CNS
RESPONSE, INC.


UNAUDITED CONDENSED
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)




Common Stock
                  
                  
                  Additional
                    Paid-in
                  
                  
                  AccumulatedFor the three months ended December 31, 2010
                  
                  Shares
                  
                  
                  Amount
                  
                  
                  Capital
                  
                  
                  Deficit
                  
                  
                  TotalBALANCE
      - September 30, 2010 (Audited)
                  
                  
                  56,023,921
                  
                  
                  $
                  56,000
                  
                  
                  $
                  29,109,600
                  
                  
                  $
                  (33,369,900
                  )
                  
                  $
                  (
      4,204,300
                  )Stock-based
      compensation
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  434,200
                  
                  
                  
                  -
                  
                  
                  
                  434,200Net
      loss for the three months ended December 31, 2010
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (97,700
                  )
                  
                  
                  (97,700
                  )Balance
      at December 31, 2010
                  
                  
                  56,023,921
                  
                  
                  $
                  56,000
                  
                  
                  $
                  29,543,800
                  
                  
                  $
                  (33,467,600
                  )
                  
                  $
                  (3,867,800
                  )





Common Stock
                  
                  
                  Additional
                    Paid-in
                  
                  
                  AccumulatedFor the three months ended December 31, 2009
                  
                  Shares
                  
                  
                  Amount
                  
                  
                  Capital
                  
                  
                  Deficit
                  
                  
                  TotalBALANCE
      - September 30, 2009 (Audited)
                  
                  
                  41,781,129
                  
                  
                  $
                  41,800
                  
                  
                  $
                  24,044,000
                  
                  
                  $
                  (25,195,900
                  )
                  
                  $
                  (
      1,110,100
                  )Stock-based
      compensation
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  183,800
                  
                  
                  
                  -
                  
                  
                  
                  183,800Issuance
      of stock in connection with the Maxim PIPE net of offering cost of
      $505,300
                  
                  
                  11,426,666
                  
                  
                  
                  11,400
                  
                  
                  
                  2,911,200
                  
                  
                  
                  -
                  
                  
                  
                  2,922,600Warrants
      issued in association with the Maxim PIPE
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  7,383,400
                  
                  
                  
                  -
                  
                  
                  
                  7,383,400Offering
      cost pertaining to the Maxim PIPE
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (7,383,400
                  )
                  
                  
                  -
                  
                  
                  
                  (7,383,400
                  )Net
      loss for the three months ended December 31, 2009
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,859,200
                  )
                  
                  
                  (1,859,200
                  )Balance
      at December 31, 2009
                  
                  
                  53,207,795
                  
                  
                  $
                  53,200
                  
                  
                  $
                  27,139,000
                  
                  
                  $
                  (27,055,100
                  )
                  
                  $
                  137,100





See
accompanying Notes to Condensed Consolidated Financial
Statements.


6


CNS
RESPONSE, INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





1.
            NATURE OF
      OPERATIONS





Organization
and Nature of Operations





CNS
Response, Inc. (the “Company”) was incorporated in Delaware on March 16, 1987,
under the name Age Research, Inc.   Prior to January 16, 2007,
the Company (then called Strativation, Inc.) existed as a “shell company” with
nominal assets whose sole business was to identify, evaluate and investigate
various companies to acquire or with which to merge.  On January 16,
2007, the Company entered into an Agreement and Plan of Merger (the “Merger
Agreement”) with CNS Response, Inc., a California corporation formed on January
11, 2000 (“CNS California”), and CNS Merger Corporation, a California
corporation and the Company’s  wholly-owned subsidiary (“MergerCo”)
pursuant to which the Company agreed to acquire CNS California in a merger
transaction wherein MergerCo would merge with and into CNS California, with CNS
California being the surviving corporation (the “Merger”). On March 7, 2007, the
Merger closed, CNS California became a wholly-owned subsidiary of the Company,
and on the same date the corporate name was changed from Strativation, Inc. to
CNS Response, Inc.




The
Company is a web-based neuroinformatic company that utilizes a patented system
that provides data to psychiatrists and other physicians/prescribers to enable
them to make a more informed decision when treating a specific patient with
mental, behavioral and/or addictive disorders.  The Company also
intends to identify, develop and commercialize new indications of approved drugs
and drug candidates for this patient population.




In
addition, as a result of its acquisition of Neuro-Therapy Clinic, Inc. (“NTC”)
on January 15, 2008, the Company provides behavioral health care
services.  NTC is a center for highly-advanced testing and treatment
of neuropsychiatric problems, including learning, attentional and behavioral
challenges, mild head injuries, as well as depression, anxiety, bipolar and all
other common psychiatric disorders. Through this acquisition, the Company
expects to advance neurophysiology data collection, beta-test planned
technological advances in rEEG, advance physician training in rEEG and
investigate practice development strategies associated with rEEG.




Going
Concern Uncertainty




The
accompanying unaudited condensed consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America which contemplate continuation of the company as a
going concern.  The Company has a limited operating history and its
operations are subject to certain problems, expenses, difficulties, delays,
complications, risks and uncertainties frequently encountered in the operation
of a new business. These risks include the failure to develop or supply
technology or services to meet the demands of the marketplace, the ability to
obtain adequate financing on a timely basis, the failure to attract and retain
qualified personnel, competition within the industry, government regulation and
the general strength of regional and national economies.




To date,
the Company has financed its cash requirements primarily from debt and equity
financings.  It will be necessary for the Company to raise additional
funds.  The Company’s liquidity and capital requirements depend on
several factors, including the rate of market acceptance of its services, the
future profitability of the Company, the rate of growth of the Company’s
business and other factors described elsewhere in this Quarterly
Report.  The Company is currently exploring additional sources of
capital but there can be no assurances that any financing arrangement will be
available in amounts and on terms acceptable to the Company.





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES




Basis
of Consolidation




The
unaudited condensed consolidated financial statements of CNS Response, Inc.
(“CNS,” “we,” “us,” “our” or the “Company”) have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission and include all
the accounts of CNS and its wholly owned subsidiaries CNS California and
NTC.  Certain information and note disclosures, normally included in
financial statements prepared in accordance with accounting principles generally
accepted in the United States, have been condensed or omitted pursuant to such
rules and regulations. The unaudited condensed consolidated financial statements
reflect all adjustments, consisting only of normal recurring adjustments,
necessary for a fair statement of our financial position as of December 31, 2010
and our operating results, cash flows, and changes in stockholders’ equity for
the interim periods presented. The September 30, 2010 balance sheet was derived
from our audited consolidated financial statements but does not include all
disclosures required by accounting principles generally accepted in the United
States of America. These unaudited condensed consolidated financial statements
and the related notes should be read in conjunction with our audited
consolidated financial statements and notes for the year ended September 30,
2010 which are included in our current report on Form 10-K, filed with the
Securities and Exchange Commission on December 21, 2010.


7


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The
preparation of financial statements in accordance with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities and revenues and expenses in the
financial statements. Examples of estimates subject to possible revision based
upon the outcome of future events include, among others, recoverability of
long-lived assets and goodwill, stock-based compensation, the allowance for
doubtful accounts, the valuation of equity instruments, use and other taxes.
In
the opinion of management, these unaudited condensed consolidated financial
statements contain all adjustments (consisting of normal recurring adjustments,
except as otherwise indicated) necessary for a fair presentation for the periods
presented as required by Regulation S-X, Rule 10-01.Actual results could
differ from those estimates.





The
results of operations for the three months ended December 31, 2010 are not
necessarily indicative of the results that may be expected for future periods or
for the year ending September 30, 2011.





Derivative
Liabilities





The
Company applies ASC Topic 815-40, “Derivatives and Hedging,” which provides a
two-step model to determine whether a financial instrument or an embedded
feature is indexed to an issuer’s own stock and thus able to qualify for the
scope exception in ASC 815-10-15-74. This standard triggers liability accounting
on all instruments and embedded features exercisable at strike prices based on
future equity-linked instruments issued at a lower rate.  Using the
criteria in ASC 815, the Company determines which instruments or embedded
features that require liability accounting and records the fair values as a
derivative liability. The changes in the values of the derivative liabilities
are shown in the accompanying consolidated statements of operations as “gain
(loss) on change in fair value of derivative liabilities.”





On
September 26, 2010, the Company’s board of directors approved a term sheet to
modify the terms of six convertible notes outstanding at that date in order to
induce additional investment in the form of convertible debt. The original
convertible notes were due in December 2010 with accrued interest at 9%,
convertible into common shares at $0.50 per share and had warrants exercisable
at strike price between $0.50 and $0.56. The Company modified the terms of these
notes to be due 12 months from the modification date with accrued interest at
9%, convertible into common shares at $0.30 per share, 50% warrant coverage
exercisable at $0.30 per share and increased the principal for accrued interest
through the modification date. Both the convertible note and warrants contained
ratchet provisions, which under ASC 815 required bifurcation of the conversion
feature and warrants for derivative liability treatment. As of September 30,
2010 the derivative liability was $2,061,900, which was comprised of the warrant
liability of $889,100 and the debt conversion option liability of
$1,172,800.  During the three months ended December 31, 2010, an
additional $2,000,000 of convertible promissory notes were sold and 3,333,329
warrants issued.  Additionally, all derivative liabilities were
revalued as of December 31, 2010 in accordance with ASC 815.  As of
December 31, 2010, the derivative liability was $1,888,300, which was comprised
of a warrant liability of $1,029,500 and a debt conversion option liability of
$858,800.





Fair
Value of Financial Instruments




ASC
825-10 (formerly SFAS 107, “Disclosures about Fair Value of Financial
Instruments”) defines financial instruments and requires disclosure of the fair
value of financial instruments held by the Company. The Company considers the
carrying amount of cash, accounts receivable, other receivables, accounts
payable and accrued liabilities, to approximate their fair values because of the
short period of time between the origination of such instruments and their
expected realization.





The
Company also analyzes all financial instruments with features of both
liabilities and equity under ASC 480-10 (formerly SFAS 150, “Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity”), ASC 815-10 (formerly SFAS No 133, “Accounting for Derivative
Instruments and Hedging Activities”) and ASC 815-40 (formerly EITF 00-19,
“Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company’s Own Stock”).





The
Company adopted ASC 820-10 (formerly SFAS 157, “Fair Value Measurements”) on
January 1, 2008. ASC 820-10 defines fair value, establishes a three-level
valuation hierarchy for disclosures of fair value measurement and enhances
disclosure requirements for fair value measures. The three levels are defined as
follow:





·
            Level 1   inputs
      to the valuation methodology are quoted prices (unadjusted) for identical
      assets or liabilities in active
  markets.





·
            Level 2   inputs
      to the valuation methodology include quoted prices for similar assets and
      liabilities in active markets, and inputs that are observable for the
      assets or liability, either directly or indirectly, for substantially the
      full term of the financial
instruments.





·
            Level 3   inputs
      to the valuation methodology are unobservable and significant to the fair
      value.


8


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The
Company’s warrant liability is carried at fair value totaling $1,029,500 and
$889,100, as of December 31, 2010 and September 30, 2010,
respectively.  The Company’s conversion option liability is carried at
fair value totaling $858,800 and $1,172,800 as of December 31, 2010 and
September 30, 2010, respectively.  The Company used Level 2 inputs for
its valuation methodology for the warrant liability and conversion option
liability as their fair values were determined by using the Black-Scholes option
pricing model using the following assumptions:





December 31, 2010Annual
      dividend yield
                  
                  
                  -Expected
      life (years)
                  
                  
                  1.0-3.5Risk-free
      interest rate
                  
                  
                  2.02
                  %Expected
      volatility
                  
                  
                  141%-277
                  %





Fair Value
                  
                  Fair Value Measurements atAs of
                  
                  December 31, 2010December 31,
                  
                  Using Fair Value Hierarchy2010
                  
                  Level 1
                  
                  Level 2
                  
                  Level 3LiabilitiesWarrant
      liability
                  
                  $
                  1,029,500
                  
                  
                  $
                  -
                  
                  
                  $
                  1,029,500
                  
                  
                  $
                  -Secured
      convertible promissory note
                  
                  
                  3,023,900
                  
                  
                  
                  
                  
                  
                  
                  3,023,900
                  
                  
                  
                  -Conversion
      option liability
                  
                  
                  858,800
                  
                  
                  
                  -
                  
                  
                  
                  858,800
                  
                  
                  
                  -Total
      accrued derivative liabilities
                  
                  $
                  4,912,200
                  
                  
                  $
                  -
                  
                  
                  $
                  4,912,200
                  
                  
                  $
                  -





As of
December 31, 2010 the Company recognized a gain of $4,217,500 on change in the
fair value of accrued derivative liabilities and did not identify any other
assets or liabilities that are required to be presented on the balance sheet at
fair value in accordance with ASC 825-10.





Reclassifications





Certain
amounts previously reported have been reclassified to conform to the current
period presentation. The reclassifications were made to change the income
statement presentation to provide the users of the financial statements
additional information related to the operating results of the Company. These
reclassifications include reclassifying the Company’s patent costs to
General and Administrative costs, as these patent related expenditures were
previously grouped with Research and Development costs.  The
reclassifications had no effect on consolidated net income or consolidated
assets and liabilities.




Recent
Accounting Pronouncements





In June
2009, the FASB approved its Accounting Standards Codification, or Codification,
as the single source of authoritative United States accounting and reporting
standards applicable for all non-governmental entities, with the exception of
the SEC and its staff. The Codification, which changes the referencing of
financial standards, is effective for interim or annual financial periods ending
after September 15, 2009. Therefore, starting from fiscal year end 2009, all
references made to US GAAP will use the new Codification numbering system
prescribed by the FASB. As the Codification is not intended to change or alter
existing US GAAP, it did not have any impact on the Company’s unaudited
condensed consolidated financial statements.





As a
result of the Company’s implementation of the Codification during the year ended
September 30, 2009, previous references to new accounting standards and
literature are no longer applicable. In the current interim financial
statements, the Company will provide reference to both new and old guidance to
assist in understanding the impact of recently adopted accounting literature,
particularly for guidance adopted since the beginning of the current fiscal year
but prior to the Codification.





In
January 2010, the FASB issued Accounting Standards Update No. 2010-06 (ASU
2010-06), “Fair Value Measurements and Disclosures (Topic 820) – Improving
Disclosures About Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10
that requires new disclosures and provides clarification of existing
disclosures. ASU 2010-06 also includes conforming amendments to the guidance on
employers’ disclosures about postretirement benefit plans assets (Subtopic
715-20). ASU 2010-06 is effective for interim and annual reporting periods
beginning after December 15, 2009, except for the disclosures about purchases,
sales, issuances, and settlements in the roll forward of activity in Level 3
fair value measurements. Those disclosures are effective for fiscal years
beginning after December 15, 2010, and for interim periods within those fiscal
years. The Company does not expect the impact of the adoption of ASU 2010-06 to
have a material impact on its unaudited condensed consolidated financial
statements.


9


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


In
February 2010, the FASB issued Accounting Standards Update No. 2010-09 (“ASU
2010-09”) as amendments to certain recognition and disclosure requirements. The
amendments remove the requirement for an SEC filer to disclose a date in both
issued and revised financial statements. Revised financial statements include
financial statements revised as a result of either correction of an error or
retrospective application of U.S. GAAP. Those amendments remove potential
conflicts with the SEC’s literature. All of the amendments in ASU 2010-09 were
effective upon issuance for interim and annual periods. The adoption of ASU
2010-09 did not have a material impact on the Company’s unaudited condensed
consolidated financial statements.





In April
2010, the FASB issued Accounting Standards Update 2010-12 (“ASU 2010-12”),
“Income Taxes (Topic 740): Accounting for Certain Tax Effects of the 2010 Health
Care Reform Acts”.  After consultation with the FASB, the SEC stated
that it “would not object to a registrant incorporating the effects of the
Health Care and Education Reconciliation Act of 2010 when accounting for the
Patient Protection and Affordable Care Act.” The Company does not expect the
provisions of ASU 2010-12 to have a material impact on the Company’s unaudited
condensed consolidated financial statements.





In April
2010, the FASB issued Accounting Standards Update 2010-13 (“ASU 2010-13”),
Compensation-Stock Compensation (Topic 718): Effect of Denominating the Exercise
Price of a Share-Based Payment Award in the Currency of the Market in Which the
Underlying Equity Security Trades - a consensus of the FASB Emerging Issues Task
Force.  The amendments in this Update are effective for fiscal years,
and interim periods within those fiscal years, beginning on or after December
15, 2010.  Earlier application is permitted.  The Company
does not expect the provisions of ASU 2010-13 to have a material impact on the
Company’s unaudited condensed consolidated financial statements.





3.
            CONVERTIBLE DEBT AND EQUITY
      FINANCINGS





2009 Private Placement Transactions





On August 26, 2009, we received gross
proceeds of approximately $2,043,000 in the first closing of our private
placement transaction with six accredited investors.  Pursuant to
Subscription Agreements entered into with the investors, we sold approximately
38 Investment Units at $54,000 per Investment Unit.  Each “Investment
Unit” consists of 180,000 shares of our common stock and a five year
non-callable warrant to purchase 90,000 shares of our common stock at an
exercise price of $0.30 per share.  After commissions and expenses, we
received net proceeds of approximately $1,792,300 upon the first closing of our
private placement.  On December 24, 2009, we had a second closing of
our private placement in which we received additional gross proceeds of
approximately $2,996,000 from 24 accredited investors.  At the second
closing, we sold approximately 55 Investment Units on the same terms and
conditions as the Investment Units sold at the first closing.  After
commissions and expenses, we received net proceeds of approximately $2,650,400
in connection with this second closing of our private placement.  On
December 31, 2009, we had a third closing of our private placement in which we
received additional gross proceeds of approximately $432,000 from five
accredited investors.  At the third closing, we sold eight Investment
Units on the same terms and conditions as the Investment Units sold at the first
closing. After commissions and expenses, we received net proceeds of
approximately $380,200 in connection with this third closing of our private
placement.  On January 4, 2010, the Company completed its fourth and
final closing of its private placement, resulting in additional gross proceeds
to the Company of $108,000 from two accredited investors.  At this
fourth closing, we sold two Investment Units on the same terms and conditions as
the Investment Units sold at the first closing. After commissions and expenses,
we received net proceeds of approximately $95,000 in connection with this final
closing of our private placement.   These private placement
transactions are described in further detail in “Liquidity and Capital
Resources” below and Note 3 to the audited consolidated financial
statements.




Prior to our private placement, we
raised aggregate proceeds of $1,700,000 in fiscal year 2009 through the issuance
of secured convertible promissory notes on each of March 30, May 14, and June
12, 2009.  Upon the first closing of our private placement on August
26, 2009, these notes were converted into shares of our common stock, as more
fully described in Note 3 of the audited consolidated financial
statements.


10


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


2010
Private Placement Transactions





During
2010 we entered into a series of Bridge Note and Warrant Purchase Agreements as
described in detail below.  On September 26, 2010, the Company’s Board
approved an approximate aggregate offering amount of $3 million by January 31,
2011, including for the exchange of Bridge Notes and Deerwood Notes and interest
on those notes.  The fund raising efforts were successful and new
notes in the aggregate principal amount of approximately $3 million were issued
by November 12, 2010.





Bridge Notes and Warrants





On June 3, 2010, we entered into a
Bridge Note and Warrant Purchase Agreement with John Pappajohn to purchase two
secured promissory notes (each, a “Bridge Note”) in the aggregate principal
amount of $500,000, with each Bridge Note in the principal amount of $250,000
maturing on December 2, 2010.  On June 3, 2010, Mr. Pappajohn loaned
the Company $250,000 in exchange for the first Bridge Note (there were no
warrants issued in connection with this first note) and on July 25, 2010, Mr.
Pappajohn loaned us $250,000 in exchange for the second Bridge
Note.  In connection with his purchase of the second Bridge Note, Mr.
Pappajohn received a warrant to purchase up to 250,000 shares of our common
stock.  The exercise price of the warrant (subject to anti-dilution
adjustments, including for issuances of securities at prices below the
then-effective exercise price) was $0.50 per share.





Pursuant to a separate agreement that
we entered into with Mr. Pappajohn on July 25, 2010, we granted him a right to
convert his Bridge Notes into shares of our common stock at a conversion price
of $0.50.  The conversion price was subject to customary anti-dilution
adjustments, but would never be less than $0.30. Each Bridge Note accrued
interest at a rate of 9% per annum.





Deerwood Notes and
Warrants





On July 5, 2010 and August 20, 2010, we
issued unsecured promissory notes (each, a “Deerwood Note”) in the aggregate
principal amount of $500,000 to Deerwood Partners LLC and Deerwood Holdings LLC,
with each investor purchasing two notes in the aggregate principal amount of
$250,000.  Our director George Kallins and his spouse are the managing
members of these investors.  The Deerwood Notes mature on December 15,
2010.  We received $250,000 in gross proceeds from the issuance of the
first two notes on July 5, 2010 and another $250,000 in gross proceeds from the
issuance of the second two notes on August 20, 2010.   In
connection with the August 20, 2010 transaction, each of the two investors also
received a warrant to purchase up to 75,000 shares of our common stock at an
exercise price (subject to anti-dilution adjustments, including for issuances of
securities at prices below the then-effective exercise price) of $0.56 per
share.




SAIL Venture Partners L.P. (“SAIL”), of
which our director David Jones is a managing partner, issued unconditional
guaranties to each of the Deerwood investors, guaranteeing the prompt and
complete payment when due of all principal, interest and other amounts under
each Deerwood Note.  The obligations under each guaranty were
independent of our obligations under the Deerwood Notes and separate actions
could be brought against the guarantor.  We entered into an oral agreement
to indemnify SAIL and grant to SAIL a security interest in our assets in
connection with the guaranties. In addition, on August 20, 2010, we granted SAIL
warrants to purchase up to an aggregate of 100,000 shares of common stock at an
exercise price (subject to anti-dilution adjustments, including for issuances of
securities at prices below the then-effective exercise price) of $0.56 per
share.




Each Deerwood Note accrued interest at
a rate of 9% per annum and was convertible into shares of our common stock
at a conversion price of $0.50.  The conversion price was subject to
customary anti-dilution adjustments, but would never be less than
$0.30.





October Notes and Warrants




On October 1, 2010, we entered into a
Note and Warrant Purchase Agreement (the “Purchase Agreement”) with John
Pappajohn and SAIL as investors, pursuant to which we issued to the investors
secured convertible promissory notes (the “October Notes”) in the aggregate
principal amount of $1,011,700 and warrants to purchase up to 1,686,144 shares
of common stock. The Company received $500,000 in gross proceeds from the
issuance to these investors of October Notes in the aggregate principal amount
of $500,000 and related warrants to purchase up to 833,332 shares.  We
also issued October Notes in the aggregate principal amount of $511,700, and
related warrants to purchase up to 852,812 shares, to Mr. Pappajohn in exchange
for the cancellation of the two Bridge Notes originally issued to him on June 3,
2010 and July 25, 2010 in the aggregate principal amount of $500,000 (and
accrued and unpaid interest on those notes) and a warrant to purchase up to
250,000 shares originally issued to him on July 25, 2010. The transaction closed
on October 1, 2010.


11


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




On
October 7 and October 12, 2010, a third and fourth accredited investor,
respectively, executed the Purchase Agreement. In connection therewith, we
issued October Notes in the aggregate principal amount of $600,000 and warrants
to purchase up to 999,999 shares of common stock of the Company, to such
investors on those dates.  We received $588,000 in net proceeds from
these investors, after paying $12,000 to the placement agent as described below.
Monarch Capital Group LLC (“Monarch”) acted as non-exclusive placement agent
with respect to the October 12, 2010 placement of October Notes in the aggregate
principal amount of $100,000 and related warrants, pursuant to an engagement
agreement, dated September 30, 2010, between us and Monarch. Under the
engagement agreement, in return for its services as non-exclusive placement
agent, Monarch was entitled to receive (a) a cash fee equal to 10% of the gross
proceeds raised from the sale of October Notes to investors introduced to the
Company by Monarch; (b) a cash expense allowance equal to 2% of the gross
proceeds raised from the sale of October Notes to such investors; and (c)
five-year warrants (the “Placement Agent Warrants”) to purchase common stock of
the Company equal to 10% of the shares issuable upon conversion of October Notes
issued to such investors.  In connection with the October 12, 2010
closing, Monarch received a cash fee of $10,000 and a cash expense allowance of
$2,000 and, on October 25, 2010, received Placement Agent Warrants to purchase
33,333 shares of the Company’s common stock at an exercise price of $0.33 per
share.




On October 21 and October 28, 2010, a
fifth and sixth accredited investor executed the Purchase Agreement. In
connection therewith, we issued October Notes in the aggregate principal amount
of $250,000 and warrants to purchase up to 416,666 shares of common stock to
such investors on that date. We received $250,000 in net proceeds from the
issuance to these investors.




On
November 3, 2010, three affiliated entities, identified below, executed the
Purchase Agreement.  In connection therewith, we issued October Notes
in the aggregate principal amount of $762,300 and warrants to purchase up to
1,270,414 shares of common stock, as follows:  (a) We received
$250,000 in gross proceeds from the issuance to BGN Acquisition Ltd., LP, an
entity controlled by our director George Kallins, of October Notes in the
aggregate principal amount of $250,000 and related warrants to purchase up to
416,666 shares.  (b)  We also issued October Notes in the
aggregate principal amount of $512,300, and related warrants to purchase up to
512,250 shares, to Deerwood Holdings LLC and Deerwood Partners LLC, two entities
controlled by Mr. Kallins, in exchange for the cancellation of the Deerwood
Notes originally issued on July 5, 2010 and August 20, 2010 in the aggregate
principal amount of $500,000 (and accrued and unpaid interest on those notes)
and warrants to purchase an aggregate of up to 150,000 shares originally issued
on August 20, 2010.  The related guaranties and oral indemnification
and security agreement that had been entered into in connection with the
Deerwood Notes were likewise terminated.   SAIL, of which our
director David Jones is a managing partner, issued unconditional guaranties to
each of the Deerwood investors, guaranteeing the prompt and complete payment
when due of all principal, interest and other amounts under the October Notes
issued to such investors.  The obligations under each guaranty are
independent of our obligations under the October Notes and separate actions may
be brought against the guarantor.  In connection with its serving as
guarantor, we granted SAIL warrants to purchase up to an aggregate of 341,498
shares of common stock.  The warrants to purchase 100,000 shares of
common stock previously granted to SAIL on August 20, 2010 were
canceled.




On
November 12, 2010, a tenth accredited investor executed the Purchase
Agreement.  In connection therewith, the Company issued Notes in the
aggregate principal amount of $400,000 and Warrants to purchase up to 666,666
shares of common stock of the Company, to the investor on such
date.   The Company received $352,000 in net proceeds from the
investor.   Monarch acted as non-exclusive placement agent with
respect to the placement of the Note in the aggregate principal amount of
$400,000 and related Warrants, pursuant to the abovementioned engagement
agreement, dated September 30, 2010.  In connection with the November
12, 2010 closing, Monarch received a cash fee of $40,000 and a cash expense
allowance of $8,000 and will receive a Placement Agent Warrant to purchase
133,333 shares of the Company’s common stock at an exercise price of $0.33 per
share.





The
Purchase Agreement provides for the issuance and sale of October Notes, for cash
or in exchange for outstanding convertible notes, in the aggregate principal
amount of up to $3,000,000 plus an amount corresponding to accrued and unpaid
interest on any exchanged notes, and warrants to purchase a number of shares
corresponding to 50% of the number of shares issuable on conversion of the
October Notes.  The agreement provides for multiple closings, but
mandates that no closings may occur after January 31, 2011.  The
Purchase Agreement also provides that the Company and the holders of the October
Notes will enter into a registration rights agreement covering the registration
of the resale of the shares underlying the October Notes and the related
warrants.




The
October Notes mature one year from the date of issuance (subject to earlier
conversion or prepayment), earn interest equal to 9% per year with interest
payable at maturity, and are convertible into shares of common stock of the
Company at a conversion price of $0.30. The conversion price is subject to
adjustment upon (1) the subdivision or combination of, or stock dividends paid
on, the common stock; (2) the issuance of cash dividends and distributions on
the common stock; (3) the distribution of other capital stock, indebtedness or
other non-cash assets; and (4) the completion of a financing at a price below
the conversion price then in effect.  The October Notes are
furthermore convertible, at the option of the holder, into securities to be
issued in subsequent financings at the lower of the then-applicable conversion
price or price per share payable by purchasers of such
securities.  The October Notes can be declared due and payable upon an
event of default, defined in the October Notes to occur, among other things, if
the Company fails to pay principal and interest when due, in the case of
voluntary or involuntary bankruptcy or if the Company fails to perform any
covenant or agreement as required by the October Note.




Our
obligations under the terms of the October Notes are secured by a security
interest in the tangible and intangible assets of the Company, pursuant to a
Security Agreement, dated as of October 1, 2010, by and between us and John
Pappajohn, as administrative agent for the holders of the October
Notes.  The agreement and corresponding security interest terminate if
and when holders of a majority of the aggregate principal amount of October
Notes issued have converted their October Notes into shares of common
stock.


12


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The
warrants related to the October Notes expire seven years from the date of
issuance and are exercisable for shares of common stock of the Company at an
exercise price of $0.30.  Exercise price and number of shares issuable
upon exercise are subject to adjustment (1) upon the subdivision or combination
of, or stock dividends paid on, the common stock; (2) in case of any
reclassification, capital reorganization or change in capital stock and (3) upon
the completion of a financing at a price below the exercise price then in
effect.Any provision
of the October Notes or related warrants can be amended, waived or modified upon
the written consent of the Company and holders of a majority of the aggregate
principal amount of such notes outstanding.  Any such consent will
affect all October Notes or warrants, as the case may be, and will be binding on
all holders thereof.




The
Placement Agent Warrants have an exercise price equal to 110% of the conversion
price of the Notes and an exercise period of five years.  The terms of
the Placement Agent Warrants, except for the exercise price and period, are
identical to the terms of the warrants related to the October
Notes.




In issuing the securities described in
this section without registration under the Securities Act, the Company relied
upon the exemption from registration contained in Section 4(2) of the Securities
Act and in Regulation D promulgated thereunder, as the
securities  were issued to accredited investors, without a view to
distribution, and were not issued through any general solicitation or
advertisement.




As of
December 31, 2010 outstanding convertible promissory notes were $3,023,900
(including $23,900 corresponding to accrued and unpaid interest on the exchanged
notes) and derivative liability was $2,061,900. During the three month period
ended December 31, 2010 the Company amortized $600,300 of debt
discount.


4.
            STOCKHOLDERS’
      EQUITY




Common
and Preferred Stock




As of
December 31, 2010 the Company is authorized to issue 750,000,000 shares of
common stock.




As of
December 31, 2010, CNS California is authorized to issue 100,000,000 shares of
two classes of stock, 80,000,000 of which was designated as common shares and
20,000,000 of which was designated as preferred shares.




As of
December 31, 2010, Colorado CNS Response, Inc. is authorized to issue 1,000,000
shares of common stock.




As of
December 31, 2010, Neuro-Therapy Clinic, Inc., a wholly-owned subsidiary of
Colorado CNS Response, Inc., is authorized to issue 10,000 shares of common
stock, no par value per share.




Stock-Option
Plan




On August
3, 2006, CNS California adopted the CNS California 2006 Stock Incentive Plan
(the “2006 Plan”). The 2006 Plan provides for the issuance of awards in the form
of restricted shares, stock options (which may constitute incentive stock
options (ISO) or non-statutory stock options (NSO), stock appreciation rights
and stock unit grants to eligible employees, directors and consultants and is
administered by the board of directors. A total of 10 million shares of stock
were initially reserved for issuance under the 2006
Plan.




The 2006
Plan initially provided that in any calendar year, no eligible employee or
director shall be granted an award to purchase more than 3 million shares of
stock. The option price for each share of stock subject to an option shall be
(i) no less than the fair market value of a share of stock on the date the
option is granted, if the option is an ISO, or (ii) no less than 85% of the fair
market value of the stock on the date the option is granted, if the option is a
NSO; provided, however, if the option is an ISO granted to an eligible employee
who is a 10% shareholder, the option price for each share of stock subject to
such ISO shall be no less than 110% of the fair market value of a share of stock
on the date such ISO is granted. Stock options have a maximum term of ten years
from the date of grant, except for ISOs granted to an eligible employee who is a
10% shareholder, in which case the maximum term is five years from the date of
grant. ISOs may be granted only to eligible employees.




On March
3, 2010, the Board of Directors approved an amendment to the 2006 Plan which
increased the number of shares reserved for issuance under the 2006 Plan from 10
million to 20 million shares of stock.  The amendment also increased
the limit on shares issued within a calendar year to any eligible employee or
director from 3 million to 4 million shares of stock.  The amendment
was approved by shareholders at the annual meeting held on April 27,
2010.




On March
3, 2010, the Board of Directors also approved the grant of 9,150,000 options to
staff members, directors, advisors and consultants, of which 8,650,000 were in
fact granted.  For staff members the options will vest equally over a
48 month period while for directors, advisors and consultants the options will
vest equally over a 36 month period.  The effective grant date for
accredited investors was March 3, 2010 and the exercise price of $0.55 per share
was based on the quoted closing share price of the Company’s stock at the time
of grant.  For non-accredited investors the grant date will be
determined at some time after obtaining a permit from the State of California
allowing the granting of options to non-accredited investors.  This
permit was granted by the State of California in July 2010.  No
options have been granted to non-accredited investors at this
time.


13


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


On July
5, 2010, the Board of Directors also approved an additional grant of 800,000
options to a new member of the executive management team, a new member of the
board of directors and a new advisor to the Company.  The respective
vesting periods are the same as those for the abovementioned March 3, 2010
grants.  The effective grant date for these accredited investors was
July 5, 2010 and the exercise price of $0.40 per share was based on the quoted
closing share price of the Company’s stock on July 2, 2010 as markets were
closed for the 4th of July
holiday weekend.





As of
December 31, 2010, 2,124,740 options were exercised and there were 15,250,121
options and 183,937 restricted shares outstanding under the amended 2006 Plan
leaving 2,441,202 shares available for issuance of future awards.




Stock-based
compensation expense is recognized over the employees’ or service provider’s
requisite service period, generally the vesting period of the award. Stock-based
compensation expense included in the accompanying statements of operations for
the periods ended December 31, 2010 and 2009 is as follows:





For the three months ended December 31,2010
                      
                      
                      2009Operations
                      
                      $
                      2,500
                      
                      
                      $
                      4,000Research
      and development
                      
                      
                      89,300
                      
                      
                      
                      65,000Sales
      and marketing
                      
                      
                      66,900
                      
                      
                      
                      29,600General
      and administrative
                      
                      
                      275,500
                      
                      
                      
                      85,200Total
                      
                      $
                      434,200
                      
                      
                      $
                      183,800





Total
unrecognized compensation as of December 31, 2010 amounted to
$3,834,400.





A summary
of stock option activity is as follows:





Number of
                  Shares
                
                Weighted Average
                  Exercise PriceOutstanding
      at September 30, 2010
                
                
                15,670,973
                
                
                $
                0.62Granted
                
                
                -
                
                
                $
                -Exercised
                
                
                -
                
                
                $
                -Forfeited
                
                
                (420,852
                )
                
                $
                0.69Outstanding
      at December 31, 2010
                
                
                15,250,121
                
                
                $
                0.62




Following
is a summary of the status of options outstanding at September 30,
2010:





Exercise Price
                    
                    Number of Shares
                    
                    Weighted Average
                      Contractual Life
                    
                    Weighted Average
                      Exercise Price$0.12
                    
                    
                    859,270
                    
                    10
      years
                    
                    $
                    0.12$0.132
                    
                    
                    987,805
                    
                    7
      years
                    
                    $
                    0.132$0.30
                    
                    
                    135,700
                    
                    10
      years
                    
                    $
                    0.30$0.59
                    
                    
                    28,588
                    
                    10
      years
                    
                    $
                    0.59$0.80
                    
                    
                    140,000
                    
                    10
      years
                    
                    $
                    0.80$0.89
                    
                    
                    968,875
                    
                    10
      years
                    
                    $
                    0.89$0.96
                    
                    
                    352,974
                    
                    10
      years
                    
                    $
                    0.96$1.09
                    
                    
                    2,513,549
                    
                    10
      years
                    
                    $
                    1.09$1.20
                    
                    
                    243,253
                    
                    5
      years
                    
                    $
                    1.20$0.51
                    
                    
                    41,187
                    
                    10
      years
                    
                    $
                    0.51$0.40
                    
                    
                    856,000
                    
                    10
      years
                    
                    $
                    0.40$0.55
                    
                    
                    8,122,920
                    
                    10
      years
                    
                    $
                    0.55Total
                    
                    
                    15,250,121
                    
                    
                    
                    $
                    0.62


14


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Warrants
to Purchase Common Stock




At
October 1, 2009, there were warrants outstanding to purchase 15,537,485
shares.  During the year ended September 30, 2010, a further 9,300,161
warrants were granted, of which 500,000 were cancelled and replaced with
1,706,560 warrants pursuant to the Note and Warrant Purchase agreement dated
October 1, 2010 as described below and in note 3.  Furthermore
3,333,333 warrants were exercised.  The warrant activity is described
as follows:





Warrants to Purchase
                                
                                Exercise
                                  Price
                                
                                Issued in Connection With:5,893,334
      shares
                                
                                $
                                0.30
                                
                                Associated
      with the second, third and fourth closing of the private placement
      transaction of 11,786,667 shares at $0.30 with 50% warrant coverage as
      described in Note 31,200,267
      shares
                                
                                $
                                0.33
                                
                                Associated
      with warrants for the lead and secondary placement agents for private
      placement as described in Note 3(3,333,333)
      shares
                                
                                $
                                0.30
                                
                                These
      warrants were surrendered in a net issue exercise and 2,456,126 shares
      were issued in lieu of cash.500,000
      shares
                                
                                $
                                0.30
                                
                                These
      warrants were granted to individual staff members of Equity Dynamics, Inc.
      a Company owned by Mr. Pappajohn, for their efforts in providing
      consulting services associated with the Company’s financing
      activities.852,812
      shares
                                
                                $
                                0.30
                                
                                These
      warrants were issued to Mr. John Pappajohn, a Director of the Company,
      pursuant to the October 1, 2010 Note and Warrant Purchase agreement
      described in note 3; whereby two outstanding convertible notes of $250,000
      each, issued on June 3 and July 25, 2010 respectively, and 250,000
      outstanding warrants issued on July 25, 2010, with an exercise price of
      $0.50 were cancelled and exchanged on October 1, 2010 for two new notes of
      $250,000 each plus unpaid interest and warrants to purchase 852,812 shares
      of common stock.256,125
      shares
                                
                                $
                                0.30
                                
                                These
      warrants were issued to Deerwood Partners, LLC which is controlled by Dr.
      George Kallins, a Director of the Company, pursuant to the October 1, 2010
      Note and Warrant Purchase agreement described in note 3; whereby two
      outstanding convertible notes of $125,000 each, issued on July 5 and
      August 20, 2010 respectively, and 75,000 outstanding warrants issued on
      August 20, 2010, with an exercise price of $0.56 were cancelled and
      exchanged on November 3, 2010 for two new notes of $125,000 each plus
      unpaid interest and warrants to purchase 256,125 shares of common
      stock.256,125
      shares
                                
                                $
                                0.30
                                
                                These
      warrants were issued to Deerwood Holdings, LLC which is controlled by Dr.
      George Kallins, a Director of the Company, pursuant to the October 1, 2010
      Note and Warrant Purchase agreement described in note 3; whereby two
      outstanding convertible notes of $125,000 each, issued on July 5 and
      August 20, 2010 respectively, and 75,000 outstanding warrants issued on
      August 20, 2010, with an exercise price of $0.56 were cancelled and
      exchanged on November 3, 2010 for two new notes of $125,000 each plus
      unpaid interest and warrants to purchase 256,125 shares of common
      stock.341,498
      shares
                                
                                $
                                0.30
                                
                                These
      warrants were issued to SAIL, of which Mr. David Jones, a Director of the
      Company, is a managing partner. SAIL had undertaken to guarantee the four
      abovementioned Deerwood notes which were issued on July 5 and August 20,
      2010. For this guarantee SAIL was issued 100,000 warrants on August 20,
      2010 with an exercise price of $0.56. Upon the cancellation and exchange
      of the Deerwood notes on November 3, 2010, SAIL undertook to guarantee the
      four new Deerwood notes in exchange for the cancellation of the SAIL’s
      100,000 outstanding warrants which were replaced with new
      341,498.




15


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


At
September 30, 2010, there were warrants outstanding to purchase 21,504,313
shares of the Company’s common stock which includes a net 1,206,560 shares which
were the result of the cancellation and reissuance of warrants in accordance
with the Note and Warrant Purchase Agreement of October 1, 2010 detailed above
and in Note 3.





For the
three months ended December 31, 2010, no warrants were exercised and an
additional 3,499,995 warrants were issued as follows:





3,333,329
      shares
                    
                    $
                    0.30
                    
                    These
      warrants were issued to eight investors who purchased notes for $2,222,220
      pursuant to the October 1, 2010 Note and Warrant Purchase agreement
      described in note 3. These investors included three directors of the
      Company, Mr. David Jones, Mr. John Pappajohn and Dr. George Kallins, each
      of whom purchased notes for $250,000 ($750,000 in aggregate) either
      directly or through an entity that they control.166,666
      shares
                    
                    $
                    0.33
                    
                    These
      warrants were issued Monarch Capital who acted as placement agents in
      raising $500,000 from two investors who purchase notes pursuant to the
      Note and Warrant Purchase agreement described in note
  3.





At
December 31, 2010, there were warrants outstanding to purchase 25,004,308 shares
of the Company’s common stock.  The exercise price of the outstanding
warrants range from $0.01 to $1.812 with a weighted average exercise price of
$0.52.  The warrants expire at various times through
2017.





5.
            RELATED
      PARTY TRANSACTIONS





As at
December 31, 2010, accrued consulting fees included $27,000 due to a director in
accordance with a 12 month consulting agreement, the term of which ended on
December 31, 2010.  In December, 2010 a payment of $9,000 was made to
that director in connection with the consulting agreement. The consulting
agreement was automatically renewed effective January 1, 2011.


16


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


On June
3, 2010, the Company entered into a Bridge Note and Warrant Purchase Agreement
with John Pappajohn to purchase two secured promissory notes in the aggregate
principal amount of $500,000. For further detail, please refer to the section
2010 Promissory Note
Transactionsin Note 3 above.





On July
5, 2010 and August 20, 2010, the Company issued unsecured promissory notes
(each, a “Deerwood Note”) in the aggregate principal amount of $500,000 to
Deerwood Partners LLC and Deerwood Holdings LLC, which are entities controlled
by Dr George Kallins.  For further detail, please refer to the section
2010 Promissory Note
Transactionsin Note 3 above.





On July
5, 2010 the Board granted warrants to purchase 500,000 shares of common stock to
members of staff of Equity Dynamics, Inc, a company owned by Mr. Pappajohn, for
consulting services they had rendered to the Company, advising on and assisting
with fund raising activities.  Using the Black-Scholes model, these
warrants were valued at $199,000 and expensed to consulting
fees.   These warrants have an exercise price of $0.30 cents per
share, are exercisable from the date of grant and have a term of 10 years from
the date of grant.




On
October 1, 2010, the Company entered into a Bridge Note and Warrant Purchase
Agreement with John Pappajohn to purchase a secured promissory note in the
principal amount of $250,000. Additionally, the Company entered into a Bridge
Note and Warrant Purchase Agreement with SAIL Venture Partners, LLP, of which
our Director, David Jones, is a managing partner, to purchase a secured
promissory note in the principal amount of $250,000.  For further
detail, please refer to the section 2010 Promissory Note Transactionsin Note 3 above.





On
November 3, 2010, the Company entered into a Bridge Note and Warrant Purchase
Agreement with BGN Acquisitions Ltd. LP, of which our Director, Dr. George
Kallins, is the general partner, to purchase a secured promissory note in the
principal amount of $250,000. For further detail, please refer to the section
2010 Promissory Note
Transactionsin Note 3 above.





On
November 24, 2010 the Board of Directors, excluding Mr. Pappajohn, resolved to
ratify an engagement agreement with Equity Dynamics, Inc. a company owned by Mr.
Pappajohn, to provide financial advisory services to assist the Company with the
Company’s fund raising efforts.  These efforts have included advice
and assistance with the preparation of Private Placement Memoranda, investor
presentations, financing strategies, identification of potential and actual
investors, and introductions to placement agents and investment bankers. The
engagement agreement calls for a retainer fee of $10,000 per month starting
February 1, 2010.  As of December 31, 2010 the Company had accrued
$110,000 for the services provided by Equity Dynamics of which $60,000 has been
paid, leaving $50,000 due and outstanding as at December 31,
2010.  The term of the agreement is for 12 months from its initiation
and can be cancelled by either party, with or without cause, with 30 days
written notice.





6.
            REPORTABLE
      SEGMENTS





The
Company operates in two business segments:  referenced neurometric
information services and clinical services.  Neurometric Information
Services (formerly called Laboratory Information Services), provides data to
psychiatrists and other physicians/prescribers to enable them to make a more
informed decision when treating a specific patient with mental, behavioral
and/or addictive disorders provides reports (“rEEG Reports”).  Clinic
operates NTC, a full service psychiatric practice.





The
following tables show operating results for the Company’s reportable segments,
along with reconciliation from segment gross profit to (loss) from operations,
the most directly comparable measure in accordance with generally accepted
accounting principles in the United States, or GAAP:





Three months ended December 31, 2010Reference
                              Neurometric
                            
                            
                            Clinic
                            
                            
                            Eliminations
                            
                            
                            TotalRevenues
                            
                            
                            34,400
                            
                            
                            
                            120,600
                            
                            
                            
                            (7,100
                            )
                            
                            
                            147,900Operating
      expenses:Cost
      of revenues
                            
                            
                            36,100
                            
                            
                            
                            7,100
                            
                            
                            
                            (7,100
                            )
                            
                            
                            36,100Research
      and development
                            
                            
                            355,400
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            355,400Sales
      and marketing
                            
                            
                            243,700
                            
                            
                            
                            3,000
                            
                            
                            
                            -
                            
                            
                            
                            246,700General
      and administrative
                            
                            
                            832,700
                            
                            
                            
                            221,100
                            
                            
                            
                            
                            
                            
                            
                            1,053,800Total
      operating expenses
                            
                            
                            1,467,900
                            
                            
                            
                            231,200
                            
                            
                            
                            (7,100
                            )
                            
                            
                            1,692,000Loss
      from operations
                            
                            $
                            (1,433,500
                            )
                            
                            $
                            (110,600
                            )
                            
                            $
                            -
                            
                            
                            $
                            (1,544,100
                            )


17


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Three months ended December 31, 2009Reference
                  Neurometric
                
                
                Clinic
                
                
                Eliminations
                
                
                TotalRevenues
                
                
                26,400
                
                
                
                154,400
                
                
                
                (37,300
                )
                
                
                143,500Operating
      expenses:Cost
      of revenues
                
                
                29,600
                
                
                
                4,000
                
                
                
                (4,000
                )
                
                
                29,600Research
      and development
                
                
                233,200
                
                
                
                -
                
                
                
                -
                
                
                
                233,200Sales
      and marketing
                
                
                198,400
                
                
                
                2,000
                
                
                
                -
                
                
                
                200,400General
      and administrative
                
                
                1,422,000
                
                
                
                148,400
                
                
                
                (33,300
                )
                
                
                1,537,100Total
      operating expenses
                
                
                1,883,200
                
                
                
                154,400
                
                
                
                (37,300
                )
                
                
                2,000,300Loss
      from operations
                
                $
                (1,856,800
                )
                
                $
                -
                
                
                $
                -
                
                
                $
                (1,856,800
                )




The
following table includes selected segment financial information as of December
31, 2010, related to total assets:





Reference
                    Neurometric
                  
                  
                  Clinic
                  
                  
                  TotalTotal
      assets
                  
                  $
                  810,500
                  
                  
                  $
                  38,700
                  
                  
                  $
                  849,200





7.
            EARNINGS PER
      SHARE





In
accordance with ASC 260-10 (formerly SFAS 128, “Computation of Earnings Per
Share”), basic net income (loss) per share is computed by dividing the net
income (loss) to common stockholders for the period by the weighted average
number of common shares outstanding during the period. Diluted net income (loss)
per share is computed by dividing the net income (loss) for the period by the
weighted average number of common and dilutive common equivalent shares
outstanding during the period.  For the three months ended December
31, 2010 and 2009, the Company has excluded all common equivalent shares from
the calculation of diluted net loss per share as such securities are
anti-dilutive.




A summary
of the net income (loss) and shares used to compute net income (loss) per share
for the three months ended December 31, 2010 and 2009 is as
follows:




2010
                
                
                2009Net
      loss for computation of basic net income (loss) per share
                
                $
                (97,700
                )
                
                $
                (1,859,200
                )Net
      income (loss) for computation of dilutive net income (loss) per
      share
                
                $
                (97,700
                )
                
                $
                (1,859,200
                )Basic
      net income (loss) per share
                
                $
                0.00
                
                
                $
                (0.04
                )Diluted
      net income (loss) per share
                
                $
                0.00
                
                
                $
                (0.04
                )Basic
      weighted average shares outstanding
                
                
                56,023,921
                
                
                
                42,584,297Dilutive
      common equivalent shares
                
                
                -
                
                
                
                -Diluted
      weighted average common shares
                
                
                56,023,921
                
                
                
                42,584,297Anti-dilutive
      common equivalent shares not included in thecomputation
      of dilutive net loss per share:Convertible
      debt
                
                
                2,611,595
                
                
                
                -Warrants
                
                
                24,322,648
                
                
                
                16,089,296Options
                
                
                15,551,655
                
                
                
                6,630,174


18


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


8.
            COMMITMENTS AND CONTINGENT
      LIABILITIES





Litigation




From time
to time, the Company may be involved in litigation relating to claims arising
out of the Company’s operations in the ordinary course of business. Other than
as set forth below, the Company is not currently party to any legal proceedings,
the adverse outcome of which, in the Company’s management’s opinion,
individually or in the aggregate, would have a material adverse effect on the
Company’s results of operations or financial position.





Since
June of 2009, the Company has been involved in litigation against Leonard J.
Brandt, a stockholder, former director and the Company’s former Chief Executive
Officer (“Brandt”) in the Delaware Chancery Court and the United States District
Court for the Central District of California.  At the conclusion of a
two-day trial that commenced December 1, 2009, the Chancery
Court entered judgment for the Company and dismissed with prejudice
Brandt's action brought pursuant to Section 225 of the Delaware General
Corporation Law, which sought to oust the incumbent directors other than
Brandt.  The Chancery Court thereby found that the purported special
meeting of stockholders convened by Brandt on September 4, 2009 was not valid
and that the directors purportedly elected at that meeting are not entitled to
be seated.  On January 4, 2010, Brandt filed an appeal with the
Supreme Court of the State of Delaware in relation to the case.  On
April 20, 2010, the Delaware Supreme Court affirmed the ruling of the Chancery
Court.




The Chancery
Court also denied an injunction sought by Mr. Brandt to prevent the voting
of shares issued by the Company in connection with the Company’s bridge
financing in June 2009, and securities offering in August 2009, and dismissed
Brandt's claims regarding those financings and stock issuances. 
On January 4, 2010, Brandt also filed an appeal in relation to this ruling with
the Delaware Supreme Court which, on April 20, 2010, affirmed the ruling of the
Chancery Court.




The
Chancery Court also dismissed with prejudice another action brought by Mr.
Brandt, in which he claimed he had not been provided with information owed to
him.




In July
2009, the Company filed an action in the United States District Court for the
Central District of California against Mr. Brandt and certain
others.  The Company’s complaint alleged a variety of violations of
federal securities laws, including anti-fraud based claims under
Rule 14a-9, solicitation of proxies in violation of the filing and
disclosure dissemination requirements of Regulation 14A, and material
misstatements and omissions in and failures to promptly file amendments to
Schedule 13D.  Mr. Brandt and the other defendants filed
counterclaims against us, alleging violations of federal securities laws
relating to alleged actions and statements taken or made by the Company or the
Company’s officers and directors in connection with Mr. Brandt’s proxy and
consent solicitations.  On March 10, 2010, the Company dismissed the
Company’s claims against EAC, and EAC dismissed its claims against the Company
and Mr. Carpenter.  On April 10, 2010, Mr. Brandt's attorneys moved to
withdraw from representing Mr. Brandt in the case.  On July 7, 2010,
Mr. Brandt moved to dismiss his counterclaims against the Company and the
Company consented to dismiss its complaint against Mr. Brandt.  On
July 13, 2010, all of the Company’s claims and Mr. Brandt’s counterclaims in
such action were dismissed.  This resolved all pending actions between
the Company and Mr. Brandt.




The
Company has expended substantial resources to pursue the defense of legal
proceedings initiated by Mr. Brandt.  The Company does not know
whether Mr. Brandt will institute new claims against the Company and the
defense of any such claims could involve the expenditure of additional resources
by the Company.




Lease
Commitments




The
Company leased its headquarters and Neurometric Information Services space under
an operating lease which terminated on November 30, 2009. The Company continued
to lease the space on a month-to-month basis through January 22, 2010 at which
time the Company moved to its new premises.


19


CNS
RESPONSE, INC.
 NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


On
December 30, 2009 the Company entered a three year lease, commencing February 1,
2010 and terminating on January 30, 2013 for its new Headquarters and
Neurometric Information Services business premises located at 85 Enterprise,
Aliso Viejo, California 92656.  The 2,023 square foot facility has an
average cost for the lease term of $3,600 per month.  The remaining
lease obligation totals $100,900: being $35,300, $49,000 and $16,600 for fiscal
years 2011, 2012 and 2013 respectively.




The
Company leases space for its Clinical Services operations under an operating
lease.  The original lease terminated on February 28, 2010 and a 37
month extension to the lease was negotiated commencing April 1, 2010 and
terminating April 30, 2013. The 3,542 square foot facility has an average cost
for the lease term of $5,100 per month. The remaining lease obligation totals
$147,000: being $42,900, $65,400 and $38,700 for fiscal years 2011, 2012 and
2013 respectively.




The
Company also sub-leased space for its Clinical Services operations on a
month-to-month basis for $1,000 per month up until March 2010 when it terminated
this sub-lease and gave up the space.




The
Company incurred rent expense of $27,000 and $37,600 for the three months
ended December 31, 2010 and 2009.




On
November 8, 2010 we entered into a financial lease to acquire EEG equipment
costing $15,900.  The term of the lease is 48 months ending October
2014 and the monthly payment is $412. As of December 31, 2010 the remaining
lease obligation is $18,400: being $3,700, $4,900, $4,900 and $4,900 for fiscal
years 2011, 2012, 2013 and 2014 respectively.




9.
            SUBSEQUENT
      EVENTS




2011 Private Placement
Transactions





Events
subsequent to December 31, 2010 have been evaluated through to the date that
these financial statements were issued, to determine whether any events should
be disclosed to keep the financial statements from being
misleading.  The following events occurred since December 31,
2010.





On
January 20, February 3 and February 8, 2011, we sold convertible unsecured
notes (the “Unsecured Notes”) in an aggregate principal amount of $350,000 and
warrants to purchase 583,552 shares of common stock to three accredited
investors in connection with a new private placement pursuant to a note and
warrant purchase agreement, under which we can issue an aggregate of up to $5
million in aggregate principal amount of Unsecured Notes, as well as related
warrants.  The terms of the Unsecured Notes are identical to the terms
of the October Notes, except that (i) the Unsecured Notes are not secured by any
of our assets, (ii) the Unsecured Notes are subordinated in all respects to our
obligations under the October Notes and the related guaranties issued to certain
investors by SAIL and (iii) the Company is not subject to a restrictive covenant
to use the use of proceeds from the sale of the Unsecured Notes only for current
operations.  The terms of the new warrants are identical to the terms
of the warrants issued in connection with the October Notes.


20





Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations




The
information contained in this Form 10-Q is intended to update the information
contained in our Annual Report on Form 10-K for the year ended September 30,
2010 and presumes that readers have access to, and will have read, the
“Management's Discussion and Analysis or Plan of Operation” and other
information contained in such Form 10-K. The following discussion and analysis
also should be read together with our consolidated financial statements and the
notes to the consolidated financial statements included elsewhere in this Form
10-Q.




This
discussion summarizes the significant factors affecting the condensed
consolidated operating results, financial condition and liquidity and cash flows
of CNS Response, Inc. for the three months ended December 31, 2010 and
2009.  Except for historical information, the matters discussed in
this management's discussion and analysis or plan of operation and elsewhere in
this Quarterly Report on Form 10-Q, are “forward-looking statements” within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, that include information
relating to future events, future financial performance, strategies,
expectations, competitive environment, regulation and availability of
resources.  These forward-looking statements include, without
limitation, statements regarding: proposed new products or services; our
statements concerning litigation or other matters; statements concerning
projections, predictions, expectations, estimates or forecasts for our business,
financial and operating results and future economic performance; statements of
management’s goals and objectives; trends affecting our financial condition,
results of operations or future prospects; our financing plans or growth
strategies; and other similar expressions concerning matters that are not
historical facts.  Words such as “may,” “will,” “should,” “could,”
“would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,”
“future,” “intends,” “plans,” “believes” and “estimates,” and similar
expressions, as well as statements in future tense, identify forward-looking
statements.




Forward-looking
statements should not be read as a guarantee of future performance or results,
and will not necessarily be accurate indications of the times at, or by which,
that performance or those results will be achieved. Forward-looking statements
are based on information available at the time they are made and/or management’s
good faith belief as of that time with respect to future events, and are subject
to risks and uncertainties that could cause actual performance or results to
differ materially from those expressed in or suggested by the forward-looking
statements. Important factors that could cause these differences include, but
are not limited to:





            our inability to raise
      additional funds to support operations and capital
      expenditures;






            our inability to achieve
      greater and broader market acceptance of our products and services in
      existing and new market
segments;






            our inability to successfully
      compete against existing and future
  competitors;






            our inability to manage and
      maintain the growth of our
business;






            our inability to protect our
      intellectual property rights;
and






            other factors discussed under
      the headings “Risk Factors” and “Business” in our Annual Report on Form
      10-K and this Quarterly Report on Form
  10-Q.




Forward-looking
statements speak only as of the date they are made. You should not put undue
reliance on any forward-looking statements. We assume no obligation to update
forward-looking statements to reflect actual results, changes in assumptions or
changes in other factors affecting forward-looking information, except to the
extent required by applicable securities laws.  If we do update one or
more forward-looking statements, no inference should be drawn that we will make
additional updates with respect to those or other forward-looking
statements.




21





Overview





We are a
web-based neuroinformatic analysis company with two distinct business segments.
Our primary business is the Neurometric Information Services (formerly called
Laboratory Information Services) business operated by CNS California, which is
focused on neurometric analysis, research, development and the commercialization
of a patented system that provides data to psychiatrists and other physicians to
enable them to make more informed, patient-specific decisions when treating
individual patients with behavioral (psychiatric and/or addictive)
disorders.  Our secondary Clinical Services business, operated by our
wholly-owned subsidiary, Neuro-Therapy Clinic (“NTC”), is a full service
psychiatric clinic.




Neurometric
Information Services




Traditionally,
prescription of medication for the treatment of behavioral disorders (such as
depression, bipolar disorders, eating disorders, addiction, anxiety disorders,
ADHD and schizophrenia) has been primarily based on symptomatic factors, while
the underlying physiology and pathology of the disorder can rarely be analyzed,
which often results in multiple ineffective, costly, and often lengthy, courses
of treatment before the effective medications are identified.  Some
patients never find effective medications.




We
believe that our technology offers an improvement upon traditional methods for
determining a course of medication for patients suffering from non-psychotic
behavioral disorders because our technology is designed to correlate the success
of courses of medication with the neurophysiological characteristics of a
particular patient. Our technology provides medical professionals with
medication sensitivity data for a subject patient based upon the identification
and correlation of treatment outcome information from other patients with
similar neurophysiologic characteristics.   This treatment
outcome information is contained in a proprietary outcomes database which
consists of over 17,000 medication trials for patients with psychiatric or
addictive problems (the “CNS
Database ”).  For each patient in the CNS Database, we have
compiled electroencephalographic (“EEG ”) scans, symptoms and
outcomes often across multiple treatments from multiple psychiatrists and
physicians.  This patented technology, called “Referenced-EEG®” or
“rEEG®”, represents an innovative approach to identifying effective medications
for patients suffering from debilitating behavioral disorders.




With
rEEG®, physicians order a digital EEG for a patient, which is then evaluated
with reference to the CNS Database.  By providing this reference
correlation, an attending physician can better determine a treatment strategy
with the knowledge of how other patients having similar brain function have
previously responded to a myriad of different treatment
alternatives.  Analysis of this complete data set yielded a platform
of 74 neurometric variables that have shown utility in characterizing patient
response to diverse medications.  This platform then allows a new
patient to be characterized, based on these 74 neurometric variables, and the
database to be queried to understand the statistical probability of how patients
with similar brain patterns have previously responded to the medications
currently in the database. This technology allows us to create and provide
simple reports (“rEEG
Reports ”) to the prescriber that summarizes historical treatment success
of specific medications for those patients with similar neurometric brain
patterns.   It provides neither a diagnosis nor a specific
treatment, but like all lab results, provides objective, evidenced-based
information to help the prescriber in their decision-making.




Our
Neurometric Information Services business is focused on increasing the demand
for our rEEG Reports. We believe the key factors that will drive broader
adoption of our rEEG Reports will be the acceptance by healthcare providers and
patients of their benefit, the demonstration of the cost-effectiveness of using
our technology, the reimbursement by third-party payers, the expansion of our
sales force and increased marketing efforts.




In
addition to its utility in providing psychiatrists and other
physicians/prescribers with medication sensitivity guidance, rEEG provides us
with significant opportunities in the area of pharmaceutical development. 
rEEG, in combination with the information contained in the CNS Database, has the
potential to enable the identification of novel uses for neuropsychiatric
medications currently on the market and in late stages of clinical development,
as well as in aiding the identification of neurophysiologic characteristics of
clinical subjects that may be successfully treated with neuropsychiatric
medications in the clinical testing stage. We intend to enter into relationships
with established drug and biotechnology companies to further explore these
opportunities, although no relationships are currently
contemplated.  The development of pathophysiological markers as the
new method for identifying the correct patient population to research is being
encouraged by both The National Institute of Mental Health (NIMH) and The Food
and Drug Administration (FDA).




Clinical
Services




In
January 2008, we acquired our then largest customer, the Neuro-Therapy Clinic,
Inc.  Upon the completion of the transaction, NTC became a
wholly-owned subsidiary of ours. NTC operates one of the larger psychiatric
medication management practices in the state of Colorado, with six full time and
seven part time employees including psychiatrists and clinical nurse specialists
with prescribing privileges.  Daniel A. Hoffman, M.D. is the medical
director at NTC, and, after the acquisition, became our Chief Medical Officer
and more recently, our President.


22




NTC,
having performed a significant number of rEEG’s, serves as an important resource
in our product development, the expansion of our CNS Database, production system
development and implementation, along with the integration of our rEEG services
into a medical practice.  Through NTC, we also expect to develop
marketing and patient acquisition strategies for our Neurometric Information
Services business. Specifically, NTC is learning how to best communicate the
advantages of rEEG to patients and referring physicians in the local
market.  We will share this knowledge and developed communication
programs learned through NTC with other physicians using our services, which we
believe will help drive market acceptance of our services.  In
addition, we plan to use NTC to train practitioners across the country in the
uses of rEEG technology.




We view
our Clinical Services business as secondary to our Neurometric Information
Services business, and we have no current plans to expand this
business.




Business
operations




Since our
inception, we have generated significant net losses. As of December 31, 2010, we
had an accumulated deficit of approximately $33.5 million, and as of December
31, 2009, our accumulated deficit was approximately $27.0 million.  We
incurred operating losses of $1.5 million and $1.8 million for the three months
ended December 31, 2010 and 2009, respectively and incurred net losses of $98
thousand and $1.8 million for those respective periods (with the low net loss in
the quarter ended December 31, 2010 being primarily due to the effect of a
non-cash gain on change in fair value of derivative liabilities).  We
expect our net losses to continue for at least the next couple of years. We
anticipate that a substantial portion of our capital resources and efforts will
be focused on the scale-up of our commercial organization, research and product
development and other general corporate purposes.  Research and
development projects include the completion of more clinical trials which are
necessary to further validate the efficacy of our products and services relating
to our rEEG technology across different types of behavioral disorders; the
enhancement of the CNS Database and rEEG process, and to a lesser extent, the
identification of new medications that are often combinations of approved
drugs.  We anticipate that future research and development projects
will be funded by grants or third-party sponsorship.





As of
December 31, 2010, our current liabilities of approximately $4.7 million
exceeded our current assets of approximately $0.8 million by approximately
$3.9 million and our net losses will continue for the foreseeable
future.  As part of the $4.7 million of current liabilities we had
$3.0 million, plus accrued interest, of secured convertible debt which is
discounted to $0.6 million.  Since December 31, 2010, we have raised
an additional $350,000 from the issuance of subordinated convertible debt;
however, we still need additional funding to continue our operations plus
substantial additional funding before we can increase the demand for our rEEG
services.  We are currently exploring additional sources of capital;
however, we do not know whether additional funding will be available on
acceptable terms, or at all, especially given the economic conditions that
currently prevail.  Furthermore, any additional equity funding may result
in significant dilution to existing stockholders, and, if we incur additional
debt financing, a substantial portion of our operating cash flow may be
dedicated to the payment of principal and interest on such indebtedness, thus
limiting the funds available for our business activities.  If adequate
funds are not available, we may be required to delay or curtail significantly
our development and commercialization activities.  This would have a
material adverse effect on our business, financial condition and/or results of
operations and could ultimately cause us to have to cease
operations.




The
Private Placement Transactions




The
2010 and 2011 Private Placement Transactions





From June
3 through November 12, 2010, we raised $3.0 million through the sale of secured
convertible notes and warrants to accredited investors. Of such amount, $1.75
million was purchased by members of our Board of Directors or their affiliate
companies.  See “Part II - Item 2. Unregistered Sales
of Equity Securities and Use of Proceeds.”  On January 20,
February 3 and February 8, 2011, we sold convertible unsecured notes in an
aggregate principal amount of $350,000 and warrants to purchase 583,332
shares of common stock to accredited investors.  See “Part II - Item
5. Other Information.”


23





Critical
Accounting Policies and Significant Judgments and Estimates





This
management’s discussion and analysis of financial condition and results of
operations is based on our unaudited condensed consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these unaudited
condensed consolidated financial statements requires management to make
estimates and judgments that affect the reported amounts of assets, liabilities
and expenses and the disclosure of contingent assets and liabilities at the date
of the financial statements, as well as revenues and expenses during the
reporting periods. We evaluate our estimates and judgments on an ongoing basis.
We base our estimates on historical experience and on various other factors we
believe are reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying value of assets and liabilities
that are not readily apparent from other sources. Actual results could therefore
differ materially from those estimates under different assumptions or
conditions.




The
following critical accounting policies reflect our more significant estimates
and assumptions used in the preparation of our unaudited condensed consolidated
financial statements.




Revenue
Recognition




We have
generated limited revenues since our inception.  Revenues for our
Laboratory Service product are recognized when a rEEG Report is delivered to a
client-physician.  For our Clinical Services, revenues are recognized
when the services are performed.




Stock-based
Compensation Expense




Stock-based
compensation expense, which is a non-cash charge, results from stock option
grants.  Compensation cost is measured at the grant date based on the
calculated fair value of the award.  We recognize stock-based
compensation expense on a straight-line basis over the vesting period of the
underlying option. The amount of stock-based compensation expense expected to be
amortized in future periods may decrease if unvested options are subsequently
cancelled or may increase if future option grants are made.





Derivative
accounting for convertible debt and warrants





The
Company analyzes all financial instruments with features of both liabilities and
equity under ASC 480-10 and ASC 815-10 whereby the Company determines the fair
market carrying value of a financial instrument using the Black-Scholes model
and revalues the fair market value on a quarterly basis.  Any changes
in carrying value flow through as other income (expense) in the income
statement.





Results of Operations for the Three Months Ended
December 31, 2010 and 2009




As earlier described, we operate in two business
segments: NeurometricInformationServices and Clinical Services.  Our
NeurometricInformationServices business focuses on the delivery of
reports ("rEEG Reports") that enable psychiatrists and other
physician/prescribers to make more informed, patient-specific decisions when
treating individual patients for behavioral (psychiatric and/or addictive)
disorders based on the patient's own physiology. Our Clinical Services business
operated through NTC provides full service psychiatric
services.




The following table presents consolidated statement
of operations data for each of the periods indicated as a percentage of
revenues.




Three months December 31,2010
                  
                  
                  2009Revenues
                  
                  
                  100
                  %
                  
                  
                  100
                  %Cost
      of revenues
                  
                  
                  24
                  
                  
                  
                  21Gross
      profit
                  
                  
                  76
                  
                  
                  
                  79Research
      and development
                  
                  
                  240
                  
                  
                  
                  163Sales
      and marketing
                  
                  
                  167
                  
                  
                  
                  140General
      and administrative expenses
                  
                  
                  713
                  
                  
                  
                  1,071Operating
      loss
                  
                  
                  (1,044
                  )
                  
                  
                  (1,294
                  )Other
      income (expense), net
                  
                  
                  978
                  
                  
                  
                  (2
                  )Net
      income (loss)
                  
                  
                  (66
                  )%
                  
                  
                  (1,296
                  )%


24





Revenues




Three Months ended
                      December 31,2010
                    
                    
                    2009
                    
                    
                    Percent
                      ChangeNeurometric
      Information Service Revenues
                    
                    $
                    27,300
                    
                    
                    $
                    22,400
                    
                    
                    
                    22
                    %Clinical
      Service Revenues
                    
                    
                    120,600
                    
                    
                    
                    121,100
                    
                    
                    
                    -
                    %Total
      Revenues
                    
                    $
                    147,900
                    
                    
                    $
                    143,500
                    
                    
                    
                    3
                    %





With respect to our Neurometric Information
Services business the number of paid rEEG Reports delivered increased from 58
for the three months ended December 31, 2009, to 69 for the three month ended
December 31, 2010, while the average revenue per report increased from $386 to
$395 per report for the three months ended December 31, 2010.  The
total numbers of free rEEG reports processed were 20 and 19 for the three months
ended December 31, 2009 and 2010 respectively.  These free rEEG
reports are used for training, database-enhancement and compassionate-use
purposes.





Clinical
Service revenues remained constant for the two three month periods ended
December 31, 2010 and 2009 respectively.  Although we had hired an
additional psychiatrist, she was unable to significantly impact revenue growth
as she needed to be vetted and approved by the healthcare insures before being
reimbursed for billings.  These approvals have now all been received
and we anticipate that revenues will grow.




Cost of Revenues




Three Months ended
                                                December 31,2010
                                              
                                              
                                              2009
                                              
                                              
                                              Percent
                                                ChangeCost
      of Neurometric Information Services revenues
                                              
                                              $
                                              36,100
                                              
                                              
                                              $
                                              29,600
                                              
                                              
                                              
                                              22
                                              %





Cost of
Neurometric Information Services revenues consists of payroll, consulting, and
other miscellaneous costs.  Consulting costs primarily represent
external costs associated with the processing and analysis of rEEG Reports and
range between $75 and $100 per rEEG Report.  For the three months
ended December 31, 2010, cost of revenues of $36,100 consist primarily of direct
labor and benefit costs of $27,500, which includes stock-based compensation, and
consulting fees of $7,000.  For the same period ended December 31,
2009, cost of revenues of $29,700 consisted primarily of direct labor and
benefit costs of $24,700, including stock-based compensation, and consulting
fees of $5,000.  We expect costs of revenues will increase as an
absolute number as more rEEG Reports are processed. However, we expect the cost
of revenues to decrease as a percentage of revenues as we improve our operating
efficiency and increase the automation of certain processes.




Research and Development





Three Months ended
                                          December 31,2010
                                        
                                        
                                        2009
                                        
                                        
                                        Percent
                                          ChangeNeurometric
      Information Services research and development
                                        
                                        $
                                        355,400
                                        
                                        
                                        $
                                        222,600
                                        
                                        
                                        
                                        59
                                        %





Research
and development expenses consist of payroll costs (including stock-based
compensation costs), consulting fees, clinical study costs and other
miscellaneous costs.  Research and development costs for the three
months ended December 31, 2010, included the following: payroll and
benefit costs (including stock based compensation) of $272,700, consultant
costs of $58,000 and other miscellaneous costs of $24,700 which include travel,
database and support costs.  For the comparable period for 2009,
research and development costs included: payroll and benefit costs (including
stock based compensation) of $189,500, consultant costs of $18,400 and
other miscellaneous costs of $14,700 which included travel, database and support
costs.


25





Comparing
the three months ended December 31, 2010 with the corresponding period in
2009, the focus of the research and development department moved from
conducting the clinical study to analyzing the data and drafting scientific
papers for publications.  Additionally, the focus moved to enhancing
the rEEG production system and efforts related to our 510(k) application with
the FDA.  With this shift in focus, consulting fees increased by
$39,600: in total $3,000 was spent on research and $55,000 was spent on product
enhancements and compliance in the three months ended December 31,
2010.   Payroll and benefits increased by $83,200 in the 2010
period compared to the prior year period primarily due to the reassignment of a
staff member between departments, the increase in stock-based compensation
and the accrual of severance pay.




Sales and marketing





Three Months ended
                                                                  December 31,2010
                                                                
                                                                
                                                                2009
                                                                
                                                                
                                                                Percent
                                                                  ChangeSales
      and MarketingNeurometric
      Information Services
                                                                
                                                                $
                                                                243,700
                                                                
                                                                
                                                                $
                                                                198,400
                                                                
                                                                
                                                                
                                                                23
                                                                %Clinical
      Services
                                                                
                                                                
                                                                3,000
                                                                
                                                                
                                                                
                                                                2,000
                                                                
                                                                
                                                                
                                                                50
                                                                %Total
      Sales and Marketing
                                                                
                                                                $
                                                                246,700
                                                                
                                                                
                                                                $
                                                                200,400
                                                                
                                                                
                                                                
                                                                23
                                                                %





Sales and
marketing expenses associated with our Neurometric Information Services business
consist primarily of payroll and benefit costs, including stock-based
compensation; advertising and marketing; consulting fees and conference and
travel expenses.  Sales and marketing expenses for the three
months ended December 31, 2010 included the following expenses: payroll and
benefits $175,700, advertising and marketing $3,600, consulting $36,800 and
conferences and travel $23,900. For the comparable period in 2009, expenses were
as follows: payroll and benefits $135,600, advertising and marketing $33,200,
consulting $22,600 and conferences and travel $2,700.





Comparing
the three months ended December 31, 2010, with the same period in
2009; payroll and benefits increased by $40,100 in the 2010 period
primarily as a result of the recruitment of our Executive Vice President and
Chief Marketing Officer to lead our marketing efforts in pursuing contracts with
large targeted organizations.  Advertising and marketing expenses
decreased by $29,600 as advertising was had been curtailed while the Company had
awaited resolution to its 510(k) application with the
FDA.  Consequently, in the three months ended December 31, 2010,
marketing efforts were still limited to the development of the
provider network and focused on payer organizations, whereas for the 2009
period, the Company was more actively executing its advertising and marketing
plans.  Conference and travel expenses increased by $21,200 in the
2010 period as our targeted customers were predominately based on the East
Coast, necessitating multiple cross-country visits to these key clients.





The
Clinical Services sales and marketing expenses consists of advertising to
attract patients to the clinic. During the three months ended December 31, 2010,
Clinical Services marketing expenditures were approximately the same as in the
prior year’s period.  We anticipate a moderate increase in marketing
expenditure as we have determined that select radio advertizing is effective in
attracting new patients to the clinic: with the addition of our newly
recruited psychiatrist, the clinic’s capacity to treat new patients has
increased.




General and administrative





Three Months ended
                                                                December 31,2010
                                                              
                                                              
                                                              2009
                                                              
                                                              
                                                              Percent
                                                                ChangeGeneral
      and administrativeNeurometric
      Information Services
                                                              
                                                              $
                                                              832,700
                                                              
                                                              
                                                              $
                                                              1,399,300
                                                              
                                                              
                                                              
                                                              (40
                                                              )%Clinical
      Services
                                                              
                                                              
                                                              221,100
                                                              
                                                              
                                                              
                                                              148,400
                                                              
                                                              
                                                              
                                                              49
                                                              %Total
      General and administrative
                                                              
                                                              $
                                                              1,053,800
                                                              
                                                              
                                                              $
                                                              1,547,700
                                                              
                                                              
                                                              
                                                              (31
                                                              )%


26





General
and Administrative expenses for our Neurometric Information Services business
are largely comprised of payroll and benefit costs, including stock based
compensation, legal, patent costs, other professional and consulting fees,
general administrative and occupancy costs, conference and travel and
miscellaneous costs.  For the three months ended December 31,
2010, General and Administrative costs included the following: salaries and
benefit costs of $413,300; legal fees of $113,200; other professional and
consulting fees of $149,100; general administrative and occupancy costs of
$50,600; patent costs of $58,800; marketing and investor relations expenses of
$3,300 and conference and travel expenses of $25,200.  For the same period
in 2009, General and Administrative costs included the following: salaries
and benefit costs of $140,600; legal fees of $877,600; other professional
and consulting fees of $176,600; general administrative and occupancy costs of
$63,700; patent costs of $10,600; marketing and investor relations expenses of
$68,600 and conference and travel expenses of $48,800.





With
respect to our Neurometric Information Services business, in the three months
ended December 31, 2010, compared to the same period in 2009, payroll and
benefit expenses increased by a net $272,700, of which $190,300 was due to an
increase in stock-based compensation primarily due to accounting for vested
option grants given to employees, directors, advisors and consultants in March
and July of 2010.  The balance of the increase, $82,400, was due to
(i) the addition of the Chief Financial Officer (CFO), who was previously
engaged as a consultant, and joined the staff in mid February 2010 and (ii) the
Board-approved increase in salary of our Chief Executive Officer
(CEO).   Professional and consulting fees decreased by a net
$27,454 which was partly due to the mix of consulting services used in fiscal
2010: these fees included $30,000 associated with financial advisory services
used to obtain funding, $5,500 used for accounting services, $19,000 used for
public relations services and $21,800 used for consultants who have experience
with health insurance payers.  Legal fees decreased by a net $764,400
which was made up of a $771,500 reduction in litigation fees in defending
against actions brought by Mr. Brandt plus a $30,500 insurance reimbursement
paid on behalf of SAIL Venture Partners, LP, which was a co-defendant in the
litigation. This reimbursed expense had originally been accrued by the
Company. All matters between Mr. Brandt and us have either been dismissed
or adjudicated in our favor.  Non-litigation related legal expense
increased by $37,600 partly due to the work undertaken with the Company’s
registration statement and financing efforts.  General administrative
and occupancy costs decreased by $13,100 due to general decreases in
expenditures.  Patent costs increased by $48,200, of which
$44,000 was for the filing of European patent applications.  Marketing
and investor relations expenses decreased by $65,300 as expenses associated
with a publicity campaign planned for the 2009 period did not recur in the 2010
period.  Conference and travel costs decreased by $53,400 in the
2010 period as travel associated with the litigation and financings in the 2009
period did not recur.





General
and Administrative expenses for our Clinical Services business includes all
costs associated with operating NTC.  This includes payroll costs,
medical supplies, occupancy costs and other general and administrative support
costs.  These costs increased by $72,700 to $221,100 in the three
months ending December 31, 2010, from $148,400 in the 2009
quarter.  This increase is partly due to the hiring of an additional
psychiatrist and partly due to the reduced reimbursement by Neurometric
Information Services of NTC staff who had worked on the Company’s clinical trial
which ended in 2009.





Other
income (expense)





Three Months ended
                                                            December 31,2010
                                                          
                                                          
                                                          2009
                                                          
                                                          
                                                          Percent
                                                            ChangeNeurometric Information
      Services income (expense), net
                                                          
                                                          $
                                                          1,447,700
                                                          
                                                          
                                                          $
                                                          (1,400
                                                          )
                                                          
                                                          
                                                          *
                                                          %Clinical
      Services income (expense)
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          (200
                                                          )
                                                          
                                                          
                                                          *
                                                          %Total
      other income (expense)
                                                          
                                                          $
                                                          1,447,700
                                                          
                                                          
                                                          $
                                                          (1,600
                                                          )
                                                          
                                                          
                                                          *
                                                          %*
      not meaningful




For the three months ended December 31, 2010, net
other income for Neurometric Information Services was $1,447,700 as a result of
the following:




Firstly,
we incurred non-cash interest charges totaling $2,626,600 on our promissory
notes which accrue interest at 9%, on our warrant discount amortization and our
warrant and note conversion derivative liability charges.  Interest
paid in cash for the quarter was approximately $1,000.


27


Secondly,
finance fees totaling $142,700 were incurred in association with our private
placement of convertible notes (the October Notes).  Of these finance
fees $60,000 was paid in cash and $82,700 was the fair value of warrants that
were issued to the placement agent and SAIL Venture Partners, LP guarantying the
Deerwood notes (See Note 3 to
the financial statements and Private Placement Transactions
above).




Lastly,
our derivative liabilities for the conversion feature and warrants associated
with the October notes were revalued at December 31, 2010.  As a
result of the revaluation of these derivatives, which is required on a quarterly
basis under ASC 815, a non-cash gain of $4,217,500 was booked.  This
large gain was due to a decline in the market price of our stock on the last two
trading days of the calendar year 2010 with the closing price being at $0.20 on
December 31, 2010.  The average closing market price of our stock for
the three months ending December 31, 2010 was $0.45.  Since the
derivative liabilities are valued using the Black-Scholes model, the combination
of the high volatility of our stock price and the low price at the end of the
period resulted in an anomalous large gain.  If and when the market
price of our stock reverts to its recent average level, this gain will unwind
and will result in a loss on valuation of derivative liabilities in future
periods.




For the
three months ending December 2009, Neurometric Information Services and Clinical
Services combined incurred a net interest charge of $1,600. There were no
significant transactions during this period which impacted the “Other
Income” line item.




Net
Loss





Three Months ended
                                                        December 31,2010
                                                      
                                                      
                                                      2009
                                                      
                                                      
                                                      Percent
                                                        ChangeNeurometric
      Information Services net profit (loss)
                                                      
                                                      $
                                                      12,900
                                                      
                                                      
                                                      $
                                                      (1,859,000
                                                      )
                                                      
                                                      
                                                      (6
                                                      )%Clinical
      Services net loss
                                                      
                                                      
                                                      (110,600
                                                      )
                                                      
                                                      
                                                      (200
                                                      )
                                                      
                                                      
                                                      5530
                                                      %Total
      Net Loss
                                                      
                                                      $
                                                      (97,700
                                                      )
                                                      
                                                      $
                                                      (1,859,200
                                                      )
                                                      
                                                      
                                                      (4
                                                      )%





The net
profit for our Neurometric Information Services business of approximately $13
thousand for the three months ended December 31, 2010 compared to the 2009
quarter’s loss of $1.86 million was almost entirely due to the gain on the
valuation of derivative liabilities as explained above under “Other Income
(expense)”.  Disregarding the effect of the gain on the valuation of
derivative liabilities net of the non-cash interest charges in establishing the
derivative liabilities during the three months ended December 31, 2010, our net
loss during that period would have been $1.75.  Additionally, we also
experienced a significant reduction in our General and Administrative expenses
in the 2010 quarter compared to the corresponding prior year period as a result
of not having the Brandt litigation, which occurred in 2009




The
increase in the net loss for our Clinical Services business of approximately
$110 thousand for the three months ended December 31, 2010 as compared to the
corresponding prior year period was the result of the reduced reimbursement by
Neurometric Information Services for Clinical Services staff who worked on the
clinical trial which ended in 2009; additionally, expenses were also impacted by
the costs associated with the hiring of a new psychiatrist. Although we needed
an additional psychiatrist on staff to help drive up revenues, she was unable to
bill healthcare insurers until she was vetted and approved by the insurers.
These approvals were finally all received in December; however this was too late
to significantly impact revenue growth for the quarter.




Liquidity and Capital
Resources




Since our
inception, we have incurred significant losses.  As of December 31,
2010, we had an accumulated deficit of approximately $33.5 million. We have not
yet achieved profitability and anticipate that we will continue to incur net
losses for the foreseeable future. We expect that our research and development,
sales and marketing and general and administrative expenses will continue to
grow and, as a result, we will need to generate significant product revenues to
achieve profitability. We may never achieve profitability.




As of
December 31, 2010, we had approximately $697,000 in cash and cash equivalents
and a working capital deficit of approximately $3.9 million compared to
approximately $1.9 million in cash and cash equivalents and a working capital
balance of approximately $106,000 at December 31, 2009.  The working
capital deficit as of December 31, 2010 includes the $3.0 million, plus accrued
interest, of secured convertible promissory notes (Bridge Notes and Deerwood
Notes) outstanding as of that date which have been discounted down to
approximately $600,000.


28


Operating
Capital and Capital Expenditure Requirements




Our
continued operating losses and limited capital raise substantial doubt about our
ability to continue as a going concern, and we need to raise substantial
additional funds in the next 12 months in order to continue to conduct our
business.  Until we can generate a sufficient amount of revenues to
finance our cash requirements, which we may never do, we expect to finance
future cash needs primarily through public or private equity offerings, debt
financings, borrowings or strategic collaborations.





We need
additional funds to continue our operations and will need substantial additional
funds before we can increase demand for our rEEG services.  We are
currently exploring additional sources of capital; however, we do not know
whether additional funding will be available on acceptable terms, or at all,
especially given the economic conditions that currently prevail.  In
addition, any additional equity funding may result in significant dilution to
existing stockholders, and, if we incur additional debt financing, a substantial
portion of our operating cash flow may be dedicated to the payment of principal
and interest on such indebtedness, thus limiting funds available for our
business activities.  We expect to continue to incur operating losses
in the future and to make capital expenditures to expand our research and
development programs (including upgrading our CNS Database) and to scale up our
commercial operations and marketing efforts.   If adequate funds
are not available, it would have a material adverse effect on our business,
financial condition and/or results of operations, and could ultimately cause us
to have to cease operations.




Sources
of Liquidity




Since our
inception substantially all of our operations have been financed primarily from
equity and debt financings.  Through December 31, 2010, we had
received proceeds of approximately $13.7 million from the sale of stock,
$9.7 million from the issuance of convertible promissory notes and
$220,000 from the issuance of common stock to employees in connection with
expenses paid by such employees on behalf of the Company.




From June
3, 2010 through to November 12, 2010, we raised $3.0 million through the sale of
secured convertible notes and warrants (the October Notes).  Of such
amount, $1.75 million was purchased by members of our Board of Directors or
their affiliate companies.  In January and February 2011, the Company
has raised an additional $350,000 through the sale of subordinated convertible
notes and warrants.  See Note 3 of the financial
statements, “Private Placement Transactions” above.





Cash
Flows




Net cash
used in operating activities was $1.2 million for the three months ended
December 31, 2010 compared to $2.0 million for the three months ended December
31, 2009.  The decrease in cash used of $0.8 million is attributable
to the reduction in legal fees associated with the Brandt
litigation.




Net cash
used in investing activities increased to $15,900 for the three months ended
December 31, 2010, as compared to $0 for the three months ended December 31,
2009.  Our investing activities related to the purchase of EEG
equipment to be used by a customer.




Net cash
proceeds from financing activities for the three months ended December 31, 2010
were approximately $1.8 million, net of offering costs, raised through our sale
of secured convertible notes and warrants (the October
Notes).  Additionally, we also entered into a capital lease of $15,900
to finance the purchase of the above mentioned EEG equipment.  These
proceeds were partly offset by the repayment of $24,700 on a promissory note
issued to Daniel Hoffman in connection with our acquisition of NTC.





For
the three months ended December 31, 2009 proceeds from financing activities were
approximately $2.9, net of offering costs, in connection with the second and
third closings of our 2009 private placement transaction.  These
proceeds were partly offset by the repayment of $22,900 on the above mentioned
promissory note issued to Daniel Hoffman.




Contractual
Obligations and Commercial Commitments





On
December 30, 2009 the Company entered a three year lease, commencing February 1,
2010 and terminating on January 30, 2013 for its new Headquarters and
Neurometric Information Services business premises located at 85 Enterprise,
Aliso Viejo, California 92656.  The 2,023 square foot facility has an
average cost for the lease term of $3,600 per month.  The remaining
lease obligation totals $100,900: being $35,300, $49,000 and $16,600 for fiscal
years 2011, 2012 and 2013 respectively.


29




The
Company also leases space for its Clinical Services operations under an
operating lease.   The original term of this lease expired on February
28, 2010 and a 37 month extension to the lease was negotiated commencing April
1, 2010 and terminating April 30, 2013. The 3,542 square foot facility has an
average cost for the lease term of $5,100 per month. The remaining lease
obligation totals $147,000: being $42,900, $65,400 and $38,700 for fiscal years
2011, 2012 and 2013 respectively.




The
Company also sub-leased space for its Clinical Services operations on a
month-to-month basis for $1,000 per month up until March 2010 when it terminated
this sub-lease and gave up the space.




The
Company incurred rent expense of $27,000 and $37,600 for the three months
ended December 31, 2010 and 2009.





On
November 8, 2010 we entered into a finance lease to purchase EEG equipment
costing $15,900.  The term of this lease is 48 months ending October
2014 and the monthly payment is $412. As of December 31, 2010 the remaining
lease obligation is $18,400: being $3,700, $4,900, $4,900 and $4,900 for fiscal
years 2011, 2012, 2013 and 2014 respectively.





Derivative
Liability





Current
liabilities include $1.9 million of derivative liability. This amount
includes:





1.
            $1.0
      million, which represents the fair value liability associated with the
      warrants issued in conjunction with the October
  Notes.





2.
            $0.9
      million, which represent the fair value liability associated with the
      conversion option of the October Notes. (Please
      see Note 3 to the financial statements or “Private Placement Transactions”
      above.)








The
carrying value of these derivative liabilities will be reassessed each quarter
and any change in the carrying value will be booked to other income (expense) in
the income statement.  For the three months ended December 31, 2010 we
booked a gain of $4.2 million in the carrying value of these
derivatives.





Operating
Capital and Capital Expenditure Requirements




We expect
to continue to incur operating losses in the future and to make capital
expenditures to expand our research and development programs (including
upgrading our CNS Database) and to scale up our commercial operations and
marketing efforts. We expect that our existing cash will be used to fund working
capital and for capital expenditures and other general corporate purposes,
including the repayment of debt incurred as a result of our litigation with
Brandt. Although since December 31, 2010 we have raised gross
proceeds of $0.4 million through the sale of unsecured convertible
promissory notes, we anticipate that our cash on hand (including the proceeds
from these promissory notes) and cash generated through our operations will not
be sufficient to fund our operations the next 12 months.  In addition
we will have to repay the outstanding notes plus interest beginning on October
1, 2011.  We therefore anticipate raising additional funds in the near
future.




The
amount of capital we will need to conduct our operations and the time at which
we will require such capital may vary significantly depending upon a number of
factors, such as:





·
            the
      amount and timing of costs we incur in connection with our research and
      product development activities, including enhancements to our CNS Database
      and costs we incur to further validate the efficacy of our rEEG
      technology;





·
            the
      amount and timing of costs we incur in connection with the expansion of
      our commercial operations, including our selling and marketing
      efforts;





·
            whether
      we incur additional consulting and legal fees in our efforts to obtain
      510(k) clearance from the FDA.





·
            if
      we expand our business by acquiring or investing in complimentary
      businesses.





Until we
can generate a sufficient amount of revenues to finance our cash requirements,
which we may never do, we expect to finance future cash needs primarily through
public or private equity offerings, debt financings, borrowings or strategic
collaborations. The issuance of equity securities may result in dilution to
stockholders. We do not know whether additional funding will be available on
acceptable terms, or at all, especially given the economic conditions that
currently prevail. If we are not able to secure additional funding when needed,
we may have to delay, reduce the scope of or eliminate one or more research and
development programs or selling and marketing initiatives, and implement other
cost saving measures.


30




Income
Taxes




Since
inception, we have incurred operating losses and, accordingly, have not recorded
a provision for federal income taxes for any periods presented.  As of
September 30, 2010, we had net operating loss carryforwards for federal income
tax purposes of $24.7 million. If not utilized, the federal net operating loss
carryforwards will begin expiring in 2029. Utilization of net operating loss and
credit carryforwards may be subject to a substantial annual limitation due to
restrictions contained in the Internal Revenue Code that are applicable if we
experience an “ownership change”. The annual limitation may result in the
expiration of our net operating loss and tax credit carryforwards before they
can be used.




Off-Balance Sheet Arrangements




We have no off-balance sheet arrangements or
financing activities with special purpose entities.




Item 3.
            Quantitative
      and Qualitative Disclosures about Market
Risk.




Not
applicable.




Item
      4.
            Controls
      and Procedures.




Disclosure
Controls and Procedures




Our
management, including our principal executive officer (PEO) and principal
financial officer (PFO), conducted an evaluation of the effectiveness of our
disclosure controls and procedures, as defined by paragraph (e) of Exchange Act
Rules 13a-15, as of December 31, 2010, the end of the period covered by
this report.  Based on this evaluation, our PEO and PFO concluded that
our disclosure controls and procedures were not effective as of December 31,
2010 for the reasons described below.





The
following significant deficiency was identified, which in combination with other
deficiencies may constitute a material weakness (as defined below):





·
            We
      do not have a comprehensive and formalized accounting and procedures
      manual.





A
“material weakness” is a deficiency, or combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will
not be prevented or detected on a timely basis.




A
“significant deficiency” is a deficiency, or combination of deficiencies, in
internal control over financial reporting that is less severe than a material
weakness, yet important enough to merit attention by those responsible for
oversight of our financial reporting.




To the
knowledge of our management, including our PEO and PFO, none of the
aforementioned significant deficiencies led to a misstatement of our results of
operations for the three months ended December 31, 2010, or statement of
financial position as of December 31, 2010.





The
Company is planning to develop a comprehensive and formal accounting and
procedures manual and has identified a resource to assist with the development
of such manual.


31





Changes
in Internal Control Over Financial Reporting




Other
than as stated above, there were no changes in our internal control over
financial reporting or in other factors identified in connection with the
evaluation required by paragraph (d) of exchange act rules 13a-15 or 15d-15 that
occurred during the quarter ended December 31, 2010 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.


32


PART
II


OTHER INFORMATION




Item
      1.
            Legal
      Proceedings




Please
see Note 8 to our Notes to Unaudited Condensed Consolidated Financial Statements
for a description of our litigation with Leonard Brandt.





Item
      1A.
            Risk
      Factors




Investing
in our securities involves risks.  In addition to the other
information in this quarterly report on Form 10-Q, stockholders and potential
investors should carefully consider the risks and uncertainties discussed in the
section "Item 1.A.  Risk Factors" in our annual report on Form 10-K
for the year ended September 30, 2010.  If any of the risks and
uncertainties set forth herein and therein actually materialize, our business,
financial condition and/or results of operations could be materially adversely
affected, the trading price of our common stock could decline and a stockholder
could lose all or part of his or her investment. The risks and uncertainties
described in this quarterly report on Form 10-Q and our annual report on Form
10-K for the year ended September 30, 2010 are not the only ones we
face.  Additional risks and uncertainties not presently known to us or
that we currently consider immaterial may also impair our business
operations.




In
addition, this quarterly report on Form 10-Q contains forward-looking
statements. Our actual results could differ materially from those anticipated in
those forward-looking statements as a result of various factors, including those
set forth in “Item 1A. Risk Factors” of our annual report on Form 10-K for the
year ended September 30, 2010.  Please see the introductory section to
“Part I - Item 2. Management’s Discussion of Financial Condition and Results of
Operations” in this quarterly report on Form 10-Q for further information on
these forward-looking statements.




Item
      2.
            Unregistered
      Sales of Equity Securities and Use of
Proceeds




Bridge
Notes and Warrants





On June
3, 2010, we entered into a Bridge Note and Warrant Purchase Agreement with John
Pappajohn to purchase two secured promissory notes (each, a “Bridge Note”) in
the aggregate principal amount of $500,000, with each Bridge Note in the
principal amount of $250,000 maturing on December 2, 2010. On June 3, 2010,
Mr. Pappajohn loaned the Company $250,000 in exchange for the first Bridge Note
(there were no warrants issued in connection with this first note) and on July
25, 2010, Mr. Pappajohn loaned us $250,000 in exchange for the second Bridge
Note. In connection with his purchase of the second Bridge Note, Mr.
Pappajohn received a warrant to purchase up to 250,000 shares of our common
stock. The exercise price of the warrant (subject to anti-dilution
adjustments, including for issuances of securities at prices below the
then-effective exercise price ) was $0.50 per share.





Pursuant
to a separate agreement that we entered into with Mr. Pappajohn on July 25,
2010, we granted him a right to convert his Bridge Notes into shares of our
common stock at a conversion price of $0.50. The conversion price was
subject to customary anti-dilution adjustments, but would never be less than
$0.30. Each Bridge Note accrued interest at a rate of 9% per annum.





Deerwood
Notes and Warrants





On July
5, 2010 and August 20, 2010, we issued unsecured promissory notes (each, a
“Deerwood Note”) in the aggregate principal amount of $500,000 to Deerwood
Partners LLC and Deerwood Holdings LLC, with each investor purchasing two notes
in the aggregate principal amount of $250,000. Our director George Kallins and
his spouse are the managing members of these investors. The Deerwood Notes
mature on December 15, 2010.  We received $250,000 in gross proceeds from
the issuance of the first two notes on July 5, 2010 and another $250,000 in
gross proceeds from the issuance of the second two notes on August 20,
2010. In connection with the August 20, 2010 transaction, each of the two
investors also received a warrant to purchase up to 75,000 shares of our common
stock at an exercise price (subject to anti-dilution adjustments, including for
issuances of securities at prices below the then-effective exercise price ) of
$0.56 per share.





SAIL
Venture Partners L.P. (“SAIL”), of which our director David Jones is a managing
partner, issued unconditional guaranties to each of the Deerwood investors,
guaranteeing the prompt and complete payment when due of all principal, interest
and other amounts under each Deerwood Note.  The obligations under each
guaranty were independent of our obligations under the Deerwood Notes and
separate actions could be brought against the guarantor.  We entered into
an oral agreement to indemnify SAIL and grant to SAIL a security interest in our
assets in connection with the guaranties. In addition, on August 20, 2010, we
granted SAIL warrants to purchase up to an aggregate of 100,000 shares of common
stock at an exercise price (subject to anti-dilution adjustments, including for
issuances of securities at prices below the then-effective exercise price ) of
$0.56 per share.


33





Each
Deerwood Note accrued interest at a rate of 9% per annum and  was
convertible into shares of our common stock at a conversion price of
$0.50. The conversion price was subject to customary anti-dilution
adjustments, but would never be less than $0.30.




October
Notes and Warrants




On
October 1, 2010, in connection with a new private placement of convertible
promissory notes (the “October Notes”) and warrants expected to be completed
with new independent investors, we entered into a Note and Warrant Purchase
Agreement (the “Purchase Agreement”) with John Pappajohn and SAIL as investors .
Pursuant to this agreement, we issued to the investors October Notes in the
aggregate principal amount of $1,011,700 and warrants to purchase up to
1,686,144 shares of common stock. The Company received $500,000 in gross
proceeds from the issuance to these investors of October Notes in the aggregate
principal amount of $500,000 and related warrants to purchase up to 833,332
shares. We also issued October Notes in the aggregate principal amount of
$511,700, and related warrants to purchase up to 852,812 shares, to Mr.
Pappajohn in exchange for the cancellation of the two Bridge Notes originally
issued to him on June 3, 2010 and July 25, 2010 in the aggregate principal
amount of $500,000 (and accrued and unpaid interest on those notes) and a
warrant to purchase up to 250,000 shares originally issued to him on July 25,
2010. The transaction closed on October 1, 2010.




On
October 7, 2010 and October 12, 2010, a third and fourth accredited investor
previously unrelated to us executed the Purchase Agreement. In connection
therewith, we issued October Notes in the aggregate principal amount of $600,000
and warrants to purchase up to 999,999 shares of common stock of the Company, to
such investors on those dates. We received $588,000 in net proceeds from these
investors, after paying $12,000 to the placement agent as described below.
Monarch Capital Group LLC (“Monarch”) acted as non-exclusive placement agent
with respect to the October 12, 2010 placement of October Notes in the aggregate
principal amount of $100,000 and related warrants, pursuant to an engagement
agreement, dated September 30, 2010, between us and Monarch. Under the
engagement agreement, in return for its services as non-exclusive placement
agent, Monarch was entitled to receive (a) a cash fee equal to 10% of the gross
proceeds raised from the sale of October Notes to investors introduced to the
Company by Monarch; (b) a cash expense allowance equal to 2% of the gross
proceeds raised from the sale of October Notes to such investors; and (c)
five-year warrants (the “Placement Agent Warrants”) to purchase common stock of
the Company equal to 10% of the shares issuable upon conversion of October Notes
issued to such investors. In connection with the October 12, 2010 closing,
Monarch received a cash fee of $10,000 and a cash expense allowance of $2,000
and, on October 25, 2010, received Placement Agent Warrants to purchase 33,333
shares of the Company’s common stock at an exercise price of $0.33 per
share.




On
October 21 and October 28, 2010, a fifth and sixth accredited investor
previously unrelated to us executed the Purchase Agreement. In connection
therewith, we issued October Notes in the aggregate principal amount of $250,000
and warrants to purchase up to 416,666 shares of common stock to such investors
on that date. We received $250,000 in net proceeds from the issuance to these
investors.




On
November 3, 2010, three affiliated entities, identified below, executed the
Purchase Agreement. In connection therewith, we issued October Notes in the
aggregate principal amount of $762,300 and warrants to purchase up to 1,270,414
shares of common stock, as follows: (a) we received $250,000 in gross proceeds
from the issuance to BGN Acquisition Ltd., LP, an entity controlled by our
director George Kallins, of October Notes in the aggregate principal amount of
$250,000 and related warrants to purchase up to 416,666 shares ; and  (b)
we also issued October Notes in the aggregate principal amount of $512,300, and
related warrants to purchase up to 512,250 shares, to Deerwood Holdings LLC and
Deerwood Partners LLC, two entities controlled by Dr . Kallins, in exchange for
the cancellation of the Deerwood Notes originally issued on July 5, 2010 and
August 20, 2010 in the aggregate principal amount of $500,000 (and accrued and
unpaid interest on those notes) and warrants to purchase an aggregate of up to
150,000 shares originally issued on August 20, 2010. The related guaranties and
oral indemnification and security agreement that had been entered into in
connection with the Deerwood Notes were likewise terminated.  SAIL, of
which our director David Jones is a managing partner, issued unconditional
guaranties to each of the Deerwood investors, guaranteeing the prompt and
complete payment when due of all principal, interest and other amounts under the
October Notes issued to such investors. The obligations under each guaranty are
independent of our obligations under the October Notes and separate actions may
be brought against the guarantor. In connection with its serving as guarantor,
we granted SAIL warrants to purchase up to an aggregate of 341,498 shares of
common stock. The warrants to purchase 100,000 shares of common stock previously
granted to SAIL on August 20, 2010 were canceled.


34





On
November 12, 2010, another accredited investor previously unrelated to us
executed the Purchase Agreement. In connection therewith, the Company issued
Notes in the aggregate principal amount of $400,000 and Warrants to purchase up
to 666,666 shares of common stock of the Company, to the investor on such
date.  The Company received $352,000 in net proceeds from the
investor.  Monarch acted as non-exclusive placement agent with respect
to the placement of the Note in the aggregate principal amount of $400,000 and
related Warrants, pursuant to the abovementioned engagement agreement, dated
September 30, 2010. In connection with the November 12, 2010 closing, Monarch
received a cash fee of $40,000 and a cash expense allowance of $8,000 and will
receive a Placement Agent Warrant to purchase 133,333 shares of the Company’s
common stock at an exercise price of $0.33 per share.





The
Purchase Agreement provides for the issuance and sale of October Notes, for cash
or in exchange for outstanding convertible notes, in the aggregate principal
amount of up to $3,000,000 plus an amount corresponding to accrued and unpaid
interest on any exchanged notes, and warrants to purchase a number of shares
corresponding to 50% of the number of shares issuable on conversion of the
October Notes. The agreement provides for multiple closings, but mandates that
no closings may occur after January 31, 2011.  The Purchase Agreement
also provides that the Company and the holders of the October Notes will enter
into a registration rights agreement covering the registration of the resale of
the shares underlying the October Notes and the related warrants.




The
October Notes mature one year from the date of issuance (subject to earlier
conversion or prepayment), earn interest equal to 9% per year with interest
payable at maturity, and are convertible into shares of common stock of the
Company at a conversion price of $0.30. The conversion price is subject to
adjustment upon (1) the subdivision or combination of, or stock dividends paid
on, the common stock; (2) the issuance of cash dividends and distributions on
the common stock; (3) the distribution of other capital stock, indebtedness or
other non-cash assets; and (4) the completion of a financing at a price below
the conversion price then in effect. The October Notes are furthermore
convertible, at the option of the holder, into securities to be issued in
subsequent financings at the lower of the then-applicable conversion price or
price per share payable by purchasers of such securities. The October Notes can
be declared due and payable upon an event of default, defined in the October
Notes to occur, among other things, if the Company fails to pay principal and
interest when due, in the case of voluntary or involuntary bankruptcy or if the
Company fails to perform any covenant or agreement as required by the October
Note.




Our
obligations under the terms of the October Notes are secured by a security
interest in the tangible and intangible assets of the Company, pursuant to a
Security Agreement, dated as of October 1, 2010, by and between us and John
Pappajohn, as administrative agent for the holders of the October Notes. The
agreement and corresponding security interest terminate if and when holders of a
majority of the aggregate principal amount of October Notes issued have
converted their October Notes into shares of common stock.




The
warrants related to the October Notes expire seven years from the date of
issuance and are exercisable for shares of common stock of the Company at an
exercise price of $0.30. Exercise price and number of shares issuable upon
exercise are subject to adjustment (1) upon the subdivision or combination of,
or stock dividends paid on, the common stock; (2) in case of any
reclassification, capital reorganization or change in capital stock and (3) upon
the completion of a financing at a price below the exercise price then in
effect. Any provision of the October Notes or related warrants can be amended,
waived or modified upon the written consent of the Company and holders of a
majority of the aggregate principal amount of such notes outstanding. Any such
consent will affect all October Notes or warrants, as the case may be, and will
be binding on all holders thereof.




The
Placement Agent Warrants have an exercise price equal to 110% of the conversion
price of the Notes and an exercise period of five years. The terms of the
Placement Agent Warrants, except for the exercise price and period, are
identical to the terms of the warrants related to the October
Notes.




For a
table showing the differences in terms between the October Notes (and related
warrants), on the one hand, and the exchanged Bridge Notes and Deerwood Notes
(and related warrants), on the other hand, please refer to the table below. See
also Notes 3 and 13 to the audited financial statements.





Differences
between October Notes and Bridge Notes/Deerwood Notes




As
disclosed above, (i) Bridge Notes in the aggregate principal amount of $500,000
(and accrued and unpaid interest thereon) and a related warrant to purchase up
to 250,000 shares were exchanged by Mr. Pappajohn for October Notes in the
aggregate principal amount of $511,688 and related warrants to purchase up to
852,812 shares, (ii) Deerwood Notes in the aggregate principal amount of
$500,000 (and accrued and unpaid interest thereon) and a related warrant to
purchase up to 150,000 shares were exchanged by the Deerwood investors for
October Notes in the aggregate principal amount of $512,250 and related warrants
to purchase up to 512,250 shares, and (iii) warrants to purchase 100,000 issued
to SAIL in connection with its guaranties relating to the Deerwood Notes were
exchanged for warrants to purchase 341,498 shares. The terms of the October
Notes (and related warrants) differed from the terms of the Bridge Notes and
Deerwood Notes (and related warrants) as follows:


35





Term
                
                Bridge Note/Deerwood Note
                
                October NoteMaturity
                
                December
      15, 2010
                
                One
      year from the date of issuanceInitial
      Conversion Price
                
                $0.50,
      with any adjustment being subject to a $0.30 floor
                
                $0.30If
      Company issues common stock (or securities convertible, exercisable or
      exchangeable for common stock), at a consideration (or conversion,
      exercise or exchange price) (the “Offering Price”) less than the
      Conversion Price, Conversion Price will be adjusted to match the Offering
      Price (“Ratchet”)
                
                No
                
                YesPrepayment
      upon financing with aggregate proceeds of not less than
      $3million
                
                Yes
                
                NoNoteholder
      has Security Interest
                
                Yes
      (Bridge Note)
                  
                  No
      (Deerwood Note)
                
                Yes.
      Benefits of security agreement expire on the date that holders of a
      majority of aggregate principal amount of notes issued have converted
      their Notes in accordance with their terms.Events
      of Default (Differences only)
                
                ·     
      General assignment to creditors
                  
                  ·     
      Bankruptcy proceeding, which is not dismissed within 60
      days
                  
                  ·     
      Entry of final judgment for the payment of money in excess of $25,000 and
      failure to satisfy for 30 days
                
                ·     
      Voluntary bankruptcy filing
                  
                  ·     
      Failure to comply with Use of Proceeds covenant in purchase
      agreement
                  
                  ·     
      Court enters bankruptcy order that is not vacated, set aside or reversed
      within 60 daysOption
      to convert notes into securities to be issued in subsequent financings at
      the lower of conversion price or price per share payable by purchasers of
      such securities
                
                No
                
                YesAmendments,
      waivers or modification of the note or related warrants requires written
      consent of the holders of a majority of the aggregate principal amount of
      the notes outstanding, and such written consent will be binding on all
      holders
                
                N/A
      - single investors
                
                Yes




36





Warrant
      Coverage
              
              25%
      (in case of Deerwood Notes, 40% of which was issued to guarantor of
      Deerwood Notes)
              
              50%
      (in case of Deerwood entities, 40% of which was issued to guarantor of
      notes issued to Deerwood entities)Initial
      Exercise Price of Warrants
              
              $0.50
      (Bridge Note); $0.56 (Deerwood Note)
              
              $0.30Ratchet
      as applied to Warrants (see definition above)
              
              Results
      in a decrease in exercise price
              
              Results
      in a decrease in exercise price and corresponding increase in number of
      shares issuable




The
exchange for the October Notes did not trigger anti-dilution adjustments to the
conversion prices of the Bridge Notes or Deerwood Notes. Had the warrants issued
in connection with the Bridge Notes and the Deerwood Notes not been exchanged
for new warrants as described above, the exercise price of the warrants so
issued would have been reduced to $0.30 as a result of the issuance of October
Notes and new warrants in accordance with the anti-dilution provisions
of the warrants issued in connection with the Bridge Notes and the Deerwood
Notes.




Item
      5.
            Other
      Information




On
January 20, February 3 and February 8, 2011, we sold convertible unsecured
notes (the “Unsecured Notes”) in an aggregate principal amount of $350,000 and
warrants to purchase 583,332 shares of common stock to three accredited
investors in connection with a new private placement pursuant to a note and
warrant purchase agreement, under which we can issue an aggregate of up to $5
million in aggregate principal amount of Unsecured Notes, as well as related
warrants.  The terms of the Unsecured Notes are identical to the terms
of the October Notes, except that (i) the Unsecured Notes are not secured by any
of our assets, (ii) the Unsecured Notes are subordinated in all respects to our
obligations under the October Notes and the related guaranties issued to certain
investors by SAIL and (iii) the Company is not subject to a restrictive covenant
to use the use of proceeds from the sale of the Unsecured Notes only for current
operations.  The terms of the new warrants are identical to the terms
of the warrants issued in connection with the October Notes.




Item 6.
            Exhibits




The
following exhibits are filed as part of this report or incorporated by reference
herein:




Exhibit
                    Number
                  
                  Exhibit Title10.38
                  
                  Form
      of Note and Warrant Purchase Agreement, dated October 1, 2010, by and
      between the Registrant and the Investors party
      thereto.  Incorporated by reference to Exhibit 10.1 to the
      Registrant's Current Report on Form 8-K (File Number 000-26285) filed with
      the Securities and Exchange Commission on October 7,
  2010.10.39
                  
                  Security
      Agreement, dated October 1, 2010, by and between the Registrant and John
      Pappajohn, as administrative agent for the secured
      parties.  Incorporated by reference to Exhibit 10.2 to the
      Registrant's Current Report on Form 8-K (File Number 000-26285) filed with
      the Securities and Exchange Commission on October 7,
      2010.10.40
                  
                  Form
      of October Note.  Incorporated by reference to Exhibit 4.1 to
      the Registrant's Current Report on Form 8-K (File Number 000-26285) filed
      with the Securities and Exchange Commission on October 7,
      2010.10.41
                  
                  Form
      of October Warrant.  Incorporated by reference to Exhibit 4.2 to
      the Registrant's Current Report on Form 8-K (File Number 000-26285) filed
      with the Securities and Exchange Commission on October 7,
      2010.10.42
                  
                  Form
      of Placement Agent Warrant issued to Monarch Capital Group,
      LLC.  Incorporated by reference to Exhibit 4.3 to the
      Registrant's Current Report on Form 8-K (File Number 000-26285) filed with
      the Securities and Exchange Commission on October 27,
      2010.10.44
                  
                  Form
      of Guaranty, dated as of November 3, 2010, by SAIL Venture Partners, LP in
      favor of [Deerwood Holdings, LLC][Deerwood Partners,
      LLC].  Incorporated by reference to Exhibit 10.44 to the
      Registrant’s Annual Report on Form 10-K (File No. 000-26285) filed with
      the Commission on December 21, 2010.31.1
                  
                  Certification
      of Principal Executive Officer pursuant to Securities Exchange Act Rules
      13a-14(a) and 15d-14(a) as adopted pursuant to section 302 of the
      Sarbanes-Oxley Act of 2002.31.2
                  
                  Certification
      of Principal Financial Officer pursuant to Securities Exchange Act Rules
      13a-14(a) and 15d-14(a) as adopted pursuant to section 302 of the
      Sarbanes-Oxley Act of 2002.32.1
                  
                  Certification
      of Principal Executive Officer and Principal Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to section 906 of the
      Sarbanes-Oxley Act of
2002.


37


SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.




CNS
      Response, Inc.Date:
      February 14, 2010
                        
                        /s/
      George CarpenterBy:
                        George
      CarpenterIts:
                        Chief
      Executive Officer(Principal
      Executive Officer)/s/
      Paul BuckBy:
                        Paul
      BuckIts:
                        Chief
      Financial Officer(Principal
      Financial Officer)


38