Quarterly Report (10-q)

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, 2016

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

For the transition period from _____ to _____

Commission file number 0-28685

VERTICAL COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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

101 West Renner Road, Suite 300

Richardson, TX 75082

(Address of principal executive offices)

(972) 437-5200

(Registrant’s Telephone Number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

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

Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

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

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

As of November 21, 2016, the issuer had 1,162,738,121 shares of common stock, par value $0.00001, issued and 1,122,738,121 outstanding.

PART I

FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

	September 30,		December 31,
	2016		2015
Assets
Current assets
Cash	$	18,513	$	37,141
Accounts receivable, net of allowance for bad debts of $82,674 and $97,973		91,048		382,463
Prepaid expenses and other current assets		12,326		57,488
Total current assets		121,887		477,092

Property and equipment, net of accumulated depreciation of $1,043,219 and $1,038,609		5,421		2,375
Intangible assets, net of accumulated amortization of $319,514 and $319,413		6,690		1,181,661
Deposits and other		8,091		7,909

Total assets	$	142,089	$	1,669,037

Liabilities and Stockholders’ Deficit
Current liabilities:
Accounts payable and accrued liabilities	$	11,599,646	$	10,536,974
Accounts payable to related parties		140,877		108,379
Bank overdraft		126		52
Deferred revenue		1,300,584		1,658,158
Derivative liabilities		425,740		-
Convertible debentures, net of unamortized discounts of $171,666 and $110,121		1,037,595		499,879
Current portion - notes payable		4,943,710		4,897,141
Current portion - notes payable to related parties, net of unamortized discounts of $29,713 and $20,798		278,529		417,445
Total current liabilities		19,726,807		18,118,028

Total liabilities		19,726,807		18,118,028

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

(Continued from previous page)

	September 30,			December 31,
	2016			2015
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 49,250 shares issued and outstanding as of September 30, 2016 and 48,500 issued and outstanding as of December 31, 2015		9,724,810			9,700,000
Series B 10% Convertible Cumulative Preferred stock; $0.001 Par Value; 375,000 shares authorized; 7,200 shares issued and outstanding		246			246
Series C 4% Convertible Cumulative Preferred stock; $100.00 par value; 200,000 shares authorized; 50,000 shares issued and outstanding		200,926			200,926
Series D 15% Convertible Cumulative Preferred stock; $0.001 Par Value; 300,000 shares authorized; 25,000 shares issued and outstanding		852			852
		9,926,834			9,902,024

Stockholders' Deficit
Common Stock; $.00001 par value; 2,000,000,000 shares authorized 1,156,238,121 issued and 1,116,238,121 outstanding as of September 30, 2016 and 1,114,601,656 issued and 1,084,601,656 outstanding as of December 31, 2015		11,563			11,147
Treasury stock; 40,000,000 as of September 30, 2016 and 30,000,000 as of December 31, 2015		(400	)		(300	)
Additional paid-in capital		23,300,896			22,252,823
Accumulated deficit		(53,458,325	)		(49,739,924	)
Accumulated other comprehensive income – foreign currency translation		420,185			558,668

Total Vertical Computer Systems, Inc. stockholders’ deficit		(29,726,081	)		(26,917,586	)

Noncontrolling interest		214,529			566,571
Total stockholders’ deficit		(29,511,552	)		(26,351,015	)

Total liabilities and stockholders' deficit	$	142,089		$	1,669,037

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
Revenues
Licensing and software	$	7,290		$	22,500		$	19,290		$	22,500
Software maintenance		819,450			850,287			2,449,058			2,742,035
Cloud-based offering		75,099			86,417			199,565			248,444
Consulting services		49,403			54,967			197,400			186,221
Other		2,019			11,023			10,550			36,811
Total revenues		953,261			1,025,194			2,875,863			3,236,011

Cost of revenues		(392,058	)		(465,614	)		(1,156,522	)		(1,377,496	)

Gross profit		561,203			559,580			1,719,341			1,858,515

Operating expenses:
Selling, general and administrative expenses		1,126,309			563,406			2,602,957			2,124,196
Depreciation and amortization		325			-			758			38,412
Bad debt expense		29,276			8,927			41,203			59,808
Impairment of software costs		1,421,155			-			1,421,155			-
Total operating expenses		2,577,065			572,333			4,066,073			2,222,416

Operating loss		(2,015,862	)		(12,753	)		(2,346,732	)		(363,901	)

Other income (expense):
Interest income		23			1			41			7
Gain (Loss) on derivative liabilities		160,326			-			49,291			(78,680	)
Gain (Loss) on debt extinguishment		-			(173,193	)		35,969			(323,193	)
Forbearance fees		(2,500	)		(699,900	)		(19,600	)		(948,900	)
Interest expense		(550,189	)		(64,819	)		(1,453,234	)		(588,583	)

Net loss before noncontrolling interest and income tax (expense) benefit		(2,408,202	)		(950,664	)		(3,734,265	)		(2,303,250	)
Income tax (expense) benefit		1,154			(675,895	)		103,910			(562,373	)
Net loss before noncontrolling interest		(2,409,356	)		(274,769	)		(3,838,175	)		(1,740,877	)
Net income (loss) attributable to noncontrolling interest		149,114			(36,588	)		119,774			(64,203	)
Net loss attributable to Vertical Computer Systems, Inc.		(2,260,242	)		(311,357	)		(3,718,401	)		(1,805,080	)
Dividends applicable to preferred stock		(147,000	)		(147,000	)		(441,000	)		(441,000	)

Net loss available to common stockholders	$	(2,407,242	)	$	(458,357	)	$	(4,159,401	)	$	(2,246,080	)

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

Basic and diluted weighted average common shares outstanding		1,114,227,854			1,057,869,945			1,100,341,934			1,022,277,163

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

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,
	2016			2015			2016			2015
Comprehensive loss
Net loss	$	(2,409,356	)	$	(274,769	)	$	(3,838,175	)	$	(1,740,877	)
Translation adjustments		35,715			209,796			(138,483	)		375,104
Comprehensive loss		(2,373,641	)		(64,973	)		(3,976,658	)		(1,365,773	)
Comprehensive income (loss) attributable to noncontrolling interest		(149,114	)		(36,588	)		(119,774	)		(64,203	)
Comprehensive loss attributable to Vertical Computer Systems, Inc.	$	(2,522,755	)	$	(101,561	)	$	(4,096,432	)	$	(1,429,976	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

December 31, 2015 through September 30, 2016

(Unaudited)

													Additional						Other			Non-
	Common Stock						Treasure Stock						Paid-in			Accumulated			Comprehensive			controlling
	Shares			Amount			Shares			Amount			Capital			Deficit			Interest			Interest			Total
Balances at December 31, 2015		1,114,601,656		$	11,147			(30,000,000	)		(300	)	$	22,252,823		$	(49,739,924	)	$	558,668		$	566,571		$	(26,351,015	)
Amortization of restricted stock awards		-			-			-			-			179,351			-			-			-			179,351
Forfeited restricted stock awards		-			-			-			-			(1,145	)		-			-			-			(1,145	)
Shares issued to subsidiary and held in treasury		10,000,000			100			(10,000,000	)		(100	)		-			-			-			-			-
Shares issued for vested restricted stock awards		1,175,000			12			-			-			(12	)		-			-			-			-
Cancellation of shares issued for loan forbearance		(1,000,000	)		(10	)		-			-			(28,890	)		-			-			-			(28,900	)
Shares issued for accounts payable		1,500,000			15			-			-			37,485			-			-			-			37,500
Shares issued for services		3,000,000			30			-			-			66,520			-			-			-			66,550
Shares issued for related party accounts payable		5,000,000			50			-			-			99,950			-			-			-			100,000
Shares issued with convertible debt		6,650,000			66			-			-			171,260			-			-			-			171,326
Shares issued for conversion of convertible debt		5,311,465			53			-			-			73,947			-			-			-			74,000
Shares issued for payment of note principal		5,000,000			50			-			-			92,450			-			-			-			92,500
Reclassification of warrants as derivative liabilities		-			-			-			-			(121,258	)		-			-			-			(121,258	)
Settlement of derivative liability upon conversion of debt		-			-			-			-			47,219			-			-			-			47,219
Shares issued for deferment of unpaid salary and fees for services		3,500,000			35			-			-			78,715			-			-			-			78,750
Shares and subsidiary shares issued for equity subscriptions		1,500,000			15			-			-			124,110			-			-			(26	)		124,099
Dividends paid by subsidiary to non-controlling interest		-			-			-			-			-			-			-			(222,500	)		(222,500	)
Issuance of subsidiary shares for services		-			-			-			-			212,171			-			-			(9,742	)		202,429
Issuance of subsidiary shares for debt extension														16,200												16,200
Other comprehensive income translation adjustment		-			-			-			-			-			-			(138,483	)		-			(138,483	)
Net loss		-			-			-			-			-			(3,718,401	)		-			(119,774	)		(3,838,175	)
Balances at September 30, 2016		1,156,238,121		$	11,563			(40,000,000	)		(400	)	$	23,300,896		$	(53,458,325	)	$	420,185		$	214,529		$	(29,511,552	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
	2016			2015

Cash flows from operating activities
Net loss	$	(3,838,175	)	$	(1,740,877	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		758			38,412
Amortization of debt discounts		516,967			10,570
Common shares issued for services		66,550			-
Forfeited restricted stock awards		(1,145	)		-
Common shares issued for stock compensation		-			20,000
Write-off of property and equipment		-			4,905
Bad debt expense		41,203			59,808
Forbearance fees paid with common stock		-			933,900
Cancellation of common shares issued for loan forbearance		(28,900	)		-
Impairment of software development costs		1,421,155			-
Loss/(gain) on extinguishment of debt and accrued interest		(35,969	)		323,193
Loss/(gain) on derivatives		(49,291	)		78,680
Amortization of restricted stock awards		258,101			9,808
Amortization of subsidiary restricted stock awards		202,429			-
Settlement of accrued income taxes		-			(562,373	)
Changes in operating assets and liabilities:
Accounts receivable		256,717			350,475
Prepaid expenses and other assets		45,039			(11,500	)
Accounts payable and accrued liabilities		1,179,000			486,046
Accounts payable related parties		32,498			35,510
Deferred revenue		(411,142	)		(346,110	)
Net cash used in operating activities		(344,205	)		(148,564	)

Cash flow from investing activities:
Software development		(246,184	)		(489,148	)
Purchase of property and equipment		(3,804	)		-
Net cash used in investing activities		(249,988	)		(489,148	)

Cash flows from financing activities:
Borrowings on notes payable		111,900			335,333
Borrowings on convertible debentures		665,000			550,000
Payments of notes payable		(63,699	)		(52,448	)
Issuance of stock subscriptions		150,000			-
Payments on related party debt		-			(780	)
Dividends paid		(222,500	)		(92,500	)
Bank overdraft		74			(5,719	)
Net cash provided by financing activities		640,775			733,886

Effect of changes in exchange rates on cash		(65,210	)		42,421

Net change in cash and cash equivalents		(18,628	)		138,595
Cash and cash equivalents, beginning of period		37,141			117,866
Cash and cash equivalents, end of period	$	18,513		$	256,461

See accompanying notes to unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

(Continued from previous page)

	Nine Months Ended September 30,
	2016		2015

Supplemental disclosures of cash flow information:
Cash paid for interest	$	172,618	$	98,857

Non-cash investing and financing activities:
Common shares issued for conversion of debt and accrued interest		74,000		432,720
Common shares issued on settlement of debt and accrued interest		92,500
Common stock issued for settlement of derivative liabilities		47,219		130,399
Debt discount due to shares and warrants issued with debt		171,326		153,288
Issuance of shares for settlement of accounts payable and related party accounts payable		137,500		-
Debt discount due to derivative liabilities		399,901		-
Common shares issued for vested incentive restricted stock		12		-
Reclassification of warrants as derivative liabilities		121,258		-
Debt discount due to convertible debt extensions		16,200		-

See accompanying notes to unaudited consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 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, stock warrants 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, 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 nine months ended September 30, 2016, the Company capitalized an aggregate of $246,184 related to software development and wrote off $1,421,155 of impaired software development costs.

During the nine months ended September 30, 2015, the Company capitalized an aggregate of $489,148 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 nine months ended September 30, 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 September 30, 2016, we had negative working capital of approximately $19.6 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, 2016:

December 31, 2015	$	5,397,020
Borrowings from convertible debentures		665,000
Repayments of third party notes		(63,699	)
Borrowings from third parties		111,900
Conversion of debt principal to common stock		(67,639	)
Debt discounts due to stock, warrants and derivative liabilities		(538,457	)
Amortization of debt discounts		476,912
Effect of currency exchange		268
September 30, 2016	$	5,981,305

During the nine months ended September 30, 2016, the Company entered into subscription agreements under which third party subscribers purchased 750 shares of Series A 4% Convertible Cumulative Preferred Stock of the Company (“VCSY Series A Preferred Stock”) for $150,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 1,500,000 shares of common stock of the Company with the Rule 144 restrictive legend, 75,000 shares of common stock of Ploinks, Inc., 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $24,810. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company’s common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $99,238. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $24,861. The fair market value of all warrants issued to the subscribers was $1,091 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the nine months ended, September 30, 2016, $74,000 of principal, interest and fees under a convertible note issued in the principal amount of $80,000 were converted into 5,311,465 unrestricted common shares of the Company.

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 is required to 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 nine months ended September 30, 2016, NOW Solutions, a subsidiary of the Company, paid dividends to Lakeshore of $222,500.

Note 4. Derivative Liability and Fair Value Measurements

Derivative liability

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 September 30, 2016, the aggregate fair value of the outstanding derivative liabilities was $425,740. For the nine months ended September 30, 2016, the net gain on the change in fair value of derivative liabilities was $49,291.

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)		0.26 – 2.84
Volatility		101% - 119%
Risk-free rate		0.23% - 0.92%

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, 2016 and December 31, 2015:

	Fair value measurements on a recurring basis
	Level 1		Level 2		Level 3
As of September 30, 2016:
Liabilities
Derivative liabilities – convertible debt and warrants	$	-	$	-	$	425,740

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 nine months ended September 30, 2016:

Fair value as of December 31, 2015	$	-
Additions recognized as debt discounts		399,901
Additions reclassified from equity		121,258
Additions from warrants issued with preferred stock subscription		1,091
Reduction due to settlement upon conversion		(47,219	)
Gain on change in fair value of derivatives		(49,291	)
Fair value as of September 30, 2016	$	425,740

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 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.

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 exchange for the cancellation of $130,000 in principal owed 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. A gain on debt extinguishment of $37,500 was recorded for the period ended September 30, 2016.

In May 2016, the Company and William Mills 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 to Mr. Mills in exchange for the cancellation of $100,000 in fees owed for services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. 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 to the third party 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. A loss on debt extinguishment of $1,531 was recorded for the period ended September 30, 2016.

In May 2016, the Company issued 500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to a third party for services rendered. The fair market value of the shares was $11,550 and was recorded as legal fees for the period ended September 30, 2016.

Also in May 2016, the Company issued 500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to another third party for services rendered. The fair market value of the shares was $11,000 and was recorded as tax consulting fees for the period ended September 30, 2016.

In June 2016, the Company granted 1,500,000 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 under which the shares vest in equal installments over a 6 month to 30-month period. The fair market value of the shares was $33,750 and is being amortized to expense over the vesting period. For the period ended September 30, 2016, $15,288 was amortized to stock compensation expense.

In June 2016, the Company granted 3,500,000 unregistered shares of the Company’s common stock with the Rule 144 restrictive legend to employees and a former employee of the Company and its subsidiaries pursuant to an amended agreement to defer payroll. For additional details, please see “Related Party Transactions” in Note 6. The fair market value of the shares was $78,750.

During the nine months ended September 30, 2016, the Company issued convertible debentures in the aggregate principal amount of $665,000 to various 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 loans, the Company also issued a total of 6,650,000 shares of common stock of the Company to the lenders with the Rule 144 restrictive legend and 3 year warrants under which each lender may purchase in aggregate a total of 6,650,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share. In connection with the issuance of shares of common stock and warrants, the Company recorded a discount of $385,779 against the face value of the loans based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as derivative liabilities. The discount is being amortized over twelve months and $141,885 of amortization expense was recognized for the nine months ended September 30, 2016.

During the nine months ended September 30, 2016, the Company entered into subscription agreements under which third party subscribers purchased 750 shares of VCSY Series A Preferred Stock for $150,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 1,500,000 shares of common stock of the Company with the Rule 144 restrictive legend, 75,000 shares of common stock of Ploinks, Inc., 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $24,810. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company’s common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $99,238. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $8,100. The fair market value of all warrants issued to the subscribers was $24,861 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the nine months ended September 30, 2016, 1,175,000 VCSY common shares issued under restricted stock agreements to consultants and employees of the Company vested.

During the nine months ended September 30, 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 nine months ended September 30, 2016.

Stock compensation expense for the amortization of restricted stock awards for Ploinks, Inc. and VCSY stock was $429,577 for the nine months ended September 30, 2016. As of September 30, 2016, there were 19,305,000 shares of unvested stock compensation awards to employees and 16,600,000 shares of unvested stock compensation awards to non-employees for VCSY stock. As of September 30, 2016, there were 5,225,999 shares of unvested stock compensation awards to employees for Ploinks, Inc. stock.

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 nine months ended September 30, 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		-		-		6,875,000	$	.102
Options/Warrants exercised		-		-		-		-
Options/Warrants expired/cancelled		-		-		-		-
Outstanding at September 30, 2016		-		-		13,675,000	$	.098

The weighted average remaining life of the outstanding warrants as of September 30, 2016 was 2.295. The intrinsic value of the exercisable warrants as of September 30, 2016 was $.022.

Note 6. Related Party Transactions

The following table reflects our related party debt activity, including our convertible debt, for the nine months ended September 30, 2016:

December 31, 2015	$	417,445
Settlement of debt principal to common stock		(130,000	)
Debt discounts due to stock, warrants and derivative liabilities		(48,970	)
Amortization of debt discounts		40,055
Effect of currency exchange		(1	)
September 30, 2016	$	278,529

As of September 30, 2016, and December 31, 2015, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $140,877 and $108,379, respectively. The payables are unsecured, non-interest bearing and due on demand.

In May 2016, the Company and William Mills 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 to Mr. Mills in exchange for the cancellation of $100,000 in fees owed services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

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, which remain 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 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 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 deferred salary plus 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 the 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.”

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.

Note 8. Subsequent Events

During the period that runs from October 1, 2016 through November 21, 2016, the Company entered into subscription agreements under which third party subscribers purchased 1,000 shares of VCSY Series A Preferred Stock for $200,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 2,000,000 shares of common stock of the Company with the Rule 144 restrictive legend, 100,000 shares of common stock of the Company’s subsidiary, Ploinks, Inc., 2 year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2 year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share.

During the period that runs from October 1, 2016 through November 21, 2016, 4,500,000 VCSY common shares issued under restricted stock agreements to consultants and employees of the Company vested.

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

Revenue Recognition

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

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

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

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

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

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

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

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

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

Allowances for Doubtful Accounts

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

Deferred Taxes

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

Stock-Based Compensation Expense

We account for share-based compensation in accordance with the provisions of share-based payments, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock. Equity instruments issued to other than employees are valued at the earlier of a commitment date or upon completion of the services, based on the fair value of the equity instruments, and are recognized as expense over the service period.

Valuation of the Embedded and Warrant Derivatives

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

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

Recently Issued Accounting Pronouncements

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

Results of Operations

Three and Nine Months Ended September 30, 2016 Compared To Three and Nine Months Ended September 30, 2015

Total Revenues. We had total revenues of $953,261 and $1,025,194 for the three months ended September 30, 2016 and 2015, respectively. The decrease in total revenues was $71,933 for the three months ended September 30, 2016 representing a 7.0% decrease compared to the total revenues for the three months ended September 30, 2015. Substantially all the revenues for the three months ended September 30, 2016 and 2015 were related to the business operations of NOW Solutions. Revenue from SnAPPnet, Inc. was $12,440 or 1.3% of total revenues for the three months ended September 30, 2016 and $22,528 or 2.2%of total revenues for the three months ended September 30, 2015.

Revenues for the three months ended September 30, 2016 and 2015 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. There were $7,290 of new licensing sales of our emPath® product during the third quarter of 2016 as compared to $22,500 for the same period in 2015. Software maintenance in the three months ended September 30, 2016 decreased by $30,837or 3.6% from the same period in the prior year. The revenue decrease in software maintenance is related to the loss of US maintenance revenue. Consulting revenue, in the three months ended September 30, 2016 decreased by $5,564 from the same period in the prior year, which represents a 10.1% decrease. This decrease was due to reduced consulting services for version upgrades and enhancements to existing accounts during the third quarter of 2016. Cloud-based revenues were $75,099 for the three months ended September 30, 2016 compared to $86,417 for the same period in the prior year, representing a $11,318 decrease or 13.1%. The decrease is related to a reduction in Canadian cloud-based revenue and SnAPPnet revenue. Other revenue in the three months ended September 30, 2016 decreased by $9,004 or 81.7% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

We had total revenues of $2,875,863 and $3,236,011 for the nine months ended September 30, 2016 and 2015, respectively. The decrease in total revenues was $360,148 for the nine months ended September 30, 2016 representing a 11.1% decrease compared to the total revenues for the nine months ended September 30, 2015. Substantially all the revenues for the nine months ended September 30, 2016 and 2015 were related to the business operations of NOW Solutions. Revenue from SnAPPnet, Inc. was $48,286 or 1.68% of total revenues for the nine months ended September 30, 2016 and $61,966 or 1.9% of total revenues for the nine months ended September 30, 2015.

Revenues for the nine months ended September 30, 2016 and 2015 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from new software licenses decreased by $3,210 or 14.3% compared to that for the nine months ended September 30, 2015. Software maintenance in the nine months ended September 30, 2016 decreased by $292,977 or 10.7% from the same period in the prior year. The revenue decrease in software maintenance is related to the loss of US and Canada maintenance revenue and the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the nine months ended September 30, 2016, increased by $11,179 from the same period in the prior year, which represents a 6.0% increase. This increase was primarily due to increased consulting services for version upgrades and enhancements to existing accounts in Canada during the nine months ended September 30, 2016. Cloud-based revenues were $199,565 for the nine months ended September 30, 2016 compared to $248,444 for the same period in the prior year, representing a $48,879 decrease or 19.7%. The decrease is primarily related a reduction in US cloud-based revenue and SnAPPnet revenue. Other revenue in the nine months ended September 30, 2016 decreased by $26,261 or 71.3% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $392,058 for the three months ended September 30, 2016, compared to $465,614 for the three months ended September 30, 2015. The decrease in cost of revenues of $73,556 represents a 15.8% decrease. The decrease in direct cost of revenues was primarily due to decreases in consulting fees, commissions and renegotiated hosting fees.

For the nine months ended September 30, 2016, direct costs of revenues were $1,156,522 compared to $1,377,496 for the same period in 2015, resulting in a decrease of $220,974 or 16.0%. The decrease in direct cost of revenues was primarily due to decreases in consulting fees, commissions, travel expenses and renegotiated hosting fees.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $1,126,309 and $563,406 in the three months ended September 30, 2016 and 2015, respectively. The increase of $562,903 is 99.9% more than the same period in 2015. We had increased salaries, stock compensation and penalties.

For the nine months ended September 30, 2016 we had selling, general and administrative expenses of $2,602,957 compared to $2,124,196 for the nine months ended September 30, 2015. The increase of $478,761 was 22.5% higher than the same period in 2015. We had increased salaries, stock compensation and consulting fees somewhat offset by decreased legal fees and shareholder communications.

Depreciation and amortization . For the three months ended September 30, 2016, we had depreciation and amortization of $325 compared to $0 for the three months ended September 30, 2015. For the nine months ended September 30, 2016 and 2015, $758 and $38,412, respectively of depreciation and amortization was recorded.

Bad debt expense . During the three and nine months ended September 30, 2016, $29,276 and $41,203, respectively was recorded for accounts receivables that was greater than ninety days past due. During the three and nine months ended September 30, 2015, $8,927 and $59,808, respectively was recorded for accounts receivables that was greater than ninety days past due.

Impairment of software costs . During the three months ended September 30, 2016, $1,421,155 of Ploinks™ software development costs was expensed as impaired as management was unable to support the net realizable value required by GAAP due to the uniqueness of Ploinks™ and lack of third-party information related to user growth rates for mobile devices’ apps. Although the Company has written these costs to expense, management will go to market with Ploinks™ once the application is complete.

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 $160,326 for the three months ended September 30, 2016 compared to $0 for the comparable period in 2015. The gain on derivative liabilities was $49,291 for the nine months ended September 30, 2016 compared to a loss of $78,680 for the nine months ended September 30, 2015.

Forbearance Fees . Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended September 30, 2016 were $2,500 compared to $699,900 for the three months ended September 30, 2015. The fees for the three months ended September 30, 2016 are related to a lender of VCSY. The fees for the three months ended September 30, 2015 are related to the fair market value of 10 million shares of VCSY common stock with the rule 144 restrictive legend issued to a VCSY lender and 22 million shares of VCSY common stock with the rule 144 restrictive legend issued to the senior secured lenders of NOW Solutions.

Forbearance fees for the nine months ended September 30, 2016 were $19,600 compared to $948,900 for the nine months ended September 30, 2015. The fees for the nine months ended September 30, 2016 are related to a VCSY lender. The fees for the nine months ended September 30, 2015 are related to the fair market value of 10 million shares of VCSY common stock with the rule 144 restrictive legend issued to a VCSY lender and 22 million shares of VCSY common stock with the rule 144 restrictive legend issued to the senior secured lenders of NOW Solutions.

Loss on Debt Extinguishment . We had a $35,969 gain on debt extinguishment for the nine months ended September 30, 2016. The gain relates to the fair market value of the issuance of 5 million shares with the rule 144 restrictive legend of VCSY common stock to a NOW Solutions lender to settle a portion of debt principal.

We had a $173,193 and $323,193 loss on debt extinguishment for the three and nine months ended September 30, 2015. The loss relates to the fair market value of the issuance of 28,556,522 shares with the rule 144 restrictive legend of VCSY common stock to VCSY, NOW Solutions and Priority Time lenders to settle debt and accrued interest payments.

Interest Expense . We had interest expense of $550,189 and $64,819 for the three months ended September 30, 2016 and 2015, respectively. Interest expense increased by $485,370 representing an increase of 748.8% compared to the same expense in the three months ended September 30, 2015. The increase was due to interest and debt discounts related to the issuance of convertible debentures in 2016 and an adjustment credit in 2015 on interest recorded in a prior year on the settlement of Canadian income taxes.

For the nine months ended September 30, 2016, we had interest expense of $1,453,234 compared to $588,583 for the same period in 2015, representing an increase of $864,651 or 146.9% for the period. The increase was due to interest and debt discounts related to the issuance of convertible debentures in 2016 and an adjustment credit in 2015 on interest recorded in a prior year on the settlement of Canadian income taxes.

Net loss before income taxes. We had a net loss before income taxes of $2,408,202 and $950,664 for the three months ended September 30, 2016 and 2015, respectively. The net loss before income taxes for the three months ended September 30, 2016 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 $2,015,862. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities. The net loss before income taxes for the three months ended September 30, 2015 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $12,753. This loss was increased by forbearance fees, loss on debt extinguishment and interest expense.

We had a net loss before income taxes of $3,734,265 and $2,303,250 for the nine months ended September 20, 2016 and 2015, respectively. The net loss before income taxes for the nine months ended September 30, 2016 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 $2,346,732. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities and gain on debt extinguishments. The net loss before income taxes for the nine months ended September 30, 2015 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $363,901. This loss was increased by forbearance fees, loss on derivative liability, loss on debt extinguishment and interest expense.

Income tax benefit . We had income tax expense of $1,154 and $103,910 for the three and nine months ended September 30, 2016, respectively. Income tax expense is related to NOW Solutions, a 75% owned subsidiary of the Company.

We had an income tax benefit of $675,895 and $562,373 for the three and nine months ended September 30, 2015, respectively. The income tax benefit is primarily related to an adjustment for the settlement of Canadian income taxes recorded in a previous year.

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $147,000 for both the three months ended September 30, 2016 and 2015 and $441,000 for both the nine months ended September 30, 2016 and 2015.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $2,407,242 and $458,357 for the three months ended September 30, 2016 and 2015, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

We had a net loss attributed to common stockholders of $4,159,401 and $2,246,080 for the nine months ended September 30, 2016 and 2015, respectively. Net loss available to common stockholders was due to the factors discussed above.

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the nine months ended September 30, 2016 and 2015, respectively.

Liquidity and Capital Resources

At September 30, 2016, we had non-restricted cash-on-hand of $18,513 compared to $37,141 at December 31, 2015.

Net cash used in operating activities for the nine months ended September 30, 2016 was $344,205 compared to net cash used in operating activities of $148,564 for the nine months ended September 30, 2015. During the nine months ended September 30, 2016 we received $2,501,986 of cash from customers, used $2,082,806 for payroll, benefits and payroll taxes, $172,618 for interest payments, $208,101 for professional fees, $37,647 for insurance payments, $87,603 for tax payments other than payroll and $257,416 for accounts payable to vendors.

Net cash used in operating activities for the nine months ended September 30, 2015 was $148,564 compared to net cash used in operating activities of $24,702 for the nine months ended September 30, 2014. During the nine months ended September 30, 2015 we received $3,485,041 of cash from customers, used $1,925,341 for payroll, benefits and payroll taxes, $98,857 for interest payments, $378,691 for professional fees, $96,006 for insurance payments, $215,063 for tax payments other than payroll, $79,186 for audit fees and $840,460 for accounts payable to vendors.

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 $357,574 or 21.6% from the balance at December 31, 2015. 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 $382,463 at December 31, 2015 to $91,048 (net of allowance for bad debts) at September 30, 2016. 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 accounts payable and accrued liabilities went from $10,645,353 at December 31, 2015 to $11,740,523 at September 30, 2016. The change is primarily related to increased accounts payable, executive payroll, payroll taxes and accrued interest, partially offset by decreased accounts payable. The resulting balance at September 30, 2016 is 127 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, 2016 and September 30, 2015 of $246,184 and $489,148, respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers, and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

For the nine months ended September 30, 2016, we had $776,900 of new debt funding, $150,000 of equity financing, repaid $241,337 to lenders and paid $222,500 of dividends to noncontrolling shareholders of NOW Solutions. For the nine months ended September 30, 2015, we paid $53,228 of principal on notes payable and related party notes payable, paid dividends of $92,500 to NOW Solutions noncontrolling interest owners and had $885,333 of new debt funding in the same period.

The total change in cash for the nine months ended September 30, 2016 was a decrease of $18,628.

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, 2016		2016		2017		2018		2019		2020+
Notes payable	$	5,151,952	$	5,151,952	$	-	$	-	$	-	$	-
Convertible debentures		1,309,261		644,261		665,000		-		-		-
Operating lease		164,210		20,534		82,649		61,027		-		-
Total	$	6,625,423	$	5,816,747	$	747,649	$	61,027	$	-	$	-

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

	September 30, 2016		December 31, 2015

In default	$	4,921,952	$	4,340,382
Not in default		1,539,261		1,605,000

Total Notes Payable	$	6,461,213	$	5,945,382

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 noncontrolling interest of $3,838,175 and $1,740,877 for the nine months ended September 30, 2016 and 2015, 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, 2016, we had negative working capital of approximately $19.6 million (although this figure includes deferred revenue of approximately $1.3 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, 2015, as filed on April 14, 2016.

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, 2015.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

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, 2015, as filed on April 14, 2016.

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

During the nine months ended September 30, 2016, 1,175,000 VCSY common shares issued under restricted stock agreements to consultants and employees of the Company vested.

During the period that runs from October 1, 2016 through November 21, 2016, 4,500,000 VCSY common shares issued under restricted stock agreements to consultants and employees of the Company vested.

Item 3. Defaults Upon Senior Securities

Note payable of $1,759,150 issued by NOW Solutions to Lakeshore Investment, LLC, dated January 9, 2013. The note is secured with the assets of NOW Solutions, Priority Time Systems, SnAPPnet, and the SiteFlash™ assets and bears a default interest rate of 16%. As of November 21, 2016, the outstanding principle and accrued interest currently due under the note is $1,620,067.

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 21, 2016	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 21, 2016	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

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

SIGNATURES

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

	VERTICAL COMPUTER SYSTEMS, INC.

November 21, 2016	By:	/s/ Richard Wade
		Richard Wade
		President and Chief Executive Officer
		(Principal Executive Officer and Principal Accounting Officer)

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