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,
2016. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”,
“we”, the “Company” or “VCSY”, as applicable). Vertical’s subsidiaries which currently
maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), an 80%
owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc.
(“Taladin”), and Vertical Healthcare Solutions, Inc. (“VHS”), each of which a wholly-owned subsidiary of
Vertical, as well as Priority Time Systems, Inc. (“Priority Time”) a 70% owned subsidiary, Ploinks, Inc. (“Ploinks”),
a 91% 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 2016 annual report on Form
10-K have been omitted.
Earnings per share
Basic earnings per
share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of shares of
the Company’s common stock outstanding during the period. “Diluted earnings per share” reflects the potential
dilution that could occur if our share-based awards and convertible securities were exercised or converted into common stock. The
dilutive effect of our share-based awards is computed using the treasury stock method, which assumes all share-based awards are
exercised and the hypothetical proceeds from exercise are used to purchase common stock at the average market price during the
period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have
been dilutive, are included in the denominator of the diluted EPS calculation. The dilutive effect of our convertible preferred
stock and convertible debentures is computed using the if-converted method, which assumes conversion at the beginning of the year.
For the three months
ended March 31, 2017 and 2016, common stock equivalents related to the convertible debt, preferred stock and stock derivative liabilities
were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive.
Capitalized Software
Costs
Software
costs incurred internally in creating computer software products are expensed until technological feasibility has been established
upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the
product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company
considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total
estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated
economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where
the fair value is less than the carrying value.
During
the three months ended March 31, 2017 and 2016, the Company capitalized an aggregate of $0 and $143,927 respectively, related to
software development.
Recently Issued
Accounting Pronouncements
The Company does not
expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial
position, operations or cash flows.
Note 2. Going Concern
The accompanying unaudited
consolidated financial statements for the three months ended March 31, 2017 and 2016 have been prepared assuming that we will continue
as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.
The carrying amounts
of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement
values. As of March 31, 2017, we had negative working capital of approximately $21.2 million and defaulted on substantially all
of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.
Our management is continuing
its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions,
mergers, joint ventures, and/or other business combinations. The Company will require additional funds to pay down its liabilities,
as well as finance its expansion plans consistent with anticipated changes in operations and infrastructure. However, there can
be no assurance that the Company will be able to secure additional funds and that if such funds are available, whether the terms
or conditions would be acceptable to the Company and whether the Company will be able to turn into a profitable position and generate
positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.
Note 3. Notes Payable
The following table
reflects our third party debt activity, including our convertible debt, for the three months ended March 31, 2017:
December 31, 2016
|
|
$
|
5,853,145
|
|
Borrowings from third parties
|
|
|
50,000
|
|
Repayments of third party notes
|
|
|
(4,716
|
)
|
Conversion of convertible debt principal to common stock
|
|
|
(9,213
|
)
|
Debt discounts due valuation of derivative liabilities
|
|
|
(17,741
|
)
|
Amortization of debt discounts
|
|
|
245,271
|
|
Effect of currency exchange
|
|
|
48
|
|
March 31, 2017
|
|
$
|
6,116,794
|
|
During the three months
ended March 31, 2017, $10,109 of principal, interest and legal fees under a convertible note issued in the principal amount of
$80,000 was converted into 723,089 common shares.
For additional transactions
after March 31, 2017 concerning the amendment of the $80,000 convertible note, conversion of the outstanding balance of that note
into common shares and the extension of the due date of other convertible debentures, please see “Subsequent Events”
in Note 9.
Lakeshore Financing
On January 9, 2013,
NOW Solutions completed a financing transaction in the aggregate amount of $1,759,150, which amount was utilized to pay off existing
indebtedness of the Company and NOW Solutions to Tara Financial Services and Robert Farias, a former employee of the Company, and
all security interests granted to Tara Financial Services and Mr. Farias were cancelled.
In connection with
this financing, the Company and several of its subsidiaries entered into a loan agreement (the “
Loan Agreement
”),
dated as of January 9, 2013 with Lakeshore Investment, LLC (“
Lakeshore
”) under which NOW Solutions issued a
secured 10-year promissory note (the “
Lakeshore Note
”) bearing interest at 11% per annum to Lakeshore in the
amount of $1,759,150 payable in equal monthly installments of $24,232 until January 31, 2022. Upon the payment of any prepayment
principal amounts, the monthly installment payments shall be proportionately adjusted proportionately on an amortized rata
basis.
The Lakeshore Note
is secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“
SnAPPnet
”)
and the Company’s SiteFlash™ technology and cross-collateralized. Upon the aggregate principal payment of $290,000
toward the Lakeshore Note, the Company has the option to have Lakeshore release either the Priority Time collateral or the SiteFlash™
collateral. Upon payment of the aggregate principal of $590,000 toward the Lakeshore Note, Lakeshore shall release either the Priority
Time collateral or the SiteFlash™ collateral (whichever is remaining). Upon payment of the aggregate principal of $890,000
toward the Lakeshore Note, Lakeshore shall release the SnAPPnet collateral and upon full payment of the Lakeshore Note, Lakeshore
shall release the NOW Solutions collateral.
As additional consideration
for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees and direct costs) from any
litigation or settlement proceeds related to the SiteFlash™ technology to Lakeshore which was increased to 8% under an amendment
to the Loan Agreement in 2013. In addition, until the Note is paid in full, NOW Solutions agreed to pay a Lakeshore royalty of
6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management has estimated the fair
value of the royalty to be nominal as of its issuance date and no royalty was owed as of September 30, 2015 or December 31, 2014.
In December 2014, the
Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. Under the terms of the amendment,
NOW Solutions agreed to make $2,500 weekly advance payments to Lakeshore to be applied to the 25% dividend of NOW Solutions’
net income after taxes in connection with Lakeshore’s 25% minority ownership interest in NOW Solutions. Within 10 business
days after the Company files its periodic reports with the SEC, NOW Solutions will also make quarterly payment advances to Lakeshore
based on 60% of Lakeshore’s 25% share of NOW Solutions estimated quarterly net income after taxes, less any weekly payment
advances received by Lakeshore during the then-applicable quarter and the weekly $2,500 payments shall be increased or decreased
based only upon any increases or decreases of maintenance and cloud-based offering fees during the then-completed quarter (but
will not decrease below a minimum of $2,500 per week). NOW Solutions shall pay Lakeshore the balance of Lakeshore’s 25% of
NOW’s yearly net income after taxes (less any advances) within 10 business days after the Company files it annual 10-K report
with the SEC and any payments in excess of Lakeshore’s 25% of NOW yearly profit shall be credited towards future weekly advance
payments. The Company also agreed to pay attorney fees of $40,000 and paid fees of $80,000 to a former consultant and employee
of the Company who is a member of Lakeshore. In consideration of the extension to cure the default under the Lakeshore Note and
the Loan Agreement, the Company transferred a 20% ownership interest in two subsidiaries to Lakeshore: Priority Time Systems, Inc.,
and in SnAPPnet, Inc.. This resulted in an additional non-controlling interest recognized in the equity of the Company of $391,920
and $99,210 for Priority Time Systems, Inc. and SnAPPnet, Inc., respectively, during 2014. The Company had an option to buy back
Lakeshore’s ownership interest in NOW Solutions, Priority Time and SnAPPnet, Inc. (which expired on January 31, 2015).
In July 2015, we entered
into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the amendment,
the Company issued 13,000,000 common shares with the Rule 144 restrictive legend, resulting in a forbearance loss of $455,000 and
Ploinks agreed to issue 3,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares was determined
to be nominal. Also in July 2015, the Company further amended the Lakeshore Note and the Loan Agreement with Lakeshore. Pursuant
to this Agreement, the Company issued 2,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a
forbearance loss of $54,200 and paid $15,000 to Lakeshore as forbearance fees.
In August 2015, we
entered into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the
amendment, the Company issued 7,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a forbearance
loss of $175,700 and Ploinks agreed to issue 2,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares
was determined to be nominal.
Under the August 2015
agreement, the Company also agreed to make a $500,000 payment for amounts due to Lakeshore under the Lakeshore Note and the Loan
Agreement. In the event that the Company did not make the Lakeshore $500,000 payment on or before August 21, 2015, then Lakeshore
in lieu of the $500,000 payment, would obtain a purchase option (the “2015 Purchase Option”) to purchase an additional
250 shares of NOW Solutions common stock for a total purchase price of $950,000. In addition, since the Company did not make the
$500,000 payment to Lakeshore on or before August 21, 2015, no further payment on the Note was due until January 1, 2016 at which
time the Note plus all accrued interest were recalculated and the Note was re-amortized under the same interest rate and terms
as the Note and the maturity date of the Note was extended 10 years from January 1, 2016.
The Lakeshore note
is in default and the Company is currently evaluating solutions to resolve all issues with Lakeshore.
During the three months
ended March 31, 2017, the Company, through its subsidiary, accrued dividends to Lakeshore of $32,500.
Note 4. Derivative Liabilities and Fair
Value Measurements
Derivative liabilities
As of March 31, 2017,
the Company has convertible notes and common stock warrants associated with the notes that qualify as derivative liabilities under
ASC 815.
As of March 31, 2017,
the aggregate fair value of the outstanding derivative liabilities was $685,221. For the three months ended March 31, 2017, the
net gain on the change in fair value of derivative liabilities was $339,467.
The Company estimated
the fair value of the derivative liabilities using the Black-Scholes option pricing model and the following key assumptions during
2017:
|
|
2017
|
|
Expected dividends
|
|
|
0%
|
|
Expected terms (years)
|
|
|
0.10 - 2.71
|
|
Volatility
|
|
|
84% - 118%
|
|
Risk-free rate
|
|
|
0.74% - 1.27%
|
|
Fair value measurements
FASB ASC 820, Fair
Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer
a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize
the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC 820 describes three
levels of inputs that may be used to measure fair value:
Level 1
– Quoted
prices in active markets for identical assets or liabilities.
Level 2
– Observable
inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable
or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3
– Unobservable
inputs that are supported by little or no market activity and that are financial instruments whose values are determined using
pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of
fair value requires significant judgment or estimation.
If the inputs used
to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on
the lowest level of input that is significant to the fair value measurement of the instrument.
The following table provides a summary of
the fair value of our derivative liabilities as of March 31, 2017 and December 31, 2016:
|
|
Fair value measurements on a recurring basis
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
As of March 31, 2017:
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivative liabilities – convertible debt
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
685,221
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2016:
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivatives
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
1,014,192
|
|
The estimated fair
value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities and deferred
revenue approximates their carrying value due to their short-term nature. The Company uses Level 3 inputs to estimate the fair
value of its derivative liabilities.
The below table presents
the change in the fair value of the derivative liabilities during the three months ended March 31, 2017:
Fair value as of December 31, 2016
|
|
$
|
1,014,192
|
|
Additions recognized as debt discounts
|
|
|
17,741
|
|
Reduction due to settlement upon conversion
|
|
|
(7,245
|
)
|
Gain on change in fair value of derivatives
|
|
|
(339,467
|
)
|
Fair value as of March 31, 2017
|
|
$
|
685,221
|
|
Note 5. Common and Preferred Stock Transactions
During the three months
ended March 31, 2017, the Company granted 3,000,000 VCSY common shares pursuant to a stock award to an employee of the Company
and its subsidiaries (at a fair market value of $72,000).
During the three months
ended March 31, 2017, $10,109 of principal, interest and legal fees under a convertible note issued in the principal amount of
$80,000 was converted into 723,089 common shares.
During the three months
ended March 31, 2017, 550,000 VCSY common shares vested under restricted stock agreements to employees and a consultant of the
Company.
During the three months
ended March 31, 2017, 200,001 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants
and employees of the Company vested.
Stock compensation
expense for the amortization of restricted stock awards was $35,167 for the three months ended March 31, 2017. As of March 31,
2017, there were 11,575,000 shares of unvested stock compensation awards to employees and 16,000,000 shares of unvested stock compensation
awards to non-employees.
Stock compensation
expense for the amortization of subsidiary’s restricted stock awards was $46,342 for the three months ended March 31, 2017.
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 March 31, 2017 concerning stock transactions, please see “Subsequent Events” in Note 9.
Note 6. Option and Warrant Activity
Option and warrant
activities during the three months ended March 31, 2017 is summarized as follows:
|
|
Incentive Stock Options
|
|
|
Non-Statutory Stock Options
|
|
|
Warrants
|
|
|
Weighted
Average Exercise Price
|
|
Outstanding at December 31, 2016
|
|
|
—
|
|
|
|
—
|
|
|
|
14,850,000
|
|
|
$
|
0.100
|
|
Options/Warrants granted
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Options/Warrants exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Options/Warrants expired/cancelled
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Outstanding at March 31, 2017
|
|
|
—
|
|
|
|
—
|
|
|
|
14,850,000
|
|
|
$
|
0.100
|
|
The weighted average remaining life of
the outstanding warrants as of March 31, 2017 was 2.23. The intrinsic value of the exercisable warrants as of March 31, 2017 was
$.0195.
Note 7. Related Party Transactions
.
The following table
reflects our related party debt activity, including our convertible debt, for the three months ended March 31, 2017:
December 31, 2016
|
|
$
|
308,242
|
|
Amortization of debt discounts
|
|
|
—
|
|
March 31, 2017
|
|
$
|
308,242
|
|
As of March 31, 2017
and December 31, 2016, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in
an aggregate amount of $137,532 and $139,546, respectively. The payables are unsecured, non-interest bearing and due on demand.
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 shall transfer and assign
ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft
Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued
liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments
due under the settlement agreement as of the date of this Report and each party is alleging the other party is in breach of the
settlement agreement. We intend to resolve all disputes with InfiniTek.
On February 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. The Company has $112,985 of principal and interest
accrued as of March 31, 2017. 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.
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. The Company has $260,286 of principal and interest
accrued as of March 31, 2017. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions,
Inc., No. 65/502/17.
Note 9. Subsequent Events
During the period from
April 1 to May 22, 2017, the Company amended a convertible note originally issued to a third party lender in the principal amount
of $80,000 to $90,000, cancelled a $10,000 note payable issued to the third party lender, and converted the $12,312 in outstanding
principal and interest of the amended convertible note into 965,673 shares of the Company’s common stock.
During the period from
April 1 to May 22, 2017, the Company entered into a restricted stock agreement for 120,000 shares of the Company’s common
stock with the Rule 144 restrictive legend with an employee of the Company under which the shares vest in equal installments over
a 30-month period.
During the period from
April 1 to May 22, 2017, the Company granted 250,500 shares of the common stock of Ploinks, Inc. to third party lenders in connection
with 3 to 6-month extensions of convertible debentures in the principal amount of $885,000 issued in 2015 and 2016.
During the period from
April 1 to May 22, 2017, the Company granted 300,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of
a subsidiary of the Company’s pursuant to a restricted stock agreement with the Company. 150,000 shares vested immediately
upon grant of the shares and 150,000 shares will vest in 4 months from the date of grant.
During the period from
April 1 to May 22, 2017, Ploinks, Inc. granted 60,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of
the Company pursuant to a restricted stock agreement with Ploinks, Inc. These shares typically vest over a 30 month period in equal
installments and the fair value of the awards is being expensed over this vesting period.