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EX-32.1 - EXHIBIT 32.1 - VERTICAL COMPUTER SYSTEMS INCs114093_ex32-1.htm
EX-31.1 - EXHIBIT 31.1 - VERTICAL COMPUTER SYSTEMS INCs114093_ex31-1.htm

 

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2018

 

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 200 

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  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 ☒  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 

      Emerging growth company

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.       

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):  Yes No

 

As of November 27, 2018, the issuer had 1,197,115,201 shares of common stock, par value $0.00001, issued and 1,157,115,201 outstanding.

 

1

 

 

PART I

FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets  

(Unaudited)  

 

   September 30,   December 31, 
   2018   2017 
Assets          
Current assets          
Cash  $224,369   $62,084 
Accounts receivable, net of allowance for bad debts of $196,292 and $234,439   172,041    349,002 
Prepaid expenses and other current assets   21,238    5,312 
Total current assets   417,648    416,398 
           
Property and equipment, net of accumulated depreciation of $1,043,571 and $1,044,936   6,940    9,211 
Intangible assets, net of accumulated amortization of $319,403 and $319,504   6,690    6,690 
Deposits and other   7,881    8,037 
           
Total assets  $439,159   $440,336 
           
Liabilities and Stockholders’ Deficit          
Current liabilities:          
Accounts payable and accrued liabilities  $15,532,354   $14,122,394 
Accounts payable to related parties   183,641    148,760 
Deferred revenue   1,214,844    1,752,421 
Derivative liabilities   63,576    159,537 
Convertible debentures, net of unamortized discounts of $0 and $75,705   1,255,969    1,164,295 
Notes payable, net of discounts of $2,614 and $0   6,705,116    3,775,703 
Notes payable and convertible debt to related parties   353,242    308,242 
Total current liabilities   25,308,742    21,431,352 
           
Non-current portion – notes payable       2,158,140 
           
Total liabilities   25,308,742    23,589,492 

 

See accompanying notes to the unaudited consolidated financial statements. 

 

(Continued on next page)

 

2

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

 

(Continued from previous page)          

 

   September 30,   December 31, 
   2018   2017 
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value;          
250,000 shares authorized; 52,800 shares issued and outstanding   10,255,185    10,255,185 
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 
    10,457,209    10,457,209 
           
Stockholders’ Deficit          
Common Stock; $.00001 par value; 2,000,000,000 shares authorized          
1,191,165,201 issued and 1,151,165,201 outstanding as of September 30, 2018 and 1,188,095,201 issued and 1,148,095,201 outstanding as of December 31, 2017   11,913    11,883 
Treasury stock; 40,000,000 as of September 30, 2018 and December 31, 2017   (400)   (400)
Additional paid-in capital   24,929,677    24,609,424 
Accumulated deficit   (60,021,033)   (58,087,916)
Accumulated other comprehensive income – foreign currency translation   423,180    339,051 
           
Total Vertical Computer Systems, Inc. stockholders’ deficit   (34,656,663)   (33,127,958)
           
Non-controlling interest   (670,129)   (478,407)
Total stockholders’ deficit   (35,326,792)   (33,606,365)
           
Total liabilities and stockholders’ deficit  $439,159   $440,336 

 

See accompanying notes to the unaudited consolidated financial statements.

 

3

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
Revenues                
Licensing and software  $50,000   $294   $150,081   $811 
Software maintenance   744,960    774,276    2,320,619    2,371,052 
Cloud-based offering   54,041    48,648    143,093    174,315 
Consulting services   134,874    88,472    438,714    264,964 
Other   14,254    9,028    31,601    11,925 
Total revenues   998,129    920,718    3,084,108    2,823,067 
                     
Cost of revenues   (399,993)   (357,689)   (1,153,507)   (1,170,484)
                     
Gross profit   598,136    563,029    1,930,601    1,652,583 
                     
Operating expenses:                    
Selling, general and administrative expenses   765,227    994,410    2,404,599    2,973,669 
Depreciation and amortization   788    324    2,364    974 
Bad debt expense (recovery)   (12,549)   40,520    (35,561)   (24,147)
Total operating expenses   753,466    1,035,254    2,371,402    2,950,496 
                     
Operating loss   (155,330)   (472,225)   (440,801)   (1,297,913)
                     
Other income (expense):                    
Interest income   2    1    8    17 
Gain on derivative liabilities   33,032    305,914    129,346    925,812 
Non-operating penalties           (125,850)    
Forbearance fees               (6,000)
Interest expense   (523,875)   (374,914)   (1,432,364)   (1,393,517)
                     
Net loss before non-controlling interest and    income tax expense (benefit)   (646,171)   (541,224)   (1,869,661)   (1,771,601)
Income tax expense (benefit)   19,028    (41,185)   153,023    79,014 
Net loss before non-controlling interest   (665,199)   (500,039)   (2,022,684)   (1,850,615)
Net loss attributable to non-controlling interest   25,582    42,939    89,567    79,800 
Net loss attributable to Vertical Computer Systems, Inc.   (639,617)   (457,100)   (1,933,117)   (1,770,815)
Dividends applicable to preferred stock   (155,600)   (155,604)   (466,800)   (462,009)
                     
Net loss available to common stockholders  $(795,217)  $(612,704)  $(2,399,917)  $(2,232,824)
                     
Basic and diluted net loss per share  $(0.00)  $(0.00)  $(0.00)  $(0.00)
                     
Basic weighted average common shares outstanding   1,151,162,484    1,138,224,766    1,149,804,908    1,134,412,731 
Diluted weighted average common shares outstanding   1,207,520,965    1,138,224,766    1,206,163,389    1,134,412,731 

 

  

See accompanying notes to the unaudited consolidated financial statements. 

 

(Continued on next page)

 

4

 

 

Vertical Computer Systems, Inc. and Subsidiaries 

Consolidated Statements of Operations and Comprehensive Loss 

(Unaudited)

 

(Continued from previous page)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
Comprehensive loss                
Net loss  $(665,199)  $(500,039)  $(2,022,684)  $(1,850,615)
Translation adjustments   (6,152)   (66,383)   84,129    (101,563)
Comprehensive loss   (671,351)   (566,422)   (1,938,555)   (1,952,178)
Comprehensive loss attributable to non-controlling interest   25,582    42,939    89,567    79,800 
Comprehensive loss attributable to Vertical Computer Systems, Inc.  $(645,769)  $(523,483)  $(1,848,988)  $(1,872,378)

 

See accompanying notes to the unaudited consolidated financial statements.

 

5

 

 

Vertical Computer Systems, Inc. and Subsidiaries  

Consolidated Statement of Stockholders’ Deficit 

December 31, 2017 through September 30, 2018 

(Unaudited)

 

   Common Stock   Treasury Stock  

Additional

Paid-in

   Accumulated   Other Comprehensive   Non-controlling     
   Shares   Amount   Shares   Amount   Capital   Deficit   Income   Interest   Total 
Balances at December 31, 2017   1,188,095,201   $11,883   $(40,000,000)  $(400)  $24,609,424   $(58,087,916)  $339,051   $(478,407)  $(33,606,365)
Amortization of restricted stock awards                   33,127                33,127 
Amortization of subsidiary restricted stock awards                   52,299                52,299 
Shares issued for vested restricted stock awards   570,000    5            (5)                
Issuance of subsidiary shares for debt extensions                   103,656            (4,557)   99,099 
Issuance of subsidiary shares for services                   3,046            (3,046)    
Issuance of shares for subsidiary non-operating penalties   2,500,000    25            32,975                33,000 
Issuance of subsidiary shares for subsidiary non-operating penalties                   97,070            (4,220)   92,850 
Discount from warrants issued with debt                   4,823                4,823 
Derivative liability for warrants issued with convertible debt                   (6,738)               (6,738)
Dividends paid to non-controlling interest holders                               (89,090)   (89,090)
Dividends declared but unpaid to non-controlling interest holders                               (1,242)   (1,242)
Other comprehensive income translation adjustment                           84,129        84,129 
Net loss                       (1,933,117)       (89,567)   (2,022,684)
Balances at September 30, 2018   1,191,165,201   $11,913    (40,000,000)   (400)  $24,929,677   $(60,021,033)  $423,180   $(670,129)  $(35,326,792)

 

 See accompanying notes to the unaudited consolidated financial statements.

 

6

 

 

Vertical Computer Systems, Inc. and Subsidiaries 

Consolidated Statements of Cash Flows 

(Unaudited) 

     
   Nine Months Ended September 30, 
   2018   2017 
         
Cash flows from operating activities          
Net loss  $(2,022,684)  $(1,850,615)
Adjustments to reconcile net loss to net cash used in operating activities:          
Depreciation and amortization   2,364    974 
Amortization of debt discounts   219,641    411,603 
Common shares issued for services       21,060 
Common shares issued to employees       84,800 
Issuance of shares for subsidiary non-operating penalties   125,850     
Bad debt recovery   (35,561)   (24,147)
Gain on derivatives   (129,346)   (925,812)
Amortization of restricted stock awards   33,127    99,963 
Amortization of subsidiary restricted stock awards   52,299    246,276 
Changes in operating assets and liabilities:          
Accounts receivable   211,559    101,382 
Prepaid expenses and other assets   (15,420)   6,838 
Accounts payable and accrued liabilities   1,415,512    1,824,065 
Accounts payable related parties   34,881    1,444 
Deferred revenue   (508,652)   (506,154)
Net cash used in operating activities   (616,430)   (508,323)
           
Cash flow from investing activities:          
Purchase of property and equipment        
Net cash used in investing activities        
           
Cash flows from financing activities:          
Borrowings on notes payable   795,100    301,500 
Borrowings on convertible debentures       110,000 
Borrowings on related party debt   45,000     
Payments of notes payable   (20,944)   (159,705)
Issuance of preferred stock       260,000 
Dividends paid by subsidiary to non-controlling interest   (89,090)    
Bank overdraft       3,408 
Net cash provided by financing activities   730,066    515,203 
           
Effect of changes in exchange rates on cash   48,649    (18,773)
           
Net change in cash and cash equivalents   162,285    (11,893)
Cash and cash equivalents, beginning of period   62,084    190,448 
Cash and cash equivalents, end of period  $224,369   $178,555 

 

See accompanying notes to unaudited consolidated financial statements.

 

(Continued on next page)

 

7

 

 

Vertical Computer Systems, Inc. and Subsidiaries 

Consolidated Statements of Cash Flows 

(Unaudited)

 

(Continued from previous page)

 

   Nine Months Ended September 30, 
   2018   2017 
           
Supplemental disclosures of cash flow information:          
Cash paid for interest  $268,747   $32,163 
Cash paid for income taxes        
           
Non-cash investing and financing activities:          
Common shares issued for conversion of debt and accrued interest       22,421 
Settlement of derivative liability upon conversion of debt       19,566 
Debt discount due to shares and warrants issued with convertible debt   26,647    17,390 
Debt discount due to derivative liabilities       18,653 
Debt discount due to subsidiary shares issued for debt extensions   99,099    89,017 
Common shares issued for vested restricted stock awards   5    11 
Debt discount due to warrants issued with debt   4,823     
Reclassification of warrants as derivative liabilities   6,738     
Non-controlling interest adjustment to equity       459,982 
Debt modification       10,000 
Dividends declared but unpaid to non-controlling interest holders  $1,242   $97,500 

  

See accompanying notes to unaudited consolidated financial statements.

 

8

 

  

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, 2017. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company,” “Vertical”, or “VCSY”, as applicable). Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), an 80% owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. (“Taladin”), and Vertical Healthcare Solutions, Inc. (“VHS”), each of which a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”), an 80% owned subsidiary, Ploinks, Inc. (“Ploinks”), an 87% 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 2017 annual report on Form 10-K have been omitted.

 

Revenue Recognition

 

On January 1, 2018, the company adopted ASU No. 2016-12, “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients” using the modified retrospective method applied to those contracts which were not completed as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under Topic 605. There was no impact to the opening balance of accumulated deficit as of January 1, 2018 or revenues for the quarter ended September 30, 2018, as a result of applying Topic 606.

 

The Company applies a five-step approach in determining the amount and timing of revenue to be recognized: (1) identifying the contract with a customer, (2) identifying the performance obligations in the contract, (3) determining the transaction price, (4) allocating the transaction price to the performance obligations in the contract and (5) recognizing revenue when the performance obligation is satisfied. Substantially all the Company’s revenue is recognized at the time control of the products transfers to the customer.

 

ASC 606-10-50-5 requires that entities disclose disaggregated revenue information in categories (such as type of good or service, geography, market, type of contract, etc.). ASC 606-10-55-89 explains that the extent to which an entity’s revenue is disaggregated depends on the facts and circumstances that pertain to the entity’s contracts with customers and that some entities may need to use more than one type of category to meet the objective for disaggregating revenue.

 

The Company disaggregates revenue by industry as well as by country to depict the nature and economic characteristics affecting revenue. The following table presents our revenue disaggregated by industry for the three and nine months ended:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
Industry  2018   2017   2018   2017 
                 
Agriculture  $69,535   $70,749   $212,271   $255,653 
Automotive   9,339    7,132    23,877    21,133 
Distribution   15,686    33,439    63,661    65,991 
Education   197,160    171,490    632,113    495,605 
Financial Services   18,605    18,720    62,294    55,329 
Government   124,311    99,755    388,458    327,450 
Healthcare   270,926    292,538    918,632    891,430 
Manufacturing   55,792    54,813    177,315    161,900 
Manufacturing Services   8,401    11,133    27,764    31,894 
Media   28,072    28,288    86,211    81,436 
Oil and Gas   55,016    48,929    155,968    144,012 
Pulp and Paper Distribution   23,126    23,935    70,455    89,685 
Pulp and Paper Manufacturing   5,150    4,975    15,414    14,074 
Engineering       25,681    34,777    93,089 
Government Contractor   117,010    28,847    214,898    93,575 
Other       294        811 
Total revenues  $998,129   $920,718   $3,084,108   $2,823,067 

 

9

 

 

The following table presents our revenue disaggregated by country for the three and nine months ended:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
Country  2018   2017   2018   2017 
                 
Canada  $612,629   $579,564   $1,975,042   $1,723,187 
United States   385,500    341,154    1,109,066    1,099,880 
Total revenues  $998,129   $920,718   $3,084,108   $2,823,067 
                     

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 nine months ended September 30, 2018 and 2017, 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. For the three and nine months ended September 30, 2018 and 2017, the Company had 56,358,481 and 83,059,735 potential common shares under convertible notes, which were included in the calculation of diluted loss per share.

 

Recently Issued Accounting Pronouncements

 

In February 2016, the FASB issued ASU No. 2016-02,” Leases” (Topic 842) which includes a lessee accounting model that recognizes two types of leases - finance leases and operating leases. The standard requires that a lessee recognize on the balance sheet assets and liabilities for leases with lease terms of more than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee will depend on its classification as a finance or an operating lease. New disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases are also required. These disclosures include qualitative and quantitative requirements, providing information about the amounts recorded in the financial statements. ASU 2016-02 will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the effect its adoption of this standard, if any, on our consolidated financial position, results of operations or cash flows.

 

In May 2017, the FASB issued ASU No. 2017-09, “Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting”, to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, Compensation—Stock Compensation, to a change to the terms or conditions of a share-based payment award. The ASU provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in ASC 718. The amendments are effective for fiscal years beginning after December15, 2017 and should be applied prospectively to an award modified on or after the adoption date. Early adoption is permitted, including adoption in an interim period. The Company adopted the standard on January 1, 2018 and the amendment did not have a material impact on its consolidated financial statements.

 

10

 

 

In July 2017, the FASB issued ASU No. 2017-11, “Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception”. The ASU was issued to address the complexity associated with applying generally accepted accounting principles (GAAP) for certain financial instruments with characteristics of liabilities and equity. The ASU, among other things, eliminates the need to consider the effects of down round features when analyzing convertible debt, warrants and other financing instruments. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value because of the existence of a down round feature. The amendments are effective for fiscal years beginning after December 15, 2018 and should be applied retrospectively. Early adoption is permitted, including adoption in an interim period. The Company is currently evaluating the effect its adoption of this standard, if any, on our consolidated financial position, results of operations or cash flows.

 

In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows - Restricted Cash (Topic 230), which amends the existing guidance relating to the disclosure of restricted cash and restricted cash equivalents on the statement of cash flows. ASU 2016-18 is effective for the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year, and early adoption is permitted. The adoption of ASU 2016-18 had no effect on our Consolidated Condensed Statements of Cash Flows.

 

Note 2. Going Concern

 

The accompanying unaudited consolidated financial statements for the nine months ended September 30, 2018 and 2017 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 September 30, 2018, we had negative working capital of approximately $24.9 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 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 nine months ended September 30, 2018:

 

December 31, 2017  $7,098,138 
Repayments of third party notes   (20,944)
Borrowings from third parties   795,100 
Debt discounts due to stock, warrants and derivative liabilities   

(130,569

)
Amortization of debt discounts   219,641 
Effect of currency exchange   (281)
September 30, 2018  $7,961,085 
      

During the nine months ended September 30, 2018, the Company borrowed $282,000 from a third party lender at 10% interest per annum, and the Company made total payments of $20,944 on notes payable to third parties.

 

During the nine months ended September 30, 2018, the Company issued promissory notes to third party lenders in the aggregate principal amount of $470,000 for loans made by these lenders in the same amount to the Company. These notes bear interest at 10% per annum and are due within 90 days of the date the respective note was issued and on demand. In connection with the loans, the Company issued 1-year to 3-year warrants to purchase an aggregate total of 2,700,000 shares of VCSY common stock at a purchase price of $0.10-$0.20 per share to certain third party lenders.

 

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During the nine months ended September 30, 2018, the Company extended the term of certain warrants to purchase a total of 12,100,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted a total of 320,199 shares of the common stock of Ploinks, Inc. to third party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $1,210,000 that were issued from 2015 through 2017. The aggregate fair market value of the Ploinks shares was determined to be $99,102 and was recorded as debt discount and is being amortized through the term of the convertible debenture. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification. The due dates for all these convertible debentures were extended until October 1, 2018.

 

During the nine months ended September 30, 2018, NOW Solutions issued a note payable in the principal amount of $43,100, to a third party bearing interest at 10% annum for advances made on behalf of NOW Solutions in 2013.

 

On July 25, 2018, Taladin executed an amendment to a pledge agreement (the “Amended Pledge Agreement”) with a third party lender. In connection with the Amended Pledge Agreement, the Company and NOW Solutions also executed an amendment of certain promissory notes (the “Taladin Pledged Notes”) issued to the lender by the Company and NOW Solutions to a third party lender in the aggregate principal amount of $715,000. The outstanding balance due under the Notes as of June 30, 2018, including interest, was $2,093,334 (plus $280,000 in penalties).

 

Under the original pledge agreement, Taladin pledged 20,000,000 shares (the “Taladin Pledged Shares”) of the Company’s common stock to the lender to secure obligations under the Taladin Pledged Notes, as amended, consisting of (a) promissory note issued by NOW Solutions in the principal amount of $215,000 issued on September 4, 2003 and assigned to the lender effective on January 4, 2004, (b) the promissory note issued by VCSY in the principal amount of $200,000 issued on October 24, 2006 and (c) the promissory note issued by VCSY in the principal amount of $300,000 issued on March 5, 2007.

 

Terms of the Amended Pledge Agreement. Under the terms of the Amended Pledge Agreement, in lieu of selling the Taladin Pledged Shares pursuant to the original terms of the pledge agreement, Taladin and the lender agreed that Taladin, or a party acting on Taladin’s behalf, had the right to purchase a total of 10,000,000 shares of the Taladin Pledged Shares from Taladin at a purchase price of $0.015 per share over a certain period of time. The Company made $150,000 in payments to the lender and all rights to the 10,000,000 shares of the Pledged Stock have been retained by Taladin.

 

Terms of the Amendment of the Notes. Under the terms of the amendment to the Taladin Pledged Notes, all defaults under these notes were cured; however, the default interest rate of 16% continues to apply, subject to the terms of the amendment of the Taladin Pledged Notes. The Taladin Pledged Notes have been amended as follows: (a) $125,000 will applied to the currently outstanding penalties in the amount of $280,000, which were deemed to be paid in full (and the remaining $155,000 in penalties were cancelled) and (b) a payment of $25,000 was applied toward the Taladin Pledged Notes; (c) beginning on September 1, 2018, and continuing on the first day of each month thereafter, the Company shall make $25,000 monthly installments payments until January 31, 2020 (the “Maturity Date”) at which time all outstanding amounts under the Taladin Pledged Notes will be due; (d) upon an additional payment of $175,000, the annual interest rate for all of the Taladin Pledged Notes will be reduced to an annual interest rate of 12%, provided that if, at any time the delinquent monthly payments exceed $75,000, the annual interest rate will be raised to an annual interest rate of 16%.

 

Lakeshore Financing

 

On January 9, 2013, 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 original amount of $1,759,150 and payable in equal monthly installments of $24,232 until January 31, 2022. Upon the payment of any prepayment principal amounts, the monthly installment payments will be adjusted proportionately on an amortized rata basis. 

 

The Lakeshore Note was originally secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“SnAPPnet”) and the Company’s SiteFlash™ technology, which were all cross-collateralized. Upon full payment of the Lakeshore Note, Lakeshore will be obligated to 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 which was increased to 8% under an amendment to the Loan Agreement in 2013. In addition, until the Note is paid in full, NOW Solutions agreed to pay Lakeshore a 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 December 31, 2017 or December 31, 2016.

 

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Under an amendment of the Lakeshore Note and the Loan Agreement executed on January 31, 2013, Vertical was obligated to transfer 25% of its ownership interest in NOW Solutions in the event certain principal payments were not timely made to Lakeshore. When the last forbearance agreement with Lakeshore expired, Lakeshore became a 25% minority owner of NOW Solutions on October 1, 2013.

 

In December 2014, the Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. In consideration of an extension Lakeshore granted to NOW Solutions to cure the default under the Lakeshore Note and the Loan Agreement, the Company transferred a 20% ownership interest in two subsidiaries to Lakeshore: Priority Time Systems, Inc., and SnAPPnet, Inc.

 

In December 2017, the Vertical and NOW Solutions and Lakeshore entered into an amendment (the “2017 Lakeshore Loan Amendment “) to the Loan Agreement and the Lakeshore Note issued to Lakeshore. Pursuant to the terms of this amendment, the principal balance of the Note was amended to $2,291,395, which included (a) all unpaid dividends and outstanding attorneys’ fees in the amount of $250,000 and (b) all outstanding accrued interest in the amount of $414,364. Under the 2017 Lakeshore Loan Amendment, any existing defaults under the Lakeshore Note and related security agreements were cured, the interest rate reverted to the non-default rate of 11% interest per annum, the Lakeshore Note was re-amortized and the term of the Lakeshore Note was extended for an additional 10 years, with monthly installment payments consisting of $31,564 due on the 10th day of each month, beginning on January 10, 2018. In addition, the security agreements for the SiteFlash assets, the assets of Priority Time, and the assets of SnAPPnet were cancelled and Lakeshore agreed to file notices of termination of all UCC lien statements in connection with these assets. The security agreement concerning the assets of NOW Solutions remain in effect and upon full payment of the Lakeshore Note, Lakeshore will release the NOW Solutions collateral. Furthermore, the interest in “Net Claim Proceeds” from the SiteFlash Assets was increased from 8% to 20% under this amendment.

 

The 2017 Lakeshore Loan Amendment also provides that if NOW Solutions makes any advance toward net income (less Vertical’s management fee and management allocations) to Vertical, then NOW Solutions shall pay Lakeshore 25% share of such an advance no later than one business day after Vertical receives its 75% percent share. In the event NOW Solutions does not make payment to Lakeshore, the loan will be in default and NOW Solutions has five business days from discovery and notice by Lakeshore to make payment plus a penalty in the amount of 20% of the unpaid 25% share amount.

 

In order to facilitate the execution of the 2017 Lakeshore Loan Amendment which resulted in the cure of any existing defaults under the Loan Agreement and the Note, as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time, the Company issued 2,500,000 VCSY common shares at a fair market value of $35,400 and 300,000 Ploinks common shares at a fair market value of $92,850 to certain third party purchasers of 600,000 shares of VHS Series A Preferred Stock from a member of Lakeshore. The Company recorded a loss on debt extinguishment of $128,250 during the year ended December 31, 2017.

 

During the nine months ended September 30, 2018, the Company, through its subsidiary, declared dividends to Lakeshore of $90,332 of which $89,090 were paid and $1,242 were left accrued. During the nine months ended September 30, 2017, the Company, through its subsidiary, declared dividends to Lakeshore of $65,000 which were added to the note balance as part of the December 2017 amendment discussed above.

 

For additional transactions and updates concerning notes payable after September 30, 2018, please see “Subsequent Events” in Note 9.

 

Note 4. Derivative Liability and Fair Value Measurements

 

Derivative liability

 

As of September 30, 2018, the Company has convertible notes and common stock warrants that qualify as derivative liabilities under ASC 815.

 

As of September 30, 2018, the aggregate fair value of the outstanding derivative liabilities was $63,576. For the nine months ended September 30, 2018, the net gain on the change in fair value of derivative liabilities was $129,346.

 

The Company estimated the fair value of the derivative liabilities using the Black-Scholes option pricing model and the following key assumptions during 2018:

 

  2018
Expected dividends 0%
Expected terms (years) 0.21 – 2.92
Volatility 38% - 164%
Risk-free rate 2.19% - 2.88%

 

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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 September 30, 2018 and December 31, 2017:

 

   Fair value measurements on a recurring basis 
  

Level 1

  

Level 2

  

Level 3

 
As of September 30, 2018:               
Liabilities               
Derivative liabilities – convertible debt and warrants  $   $   $63,576 
                
As of December 31, 2017:               
Liabilities               
Derivative liabilities - convertible debt and warrants  $   $   $159,537 

 

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 Company uses Level 3 inputs to estimate the fair value of its derivative liabilities.

 

The below table presents the change in the fair value of the derivative liabilities during the nine months ended September 30, 2018:

 

Fair value as of December 31, 2017  $159,537 
Additions recognized as debt discounts   26,647 
Additions due to warrant derivative   6,738 
Gain on change in fair value of derivatives   (129,346)
Fair value as of September 30, 2018  $63,576 

 

Note 5. Common and Preferred Stock Transactions

 

On July 25, 2018, Taladin executed an amendment to a pledge agreement (the “Amended Pledge Agreement”) with a third party lender. Under the original pledge agreement, Taladin pledged 20,000,000 shares (the “Taladin Pledged Shares”) of the Company’s common stock to the lender to secure obligations under the Taladin Pledged Notes, as also amended. Under the terms of the Amended Pledge Agreement, in lieu of selling the Taladin Pledged Shares pursuant to the original terms of the pledge agreement, Taladin and the lender agreed that Taladin, or a party acting on Taladin’s behalf, had the right to purchase a total of 10,000,000 shares of the Taladin Pledged Shares from Taladin at a purchase price of $0.015 per share over a certain period of time. The Company made $150,000 in payments to the lender and all rights to the 10,000,000 shares of the Pledged Stock have been retained by Taladin.

 

14

 

 

During the nine months ended September 30, 2018, the Company issued promissory notes to third party lenders in the aggregate principal amount of $470,000 for loans made by these lenders in the same amount to the Company. These notes bear interest at 10% per annum and are due within 90 days of the date the respective note was issued and on demand. In connection with the loans, the Company issued 1-year to 3-year warrants to purchase an aggregate total of 2,700,000 shares of VCSY common stock at a purchase price of $0.10-$0.20 per share to certain third party lenders.

 

During the nine months ended September 30, 2018, the Company issued an additional 2,500,000 VCSY common shares at a fair market value of $33,000 and an additional 300,000 Ploinks common shares at a fair market value of $92,850 to certain third party purchasers of 600,000 shares of VHS Series A Preferred Stock from a member of Lakeshore. These additional shares were issued to facilitate the execution of the 2017 Lakeshore Loan Amendment which resulted in the cure of any existing defaults under the Loan Agreement and the Note, as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time, when VHS did not meet performance standards. The company recorded the combined fair value of $125,850 as non-operating penalties in other income (expense) for the six months ended June 30, 2018.

 

During the nine months ended September 30, 2018, the Company extended the term of certain warrants to purchase an aggregate total of 225,000 shares of VCSY common stock at a purchase price of $0.10 and $0.20 per share for an additional 1-year period to third party subscribers who purchased an aggregate total of 750 shares of VCSY Series A Preferred Convertible Stock in the aggregate amount of $150,000.

 

During the nine months ended September 30, 2018, the Company extended the term of certain warrants to purchase a total of 12,100,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted a total of 320,199 shares of the common stock of Ploinks, Inc. to third party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $1,210,000 that were issued from 2015 through 2017. The due dates for all these convertible debentures were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

During the nine months ended September 30, 2018, 570,000 shares of VCSY common stock issued to employees of the Company vested.

 

During the nine months ended September 30, 2018, warrants to purchase 1,000,000 shares of VCSY common stock at a purchase price of $0.10 per share expired.

 

During the nine months ended September 30, 2018, 289,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

Stock compensation expense for the amortization of restricted stock awards was $33,127 for the nine months ended September 30, 2018. As of September 30, 2018, there were 5,490,000 shares of unvested stock compensation awards to employees and 15,500,000 shares of unvested stock compensation awards to non-employees.

 

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

 

For additional transactions after September 30, 2018 concerning stock transactions, please see “Subsequent Events” in Note 9.

 

Note 6. Option and Warrant Activity

 

Option and warrant activities during the nine months ended September 30, 2018 is summarized as follows:

 

   Incentive Stock Options   Non-Statutory Stock Options   Warrants   Weighted Average Exercise Price 
Outstanding at December 31, 2017           16,340,000   $0.101 
Options/Warrants granted           2,700,000   $0.181 
Options/Warrants exercised                
Options/Warrants expired/cancelled           1,000,000    0.10 
Outstanding at September 30, 2018           18,040,000   $0.114 

 

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The weighted average remaining life of the outstanding warrants as of September 30, 2018 was 1.79. The intrinsic value of the exercisable warrants as of September 30, 2018 was $0.009.

 

For additional transactions after September 30, 2018 concerning warrants and stock options, please see “Subsequent Events” in Note 9.

 

Note 7. Related Party Transactions

 

The following table reflects our related party debt activity, including our convertible debt, for the nine months ended September 30, 2018:

 

December 31, 2017  $308,242 
Borrowings from related party   45,000 
September 30, 2018  $353,242 

 

During the nine months ended September 30, 2018, a director of the Company loaned the Company $45,000. The debt bears interest at 10% and is payable upon demand.

 

As of September 30, 2018, and December 31, 2017, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $183,641 and $148,760, respectively. The payables are unsecured, non-interest bearing and due on demand.

 

As of September 30, 2018, and December 31, 2017, the Company has accrued payroll to certain current and former employees of $2,857,777 and $2,770,684, respectively.

 

On June 30, 2016, the Company amended an agreement (originally entered into in July 2010) with certain former and current employees of the Company, concerning the deferral of payroll claims of approximately $883,190 for salary earned from 2012 to June 30, 2016 and $1,652,113 for salary earned from 2001 to 2012. The deferral period ended on December 31, 2016 at which time payroll claims of approximately $878,099 for salary earned from 2012 to December 31, 2016 and $1,652,113 for salary earned from 2001 to 2012, remained unpaid and is reflected as a current liability on the Company’s consolidated financial statements.

 

Pursuant to the terms of the amended agreement, each current and former employee who is a party to the agreement (the “Employee(s)”) agreed to defer payment of salary from the date of the agreement (“Salary Deferral”) for a period of three months for salary earned from July 1, 2012 to June 30, 2016 and for a period of six months for salary earned from 2001 to June 30, 2012. In consideration for the Salary Deferral, the Company issued a total 3,500,000 shares of the Company’s common stock during 2016 with the Rule 144 restrictive legend (at a fair market value of $78,750) and agreed to pay each Employee a sum equal to the amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which such salary was earned, plus a bonus (the “Bonus”) of nine percent interest, compounded annually until such time as the unpaid salary has been paid in full. The Company and the Employees have agreed that the Bonus will be paid from amounts anticipated to be paid to the Company in respect of specified intellectual property assets of the Company.

 

In order to effect the payments due under this agreement, the Company assigned to the Employees a twenty percent interest in any net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims and any license fees paid by a subsidiary of the Company or third party to the Company regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629 (plus any continuation patents) on Adhesive Software’s SiteFlash™ Technology, (b) U.S. patent #7,076,521 (plus any continuation patents) in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent U.S. Patent No. #8,578,266 and #9,405,736 (plus any continuation patents) in respect to “Method and System for Automatically Downloading and Storing Markup Language Documents into a Folder Based Data Structure,” and (d) any license payments made (i) by a subsidiary of the Company to the Company in connection with a licensing or distribution agreement between the Company and such subsidiary or (ii) by third party to the Company in connection with a licensing or distribution agreement between the Company and a third party.

 

16

 

  

Under the terms of this agreement, the Bonus is contingent on payment of unpaid wages. In addition, the Bonus is contingent upon generating revenues from the sources of the twenty percent interests in net proceeds assigned to the current and former employees. The interests that were assigned under the agreement for net proceeds consist of the underlying patents of the SiteFlash™ and Emily™ technologies and licensing under distribution and licensing agreements between the Company and subsidiaries and between the Company and third parties. Currently, there is no foreseeable income to be generated from these sources to which a twenty percent interest can reasonably be projected or otherwise applies to. There is no pending litigation regarding any of these patents. In addition, with respect to any licenses from Vertical to its subsidiaries, the licenses of technology underlying these patents were for a three percent royalty on gross revenues. If there were income, any payments under this agreement would likely be minimal. Currently, there is no income being generated from licensing. No subsidiary is currently offering a product to the market using these licensed technologies nor does Vertical have any agreement to license these technologies to a third party.

 

Since payment of the Bonus is contingent upon first paying all unpaid salary and there are no foreseeable revenues to pay the twenty percent interest in these technologies, it is doubtful at the present time that any Bonus will be paid and therefore the Bonus was not accrued as of September 30, 2018 and December 31, 2017 as this contingent liability is considered remote. Cumulative bonus interest through September 30, 2018 is $4,984,867.

 

Note 8. 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 had agreed to 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 Company made $37,500 in payments due under the settlement agreement through May 7, 2012 and each party had alleged the other party was in breach of the settlement agreement.

 

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company. The Company has $130,839 of principal and interest accrued as of September 30, 2018.

 

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses. On September 8, 2017, the court awarded Mr. Wolman a judgment in the amount of $282,299, which accrues interest at the rate of 16% per annum plus attorney’s fees as to be determined by the court. The Company has $340,883 of principal and accrued interest as of September 30, 2018. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

 

Note 9. Subsequent Events

 

During the period that runs from October 1, 2018 through November 27, 2018, the Company issued a promissory note to a third party lender in the principal amount of $100,000 for a loan made by the lender in the same amount to the Company. The note bears interest at 10% per annum and is due within 90 days of the date the respective note was issued. In connection with the loan, the Company issued 1-year warrants to purchase an aggregate 2,000,000 shares of VCSY common stock at a purchase price of $0.10-$0.20 per share to the third party lender.

 

During the period that runs from October 1, 2018 through November 27, 2018, 5,950,000 shares of VCSY common stock issued under restricted stock agreements to employees and consultants of the Company and a subsidiary of the Company vested.

 

17

 

 

During the period that runs from October 1, 2018 through November 27, 495,334 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

During the period that runs from October 1, 2018 through November 27, 2018, the Company issued certain 3-year warrants to purchase an aggregate total of 12,100,000 shares of VCSY common stock at a purchase price of $0.10 per share to third party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $12,100,000 that were issued from 2015 through 2017. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification. The due dates for all these convertible debentures were extended until January 15, 2019.

 

During the period that runs from October 1, 2018 through November 27, 2018, the Company extended the term of certain warrants to purchase an aggregate total of 450,000 shares of VCSY common stock at a purchase price of $0.10 and $0.20 per share for an additional 1-year period to third party subscribers who purchased an aggregate total of 1,500 shares of VCSY Series A Preferred Convertible Stock in the aggregate amount of $300,000.

 

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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 nine months ended September 30, 2018 and 2017, $0 and $0 of internal costs were capitalized, respectively.

 

Revenue Recognition

 

On January 1, 2018, the company adopted ASU No. 2016-12, “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients” using the modified retrospective method applied to those contracts which were not completed as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under Topic 605. There was no impact to the opening balance of accumulated deficit or revenues for the quarter ended June 30, 2018 as a result of applying Topic 606.

 

The Company applies a five-step approach in determining the amount and timing of revenue to be recognized: (1) identifying the contract with a customer, (2) identifying the performance obligations in the contract, (3) determining the transaction price, (4) allocating the transaction price to the performance obligations in the contract and (5) recognizing revenue when the performance obligation is satisfied. Substantially all the Company’s revenue is recognized at the time control of the products transfers 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.

 

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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 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.

 

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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

 

In February 2016, the FASB issued ASU No. 2016-02,” Leases” (Topic 842) which includes a lessee accounting model that recognizes two types of leases - finance leases and operating leases. The standard requires that a lessee recognize on the balance sheet assets and liabilities for leases with lease terms of more than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee will depend on its classification as a finance or an operating lease. New disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases are also required. These disclosures include qualitative and quantitative requirements, providing information about the amounts recorded in the financial statements. ASU 2016-02 will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the effect its adoption of this standard, if any, on our consolidated financial position, results of operations or cash flows.

 

In May 2017, the FASB issued ASU No. 2017-09, “Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting”, to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, Compensation—Stock Compensation, to a change to the terms or conditions of a share-based payment award. The ASU provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in ASC 718. The amendments are effective for fiscal years beginning after December15, 2017 and should be applied prospectively to an award modified on or after the adoption date. Early adoption is permitted, including adoption in an interim period. The Company adopted the standard on January 1, 2018 the amendment did not have a material impact on its consolidated financial statements.

 

In July 2017, the FASB issued ASU No. 2017-11, “Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception”. The ASU was issued to address the complexity associated with applying generally accepted accounting principles (GAAP) for certain financial instruments with characteristics of liabilities and equity. The ASU, among other things, eliminates the need to consider the effects of down round features when analyzing convertible debt, warrants and other financing instruments. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. The amendments are effective for fiscal years beginning after December 15, 2018 and should be applied retrospectively. Early adoption is permitted, including adoption in an interim period. The Company is currently evaluating the effect its adoption of this standard, if any, on our consolidated financial position, results of operations or cash flows.

 

Results of Operations

 

Three and Nine Months Ended September 30, 2018 Compared To Three and Nine Months Ended September 30, 2017

 

Total Revenues. We had total revenues of $998,129 and $920,718 for the three months ended September 30, 2018 and 2017, respectively. The increase in total revenues was $77,411 for the three months ended September 30, 2018 representing an 8.4% increase compared to the total revenues for the three months ended September 30, 2017. Substantially all the revenues for the three months ended September 30, 2018 and 2017 were related to the business operations of NOW Solutions.

 

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Revenues for the three months ended September 30, 2018 and 2017 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. There were $50,000 of new licensing sales of our Empath® product during the third quarter of 2018 as compared to $294 of new licensing sales of our Ploinks® product for the same period in 2017. Software maintenance in the three months ended September 30, 2017 decreased by $29,316 or 3.8% from the same period in the prior year. The revenue decrease in software maintenance is primarily related to the loss of US maintenance revenue combined with unfavorable currency rate changes on our Canadian maintenance revenue partially offset by increases in Canada maintenance revenue. Consulting revenue, in the three months ended September 30, 2017 increased by $46,402 from the same period in the prior year, which represents a 52.4% increase. This increase was due to increased consulting services for version upgrades and enhancements to existing accounts in the third quarter of 2018 compared to the third quarter of 2017. Cloud-based revenues were $54,041 for the three months ended September 30, 2018 compared to $48,648 for the same period in the prior year, representing a $5,393 increase or 11.1%. The increase is related to increases in US cloud-based revenue for NOW Solutions partially offset by a decrease in SnAPPnet revenue. Other revenue in the three months ended September 30, 2018 increased by $5,226 from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses and other miscellaneous revenues.

 

We had total revenues of $3,084,108 and $2,823,067 for the nine months ended September 30, 2018 and 2017, respectively. The increase in total revenues was $261,041 for the nine months ended September 30, 2018 representing a 9.2% increase compared to the total revenues for the nine months ended September 30, 2017. Substantially all the revenues for the nine months ended September 30, 2018 and 2017 were related to the business operations of NOW Solutions.

 

Revenues for the nine months ended September 30, 2018 and 2017 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. There were $150,081 of new licensing sales of our Empath® product during the nine months ended September 30, 2018 as compared to $811 of new licensing sales of our Ploinks® product for the same period in 2017. Software maintenance in the nine months ended September 30, 2018 decreased by $50,433 or 2.1% from the same period in the prior year. The revenue decrease in software maintenance is related to the loss of US and early pay discounts partially offset by an increase in Canadian maintenance revenue and favorable currency rate change. Consulting revenue, in the nine months ended September 30, 2018, increased by $173,750 from the same period in the prior year, which represents a 65.6% increase. This increase was primarily due to increased consulting services for version upgrades and enhancements to existing accounts in the US and Canada during the nine months ended September 30, 2017. Cloud-based revenues were $143,093 for the nine months ended September 30, 2018 compared to $174,315 for the same period in the prior year, representing a $31,222 decrease or 17.9%. The decrease is primarily related to a reduction in Canadian cloud-based revenue and SnAPPnet revenue partially offset by an increase in US cloud-based revenue. Other revenue in the nine months ended September 30, 2017 increased by $19,676 from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses and other miscellaneous revenues.

 

Cost of Revenues. We had direct costs associated with our revenues of $399,993 for the three months ended September 30, 2018, compared to $357,689 for the three months ended September 30, 2017. The increase in cost of revenues of $42,304 represents a 11.8% increase. The increase in direct cost of revenues was primarily due to increases in payroll and travel expenses.

 

For the nine months ended September 30, 2018, direct costs of revenues were $1,153,507 compared to $1,170,484 for the same period in 2017, resulting in a decrease of $16,977 or 1.5%. The decrease in direct cost of revenues was primarily due to decreases in payroll and travel expenses.

 

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $765,227 and $994,410 in the three months ended September 30, 2018 and 2017, respectively. The decrease of $229,183 is 23.0% less than the same period in 2017. We had decreased payroll, stock compensation and travel expenses.

 

For the nine months ended September 30, 2018, we had selling, general and administrative expenses of $2,404,599 compared to $2,973,669 for the nine months ended September 30, 2017. The decrease of $569,070 was 19.1% lower than the same period in 2017. We had decreased payroll, stock compensation, travel expenses, legal fees and penalties partially offset by increased consulting fees.

 

Depreciation and amortization. For the three months ended September 30, 2018, we had depreciation and amortization of $788 compared to $324 for the three months ended September 30, 2017. For the nine months ended September 30, 2018 and 2017, $2,364 and $974, respectively, of depreciation and amortization was recorded.

 

Bad debt expense/recovery. During the three months ended September 30, 2018 we had bad debt recoveries of $12,549 compared to bad debt expense of $40,520 for the period ended September 30, 2017. During the nine months ended September 30, 2018 and 2017 we had $35,561 and $24,147 of bad debt recoveries, respectively. Bad debt expense relates to account receivables that were greater than ninety days past due. Bad debt recovery relates to collections of accounts receivables previously expense and subsequently collected.

 

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Gain/Loss on Derivative Liability. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock, common stock warrants, and convertible debentures. Market value for common stock warrants and convertible debentures is determined using the Black-Scholes Model. The gain on derivative liabilities was $33,032 for the three months ended September 30, 2018 compared to $305,914 for the comparable period in 2017. The gain on derivative liabilities was $129,346 for the nine months ended September 30, 2018 compared to a gain of $925,812 for the nine months ended September 30, 2017.

 

Forbearance Fees. Forbearance fees relate to fees charged by our lenders on loans in default. The company had no forbearance fees for the three months ended September 30, 2018 and 2017.

 

Forbearance fees for the nine months ended September 30, 2018 were $0 compared to $6,000 for the nine months ended September 30, 2017. The fees for the nine months ended September 30, 2017 are related to a VCSY lender.

 

Interest Expense. We had interest expense of $523,875 and $374,914 for the three months ended September 30, 2018 and 2017, respectively. Interest expense increased by $148,961 representing an increase of 39.7% compared to the same expense in the three months ended September 30, 2017. The increase was due to additional borrowings in the three months ended September 30, 2018 and interest on loans going into default.

 

For the nine months ended September 30, 2018, we had interest expense of $1,432,364 compared to $1,393,517 for the same period in 2017, representing an increase of $38,847 or 2.8% for the period. The increase was due to interest on loans going into default.

 

Net loss before non-controlling interest and income taxes. We had a net loss before non-controlling interest and income taxes of $646,171 and $541,224 for the three months ended September 30, 2018 and 2017, respectively. The net loss before non-controlling interest and income taxes for the three months ended September 30, 2018 was due to the factors discussed above for revenues, cost of revenues, bad debt expense and selling, general and administrative expenses, which essentially gave us an operating loss of $155,330. This loss was increased by interest expense and reduced by gain on derivative liabilities. The net loss before non-controlling interest and income taxes for the three months ended September 30, 2017 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 $472,225 This loss was increased by interest expense and reduced by gain on derivative liabilities.

 

We had a net loss before non-controlling interest and income taxes of $1,869,661 and $1,771,601 for the nine months ended September 20, 2018 and 2017, respectively. The net loss before income taxes for the nine months ended September 30, 2018 was due to the factors discussed above for revenues, cost of revenues, bad debt expense and selling, general and administrative expenses, which essentially gave us an operating loss of $440,801. This loss was increased by interest expense and non-operating penalties and reduced by gain on derivative liabilities. The net loss before income taxes for the nine months ended September 30, 2017 was due to the factors discussed above for revenues, cost of revenues, bad debt expense, impairment of software development costs and selling, general and administrative expenses, which essentially gave us an operating loss of $1,297,913. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities.

 

Income tax expense/benefit. We had an income tax expense of $19,028 and $153,023 for the three and nine months ended September 30, 2018 and 2017, respectively. Income taxes are related to NOW Solutions, a 75% owned subsidiary of the Company.

 

We had income tax benefit of $41,185 and income tax expense of $79,014 for the three and nine months ended September 30, 2017, respectively. Income tax expense and benefit is related to NOW Solutions, a 75% owned subsidiary of the Company.

 

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 $155,600 and $155,604 for the three months ended September 30, 2018 and 2017, respectively and $466,800 and $462,009 for the nine months ended September 30, 2018 and 2017, respectively.

 

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $795,217 and $612,704 for the three months ended September 30, 2018 and 2017, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

 

We had a net loss attributed to common stockholders of $2,399,917 and $2,232,824 for the nine months ended September 30, 2018 and 2017, respectively. Net loss available to common stockholders was due to the factors discussed above.

 

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Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the nine months ended September 30, 2018 and 2017, respectively.

 

Liquidity and Capital Resources

 

At September 30, 2018, we had non-restricted cash-on-hand of $224,369 compared to $62,084 at December 31, 2017.

 

Net cash used in operating activities for the nine months ended September 30, 2018 was $616,430 compared to net cash used in operating activities of $508,323 for the nine months ended September 30, 2017.

 

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 $537,577 or 30.7% from the balance at December 31, 2017. The decrease was due to a higher number of customers on calendar year maintenance agreements which results in higher deferred revenue in December.

 

Our accounts receivable trade decreased from $349,002 at December 31, 2017 to $172,041 (net of allowance for bad debts) at September 30, 2018. 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 September.

 

The combined accounts payable to related parties and accounts payable and accrued liabilities went from $14,271,154 at December 31, 2017 to $15,717,995 at September 30, 2018. The increase is primarily related to an increase in accrued interest and accrued payroll. The resulting balance at September 30, 2018 is 91 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 nine months ended September 30, 2018 and September 30, 2017 of $0 and $0, respectively. Equipment relates to 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 nine months ended September 30, 2018, we had $840,100 of new debt funding, repaid $20,944 to lenders and paid $89,090 of dividends to non-controlling shareholders of NOW Solutions. For the nine months ended September 30, 2017, we had $411,500 of new debt funding, $260,000 of equity financing, repaid $178,918 to lenders and accrued $97,500 of dividends to non-controlling shareholders of NOW Solutions.

 

The total change in cash for the nine months ended September 30, 2018 was an increase of $162,285.

 

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.

 

   Balance at  

Due in Next Five Years

 
Contractual Obligations  September 30, 2018   2018   2019   2020   2021   2022+ 
                               
Notes payable  $6,960,972   $6,960,972   $   $   $   $ 
Convertible debentures   

1,355,969

    1,355,969                 
Operating lease    260,858    21,539    86,154    81,932    71,233     
Total  $8,577,799   $8,338,480   $86,154   $81,932   $71,233   $ 

 

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

 

   September 30, 2018   December 31, 2017 
           
In default  $5,703,473   $3,390,190 
Not in default   2,613,468    4,091,895 
           
Total Notes Payable  $8,316,941   $7,482,085 

 

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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 before non-controlling interest of $2,022,684 and $1,850,615 for the nine months ended September 30, 2018 and 2017, respectively and 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 September 30, 2018, we had negative working capital of approximately $24.9 million (although this figure includes deferred revenue of approximately $1.2 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. 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, 2017, as filed on May 10, 2018.

 

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, 2017.

 

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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 had agreed to 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 Company made $37,500 in payments due under the settlement agreement through May 7, 2012 and each party had alleged the other party was in breach of the settlement agreement.

 

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company. The Company has $130,839 of principal and interest accrued as of September 30, 2018.

 

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses. On September 8, 2017, the court awarded Mr. Wolman a judgment in the amount of $282,299, which accrues interest at the rate of 16% per annum plus attorney’s fees as to be determined by the court. The Company has $340,883of principal and accrued interest as of September 30, 2018. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

 

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, 2017, as filed on May 10, 2018.

 

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

 

On July 25, 2018, Taladin executed an amendment to a pledge agreement (the “Amended Pledge Agreement”) with a third party lender. Under the original pledge agreement, Taladin pledged 20,000,000 shares (the “Taladin Pledged Shares”) of the Company’s common stock to the lender to secure obligations under the Taladin Pledged Notes, as also amended. Under the terms of the Amended Pledge Agreement, in lieu of selling the Taladin Pledged Shares pursuant to the original terms of the pledge agreement, Taladin and the lender agreed that Taladin, or a party acting on Taladin’s behalf, had the right to purchase a total of 10,000,000 shares of the Taladin Pledged Shares from Taladin at a purchase price of $0.015 per share over a certain period of time. The Company made $150,000 in payments to the lender and all rights to the 10,000,000 shares of the Pledged Stock have been retained by Taladin.

 

During the nine months ended September 30, 2018, the Company issued promissory notes to third party lenders in the aggregate principal amount of $470,000 for loans made by these lenders in the same amount to the Company. These notes bear interest at 10% per annum and are due within 90 days of the date the respective note was issued and on demand. In connection with the loans, the Company issued 1-year to 3-year warrants to purchase an aggregate total of 2,700,000 shares of VCSY common stock at a purchase price of $0.10-$0.20 per share to certain third party lenders.

 

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During the nine months ended September 30, 2018, the Company issued an additional 2,500,000 VCSY common shares at a fair market value of $33,000 and an additional 300,000 Ploinks common shares at a fair market value of $92,850 to certain third party purchasers of 600,000 shares of VHS Series A Preferred Stock from a member of Lakeshore. These additional shares were issued to facilitate the execution of the 2017 Lakeshore Loan Amendment which resulted in the cure of any existing defaults under the Loan Agreement and the Note, as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time, when VHS did not meet performance standards. The company recorded the combined fair value of $125,850 as non-operating penalties in other income (expense) for the six months ended June 30, 2018.

 

During the nine months ended September 30, 2018, the Company extended the term of certain warrants to purchase a total of 500,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted 9,100 shares of the common stock of Ploinks, Inc. to third party lenders in connection with certain extensions of convertible debentures in the principal amount of $65,000 that were issued in 2016 and 2017. The due dates for all these convertible extensions were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

During the nine months ended September 30, 2018, the Company extended the term of certain warrants to purchase an aggregate total of 225,000 shares of VCSY common stock at a purchase price of $0.10 and $0.20 per share for an additional 1-year period to third party subscribers who purchased an aggregate total of 750 shares of VCSY Series A Preferred Convertible Stock in the aggregate amount of $150,000.

 

During the nine months ended September 30, 2018, the Company extended the term of certain warrants to purchase a total of 12,100,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted a total of 320,199 shares of the common stock of Ploinks, Inc. to third party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $1,210,000 that were issued from 2015 through 2017. The due dates for all these convertible debentures were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

During the nine months ended September 30, 2018, 570,000 shares of VCSY common stock issued to employees of the Company vested.

 

During the nine months ended September 30, 2018, warrants to purchase 1,000,000 shares of VCSY common stock at a purchase price of $0.10 per share expired.

 

During the nine months ended September 30, 2018, 289,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

During the period that runs from October 1, 2018 through November 27, 2018, the Company issued a promissory note to a third party lender in the principal amount of $100,000 for a loan made by the lender in the same amount to the Company. The note bears interest at 10% per annum and is due within 90 days of the date the respective note was issued. In connection with the loan, the Company issued 1-year warrants to purchase an aggregate 2,000,000 shares of VCSY common stock at a purchase price of $0.10-$0.20 per share to the third party lender.

 

During the period that runs from October 1, 2018 through November 27, 2018, 5,950,000 shares of VCSY common stock issued under restricted stock agreements to employees and consultants of the Company and a subsidiary of the Company vested.

 

During the period that runs from October 1, 2018 through November 27, 495,334 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

  

During the period that runs from October 1, 2018 through November 27, 2018, the Company issued certain 3-year warrants to purchase an aggregate total of 12,100,000 shares of VCSY common stock at a purchase price of $0.10 per share to third party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $12,100,000 that were issued from 2015 through 2017. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification. The due dates for all these convertible debentures were extended until January 15, 2019. 

 

During the period that runs from October 1, 2018 through November 27, 2018, the Company extended the term of certain warrants to purchase an aggregate total of 450,000 shares of VCSY common stock at a purchase price of $0.10 and $0.20 per share for an additional 1-year period to third party subscribers who purchased an aggregate total of 1,500 shares of VCSY Series A Preferred Convertible Stock in the aggregate amount of $300,000.

 

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Item 3.Defaults Upon Senior Securities

 

Note payable, amended, of $2,291,395, issued by NOW Solutions to Lakeshore Investment, LLC, dated January 9, 2013.  The note is secured with the assets of NOW Solutions and bears a default interest rate of 16%. As of November 27, 2018, the outstanding principle and accrued interest currently due under the note is $2,338,709.

 

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:

 

Exhibit No.

 

Description 

 

Location 

         
31.1   Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 27, 2018   Provided herewith
         
32.1   Certification of Principal Executive Officer and Principal Accounting Officer Pursuant Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated November 27, 2018   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 Document   Provided herewith

 

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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.
   
November 27, 2018 By: /s/   Richard Wade
    Richard Wade
 

 

President and Chief Executive Officer

(Principal Executive Officer and

Principal Accounting Officer)

 

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