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 June 30, 2018

 

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

 

For the transition period from _____ to _____

 

 

 

Commission file number 0-28685

 

 

 

VERTICAL COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

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

 

101 West Renner Road, Suite 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 ☒  No ☐

 

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

Yes ☒   No ☐

 

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

Large accelerated filer ☐   Accelerated filer                       ☐
Non-accelerated filer    ☐ (Do not check if a smaller reporting company) Smaller reporting company      ☒
    Emerging Growth Company    ☐

 

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

 

As of August 21, 2018, the issuer had 1,190,915,201 shares of common stock, par value $0.00001, issued and 1,150,915,201 outstanding.

 

1

 

 

PART I

FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

 

    June 30,     December 31,  
    2018     2017  
Assets            
Current assets                
Cash   $ 101,164     $ 62,084  
Accounts receivable, net of allowance for bad debts of $207,947 and $234,439     108,911       349,002  
Prepaid expenses and other current assets     19,803       5,312  
Total current assets     229,878       416,398  
                 
Property and equipment, net of accumulated depreciation of $1,043,390 and $1,044,936     7,710       9,211  
Intangible assets, net of accumulated amortization of $319,423 and $319,504     6,690       6,690  
Deposits and other     7,884       8,037  
                 
Total assets   $ 252,162     $ 440,336  
                 
Liabilities and Stockholders’ Deficit                
Current liabilities:                
Accounts payable and accrued liabilities   $ 15,122,223     $ 14,122,394  
Accounts payable to related parties     171,905       148,760  
Deferred revenue     1,555,869       1,752,421  
Derivative liabilities     89,870       159,537  
Convertible debentures, net of unamortized discounts of $39,552 and $75,705     1,200,448       1,164,295  
Notes payable     6,028,846       3,775,703  
Notes payable and convertible debt to related parties     308,242       308,242  
Total current liabilities     24,477,403       21,431,352  
                 
Non-current portion – notes payable     —       2,158,140  
                 
Total liabilities     24,477,403       23,589,492  

 

See accompanying notes to the unaudited consolidated financial statements.

 

(Continued on next page)

 

2

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

 

(Continued from previous page)            
             
    June 30,     December 31,  
    2018     2017  
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 52,800 shares issued and outstanding     10,255,185       10,255,185  
Series B 10% Convertible Cumulative Preferred stock; $0.001 Par Value; 375,000 shares authorized; 7,200 shares issued and outstanding     246       246  
Series C 4% Convertible Cumulative Preferred stock; $100.00 par value; 200,000 shares authorized; 50,000 shares issued and outstanding     200,926       200,926  
Series D 15% Convertible Cumulative Preferred stock; $0.001 Par Value; 300,000 shares authorized; 25,000 shares issued and outstanding     852       852  
      10,457,209       10,457,209  
                 
Stockholders’ Deficit                
Common Stock; $.00001 par value; 2,000,000,000 shares authorized 1,190,915,201 issued and 1,150,915,201 outstanding as of June 30, 2018 and 1,188,095,201 issued and 1,148,095,201 outstanding as of December 31, 2017     11,911       11,883  
Treasury stock: 40,000,000 as of June 30, 2018 and December 31, 2017     (400 )     (400 )
Additional paid-in-capital     24,902,525       24,609,424  
Accumulated deficit     (59,381,416 )     (58,087,916 )
Accumulated other comprehensive income – foreign currency translation     429,332       339,051  
                 
Total Vertical Computer Systems, Inc. stockholders’ deficit     (34,038,048 )     (33,127,958 )
                 
Non-controlling interest     (644,402 )     (478,407 )
Total stockholders’ deficit     (34,682,450 )     (33,606,365 )
                 
Total liabilities and stockholders’ deficit   $ 252,162     $ 440,336  

 

See accompanying notes to the unaudited consolidated financial statements.

 

3

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

 

    Three Months Ended June 30,     Six Months Ended June 30,  
    2018     2017     2018     2017  
Revenues                        
Licensing and software   $ 89,401     $ 517     $ 100,081     $ 517  
Software maintenance     772,184       789,264       1,575,659       1,596,776  
Cloud-based offering     27,790       65,964       89,052       125,667  
Consulting services     115,550       103,721       303,840       176,492  
Other     9,526       140       17,347       2,897  
Total revenues     1,014,451       959,606       2,085,979       1,902,349  
                                 
Cost of revenues     (391,037 )     (439,243 )     (753,514 )     (812,795 )
                                 
Gross profit     623,414       520,363       1,332,465       1,089,554  
                                 
Operating expenses:                                
Selling, general and administrative expenses     738,929       897,074       1,639,372       1,979,259  
Depreciation and amortization     788       325       1,576       650  
Bad debt expense (recovery)     70,131       (13,645 )     (23,012 )     (64,667 )
Total operating expenses     809,848       883,754       1,617,936       1,915,242  
                                 
Operating Loss     (186,434 )     (363,391 )     (285,471 )     (825,688 )
                                 
Other Income (Expense):                                
Gain (loss) on derivative liabilities     (45,218 )     280,431       96,314       619,898  
Non-operating penalties     (125,850 )     —       (125,850 )     —  
Forbearance fees     —       (3,000 )     —       (6,000 )
Interest income     3       1       6       16  
Interest expense     (498,769 )     (460,592 )     (908,489 )     (1,018,603 )
                                 
Net loss before non-controlling interest and income tax expense     (856,268 )     (546,551 )     (1,223,490 )     (1,230,377 )
Income tax expense (benefit)     (54,541 )     84,289       133,995       120,199  
Net loss before non-controlling interest     (801,727 )     (630,840 )     (1,357,485 )     (1,350,576 )
Net loss attributable to non-controlling interest     41,651       45,532       63,985       36,861  
Net loss attributable to Vertical Computer Systems, Inc.     (760,076 )     (585,308 )     (1,293,500 )     (1,313,715 )
Dividends applicable to preferred stock     (155,600 )     (154,933 )     (311,200 )     (306,405 )
Net loss available to common stockholders   $ (915,676 )   $ (740,241 )   $ (1,604,700 )   $ (1,620,120 )

 

See accompanying notes to the unaudited consolidated financial statements.

 

(Continued on next page)

 

4

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

 

(Continued from previous page)

 

    Three Months Ended June 30,     Six Months Ended June 30,  
    2018     2017     2018     2017  
                         
Basic and diluted net loss per share   $ (0.00 )   $ (0.00 )   $ (0.00 )   $ (0.00 )
                                 
Basic weighted average of common shares outstanding     1,150,063,553       1,133,335,130       1,149,114,869       1,132,475,119  
Diluted weighted average of common shares outstanding     1,206,422,034       1,216,394,865       1,205,473,350       1,215,534,854  
                                 
Comprehensive loss                                
Net loss   $ (801,727 )   $ (630,840 )   $ (1,357,485 )   $ (1,350,576 )
Translation adjustments     64,538       (11,191 )     90,281       (35,180 )
Comprehensive loss     (737,189 )     (642,031 )     (1,267,204 )     (1,385,756 )
Comprehensive loss attributable to non-controlling interest     41,651       45,532       63,985       36,861  
Comprehensive loss attributable to Vertical Computer Systems, Inc.   $ (695,538 )   $ (596,499 )   $ (1,203,219 )   $ (1,348,895 )

 

See accompanying notes to the unaudited consolidated financial statements.

 

5

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

(Unaudited)

 

    Common Stock     Treasure Stock     Additional
Paid-in
Capital 		    Accumulated Deficit     Other Comprehensive Income     Non-controlling Interest     Total  
    Shares     Amount     Shares     Amount                      
Balances at December 31, 2017     1,188,095,201     $ 11,883     $ (40,000,000 )   $ (400 )   $ 24,609,424     $ (58,087,916 )   $ 339,051     $ (478,407 )   $ (33,606,365 )
Amortization of restricted stock awards     —       —       —       —       24,073       —       —       —       24,073  
Amortization of subsidiary restricted stock awards     —       —       —       —       35,246       —       —       —       35,246  
Shares issued for vested restricted stock awards     320,000       3       —       —       (3 )     —       —       —       —  
Issuance of subsidiary shares for debt extensions     —       —       —       —       100,694       —       —       (4,412 )     96,282  
Issuance of subsidiary shares for services     —       —       —       —       3,046       —       —       (3,046 )     —  
Issuance of shares for subsidiary non-operating penalties     2,500,000       25       —       —       32,975       —       —       —       33,000  
Issuance of subsidiary shares for subsidiary non-operating penalties     —       —       —       —       97,070       —       —       (4,220 )     92,850  
Dividends paid to non-controlling interest holders     —       —       —       —       —       —       —       (59,090 )     (59,090 )
Dividends declared but unpaid to non-controlling interest holders     —       —       —       —       —       —       —       (31,242 )     (31,242 )
Other comprehensive income translation adjustment     —       —       —       —       —       —       90,281       —       90,281  
Net loss     —       —       —       —       —       (1,293,500 )     —       (63,985 )     (1,357,485 )
Balances at June 30, 2018     1,190,915,201     $ 11,911       (40,000,000 )     (400 )   $ 24,902,525     $ (59,381,416 )   $ 429,332     $ (644,402 )   $ (34,682,450 )

 

See accompanying notes to the unaudited consolidated financial statements.

 

6

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

    Six Months Ended June 30,  
    2018     2017  
             
Cash flows from operating activities                
Net loss   $ (1,357,485 )   $ (1,350,576 )
Adjustments to reconcile net loss to net cash used in operating activities:                
Depreciation and amortization     1,576       650  
Amortization of debt discounts     159,085       372,210  
Common shares issued to an employee     —       72,000  
Common shares issued for services     —       4,200  
Issuance of subsidiary shares for subsidiary non-operating penalties     92,850       —  
Gain on derivatives     (96,314 )     (619,898 )
Common shares issued for subsidiary non-operating penalties     33,000       —  
Bad debt recovery     (23,012 )     (64,667 )
Amortization of restricted stock awards     24,073       67,494  
Amortization of subsidiary restricted stock awards     35,246       121,292  
Changes in operating assets and liabilities:                
Accounts receivable     260,218       196,296  
Prepaid expenses and other assets     (14,364 )     (4,418 )
Accounts payable and accrued liabilities     977,534       887,531  
Accounts payable to related parties     23,145       22,954  
Deferred revenue     (150,936 )     (213,270 )
Net cash used in operating activities     (35,384 )     (508,202 )
                 
Cash flow from investing activities:                
Software development     —       —  
Purchase of property and equipment     (75 )     —  
Net cash used in investing activities     (75 )     —  
                 
Cash flows from financing activities:                
Borrowings on notes payable     160,000       180,000  
Payments of notes payable     (64,782 )     (44,705 )
Borrowings on convertible debentures     —       60,000  
Issuance of preferred stock     —       200,000  
Dividends paid by subsidiary to non-controlling interest     (59,090 )     —  
Net cash provided by financing activities     36,128       395,295  
                 
Effect of changes in exchange rates on cash     38,411       1,834  
Net change in cash     39,080       (111,073 )
Cash, beginning of period     62,084       190,448  
Cash, end of period   $ 101,164     $ 79,375  

 

See accompanying notes to unaudited consolidated financial statements.

 

(Continued on next page)

 

7

 

 

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

(Continued from previous page)

 

    Six Months Ended June 30,  
    2018     2017  
                 
Supplemental disclosures of cash flow information:                
Cash paid for interest   $ 136,158     $ 22,759  
Cash paid for income taxes   $ —     $ —  
                 
Non-cash investing and financing activities:                
Common shares issued for vested restricted stock awards   $ 3     $ 5  
Issuance of shares for note principal and interest     —       22,421  
Settlement of derivative liability upon conversion of debt     —       19,566  
Debt discount due to derivative liabilities     —       18,653  
Debt discount due to shares and warrants issued with debt     26,647       9,916  
Debt discount due to subsidiary shares issued for debt extensions     96,282       31,914  
Non-controlling interest adjustment to equity     —       324,935  
Reclassification of debt to convertible debt     —       10,000  
Dividends accrued but unpaid to non-controlling interest holders     31,242       65,000  

 

See accompanying notes to unaudited consolidated financial statements.

 

8

 

 

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

(UNAUDITED)

 

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

 

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 2017. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company,” “Vertical”, or “VCSY”, as applicable). Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), an 80% owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. (“Taladin”), and Vertical Healthcare Solutions, Inc. (“VHS”), each of which a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”), an 80% owned subsidiary, Ploinks, Inc. (“Ploinks”), an 88% owned subsidiary and Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary. Vertical’s subsidiaries which are inactive include EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary of Vertical.

 

In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported in the 2017 annual report on Form 10-K have been omitted.

 

Revenue Recognition

 

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

 

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

 

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

 

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

 

    Three Months Ended June 30,     Six Months Ended June 30,  
Industry   2018     2017     2018     2017  
                         
Agriculture   $ 70,617     $ 87,453     $ 142,737     $ 184,904  
Automotive     7,197       6,948       14,538       14,001  
Distribution     25,440       15,434       47,975       32,552  
Education     191,647       180,717       434,953       324,115  
Financial Services     20,643       17,746       43,689       36,609  
Government     113,719       109,769       264,147       227,695  
Healthcare     348,673       287,426       639,212       591,028  
Manufacturing     63,753       53,780       121,523       107,087  
Manufacturing Services     8,507       13,621       19,363       20,761  
Media     29,112       26,360       58,139       53,148  
Oil and Gas     50,016       48,748       100,952       95,083  
Pulp and Paper Distribution     23,416       33,233       47,329       65,750  
Pulp and Paper Manufacturing     5,078       4,513       10,264       9,099  
Engineering     —       33,820       34,777       67,408  
Food Services     4,247       3,932       8,493       7,864  
Government Contractor     52,386       35,589       97,888       64,728  
Other     —       517       —       517  
Total revenues   $ 1,014,451     $ 959,606     $ 2,085,979     $ 1,902,349  

 

9

 

 

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

 

    Three Months Ended June 30,   Six Months Ended June 30,  
Country   2018   2017   2018   2017  
                         
Canada   $ 695,942   $ 583,366   $ 1,362,413   $ 1,143,623  
United States     318,509     376,240     723,566     758,726  
Total revenues   $ 1,014,451   $ 959,606   $ 2,085,979   $ 1,902,349  

 

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 six months ended June 30, 2018 and 2017, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive. For the three and six months ended June 30, 2018 and 2017, the Company had 56,358,481 and 83,059,735 potential common shares under convertible notes, which were included in the calculation of diluted loss per share.

 

Recently Issued Accounting Pronouncements

 

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

 

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

 

10

 

 

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

 

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

 

Note 2. Going Concern

 

The accompanying unaudited consolidated financial statements for the six months ended June 30, 2018 and 2017 have been prepared assuming that we will continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.

 

The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. As of June 30, 2018, we had negative working capital of approximately $24.2 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 six months ended June 30, 2018:

 

December 31, 2017   $ 7,098,138  
Borrowings on third party notes     160,000  
Repayments of third party notes     (64,782 )
Debt discounts due to parent stock and warrants and subsidiary stock issued with debt and derivative liabilities from convertible debt     (122,929 )
Amortization of debt discounts     159,085  
Effect of currency exchange     (218 )
June 30, 2018   $ 7,229,294  
         

 

During the six months ended June 30, 2018, the Company extended the term of certain warrants to purchase a total of 11,600,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted a total of 311,099 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $1,160,000 that were issued from 2015 through 2017. The due dates for all these convertible debentures were extended until October 1, 2018. The aggregate fair market value of the Ploinks shares was determined to be $96,282 and was recorded as debt discount and is being amortized through the term of the convertible debenture. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

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

 

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Lakeshore Financing

 

On January 9, 2013, the Company and several of its subsidiaries entered into a loan agreement (the “ Loan Agreement ”), dated as of January 9, 2013 with Lakeshore Investment, LLC (“ Lakeshore ”) under which NOW Solutions issued a secured 10-year promissory note (the “ Lakeshore Note ”) bearing interest at 11% per annum to Lakeshore in the original amount of $1,759,150 and payable in equal monthly installments of $24,232 until January 31, 2022. Upon the payment of any prepayment principal amounts, the monthly installment payments will be adjusted proportionately on an amortized rata basis. 

 

The Lakeshore Note was originally secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“ SnAPPnet ”) and the Company’s SiteFlash™ technology, which were all cross-collateralized. Upon full payment of the Lakeshore Note, Lakeshore will be obligated to release the NOW Solutions collateral.

 

As additional consideration for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees and direct costs) from any litigation or settlement proceeds related to the SiteFlash™ technology to Lakeshore which was increased to 8% under an amendment to the Loan Agreement in 2013. In addition, until the Note is paid in full, NOW Solutions agreed to pay Lakeshore a royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management has estimated the fair value of the royalty to be nominal as of its issuance date and no royalty was owed as of December 31, 2017 or December 31, 2016.

 

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

 

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

 

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

 

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

 

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

 

During the six months ended June 30, 2018, the Company, through its subsidiary, declared dividends to Lakeshore of $90,332 of which $59,090 were paid and $31,242 were left accrued. During the six months ended June 30, 2017, the Company, through its subsidiary, declared dividends to Lakeshore of $65,000 which were added to the note balance as part of the December 2017 amendment discussed above.

 

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Note 4. Derivative liability and fair value measurements

 

Derivative liabilities

 

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

 

As of June 30, 2018, the aggregate fair value of the outstanding derivative liabilities was $89,870. For the six months ended June 30, 2018, the net gain on the change in fair value of derivative liabilities was $96,314.

 

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

 

    2018
Expected dividends     0%
Expected terms (years)     0.01 - 3.00
Volatility     94% - 110%
Risk-free rate     2.11% - 2.63%

 

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 June 30, 2018 and December 31, 2017:

 

    Fair value measurements on a recurring basis
    Level 1   Level 2   Level 3  
As of June 30, 2018:                    
Liabilities                    
  Derivative liabilities – convertible debt   $ —   $ —   $ 89,870  
                     
As of December 31, 2017:                    
Liabilities                    
  Derivatives   $ —   $ —   $ 159,537  

 

The estimated fair value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities and deferred revenue approximates their carrying value due to their short-term nature. The Company uses Level 3 inputs to estimate the fair value of its derivative liabilities.

 

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The below table presents the change in the fair value of the derivative liabilities during the six months ended June 30, 2017:

 

Fair value as of December 31, 2017   $ 159,537  
Additions recognized as debt discounts     26,647  
Gain on change in fair value of derivatives     (96,314 )
Fair value as of June 30, 2018   $ 89,870  

 

Note 5. Common and Preferred Stock Transactions

 

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

 

During the six months ended June 30, 2018, the Company extended the term of certain warrants to purchase a total of 11,600,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted a total of 311,099 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $1,160,000 that were issued from 2015 through 2017. The due dates for all these convertible debentures were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

During the six months ended June 30, 2018, 320,000 shares of VCSY common stock issued to employees of the Company vested.

 

During the six months ended June 30, 2018, 209,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

Stock compensation expense for the amortization of restricted stock awards was $24,073 for the six months ended June 30, 2018. As of June 30, 2018, there were 5,740,000 shares of unvested stock compensation awards to employees and 15,500,000 shares of unvested stock compensation awards to non-employees.

 

Stock compensation expense for the amortization of subsidiary’s restricted stock awards was $35,244 for the six months ended June 30, 2018.

 

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

 

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

 

Note 6. Option and Warrant Activity

 

During the six months ended June 30, 2018, the Company extended the term of certain warrants to purchase a total of 11,600,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period in connection with extensions of convertible debentures in the principal amount of $1,160,000 that were issued from 2015 through 2017.

 

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

 

    Incentive Stock
Options 		    Non-Statutory
Stock
Options 		    Warrants     Weighted
Average Exercise
Price 		 
Outstanding at December 31, 2017     —       —       16,340,000     $ 0.101  
Options/Warrants granted     —       —       —       —  
Options/Warrants exercised     —       —       —       —  
Options/Warrants expired/cancelled     —       —       —       —  
Outstanding at June 30, 2018     —       —       16,340,000     $ 0.101  

 

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The weighted average remaining life of the outstanding warrants as of June 30, 2018 was 1.10. The intrinsic value of the exercisable warrants as of June 30, 2018 was $.015.

 

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

 

Note 7. Related Party Transactions

 

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

 

December 31, 2017   $ 308,242  
Amortization of debt discounts     —  
June 30, 2018   $ 308,242  

 

As of June 30, 2018, and December 31, 2017, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $171,905 and $148,760, respectively. The payables are unsecured, non-interest bearing and due on demand.

 

As of June 30, 2018, and December 31, 2017, the Company has accrued payroll to certain current and former employees of $2,849,226 and $2,770,684, respectively.

 

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

 

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

 

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

 

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

 

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Since payment of the Bonus is contingent upon first paying all unpaid salary and there are no foreseeable revenues to pay the twenty percent interest in these technologies, it is doubtful at the present time that any Bonus will be paid and therefore the Bonus was not accrued as of June 30, 2018 and December 31, 2017 as this contingent liability is considered remote. Cumulative bonus interest through June 30, 2018 is $4,850,139.

 

Note 8. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

On December 31, 2011, the Company and InfiniTek corporation (“InfiniTek”) entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek had agreed to transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The Company made $37,500 in payments due under the settlement agreement through May 7, 2012 and each party had alleged the other party was in breach of the settlement agreement.

 

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122 . William Mills is a partner of Parker Mills and the Secretary and a Director of the Company. The Company has $127,655 of principal and interest accrued as of June 30, 2018.

 

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses. On September 8, 2017, the court awarded Mr. Wolman a judgment in the amount of $282,299, which accrues interest at the rate of 16% per annum plus attorney’s fees as to be determined by the court. The Company has $325,790 of principal and accrued interest as of June 30, 2018. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

 

Note 9. Subsequent Events

 

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

 

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

 

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

 

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

 

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In August 2018, a third-party lender loaned $55,000 to the Company. The loan bears interest at 10% per annum and is due on demand.

 

In August 2018, a third-party lender loaned $120,000 to the Company. In connection with the loan, the Company issued a promissory note to the lender in the principal amount of $120,000, bearing interest at 10% per annum, which is due in 90 days from the date the promissory note was issued. The Company also issued a 3-year warrant to purchase 1,200,000 shares of the Company’s common stock at an exercise price of $0.20 per share.

 

During the period that runs from July 1, 2018 to August 21, 2018, 250,000 shares of VCSY common stock issued to an employee of a subsidiary of the Company vested.

 

During the period that runs from July 1, 2018 to August 21, 2018, 80,000 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to an employee of a subsidiary of the Company vested.

 

During the period that runs from July 1, 2018 to August 21, 2018, the Company extended the term of certain warrants to purchase a total of 500,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted 9,100 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with certain extensions of convertible debentures in the principal amount of $65,000 that were issued in 2016 and 2017. The due dates for all these convertible extensions were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

The Company is planning to hold its Annual Meeting of Stockholders at 11:00 am (Central Standard Time) on November 27, 2018 at the Company’s office building.  At the Annual Meeting, the Company may make observations regarding its financial performance and outlook.

 

Stockholders wishing to nominate a director or present a proposal to be considered at the Annual Meeting must timely submit a written notice to the Corporate Secretary of the Company at its executive offices.  In addition, any stockholder proposals submitted for inclusion in the Company’s proxy materials for the Annual Meeting must be timely received by the Corporate Secretary and will be subject to the requirements of the proxy rules adopted under the Securities Exchange Act of 1934, as amended, the Company’s charter and bylaws, and Delaware law.

 

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

 

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

 

Critical Accounting Policies

 

Capitalized Software Costs

 

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value. During the six months ended June 30, 2018 and 2017, $0 and $0 of internal costs were capitalized, respectively.

 

Revenue Recognition

 

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

 

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

 

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

 

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

 

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.

 

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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

 

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

 

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

 

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

 

Results of Operations

 

Three and six months ended June 30, 2018 compared to three and six months ended June 30, 2017

 

Total Revenues. We had total revenues of $1,014,451 and $959,606 for the three months ended June 30, 2018 and 2017, respectively. The increase in total revenues was $54,845 for the three months ended June 30, 2018 representing a 5.7% increase compared to the total revenues for the three months ended June 30, 2017. Substantially all the revenues for the three months ended June 30, 2018 were related to the business operations of NOW Solutions.

 

Total revenues for the three months ended June 30, 2018 and 2017 primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. Software licensing fees in the three months ended June 30, 2018 increased by $88,884 from the same period in the prior year. The revenue increase in Software licensing is primarily related to a licensing upgrade for one customer in Canada. Software maintenance in the three months ended June 30, 2018 decreased by $17,080 or 2.2% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to decreases with existing customer maintenance agreements in the US partially offset by increases in Canadian maintenance revenue and the effects of favorable currency rate changes. Consulting revenue, in the three months ended June 30, 2018 increased by $11,829 from the same period in the prior year, which represents a 11.4% increase. This increase was due to more demand for version upgrades and enhancements to existing customer accounts in our US operations during the second quarter of 2018. Cloud-based revenues were $27,790 for the three months ended June 30, 2018 compared to $65,964 for the same period in the prior year, representing a $38,174 decrease or 57.9%. The decrease is primarily related to the loss of SAAS customers in the US and Canada. Other revenue in the three months ended June 30, 2018 increased by $9,386 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 $2,085,979 and $1,902,349 in the six months ended June 30, 2018 and 2017, respectively. The increase in total revenues was $183,630 representing a 9.7% increase. Substantially all the revenues for the six months ended June 30, 2018 were related to the business operations of NOW Solutions.

 

Total revenues for the six months ended June 30, 2018 and 2017 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from new software licenses increased $99,564 compared to that for the six months ended June 30, 2017. The revenue increase in Software licensing is primarily related to a licensing upgrade for two customers in Canada. Software maintenance in the six months ended June 30, 2018 decreased by $21,117 or 1.3% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to decreases with existing customer maintenance agreements in the US partially offset by increases in Canadian maintenance revenue and the effects of favorable currency rate changes. Consulting revenue, in the six months ended June 30, 2018, increased by $127,348 or 72.2% from the same period in the prior year. This increase was primarily a result of more demand for version upgrades and enhancements to existing customer accounts during the first six months of 2018. Cloud-based revenues were $89,052 for the six months ended June 30, 2018 compared to $125,667 for the same period in the prior year, representing a $36,615 decrease or 29.1% Other revenue in the six months ended June 30, 2018 increased by $14,450 from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses and other miscellaneous revenues.

 

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Cost of Revenues. We had direct costs associated with our revenues of $391,037 for the three months ended June 30, 2018, compared to $439,243 for the three months ended June 30, 2017. The decrease in cost of revenues of $48,206 represents a 11.0% decrease. The decrease in direct cost of revenues was primarily due to a decrease in payroll and related benefits. During the three months ended June 30, 2018 and 2017, $0 and $0 of internal costs were capitalized, respectively.

 

For the six months ended June 30, 2018, direct costs of revenues were $753,514 compared to $812,795 for the same period in 2017 resulting in a decrease of $59,281 or 7.3%. The decrease in direct cost of revenues was primarily due to decreased payroll and related benefits. During the six months ended June 30, 2018 and 2017, $0 and $0 of internal costs were capitalized, respectively.

 

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $738,929 and $897,074 in the three months ended June 30, 2018 and 2017, respectively. The decrease of $158,145 is 17.6% less than the same period in 2017. The decrease is primarily due to decreased payroll and related benefits, non-cash stock compensation and lower legal and professional expense partially offset by higher consulting expense and penalties.

 

For the six months ended June 30, 2018, we had $1,639,372 compared to $1,979,259 for the six months ended June 30, 2017. The $339,887 or 17.2% decrease is primarily due to decreased payroll and related benefits, non-cash stock compensation, penalties and legal expense partially offset by higher consulting expense.

 

Depreciation and Amortization . We had depreciation and amortization expense of $788 and $325 for the three months ended June 30, 2018 and 2017, respectively. Depreciation expense relates to depreciation of long lived assets. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

 

For the six months ended June 30, 2018, we had $1,576 compared to $650 for the six months ended June 30, 2017. Depreciation expense relates to depreciation of long lived assets. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

 

Bad Debt Expense (Recovery). We had bad debt expense for the three months ended June 30, 2018 of $70,131 compared to bad debt recovery of $13,645 for the three months ended June 30, 2017. Bad debt recovery relates to the collection of customer accounts greater than 90 days past due previously expensed. Bad debt expense is related to the allowance of customer accounts greater than 90 days past due.

 

For the six months ended June 30, 2018, we had bad debt recovery of $23,012 compared to bad debt recovery of $64,667 for the six months ended June 30, 2017. Bad debt recovery relates to the collection of customer accounts greater than 90 days past due previously expensed.

 

Gain (loss) on Derivative Liability . Derivative liabilities are adjusted each quarter using the Black-Scholes option pricing model. The loss on derivative liabilities was $45,218 for the three months ended June 30, 2018 compared to a gain of $280,431 for the three months ended June 30, 2017. The gain on derivative liabilities was $96,314 for the six months ended June 30, 2018 compared to a gain of $619,898 for the six months ended June 30, 2017.

 

Forbearance Fees . Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended June 30, 2018 were $0 compared to $3,000 for the three months ended June 30, 2017. The fees for the three months ended June 30, 2018 were related to forbearance of a NOW Solutions note payable. The fees for the three months ended June 30, 2017 are related to forbearance of a VCSY note payable.

 

Forbearance fees for the six months ended June 30, 2018 were $0 compared to $6,000 for the six months ended June 30, 2017. The fees for the six months ended June 30, 2018 were related to forbearance of a NOW Solutions note payable. The fees for the six months ended June 30, 2017 are related to forbearance of a VCSY note payable.

 

Non-operating Penalties . Non-operating penalties for the three months ended June 30, 2018 were $125,850 compared to $0 for the three months ended June 30, 2017. The fees for the three months ended June 30, 2018 were related to the issuance of an additional 2,500,000 VCSY common shares at a fair market value of $33,000 and an additional 300,000 Ploinks common shares at a fair market value of $92,850 to certain third-party purchasers of 600,000 shares of VHS Series A Preferred Stock. These additional shares were issued to facilitate the execution of the 2017 Lakeshore Loan Amendment which resulted in the cure of any existing defaults under the Loan Agreement and the Note, as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time, when VHS did not meet performance standards.

 

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Non-operating penalties for the six months ended June 30, 2018 were $125,850 compared to $0 for the six months ended June 30, 2017. The fees for the six months ended June 30, 2018 were related to forbearance of a NOW Solutions note payable. These additional shares were issued to facilitate the execution of the 2017 Lakeshore Loan Amendment which resulted in the cure of any existing defaults under the Loan Agreement and the Note, as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time, when VHS did not meet performance standards.

 

Interest Expense . We had interest expense of $498,769 and $460,592 for the three months ended June 30, 2018 and 2017, respectively. Interest expense increased in 2018 by $38,177 representing an increase of 8.3% compared to the same expense in the three months ended June 30, 2017. The increase was related to default interest on NOW Solutions senior secured note payable.

 

For the six months ended June 30, 2018, we had interest expense of $908,489 compared to $1,018,603 for the same period in 2017, representing a $110,114 or 10.8% decrease for the period. The decrease is primarily due to fully amortized debt discounts on convertible debt issued with stock and warrants.

 

Net Loss before non-controlling interest and income taxes. We had a net loss before non-controlling interest and income taxes of $856,268 and $546,551 for the three months ended June 30, 2018 and 2017, respectively. The net loss for the three months ended June 30, 2018 was due to the factors discussed above for revenues, cost of revenues, selling, general and administrative expenses, depreciation and amortization and bad debts which essentially gave us an operating loss of $186,434. The loss was increased by interest expense, non-operating penalties and a loss on derivative liabilities, resulting in a net loss before non-controlling interest and income taxes of $856,268 for the three months ended June 30, 2018. The net loss for the three months ended June 30, 2017 was due to the factors discussed above for revenues, cost of revenues, selling general and administrative expenses, depreciation and amortization and bad debts which essentially gave us operating loss of $363,391. This was increased by interest expense and forbearance fees and reduced by a gain on derivative liabilities, resulting in a net loss before non-controlling interest and income taxes of $546,551 for the three months ended June 30, 2017.

 

We incurred net losses before non-controlling interest and income taxes of $1,223,490 and $1,230,377 for the six months ended June 30, 2018 and 2017, respectively. The changes were due to the reasons discussed above for revenues, cost of revenues, selling, general and administrative expenses, depreciation and amortization and bad debts which essentially gave us an operating loss of $285,471. This loss was increased by interest expense, non-operating penalties and reduced by a gain on derivative liabilities, resulting in a net loss before non-controlling interest and income taxes of $ 1,223,490 for the three months ended June 30, 2018. The net loss for the three months ended June 30, 2017 was due to the factors discussed above for revenues, cost of revenues, selling, general and administrative expenses, depreciation and amortization and bad debts which essentially gave us operating loss of $825,688. This loss was increased by interest expense and forbearance fees and reduced by a gain on derivative liabilities, resulting in a net loss before non-controlling interest and income taxes of $1,230,377 for the three months ended June 30, 2017.

 

Income Tax Provision (Benefit) . We had an income tax benefit of $54,541 and income tax expense of $133,995 for the three and six months ended June 30, 2018, respectively. We had an income tax provision of $84,289 and $120,199 for the three and six months ended June 30, 2017. Income taxes are related to US and foreign income taxes of NOW Solutions, a 75% owned subsidiary of the Company.

 

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $155,600 and $154,933 for the three months ended June 30, 2018 and 2017, respectively and $311,200 and $306,405 for the six months ended June 30, 2018 and 2017, respectively.

 

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $915,676 and $740,241 for the three months ended June 30, 2018 and 2017, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

 

We had a net loss attributed to common stockholders of $1,604,700 and $1,620,120 for the six months ended June 30, 2018 and 2017, 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 six months ended June 30, 2018 and 2017, respectively.

 

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Liquidity and Capital Resources

 

At June 30, 2018, we had non-restricted cash-on-hand of $101,164 compared to $62,084 at December 31, 2017.

 

Net cash used in operating activities for the six months ended June 30, 2018 was $35,384 compared to net cash used in operating activities of $508,202 for the six months ended June 30, 2017.

 

A large portion of our cash (and revenue) comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. Deferred revenue decreased $196,552 or 11.2% from the balance at December 31, 2017. The decrease was due to a higher number of customers on calendar year maintenance agreements which results in higher deferred revenue in December.

 

Our accounts receivable trade decreased from $349,002 at December 31, 2017 to $108,911 (net of allowance for bad debts) at June 30, 2018. The decrease is a result of seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to June.

 

The combined accounts payable to related parties and accounts payable and accrued liabilities went from $14,271,154 at December 31, 2017 to $15,294,128 at June 30, 2018. The increase is primarily related to an increase in accrued interest and accrued payroll. The resulting balance at June 30, 2018 is 140 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 six months ended June 30, 2018 and June 30, 2017 of $0 and $0, 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 six months ended June 30, 2018, we had $160,000 of new debt funding and repaid $64,782 in debt funding and paid $59,090 in dividends. For the six months ended June 30, 2017, we had $240,000 of new debt funding, $200,000 in equity funding and repaid $44,705 in debt funding.

 

The total change in cash for the six months ended June 30, 2018 was an increase of $39,080.

 

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   June 30, 2018     2018     2019     2020     2021              2022+  
Notes payable   $ 6,237,088     $ 6,237,088     $ —     $ —     $ —     $ —  
Convertible debenture     1,340,000       1,340,000       —       —       —       —  
Operating lease     35,825       23,157       8,445       4,223       —       —  
Total   $ 7,612,914     $ 7,600,246     $ 8,445     $ 4,223     $ —     $ —  

 

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

 

    June 30, 2018     December 31, 2017  
         
In default   $ 5,616,588     $ 3,390,190  
Not in default     1,960,500       4,091,895  
                 
Total Notes Payable   $ 7,577,088     $ 7,482,085  

 

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 attributable to common stock holders of $1,604,700 and $1,620,120 for the six months ended June 30, 2018 and 2017, respectively and have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at June 30, 2018, we had negative working capital of approximately $24.2 million (although this figure includes deferred revenue of approximately $1.6 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

 

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

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Not applicable.

 

Item 4. Controls and Procedures

 

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

 

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2017, as filed on May 10, 2018.

 

There have been no material changes in our internal control over financial reporting since our reporting on Form 10-K for the year ended December 31, 2017. 

 

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PART II

OTHER INFORMATION

 

Item 1. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

On December 31, 2011, the Company and InfiniTek corporation (“InfiniTek”) entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek had agreed to transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The Company made $37,500 in payments due under the settlement agreement through May 7, 2012 and each party had alleged the other party was in breach of the settlement agreement.

 

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122 . William Mills is a partner of Parker Mills and the Secretary and a Director of the Company. The Company has $127,655 of principal and interest accrued as of June 30, 2018.

 

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses. On September 8, 2017, the court awarded Mr. Wolman a judgment in the amount of $282,299, which accrues interest at the rate of 16% per annum plus attorney’s fees as to be determined by the court. The Company has $325,790 of principal and accrued interest as of June 30, 2018. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

 

Item 1A. Risk Factors

 

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2017, as filed on May 10, 2018.

 

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

 

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

 

During the six months ended June 30, 2018, the Company extended the term of certain warrants to purchase a total of 11,600,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted a total of 311,099 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with certain extensions of convertible debentures in the aggregate principal amount of $1,160,000 that were issued from 2015 through 2017. The due dates for all these convertible debentures were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

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During the six months ended June 30, 2018, 320,000 shares of VCSY common stock issued to employees of the Company vested.

 

During the six months ended June 30, 2018, 209,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

On July 25, 2018, Taladin executed an amendment to a pledge agreement with a third-party lender. The Company and NOW Solutions also executed an amendment of certain promissory notes issued to the lender by the Company and NOW Solutions in the aggregate principal amount of $715,000. Under the terms of the Amended Pledge Agreement, in lieu of selling the Pledged Shares pursuant to the original terms of the pledge agreement, Taladin and the lender agreed that Taladin, or a party acting on Taladin’s behalf, may purchase a total of 10,000,000 shares of the Pledged Shares from Taladin at a purchase price of $0.015 per share over a certain period of time.  The Company made $150,000 in payments to the lender and all rights to 10,000,000 shares of the Pledged Stock will be retained by Taladin.

 

During the period that runs from July 1, 2018 to August 21, 2018, 250,000 shares of VCSY common stock issued to an employee of a subsidiary of the Company vested. 

 

During the period that runs from July 1, 2018 to August 21, 2018, 80,000 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to an employee of a subsidiary of the Company vested.

 

During the period that runs from July 1, 2018 to August 21, 2018, the Company extended the term of certain warrants to purchase a total of 500,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted 9,100 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with certain extensions of convertible debentures in the principal amount of $65,000 that were issued in 2016 and 2017. The due dates for all these convertible extensions were extended until October 1, 2018. The incremental change in the fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.

 

Item 3. Defaults Upon Senior Securities

 

Note payable, amended, of $2,291,395, issued by NOW Solutions to Lakeshore Investment, LLC, dated January 9, 2013.  The note is secured with the assets of NOW Solutions and bears a default interest rate of 16%. As of August 21, 2018, the outstanding principle and accrued interest currently due under the note is $2,291,918.

 

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 August 21, 2018 Provided herewith
32.1 Certification of Principal Executive Officer and Principal Accounting Officer Pursuant Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated August 21, 2018 Provided herewith
101.INS XBRL Instance Document Provided herewith

 

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Exhibit No.

Description

Location

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

 

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.
     
August 21, 2018 By: /s/    Richard Wade
    Richard Wade
   

President and Chief Executive Officer

(Principal Executive Officer and Principal Accounting Officer)

 

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