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,
2015. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”,
“we”, the “Company” or “VCSY”, as applicable). Vertical’s subsidiaries which currently
maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), 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”) a 70% owned subsidiary, Ploinks, Inc. (“Ploinks”)
(formerly, OptVision Research, Inc.), a 93% 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 2015 annual
report on Form 10-K have been omitted.
Earnings per share
Basic earnings per share is calculated
by dividing net income (loss) available to common stockholders by the weighted average number of shares of the Company’s
common stock outstanding during the period. “Diluted earnings per share” reflects the potential dilution that could
occur if our share-based awards and convertible securities were exercised or converted into common stock. The dilutive effect
of our share-based awards is computed using the treasury stock method, which assumes all share-based awards are exercised and
the hypothetical proceeds from exercise are used to purchase common stock at the average market price during the period. The incremental
shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included
in the denominator of the diluted EPS calculation. The dilutive effect of our convertible preferred stock and convertible debentures
is computed using the if-converted method, which assumes conversion at the beginning of the year.
For the three months
ended March 31, 2016 and 2015, common stock equivalents related to the convertible debentures, convertible debt and preferred
stock and stock derivative liability were not included in the calculation of the diluted earnings per share as their effect would
be anti-dilutive.
Reclassifications
Certain reclassifications
have been made to the prior periods to conform to the current period presentation.
Capitalized
Software Costs
Software
costs incurred internally in creating computer software products are expensed until technological feasibility has been established
upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that
the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company
considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total
estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated
economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where
the fair value is less than the carrying value.
During
the three months ended March 31, 2016 and 2015, the Company capitalized an aggregate of $143,927 and $142,253 respectively, related
to software development.
Recently Issued
Accounting Pronouncements
The Company does not
expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial
position, operations or cash flows.
Note 2. Going Concern
The accompanying unaudited
consolidated financial statements for the three months ended March 31, 2016 and 2015 have been prepared assuming that we will
continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.
The carrying amounts
of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement
values. As of March 31, 2016, we had negative working capital of approximately $18.5 million and defaulted on substantially all
of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.
Our management is
continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible
acquisitions, mergers, joint ventures, and/or other business combinations. The Company will require additional funds to pay down
its liabilities, as well as finance its expansion plans consistent with anticipated changes in operations and infrastructure.
However, there can be no assurance that the Company will be able to secure additional funds and that if such funds are available,
whether the terms or conditions would be acceptable to the Company and whether the Company will be able to turn into a profitable
position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome
of this uncertainty.
Note 3. Notes Payable
The following table
reflects our third party debt activity, including our convertible debt, for the three months ended March 31, 2016:
December 31, 2015
|
|
$
|
5,397,020
|
|
Payments of third party notes
|
|
|
(62,190
|
)
|
Debt discounts due valuation of derivative liabilities
|
|
|
(302,473
|
)
|
Amortization of debt discounts
|
|
|
85,742
|
|
Effect of currency exchange
|
|
|
125
|
|
March 31, 2016
|
|
|
5,118,224
|
|
Lakeshore Financing
On January 9, 2013,
NOW Solutions completed a financing transaction in the aggregate amount of $1,759,150, which amount was utilized to pay off existing
indebtedness of the Company and NOW Solutions to Tara Financial Services and Robert Farias, a former employee of the Company,
and all security interests granted to Tara Financial Services and Mr. Farias were cancelled.
In connection with
this financing, the Company and several of its subsidiaries entered into a loan agreement (the “
Loan Agreement
”),
dated as of January 9, 2013 with Lakeshore Investment, LLC (“
Lakeshore
”) under which NOW Solutions issued a
secured 10-year promissory note (the “
Lakeshore Note
”) bearing interest at 11% per annum to Lakeshore in the
amount of $1,759,150 payable in equal monthly installments of $24,232 until January 31, 2022. Upon the payment of any prepayment
principal amounts, the monthly installment payments shall be proportionately adjusted proportionately on an amortized rata
basis.
The Lakeshore Note
is secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“
SnAPPnet
”)
and the Company’s SiteFlash™ technology and cross-collateralized. Upon the aggregate principal payment of $290,000
toward the Lakeshore Note, the Company has the option to have Lakeshore release either the Priority Time collateral or the SiteFlash™
collateral. Upon payment of the aggregate principal of $590,000 toward the Lakeshore Note, Lakeshore shall release either the
Priority Time collateral or the SiteFlash™ collateral (whichever is remaining). Upon payment of the aggregate principal
of $890,000 toward the Lakeshore Note, Lakeshore shall release the SnAPPnet collateral and upon full payment of the Lakeshore
Note, Lakeshore shall release the NOW Solutions collateral.
As additional consideration
for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees and direct costs) from any
litigation or settlement proceeds related to the SiteFlash™ technology to Lakeshore 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 a Lakeshore royalty of
6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management has estimated the fair
value of the royalty to be nominal as of its issuance date and no royalty was owed as of September 30, 2015 or December 31, 2014.
In December 2014,
the Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. Under the terms of the amendment,
NOW Solutions agreed to make $2,500 weekly advance payments to Lakeshore to be applied to the 25% dividend of NOW Solutions’
net income after taxes in connection with Lakeshore’s 25% minority ownership interest in NOW Solutions. Within 10 business
days after the Company files its periodic reports with the SEC, NOW Solutions will also make quarterly payment advances to Lakeshore
based on 60% of Lakeshore’s 25% share of NOW Solutions estimated quarterly net income after taxes, less any weekly payment
advances received by Lakeshore during the then-applicable quarter and the weekly $2,500 payments shall be increased or decreased
based only upon any increases or decreases of maintenance and cloud-based offering fees during the then-completed quarter (but
will not decrease below a minimum of $2,500 per week). NOW Solutions shall pay Lakeshore the balance of Lakeshore’s 25%
of NOW’s yearly net income after taxes (less any advances) within 10 business days after the Company files it annual 10-K
report with the SEC and any payments in excess of Lakeshore’s 25% of NOW yearly profit shall be credited towards future
weekly advance payments. The Company also agreed to pay attorney fees of $40,000 and paid fees of $80,000 to a former consultant
and employee of the Company who is a member of Lakeshore. In consideration of the extension to cure the default under the Lakeshore
Note and the Loan Agreement, the Company transferred a 20% ownership interest in Priority Time Systems, Inc., a 90% owned subsidiary
of VCSY, and in SnAPPnet, Inc., a 100% owned subsidiary of VCSY, to Lakeshore. This resulted in an additional non-controlling
interest recognized in the equity of the Company of $391,920 and $99,210 for Priority Time Systems, Inc. and SnAPPnet, Inc., respectively,
during 2014. The Company had an option to buy back Lakeshore’s ownership interest in NOW Solutions, Priority Time and SnAPPnet,
Inc. (which expired on January 31, 2015).
In July 2015, we entered
into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the amendment,
the Company issued 13,000,000 common shares with the Rule 144 restrictive legend, resulting in a forbearance loss of $455,000
and Ploinks agreed to issue 3,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares was determined
to be nominal. Also in July 2015, the Company further amended the Lakeshore Note and the Loan Agreement with Lakeshore. Pursuant
to this Agreement, the Company issued 2,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a
forbearance loss of $54,200 and paid $15,000 to Lakeshore as forbearance fees.
In August 2015, we
entered into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the
amendment, the Company issued 7,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a forbearance
loss of $175,700 and Ploinks agreed to issue 2,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks
shares was determined to be nominal.
In January 2016, the
Company re-amortized the Lakeshore Note at 11% interest per annum pursuant to the amendment of the Loan Agreement and Note executed
on August 6, 2015. The Company has made all monthly installment payments towards the Note and the $2,500 weekly payments
which will be applied toward Lakeshore’s share of dividends through the date of this Report.
The Lakeshore note
is currently in default and the Company is currently in discussions with Lakeshore to resolve all outstanding issues, including
the reconciliation payment due on January 15, 2016.
During the three months
ended March 31, 2016, the Company, through its subsidiary, paid dividends to Lakeshore of $32,500.
Note
4. Derivative Liabilities and
Fair Value Measurements
Derivative liabilities
During
2016, certain notes issued by the Company became convertible and qualified as derivative liabilities under ASC 815. In addition,
the outstanding common stock warrants associated with the notes became tainted and were required to be accounted for as derivative
liabilities under ASC 815.
As of March 31, 2016,
the aggregate fair value of the outstanding derivative liabilities was $326,223. For the three months ended March 31, 2016, the
net gain on the change in fair value of derivative liabilities was $28,712.
The Company estimated
the fair value of the derivative liabilities using the Black-Scholes option pricing model and the following key assumptions during
2016:
|
|
2016
|
|
Expected dividends
|
|
|
0%
|
|
Expected terms (years)
|
|
|
0.39 - 2.91
|
|
Volatility
|
|
|
119% - 131%
|
|
Risk-free rate
|
|
|
0.39% - 0.98%
|
|
Fair value measurements
FASB ASC 820, Fair
Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer
a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction
between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity
to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC 820 describes
three levels of inputs that may be used to measure fair value:
Level 1
– Quoted
prices in active markets for identical assets or liabilities.
Level 2
– Observable
inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable
or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3
– Unobservable
inputs that are supported by little or no market activity and that are financial instruments whose values are determined using
pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination
of fair value requires significant judgment or estimation.
If the inputs used
to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on
the lowest level of input that is significant to the fair value measurement of the instrument.
The following table provides a summary
of the fair value of our derivative liabilities as of March 31, 2016 and December 31, 2015:
|
|
Fair value measurements on a recurring
basis
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
As of March 31, 2016:
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivative liabilities – convertible debt
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
326,223
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2015:
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
None
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
-
|
|
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 three months ended March 31, 2016:
Fair value as of December 31, 2015
|
|
$
|
-
|
|
Additions recognized as debt discounts
|
|
|
302,473
|
|
Additions reclassified from equity
|
|
|
52,462
|
|
Loss on change in fair value of derivatives
|
|
|
(28,712
|
)
|
Fair value as of March 31, 2016
|
|
$
|
326,223
|
|
Note 5. Common and Preferred Stock
Transactions
In January 2016, the
Company granted 2,000,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 200,000 shares of Ploinks
common stock to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company. The aggregate
fair market value of the 2,000,000 share award was determined to be $44,000. In addition, the Company agreed to issue up to 15,000,000
common shares of the Company and 1,500,000 shares of Ploinks common stock pursuant to restricted performance stock agreements
with the consultant. These shares may vest over a term of 3 years and are based upon the Consultant achieving certain performance
criteria.
In March 2016, the
Company granted 100,000 unregistered shares of the Company’s common stock with the Rule 144 restrictive legend to a consultant
of the Company and its subsidiaries pursuant to a restricted stock agreement with the Company.
In March 2016, the
Company cancelled 1,000,000 unregistered shares of its common stock issued during 2015 to a third party lender under an agreement
to amend certain promissory notes issued by the Company and NOW Solutions in the aggregate principal amount of $715,000. Under
the amendment, the Company agreed to make $22,000 monthly payments and an additional $10,000 penalty if such monthly payment is
not timely made. The cancellation resulted in the reversal of forbearance fees expense of $28,900 during the three months ended
March 31, 2016.
In March 2016, the
Company issued 10,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to its consolidated
subsidiary Ploinks. These shares are held in treasury. In exchange, Ploinks issued 5,000,000 of its common shares to the
Company.
During the three months
ended March 31, 2016, 450,000 VCSY common shares issued under restricted stock agreements to consultants and employees of the
Company vested.
During the three months
ended March 31, 2016, the Company issued 750,000 shares of the Company’s common stock with the Rule 144 restrictive legend
to an employee of a subsidiary of the Company (at a fair market value of $15,675), pursuant to a restricted stock agreement under
which the shares vest in equal installments over a 30-month period.
During the three months
ended March 31, 2016, the
Company cancelled 200,000 previously awarded but unvested unregistered shares of the Company’s
common stock issued to an employee of the Company when the employee resigned. This resulted in the reversal of previously recognized
compensation expense of $1,145 during the three months ended March 31, 2016.
Stock compensation
expense for the amortization of restricted stock awards was $12,295 for the three months ended March 31, 2016. As of March 31,
2016, there were 2,350,000 shares of unvested stock compensation awards to employees and 15,100,000 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.
Option and warrant
activities during the three months ended March 31, 2016 is summarized as follows:
|
|
Incentive Stock
Options
|
|
|
Non-Statutory
Stock Options
|
|
|
Warrants
|
|
|
Weighted
Average Exercise
Price
|
|
Outstanding at December 31, 2015
|
|
|
-
|
|
|
|
-
|
|
|
|
6,800,000
|
|
|
$
|
.091
|
|
Options/Warrants granted
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Options/Warrants exercised
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Options/Warrants expired/cancelled
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Outstanding at March 31, 2016
|
|
|
-
|
|
|
|
-
|
|
|
|
6,800,000
|
|
|
$
|
.091
|
|
The weighted average remaining life of
the outstanding warrants as of March 31, 2016 was 2.49. The intrinsic value of the exercisable warrants as of March 31, 2016 was
$0.
Note 6. Related Party Transactions
.
The following table
reflects our related party debt activity, including our convertible debt, for the three months ended March 31, 2016:
December 31, 2015
|
|
$
|
417,445
|
|
Amortization of debt discounts
|
|
|
5,171
|
|
March 31, 2016
|
|
$
|
422,616
|
|
As of March 31, 2016
and December 31, 2015, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in
an aggregate amount of $123,371 and $108,379, respectively. The payables are unsecured, non-interest bearing and due on demand.
Note 7. Legal Proceedings
We are involved in
the following ongoing legal matters:
On December 31, 2011,
the Company and InfiniTek corporation (“InfiniTek”) entered into a settlement agreement to dismiss an action filed
by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims,
a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an
action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach
of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three
equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign
ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft
Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and
accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500
in payments due under the settlement agreement as of the date of this Report and each party is alleging the other party is in
breach of the settlement agreement. We intend to resolve all disputes with InfiniTek.
On February 4, 2014,
Victor Weber filed a lawsuit against Vertical, MRC and Richard Wade in the District Court of Clark County, Nevada for failure
to make payment of the outstanding balance due under a $275,000 promissory note issued by Vertical to Mr. Weber. On July 24 2014,
the court granted plaintiff’s motion for summary judgment against defendants. The judgment was filed on September 18, 2014.
In June 2015, the Company and Mr. Weber entered into an agreement to pay off the $365,000 outstanding balance under the judgment,
which included $275,000 in principal, accrued interest, attorney’s fees and court costs. Under the terms of the agreement,
the Company issued 10,000,000 shares of its common stock with the Rule 144 restrictive legend to Mr. Weber at a fair market value
of $250,000 in consideration of Mr. Weber’s forbearance in not taking any action to enforce the judgment. The Company also
agreed to make payments of $100,000 by June 15, 2015 and $265,000 by July 15, 2015, or in the alternative, the Company had the
option to issue another 10,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend in lieu of
making the $100,000 payment and issue an additional 15,000,000 shares of the Company’s common stock with the Rule 144 restrictive
legend in lieu of making the $265,000 payment. On June 15, 2015, the Company issued 10,000,000 shares with the Rule 144 restrictive
legend at a fair market value of $250,000 to Mr. Weber as repayment of a $100,000 payment resulting in a loss on extinguishment
of $150,000. On July 15, 2015, the Company issued 15,000,000 shares with the Rule 144 restrictive legend at a fair market value
of $408,000 to Mr. Weber as repayment of the $265,000 payment. Pursuant to the agreement, Mr. Weber filed disposition documents
that the judgment has been satisfied and this matter is resolved.
Note 8. Subsequent Events
In April 2016, the
Company and a third party noteholder entered into an agreement under which the Company issued 5,000,000 shares of the Company’s
common stock with the Rule 144 restrictive legend in lieu of $130,000 in principal owed to the noteholder under a note payable
issued by NOW Solutions with a principal amount of $213,139. The fair market value of the shares was $92,500.
In May 2016, the Company
and William Mills agreed to issue 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend in
lieu of $100,000 of fees accrued for services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market
value of the shares was $87,500. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.
In May 2016, the Company
and a third party entered into an agreement under which the Company issued 1,500,000 shares of the Company’s common stock
with the Rule 144 restrictive legend in lieu of paying $35,969 in fees, expenses, and interest owed to the third party for services
rendered to the Company and its subsidiaries. The fair market value of the shares issued was $37,500.
During the period
that runs from April 1, 2016 through May 16, 2016, the Company issued convertible debentures in the aggregate principal amount
of $285,000 to third party lenders for loans made to the Company in the same amount. The debts accrue interest at 10% per annum
and are due one year from the date of issuance. Beginning six months after issuance of the respective debentures and provided
that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has
been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price
per share of 80% of the average per share price of the Company’s common stock for the 5 trading days preceding the notice
of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued to the lender a total
of 2,850,000 shares of common stock of the Company with the Rule 144 restrictive legend and 3-year warrants under which the lenders
may purchase in aggregate a total of 2,850,000 unregistered shares of common stock of the Company at a purchase price of $0.10
per share.
During the period
that runs from April 1, 2016 through May 16, 2016, $34,000 of principal and interest under a convertible note issued in the principal
amount of $80,000 was converted into 2,464,092 unrestricted common shares of the company.