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, 2015

 

¨ 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 14, 2015, the issuer had 1,003,545,134 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,
		2015				2014
Assets
Current assets
Cash		$	119,071			$	117,866
Accounts receivable, net of allowance for bad debts of $131,562 and $97,419			120,155				560,879
Prepaid expenses and other current assets			49,134				41,387
Total current assets			288,360				720,132
Property and equipment, net of accumulated depreciation of $1,042,715 and $1,026,654			2,279				28,089
Intangible assets, net of accumulated amortization of $312,467 and $302,016			789,662				657,978
Deposits and other assets			24,138				24,388
Total assets		$	1,104,439			$	1,430,587
Liabilities and Stockholder's Deficit
Current liabilities:
Accounts payable and accrued liabilities		$	10,788,043			$	10,603,879
Accounts payable to related parties			94,059				92,191
Bank overdraft			32,257				7,699
Deferred revenue			2,053,316				2,321,044
Derivative liabilities			-				51,719
Convertible debenture			30,000				30,000
Current portion - notes payable			4,644,924				4,545,239
Current portion - notes payable to related parties			348,666				348,666
Total current liabilities			17,991,265				18,000,437
Total liabilities			17,991,265				18,000,437

 

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,
		2015				2014
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; 2,000,000,000 shares authorized;
1,003,545,134 and 999,735,151 issued and outstanding as of March 31, 2015 and December 31, 2014			10,036				9,998
Additional paid-in capital			20,075,422				19,925,061
Accumulated deficit			(47,854,216	)			(47,174,557	)
Accumulated other comprehensive income – foreign currency translation			380,586				145,808
Total Vertical Computer Systems, Inc. stockholders’ deficit			(27,388,172	)			(27,093,690	)
Noncontrolling interest			599,322				621,816
Total stockholders’ deficit			(26,788,850	)			(26,471,874	)
Total liabilities and stockholders' deficit		$	1,104,439			$	1,430,587

 

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,
		2015				2014
Revenues
Licensing and software		$	-			$	875,000
Software maintenance			890,729				1,026,363
Cloud-based offering			85,247				109,916
Consulting services			63,859				78,100
Other			15,000				14,639
Total revenues			1,054,835				2,104,018
Cost of revenues			425,862				586,718
Gross profit			628,973				1,517,300
Operating expenses:
Selling, general and administrative expenses			873,893				1,432,953
Depreciation and amortization			31,365				11,919
Bad debt expense			36,190				-
Impairment of software costs			-				192,955
Total operating expenses			941,448				1,637,827
Operating loss			(312,475	)			(120,527	)
Other income (expense):
Interest income			4				8
Gain (loss) on derivative liability			(78,680	)			4,741
Forbearance fees			-				(73,301	)
Interest expense			(255,496	)			(213,522	)
Net loss before noncontrolling interest and income tax expense			(646,647	)			(402,601	)
Income tax expense			25,506				-
Net loss before noncontrolling interest			(672,153	)			(402,601	)
Net loss attributable to noncontrolling interest			(7,506	)			(656	)
Net loss attributable to Vertical Computer Systems, Inc.			(679,659	)			(403,257	)
Dividend applicable to preferred stock			(147,000	)			(147,000	)
Net loss applicable to common stockholders		$	(826,659	)		$	(550,257	)
Basic and diluted loss per share		$	(0.00	)		$	(0.00	)
Basic and diluted weighted average of common shares outstanding			1,000,055,816				999,125,151
Comprehensive loss
Net loss		$	(672,153	)		$	(402,601	)
Translation adjustments			234,778				112,238
Comprehensive loss			(437,375	)			(290,363	)
Comprehensive loss attributable to noncontrolling interest			(7,506	)			(656	)
Comprehensive loss attributable to Vertical Computer Systems, Inc.		$	(444,881	)		$	(291,019	)

 

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, 2014			999,735,151			$	9,998			$	19,925,061			$	(47,174,557	)		$	145,808			$	621,816			$	(26,471,874	)
Shares issued for resolutions of derivative liabilities			3,309,983				33				130,366				-				-				-				130,399
Shares issued for reimbursement of stock			500,000				5				19,995				-				-				-				20,000
Dividends paid to non-controlling interest			-				-				-				-				-				(30,000	)			(30,000	)
Other comprehensive income translation adjustment			-				-				-				-				234,778				-				234,778
Net loss			-				-				-				(679,659	)			-				7,506				(672,153	)
Balances at March 31, 2015			1,003,545,134			$	10,036			$	20,075,422			$	(47,854,216	)		$	380,586			$	599,322			$	(26,788,850	)

 

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,
		2015				2014
Cash flows from operating activities
Net loss		$	(672,153	)		$	(402,601	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization			31,365				11,919
Bad debt expense			36,190				-
Impairment of software development costs			-				192,955
Loss (gain) on derivatives			78,680				(4,741	)
Stock reimbursement expense			20,000				-
Write-off of property and equipment			5,015				-
Changes in operating assets and liabilities:
Accounts receivable			390,856				(439,805	)
Prepaid expenses and other assets			6,183				(5,417	)
Accounts payable and accrued liabilities			186,028				793,313
Deferred revenue			(267,728	)			48,275
Net cash provided by (used in) operating activities			(185,564	)			193,898
Cash flow from investing activities:
Software development			(142,253	)			(33,200	)
Net cash used in investing activities			(142,253	)			(33,200	)
Cash flows from financing activities:
Borrowings on notes payable			100,000				-
Payments of notes payable			-				(23,644	)
Payments of related party debt			-				(20,992	)
Dividends paid to non-controlling interest			(30,000	)			-
Bank overdraft			24,558				32,419
Net cash provided by (used in) financing activities			94,558				(12,217	)
Effect of changes in exchange rates on cash			234,464				112,767
Net change in cash and cash equivalents			1,205				261,248
Cash and cash equivalents, beginning of period			117,866				162,709
Cash and cash equivalents, end of period		$	119,071			$	423,957
Supplemental disclosures of cash flow information:
Cash paid for interest		$	68,960			$	89,989
Non-cash investing and financing activities:
Common shares issued for accrued stock compensation		$	-			$	7,900

 

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, 2014. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable). Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), a 80% owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. (“Taladin"), Ploinks, Inc. (“Ploinks”) (formerly, OptVision Research, Inc.), Vertical Healthcare Solutions, Inc. (“VHS”), each a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”) a 70% owned subsidiary, and Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary, Vertical’s subsidiaries which are inactive include EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary of Vertical. 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 2014 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, 2015 and 2014, 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.

 

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, 2015, the Company capitalized an aggregate of $142,253 related to software development.

 

Recently Issued Accounting Pronouncements

 

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial position, operations or cash flows.

 

 

Note 2. Going Concern

 

The accompanying unaudited consolidated financial statements for the three months ended March 31, 2015 and 2014 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, 2015, we had negative working capital of approximately $17.7 million and defaulted on substantially all 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. The Company will require additional funds to pay down its liabilities, as well as finance its expansion plans consistent with anticipated changes in operations and infrastructure. However, there can be no assurance that the Company will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to the Company and whether the Company will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.

 

Note 3. Notes Payable

 

The following table reflects our third party debt activity, including our convertible debt, for the three months ended March 31, 2015:

 

December 31, 2014		$	4,575,239
Issuance of third party notes			100,000
Effect of currency exchange			(315	)
March 31, 2015			4,674,924

 

Lakeshore Financing

 

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, a former employee of the Company, and all security interests granted to Tara Financial Services and Mr. 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. Upon the payment of any prepayment principal amounts, the monthly installment payments shall be proportionately adjusted proportionately on an amortized rata basis. 

 

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 of $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 of $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 has estimated the fair value of the royalty to be nominal as of its issuance date and no royalty was owed as of March 31, 2015 or December 31, 2014.

 

 

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. As of September 30, 2013, the common shares of NOW Solutions representing a 25% ownership interest in NOW Solutions were in Lakeshore’s possession, but Lakeshore had not taken action to transfer the shares in Lakeshore’s name due to forbearance agreements that have been entered into between March and August 2013. In connection with these forbearance agreements, the Company increased the 5% interest in Net Claim Proceeds to an 8% interest, paid a $100,000 transaction fee and made other payments including the issuance of 1,000,000 common shares valued at $47,000 and $5,000 weekly payments whereby such $5,000 payments are to be applied toward a bonus of 25% of NOW Solutions’ profits for the period that runs from March 15, 2013 through September 30, 2013. The aggregate forbearance fees paid to Lakeshore for the year ended December 31, 2014 and 2013 were $197,156 and $327,867, respectively. The last forbearance agreement expired on September 30, 2013 and on October 1, 2013, Lakeshore became a 25% minority owner of NOW Solutions.  While there was an October 1, 2013 amendment to the Loan Agreement that the Company believed was in effect, whereby shares of common stock representing a 25% ownership interest of NOW Solutions (the “NOW shares”) in Lakeshore’s possession were to be returned to the Company, certain terms of the amendment were not fulfilled, resulting in the Company recognizing Lakeshore as the owner of the NOW Shares.  The initial recognition of this noncontrolling interest in NOW Solutions resulted in a loss on loan remedy of $1,457,240 during the year ended December 31, 2013.

 

In December 2014, the Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. Under the terms of the amendment, NOW Solutions agreed to make $2,500 weekly advance payments to Lakeshore to be applied to the 25% dividend of NOW Solutions’ net income after taxes. Within 10 business days after the Company files its periodic reports with the SEC, NOW Solutions will also make quarterly payment advances to Lakeshore based on 60% of Lakeshore’s 25% share of NOW Solutions estimated quarterly net income after taxes, less any weekly payment advances received by Lakeshore during the then-applicable quarter and the weekly $2,500 payments shall be increased or decreased based only upon any increases or decreases of maintenance and SaaS fees during the then-completed quarter (but will not decrease below a minimum of $2,500 per week). NOW Solutions shall pay Lakeshore the balance of Lakeshore’s 25% of NOW’s yearly net income after taxes (less any advances) within 10 business days after the Company files it annual 10-K report with the SEC and any payments in excess of Lakeshore’s 25% of NOW yearly profit shall be credited towards future weekly advance payments. The Company also agreed to pay attorney fees of $40,000 and pay $80,000 to a former consultant and employee of the Company who is a member of Lakeshore. In consideration of the extension to cure the default under the Note and Loan Agreement, the Company transferred a 20% ownership interest in Priority Time Systems, Inc., a 90% owned subsidiary of VCSY, and in SnAPPnet, Inc., a 100% owned subsidiary of VCSY, to Lakeshore. This resulted in an additional noncontrolling interest recognized in the equity of the Company of $391,920 and $99,210 for Priority Time Systems, Inc. and SnAPPnet, Inc., respectively, during 2014. The Company had an option to buy back Lakeshore’s ownership interest in NOW Solutions, Priority Time and SnAPPnet, Inc. (which expired on January 31, 2015). The Note is currently in default and the Company is in discussions with Lakeshore to cure the default and buy back Lakeshore’s ownership interests in our subsidiaries. During the three months ended March 31, 2015, the Company paid dividends to Lakeshore of $30,000.

 

In February 2015, the Company and a third party lender entered into a loan agreement under which the lender loaned Vertical $100,000. Pursuant to the loan agreement, Taladin, Inc., a subsidiary of the Company, issued a promissory note in the principal amount of $100,000 bearing interest at 12% per annum and is due on demand.

 

Note 4. Derivative liability and fair value measurements

 

Derivative liabilities

 

In March 2015, pursuant to an indemnity and reimbursement agreement executed between Mr. Valdetaro and the Company, we issued 1,000,000 shares of our common stock to reimburse Mr. Valdetaro for 1,000,000 shares of common stock transferred to Lakeshore on the Company’s behalf in connection with an extension granted by Lakeshore in August 2013. The issuance of these shares eliminated the derivative liability associated with the value of these shares. The fair market value of these shares on the date of issuance was $38,000 and resulted in the resolution of derivative liabilities.

 

In March 2015, pursuant to two indemnity and reimbursement agreements executed between Mountain Reservoir Corporation (“MRC”) and the Company, we issued a total of 2,809,983 shares of our common stock to reimburse MRC.  Of these shares, the Company was obligated to reimburse MRC with 1,309,983 shares of common stock that had been pledged by MRC and sold by a third party lender in 2009, 500,000 shares of common stock that had been wrongfully converted by the same lender in 2014, and 1,000,000 shares of common stock that had been transferred to another third party lender in 2013 on the Company’s behalf for a loan made by the lender.  MRC has assigned its claim against the third party lender for the lender’s wrongful conversion of 500,000 common shares to the Company and we are pursuing the claim in the third party lender’s bankruptcy proceeding.  The issuance of these shares eliminated the derivative liability associated with the value of these shares.   The fair market value of these shares on the date of issuance was $112,399 of which $92,399 resulted in the resolution of derivative liabilities and $20,000 was recognized as stock reimbursement expense during the three months ended March 31, 2015.

 

 

In March 2015, 1,000,000 shares of common stock pledged by an officer of the company (through a company he controls) to secure payment of a $50,000 past due loan by a third party lender were eliminated as part of the derivative liability as the lender did not exercise their rights to obtain the stock. The derivative liability associated with this obligation of $12,000 was written-off to (gain) loss on derivative liability during the three months ended March 31, 2015.

 

These contractual commitments to replace all of the shares associated with the derivative liability in 2014 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. As of March 31, 2015, the derivative liability has been eliminated since the shares have been issued or the obligation to issue the shares has been resolved. As of December 31, 2014, the aggregate fair value of the derivative liabilities was $51,719.

 

The aggregate change in the fair value of derivative liabilities was a loss of $78,680 and a gain of $4,741 for the three months ended March 31, 2015 and March 31, 2014, respectively.

 

The valuation of our embedded derivatives was determined by using the VCSY stock price at December 31, 2014 and the resolution dates. As such, our derivative liabilities were 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, 2015 and December 31, 2014:

 

		Fair value measurements on a recurring basis
		Level 1				Level 2				Level 3
As of March 31, 2015:
Liabilities
Stock derivative – 0 shares		$	-			$	-			$	-
As of December 31, 2014:
Liabilities
Stock derivative – 4,309,983 shares		$	51,719			$	-			$	-

 

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

 

In February 2015, after holding an annual stockholder meeting, the Company filed an amendment of its certificate of incorporation in the state of Delaware to increase the authorized number of shares of common stock to 2,000,000,000.

 

 

In March 2015, pursuant to an indemnity and reimbursement agreement executed between Mr. Valdetaro and the Company, we issued 1,000,000 shares of our common stock to reimburse Mr. Valdetaro for 1,000,000 shares of common stock transferred to Lakeshore on the Company’s behalf in connection with an extension granted by Lakeshore in August 2013. The issuance of these shares eliminated the derivative liability associated with the value of these shares. The fair market value of these shares on the date of issuance was $38,000 and resulted in the resolution of derivative liabilities.

 

In March 2015, pursuant to two indemnity and reimbursement agreements executed between Mountain Reservoir Corporation (“MRC”) and the Company, we issued a total of 2,809,983 shares of our common stock to reimburse MRC.  Of these shares, the Company was obligated to reimburse MRC with 1,309,983 shares of common stock that had been pledged by MRC and sold by a third party lender in 2009, 500,000 shares of common stock that had been wrongfully converted by the same lender in 2014, and 1,000,000 shares of common stock that had been transferred to another third party lender in 2013 on the Company’s behalf for a loan made by the lender.  MRC has assigned its claim against the third party lender for the lender’s wrongful conversion of 500,000 common shares to the Company and we are pursuing the claim in the third party lender’s bankruptcy proceeding.  The issuance of these shares eliminated the derivative liability associated with the value of these shares.   The fair market value of these shares on the date of issuance was $112,399 of which $92,399 resulted in the resolution of derivative liabilities and $20,000 was recognized as stock reimbursement expense during the three months ended March 31, 2015.

 

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. Related Party Transactions

 

In March 2015, pursuant to an indemnity and reimbursement agreement executed between Mr. Valdetaro and the Company, we issued 1,000,000 shares of our common stock to reimburse Mr. Valdetaro for 1,000,000 shares of common stock transferred to Lakeshore on the Company’s behalf in connection with an extension granted by Lakeshore in August 2013. The issuance of these shares eliminated the derivative liability associated with the value of these shares. The fair market value of these shares on the date of issuance was $38,000 and resulted in the resolution of derivative liabilities.

 

In March 2015, pursuant to two indemnity and reimbursement agreements executed between Mountain Reservoir Corporation (“MRC”) and the Company, we issued a total of 2,809,983 shares of our common stock to reimburse MRC.  Of these shares, the Company was obligated to reimburse MRC with 1,309,983 shares of common stock that had been pledged by MRC and sold by a third party lender in 2009, 500,000 shares of common stock that had been wrongfully converted by the same lender in 2014, and 1,000,000 shares of common stock that had been transferred to another third party lender in 2013 on the Company’s behalf for a loan made by the lender.  MRC has assigned its claim against the third party lender for the lender’s wrongful conversion of 500,000 common shares to the Company and we are pursuing the claim in the third party lender’s bankruptcy proceeding.  The issuance of these shares eliminated the derivative liability associated with the value of these shares.   The fair market value of these shares on the date of issuance was $112,399 of which $92,399 resulted in the resolution of derivative liabilities and $20,000 was recognized as stock reimbursement expense during the three months ended March 31, 2015.

 

As of March 31, 2015 and December 31, 2014, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $94,059 and $92,191, respectively. The payables are unsecured, non-interest bearing and due on demand.

 

Note 7. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

On December 31, 2011, the Company and InfiniTek corporation (“Infinitek”) entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. 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 the date of this Report 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 February 4, 2014, Victor Weber filed a lawsuit against Vertical Mountain Reservoir Corporation (“MRC”), and Richard Wade in the District Court of Clark County, Nevada for failure to make payment of the outstanding balance due under a $275,000 promissory note issued by Vertical to Mr. Weber. The plaintiff seeks payment of the principal balance due under the note $275,000, default interest at the rate of 18% per annum, attorney’s fees and court costs, and punitive damages. On July 24 2014, the court granted plaintiff’s motion for summary judgment against defendants. The judgment was filed on September 18, 2014. We are currently seeking to resolve this matter with Mr. Weber. Mr. Wade is the President and CEO of Vertical and the President of MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade is the trustee of the W5 Family Trust.

 

On October 20, 2014, Michael T. Galvan and Michelle Bates (“Galvan & Bates”) filed a lawsuit in the Court of Chancery in the State of Delaware seeking to have the court compel the Company to hold a shareholder meeting for the purpose of electing all directors of the Company, designating the time and place of a meeting and other details reasonably necessary to hold such a meeting, attorney costs and fees (including reasonable attorney’s fees), and such other relief as the court deems proper. Galvan and Bates are stockholders of the Company. This case is styled Michael T. Galvan and Michelle Bates v. Vertical Computer Systems, Inc., No. 10234. The Company held an annual meeting of shareholders on February 25, 2015. This matter is resolved.

 

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, 2015 and 2014, $142,253 and $33,200 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

 

We account for share-based compensation in accordance with the provisions of share-based payments, which requires 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 granted and the quoted price of our common stock. Equity instruments issued to other than employees are valued at the earlier of a commitment date or upon completion of the services, based on the fair value of the equity instruments, and are recognized as expense over the service period.

 

 

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

 

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial position, operations or cash flows.

 

Results of Operations

 

Three Months Ended March 31, 2015 Compared To Three Months Ended March 31, 2014

 

Total Revenues. We had total revenues of $1,054,835 and $2,104,018 in the three months ended March 31, 2015 and 2014, respectively. The decrease in total revenues was $1,049,183 for the three months ended March 31, 2015 representing a 49.9% decrease compared to the total revenues for the three months ended March 31, 2014. Of the $1,054,835 and $2,104,018 total revenues for the three months ended March 31, 2015 and 2014, respectively, $1,035,674 and $1,174,722 of such amounts were related to the business operations of NOW Solutions, a 75% owned subsidiary of the Company. Revenue from SnAPPnet, Inc. was $19,161 or 1.8% of total revenue for the three months ended March 31, 2015 and $54,296 or 2.6% of total revenues for the three months ended March 31, 2014.

 

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from licenses and software decreased by $875,000 compared to that for the three months ended March 31, 2014 due to a one-time license agreement for SiteFlash in the first quarter of 2014. Software maintenance in the three months ended March 31, 2015 decreased by $135,634 or 13.2% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to unfavorable currency rate changes on our Canadian revenue and the loss or reduction of customer maintenance agreements in the first quarter of 2015. Consulting revenue, in the three months ended March 31, 2015 decreased by $14,241 from the same period in the prior year, which represents a 18.2% decrease. This decrease was primarily due to less billable consulting services for the first quarter of 2015 compared to 2014 and the effects of unfavorable currency rate changes on our Canadian revenue. Cloud-based revenues were $85,247 for the three months ended March 31, 2015 compared to $109,916 for the same period in the prior year, representing a $24,669 decrease or 22.4%. The decrease is primarily related to renegotiation of a customer contract and unfavorable currency rate changes on our Canadian cloud-based revenue. Other revenue in the three months ended March 31, 2015 increased by $361 or 2.5% 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 $425,862 for the three months ended March 31, 2015, compared to $586,718 for the three months ended March 31, 2014. The decrease in cost of revenues of $160,856 represents a 27.4% decrease. The decrease in direct cost of revenues was primarily due to lower payroll and consulting through attrition and lower rent due to the consolidation of our office space for the three months ended March 31, 2015. During the three months ended March 31, 2015 and 2014, $142,253 and $33,200 of internal costs were capitalized, respectively.

 

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $873,893 and $1,432,953 in the three months ended March 31, 2015 and 2014, respectively. The decrease of $559,060 is 39.0% less than for the same period in 2014. The decrease is primarily due to decreased legal fees to prosecute patent infringement on the company’s intellectual property, decreased foreign taxes and tax penalties somewhat offset by increased costs related to the company’s annual shareholder’s meeting.

 

Depreciation and Amortization. We had depreciation and amortization expense of $31,365 and $11,919 for the three months ended March 31, 2015 and 2014, respectively. The increase of $19,446 or 163.2% relates to additional long lived assets purchased in 2015 as well as a true up of depreciation on existing assets. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

 

 

Bad Debt Expense. We had bad debt expense of $36,190 for the three months ended March 31, 2015 related to the allowance of customer accounts greater than 90 days past due.

 

Impairment of Software Costs. During the three months ended March 31, 2014, $192,955 of capitalized software development costs were considered impaired.

 

Income (Loss) from Operations. We had a net loss from operations of $312,475 and $120,527 for the three months ended March 31, 2015 and 2014, respectively. The increased loss was due to decreased revenues and increased depreciation and bad debt expense partially offset by decrease cost of revenue, selling, general and administrative expenses and impairment of software.

 

Gain (Loss) on Derivative Liability. 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 loss on derivative liability was $78,680 for the three months ended March 31, 2015 compared to a gain of $4,741 for the same period in 2014. During the first quarter 2015, the Company issued common shares and eliminated the derivative liabilities.

 

Forbearance Fees. Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended March 31, 2014 were $73,301. The fees are related to our senior secured debt for NOW Solutions.

 

Interest Expense. We had interest expense of $255,496 and $213,522 for the three months ended March 31, 2015 and 2014, respectively. Interest expense increased in 2015 by $41,974, representing an increase of 19.7% compared to the same expense in the three months ended March 31, 2014. The increase is primarily due to increased debt borrowings at March 31, 2015 compared to March 31, 2014 and additional interest on amounts due to vendors.

 

Net loss. We had a net loss of $646,647 and $402,601 for the three months ended March 31, 2015 and 2014, respectively. The net loss for the three months ended March 31, 2015 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 $312,475. The operating loss was increased by the loss on derivative liability and interest expense resulting in a net loss of $646,647 for the three months ended March 31, 2015. The net loss for the three months ended March 31, 2014 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 $120,527. The operating loss was decreased by the gain on derivative liability and increased by interest expense and forbearance fees, resulting in a net loss of $402,601 for the three months ended March 31, 2014.

 

Income Tax Provision. We had an income tax provision of $25,506 for the three months ended March 31, 2015. The income tax provision is related to NOW Solutions, a 75% owned subsidiary of the Company. The income tax provision is related to foreign and US income tax. No income tax provision was recorded in the first quarter of 2014 as VCSY owned 100% of NOW Solutions and was able to utilize its tax loss carry-forwards to offset NOW Solutions’ taxable income.

 

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, 2015 and 2014, respectively.

 

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $826,659 and $550,257 for the three months ended March 31, 2015 and 2014, 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, 2015 and 2014, respectively.

 

Liquidity and Capital Resources

 

At March 31, 2015, we had non-restricted cash-on-hand of $119,071 compared to $117,866 at December 31, 2014.

 

Net cash used in operating activities for the three months ended March 31, 2015 was $185,564 compared to net cash provided by operating activities of $193,898 for the three months ended March 31, 2014. For the three months ended March 31, 2015, we collected cash from our customers and other licensees of $1,456,541. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $888,794, attorney fees of $81,108, professional fees and consulting fees of $158,725 interest payments of $68,960, taxes of $15,960, and other regular trade payables of $428,558. For the three months ended March 31, 2014, we collected cash from our customers and other licensees of $1,535,110. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $480,650, attorney fees of $134,580, professional fees and consulting fees of $47,489 interest payments of $89,989, taxes (including sales tax and VAT) of $74,472, and other regular trade payables of $514,032.

 

 

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 $267,728 or 11.5% from the balance at December 31, 2014. The decrease was primarily due to the loss or reduction of customer maintenance agreements in the first quarter of 2015.

 

Our accounts receivable trade decreased from $560,879 at December 31, 2014 to $120,155 (net of allowance for bad debts) at March 31, 2015. The decrease is a primarily a result of a 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 $10,603,879 at December 31, 2014 to $10,788,043 at March 31, 2015. The resulting balance at March 31, 2015 is 90 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 for the development of new software products for the three months ended March 31, 2015 and March 31, 2014 of $142,253 and $33,200 respectively.

 

For the three months ended March 31, 2015, we borrowed $100,000 from a third party lender. For the three months ended March 31, 2014, we paid $44,636 of principal on notes payable and notes payable to related parties.

 

For the three months ended March 31, 2015, we paid $30,000 of dividends to non-controlling interests.

 

The total change in cash for the three months ended March 31, 2015 was an increase of $1,205.

 

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, 2015, the following contractual obligations and commercial commitments were outstanding:

 

		Balance at				Due in Next Five Years
Contractual Obligations		March 31, 2015				2015				2016				2017				2018				2019+
Notes payable		$	4,993,590			$	4,993,590				-				-				-				-
Convertible debts			30,000				30,000				-				-				-				-
Operating lease			42,520				38,297				4,223				-				-				-
Total		$	5,066,110			$	5,061,887			$	4,223				-				-				-

 

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

 

		March 31, 2015				December 31, 2014
In default		$	4,758,090			$	4,758,405
Not in default			265,500				165,500
Total Notes Payable		$	5,023,590			$	4,923,905

 

 

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 $679,659 for the three months ended March 31, 2015 and a net loss of $403,257 for the three months ended March 31, 2014, 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, 2015, we had negative working capital of approximately $17.7 million (although this figure includes deferred revenue of approximately $2.1 million) and have defaulted on substantially all 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. 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 the outcome of this uncertainty.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Not applicable.

  

Item 4. Controls and Procedures

 

Our management, principally our chief executive officer (who is also currently serving as our Principal Accounting 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.

 

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, 2014, as filed on April 15, 2015.

 

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, 2014.

 

PART II

OTHER INFORMATION

 

Item 1. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

On December 31, 2011, the Company and InfiniTek corporation (“Infinitek”) entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. 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 the date of this Report 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 February 4, 2014, Victor Weber filed a lawsuit against Vertical Mountain Reservoir Corporation (“MRC”), and Richard Wade in the District Court of Clark County, Nevada for failure to make payment of the outstanding balance due under a $275,000 promissory note issued by Vertical to Mr. Weber. The plaintiff seeks payment of the principal balance due under the note $275,000, default interest at the rate of 18% per annum, attorney’s fees and court costs, and punitive damages. On July 24 2014, the court granted plaintiff’s motion for summary judgment against defendants. The judgment was filed on September 18, 2014. We are currently seeking to resolve this matter with Mr. Weber. Mr. Wade is the President and CEO of Vertical and the President of MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade is the trustee of the W5 Family Trust.

 

On October 20, 2014, Michael T. Galvan and Michelle Bates (“Galvan & Bates”) filed a lawsuit in the Court of Chancery in the State of Delaware seeking to have the court compel the Company to hold a shareholder meeting for the purpose of electing all directors of the Company, designating the time and place of a meeting and other details reasonably necessary to hold such a meeting, attorney costs and fees (including reasonable attorney’s fees), and such other relief as the court deems proper. Galvan and Bates are stockholders of the Company. This case is styled Michael T. Galvan and Michelle Bates v. Vertical Computer Systems, Inc., No. 10234. The Company held an annual meeting of shareholders on February 25, 2015. This matter is resolved.

 

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, 2014, as filed on April 15, 2015.

 

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

 

In February 2015, after holding an annual stockholder meeting, the Company filed an amendment of its certificate of incorporation in the state of Delaware to increase the authorized number of shares of common stock to 2,000,000,000.

 

In March 2015, pursuant to an indemnity and reimbursement agreement executed between Mr. Valdetaro and the Company, we issued 1,000,000 shares of our common stock to reimburse Mr. Valdetaro for 1,000,000 shares of common stock transferred to Lakeshore on the Company’s behalf in connection with an extension granted by Lakeshore in August 2013. The issuance of these shares eliminated the derivative liability associated with the value of these shares. The fair market value of these shares on the date of issuance was $38,000 and resulted in the resolution of derivative liabilities.

 

In March 2015, pursuant to two indemnity and reimbursement agreements executed between Mountain Reservoir Corporation (“MRC”) and the Company, we issued a total of 2,809,983 shares of our common stock to reimburse MRC.  Of these shares, the Company was obligated to reimburse MRC with 1,309,983 shares of common stock that had been pledged by MRC and sold by a third party lender in 2009, 500,000 shares of common stock that had been wrongfully converted by the same lender in 2014, and 1,000,000 shares of common stock that had been transferred to another third party lender in 2013 on the Company’s behalf for a loan made by the lender.  MRC has assigned its claim against the third party lender for the lender’s wrongful conversion of 500,000 common shares to the Company and we are pursuing the claim in the third party lender’s bankruptcy proceeding.  The issuance of these shares eliminated the derivative liability associated with the value of these shares.   The fair market value of these shares on the date of issuance was $112,399 of which $92,399 resulted in the resolution of derivative liabilities and $20,000 was recognized as stock reimbursement expense during the three months ended March 31, 2015.

 

 

Item 3. Defaults Upon Senior Securities

 

Note payable of $1,759,150 issued by NOW Solutions to Lakeshore Investment, LLC, dated January 9, 2013. The note is secured with the assets of NOW Solutions, Priority Time Systems, SnAPPnet, and the SiteFlash™ assets and bears a default interest rate of 16%. As of May 14, 2015, the outstanding principle and accrued interest currently due under the note is $1,500,426.

  

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 14, 2015		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 14, 2015		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 14, 2015		By:	/s/ Richard Wade
			Richard Wade,
			President and Chief Executive Officer
			(Principal Executive Officer and Principal Accounting Officer)