VERTICAL COMPUTER SYSTEMS INC - FORM 10-Q

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EXCEL - IDEA: XBRL DOCUMENT - VERTICAL COMPUTER SYSTEMS INC	Financial_Report.xls
EX-31.1 - EXHIBIT 31.1 - VERTICAL COMPUTER SYSTEMS INC	v345300_ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - VERTICAL COMPUTER SYSTEMS INC	v345300_ex32-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2013

¨ 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 0-28685

_________________________

VERTICAL COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Delaware	65-0393635
(State of incorporation)	(I.R.S. Employer Identification No.)

101 West Renner Road, Suite 300

Richardson, TX 75082

(Address of principal executive offices)

(972) 437-5200

(Registrant’s Telephone Number)

________________

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 Web site, 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 x No ¨

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 a 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 May 17 2013, the issuer had 999,035,151 shares of common stock, par value $0.00001, issued and outstanding.

PART I

FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

	March 31,		December 31,
	2013		2012
Assets
Current assets
Cash	$	42,130	$	111,851
Accounts receivable, net of allowance for bad debts of $51,702 and $52,100		376,767		440,195
Prepaid expenses and other current assets		145,398		115,777
Total current assets		564,295		667,823

Property and equipment, net of accumulated depreciation of $1,025,416 and $1,021,595		26,948		27,062
Intangible assets, net of accumulated amortization of $228,252 and $217,670		867,025		871,721
Deposits and other		15,276		15,346

Total assets	$	1,473,544	$	1,581,952

Liabilities and Stockholder's Deficit
Current liabilities:
Accounts payable and accrued liabilities	$	7,684,301	$	7,466,957
Bank overdraft		18		9,624
Deferred revenue		2,591,994		2,614,714
Derivative liability		24,890		31,440
Convertible debenture		30,000		30,000
Current portion - notes payable		1,257,964		2,486,810
Current portion - notes payable to related parties		343,207		724,790
Total current liabilities		11,932,374		13,364,335

Non-current portion – notes payable		2,756,957		1,188,868

Total liabilities		14,689,331		14,553,203

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

(Continued from previous page)
	March 31,			December 31,
	2013			2012
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 48,500 shares issued and outstanding		9,700,000			9,700,000
Series B 10% Convertible Cumulative Preferred stock; $0.001 Par Value; 375,000 shares authorized; 7,200 shares issued and outstanding		246			246
Series C 4% Convertible Cumulative Preferred stock; $100.00 par value; 200,000 shares authorized; 50,000 shares issued and outstanding		200,926			200,926
Series D 15% Convertible Cumulative Preferred stock; $0.001 Par Value; 300,000 shares authorized; 25,000 shares issued and outstanding		852			852
		9,902,024			9,902,024

Stockholders' Deficit
Common Stock; $.00001 par value; 1,000,000,000 shares authorized 998,335,151 and 997,935,151 issued and outstanding as of March 31, 2013 and December 31, 2012		9,983			9,979
Additional paid-in-capital		19,262,050			19,254,154
Accumulated deficit		(41,905,935	)		(41,621,437	)
Accumulated other comprehensive income – foreign currency translation		(207,044	)		(251,848	)

Total Vertical Computer Systems, Inc. stockholders’ deficit		(22,840,946	)		(22,609,152	)

Noncontrolling interest		(276,865	)		(264,123	)
Total stockholders’ deficit		(23,117,811	)		(22,873,275	)

Total liabilities and stockholders' deficit	$	1,473,544		$	1,581,952

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

	Three Months Ended March 31,
	2013			2012
Revenues
Licensing and software	$	-		$	1,000
Software maintenance		1,085,879			1,136,672
Cloud-based offering		119,068			137,077
Consulting services		110,737			93,730
Other		28,144			21,281
Total revenues		1,343,828			1,389,760

Cost of revenues		663,616			687,873

Gross profit		680,212			701,887
Operating expenses:
Selling, general and administrative expenses		823,860			719,165
Depreciation and amortization		14,098			15,575
Bad debt expense		-			20,872
Total operating expenses		837,958			755,612

Operating loss		(157,746	)		(53,725	)

Other income (expense):
Interest income		7			14
Gain on derivative liability		6,550			1,048
Interest expense		(146,051	)		(156,670	)

Net loss		(297,240	)		(209,333	)

Net loss attributable to noncontrolling interest		12,742			19,601
Net loss attributable to Vertical Computer Systems, Inc.		(284,498	)		(189,732	)
Dividends applicable to preferred stock		(147,000	)		(147,000	)

Net loss available to common stockholders	$	(431,498	)	$	(336,732	)

Basic and diluted loss per share	$	(0.00	)	$	(0.00	)

Basic and diluted weighted average of common shares outstanding		998,075,151			997,535,151

Comprehensive loss
Net loss	$	(297,240	)	$	(209,333	)
Translation adjustments		44,804			(66,876	)
Comprehensive loss		(252,436	)		(276,209	)
Comprehensive loss attributable to noncontrolling interest		12,742			19,601
Comprehensive loss attributable to Vertical Computer Systems, Inc.	$	(239,694	)	$	(256,608	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

(Unaudited)

					Additional					Other			Non-controlling
	Common Stock				Paid-in		Accumulated			Comprehensive			Controlling
	Shares		Amount		Capital		Deficit			Interest			Interest			Total
Balances at December 31, 2012		997,935,151	$	9,979	$	19,254,154	$	(41,621,437	)	$	(251,848	)	$	(264,123	)	$	(22,873,275	)

Issuance of restricted stock		400,000		4		7,896		-			-			-			7,900

Other comprehensive income translation adjustment		-		-		-		-			44,804			-			44,804

Net loss		-		-		-		(284,498	)		-			(12,742	)		(297,240	)

Balances at March 31, 2013		998,335,151	$	9,983	$	19,262,050	$	(41,905,935	)	$	(207,044	)	$	(276,865	)	$	(23,117,811	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

	Three months ended March 31,
	2013			2012

Cash flows from operating activities
Net loss	$	(297,240	)	$	(209,333	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		14,098			15,575
Amortization of debt discounts		-			25,300
Bad debt expense		-			20,872
Gain on derivatives		(6,550	)		(1,048	)
Changes in operating assets and liabilities:
Accounts receivable		41,012			153,372
Prepaid expenses and other assets		(7,135	)		3,787
Accounts payable and accrued liabilities		225,243			(387,419	)
Deferred revenue		(22,719	)		124,207
Net cash used in operating activities		(53,291	)		(254,687	)

Cash flow from investing activities:
Software development		(5,873	)		(85,629	)
Purchase of property and equipment		(3,414	)		(1,884	)
Net cash used in investing activities		(9,287	)		(87,513	)

Cash flows from financing activities:
Borrowings on notes payable		1,759,150			430,000
Payments of notes payable		(1,419,907	)		(35,586	)
Payments of related party notes payable		(381,583	)		(5,066	)
Borrowings on related party debt		-			26,000
Bank overdraft		(9,607	)		(7,903	)
Net cash provided by (used in) financing activities		(51,947	)		407,445

Effect of changes in exchange rates on cash		44,804			(66,876	)
Net change in cash and cash equivalents		(69,721	)		(1,631	)
Cash and cash equivalents, beginning of period		111,851			132,452
Cash and cash equivalents, end of period	$	42,130		$	130,821

Supplemental disclosures of cash flow information:
Cash paid for interest	$	85,385		$	74,168

Non-cash investing and financing activities:
Common shares issued for accrued stock compensation	$	7,900		$	6,200

See accompanying notes to unaudited consolidated financial statements

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1. Organization, Basis of Presentation and Significant Accounting Policies

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 2012. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable). NOW Solutions, a wholly-owned subsidiary of Vertical currently maintains daily business operations, EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. (“PMI”) and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary and is inactive and Vertical Healthcare Solutions, Inc. (“VHS”), SnAPPnet, Inc. (“SnAPPnet”), OptVision Research, Inc. (“OVR”), Taladin, Inc. (“Taladin”), and Vertical do Brasil, each of which has minor activities, are all wholly-owned subsidiaries of Vertical. Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary, and Priority Time Systems, Inc. (“Priority Time”) a 90% owned subsidiary, are entities with minor activities. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported in the 2012 annual report on Form 10-K have been omitted.

Earnings per share

Basic earnings per share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of shares of the Company’s common stock outstanding during the period. “Diluted earnings per share” reflects the potential dilution that could occur if our share-based awards and convertible securities were exercised or converted into common stock. The dilutive effect of our share-based awards is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. The dilutive effect of our convertible preferred stock and convertible debentures is computed using the if-converted method, which assumes conversion at the beginning of the year.

For the three months ended March 31, 2013 and 2012, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive.

Reclassifications

Certain reclassifications have been made to the prior periods to conform to the current period presentation.

Recently Issued Accounting Pronouncements

In February 2013, the FASB issued ASU 2013-02 "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income" (ASU 2013-02). ASU 2013-02 amends ASU 2011-05 and requires that entities disclose additional information about amounts reclassified out of Accumulated Other Comprehensive Income (AOCI) by component. Significant amounts reclassified out of AOCI are required to be presented either on the face of the Consolidated Statements of Income and Comprehensive Income or in the notes to the financial statements. The requirements of ASU 2013-02 are effective for fiscal years and interim periods in those years beginning after December 15, 2012. The Company does not expect the adoption of ASU 2013-02 to have a material impact on the Company’s financial statements.

Note 2. Going Concern

The accompanying unaudited consolidated financial statements for the three months ended March 31, 2013 and 2012 have been prepared assuming that we will continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.

The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. As of March 31, 2013, we had negative working capital of approximately $11.4 million and defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

Our management is continuing its efforts to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations as well as to generate additional revenue through our existing businesses, including the licensing of our intellectual property. We will require additional funds to pay down our liabilities, as well as finance our expansion plans consistent with our anticipated changes in operations and infrastructure. However, there can be no assurance that we will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to us and whether we will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for this uncertainty.

Note 3. Notes Payable

The following table reflects our debt activity, including our convertible debt, for the three months ended March 31, 2013:

December 31, 2012	$	3,705,678
Repayments of third party notes		(1,419,907	)
Borrowings from third parties		1,759,150
March 31, 2013	$	4,044,921

On January 9, 2013, NOW Solutions completed a financing transaction in the aggregate amount of $1,759,150, which amount was utilized to pay off existing indebtedness of the Company and NOW Solutions to Tara Financial Services and Robert Farias, an employee of the Company and all security interests granted to Tara Financial Services and Robert Farias were cancelled.

In connection with this financing, the Company and several of its subsidiaries entered into a loan agreement (the “Loan Agreement”), dated as of January 9, 2013 with Lakeshore Investment, LLC (“Lakeshore”) under which NOW Solutions issued a secured 10-year promissory note (the “Lakeshore Note”) bearing interest at 11% per annum to Lakeshore in the amount of $1,759,150 payable in equal monthly installments of $24,232 until January 31, 2022. The Lakeshore Note contains provisions requiring additional principal reductions in the event sales by NOW Solutions exceed certain financial thresholds. The Loan Agreement contains provisions requiring certain additional principal prepayments toward the Lakeshore Note by the Company from any litigation or settlement proceeds regarding its SiteFlash technology less any attorney fees and direct costs (“Net Claim Proceeds”) and a 5% interest due to Lakeshore (as described below) and a 2% interest due to the inventor of SiteFlash.

Pursuant to the Loan Agreement, as amended, the Company also agreed to make certain principal payments toward the Lakeshore Note of (a) $90,000 by February 15, 2013, which was secured by 15% interest in the Company’s ownership of Priority Time and this payment was timely made to Lakeshore and (b) $600,000 by March 15, 2013, which was secured by 25% of the Company’s ownership interest in NOW Solutions and this payment was not made to Lakeshore. The Company is in discussions with Lakeshore concerning its failure to make this payment.

The Lakeshore Note is secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“SnAPPnet”) and the Company’s SiteFlash technology and cross-collateralized. Upon the aggregate principal payment of $290,000 toward the Lakeshore Note, the Company has the option to have Lakeshore release either the Priority Time collateral or the SiteFlash collateral. Upon payment of the aggregate principal $590,000 toward the Lakeshore Note, Lakeshore shall release either the Priority Time collateral or the SiteFlash collateral (whichever is remaining). Upon payment of the aggregate principal $890,000 toward the Lakeshore Note, Lakeshore shall release the SnAPPnet collateral and upon full payment of the Lakeshore Note, Lakeshore shall release the NOW Solutions collateral.

As additional consideration for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees and direct costs) from any litigation or settlement proceeds related to the SiteFlash technology to Lakeshore. In addition, until the Note is paid in full, NOW Solutions agreed to pay a Lakeshore royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management estimated the fair value of the royalty to be nominal as of January 9, 2013. Due to this, no value was assigned to the royalty and no associated discount was recorded against the debt. Should the royalty be determined to be anything other than nominal in the future, the Company will accrue the royalty payable on a quarterly basis.

During the three months ended March 31, 2013 and 2012, the Company made interest payments of $85,385 and $74,168, respectively.

Note 4. Derivative liability and fair value measurements

Derivative liability

During 2008, one of our officers pledged 3,000,000 shares of common stock (through a company he controls) to secure the debt owed to a third party lender. In connection with the pledge of stock, we signed an agreement to replace these shares within one year. Subsequent to this agreement, 1,309,983 shares of this stock were sold to satisfy the debt owed to the lender. This contractual commitment to replace all of the pledged shares was evaluated under FASB ASC 815-40, Derivatives and Hedging and was determined to have characteristics of a liability and therefore constituted a derivative liability under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At March 31, 2013 and December 31, 2012, the fair value of the derivative liability was $24,890 and $31,440.

The aggregate gain or loss on the change in the fair value of derivative liabilities was a gain of $6,550 and $1,048 for the three months ended March 31, 2013 and 2012, respectively.

The valuation of our embedded derivatives is determined by using the VCSY stock price at March 31, 2013. As such, our derivative liabilities have been classified as Level 1.

Fair value measurements

FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC 820 describes three levels of inputs that may be used to measure fair value:

Level 1 – Quoted prices in active markets for identical assets or liabilities.

Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 – Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation.

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level of input that is significant to the fair value measurement of the instrument.

The following table provides a summary of the fair value of our derivative liabilities as of March 31, 2013 and December 31, 2012:

	Fair value measurements on a recurring basis
	Level 1		Level 2		Level 3
As of March 31, 2013:
Liabilities
Stock derivative – 1,309,983 shares	$	24,890	$	-	$	-

As of December 31, 2012:
Liabilities
Stock derivative – 1,309,983 shares	$	31,440	$	-	$	-

The estimated fair value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities and deferred revenue approximates their carrying value due to their short-term nature. The estimated fair value of our long-term borrowings approximates carrying value since the related rates of interest approximate current market rates.

Note 5. Common and Preferred Stock Transactions

During the three months ended March 31, 2013, 400,000 shares granted to employees of the Company, valued at $7,900, vested.

As of the Date of this Report, we have determined that we currently have (i) the following shares of common stock issued, and (ii) outstanding shares of preferred stock which are convertible into the shares of common stock indicated below and a contractual commitment to issue the shares of common stock indicated below:

998,335,151		Common Stock Issued
24,250,000		Common Shares convertible from Preferred Series A Stock (48,500 shares outstanding)
27,274		Common Shares convertible from Preferred Series B Stock (7,200 shares outstanding)
5,000,000		Common Shares convertible from Preferred Series C Stock (50,000 shares outstanding)
94,700		Common Shares convertible from Preferred Series D Stock (25,000 shares outstanding)
1,309,983		Common Shares Company Is Obligated to Reimburse to an officer of the Company for Pledged Shares (for officer’s Pledged Shares Sold on the Company’s behalf)
1,029,017,108		Total Common Shares Outstanding and Accounted For/Reserved

In addition, the Company has $30,000 in an outstanding convertible debenture that had been issued to a third party.

Accordingly, given the fact that the Company currently has 1,000,000,000 shares of common stock authorized, the Company could exceed its authorized shares of common stock by approximately 30,000,000 shares if all of the financial instruments described in the table above were exercised or converted into shares of common stock (excluding the $30,000 from the outstanding debenture noted above).

We have evaluated our convertible cumulative preferred stock under the guidance set out in FASB ASC 470-20 and have accordingly classified these shares as temporary equity in the consolidated balance sheets.

Note 6. Stock Options, Warrants and Restricted Stock Awards

Stock Options and Warrants

There are currently no outstanding common stock options or warrants.

Restricted Stock

A summary of the activity of the restricted stock for the three months ended March 31, 2013 is shown below.

	Shares			Weighted Average Grant-Date Fair Value

Non Vested Balance at December 31, 2012		1,100,000		$	0.0186
Granted		-			-
Vested		(400,000	)		0.0198
Forfeited/Cancelled		-			-
Non Vested Balance at March 31, 2013		700,000		$	0.0179

As of March 31, 2013, there was $9,651 of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of less than 3 years.

Note 7. Related Party Transactions

In January 2013, the Company paid off all existing indebtedness of the Company and the underlying security interest granted to Mr. Farias was cancelled, including two promissory notes bearing interest at 10% per annum that were issued in the principal amount of $274,679 and $90,000, respectively. Mr. Farias serves as our Executive Vice-President of Business Development.

The following table reflects our related party debt activity for the three months ended March 31, 2013:

December 31, 2012	$	724,790
Repayments of related party notes		(381,583	)
March 31, 2013	$	343,207

Note 8. Legal Proceedings

We are involved in the following ongoing legal matters:

In August 2009, Parker Shumaker & Mills, LLP (“PSM”) filed a lawsuit in Los Angeles Superior Court to collect the outstanding balance of $51,238 under a promissory note issued by the Company to PSM in the principal amount of $75,000, plus interest at 6% per annum, late fees and attorneys’ fees. We issued the $75,000 note in connection with a settlement in October 2005 with PSM. In December 2009, we entered into a settlement agreement and stipulated judgment with PSM whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM. At December 31, 2012, all payments due under the settlement agreement to PSM have been made and this matter has been resolved.

On November 18, 2009, we sued InfiniTek Corporation (“InfiniTek”) in the Texas State District Court in Fort Worth, Texas for breach of contract and other claims (the “Texas Action”) seeking equitable relief and unspecified damages when a dispute between the Company and InfiniTek was not resolved. All agreements with InfiniTek have been cancelled. On January 15, 2010, InfiniTek filed a counter-claim for non-payment of amounts billed. InfiniTek claimed it was owed $195,000 plus lost opportunity costs of not less than $220,000.

On April 7, 2010, we were served with a lawsuit filed by InfiniTek in the California Superior Court in Riverside, California seeking damages in excess of $76,303 for breach of contract and lost profit (the “California Action”). This lawsuit related to one of the causes of action and the same set of underlying facts, as those in the Texas legal action. On May 7, 2010, we filed a motion to dismiss this action. On July 14, 2010, the court denied our motion. On August 13, 2010, we filed an answer to InfiniTek’s complaint, including a denial and affirmative defenses.

On December 31, 2011, the Company and InfiniTek entered into a settlement agreement whereby the Texas Action and the California Action were both dismissed. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments due under the settlement agreement as of November 16, 2012 and each party is alleging the other party is in breach of the settlement agreement. We are currently seeking to resolve all disputes with InfiniTek.

On November 15, 2010, we filed a lawsuit in the Federal District Court for the Eastern District of Texas (the “Vertical Action”) against Interwoven, Inc. ("Interwoven"), LG Electronics MobileComm U.S.A., Inc., LG Electronics, Inc., Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (collectively, the "Defendants"). We sued the Defendants for patent infringement claims under United States Patent No. 6,826,744 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) and United States Patent No. 7,716,629 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) (collectively the “the Patents-in-Suit”), both of which are owned by the Company. We seek an award of monetary damages and other relief. The case is styled Vertical Computer Systems, Inc. v Interwoven, Inc., LG Electronics Mobilecomm U.S.A., Inc., No. 2:10-CV-00490.

On November 17, 2010, we were served with a lawsuit filed on October 14, 2010 by Interwoven in the United States District Court for the Northern District of California (the “Interwoven Action”). This lawsuit is a complaint for declaratory judgment, in which Interwoven is requesting that the court find that no valid and enforceable claim of either of the two patents referenced above has been infringed by Interwoven. The case is styled Interwoven, Inc. v Vertical Computer Systems, Inc. No. 3:10-CV-4645-RS.

On January 11, 2011, Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (“Samsung”) filed a lawsuit in the United States District Court for the Northern District of California seeking to consolidate its lawsuit with the Interwoven Action. This case is styled Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc., v. Vertical Computer Systems, Inc., No. 3:11-CV-00189-RS.

On May 2, 2011, the United States District Court for the Northern District of California denied Vertical’s renewed motion to transfer the Interwoven Action to the Eastern District of Texas and granted Vertical's motion to transfer the lawsuit filed by Samsung in the Northern District of California to the Eastern district in Texas. On May 11, 2011, the United States District Court for the Eastern District of Texas granted Interwoven’s motion to transfer the case to the Northern District of California with respect to Interwoven and denied Samsung’s motion to transfer its case to the Northern district. On May 12, 2011, Vertical filed in the United States Court of Appeals for the Federal Circuit a petition for a writ of mandamus seeking review of that portion of the May 2, 2011 order by the Northern District of California which refused to transfer the Interwoven v. Vertical action to the Eastern District of Texas, which was denied on August 17, 2011.

On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order concerning the terms found in the claims of the Patents-in-Suit.

On March 8, 2012, the United States District Court for the Northern District of California in the Interwoven Action denied Interwoven’s motion to stay all judicial proceedings pending the outcome of an ex parte reexamination of each of the Patents-in-Suit by the United States Patent and Trademark Office (“USPTO”).

On October 12, 2012, the USPTO issued an ex parte reexamination certificate of United States Patent No. 7,716,629. In the ex parte reexamination certificate, Claims 21-36, 29, 30, and 32 were confirmed; Claims 1, 8, 11, 13, 28 and 31 were determined to be patentable as amended, Claims 2-6, 9, 10, 12, 14-17, 19 and 20, which were dependent on an amended claim, were determined to be patentable, and claims 7, 18 and 27 were not reexamined.

On October 25, 2012, the USPTO notified the Company of its intent to issue an ex parte reexamination certificate concerning the ex parte reexamination of United States Patent No. 6,826,744. In the notice of intent to issue ex parte reexamination certificate, the USPTO notified that the prosecution on the merits is closed in this ex parte reexamination proceeding and indicated that Claims 6, 8, 19, 22, 30, 32, 41, 44, 50, 51 were confirmed; Claims 1 and 26 were cancelled; ; Claims 12-17, 20, 34-39, 42 and 43 are not subject to reexamination; newly presented Claims 54-57 are patentable and continuation of patent claims amended: 2-5, 7, 9-11, 18, 21, 23-25, 27-29, 31, 33, 40, 45-49, 52 and 53.

On October 22, 2012, Interwoven filed a motion for summary judgment for unenforceability and invalidity of the Patents-in-Suit in the Interwoven Action. On November 4, 2012, we filed an opposition to Interwoven’s motion. On January 4, 2013, the district court denied Interwoven’s motion in its entirety. Discovery has been completed and the trial is set for August 12, 2013.

On July 8, 2011, we were served with a lawsuit in the Texas State District Court in Dallas, Texas by Clark Consulting Services, Inc. (“CCS”) for breach of contract and other claims. CCS was seeking damages from us in excess of $133,750 plus attorney’s fees and interest. On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses. In December 2011, the Company and CCS entered into a settlement agreement whereby the lawsuit was dismissed. Pursuant to the terms of the settlement agreement, the Company agreed to pay CCS $134,000, which was to be paid in installment payments. Due to the Company’s failure to make timely payments, an additional $60,000 was added to the outstanding balance. On October 26, 2012, we entered into an agreement under which we agreed to make monthly payments of $5,000 and pay the outstanding balance plus attorney’s fees and costs by February 1, 2013. As of December 31, 2012, the settlement amount of $149,000 is included in accounts payable and accrued liabilities. On January 31, 2013, the parties entered into an agreement whereby the Company agreed to make $10,000 monthly payments in February, March and April of 2013 (of which $2,500 will be applied as late fees) with payment of the outstanding balance due on May 1, 2013. On or about May 1, 2013, the parties agreed to extend the date by which the Company has to pay off the balance of the settlement amount whereby the Company agreed to make $10,000 monthly payments in May, June, July and August of 2013 (of which $2,500 will be applied as late fees) with payment of the outstanding balance due on September 1, 2013.

On October 11 2012, Micro Focus (US), Inc. (“Micro Focus”) filed a lawsuit against NOW Solutions in the United States District Court for the southern division district of Maryland alleging breaches of its contractual obligations under an independent software agreement and copyright infringement. On January 28, 2013, NOW Solutions and Micro Focus entered into a settlement agreement whereby NOW Solutions agreed to pay Micro Focus $420,000, of which $25,000 was paid in January and the remaining $375,000 balance is to be paid under a promissory note bearing no interest and payable in three monthly installments of $15,000 beginning in February with the outstanding balance due on April 30, 2013. In connection with the settlement, the Company entered into a guaranty agreement with Micro Focus concerning NOW Solutions’ obligations under the promissory note. The Company did not make the $375,000 payment due to Micro Focus. On May 1, 2013, NOW Solutions received a notice of default concerning its failure to pay the $375,000 balance due under the promissory note. Micro Focus has a confession of judgment by NOW Solutions in connection with the promissory note for the outstanding balance due under the note, plus interest at 15% and reasonable attorney’s fees. On May 15, 2013, Vertical was served with a lawsuit in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning the guaranty by Vertical to Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. Micro Focus is seeking damages of $375,000, plus attorneys’ fees of $70,000, plus interest at 15% per annum from the date the lawsuit was filed. We intend to resolve this matter with Micro Focus.

Note 9. Subsequent Events

On May 1, 2013, 150,000 shares granted to a consultant of the Company, valued at $2,325, vested.

For an update subsequent events concerning litigation, please see “Legal Proceedings” under Note 8.

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

The following discussion is a summary of the key factors management considers necessary or useful in reviewing the Company’s results of operations, liquidity and capital resources. The following discussion and analysis should be read together with the accompanying Unaudited Consolidated Financial Statements, and the cautionary statements and risk factors included below in Item 1A of Part II of this Report.

Critical Accounting Policies

Capitalized Software Costs

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value. During the three months ended March 31, 2013 and 2012, $5,873 and $85,629 of internal costs were capitalized, respectively.

Revenue Recognition

Our revenue recognition policies are in accordance with standards on software revenue recognition, which include guidance on revenue arrangements with multiple deliverables and arrangements that include the right to use of software stored on another entity’s hardware.

In the case of non-software arrangements, we apply the guidance on revenue arrangements with multiple deliverables and wherein multiple elements are allocated to each element based on the element’s relative fair value. Revenue allocated to separate elements is recognized for each element in accordance with our accounting policies described below. If we cannot account for items included in a multiple-element arrangement as separate units of accounting, they are combined and accounted for as a single unit of accounting and generally recognized as the undelivered items or services are provided to the customer.

Consulting. We provide consulting services, primarily implementation and training services, to our clients using a time and materials pricing methodology. The Company prices its delivery of consulting services on a time and materials basis where the customer is either charged an agreed-upon daily rate plus out-of-pocket expenses or an hourly rate plus out-of-pocket expenses. In this case, the Company is paid fees and other amounts generally on a monthly basis or upon the completion of the deliverable service and recognizes revenue as the services are performed.

Software License. We sell concurrent perpetual software licenses to our customers. The license gives the customer the right to use the software without regard to a specific term. We recognize the license revenue upon execution of a contract and delivery of the software, provided the license fee is fixed and determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. When the software license arrangement requires the Company to provide consulting services that are essential to the functionality of the software, the product license revenue is recognized upon the acceptance by the customer and consulting fees are recognized as services are performed.

Software licenses are generally sold as part of a multiple-element arrangement that may include maintenance and, under a separate agreement, consulting services. The consulting services are generally performed by the Company, but the customer may use a third-party to perform the consulting services. We consider these separate agreements as being negotiated as a package. The Company determines whether there is vendor specific objective evidence of fair value (‘‘VSOEFV’’) for each element identified in the arrangement, to determine whether the total arrangement fees can be allocated to each element. If VSOEFV exists for each element, the total arrangement fee is allocated based on the relative fair value of each element. In cases where there is not VSOEFV for each element, or if it is determined that services are essential to the functionality of the software being delivered, we initially defer revenue recognition of the software license fees until VSOEFV is established or the services are performed. However, if VSOEFV is determinable for all of the undelivered elements, and assuming the undelivered elements are not essential to the delivered elements, we will defer recognition of the full fair value related to the undelivered elements and recognize the remaining portion of the arrangement value through application of the residual method. Where VSOEFV has not been established for certain undelivered elements, revenue for all elements is deferred until those elements have been delivered or their fair values have been determined. Evidence of VSOEFV is determined for software products based on actual sales prices for the product sold to a similar class of customer and based on pricing strategies set forth in the Company’s standard pricing list. Evidence of VSOEFV for consulting services is based upon standard billing rates and the estimated level of effort for individuals expected to perform the related services. The Company establishes VSOEFV for maintenance agreements using the percentage method such that VSOEFV for maintenance is a percentage of the license fee charged annually for a specific software product, which in most instances is 18% of the portion of arrangement fees allocated to the software license element.

Maintenance Revenue. In connection with the sale of a software license, a customer may elect to purchase software maintenance services. Most of the customers that purchase software licenses from us also purchase software maintenance services. These maintenance services are typically renewed on an annual basis. We charge an annual maintenance fee, which is typically a percentage of the initial software license fee and may be increased from the prior year amount based on inflation or other agreed upon percentage. The annual maintenance fee generally is paid to the Company at the beginning of the maintenance period, and we recognize these revenues ratably over the term of the related contract.

While most of our customers pay for their annual maintenance at the beginning of the maintenance period, a few customers have payment terms that allow them to pay for their annual maintenance on a quarterly or monthly basis. If the annual maintenance fee is not paid at the beginning of the maintenance period (or at the beginning of the quarter or month for those few maintenance customers), we will ratably recognize the maintenance revenue if management believes the collection of the maintenance fee is imminent. Otherwise, we will defer revenue recognition until the time that the maintenance fee is paid by the customer. We normally continue to provide maintenance service while awaiting payment from customers. When the payment is received, revenue is recognized for the period that revenue was previously deferred. This may result in volatility in software maintenance revenue from period to period.

Cloud-based offering. We have contracted with third parties to provide new and existing customers with hosting facilities providing all infrastructure and allowing us to offer our currently sold software, emPath® and SnAPPnet™, on a service basis. However, a contractual right to take possession of the software license or run it on another party’s hardware is not granted to the customer. We refer to the delivery method to give functionality to new customers utilizing this service as cloud-based. Since the customer is not given contractual right to take possession of the software, the scope of ASC 350-40 does not apply. A customer using cloud-based software can enter into an agreement to purchase a software license at any time. We generate revenue from cloud-based offering as the customer utilizes the software over the Internet.

We will provide consulting services to customers in conjunction with the cloud-based offering. The rate for such service is based on standard hourly or daily billing rates. The consulting revenue is recognized as services are performed. Customers utilizing their own computer to access cloud-based functionality are charged a fee equal to the number of employees paid each month multiplied by an agreed-upon rate per employee. The revenue is recognized as the cloud-based services are rendered each month.

Allowances for Doubtful Accounts

The Company maintains allowances for doubtful accounts, for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We review delinquent accounts at least quarterly to identify potential doubtful accounts, and together with customer follow-up, estimate the amounts of potential losses.

Deferred Taxes

The Company records a valuation allowance to reduce the deferred tax assets to the amount that management believes is more likely than not to be realized in the foreseeable future, based on estimates of foreseeable future taxable income and taking into consideration historical operating information. In the event management estimates that the Company will not be able to realize all or part of its net deferred tax assets in the foreseeable future, a valuation allowance is recorded through a charge to income in the period such determination is made. Likewise, should management estimate that the Company will be able to realize its deferred tax assets in the future in excess of its net recorded assets, an adjustment to reduce the valuation allowance would increase income in the period such determination is made.

Stock-Based Compensation Expense

We account for share-based compensation in accordance with the provisions of share-based payments, which require measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares issued and the quoted price of our common stock. See Note 6 of the Consolidated Financial Statements for a further discussion of stock-based compensation.

Valuation of the Embedded and Warrant Derivatives

The valuation of our embedded derivatives is determined by using the Company’s quoted stock price. An embedded derivative is a derivative instrument that is embedded within another contract, which under a convertible note (the host contract) includes the right to convert the note by the holder, certain default redemption right premiums and a change of control premium (payable in cash if a fundamental change occurs). In accordance with the guidance on derivative instruments, embedded derivatives are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. The practical effect of this has been that when our stock price increases so does our derivative liability, resulting in a non-cash loss that reduces our earnings and earnings per share. When our stock price declines, we record a non-cash gain, increasing our earnings and earnings per share.

The fair value recorded for the derivative liability varies from period to period. This variability may result in the actual derivative liability for a period either above or below the estimates recorded on our consolidated financial statements, resulting in significant fluctuations in other income (expense) because of the corresponding non-cash gain or loss recorded.

Recently Issued Accounting Pronouncements

Results of Operations

Three Months Ended March 31, 2013 Compared To Three Months Ended March 31, 2012

Total Revenues. We had total revenues of $1,343,828 and $1,389,760 in the three months ended March 31, 2013 and 2012, respectively. The decrease in total revenues was $45,932 for the three months ended March 31, 2013 representing a 3.3% decrease compared to the total revenues for the three months ended March 31, 2012. Substantially all of the revenues for the three months ended March 31, 2013 and March 31, 2012 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $34,032 or 2.5% of total revenue for the three months ended March 31, 2013 and $28,301 or 2.0% of total revenues for the three months ended March 31, 2012.

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. The revenue from new software licenses decreased by $1,000 compared to that for the three months ended March 31, 2012 as there were no new licensing sales of our emPath® product for the 1^st quarter of 2013. Software maintenance in the three months ended March 31, 2013 decreased by $50,793 or 4.5% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to the loss of one customer in the US and one in Canada somewhat offset by contractual increases to existing customer maintenance agreements. Consulting revenue, in the three months ended March 31, 2013 increased by $17,007 from the same period in the prior year, which represents a 18.1% increase. This increase was primarily due to 2013 consulting services for two customers to install emPath® modules and to deploy emPath® at additional locations. Cloud-based revenues were $119,068 for the three months ended March 31, 2013 compared to $137,077 for the same period in the prior year, representing a $18,009 decrease or 13.1%. The decrease is primarily related to the loss of one customer after they were acquired. Other revenue in the three months ended March 31, 2013 increased by $6,863 or 32.2% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $663,616 for the three months ended March 31, 2013, compared to $687,873 for the three months ended March 31, 2012. The decrease in cost of revenues of $24,257 represents a 3.5% decrease. The decrease in direct cost of revenues was primarily due to lower travel expenses for consultants. During the three months ended March 31, 2013 and 2012, $5,873 and $85,629 of internal costs were capitalized, respectively.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $823,860 and $719,165 in the three months ended March 31, 2013 and 2012, respectively. The increase of $104,695 is 14.6% more than the same period in 2012. The increase is primarily due to increased legal fees to prosecute patent infringement on the company’s intellectual property.

Bad Debt Expense. We had no bad debt expense for the three months ended March 31, 2013 and $20,872 for the three months ended March 31, 2012. The 2012 expense related to the non-payment of a portion of one of NOW Solutions, Inc. customer invoices.

Gain (Loss) on Derivative Liability. The existing derivative liability is adjusted each quarter for changes in the market value of the Company’s common stock. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock. In general, as our stock price increases, the derivative liability increases, resulting in a loss. As our stock price decreases, the derivative liability decreases, resulting in a gain. The gain on derivative liability was $6,550 for the three months ended March 31, 2013 compared to a gain of $1,048 for the same period in 2012.

Interest Expense. We had interest expense of $146,051 and $156,670 for the three months ended March 31, 2013 and 2012, respectively. Interest expense decreased in 2013 by $10,619, representing an increase of 6.8% compared to the same expense in the three months ended March 31, 2012. The decrease was primarily due to a lower interest rate on $1,759,150 of refinanced debt.

Net loss. We had a net loss of $297,240 and $209,333 for the three months ended March 31, 2013 and 2012, respectively. The net loss for the three months ended March 31, 2013 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $157,746. The operating loss was increased by interest expense and reduced by the gain on derivative liability, resulting in a net loss of $297,240 for the three months ended March 31, 2013. For the three months ended March 31, 2013, approximately $272,000 of cost and expenses represent business development efforts for various initiatives being undertaken to launch additional products and services. For the three months ended March 31, 2012, the operating loss of $53,725 was increased by interest expense of $156,670 and reduced by the gain on derivative liability resulting in a net loss of $209,333.

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $147,000 and $147,000 for the three months ended March 31, 2013 and 2012, respectively.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $431,498 and $336,732 for the three months ended March 31, 2013 and 2012, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the three months ended March 31, 2013 and 2012, respectively.

Liquidity and Capital Resources

At March 31, 2013, we had non-restricted cash-on-hand of $42,130 compared to $111,851 at December 31, 2012.

Net cash used in operating activities for the three months ended March 31, 2013 was $53,291 compared to net cash used in operating activities of $254,687 for the three months ended March 31, 2012. For the three months ended March 31, 2013, we collected cash from our customers of $1,378,566. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $674,519, attorney fees of $54,452, professional fees and consulting fees of $77,133 interest payments of $85,385, taxes (including sales tax and VAT) of $38,688, and other regular trade payables of $501,680. For the three months ended March 31, 2012, we collected cash from our customers of $1,361,093. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $1,002,024, attorney fees of $19,500, professional fees and consulting fees of $70,416, interest payments of $74,168, taxes (including sales tax and VAT) of $174,615, and other regular trade payables of $275,057.

A large portion of our cash (and revenue) comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. Deferred revenue decreased $22,719 or 0.9%% from the balance at December 31, 2012. The decrease was due to the loss of two customer maintenance contracts somewhat offset by the impact of contractual price increases on renewing maintenance contracts during 2013.

Our accounts receivable trade decreased from $440,195 at December 31, 2012 to $376,767 (net of allowance for bad debts) at March 31, 2013. The decrease is a result of seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to March.

The accounts payable and accrued liabilities went from $7,466,957 at December 31, 2012 to $7,684,301 at March 31, 2013. The resulting balance at March 31, 2013 is 20 times more than the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

We used cash to invest in equipment and the development of software products for the three months ended March 31, 2013 and March 31, 2012 of $9,287 and $87,513 respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers, and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

For the three months ended March 31, 2013, we paid $1,801,490 of principal on notes payable and notes payable to related parties and had $1,759,150 of new debt funding in the same period. For the three months ended March 31, 2012, we paid $44,549 of principal on notes payable and notes payable to related parties and had $456,000 of new debt funding in the same period.

The total change in cash for the three months ended March 31, 2013 was a decrease of $69,721.

As of the date of the filing of this Report, we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms. Therefore, we need to raise additional funds through selling securities, obtaining loans, renegotiating the terms of our existing debt and/or increasing sales with our new products. Our inability to raise such funds or renegotiate the terms of our existing debt will significantly jeopardize our ability to continue operations.

As of March 31, 2013, the following contractual obligations and commercial commitments were outstanding:

	Balance at		Due in Next Five Years
Contractual Obligations	March 31, 2013		2013		2014		2015		2016		2017+
Notes payable	$	4,358,128	$	1,576,288	$	136,408	$	152,192	$	177,580	$	2,315,660
Convertible debts		30,000		30,000		-		-		-		-
Operating lease		193,091		69,909		93,330		29,852		-		-
Total	$	4,581,219	$	1,676,197	$	229,738	$	182,044	$	177,580	$	2,315,660

Of the above notes payable, the default status is as follows:

	March 31, 2013		December 31, 2012

In default	$	964,797	$	2,276,994
Not in default		3,393,331		2,123,474

Total Notes Payable	$	4,358,128	$	4,400,468

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We had a net loss of $297,240 for the three months ended March 31, 2013 and a net loss of $209,333 for the three months ended March 31, 2012, and we have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at March 31, 2013, we had negative working capital of approximately $11.4 million (although this figure includes deferred revenue of approximately $2.6 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

Our management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations as well as to generate additional revenue through our existing businesses, including the licensing of our intellectual property. We will require additional funds to pay down our liabilities, as well as finance our expansion plans consistent with our anticipated changes in operations and infrastructure. However, there can be no assurance that we will be able to secure additional funds and if such funds are available, whether the terms or conditions would be acceptable to us and whether we will be able to turn into a profitable position and generate positive operating cash flow. The unaudited consolidated financial statements contain no adjustment for the outcome of this uncertainty.

Related Party Transactions

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures

Our management, principally our chief financial officer and chief executive officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our management concluded that our disclosure controls and procedures as of the end of the period covered by this report were not effective such that the information required to be disclosed by us in reports filed under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding disclosure. In particular, we have identified the following material weakness of our internal controls:

There is an over-reliance upon independent financial reporting consultants for review of critical accounting areas and disclosures and material non-standard transactions.

There is a lack of sufficient accounting staff due to the size of the Company which results in a lack of segregation of duties necessary for a good system of internal control.

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2012, as filed on April 16, 2013.

There have been no material changes in our internal control over financial reporting since our reporting on Form 10-K for the year ended December 31, 2012.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order concerning the terms found in the claims of the Patents-in-Suit.

Item 1A. Risk Factors

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2012, as filed on April 16, 2013.

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

During the three months ended March 31, 2013, 400,000 shares granted to employees of the Company, valued at $7,900, vested.

On May 1, 2013, 150,000 shares granted to a consultant of the Company, valued at $2,325, vested.

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

The following documents are filed as part of this report:

31.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 17, 2013	Provided herewith

32.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 17, 2013	Provided herewith

101.INS*	XBRL Instance Document	Provided herewith

101.SCH*	XBRL Taxonomy Extension Schema	Provided herewith

101.CAL *	XBRL Taxonomy Extension Calculation Linkbase	Provided herewith

101.DEF*	XBRL Taxonomy Extension Definition Linkbase	Provided herewith

101.LAB*	XBRL Taxonomy Extension Label Linkbase	Provided herewith

101.PRE*	XBRL Taxonomy Extension Presentation Linkbase	Provided herewith

* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

SIGNATURES

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

	VERTICAL COMPUTER SYSTEMS, INC.

May 17, 2013	By:	/s/ Richard Wade
		Richard Wade,
		President and Chief Executive Officer
		(Principal Executive Officer and
		Principal Accounting Officer)

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