Quarterly Report (10-q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2017

☐ 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. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

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

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

As of November 20, 2017, the issuer had 1,184,395,201 shares of common stock, par value $0.00001, issued and 1,144,395,201 outstanding.

PART I

FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Vertical Computer Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
(Unaudited)


	September 30, 2017		December 31, 2016
Assets
Current assets
Cash	$	178,555	$	190,448
Accounts receivable, net of allowance for bad debts of $116,004 and $139,705 as of September 30, 2017 and December 31, 2016, respectively		295,829		367,278
Prepaid expenses and other current assets		3,358		10,355
Total current assets		477,742		568,081

Property and equipment, net of accumulated depreciation of $1,045,411 and $1,043,397 as of September 30, 2017 and December 31, 2016, respectively		4,106		5,097
Intangible assets, net of accumulated amortization of $319,530 and $319,513 as of September 30, 2017 and December 31, 2016, respectively		6,690		6,690
Deposits and other		8,076		8,064

Total assets	$	496,614	$	587,932

Liabilities and Stockholders’ Deficit
Current liabilities:
Accounts payable and accrued liabilities	$	14,014,574	$	12,075,298
Accounts payable to related parties		140,990		139,546
Bank overdraft		3,408		—
Deferred revenue		1,350,473		1,794,264
Derivative liabilities		93,016		1,014,192
Convertible debentures, net of unamortized discounts of $63,030 and $354,785 as of September 30, 2017 and December 31, 2016, respectively		1,176,970		899,428
Notes payable		5,200,553		4,953,717
Notes payable and convertible debt to related parties, net of unamortized discounts of $29,713 and $20,798		308,242		308,242
Total current liabilities		22,288,226		21,184,687

Total liabilities		22,288,226		21,184,687

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
(Unaudited)

(Continued from previous page)

	September 30, 2017			December 31, 2016
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 52,800 shares issued and outstanding as of September 30, 2017 and 51,500 issued and outstanding as of December 31, 2016		10,255,185			10,066,499
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			10,268,523

Stockholders’ Deficit
Common Stock; $.00001 par value; 2,000,000,000 shares authorized 1,180,105,201 issued and 1,140,105,201 outstanding as of September 30, 2017 and 1,167,841,439 issued and 1,127,841,439 outstanding as of December 31, 2016		11,801			11,679
Treasury stock; 40,000,000 as of September 30, 2017 and December 31, 2016		(400	)		(400	)
Additional paid-in capital		23,890,550			23,672,153
Accumulated deficit		(56,788,490	)		(55,017,675	)
Accumulated other comprehensive income – foreign currency translation		323,433			424,996

Total Vertical Computer Systems, Inc. stockholders’ deficit		(32,563,106	)		(30,909,247	)

Noncontrolling interest		314,285			43,969
Total stockholders’ deficit		(32,248,821	)		(30,865,278	)

Total liabilities and stockholders’ deficit	$	496,614		$	587,932

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries
Consolidated Statements of Operations and Comprehensive Loss
(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
Revenues
Licensing and software	$	294		$	7,290		$	811		$	19,290
Software maintenance		774,276			819,450			2,371,052			2,449,058
Cloud-based offering		48,648			75,099			174,315			199,565
Consulting services		88,472			49,403			264,964			197,400
Other		9,028			2,019			11,925			10,550
Total revenues		920,718			953,261			2,823,067			2,875,863

Cost of revenues		(357,689	)		(392,058	)		(1,170,484	)		(1,156,522	)

Gross profit		563,029			561,203			1,652,583			1,719,341

Operating expenses:
Selling, general and administrative expenses		994,410			1,126,309			2,973,669			2,602,957
Depreciation and amortization		324			325			974			758
Bad debt expense (recovery)		40,520			29,276			(24,147	)		41,203
Impairment of software costs		—			1,421,155			—			1,421,155
Total operating expenses		1,035,254			2,577,065			2,950,496			4,066,073

Operating loss		(472,225	)		(2,015,862	)		(1,297,913	)		(2,346,732	)

Other income (expense):
Interest income		1			23			17			41
Gain on derivative liabilities		305,914			160,326			925,812			49,291
Gain on debt extinguishment		—			—			—			35,969
Forbearance fees		—			(2,500	)		(6,000	)		(19,600	)
Interest expense		(374,914	)		(550,189	)		(1,393,517	)		(1,453,234	)

Net loss before noncontrolling interest and income tax expense (benefit)		(541,224	)		(2,408,202	)		(1,771,601	)		(3,734,265	)
Income tax expense (benefit)		(41,185	)		1,154			79,014			103,910
Net loss before noncontrolling interest		(500,039	)		(2,409,356	)		(1,850,615	)		(3,838,175	)
Net loss attributable to noncontrolling interest		42,939			149,114			79,800			119,774
Net loss attributable to Vertical Computer Systems, Inc.		(457,100	)		(2,260,242	)		(1,770,815	)		(3,718,401	)
Dividends applicable to preferred stock		(155,604	)		(147,000	)		(462,009	)		(441,000	)

Net loss available to common stockholders	$	(612,704	)	$	(2,407,242	)	$	(2,232,824	)	$	(4,159,401	)

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

Basic and diluted weighted average common shares outstanding		1,138,224,766			1,114,227,854			1,134,412,731			1,100,341,934

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

(Continued from previous page)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016

Comprehensive loss
Net loss	$	(500,039	)	$	(2,409,356	)	$	(1,850,615	)	$	(3,838,175	)
Translation adjustments		(66,383	)		35,715			(101,563	)		(138,483	)
Comprehensive loss		(566,422	)		(2,373,641	)		(1,952,178	)		(3,976,658	)
Comprehensive loss attributable to noncontrolling interest		42,939			(149,114	)		79,800			(119,774	)
Comprehensive loss attributable to Vertical Computer Systems, Inc.	$	(523,483	)	$	(2,522,755	)	$	(1,872,378	)	$	(4,096,432	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

December 31, 2016 through September 30, 2017

(Unaudited)

											Additional						Other			Non-
	Common Stock				Treasure Stock						Paid-in			Accumulated			Comprehensive			controlling
	Shares		Amount		Shares			Amount			Capital			Deficit			Interest			Interest			Total

Balances at December 31, 2016		1,167,841,439	$	11,679		(40,000,000	)		(400	)	$	23,672,153		$	(55,017,675	)	$	424,996		$	43,969		$	(30,865,278	)

Amortization of restricted stock awards		—		—		—			—			99,963			—			—			—			99,963
Shares issued for vested restricted stock awards		1,175,000		11		—			—			(11	)		—			—			—			—
Shares issued for conversion of convertible debentures		1,688,762		17		—			—			22,404			—			—			—			22,421
Shares issued for convertible debentures		1,100,000		11		—			—			12,281			—			—			—			12,292
Settlement of derivative liability upon conversion of debt		—		—		—			—			19,566			—			—			—			19,566
Shares issued to an employee		4,000,000		40		—			—			84,760			—			—			—			84,800
Issuance of subsidiary shares for services		—		—		—			—			251,251			—			—			(4,975	)		246,276
Dividends declared but unpaid to non-controlling interest holders		—		—		—			—			—			—			—			(97,500	)		(97,500	)
Shares and subsidiary shares issued for equity subscriptions		2,600,000		26		—			—			72,284			—			—			(1,570	)		70,740
Other comprehensive income translation adjustment		—		—		—			—			—			—			(101,563	)		—			(101,563	)
Issuance of shares for services		1,700,000		17		—			—			21,043			—			—			—			21,060
Issuance of subsidiary shares for debt extensions		—		—		—			—			94,838			—			—			(5,821	)		89,017
Non-controlling interest reclassification from additional paid-in capital		—		—		—			—			(459,982	)		—			—			459,982			—
Net loss		—		—		—			—			—			(1,770,815	)		—			(79,800	)		(1,850,615	)
Balances at September 30, 2017		1,180,105,201	$	11,801		(40,000,000	)		(400	)	$	23,890,550		$	(56,788,490	)	$	323,433		$	314,285		$	(32,248,821	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)


	Nine Months Ended September 30,
	2017			2016

Cash flows from operating activities
Net loss	$	(1,850,615	)	$	(3,838,175	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		974			758
Amortization of debt discounts		411,603			516,967
Common shares issued for services		21,060			66,550
Common shares issued to employees		84,800			—
Forfeited restricted stock awards		—			(1,145	)
Bad debt expense (recovery)		(24,147	)		41,203
Cancellation of common shares issued for loan forbearance		—			(28,900	)
Impairment of software development costs		—			1,421,155
Gain on extinguishment of debt and accrued interest		—			(35,969	)
Gain on derivatives		(925,812	)		(49,291	)
Amortization of restricted stock awards		99,963			258,101
Amortization of subsidiary restricted stock awards		246,276			202,429
Changes in operating assets and liabilities:
Accounts receivable		101,382			256,717
Prepaid expenses and other assets		6,838			45,039
Accounts payable and accrued liabilities		1,824,065			1,179,000
Accounts payable related parties		1,444			32,498
Deferred revenue		(506,154	)		(411,142	)
Net cash used in operating activities		(508,323	)		(344,205	)

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

Cash flows from financing activities:
Borrowings on notes payable		301,500			111,900
Borrowings on convertible debentures		110,000			665,000
Payments of notes payable		(159,705	)		(63,699	)
Issuance of stock subscriptions		260,000			150,000
Dividends paid		—			(222,500	)
Bank overdraft		3,408			74
Net cash provided by financing activities		515,203			640,775

Effect of changes in exchange rates on cash		(18,773	)		(65,210	)

Net change in cash and cash equivalents		(11,893	)		(18,628	)
Cash and cash equivalents, beginning of period		190,448			37,141
Cash and cash equivalents, end of period	$	178,555		$	18,513

See accompanying notes to unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

(Continued from previous page)


	Nine Months Ended September 30,
	2017		2016

Supplemental disclosures of cash flow information:
Cash paid for interest	$	32,163	$	172,618

Non-cash investing and financing activities:
Common shares issued for conversion of debt and accrued interest		22,421		74,000
Common shares issued on settlement of debt and accrued interest		—		92,500
Common stock issued for settlement of derivative liabilities		19,566		47,219
Debt discount due to shares and warrants issued with debt		17,390		171,326
Issuance of shares for settlement of accounts payable and related party accounts payable		—		137,500
Debt discount due to derivative liabilities		18,653		399,901
Common shares issued for vested incentive restricted stock		11		12
Reclassification of warrants as derivative liabilities		—		121,258
Debt discount due to convertible debt extensions		89,017		16,200
Non-controlling interest reclassification to additional paid-in capital		459,982		—
Debt modification		10,000		—
Dividends declared but unpaid to non-controlling interest holders		97,500		—

See accompanying notes to unaudited consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

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

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 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 90% 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 nine months ended September 30, 2017 and 2016, 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.

Capitalized Software Costs

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

During the nine months ended September 30, 2017, the Company did not capitalize any software development costs.

During the nine months ended September 30, 2016, the Company capitalized an aggregate of $246,184 related to software development and wrote off $1,421,155 of impaired software development costs.

Recently Issued Accounting Pronouncements

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

Note 2. Going Concern

The accompanying unaudited consolidated financial statements for the nine months ended September 30, 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 September 30, 2017, we had negative working capital of approximately $21.8 million and defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

Note 3. Notes Payable

The following table reflects our third-party debt activity, including our convertible debt, for the nine months ended September 30, 2017:

December 31, 2016	$	5,853,145
Borrowings from convertible debentures		110,000
Repayments of third party notes		(44,705	)
Borrowings from third parties		301,500
Repayments of convertible debentures		(115,000	)
Conversion of debt principal to common stock		(19,214	)
Debt discounts due to stock, warrants and derivative liabilities		(125,060	)
Amortization of debt discounts		411,603
Effect of currency exchange		5,254
September 30, 2017	$	6,377,523

During the nine months ended September 30, 2017, the Company borrowed $301,500 from a third party lender at 10% interest per annum, and the Company made total payment of $44,705 on note payable to third parties.

During the nine months ended September 30, 2017, the Company issued convertible debentures in the principal amount of $110,000 to third party lenders for loans made to the Company in the same amount. The debt accrues interest at 10% per annum and is due one year from the date of issuance. Beginning six months after issuance of the debenture and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company’s common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued a total of 1,100,000 shares of common stock of the Company to the lender with the Rule 144 restrictive legend and 3-year warrants under which each lender may purchase in aggregate a total of 1,100,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share. In connection with the issuance of shares of common stock and warrants, the Company recorded a discount of $12,292 and $5,098 against the face value of the loan based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as a derivative liability.

During the nine months ended September 30, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 was converted into 1,688,762 common shares. In May 2017, the Company amended the convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000 and cancelled a $10,000 note payable issued to the third party lender. This convertible note has been paid in full.

During the nine months ended September 30, 2017, the Company made payments of $126,500 of principal and interest due under 3 convertible debentures in the principal amount of $115,000 issued by the Company to a third party lenders. These convertible debentures have been paid in full.

During the nine months ended September 30, 2017, the Company granted 480,000 shares of the common stock of Ploinks, Inc. to third party lenders in connection with 6-month extensions of convertible debentures in the principal amount of $1,550,000 issued in 2015 and 2016. The aggregate fair market value of the awards was determined to be $89,017 and was recorded as debt discount, and is being amortized through the term of the convertible debenture. Certain notes issued in the prior year become convertible during 2017. Consequently, the embedded conversion feature was determined to be derivative liabilities, and the Company recognized debt discount of $18,653 derivative discount.

During the nine months ended September 30, 2017, the Company recognized total amortization of debt discount of $411,603 as interest expense.

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 nine months ended September 30, 2017, NOW Solutions, a subsidiary of the Company, accrued dividends to Lakeshore of $97,500.

For additional transactions after September 30, 2017 concerning notes payable, please see “Subsequent Events” in Note 9.

Note 4. Derivative Liability and Fair Value Measurements

Derivative liability

As of September 30, 2017, the Company has convertible notes and common stock warrants that qualify as derivative liabilities under ASC 815.

As of September 30, 2017, the aggregate fair value of the outstanding derivative liabilities was $93,016. For the nine months ended September 30, 2017, the net gain on the change in fair value of derivative liabilities was $925,812.

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 – 2.76
Volatility	97% - 116%
Risk-free rate	0.96% - 1.62%

Fair value measurements

FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC 820 describes three levels of inputs that may be used to measure fair value:

Level 1 – Quoted prices in active markets for identical assets or liabilities.

Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 – Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation.

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level of input that is significant to the fair value measurement of the instrument.

The following table provides a summary of the fair value of our derivative liabilities as of September 30, 2017 and December 31, 2016:

	Fair value measurements on a recurring basis
	Level 1		Level 2		Level 3
As of September 30, 2017:
Liabilities
Derivative liabilities – convertible debt and warrants	$	—	$	—	$	93,016

As of December 31, 2016:
Liabilities
None	$	—	$	—	$	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 nine months ended September 30, 2017:

Fair value as of December 31, 2016	$	1,014,192
Additions recognized as debt discounts		24,202
Reduction due to settlement upon conversion		(19,566	)
Gain on change in fair value of derivatives		(925,812	)
Fair value as of September 30, 2017	$	93,016

Note 5. Common and Preferred Stock Transactions

In September 2017, the Company entered into an agreement to purchase a 10% ownership interest in Priority Times Systems, Inc. from a former employee of the Company and its subsidiaries. The purchase price consists of 1,000,000 unregistered shares of VCSY common stock with the Rule 144 restrictive legend issued to the seller and $62,500 in cash payments due in equal installments over a three-month period. The aggregate fair market value of the VCSY common stock grant was determined to be $12,800 on the quoted market price of VCSY stock at date of grant. As of September 30, 2017, this transaction was not closed.

During the nine months ended September 30, 2017, the Company granted 1,700,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 230,000 shares of Ploinks, Inc. common stock to consultants of the Company and its subsidiaries pursuant to consulting agreements with the Company. The aggregate fair market value of the VCSY common stock grant was determined to be $21,060 based on the quoted market price of VCSY stock at date of grant and Ploinks, Inc. common stock grant was determined to be $71,185 based on a third party valuation of Ploinks stock. In addition, the Company agreed to issue up to a total of 4,000,000 common shares of the Company and up to a total of 500,000 shares of Ploinks, Inc. common stock pursuant to restricted performance stock agreements with the consultants. These shares may vest over a term of 3 years and are based upon the respective consultant achieving certain performance criteria.

During the nine months ended September 30, 2017, the Company entered into subscription agreements under which a third party subscriber purchased 1,300 shares of VCSY Series A Preferred Stock for $260,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 2,600,000 shares of common stock of the Company with the Rule 144 restrictive legend, 130,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscribers may purchase an aggregate total of 195,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2-year warrants under which the subscribers may purchase an aggregate total of 195,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $188,686. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company’s common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $30,505. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $40,235. The fair market value of all warrants issued to the subscribers was $574 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the nine months ended September 30, 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 nine months ended September 30, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 was converted into 1,688,762 common shares. In May 2017, the Company had amended this convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000 and cancelled a $10,000 note payable issued to the third party lender. This convertible note has been paid in full.

During the nine months ended September 30, 2017, the Company entered into restricted stock agreements to grant a total of 180,000 shares of the Company’s common stock with the Rule 144 restrictive legend with employees of the Company under which the shares vest in equal installments over a 30-month period. The fair value of the shares was $2,982 based on the quoted market price of VCSY stock on the grant date and $1,006 was amortized to expense during the nine months ended September 30, 2017.

During the nine months ended September 30, 2017, 1,175,000 VCSY common shares vested under restricted stock agreements to employees and a consultant of the Company.

During the nine months ended September 30, 2017, Ploinks, Inc. entered into restricted stock agreements to grant 90,000 unregistered shares of the common stock of Ploinks, Inc. to employees 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. The fair value of the shares was $15,765 based on a third party valuation of Ploinks stock.

During the nine months ended September 30, 2017, Ploinks, Inc. entered into restricted stock agreements to grant 230,000 unregistered shares of the common stock of Ploinks, Inc. to consultants of the Company pursuant to a restricted stock agreement with Ploinks, Inc. The fair value of the shares was $71,185 based on a third party valuation of Ploinks stock.

During the nine months ended September 30, 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 (as noted below) and 150,000 shares will vest in 4 months from the date of grant. The fair value of the shares was $32,400 based on a third party valuation of Ploinks stock.

During the nine months ended September 30, 2017 $246,276 was amortized to expense related to the issuance of Ploinks, Inc. restricted stock.

During the nine months ended September 30, 2017, 810,001 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 $99,963 for the nine months ended September 30, 2017. As of September 30, 2017, there were 11,130,000 shares of unvested stock compensation awards to employees and 16,000,000 shares of unvested stock compensation awards to non-employees.

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

For additional transactions after September 2017 concerning stock transactions, please see “Subsequent Events” in Note 9.

Note 6. Option and Warrant Activity

Option and warrant activities during the nine months ended September 30, 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		—		—		1,490,000	$	0.113
Options/Warrants exercised		—		—		—		—
Options/Warrants expired/cancelled		—		—		—		—
Outstanding at September 30, 2017		—		—		16,340,000	$	0.101

The weighted average remaining life of the outstanding warrants as of September 30, 2017 was 1.33. The intrinsic value of the exercisable warrants as of September 30, 2017 was zero.

Note 7. Related Party Transactions

Related party debt, including our convertible debt was $308,242 as of September 30, 2017 and December 31, 2016.

As of September 30, 2017 and December 31, 2016, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $140,990 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. 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.

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 $284,821 of principal and accrued interest as of September 30, 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 that runs from October 1, 2017 through November 20, 2017, the Company granted 63,000 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 $210,000 issued in 2016.

During the period that runs from October 1, 2017 through November 20, 2017, 4,290,000 VCSY common shares vested under restricted stock agreements to employees of the Company.

During the period that runs from October 1, 2017 through November 20, 2017, 270,000 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to employees of the Company and a subsidiary of the Company vested.

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

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

Critical Accounting Policies

Capitalized Software Costs

Revenue Recognition

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

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

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

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

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

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

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

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

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

Allowances for Doubtful Accounts

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

Deferred Taxes

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

Stock-Based Compensation Expense

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

Valuation of the Embedded and Warrant Derivatives

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

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

Recently Issued Accounting Pronouncements

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

Results of Operations

Three and Nine Months Ended September 30, 2017 Compared To Three and Nine Months Ended September 30, 2016

Total Revenues. We had total revenues of $920,718 and $953,261 for the three months ended September 30, 2017 and 2016, respectively. The decrease in total revenues was $32,543 for the three months ended September 30, 2017 representing a 3.4% decrease compared to the total revenues for the three months ended September 30, 2016. Substantially all the revenues for the three months ended September 30, 2017 and 2016 were related to the business operations of NOW Solutions.

Revenues for the three months ended September 30, 2017 and 2016 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. There were $294 of new licensing sales of our Ploinks ^® product during the third quarter of 2017 as compared to $7,290 of new licensing sales of our emPath® product for the same period in 2016. Software maintenance in the three months ended September 30, 2017 decreased by $45,174 or 5.5% from the same period in the prior year. The revenue decrease in software maintenance is primarily related to the loss of Canadian maintenance revenue partially offset by favorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the three months ended September 30, 2017 increased by $39,069 from the same period in the prior year, which represents a 79.1% increase. This increase was due to increased consulting services for version upgrades and enhancements to existing accounts in the third quarter of 2017 compared to the third quarter of 2016. Cloud-based revenues were $48,648 for the three months ended September 30, 2017 compared to $75,099 for the same period in the prior year, representing a $26,451 decrease or 35.2%. The decrease is related to a reduction in Canadian cloud-based revenue. Other revenue in the three months ended September 30, 2017 increased by $7,009 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 $2,823,067 and $2,875,863 for the nine months ended September 30, 2017 and 2016, respectively. The decrease in total revenues was $52,796 for the nine months ended September 30, 2017 representing a 1.8% decrease compared to the total revenues for the nine months ended September 30, 2016. Substantially all the revenues for the nine months ended September 30, 2017 and 2016 were related to the business operations of NOW Solutions.

Revenues for the nine months ended September 30, 2017 and 2016 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from new software licenses decreased by $18,479 or 95.8% compared to that for the nine months ended September 30, 2016. Software maintenance in the nine months ended September 30, 2017 decreased by $78,006 or 3.2% from the same period in the prior year. The revenue decrease in software maintenance is related to the loss of US and Canada maintenance revenue partially offset by favorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the nine months ended September 30, 2017, increased by $67,564 from the same period in the prior year, which represents a 34.2% increase. This increase was primarily due to increased consulting services for version upgrades and enhancements to existing accounts in Canada during the nine months ended September 30, 2017. Cloud-based revenues were $174,315 for the nine months ended September 30, 2017 compared to $199,565 for the same period in the prior year, representing a $25,250 decrease or 12.7%. The decrease is primarily related to a reduction in Canadian cloud-based revenue and SnAPPnet revenue. Other revenue in the nine months ended September 30, 2017 increased by $1,375 from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $357,689 for the three months ended September 30, 2017, compared to $392,058 for the three months ended September 30, 2016. The decrease in cost of revenues of $34,369 represents a 8.8% decrease. The decrease in direct cost of revenues was primarily due to decreases in payroll and travel expenses.

For the nine months ended September 30, 2017, direct costs of revenues were $1,170,484 compared to $1,156,522 for the same period in 2016, resulting in an increase of $13,962 or 1.2%. The increase in direct cost of revenues was primarily due to increases in payroll and hosting fees.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $994,410 and $1,126,309 in the three months ended September 30, 2017 and 2016, respectively. The decrease of $131,899 is 11.7% less than the same period in 2016. We had decreased stock compensation, penalties, legal fees and late charges partially offset by increased salaries and recruiting fees.

For the nine months ended September 30, 2017, we had selling, general and administrative expenses of $2,973,669 compared to $2,602,957 for the nine months ended September 30, 2016. The increase of $370,712 was 14.2% higher than the same period in 2016. We had increased salaries, recruiting fees and penalties partially offset by decreased stock compensation, travel, consulting fees and late charges.

Depreciation and amortization . For the three months ended September 30, 2017, we had depreciation and amortization of $324 compared to $325 for the three months ended September 30, 2016. For the nine months ended September 30, 2017 and 2016, $974 and $758, respectively, of depreciation and amortization was recorded.

Bad debt expense . During the three months ended September 30, 2017 and 2016, we had $40,520 and $29,276, respectively of bad debt expense related to account receivables that were greater than ninety days past due. During the nine months ended September 30, 2017, we had $24,147 of bad debt expense recoveries compared to $41,203 of bad debt expense for the nine months ended September 30, 2016 related to account receivables that were greater than ninety days past due.

Impairment of software costs . During the three months ended September 30, 2017 and 2016, $0 and $1,421,155 of Ploinks ^® software development costs were expensed as impaired as management was unable to support the net realizable value required by GAAP. This was a result of the uniqueness of Ploinks ^® and lack of third-party information related to user growth rates for mobile device applications. Although the Company had written these costs to expense, management still anticipates going to market with Ploinks ^® once the application is complete.

Gain/Loss on Derivative Liability . Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock, common stock warrants, and convertible debentures. Market value for common stock warrants and convertible debentures is determined using the Black-Scholes Model. The gain on derivative liabilities was $305,914 for the three months ended September 30, 2017 compared to $160,326 for the comparable period in 2016. The gain on derivative liabilities was $925,812 for the nine months ended September 30, 2017 compared to a gain of $49,291 for the nine months ended September 30, 2016.

Forbearance Fees . Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended September 30, 2017 were $0 compared to $2,500 for the three months ended September 30, 2016. The fees for the three months ended September 30, 2016 are related to a lender of VCSY.

Forbearance fees for the nine months ended September 30, 2017 were $6,000 compared to $19,600 for the nine months ended September 30, 2016. The fees for the nine months ended September 30, 2017 are related to a VCSY lender. The fees for the nine months ended September 30, 2016 are related to a VCSY lender.

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

Interest Expense . We had interest expense of $374,914 and $550,189 for the three months ended September 30, 2017 and 2016, respectively. Interest expense decreased by $175,275 representing a decrease of 31.9% compared to the same expense in the three months ended September 30, 2016. The decrease was due to less debt discounts in 2017 related to the issuance of convertible debentures in 2016.

For the nine months ended September 30, 2017, we had interest expense of $1,393,517 compared to $1,453,234 for the same period in 2016, representing a decrease of $59,717 or 4.1% for the period. The decrease was due to less debt discounts in 2017 related to the issuance of convertible debentures in 2016.

Net loss before income taxes. We had a net loss before income taxes of $541,224 and $2,408,202 for the three months ended September 30, 2017 and 2016, respectively. The net loss before income taxes for the three months ended September 30, 2017 was due to the factors discussed above for revenues, cost of revenues, bad debt expense, impairment of software development costs and selling, general and administrative expenses, which essentially gave us an operating loss of $472,225. This loss was increased by interest expense and reduced by gain on derivative liabilities. The net loss before income taxes for the three months ended September 30, 2016 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $2,015,862. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities.

We had a net loss before income taxes of $1,771,601 and $3,734,265 for the nine months ended September 20, 2017 and 2016, respectively. The net loss before income taxes for the nine months ended September 30, 2017 was due to the factors discussed above for revenues, cost of revenues, bad debt expense, impairment of software development costs and selling, general and administrative expenses, which essentially gave us an operating loss of $1,297,913. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities. The net loss before income taxes for the nine months ended September 30, 2016 was due to the factors discussed above for revenues, cost of revenues, bad debt expense, impairment of software development costs and selling, general and administrative expenses, which essentially gave us an operating loss of $2,346,732. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities and gain on debt extinguishments.

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

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

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 $155,604 and $147,000 for the three months ended September 30, 2017 and 2016, respectively and $462,009 and $441,000 for the nine months ended September 30, 2017 and 2016, respectively.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $612,704 and $2,407,242 for the three months ended September 30, 2017 and 2016, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

We had a net loss attributed to common stockholders of $2,232,824 and $4,159,401 for the nine months ended September 30, 2017 and 2016, respectively. Net loss available to common stockholders was due to the factors discussed above.

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the nine months ended September 30, 2017 and 2016, respectively.

Liquidity and Capital Resources

At September 30, 2017, we had non-restricted cash-on-hand of $175,147 compared to $190,448 at December 31, 2016.

Net cash used in operating activities for the nine months ended September 30, 2017 was $514,110 compared to net cash used in operating activities of $344,205 for the nine months ended September 30, 2016. During the nine months ended September 30, 2017 we received $2,519,802 of cash from customers, used $1,944,892 for payroll, benefits and payroll taxes, $32,163 for interest payments, $271,853 for professional fees, $63,495 for insurance payments, $261,915 for tax payments other than payroll and $459,594 for accounts payable to vendors.

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

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 $443,791 or 24.7% from the balance at December 31, 2016. 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 $367,278 at December 31, 2016 to $295,829 (net of allowance for bad debts) at September 30, 2017. The decrease is a result of seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to September.

The accounts payable and accrued liabilities went from $12,075,298 at December 31, 2016 to $14,014,574 at September 30, 2017. The change is primarily related to increased accounts payable, executive payroll, payroll taxes/penalties and accrued interest. The resulting balance at September 30, 2017 is 48 times more than the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

We used cash to invest in equipment and the development of software products for the nine months ended September 30, 2017 and September 30, 2016 of $0 and $246,184, respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers, and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

For the nine months ended September 30, 2017, we had $411,500 of new debt funding, $260,000 of equity financing, repaid $178,918 to lenders and accrued $97,500 of dividends to noncontrolling shareholders of NOW Solutions. For the nine months ended September 30, 2016, we had $776,900 of new debt funding, $150,000 of equity financing, repaid $241,337 to lenders and paid $222,500 of dividends to noncontrolling shareholders of NOW Solutions.

The total change in cash for the nine months ended September 30, 2017 was a decrease of $15,301.

As of the date of the filing of this Report, we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms. Therefore, we need to raise additional funds through selling securities, obtaining loans, renegotiating the terms of our existing debt and/or increasing sales with our new products. Our inability to raise such funds or renegotiate the terms of our existing debt will significantly jeopardize our ability to continue operations.

	Balance at		Due in Next Five Years
Contractual Obligations	September 30, 2017		2017		2018		2019		2020		2021+
Notes payable	$	5,408,795	$	5,408,795	$	—	$	—	$	—	$	—
Convertible debentures		1,340,000		1,230,000		110,000		—		—		—
Operating lease		100,496		39,469		61,027		—		—		—
Total	$	6,849,291	$	6,678,264	$	171,027	$	—	$	—	$	—

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

	September 30, 2017		December 31, 2016

In default	$	5,132,295	$	4,901,950
Not in default		1,616,500		1,614,222

Total Notes Payable	$	6,748,795	$	6,516,172

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We had a net loss before noncontrolling interest of $1,790,738 and $3,838,175 for the nine months ended September 30, 2017 and 2016, respectively and have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at September 30, 2017, we had negative working capital of approximately $21.8 million (although this figure includes deferred revenue of approximately $1.4 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures

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

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2016, as filed on April 24, 2017.

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, 2016.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

Item 1A. Risk Factors

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2016, as filed on April 24, 2017.

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

In May 2017, the Company granted 300,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 50,000 shares of Ploinks, Inc. common stock to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company. The aggregate fair market value of the VCSY common stock grant was determined to be $4,200 based on the quoted market price of VCSY stock at date of grant and Ploinks, Inc. common stock grant was determined to be $5,400 based on a third party valuation of Ploinks stock. In addition, the Company agreed to issue up to 1,000,000 common shares of the Company and 100,000 shares of Ploinks, Inc. common stock pursuant to restricted performance stock agreements with the consultant. These shares may vest over a term of 3 years and are based upon the Consultant achieving certain performance criteria.

In July 2017, the Company granted 500,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 30,000 shares of common stock of Ploinks, Inc. to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company.

During the nine months ended September 30, 2017, the Company recognized total amortization of debt discount of $411,603 as interest expense.

During the nine months ended September 30, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 was converted into 1,688,762 common shares. In May 2017, the Company had amended this convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000 and cancelled a $10,000 note payable issued to the third party lender. This convertible note has been paid in full.

During the nine months ended September 30, 2017 $246,276 was amortized to expense related to the issuance of Ploinks, Inc. restricted stock.

During the nine months ended September 30, 2017, 1,175,000 VCSY common shares vested under restricted stock agreements to employees and a consultant of the Company.

During the period that runs from October 1, 2017 through November 20, 2017, 4,290,000 VCSY common shares vested under restricted stock agreements to employees of the Company.

Item 3. Defaults Upon Senior Securities

Note payable of $1,759,150 issued by NOW Solutions to Lakeshore Investment, LLC, dated January 9, 2013. The note is secured with the assets of NOW Solutions, Priority Time Systems, SnAPPnet, and the SiteFlash™ assets and bears a default interest rate of 16%. As of November 20, 2017, the outstanding principle and accrued interest currently due under the note is $2,030,494.

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

The following documents are filed as part of this report:

Exhibit No.	Description	Location
31.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 20, 2017	Provided herewith

32.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated November 20, 2017	Provided herewith

101.INS*	XBRL Instance Document	Provided herewith

101.SCH*	XBRL Taxonomy Extension Schema	Provided herewith

101.CAL *	XBRL Taxonomy Extension Calculation Linkbase	Provided herewith

101.DEF*	XBRL Taxonomy Extension Definition Linkbase	Provided herewith

101.LAB*	XBRL Taxonomy Extension Label Linkbase	Provided herewith

101.PRE*	XBRL Taxonomy Extension Presentation Document	Provided herewith

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

SIGNATURES

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

	VERTICAL COMPUTER SYSTEMS, INC.

November 20, 2017	By:	/s/ Richard Wade
		Richard Wade
		President and Chief Executive Officer (Principal Executive Officer and Principal Accounting Officer)

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