UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

 

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

For the fiscal year ended December 31, 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)

 

Registrant’s telephone number: (972) 437-5200

 

Securities registered pursuant to section 12(b) of the Act:

 

Title of each class Name of each exchange on which registered
None None

 

Securities registered pursuant to section 12(g) of the Act:

 

Common Stock, par value $0.00001 per share

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  ☐  No  ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes  ☐  No  ☒

 

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 file. Yes  ☒  No  ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained in this form, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or amendment to this Form 10-K. ☐

 

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

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

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the registrant’s most recently completed second fiscal quarter: $14,934,781

 

As of May 10, 2018, the issuer had 1,188,415,201 shares of common stock, par value $0.00001, issued and 1,148,415,201 outstanding.

 

Documents incorporated by reference: None

 

 

 

 

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2017

 

TABLE OF CONTENTS  

   
PART I 2
Item 1. Business 2
Item 1A. Risk Factors 13
Item 2. Properties 17
Item 3. Legal Proceedings 17
Item 4. Mine Safety Disclosures 18
PART II 19
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 19
Item 6. Selected Financial Data 24
Item 7. Management’s Discussion and Analysis of Financial Condition And Results Of Operations 24
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 29
Item 8. Financial Statements and Supplementary Data 29
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 29
Item 9A. Controls And Procedures 30
Item 9B. Other Information 31
PART III 32
Item 10. Directors, Executive Officers and Corporate Governance 32
Item 11. Executive Compensation 34
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 38
Item 13. Certain Relationships and Related Transactions, and Director Independence 38
Item 14. Principal Accountant Fees and Services 40
PART IV 41
Item 15. Exhibits and Financial Statement Schedules 41
SIGNATURES 43

 

We caution you that the risks, uncertainties and other factors referenced above may not contain all of the risks, uncertainties and other factors that are important to you. In addition, we cannot guarantee future performance of our products and services, or results or achievements. Any forward-looking statement made by us in this Annual Report speaks only as of the date of this Annual Report or as of the date on which it is made. Except as required by law, we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information or developments, future events or otherwise, after the date of this Annual Report.

 

Trademarks and Trade names

 

We have common law, unregistered trademarks for the Company and its subsidiaries based upon use of the trademarks in the United States. This Annual Report contains references to our trademarks and to trademarks belonging to other entities. Solely for convenience, trademarks and trade names referred to in this Annual Report, including logos, artwork and other visual displays, may appear without the ® or ™ symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the rights of the applicable licensor to these trademarks and trade names. We do not intend our use or display of other companies’ trade names or trademarks to imply a relationship with, endorsement of, or sponsorship of us or our products or services by, any other companies.

 

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PART I

 

Item 1. Business

 

Forward-Looking Statements and Associated Risks. This Report contains forward-looking statements. Such forward-looking statements include statements regarding, among other things, (a) our projected sales and profitability, (b) our growth strategies, (c) anticipated trends in our industry, (d) our future financing plans, (e) our anticipated needs for working capital, and (f) the benefits related to ownership of our common stock. Forward-looking statements, which involve assumptions and describe our future plans, strategies, and expectations, are generally identifiable by use of the words “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “believe,” “intend,” or “project” or the negative of these words or other variations on these words or comparable terminology. This information may involve known and unknown risks, uncertainties, and other factors that may cause our actual results, performance, or achievements to be materially different from the future results, performance, or achievements expressed or implied by any forward-looking statements. These statements may be found under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business,” as well as in this Report generally. Actual events or results may differ materially from those discussed in forward-looking statements as a result of various factors, including, without limitation, the risks outlined under “Risk Factors” and matters described in this Report generally. In light of these risks and uncertainties, there can be no assurance that the forward-looking statements contained in this Report will in fact occur as projected.

 

Background

 

Vertical Computer Systems, Inc. (“ Vertical ”, “ VCSY ”, the “ Company ”, the “ Registrant ”, “ we ”, “ our ”, or “ us ”) was incorporated in the State of Delaware in March 1992. We operated as a non-reporting public shell company until October 1999, at which time we acquired all the outstanding capital stock of Externet World, Inc., an Internet service provider and became an operating entity. In April 2000, we acquired 100% of the outstanding common stock of Scientific Fuel Technology, Inc. (“ SFT ”), a company with no operations. Also in April 2000, we merged SFT into our company, as a consequence of which the outstanding shares of SFT were cancelled, Vertical became the surviving entity, and we assumed SFT’s reporting obligations pursuant to Rule 12g-3(a) under the Securities Exchange Act of 1934, as amended (the “ Exchange Act ”).

 

Business Overview

 

We are a global provider of application software, cloud-based and software services, Internet core technologies, and intellectual property assets through our distribution network with operations or sales in the United States, Canada and Brazil.

 

Our business model combines complementary and integrated software products along with internet core technologies, in order to create a distribution matrix that we believe is capable of penetrating multiple sectors through cross-promotion.

 

We developed a private communication platform (PCP), based upon our patented and patent-pending software technologies, that we believe can change the nature of communication on the Internet by allowing and supporting development of applications in separate sectors. In addition, the technology underlying our PCP has potential applications in the “Internet of Things” (IoT) market.

 

VCSY’s PCP eliminates the central server component in communications over the Internet, since the users have a patented web server installed on their mobile device, which may also be synchronized with their PC or other hardware components (i.e. network storage disks) and can communicate with other users who have been selected as trusted friends. VCSY’s PCP is for users who seek to obtain a higher level of security and protection for their information and for private secure communication of information with other selected users.

 

The first application built upon VCSY’s PCP is Ploinks ® , a private communication application, which was developed by our subsidiary, Ploinks, Inc. Ploinks ® provides each user with the ability to protect their data (such as messages, and images) from both unwanted data transmissions and from third parties gaining access and ownership rights to the user’s personal data without that user’s express permission. Ploinks ® is not a social media product, but users may still use all currently available social media applications. Ploinks ® provides users with a simple and new means to preserve and protect any personal data that the individual wants to keep control of and share within a protected environment. We had a soft launch of Ploinks ® in February 2017 and Ploinks Secure Personal Capsule™ (Ploinks SPC™) in October 2017. Ploinks SPC™ gives users the ability to shift their personal data and communications from cloud service provider(s) to their own personal server located on their mobile device (smartphone or tablet) and to back data up on their personal computer (or storage device) using the Puddle™, a complimentary storage and backup service to Ploinks ® .

 

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(FLOW CHART)

 

Administrative Software

 

Our main administrative application software, emPath ® , which is designed to handle complex payroll and human resources challenges, is developed, marketed and maintained by NOW Solutions. NOW Solutions, a 75% owned subsidiary, is selling its Web-based emPath ® in the United States and Canadian markets both as an in-house software solution and a Software-as-a-Service (“ SaaS ”) offering, also known as cloud-based offering. For a description of our SaaS model for emPath ®, please see the section entitled “Cloud-Based Services” below.

 

Our continuous effort to improve our emPath ® product and its cloud-based offering has allowed us to finalize and launch our new module-based initiative under which certain payroll/human resource modules can be marketed independently from emPath ® or bundled into a comprehensive solution. An upgraded version, emPath ® 7.0, was released to the general public in May 2017. Version 7.0 significant improves the user experience, is built to support all the new modern browsers and increase performance in processing payroll for emPath ® ’s large clients and is currently in various stages of implementation with NOW Solutions’ customer base.

 

Our time and attendance software, PTS , has been designed with the flexibility to meet the needs of a simple small business requirements as well as the most complex union-intensive clients through a rule-based time policy system coupled with a dashboardlets™ feature for presentations of information supporting numerous databases including Oracle, DB2 and SQL. For a description of this feature, please see the section entitled “Internet Core Technologies” below.

 

PTS will be marketed as a stand-alone best-of-breed solution through Priority Time Systems, Inc. (“ Priority Time ”) as well as an integrated module within emPath ® , which we will be marketing to emPath ® ’s existing customer base. Initial marketing efforts will be focused on the United States and Canadian markets.

 

SnAPPnet is currently sold as a best-of-breed standalone solution through our subsidiary, SnAPPnet, Inc. We are in the process of upgrading SnAPPnet look and feel, along with expanding its functionality, not only to increase the market potential but to then integrate it with emPath ® , so that it can also be sold to NOW Solutions’ customers as an emPath ® module.

 

We believe that our administrative software solutions, which offer lower set-up fees and faster implementation times compared to competing products, provide customers with significant upfront cost savings and substantial increases in productivity for administration of everyday operations.

 

3

 

 

Cloud-Based Services

 

In addition to our standard software licensing model, where the software is deployed, hosted and maintained internally by the customer, we are offering customers with an alternate delivery method: software-as-a-service, or simply “cloud-based.” Cloud-based is a software delivery model where the company develops, operates, and hosts the application in data centers for use by its customers over the Internet.

 

A cloud-based service is a cost-effective, reliable and secure way for businesses to obtain the same benefits of commercially licensed, internally operated software, without the associated complexity and high start-up costs of deploying the software in-house or the need to dedicate IT people on staff to monitor and upgrade such a system. Such services are currently under evaluation as to the marketability of making use of the VCSY secure communication platform to create new business opportunities.

 

After completing emPath ® cloud-based model to ensure a robust and competitive solution, NOW Solutions began selling that offering to existing and new clients. The cloud-based model provides a highly reliable, secure and scalable infrastructure, enabling us not only to continue servicing and expanding our current market of mid to large sized customers but also to increase our market reach by offering a solution to smaller sized customers, which otherwise may not be able to afford an in-house solution.

 

As an expanded product and as the result of our initial sales to customers with complex payroll, NOW Solutions has created a tailored cloud-based offering which provides these types of customers the cost benefits of a SaaS model while meeting their complex requirements. We are also continuing to upgrade emPath ® for our cloud-based offering utilizing emPath ® ’s powerful payroll component to provide private label contracting as well as distribution opportunities through existing payroll and HR providers in their local markets.

 

PTS , our time and attendance software, is also to be offered as a cloud-based solution, as both a standalone product (through Priority Time and VHS) and an integrated module with emPath ® (through NOW Solutions).

 

SnAPPnet™, a physician credentialing application, is currently offered as a cloud-based solution. We are in the process of upgrading SnAPPnet™ to be a complementary product to emPath ® . In addition, we are adding some key new features to the application as well as doing a design review to meet other potential markets for credentialing and markets in need of automated fillable forms. Upon completion of the upgrade, we will market SnAPPnet™ directly to hospitals and plan to offer it through VHS to physicians in the United States and to NOW Solutions’ existing customer base.

 

VCSY is in the process of placing NOW Solutions, Inc, Priority Time and SnAPPnet, Inc. under Taladin for improved marketing of its administrative software solutions in order to compete more effectively and allow for expansion internationally.

 

Software Services

 

In addition to the administrative software and cloud-based services, we offer a full range of software services that include professional services, maintenance, custom maintenance and managed services.

 

Internet Core Technologies

 

Internet core technologies provide the software foundation to support internet-based platforms for the delivery of individual software products that can be sold independently or combined with other software products for rapid deployment throughout our distribution system. We continue to develop specialized software applications that can be utilized in new products.

 

Our first patented internet core technology is SiteFlash™. The SiteFlash™ technology utilizes XML and publishes content on the Web, enabling the user to build and efficiently operate websites with the unique ability to separate form, function, and content. SiteFlash™ uses an advanced component-based structure to separate, parse, and store the various components of even the most complex web pages, permitting these components to be named, organized, filed and eventually redeployed onto the web pages of a website. Once all of the components of a web page are converted into “ objects ,” they can be grouped, as required by the user, into the three main types of web page components: content, form and function. Content includes text, pictures or multimedia. Form includes graphics and website colors, layout and design. Function includes the activities performed by or actions executed on the website. In this way, each element of a website created using SiteFlash™ is interchangeable with any other similar element, and these elements may be grouped together in almost any combination to create complex websites. This separation of form, function, and content also allows for the rapid creation of affiliated websites. SiteFlash™ architectural concepts enable integration with existing technological components within many organizations. Additional key features of SiteFlash™ are its affiliation/syndication capability, its multi-lingual capability, and its multi-modal framework (enabling use on any output device, including wireless devices such as smart phones, as well as cellular phones and other devices with Internet capability). It is contemplated that some of SiteFlash™’s components will be included in VCSY’s PCP.

 

4

 

 

The second patented Internet core technology we have developed is the Emily™ XML scripting language, a Markup Language Executive (MLE), which is Java compatible. XML is a flexible way to create common information formats and share both the format and the data on the World Wide Web, intranets, and elsewhere. The Emily™ Framework was developed to be an engineering package comparable to other Web development tools, such as Allaire Cold Fusion™ or Microsoft FrontPage™. The primary component of the Emily™ Framework is the Emily XML scripting language, a programming language that runs on Windows™, Linux and several UNIX platforms. The Emily™ Framework is used to create Web-based applications that communicate via XML and HTTP. HTTP is the set of rules for exchanging files (text, graphic images, sound, video, and other multimedia files) on the Web.

 

The third patented Internet core technology we have developed is the combination of three components: the Emily™ XML Broker, the Emily™ XML Agent and the Emily™ XML Portal. This technology has been featured as an alternative to Web Services in the 4 th Edition of the XML Handbook, by Dr. Charles Goldfarb, considered the father of XML and inventor of all markup languages. We are upgrading this technology for use in a new application we are developing simultaneously. Emily™ will be marketed in the education market as a product allowing users to create applications without being programmers.

 

The fourth Internet core technology is VCSY’s PCP, which is built using a number of patented and patent-pending applications (see Intellectual Property Assets below). Using PCP, we did a soft launch of our first product, Ploinks ® , through our subsidiary, Ploinks, Inc., in February 2017, and Ploinks SPC™ in October 2017. Ploinks SPC™ gives users the ability to shift their personal data and communications from cloud service provider(s) to their own personal server located on their mobile device (smartphone or tablet) and to back data up on their personal computer (or storage device) using the Puddle™, a complimentary storage and backup service to Ploinks ® . Ploinks ® and the Ploinks SPC™ are monthly subscription-based applications.

 

Intellectual Property Assets

 

Our SiteFlash technology is based upon the following patents: a System and Method for Generating Web sites in an Arbitrary Object Framework. This unique ability is patented under U.S. Patent No. 6,826,744 and continuation patent U.S. Patent No. 7,716,629 as well as a continuation patent (U.S. Patent No. 8,949,780) of U.S. Patent No. 7,716,629.

 

Our Emily™ core technology is the basis for a “Web-based collaborative data collection system”, which allows a disparate and distributed database to be viewed and updated as if it was a single large database. This unique ability is patented under U.S. Patent No. 7,076,521.

 

Our Emily™ XML scripting language, coupled with other Company technology, is the basis for development of mobile applications. This unique ability is patented under U.S. Patent No. 8,578,266 and its continuation patent.

 

Our patent for a “System and Method Running a Web Server on a Mobile Internet Device,” which is part of VCSY’s PCP and covers the Tiny Web Server, which is also a component of the PCP. This unique ability is patented under U.S. Patent No. 9,112,832.

 

Our patent for a “Mobile Proxy Server for Internet Server Having a Dynamic IP Address” is used in our PCP for such applications Ploinks® and Ploinks SPC™. The term “IP” stands for “Internet Protocol,” which is the principal communications protocol for the Internet. This unique ability is patented under U.S. Patent No. 9,710,425.

 

Our fiber optic patent is an invention for “Transmission of Images Over a Single Filament of Fiber Optic Cable” under U.S Patent No. 6718103.

 

We also have other mobile technologies, which are patent-pending.

 

5

 

 

Market Segments

 

Our current products address the following market segments:

 

MARKET PRODUCT OWNERSHIP/LICENSOR LICENSEE
Human Resources and Payroll emPath® NOW Solutions VHS (a) , Taladin (b)
Software development units Emily™ Vertical VHS (a)
Time and Attendance PTS™ Priority Time VHS (a) , NOW Solutions (c)
Healthcare Credentialing SnAPPnet™ SnAPPnet, Inc. VHS (a) , NOW Solutions (c)
Personal Secure Communication Ploinks® Vertical Ploinks, Inc. (d)
Personal Secure Communication Ploinks SPC™ Vertical Ploinks, Inc. (d)

 

(a) Physician market (including medical clinics but not including hospitals)

(b) Government sector

(c) Clients of NOW Solutions

(d) Personal secure communication channel for individual consumers for the US market only

 

Business Operations and Units

 

Our business operations are grouped into the following units: NOW Solutions, Ploinks, Inc., Taladin, VHS, Priority Time, SnAPPnet, Inc., Vertical do Brasil, and other subsidiaries with minimal or no activity and other limited interests. Each of the primary divisions is discussed below.

 

(FLOW CHART)  

 

Taladin, Inc.

 

Taladin, a Texas corporation, is a wholly-owned subsidiary of the Company. Taladin is being positioned to become the parent company for NOW Solutions, Priority Time and SnAPPnet in order to streamline and better coordinate the Company’s business administrative software product lines and marketing efforts. It is anticipated that Taladin will also be responsible for an enterprise private communication channel utilizing VCSY secure communication platform.

 

6

 

 

For the 12 months ended December 31, 2017, Taladin had $338,000 of assets, no revenues and a net loss of approximately $165,770.

 

NOW Solutions, Inc.

 

NOW Solutions, a Delaware corporation, is a 75% owned subsidiary of the Company. NOW Solutions specializes in end-to-end, fully integrated human resources and payroll solutions. NOW Solutions has clients in the United States and Canada ranging from private businesses to government agencies, who typically employ 500 or more employees. NOW Solutions currently markets emPath ® , a payroll and human resources and payroll solution. emPath ® meets the needs for clients who have complex payroll where they may have employees from different unions, multiple locations in different states (U.S.) and provinces (Canada), and intricate compensation structures. We believe that the competitive advantage of emPath ® is its speed of implementation through a formula-builder technology, which provides customers with rapid customization of payroll rules and calculations without the need for any programming expertise. NOW Solutions’ product suite is targeted to address the needs of management in today’s dynamic business environment and gives organizations a user-friendly, flexible, multi-lingual (i.e., English, Canadian French, Spanish, and Portuguese) software solution, without the multi-million dollar implementation and support budgets typically required to use the payroll and HR products of major competitors.

 

NOW Solutions has converted some of its existing customers to its cloud-based model. In addition, during the conversion of one of our large complex customers and in discussions with other similar complex customers, we determined that there was a critical need and opportunity in providing a solution we labeled “tailored cloud-based”, which we believe can fulfill our customers’ unique requirements while giving them the benefits of a cloud-based offering. NOW Solutions has a new version (Version 7.0) of its emPath® software that was released to the general public in May 2017. Version 7.0 significant improves the user experience, is built to support all the new modern browsers and increase performance in processing payroll for emPath ® ’s large clients.

 

Additionally, NOW Solutions has embarked on a strategy to develop and license HR products complementary to its existing suite of products that can be sold separately or integrated as emPath ® modules, which has been greatly facilitated by emPath ® ’s Web Services integration. PTS™ is the first product to be integrated within the emPath ® solution. The second product is SnAPPnet™, which is in the process of being upgraded to expand its usability beyond traditional credentialing software so that it can be used by HR departments of NOW Solutions’ existing customer to create and administer fillable forms routinely used for employees.

 

Now that Ploinks ® and the Ploinks SPC™ have been released, we intend to make presentations to selected NOW Solutions’ customers to jointly create an enterprise model utilizing VCSY’s PCP.

 

The revenue model of NOW Solutions is based upon five components: licensing and renewable annual maintenance fees, cloud-based service fees, professional consulting services, and managed services. Under the cloud-based delivery model, NOW Solutions typically collects monthly fees.

 

For the 12 months ended December 31, 2017, NOW Solutions had approximately $586,588 of total assets, revenues of approximately $3,732,608 and a net loss of approximately $199,089.

 

Ploinks, Inc.

 

Ploinks, Inc., a Texas corporation (formerly OptVision Research, Inc.), is an 88% owned subsidiary of the Company.

 

Vertical has licensed its secure communication platform to Ploinks, Inc. in the United States, for use by consumers as a personal secure communication channel. The Ploinks ® application was launched in February 2017 and Ploinks SPC™ in October 2017. Ploinks SPC™, consisting of two main components: the Ploinks® mobile application and the Puddle™, a complimentary storage and backup service to Ploinks ® , gives users the ability to shift their personal data and communications from cloud service provider(s) to their own personal server located on their mobile device (smartphone or tablet) and to backup data on their personal computer (or network storage device) using the Puddle™. Ploinks SPC™ is marketed as a secure personal cloud.

 

Ploinks ® and the Puddle™ are available on http://www.ploinks.com for a monthly subscription fee.

 

For the 12 months ended December 31, 2017, Ploinks, Inc. had approximately $169,071 of total assets, no material revenues and a net loss of $836,953.

 

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Vertical Healthcare Solutions, Inc.

 

VHS, a Texas corporation, is a wholly-owned subsidiary of the Company. VHS plans to market a new platform called the “Physicians Bridge”, which will be the basis for marketing applications to physicians utilizing other Vertical technologies and products which were licensed for the physician market by Vertical to VHS.  Vertical will also license its PCP to VHS to develop a secure communication channel for use by and between patients, physicians and staff.

 

For the 12 months ended December 31, 2017, VHS had no material assets, no revenues, and a net loss of approximately $223,685.

 

Priority Time Systems, Inc.

 

Priority Time, a Nevada corporation, is an 80% owned subsidiary of the Company. We originally purchased 90% of the common stock of Priority Time from a shareholder of Priority Time and under a shareholder agreement with the selling shareholder, we purchased 10% of the common shares of Priority Time stock held by this shareholder for 1,000,000 VCSY common shares. The shareholder agreement also provides for the licensing terms of Priority Time products to our other subsidiaries. Lakeshore Investments, LLC owns a 20% minority interest in Priority Time, which it acquired in 2013.

 

Priority Time is finalizing PTS™, a time and attendance product that is to be offered as both a standalone product and as an integrated module within emPath ® .

 

PTS™ is being developed to meet the unique and complex requirements of NOW Solutions’ customers, particularly for the medical and government markets, who provided us with specifications for an ideal time and attendance program. The most critical need of complex customers was robust flexibility which led to the creation, from the ground up, of a rule-based time and attendance application, allowing users to make for immediate changes within the application while also providing a state-of-the-art reporting ability to senior executives. The result also led to a new development platform as well as another application called “dashboardlets TM .” PTS™ will be commercially available once its integration with emPath ® is finalized.

 

We have been using our new development platform, which has allowed us to create a cloud-based solution that utilizes a rule-based system, which will better meet the needs of NOW Solutions’ most complex customers and more easily create a time and attendance product for vertical markets (i.e. medical, government, casinos, and hospitality).

 

For the 12 months ended December 31, 2017, Priority Time had no material assets, no revenues and a net loss of approximately $1,768.

 

SnAPPnet, Inc.

 

SnAPPnet, Inc., a Texas corporation, is an 80% owned subsidiary of the Company. On May 21, 2010, SnAPPnet, Inc. purchased substantially all the assets of Pelican Applications, LLC (“ Pelican ”) in exchange for $5,335 cash, 100,000 shares of Series B Convertible Preferred Stock of VHS, and other contingent consideration. The assets acquired included a software application product known as SnAPPnet™ which is currently used for physician credentialing, as well as Pelican’s entire customer base. We intend to utilize the SnAPPnet™ software to expand its offering to physicians through VHS, and to adapt the software to meet the needs of NOW Solutions’ hospital clients who need a credentialing product for their staff.

 

SnAPPnet™ core application is being rewritten to utilize our new administrative development platform, including our proprietary dashboardlets™. A revised and improved SnAPPnet™ application should open new opportunities in markets in need of automated fillable forms.

 

For the 12 months ended December 31, 2017, SnAPPnet, Inc. had assets of approximately $7,656, revenues of approximately $36,907 and a net loss of approximately $11,206.

 

Government Internet Systems, Inc.

 

GIS, a Nevada corporation is our 84.5% owned subsidiary. Vertical licensed ResponseFlash™ to GIS in order to market and distribute this technology to government entities (excluding state universities and schools) in the United States. Marketing is currently on hold and the business opportunities are being reviewed in conjunction with VCSY secure communication platform.

 

For the 12 months ended December 31, 2017, GIS had no assets, no material revenue and net loss of approximately $10,139.

 

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Vertical do Brasil

 

Our 99% owned subsidiary, Vertical do Brasil, a Brazilian company, performs software development services on behalf of the Company and its subsidiaries. NOW Solutions, Inc. owns 1% of Vertical do Brasil.

 

For the 12 months ended December 31, 2017, Vertical do Brasil had assets of approximately $2,145, no revenues and no material net income or loss.

 

The following corporations are inactive:

 

Vertical Internet Solutions, Inc.

 

VIS, a California corporation, is a wholly-owned subsidiary of the Company. VIS is inactive and we currently have no plans regarding this subsidiary.

 

For the 12 months ended December 31, 2017, VIS had no material assets, no material revenue and no expenses.

 

EnFacet, Inc.

 

EnFacet, a Texas corporation, is a wholly-owned subsidiary of the Company. EnFacet is inactive and we currently have no plans regarding this subsidiary.

 

For the 12 months ended December 31, 2017, EnFacet had no material assets and a net loss of $28.

 

Globalfare.com

 

Globalfare, a Nevada corporation, is a wholly-owned subsidiary of the Company. Globalfare is inactive and we currently have no plans regarding this subsidiary.

 

For the 12 months ended December 31, 2017, Globalfare had no assets and a net loss of $99.

 

Pointmail.com, Inc.

 

Pointmail, a California corporation, is a wholly-owned subsidiary of the Company. Pointmail is inactive and we currently have no plans regarding this subsidiary.

 

For the 12 months ended December 31, 2017, Pointmail had no assets, no revenues and no expenses.

 

Competition

 

We face substantial competition from software and hardware vendors, system integrators, and multinational corporations focused upon information technology and security.

 

In the realm of application software, NOW Solutions’ competitors include Oracle, Lawson, Cyborg/Hewitt, Kronos, DLGL, Ultimate and SAP. Our cloud-based emPath ® competes with ADP, Ceridian, Ultimate Software and Quicken. However, while NOW Solutions competes with these companies, our HR/payroll product is utilized by our many of our customers in conjunction with many of these companies’ other modules.

 

Priority Time’s competitors include Kronos, NOVAtime Technology, Asure Software, Insperity (formerly known as Administaff), and Qqest Software Systems.

 

SnAPPnet, Inc. competes with several small and mid-sized competitors in the healthcare credentialing business sector. SnAPPnet’s competitors include EchoApps (Heathline Systems), Win/Staff PRO-FILE (Win/Staff), Medkinetics Pro (Medkinetics), IntelliAppsSE (Intellisoft Group, Inc.), OneAPP (Sy.Med) and CACTUS Software.

 

It is anticipated the consolidation of NOW Solutions, Inc, Priority Time and SnAPPnet, Inc. under Taladin will increase the company’s ability to compete with the larger competitive products.

 

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Ploinks SPC™ is an all-in-one secure communication solution for individuals that we believe has no direct competition to our knowledge, but finds competitors in some of its areas, such as Snapchat and Instagram for sharing of images, Whisper, WhatsApp, Facebook messenger in the area of secure messaging, WhatsApp, Viber for voice calling, as well as Dropbox, GoDaddy, Amazon, Microsoft and Google for data storage.

 

Our primary competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical and marketing resources than we do. However, NOW Solutions has a number of large complex clients including cities and counties in the United States that have been users of our HR/Payroll software for many years (10 -25 years) and are highly referenceable. We cannot guarantee that we will be able to compete successfully against current or future competitors or that competitive pressure will not have a material and adverse effect on our financial position, results of operations and cash flows.

 

Our ability to compete will also depend upon our ability to continually improve our products and services, the enhancements we develop, the quality of our customer service, and the ease of use, performance, price and reliability of our products and services.

 

We believe, however, that we possess certain competitive advantages for the following reasons:

 

1. We have a number of proprietary patented and patent-pending technologies that can be utilized in our offerings.

 

2. NOW Solutions has an outstanding customer support department that has supported large complex entities for decades, and many of these large entities are leaders in their respective industries.

 

3. emPath ® ’s inherent strengths include its formula builder, the use of one single database (where competing products may use two or more), and a strong, highly identifiable customer base it can reference.

 

4. emPath ® is built on a state-of-the-art Microsoft.net platform, allowing for rapid software development and interoperability with other software packages.

 

5. emPath ® supports a global platform with one database for both payroll and HR.

 

6. Our development platform (including the dashboardlets™ feature) provides a consistent business intelligence tool across our administrative software product line.

 

7. We can cross-promote our administrative software applications between our subsidiaries and through strategic alliances with third party companies.

 

8. Our new secure communication platform is based upon certain trade secrets and revolutionary technology that incorporates our patented and patent-pending technologies.

 

9. PCP technology will create an added advantage for NOW Solutions existing customers and potential new customers. by eliminating certain risks being encountered by companies through hijacking email addresses, etc….

 

Strategic Overview

 

The Company’s product portfolio reflects a number of unique characteristics and advantages that have been developed or acquired over time. At present, we are actively pursuing the strategy of (a) further developing the technologies owned by the Company and our subsidiaries and (b) combining all the technologies owned by the Company and our subsidiaries into viable product offerings.

 

The key components of our strategy are to:

 

1. Leverage our profitable subsidiary, NOW Solutions, that has a highly-referenceable client base, including companies that are leaders in their industries and have been users of emPath ® and its predecessor product for over 25 years for their payroll and human resource needs.

 

2. Develop a portfolio of patented technologies that we can license to third parties or utilize internally to strengthen our existing and projected product offerings.

 

3. Build a network of compatible partners and acquisition or licensing of products that complement our existing offerings.

 

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4. Maximize the unique features of our software development platform to launch our new PTS™ and SnAPPnet™ products as well as other products to NOW Solutions’ customer base and, at the same time, have those customers assist us in development of product specifications for their own vertical markets.

 

5. Build and integrate new commercially viable products utilizing our patented technology and other administrative software.

 

6. Expand the reach of emPath ® internationally beyond the U.S. and Canada utilizing non-competitive local distributors in foreign countries.

 

7. Develop proprietary applications on our secure communication platform and, with licensing agreements, provide a structure whereby third-party applications can be developed upon that platform to be then distributed.

 

8. Have third party verification as to the capability and comparison in the marketplace.

 

9. Enter into strategic alliances with companies that can benefit from promoting our technology.

 

The software development leg of our strategy is two-fold. The first is to further enhance our existing solutions and develop new products in order to better compete with the large ERP providers like SAP and Oracle by providing complex best-of-breed alternative offerings that are more cost-effective solutions. The second is to continue developing our intellectual property internally for mass market, best-of-breed solutions offered as cloud-based solutions that incorporate the advantages of our complex solutions. In each such instance, the software development leg of our strategy will be augmented by exploring solutions that can be linked to federal and state government programs for cost savings.

 

Our new mobile strategy is intended to make us a dominant player in the mobile space for the private communication sector that also serves as a complement to the social media market, as well as providing solutions in the healthcare and corporate markets. The goal is to become a provider with an all-in-one solution incorporating technology between a mobile device and different data storage units.

 

One key to the success of our strategies is to leverage our core capabilities, by entering into co-marketing agreements with other companies, particularly those who offer best-of-breed products that complement our product offerings. Our objective is to enter into distinct co-marketing agreements whereby each business unit will have a separate agreement with the co-marketing partner for its particular target market. To supplement this approach, our business units will enter into agreements with each other where they can more successfully cross-promote and market their respective products. We are also identifying complementary products from third parties which we can private label and sell as part of our existing product offering or separately.

 

Proprietary Rights

 

We rely upon a combination of patent, copyright, trademark, trade secret laws, and contract provisions and to protect our proprietary rights in our technologies, products and services.  We distribute our products and services under agreements that grant users or customers a license to use our products and services and rely upon the protections afforded by the copyright laws to protect against the unauthorized reproduction of our products.  In addition, we protect our trade secrets and other proprietary information through confidentiality agreements with employees, consultants and other business partners.  emPath ® , PTS™, SnAPPnet™ and Ploinks ® are protected by copyright and trademark. 

 

Our patent portfolio consists of the following technologies and related products:

 

The United States Patent and Trademark Office (“USPTO”) granted us a patent (No. 6,718,103) for an invention for “Transmission of Images over a Single Filament Fiber Optic Cable” in April 2004.  This patent is in a theoretical stage only and is intended to be used for transmitting images on fiber optics that might improve in orders of magnitude today’s capacity of fiber optics to transmit images and data. 

 

The USPTO granted us a patent (No. 6,826,744) for an invention for “System and Method for Generating Web Sites in an Arbitrary Object Framework” on November 30, 2004. On May 11, 2010, we were granted a continuation patent (U.S. Patent No. 7,716,629) of U.S. Patent No. 6,826,744 by the USPTO.  All pending new claims were granted in the continuation patent for U.S. Patent No. 7,716,629, which has increased the scope of the original patent by adding 32 new claims to the original 53 claims.  On February 3, 2015, we were granted a continuation patent (U.S. Patent No. 8,949,780) of U.S. Patent No. 7,716,629. All pending new claims were granted in the continuation patent for U.S. Patent No. 8,949,780, which has increased the scope of the continuation patent and the original patent by adding 24 new claims. 

 

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Together, these patents are the foundation of our SiteFlash™ platform.

 

The USPTO granted us a patent (No. 7,076,521) for an invention for a “Web-based collaborative data collection system” on July 11, 2006.  This patent covers various aspects of the Emily™ XML Enabler Agent and the Emily™ XML Broker. 

 

The USPTO granted us a patent (No. 8,578,266) for a “Method and Systems for Automatically Downloading and Storing Markup Language Documents into a Folder Based Data Structure” (formerly, a “Method and System for Providing a Framework for Processing Markup Language Documents”) on November 5, 2013. In August 2016, we were granted a continuation patent (U.S. Patent No. 9,405,736) of U.S. Patent No. 8,578,266 which allowed Claims 1-19 and 21 and amended claims 1, 14, and 21. These patents cover the Emily™ scripting language.

 

The USPTO granted us a patent (No. 9,112,832) for a “System and Method Running a Web Server on a Mobile Internet Device” on August 18, 2015. This patent is incorporated into our secure communication platform and covers the Tiny Web Server, which is also a component of our secure communication platform.

 

The USPTO granted us a patent (U.S. Patent No. 9,710,425) for a “Mobile Proxy Server for Internet Server Having a Dynamic IP Address” on July 8, 2017. The term “IP” stands for “Internet Protocol,” which is the principal communications protocol for the Internet. This patented technology is incorporated in the Company’s PCP and its products.

 

We also have several patent-pending software technologies and licensed software:

 

In 2011, we filed two provisional applications for patents relating to our patent application filed in 2010 and these have been replaced with non-provisional patent applications which were filed in 2012, one of which is still pending.

 

In 2013, we filed six patent applications (including provisional patent applications).

 

In 2014, we filed two provisional patent applications, which have been replaced with non-provisional patent applications and filed in 2015. These patent applications are still pending.

 

The Company acquired rights for U.S. Patent No. 8,903,371 (cellular telephone system and method), which was issued on December 2, 2014 under an assignment from Luiz Valdetaro, a co-inventor who is also an employee and the Chief Technology Officer of the Company.

 

Although we intend to protect our intellectual property rights as described above, there can be no assurance that these measures will be successful.  Policing unauthorized use of our products and services is difficult and the steps taken may not prevent the misappropriation of our technology intellectual property rights.  In addition, effective patent, trademark, trade secret and copyright protection may be unavailable or limited in certain foreign countries.  We seek to protect the source code of some of our products as trade secrets and as unpublished copyright works.  Source code for certain products has been or will be published in order to obtain patent protection or to register copyright in such source code.  We believe that our products, trademarks and other proprietary rights do not infringe on the proprietary rights of third parties.  There can be no assurance that third parties will not assert infringement claims against us in the future with respect to current or future features or content of services or products or, if so asserted that any such claims will not result in litigation or require us to enter into royalty arrangements.

 

Regulatory Environment; Public Policy

 

In the United States and most countries in which we conduct our operations, we are generally not regulated other than pursuant to laws applicable to businesses in general and value-added services specifically. In some countries, we are subject to specific laws regulating the availability of certain material related to, or to the obtaining of, personal information. Adverse developments in the legal or regulatory environment relating to the interactive online services and Internet industry in the United States, Canada, Europe, Asia, Latin America or elsewhere could have a material adverse effect on our business, financial condition and operating results. A number of legislative and regulatory proposals from various international bodies and foreign and domestic governments in the areas of telecommunications regulation, particularly related to the infrastructures on which the Internet rests, access charges, encryption standards and related export controls, content regulation, consumer protection, advertising, intellectual property, privacy, electronic commerce, and taxation, tariff and other trade barriers, among others, have been adopted or are now under consideration. We are unable at this time to predict which, if any, of the proposals under consideration may be adopted and, with respect to proposals that have been or will be adopted, whether they will have a beneficial or an adverse effect on our business, financial condition and operating results.

 

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Employees

 

As of May 10, 2018, we had 19 full-time and 4 part-time employees (16 are employed in the United States and 7 in Canada), 1 full-time consultant and 1 part-time consultant. We are not a party to any collective bargaining agreements.

 

Item 1A. Risk Factors

 

Risk Factors Related to Our Business, Operating Results and Financial Condition

 

We are subject to various risks that may materially harm our business, financial condition and results of operations. You should carefully consider the risks and uncertainties described below and the other information in this filing before deciding to purchase our common stock. If any of these risks or uncertainties actually occurs, our business, financial condition or operating results could be materially harmed. In that case, the trading price of our common stock could decline and you could lose all or part of your investment.

 

We Have Historically Incurred Losses and May Continue to Do So in the Future.

 

We had a net loss before non-controlling interest of $3,302,089 and $5,466,230 for the years ended December 31, 2017 and 2016, respectively, and have historically incurred losses. Accordingly, we have and may continue to experience significant liquidity and cash flow problems because our operations are not profitable. No assurances can be given that we will be successful in reaching or maintaining profitable operations.

 

We Have Been Subject to a Going Concern Opinion from Our Independent Auditors, Which Means That We May Not Be Able to Continue Operations Unless We Obtain Additional Funding.

 

The report of our independent registered public accounting firm included an explanatory paragraph in connection with our financial statements for the years ended December 31, 2017 and 2016. This paragraph states that our recurring net losses, negative working capital and accumulated deficit, the substantial funds used in our operations and the need to raise additional funds to accomplish our objectives raise substantial doubt about our ability to continue as a going concern. Our ability to develop our business plan and to continue as a going concern depends upon our ability to raise capital, to succeed in the licensing of our intellectual property and to achieve improved operating results. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

Our Ability to Continue as a Going Concern Is Dependent on Our Ability to Raise Additional Funds and to Establish Profitable Operations.

 

The accompanying consolidated financial statements for the years ended December 31, 2017 and 2016 have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.

 

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We have suffered significant recurring operating losses, used substantial funds in our operations, and need to raise additional funds to accomplish our objectives. Stockholders’ deficit at December 31, 2017 was $34.0 million. Additionally, at December 31, 2017, we had negative working capital of approximately $21.0 million (although it includes deferred revenue of approximately $1.8 million) and have defaulted on substantially all our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

 

Our Success Depends On Our Ability to Generate Sufficient Revenues to Pay for the Expenses of Our Operations.

 

We believe that our success will depend upon our ability to generate revenues from our secure communication platform, SiteFlash™ and Emily™ technology products through licensing and development of commercially viable products , as well as increased revenues from NOW Solutions’ products and services as well as the successful launch of our new products by our subsidiaries (such as SnAPPnet™, and PTS™, Emily™ and web server applications), none of which can be assured. Our ability to generate revenues is subject to substantial uncertainty and our inability to generate sufficient revenues to support our operations and debt repayment could require us to curtail or suspend operations. Such an event would likely result in a decline in our stock price.

 

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Our Success Depends On Our Ability to Obtain Additional Capital.

 

We have funding that is expected to be sufficient to fund our present operations for three months. However, we will need significant additional funding in order to complete our business plan objectives. Accordingly, we will have to rely upon additional external financing sources to meet our cash requirements. Management will continue to seek additional funding in the form of equity or debt to meet our cash requirements. Other than common or preferred stock in our subsidiaries, we do not have any common stock available to issue to raise money. However, there is no guarantee we will raise sufficient capital to execute our business plan. In the event that we are unable to raise sufficient capital, our business plan will have to be substantially modified and operations curtailed or suspended.

 

We Have a Working Capital Deficit, Which Means That Our Current Assets on December 31, 2017 Were Not Sufficient to Satisfy Our Current Liabilities on That Date.

 

We had a working capital deficit of approximately $21.0 million at December 31, 2017, which means that our current liabilities exceeded our current assets by approximately $21.0 million (although it includes deferred revenue of approximately $1.8 million). Current assets are assets that are expected to be converted into cash within one year and, therefore, may be used to pay current liabilities as they become due. Our working capital deficit means that our current assets on December 31, 2017 were not sufficient to satisfy all of our current liabilities on that date.

 

Our Operating Results May Fluctuate Because of a Number of Factors, Many of Which Are Outside of Our Control.

 

Our operating results may fluctuate significantly as a result of variety of factors, many of which are outside of our control. These factors include, among others, the following:

 

the demand for our SiteFlash™, Emily™ and other proprietary technologies;

the demand for our administrative software products and services: emPath®, PTS™, and SnAPPnet™;

the demand for our personal secure communication application Ploinks ® and Ploinks SPC™;

introduction of new products and services by us and our competitors;

costs incurred with respect to acquisitions;

price competition or pricing changes in the industry;

technical difficulties or system failures;

general economic conditions and economic conditions specific to the Internet and Internet media and communication platforms; and

the licensing of our intellectual property;

government regulations.

 

We Face Product Development Risks Due to Rapid Changes in Our Industry. Failure to Keep Pace with These Changes Could Harm Our Business and Financial Results.

 

The markets for our products are characterized by rapid technological developments, continually-evolving industry trends and standards and ongoing changes in customer requirements. Our success depends on our ability to timely and effectively keep pace with these developments.

 

Keeping Pace with Industry Changes.  

 

We must enhance and expand our product offerings to reflect industry trends, new technologies and new operating environments as they become increasingly important to customer deployments. We must continue to expand our business models beyond traditional software licensing and subscription models, including, by way of example, use of cloud based offering as an increasingly important method and business model for the delivery of applications. We must also continuously work to ensure that our products meet changing industry certifications and standards. Failure to keep pace with any changes that are important to our customers could cause us to lose customers and could have a negative impact on our business and financial results.

 

Impact of Product Development Delays or Competitive Announcements.  

 

Our ability to adapt to changes can be hampered by product development delays. We may experience delays in product development as we have at times in the past. Complex products like ours may contain undetected errors or version compatibility problems, particularly when first released, which could delay or adversely impact market acceptance. We may also experience delays or unforeseen costs associated with integrating products we acquire with products we develop because we may be unfamiliar with errors or compatibility issues of products we did not develop ourselves. We may choose not to deliver a partially-developed product, thereby increasing our development costs without a corresponding benefit. This could negatively impact our business.

 

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Our Failure to Maintain and Increase Acceptance of Our Cloud-Based Offerings Would Inhibit Our Growth Or Cause a Significant Decline in Our Revenues.

 

Our future success depends on maintaining and increasing acceptance of our cloud-based offering, particularly, of emPath® and PTS™. Any decrease in the demand for these products would have a material adverse effect on our business, operating results and financial condition and would place a significant strain on our management and operations.

 

If We Are Unable to Make Periodic Updates for Our Products Concerning Changes in Tax Laws and Other Regulations on a Timely Basis Acceptance of Our Products in the Market could Be Adversely Affected And Our Revenues Would Decline.

 

Products like emPath® are affected by changes in tax laws and regulations, and we must generally update such products on an annual or periodic basis to maintain their accuracy and competitiveness. We cannot be certain we will be able to release these updates on a timely basis in the future. Any failure to do so could have a material adverse effect on the acceptance of our products. Additionally, any significant changes in tax laws or regulations applicable to such products could require us to make significant investments in modifications of these products, leading to significant and unexpected costs.

 

Errors and Defects in Our Software Could Affect Sales of Our Products.

 

The software products we offer may contain undetected errors, defects, or failures when first introduced or as new versions are released. Testing of software products presents many challenges since it is difficult to anticipate and simulate the wide range of software computing environments in which our customers use these products. While we test our products extensively, from time-to- time, we have discovered errors or defects in our products. These defects and errors may result in any of the following:

 

Delays in the release of our new products, versions and upgrades

Increased costs to fix such defects and errors, in turn leading to a strain on our software development resources

Design modifications of the product

A decrease in customer satisfaction with, our products and a decrease in sales, and a loss of existing and potential customers

 

Even after our products are tested by us and by current and prospective customers, errors and defects may be discovered after the commercial release has commenced, which may result in loss of or delay in market acceptance which could have a material adverse impact upon our business, operating results and financial condition.

 

Our software products may be vulnerable to break-ins and similar disruptive problems; addressing these issues may be expensive and require a significant amount of our resources.

 

We have included security features in our products that are intended to protect the privacy and integrity of customer data. Despite the existence of these security features, our software products may be vulnerable to break-ins and similar disruptive problems. Addressing these evolving security issues may be expensive and require a significant amount of our resources.

 

The Sale and Support of Software Products and the Performance of Related Services by Us Entail the Risk of Product or Service Liability Claims, Which Could Significantly Affect Our Financial Results.

 

Customers use our products in connection with the preparation and filing of tax returns and other regulatory reports. If any of our products contain errors that produce inaccurate results upon which users rely, or cause users to misfile or fail to file required information, we could be subject to liability claims from users. Our cloud-based usage licenses and maintenance renewal agreements with our customers typically contain provisions intended to limit our liability to such claims, but such provisions may not be effective in doing so. These contractual limitations may not be legally enforceable and may not afford us with adequate protection against product liability claims in certain jurisdictions. If a successful claim for product or service liability was brought against us, this could result in substantial cost to us and divert management’s attention from our operations.

 

International Operations of Our Business Subject Us to Additional Risks in Those Foreign Countries.

 

Our international operations are subject to additional risks, which increase our exposure to foreign laws and regulations. Over time, our international operations may grow and increase their significance to our business.  Sales to international customers subject our business to a number of risks, including foreign currency fluctuations, unexpected changes in regulatory requirements related to software, international political and economic instability, international tax laws, compliance with multiple, changing, and possibly conflicting governmental laws and regulations, and difficulty in staffing and managing foreign operations,. In addition, there may be weaker protection for our intellectual property abroad than in the United States, and we may have difficulties in enforcing such rights abroad.  If we are not able to comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potentially become involved in litigation. In addition, in the event sales to any of our customers outside of the United States are delayed or canceled because of any of the risks described above, our revenues may be negatively impacted.

 

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Security and Privacy Breaches Could Adversely Impact Our Business.

 

                For services such as our cloud-based offerings, we may electronically store personal information about our clients and their employees.  We take security measures to protect against the unauthorized access and disclosure of such information.  However, there is no guarantee the precautions we take will be successful in protecting against all security breaches that may result in unauthorized access to such information.  If our security measures are breached or if our services are subject to attacks that degrade or deny the ability of our clients to access our services, we may incur significant financial, legal, and regulatory exposure.

 

Privacy Concerns Could Result in Changes of Regulations or Laws That Affect Our Business.

 

Personal privacy is a significant issue in the United States as well as in other countries where our customers operate. Consequently, we are subject to regulations concerning the use of personal information we collect. Changes to regulations or laws affecting privacy that apply to our business could impose additional costs and potential liability on us and could also limit our use and disclosure of such information.  If we are required to change our business activities or revise or eliminate services, our business could be adversely affected.

 

We May Have Difficulty Managing Our Growth and Integrating Recently Acquired Companies.

 

Our recent growth through acquisitions and licensing of new solutions, coupled with our development efforts to create new commercially viable products and improve existing ones, has placed a significant strain on our managerial, operational, and financial resources. To manage our growth, we must continue to implement and improve our operational and financial systems and to expand, train, and manage our employee base. Any inability to manage growth effectively could have a material adverse effect on our business, operating results, and financial condition. Further, acquisition transactions are accompanied by a number of risks, including the following:

 

the difficulty of assimilating the operations and personnel of the acquired companies;

the potential disruption of our ongoing business and distraction of management;

the difficulty of incorporating acquired technology or content and rights into our products and media properties;

the correct assessment of the relative percentages of in-process research and development expense which needs to be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset;

the failure to successfully develop an acquired in-process technology resulting in the impairment of amounts currently capitalized as intangible assets;

unanticipated expenses related to technology integration;

the maintenance of uniform standards, controls, procedures and policies;

the impairment of relationships with employees and customers as a result of any integration of new personnel; and

the potential unknown liabilities associated with acquired businesses.

 

We may not be successful in addressing these risks or any other problems encountered in connection with acquisitions. Our failure to address these risks could negatively affect our business operations through lost opportunities, revenues or profits, any of which would likely result in a lower stock price.

 

Our Success Depends On Our Ability to Protect Our Proprietary Technology.

 

Our success is dependent, in part, upon our ability to protect and leverage the value of proprietary technology, including our private communications platform technology (which includes the Ploinks® and Ploinks SPC™ products), our patented SiteFlash™ and Emily™ technologies, our patent-pending technologies and administrative software solutions like emPath®, PTS™, and SnAPPnet™, as well as our trade secrets, trade names, trademarks, service marks, domain names and other proprietary rights we either currently have or may have in the future. Given the uncertain application of existing trademark laws to the Internet and copyright laws to software development, there can be no assurance that existing laws will provide adequate protection for our technologies, sites or domain names. Policing unauthorized use of our technologies, content and other intellectual property rights entails significant expenses and could otherwise be difficult or impossible to do given the global nature of the Internet and our potential markets.

 

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If Demand for Our Products Grow Quickly, We May Lack the Capacity Needed to Meet Demand or We May Be Required to Increase Our Capital Spending Significantly.

 

Our current plans may not be sufficient to meet our capacity needs for the foreseeable future or may not be implemented quickly enough to meet growing demand. Moreover, if we make significant capital expenditures to increase capacity and demand does not increase as we expect, these expenditures would adversely affect our profitability and return on capital.

 

Our Stock Price Has Historically Been Volatile, Which May Make It More Difficult for Shareholders to Resell Shares When They Choose To At Prices They Find Attractive.

 

The trading price of our common stock has been and may continue to be subject to wide fluctuations. The stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new products and media properties by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable, and news reports relating to trends in our markets. In addition, the stock market in general, and the market prices for Internet-related and technology-related companies in particular, have experienced extreme volatility that often has been unrelated to the operating performance of such companies. These broad market and industry fluctuations may adversely affect the price of our stock, regardless of our operating performance.

 

Our Common Stock Is Deemed To Be “Penny Stock,” Which May Make It More Difficult for Investors to Sell Their Shares Due To Suitability Requirements.

 

Our common stock is deemed to be “penny stock” as that term is defined in Rule 3a51-1 promulgated under the Exchange Act. Penny stocks are stocks:

 

1. With a price of less than $5.00 per share;

2. That are not traded on a recognized national exchange;

3. Whose prices are not quoted on the NASDAQ automated quotation system (NASDAQ listed stock must have a price of not less than $5.00 per share); or

4. In issuers with net tangible assets less than $2 million (if the issuer has been in continuous operation for at least three years) or $5 million (if in continuous operation for less than three years), or with average revenues of less than $6 million for the last three years.

 

Broker/dealers dealing in penny stocks are required to provide potential investors with a document disclosing the risks of penny stocks. Moreover, broker/dealers are required to determine whether an investment in a penny stock is a suitable investment for a prospective investor. These requirements may reduce the potential market for our common stock by reducing the number of potential investors. This may make it more difficult for investors in our common stock to sell shares to third parties or to otherwise dispose of them. This could cause our stock price to decline.

 

Item 2. Properties

 

The Company and NOW Solutions’ headquarters are currently located at 101 West Renner Road, Suite 300, Richardson, Texas, and comprise approximately 4,000 square feet. NOW Solutions has other offices at 6205 Airport Road, Building B, Suite 214, Mississauga, Ontario, Canada, which comprises 793 square feet. These locations are leased from third parties and the premises are in good condition. We believe that our facilities are adequate for our present needs and near-term growth, and that additional facilities will be available at acceptable rates as we need them. Our other subsidiaries may be reached through our Richardson, Texas headquarters.

 

Item 3. Legal Proceedings

 

We are involved in the following ongoing legal matters:

 

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

 

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On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122 . William Mills is a partner of Parker Mills and the Secretary and a Director of the Company. The Company has $121,617 of principal and interest accrued as of December 31, 2017.

 

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 $298,016 of principal and accrued interest as of December 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.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

18

 

 

PART II

 

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

 

Our common equity is traded on the OTC Markets and quoted on the OTCQB under the symbol “VCSY.” The OTCQB may also be referred to as “OTCMKTS” or “Other OTC”.

 

The following is the range of high and low closing bid prices of our stock, for the periods indicated below.

 

      High     Low  
               
Quarter Ended December 31, 2017     $ 0.0180     $ 0.0120  
Quarter Ended September 30, 2017     $ 0.0158     $ 0.0115  
Quarter Ended June 30, 2017     $ 0.0200     $ 0.0112  
Quarter Ended March 31, 2017     $ 0.0290     $ 0.0193  
Quarter Ended December 31, 2016     $ 0.0475     $ 0.0121  
Quarter Ended September 30, 2016     $ 0.0480     $ 0.0205  
Quarter Ended June 30, 2016     $ 0.0370     $ 0.0226  
Quarter Ended March 31, 2016     $ 0.0300     $ 0.0176  

 

 

The above quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

 

Number of Holders

 

As of May 10, 2018, there were 1,939 holders of record of VCSY common stock.

 

Equity Securities Under Compensation Plans

 

Equity Compensation Plan Information
Plan category     Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
    Weighted-average
exercise price of
outstanding options,
warrants and rights
    Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a))
 
      (a)       (b)       (c)  
Equity compensation plans approved by security holders                  
Equity compensation plans not approved by security holders                        
Stock Options                  
Warrants                  
Unvested Restricted Stock Awards     6,640,000     $ 0.02        
Total     6,640,000     $ 0.02        

 

  (1) Other than individual agreements with employees, directors and third-party consultants, we do not have any equity compensation plans (i.e., stock option plans or restricted stock plans) that have been approved by security holders.

 

  (2) No stock options were issued to employees or consultants during the year ended December 31, 2017.

 

  (3) No warrants to purchase common stock were issued to employees or consultants during the year ended December 31, 2017.

 

  (4)

Of the 6,640,000 common shares of restricted stock that had not vested at December 31, 2017 and were issued in connection with individual restricted stock agreements executed in 2016 and 2017 with employees of the Company and its subsidiaries, 320,000 have vested through May 10, 2018.

  

19

 

 

Dividends

 

We have outstanding shares of Series A and Series C 4% Convertible Cumulative Preferred stock that accrue dividends (if such dividends are declared) at a rate of 4% on a semi-annual basis. The total dividends applicable to Series A and Series C Preferred Stock were $616,667 and $592,472 for the years ended December 31, 2017 and 2016, respectively. Our Board of Directors did not declare any dividends on our outstanding shares of Series A or Series C Preferred Stock during 2017 or 2016, nor has the Company paid any dividends on our outstanding shares of Series A or Series C Preferred Stock since 2001. We intend to retain future earnings, if any, to provide funds for use in the operation and expansion of our businesses. Accordingly, we do not anticipate paying cash dividends on any of our capital stock, including preferred stock, in the near future. For additional information concerning dividends, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

 

Unregistered Sales of Securities

 

During the last two years, we issued the following unregistered securities:

 

In March 2016, the Company cancelled 1,000,000 unregistered shares of its common stock issued during 2015 to a third party lender under an agreement to amend certain promissory notes issued by the Company and NOW Solutions in the aggregate principal amount of $715,000. Under the amendment, the Company agreed to make $22,000 monthly payments and an additional $10,000 penalty if such monthly payment is not timely made.

 

In March 2016, the Company issued 10,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to its consolidated subsidiary Ploinks, Inc. These shares are held in treasury. In exchange, Ploinks, Inc. issued 5,000,000 of its common shares to the Company.

 

In April 2016, the Company and a third-party noteholder entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend in exchange for the cancellation of $130,000 in principal owed under a note payable issued by NOW Solutions with a principal amount of $213,139. The fair market value of the shares was $92,500. A gain on debt extinguishment of $37,500 was recorded for the year ended December 31, 2016.

 

In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed for services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. Mr. Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

 

In May 2016, the Company and a third party entered into an agreement under which the Company issued 1,500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to the third party in lieu of paying $35,969 in fees, expenses, and interest owed to the third party for services rendered to the Company and its subsidiaries.  The fair market value of the shares issued was $37,500.  A loss on debt extinguishment of $1,531 was recorded for the year ended December 31, 2016.

 

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

 

During the year ended December 31, 2016, the Company issued 3,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to third-party consultants for services. The fair market value of the shares was $66,550 and was recorded as consulting fees for the year ended December 31, 2016.

 

20

 

 

During the year ended December 31, 2016, the Company issued convertible debentures in the aggregate principal amount of $715,000 to various third-party lenders for loans made to the Company in the same amount. The debts accrue interest at 10% per annum and are due one year from the date of issuance. Beginning six months after issuance of the respective debentures and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company’s common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loans, the Company also issued a total of 7,150,000 shares of common stock of the Company to the lenders with the Rule 144 restrictive legend and 3-year warrants under which each lender may purchase in aggregate a total of 7,150,000 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 $186,967 against the face value of the loans based on the relative fair market value of the common stock of $114,413 and the full fair market value of the warrants of $72,554. The warrants are accounted for as derivative liabilities. The discount is being amortized over twelve months and amortization expense was recognized for the year ended December 31, 2016.

 

During the year ended December 31, 2016, $82,001 of principal, interest and fees under a convertible note issued in the principal amount of $80,000 were converted into 5,914,783 unrestricted common shares of the Company.

 

During the year ended December 31, 2016, the Company entered into subscription agreements under which third party subscribers purchased 3,000 shares of VCSY Series A Preferred Stock for $600,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 6,000,000 shares of common stock of the Company with the Rule 144 restrictive legend, 300,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscribers may purchase an aggregate total of 450,000 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 450,000 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 $366,499. 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 $229,496. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $3,416. The fair market value of all warrants issued to the subscribers was $4,005 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

 

During the year ended December 31, 2016, the Company cancelled 200,000 previously awarded but unvested unregistered shares of the Company’s common stock issued to an employee of the Company when the employee resigned. This resulted in the reversal of previously recognized compensation expense of $1,145 during the year ended December 31, 2016.

 

During the year ended December 31, 2016, the Company granted 18,250,000 unregistered shares of its common stock pursuant to restricted stock agreements. Shares under restricted stock agreements typically vest over a period of 1-3 years in various installments and the fair value of the awards is being expensed over the vesting periods. The aggregate fair market value of the awards was determined to be $361,365. Stock compensation expense of $229,223 has been recorded for the year ended December 31, 2016 as additional paid-in capital.

 

Stock compensation expense for the amortization of restricted stock awards for VCSY stock was $229,223 for the year ended December 31, 2016. As of December 31, 2016, there were 13,125,000 shares of unvested VCSY common stock compensation awards to employees and consultants.

 

During the year ended December 31, 2016, 7,175,000 VCSY common shares issued under restricted stock agreements to employees of the Company were vested.

 

During the year ended December 31, 2016, the Company granted 150,000 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 $500,000 issued in 2015. The aggregate fair market value of the awards was determined to be $16,200 and was recorded as debt discount and amortized through the term of the note.

 

During the year ended December 31, 2016, Ploinks, Inc. granted 1,000,000 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 3 years in various installments and the fair value of the awards is being expensed over this vesting period. The aggregate fair market value of the awards was determined to be $108,000. Stock compensation expense of $70,800 has been recorded for the year ended December 31, 2016.

 

During the year ended December 31, 2016, the Company granted 4,286,000 unregistered shares of the common stock of Ploinks, Inc. to employees and consultants of the Company and its subsidiaries pursuant to restricted stock agreements with the Company. These shares typically vest over 3 years in various installments and the fair value of the awards is being expensed over this vesting period. The aggregate fair market value of the awards was determined to be $462,888. Stock compensation expense of $264,227 has been recorded for the year ended December 31, 2016. These shares were issued out of shares owned by VCSY.

 

21

 

 

During the year ended December 31, 2016, 2,332,001 unregistered shares of the common stock of Ploinks, Inc. to employees and consultants of the Company and its subsidiaries granted under restricted stock agreement vested.

 

During the year ended December 31, 2016, 133,334 unregistered shares of the common stock of Ploinks, Inc. granted to an employee of the Company under a restricted stock agreement were cancelled.

 

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 consisted 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.

 

In December 2017, in order to facilitate the amendment of the Lakeshore Loan Agreement and the Lakeshore Note, which resulted in the curing any existing defaults under the Lakeshore Loan Agreement and the Lakeshore Note as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time which secured the Lakeshore Note, the Company issued 2,500,000 VCSY common shares at a fair market value of $35,400 and 300,000 Ploinks common shares at a fair market value of $92,850 to third party purchasers of 600,000 shares of VHS Series A Preferred Stock from a member of Lakeshore. For additional details concerning the amendment of the Lakeshore Loan and the Lakeshore Note, please see the “Lakeshore Financing” subsection under “Notes Payable and Convertible Debts” of Note 8.

 

During the year ended December 31, 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 year ended December 31, 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 year ended December 31, 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).

 

22

 

 

During the year ended December 31, 2017, the Company granted a total of 651,700 shares of the common stock of Ploinks, Inc. to third party lenders in connection with a series of 3 and 6-month extensions of convertible debentures in the aggregated principal amount of $1,200,000 issued in 2015 and 2016. The aggregate fair market value of the awards was determined to be $142,156 and was recorded as debt discount and is being amortized through the term of the convertible debenture. Certain notes issued in the prior year(s) become convertible during 2017. Consequently, the embedded conversion feature was determined to be derivative liabilities, and the Company recognized a derivative debt discount.

 

During the year ended December 31, 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 year ended December 31, 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 year ended December 31, 2017.

 

During the year ended December 31, 2017, 3,665,000 VCSY common shares vested under restricted stock agreements to employees and two consultants of the Company.

 

During the year ended December 31, 2017, 3,000,000 VCSY common shares were issued to an employee of the Company. The fair market value of the shares was $72,000.

 

During the year ended December 31, 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 year ended December 31, 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 year ended December 31, 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 year ended December 31, 2017 $27,482 was amortized to expense related to the issuance of Ploinks, Inc. restricted stock.

 

During the year ended December 31, 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 $116,180 for the year ended December 31, 2017. As of December 31, 2017, there were 6,140,000 shares of unvested stock compensation awards to employees and 15,500,000 shares of unvested stock compensation awards to non-employees.

 

During the period that runs from January 1, 2018 through May 10, 2018, the Company extended the term of certain warrants to purchase a total of 5,400,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted 83,200 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with 3 and 6-month extensions of convertible debentures in the principal amount of $540,000 that were issued in 2015 and 2016.

 

During the period that runs from January 1, 2018 through May 10, 2018, 320,000 shares of VCSY common stock issued to employees of the Company vested.

 

During the period that runs from January 1, 2018 through May 10, 2018, 209,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

23

 

 

Item 6. Selected Financial Data

 

Not applicable.

 

Item 7. 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 our results of operations, liquidity and capital resources. The following discussion and analysis should be read together with the Consolidated Financial Statements and Notes of Vertical Computer Systems, Inc. and its subsidiaries included in Item 8 of this Report, and the cautionary statements and risk factors included in Item 1A of this Report.

 

Critical Accounting Policies

 

Capitalized Software Costs

 

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value. During the year ended December 31, 2017 and 2016, $0 and $246,184 of internal costs were capitalized, respectively.

 

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.

 

24

 

 

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 a third party to provide new and existing customers with a hosting facility providing all infrastructure and allowing us to offer our currently sold software, emPath®, 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 require 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 issued and the quoted price of our common stock. See Note 10 of the Consolidated Financial Statements for a further discussion of stock-based compensation.

 

25

 

 

Valuation of the Embedded and Warrant Derivatives

 

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

 

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

 

Recently Issued Accounting Pronouncements

 

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

 

In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients , to clarify certain core recognition principles including collectability, sales tax presentation, noncash consideration, contract modifications and completed contracts at transition and disclosures no longer required if the full retrospective transition method is adopted. The effective date and transition requirements for these amendments are for annual reporting periods beginning after December 15, 2017, including interim reporting periods therein, and that would also permit public entities to elect to adopt the amendments as of the original effective date as applicable to reporting periods beginning after December 15, 2016. The new guidance allows for the amendment to be applied either retrospectively to each prior reporting period presented or retrospectively as a cumulative-effect adjustment as of the date of adoption. The Company adopted the standard on January 1, 2018 and does not anticipate this amendment will have a material impact on its consolidated financial statements.

 

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

 

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

 

Results of Operations

 

Year ended December 31, 2017 Compared To Year Ended December 31, 2016

 

Total Revenues. We had total revenues of $3,770,326 and $3,827,675 for the years ended December 31, 2017 and 2016, respectively. The decrease in total revenue was $57,349 for the year ended December 31, 2017, representing a 1.5% decrease compared to the total revenue for the year ended December 31, 2016. The decrease in revenue was primarily due to a $97,331 decrease in software maintenance, a $65,174 decrease in cloud-based offering somewhat offset by a $114,259 increase in consulting services. Of the $3,770,326 and $3,827,675 total revenues for the years ended December 31, 2017 and 2016, respectively, $3,732,608 and $3,768,420 of such amounts were related to the business operations of NOW Solutions, a 75% owned subsidiary of the Company.

 

The revenues from licenses and software consist of fees we bill for NOW Solutions’ new payroll and human resources (“ PRHR ”) software licenses. These fees decreased $18,479 for the year ended December 31, 2017 compared to the year ended December 31, 2016.

 

Software maintenance revenue is generated from existing customers of our PRHR software who want the continued benefit of tax updates, customer support, and software enhancements. Software maintenance revenue decreased by $97,331 or 3.0% from the year ended December 31, 2016 to the same period in 2017. The decrease was due to the loss of customer contracts somewhat offset by the effect of favorable currency exchange rates on our Canadian maintenance revenue.

 

Consulting revenue for the year ended December 31, 2017 increased by $114,259 from the same period in the prior year, representing a 40.6% increase. This increase was primarily due to a rise in Canadian customer needs for software upgrade implementation and customization and the effect of favorable currency exchange rates on our Canadian consulting revenue in 2017.

 

Cloud-based revenue decreased $65,174 or 23.3% for the year ended December 31, 2017 compared to the same period in 2016. The decrease was primarily related to user base adjustments for our Canadian cloud-based customers.

 

Other revenues, consisting primarily of reimbursable travel expenses, increased by $9,376 or 75.0% for the year ended December 31, 2017 compared to the same period for 2016. The increase was mainly attributable to higher reimbursable travel in 2017 due to increased consultant travel.

 

Cost of Revenues. We had direct costs associated with the above revenues of $1,574,645 for the year ended December 31, 2017 compared to $1,524,853 for the same period of 2016, representing an increase of $49,792 or 3.3%. These direct costs are primarily related to costs providing customer support, professional services, software upgrades and enhancements. The increase in direct costs is primarily related to increased payroll and hosting fees for the year ended December 31, 2017 compared to the same period for 2016.

 

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Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $4,311,088 and $3,871,572 for the years ended December 31, 2017 and 2016, respectively. The total selling, general and administrative expenses for the year ended December 31, 2017 increased by $439,516 compared to the selling, general and administrative expenses for the year ended December 31, 2016, representing an 11.4% increase. The increase was primarily due to increases in salaries and benefits (as we did not capitalize salaries in 2017 vs 6 months of capitalized salaries in 2016) and penalties partially offset by decreases in consulting expenses, non-cash stock compensation and legal fees.

 

Depreciation and Amortization . We had depreciation and amortization of $1,453 for 2017 compared to $1,083 in 2016. The increase is due to depreciation on computer equipment purchased in 2017.

 

Bad Debt Expense . We had bad debt expense of $93,757 for 2017 compared to $98,896 in 2016. The 2017 and 2016 expenses were related to a reserve for several customer accounts greater than 90 days past due.

 

Impairment of Software Costs. For the year ended December 31, 2016, $1,421,155 of capitalized software development costs related to Ploinks development was written off as impaired.

 

Operating Loss. We had an operating loss of $2,210,617 for the year ended December 31, 2017 compared to operating loss of $3,089,884 for the year ended December 31, 2016, a difference of $879,267. The decrease in operating loss between 2017 and 2016 is primarily a result the impairment of Ploinks ® development costs in 2016 partially offset by increased selling, general and administrative expenses.

 

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 liability was $879,780 for the year ended December 31, 2017 compared to a loss on derivative liability of $268,728 for the year ended December 31, 2016.

 

Interest Expense . We had interest expense of $1,819,147 and $1,998,762 for the years ended December 31, 2017 and 2016, respectively. Interest expense decreased for the year ended December 31, 2017 by $179,615, representing a 9.0% decrease compared to interest expense for the year ended December 31, 2016. The decrease was primarily due to fully amortized debt discounts related to convertible debentures.

 

Interest Income. Interest income for the year ended December 31, 2017 was $21 compared to $53 for the year ended December 31, 2016.

 

Forbearance Fees . Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the year ended December 31, 2017 were $12,000 compared to $58,500 for the same period in 2016. Forbearance fees for 2017 related a lender of Vertical Healthcare Solutions. Forbearance fees for 2016 related to lenders of VCSY and NOW Solutions.

 

Gain/Loss on Extinguishment of Debt. For the year ended December 31, 2017, we had a $128,250 loss on extinguishment of debt. The loss relates to the fair market value of VCSY and Ploinks’ stock issued to third-party investors as incentive to purchase Vertical Healthcare Solutions preferred stock from NOW Solutions senior secured lender. For the year ended December 31, 2016, we had a gain of $35,969. The gain relates to the fair market value of 5 million shares of VCSY common stock issued to a NOW Solutions lender to settle a portion of debt principal.

 

Net Loss before Income Tax Expense. We had a net loss before income tax expense of $3,290,213 for the year ended December 31, 2017 compared to a net loss of $5,379,852 for the year ended December 31, 2016. The net loss before income tax expense for 2017 was primarily due to an operating loss of $2,210,617 increased by $12,000 of forbearance fees, loss on debt extinguishment of $128,250 and interest expense of $1,819,147, partially reduced by a gain on derivative liabilities of $879,780. The net loss before income tax expense for 2016 was primarily due to an operating loss of $3,089,884 increased by $58,500 of forbearance fees, loss on derivative liabilities of $268,728 and interest expense of $1,998,762.

  

Income Tax Expense/Benefit . We had income tax expense of $11,876 and $86,378 for the year ended December 31, 2017 and 2016, respectively. Income taxes expense for both years relates to NOW Solutions, a 75% owned subsidiary of the Company.

 

Dividend Applicable to Preferred Stock. The Company has outstanding Series A 4% Convertible Cumulative Preferred Stock that accrue dividends (if such dividends are declared) at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% Convertible Cumulative Preferred Stock that accrue dividends (if such dividends are declared) at a rate of 4% on a quarterly basis. For the years ended December 31, 2017 and 2016, the total dividends applicable to Series A and Series C Preferred Stock (from prior years) were $616,667 and $592,472, respectively. The Company did not declare or pay any dividends in 2017 or 2016.

 

27

 

 

Net Loss Applicable to Common Stockholders. We had net loss attributed to common stockholders of $3,686,908 and $5,870,223 for the years ended December 31, 2017 and 2016, respectively. Net loss applicable to common stockholders for the year ended December 31, 2017 decreased by $2,183,315 compared to December 31, 2016. The net loss applicable to common stockholders was due to the combination of factors described above.

 

Net Loss Per Share. The Company had a net loss per share of $0.00 and $0.01 for the years ended December 31, 2017 and 2016, respectively.

 

Financial Condition, Liquidity, Capital Resources and Recent Developments

 

At December 31, 2017, we had non-restricted cash-on-hand of $62,084 compared to $190,448 at December 31, 2016.

 

Net cash used in operating activities for the year ended December 31, 2017 was $685,677 compared to net cash used in operating activities of $486,755 for the year ended December 31, 2016.

 

The majority of 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. During 2017, our deferred maintenance revenue (a liability) decreased slightly from $1,794,264 to $1,752,421. The decrease was primarily due to a decrease in deferred revenue for non-renewal of maintenance for certain US customers partially offset by an increase in Canadian deferred revenue due to currency exchange rates.

 

Our accounts receivable decreased from $367,278 at December 31, 2016 to $349,002 at December 31, 2017 (net of allowance for bad debts). The decrease in receivables of $18,276 was primarily due to faster collections on Canadian receivables.

 

Accounts payable, accounts payable to related parties and accrued liabilities increased from $12,214,844 at December 31, 2016 to $14,271,154 at December 31, 2017. The increase of $2,056,310 was primarily related to an increase in accounts payable, accrued payroll, accrued payroll taxes/penalties and accrued interest on notes payable. The balance in accounts payable and accrued liabilities is approximately 40.9 times the balance in accounts receivable. This is one of the reasons we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

 

Net cash used in investing activities for the year ended December 31, 2017 was $5,568 consisting of the purchase of computer equipment. Net cash used in investing activities for the year ended December 31, 2016 was $249,989 consisting of the development of software products and purchase of computer equipment.

 

Net cash provided by financing activities for the year ended December 31, 2017 was $580,795 consisting of borrowings on notes payable of $370,500, borrowings on convertible debentures of $110,000 and issuance of stock subscriptions of $260,000 partially offset by repayments on notes payable of $159,705. Net cash provided by financing activities for the year ended December 31, 2016 was $1,076,249 consisting of borrowings on notes payable of $170,000, borrowings on convertible debentures of $715,000 and issuance of stock subscriptions of $600,000 somewhat offset by repayments on notes payable of $113,699, dividends paid to non-controlling subsidiary shareholders of $295,000 and a decrease in back overdrafts of $52.

 

The total change in cash and cash equivalents for the year ended December 31, 2017 when compared to the year ended December 31, 2016 was a decrease of $128,364.

 

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, increasing sales of our products and services and/or succeed in licensing our intellectual property. Our inability to raise such funds or renegotiate the terms of our existing debt will significantly jeopardize our ability to continue operations.

 

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Contractual Obligations and Commercial Commitments

 

As of December 31, 2017, the following contractual obligations and commercial commitments were outstanding:

 

    Balance at     Due in Next Five Years                          
                                                 
Contractual Obligations   12/31/17     2018     2019     2020     2021     2022+  
                                                 
Notes payable   $ 6,142,085     $ 3,983,945     $ 148,722     $ 165,932     $ 185,134     $ 1,658,352  
Convertible debts     1,340,000       1,340,000                          
Operating lease     77,918       65,250       8,445       4,223              
Total   $ 7,560,003     $ 5,389,195     $ 157,167     $ 170,155     $ 185,134     $ 1,658,352  


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

 

    2017     2016  
In default   $ 3,390,190     $ 4,901,950  
Not in default     4,091,895       1,614,222  
Total Notes Payable   $ 7,482,085     $ 6,516,172  

 

Going Concern Uncertainty

 

We had a net loss before non-controlling interest of $3,302,089 and $5,466,230 for the years ended December 31, 2017 and 2016, respectively, and have historically incurred losses. In addition, we had a working capital deficit of approximately $21.0 million at December 31, 2017. The foregoing raises substantial doubt about our ability to continue as a going concern.

 

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.

 

Furthermore, we are exploring certain opportunities with a number of companies to participate in co-marketing of each other’s products. We are proceeding to license our intellectual property to third parties. The exact results of our opportunities to license our intellectual property to other parties are unknown at this time.

 

Off-Balance Sheet Arrangements.

 

None.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

None.

 

Item 8. Financial Statements and Supplementary Data

 

Please refer to the Audited Consolidated Financial Statements of the Company and its subsidiaries for the fiscal years ended December 31, 2017 and 2016, which are attached to this Report.

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None

 

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Item 9A. Controls and Procedures

 

Evaluation of Disclosure 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. In particular, we have identified the material weaknesses described below.

 

Management’s Annual Report on Internal Control over Financial Reporting

 

Our management is responsible for establishing and maintaining disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act for the Company.

 

In order to ensure whether our internal control over financial reporting is effective, management has assessed such controls for its financial reporting as of December 31, 2016. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

 

In performing this assessment, management has identified the following material weaknesses as of December 31, 2017:

 

There is an over-reliance upon independent financial reporting consultants for review of critical accounting areas and disclosures and material non-standard transactions.

There is a lack of sufficient accounting staff due to the size of the Company which results in a lack of segregation of duties necessary for a good system of internal control.

There is a lack of control procedures that include multiple levels of supervision and review. Certain parts of the work of our chief financial officer are not monitored or reviewed.

Consolidation and currency translations are performed manually.

 

The absence of adequate segregation of duties may have an effect on the systems which we use in the evaluating and processing of certain accounts and areas and in the posting and recording of journal entries into certain accounts, as described below:

 

Although we implemented a new accounting system effective January 1, 2009 that allows for the consolidation of the various entities in Vertical Computer Systems along with the translation from local currency to reporting currency, the system needs to be refined in order to perform currency translations accurately. As a result, we continue to performing our consolidation and currency translations manually. This will be remediated once funds become available to effectively implement needed system changes.

Improving the control and oversight of the duties relating to the systems we use in the evaluation and processing of certain accounts and areas in the posting and recording of journal entries into certain accounts (in which material weaknesses have been identified as described above).  This improvement should include reviews by management of the accounting processes as well as a reorganization of some of the accounting functions. In January 2010, we contracted with a consulting firm to assess our internal controls over financial reporting and propose improvements that can be implemented given our size and number of employees. The company has not yet implemented these improvements in their entirety as of the filing of this report due to employee turnover and resource limitations.

Improving the segregation of duties relating to the processing of accounts and the recording of journal entries into certain accounts. The company has recently increased the size of its accounting staff which will allow for needed segregation of duties within the organization. As of the date of this report, the company is evaluating and reorganizing the duties of its accounting staff in order to address this internal control weakness.

 

As a result of these material weaknesses in our internal control over financial reporting, our management concluded that our internal control over financial reporting as of December 31, 2017 was not effective based on the criteria set forth by COSO in Internal Control – Integrated Framework. A material weakness in internal control over financial reporting is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

 

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Management’s Plan for Remediation of Material Weaknesses

 

In light of the conclusion that our internal control over financial reporting was not effective, our management is in the process of implementing a plan intended to remediate such ineffectiveness and to strengthen our internal controls over financial reporting through the implementation of certain remedial measures, which include:

 

We have implemented a new accounting system effective January 1, 2009 that allows for the consolidation of the various entities in Vertical Computer Systems along with the translation from local currency to reporting currency. Although the system eliminates many of the manual steps in translation and consolidation, many of the steps continue to be manual. This system also allows for some automation for recording software maintenance revenue and the recording of the deferred revenue liability account. This automation improves the accuracy of these accounts and is no longer considered a material weakness.

Improving the control and oversight of the duties relating to the systems we use in the evaluation and processing of certain accounts and areas in the posting and recording of journal entries into certain accounts (in which material weaknesses have been identified as described above). This improvement should include reviews by management of the accounting processes as well as a reorganization of some of the accounting functions. In January 2010, we contracted with a consulting firm to assess our internal controls over financial reporting and propose improvements that can be implemented given our size and number of employees.

Improving the segregation of duties relating to the processing of accounts and the recording of journal entries into certain accounts. This improvement is expected to come based on recommendations from the consulting firm assessing our internal controls over financial reporting.

 

This annual report does not include an attestation report of our public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.

 

Item 9B. Other Information

 

None.

 

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PART III

 

Item 10. Directors, Executive Officers and Corporate Governance

 

Our present directors and executive officers are as follows:

 

Name

 

Age

 

Position

 

Tenure

Richard S. Wade   74   President, Chief Executive Officer and Director   17 years
William K. Mills   59   Secretary and Director   17 years

 

Richard S. Wade, President, Chief Executive Officer (Principal Executive Officer and Principal Accounting Officer) and Director of VCSY, Chairman and Director of NOW Solutions

 

Richard S. Wade is President, CEO and Chairman of the Board of the Company and has been a director since October 1999. Before coming to Externet World, Inc. in mid-1999, and then transitioning to what is now the Company in late 1999, Mr. Wade held a number of executive positions with companies in the Pacific Rim from 1983 through early 1999, including the position of Chief Operating Officer of Struthers Industries, Inc., a public company in the business of wireless applications. Prior to these executive positions, Mr. Wade spent over 10 years with Duty Free Shoppers, Inc., culminating in his attaining the positions of president of their Mid-Pacific Division and then president of their U.S. Division. Prior to that, Mr. Wade was a CPA and staff auditor with Peat, Marwick & Mitchell. Over the course of his career, Mr. Wade has accumulated experience in retail operations, distribution, international operations, and financial matters. The breadth of Mr. Wade’s managerial and operational experience led the Board of Directors to believe this individual is qualified to serve as a director of the Company. Mr. Wade earned his Bachelor of Science in Accounting at Brigham Young University, a Master of Science in Business Policy from Columbia University Business School and received a certificate of recognition from the government of Guam.

 

William K. Mills, Secretary and Director of VCSY

 

William K. Mills has been a director since December 2000. Mr. Mills is a founding partner of Parker Shumaker Mills, LLP (formerly Parker Mills, LLP) where he specializes in complex commercial business representations, including transactional and litigation matters, such as legal malpractice, intellectual property and general corporate and governmental representations since 1995. Between 1991 and 1994, Mr. Mills was a senior attorney and partner with Lewis, D’Amato, Brisbois & Bisgaard, prior to which he was a senior attorney with Radcliff & West from 1989 to 1991, senior associate with Buchalter, Nemer Fields & Younger from 1987 to 1991 and an attorney with Daniels, Baratta & Fine from 1982 to 1987. Mr. Mills holds a J.D. from UCLA Law School and an A.B. in American Government from Harvard College. Active in professional and community organizations, Mr. Mills has served as General Counsel to the California Association of Black Lawyers, a member of the Los Angeles County Bar Judicial Appointments Committee, and a Board Member of the John M. Langston Bar Association. Mr. Mills has also served on the boards of the Didi Hirsch Mental Health Foundation, the United Way’s Los Angeles Metropolitan Region Board, the Los Angeles City Ethics Commission, and the Los Angeles County Judicial Procedures Commission. The breadth of Mr. Mills’ professional and legal experience led the Board of Directors to believe this individual is qualified to serve as a director of the Company.

 

Significant Employees of the Company

 

Luiz Valdetaro, Chief Technology Officer of VCSY and NOW Solutions, Director of NOW Solutions

 

Prior to joining the Company, Mr. Valdetaro was previously a consultant (1993-1997) and Chief Technology Officer (1997-1999) of Diversified Data Resources, a software company. Prior to that, Mr. Valdetaro was a Senior Systems Engineer for System/One and EDS, after System/One was acquired by EDS. Prior to that, Mr. Valdetaro was a senior systems engineer for Bank of America. Mr. Valdetaro is a graduate of Pontific Catholic University, Rio de Janeiro, Brazil with a B.S. in Electronic Engineering and a M.S. in Systems Engineering.

 

Laurent Tetard, Chief Operating Officer-SaaS

 

Mr. Tetard joined the Company in 1999, where he oversaw business development, managed software design projects and handled daily operations. His responsibilities included working with clients and strategic partners to develop business plans, implement strategies and methodologies to support software development. Combining his education and experience, Mr. Tetard has specialized in managing design, implementation, documentation and installation of Internet compatible applications. From 1994 to 1996, Mr. Tetard was a Public Relations Officer with the French Air Force, in Toulouse, France. Earlier in his career, he completed a thesis in collaboration with the French Aeronautics and Space Research Center (“ ONERA ”) and served engineering internships at Aerospatiale, France. Mr. Tetard is an honor’s graduate of the noted French Ecole Nationale Superieure D’arts et Metiers (“ ENSAM ”), with a BS in Engineering and a MS in Multidisciplinary Engineering.

 

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Harold Frazier, Jr., Director of Mobile Software Development

 

Harold Frazier, Jr. serves as the Director of Mobile Software Development of Vertical Computer Systems, Inc. He graduated from the University of Michigan, Ann Arbor with a B.S. in Computer Science. Since 2004, Mr. Frazier has focused on creating enterprise mobile software solutions in the education, social media, security, automotive and medical industries.

 

Significant Employees of NOW Solutions

 

Marianne M. Franklin, President and Chief Executive Officer

 

Marianne M. Franklin is President and Chief Executive Officer of NOW Solutions. Ms. Franklin brings her experience in the payroll and human resources industry, which included over eight years working at Ross Systems, most recently as Vice President of North American sales. Prior to this function, Ms. Franklin was Director of Ross’ HR/Payroll Canadian Sales. Ms. Franklin’s background also includes two years with ADP and 13 years in the banking industry, working with payroll products.

 

Jamie Patterson, Director of Software Development

 

Mr. Patterson joined the Company in 2006, originally as the Quality Assurance Manager, after working as an independent contractor for the company for three years. In 2000, he joined the Hewlett-Packard Company as a Research and Development Software Engineer.  From 1992 to 2000 he worked for Ross Systems starting as a Support Analyst in the Customer Support Department. In 1993 he began developing software in the Integration Services department and Product Development department.  Prior to Ross Systems, he worked as an IT engineer and software developer supporting a payroll application.  Mr. Patterson is a graduate of University of Texas at Arlington with a Masters of Computer Science and Engineering degree and from the University of Washington with a B.S. in Civil Engineering.

 

Compliance with Section 16(a) of the Exchange Act

 

Section 16(a) of the Exchange Act requires the Company’s officers and directors, and persons who own more than 10% of a registered class of the Company’s equity securities, to file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file.

 

Except as noted in this paragraph, to the best of the Company’s knowledge, and based solely on a review of the copies of such forms furnished to the Company, or written representations that no other forms were required, all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% stockholders have been met for the year ended December 31, 2017. Mr. Wade did not timely report two transactions on Form 4 or timely file a Form 5 for the year ended December 31, 2017.  Mr. Wade filed his Form 5 with respect to the two 2017 transactions on April 12, 2018.  Mr. Mills did not timely file a Form 5 for the year ended December 31, 2017. Mr. Mills filed his Form 5 on March 20, 2018.

 

Code of Ethics

 

We have adopted a Code of Ethics that applies to our Principal Executive Officer, Principal Accounting Officer and other persons performing executive functions, as well as all other employees and directors of the Company and its subsidiaries. Our Code of Ethics is filed as Exhibit 14.1 to this Report and is available at our Internet website located at http://www.vcsy.com/investor.php .

 

Corporate Governance

 

Family Relationships

 

There are no family relationships between or among the directors, executive officers or persons nominated or charged by us to become directors or executive officers.

 

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Involvement in Legal Proceedings

 

To the best of our knowledge, during the past five years, none of the following occurred with respect to a present or former director or executive officer of the Company:

 

(1) any bankruptcy petition filed by or against such person or any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time;

 

(2) any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses);

 

(3) being subject to any order, judgment or decree, not subsequently reversed, suspended or vacated, of any court of any competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; or

 

(4) being found by a court of competent jurisdiction (in a civil action), the SEC or the Commodities Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended or vacated.

 

Board of Directors Meetings and Subcommittees.

 

Meetings . Our Board of Directors held several meetings during the fiscal year ended December 31, 2016. All board actions were completed through unanimous written consents.

 

Audit Committee and Financial Expert . Our Board of Directors (the “ Board ”) does not have a separate audit committee. Although Mr. Wade (a member of the Board) has the qualifications of an “audit committee financial expert” as defined in Item 407(d)(5), Mr. Wade would not be deemed independent since he is an employee of the Company. At this point, we do not intend to establish a separate audit committee as this function will be performed by our full Board of Directors.

 

Compensation Committee . As all our executive officers are currently under employment agreements or are at-will employees, we do not have a separate compensation committee. At this point, we do not intend to establish a separate compensation committee as this function will be performed by our full Board of Directors.

 

Nominating Committee . We do not currently have a separate nominating committee as this function is performed by our full Board of Directors.

 

Shareholder Communication . We communicate regularly with shareholders through press releases, as well as annual, quarterly, and current (Form 8-K) reports. Our Chief Executive Officer addresses investor concerns on an on-going basis. Interested parties, including shareholders and other security holders, may communicate directly with our Board of Directors or with individual directors by writing to our Chief Executive Officer at 101 W. Renner Road, Suite 300, Richardson, TX 75082.

 

Item 11. Executive Compensation

 

The following table shows all the cash compensation paid by the Company, as well as certain other compensation paid or accrued, during the fiscal years ended December 31, 2016 and 2017 to our highest paid executive officers and employees, who were employed by us during 2016 and 2017. No restricted stock awards, long-term incentive plan payouts or other types of compensation, other than the compensation identified in the chart below, were paid to these executive officers during these fiscal years. Except as set forth below, no other executive officer of Vertical earned a total annual salary and bonus for any of these years in excess of $100,000.

 

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SUMMARY COMPENSATION TABLE

 

The below table shows information of compensation of the named officers for fiscal years ended December 31, 2016 and December 31, 2017:

 

     

Annual Compensation

   

Long-Term Compensation

 
                                   

Awards

 

   

Payouts

 

 

Name and
Principal
Position

   

Year

   

Salary

   

Bonus (5)

   

Other
Annual
Compensation

   

Restricted
Stock
Award(s)

   

Options/
SARs

   

LTIP
Payouts

   

All Other
Compensation

 
           

($)

   

($)

   

($)

   

($)

   

(#)

   

($)

   

($)

 
                                                                 
Richard Wade (1)     2017     $ 300,000                                      
President/ Chief
Executive Officer
    2016     $ 300,000                   112,500                    
                                                                 
Luiz Valdetaro (2)     2017     $ 200,000                                      
Chief Technology Officer     2016     $ 200,000                   67,500                    
                                                                 
Laurent Tetard (3)     2017     $ 210,000                                      
Chief Operating Officer-SaaS     2016     $ 193,333                   33,750                    
                                                                 

James Salz (4)

    2017     $ 185,000                                      
Corporate Counsel     2016     $ 168,333                   33,750                    

 

(1) Mr. Wade deferred $881,688 of salary earned during the period from 2002 through 2008, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For 2012, 2013, 2014, 2015, 2016 and 2017, the Company accrued unpaid salary for Mr. Wade of $62,500, $37,500, $25,000, $87,500, $16,372 and $67,218 respectively. The restricted stock award for Mr. Wade was granted under a restricted stock agreement for 5,000,000 VCSY common shares, under which 3,000,000 shares were vested at December 31, 2017.

(2) Mr. Valdetaro deferred $467,071 of salary earned during the period from 2002 through 2007, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For 2012, 2013, 2014, 2015, 2016 and 2017, the Company accrued unpaid salary for Mr. Valdetaro of $41,667, $66,667, $41,667, $66,667, $58,078 and $95,976, respectively. The restricted stock award for Mr. Valdetaro was granted under a restricted stock agreement for 3,000,000 VCSY common shares, under which 2,000,000 shares were vested at December 31, 2017.

(3) Prior to 2012, Mr. Tetard served as the Executive Vice President of International Operations of NOW Solutions. Mr. Tetard deferred $98,438 of salary earned during the period from 2002 through 2007, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For 2012, 2016 and 2017, the Company accrued unpaid salary for Mr. Tetard of $20,625, $8,334 and $8,750, respectively. The restricted stock award for Mr. Tetard was granted under a restricted stock agreement for 1,500,000 VCSY common shares, under which 1,000,000 shares were vested at December 31, 2017.

(4) Mr. Salz deferred $185,914 of salary earned during the period from 2002 through 2007, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For 2012, 2013, 2014, 2015, 2016 and 2017, the Company accrued unpaid salary for Mr. Salz of $27,498, $55,000, $73,336, $48,125, $42,083 and $126,042, respectively. The restricted stock award for Mr. Salz was granted under a restricted stock agreement and an award for 1,500,000 VCSY common shares, under which 1,000,000 shares were vested at December 31, 2017.

(5) All executives are entitled to an annual bonus from a bonus pool for executives equal to 5% of the Company taxable income before net operating loss deduction and special deductions from the federal tax return filed. Each executive’s share of the bonus pool is equal to the percentage of their annual base compensation to the total of the combined annual base compensation of all executives in the pool.

 

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No options or warrants held by executive officers or directors were granted or exercised during the fiscal years ended December 31, 2017 and 2016.

 

In December 2001, we executed an employment agreement with Richard Wade pursuant to which Mr. Wade serves as Chief Executive Officer and President of the Company. The agreement currently renews on annual basis unless terminated by either party. Under the agreement, Mr. Wade receives an annual base salary of $300,000 In the event the agreement is terminated by Mr. Wade’s death, his estate shall be entitled to compensation accrued to the time of death plus the lesser of one year’s base compensation or the compensation due through the remainder of the employment term. In the event of termination by the Company without cause, Mr. Wade would receive base compensation for the remainder of the employment term.

 

In January 2012, we executed an employment agreement with Luiz Valdetaro to serve as Chief Technology Officer of the Company and its subsidiaries. The initial term of the agreement was 2 years and renews on annual basis unless terminated by either party. Under the agreement, Mr. Valdetaro receives an annual base salary of $200,000. In the event the employment agreement is terminated by Mr. Valdetaro’s death, his estate shall be entitled to compensation accrued to the time of death plus the lesser of one year’s base compensation or the compensation due for the lesser of 12 months or through the remainder of the employment term. In the event of termination by the Company without cause, Mr. Valdetaro would receive base compensation for no less than six months of the remainder of the employment term. Mr. Valdetaro may also terminate his employment for good reason and shall be entitled to continued health insurance benefits and base compensation at the rate in effect at the time of his termination for good reason through the end of twelve months after which his employment is terminated for good reason.

 

In February 2012, we executed an employment agreement with Laurent Tetard to serve as Chief Operating Officer-SaaS of the Company and its subsidiaries. The initial term of the agreement was 2 years and renews on annual basis unless terminated by either party. Under the agreement, Mr. Tetard receives an annual base salary of $190,000. In the event the employment agreement is terminated by Mr. Tetard’s death, his estate shall be entitled to compensation accrued to the time of death plus the lesser of one year’s base compensation or the compensation due for the lesser of 12 months or through the remainder of the employment term. In the event of termination by the Company without cause, Mr. Tetard would receive base compensation for no less than six months of the remainder of the employment term. Mr. Tetard may also terminate his employment for good reason and shall be entitled to continued health insurance benefits and base compensation at the rate in effect at the time of his termination for good reason through the end of twelve months after which his employment is terminated for good reason. In connection with the employment agreement, the Company issued Mr. Tetard 600,000 shares of its common stock at a fair market value of $13,500 and VHS issued 15,000 shares of Series B Preferred Stock of VHS at a fair market value which is nominal.

 

Outstanding Equity Awards

 

The below table shows information of outstanding equity awards of the named officers at the end of 2017:

 

OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END (2016)
Option Awards Stock Awards
   
Name Number of
Securities
Underlying
Unexercised
Options (#)
Exercisable
Number of
Securities
Underlying
Unexercised
Options (#)
non-
exercisable
Equity
Incentive
Plan
Awards:
Number of
Securities
Underlying
Unexercised
Unearned
Options (#)
Option
Exercise
Price ($)
Option
Expiration
Date
Number of
Shares or
Units of
Stock That
Have Not
Vested (#)
Market
Value of
Shares or
Units of
Stock That
Have Not
Vested ($)
Equity
Incentive
Plan
Awards:
Number of
Unearned
Shares,
Units or
Other Rights
That Have
Not Vested
(#)
Equity
Incentive
Plan
Awards:
Market or
Payout
Value of
Unearned
Shares,
Units or
Other
Rights That
Have Not
Vested ($)
                   
Richard Wade, President/ Chief Executive Officer (1)           2,000,000      
                   
Luiz Valdetaro, Chief Technology Officer (2)           1,000,000      
                   
Laurent Tetard, Chief Operating Officer-SaaS (3)           500,000      
                   

James Salz, Corporate Counsel (4)

          500,000      
                   

 

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(1) Pursuant to a restricted stock agreement with the Company, Mr. Wade, the Company’s President and CEO, was issued 5,000,000 unregistered shares of VCSY common stock (at a fair market value of $112,500 in June 2016, based upon the total number of shares issued and the share price on the date of the grant), vesting in equal installments over a 28-month period, of which 3,000,000 shares had vested at December 31, 2017.

(2) Pursuant to a restricted stock agreement with the Company, Mr. Valdetaro, the Company’s Chief Technology Officer, was issued 3,000,000 unregistered shares of VCSY common stock (at a fair market value of $67,500 in June 2016, based upon the total number of shares issued and the share price on the date of the grant), vesting in equal installments over a 28-month period, of which 2,000,000 shares had vested at December 31, 2017.

(3) Pursuant to a restricted stock agreement with the Company, Mr. Tetard, the Company’s COO-SAAS, was issued 1,500,000 unregistered shares of VCSY common stock (at a fair market value of $33,750 in June 2016, based upon the total number of shares issued and the share price on the date of the grant), vesting in equal installments over a 28-month period, of which 1,000,000 shares had vested at December 31, 2017.

(4) Pursuant to a restricted stock agreement with the Company, Mr. Salz, the Company’s Corporate Counsel, was issued 1,500,000 unregistered shares of VCSY common stock (at a fair market value of $33,750 in June 2016, based upon the total number of shares issued and the share price on the date of the grant), vesting in equal installments over a 28-month period, of which 1,000,000 shares had vested at December 31, 2017.

 

Narrative Disclosure to Outstanding Equity Awards at Fiscal Year End

 

Stock Option Plan. The Company has no formal stock option plan and has issued no stock options or warrants to any employees or to any other parties and do not have any stock options outstanding.

 

Stock Awards . The Company’s restricted stock agreements generally provide for the stock to vest in equal installments over a 1 to 3-year period. In the event the employee is terminated without cause, a portion of the remaining unvested stock will vest on a pro-rata basis.

 

COMPENSATION OF DIRECTORS

 

We do not pay any compensation to our employee directors for their service on the Board. However, we do pay our non-employee directors as indicated below. The below table provides compensation for all non-employee directors in 2017:

 

DIRECTOR COMPENSATION                                          

Name

 

Fees
Earned or
Paid in
Cash

   

Stock
Awards

   

Option
Awards

   

Non-Equity
Incentive Plan
Compensation

   

Nonqualified
Deferred
Compensation
Earnings

   

All Other
Compensation

   

Total

 
   

($)

   

($)

   

($)

   

($)

   

($)

   

(#)

   

($)

 
William Mills (1)     42,000                                     42,000  

 

(1) In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed for services previously rendered by Mr. Mills as a Director and the Secretary of the Company. The fair market value of the shares was $100,000.

 

Narrative Disclosure to Director Compensation Table

 

Non-employee directors were entitled to receive $3,500 per month in 2017 and 2016.

 

37

 

 

Reimbursement of Expenses

 

The Company reimburses travel expenses of members for their attendance at Board meetings.

 

Compensation Risks Assessment

 

As required by rules adopted by the SEC, management has made an assessment of the Company’s compensation policies and practices with respect to all employees to determine whether risks arising from those policies and practices are reasonably likely to have a material adverse effect on the Company. In doing so, management considered various features and elements of the compensation policies and practices that discourage excessive or unnecessary risk taking. As a result of the assessment, the Company has determined that its compensation policies and practices do not create risks that are reasonably likely to have a material adverse effect on the Company.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

Security Ownership By Named Executive Officers, Directors and Beneficial Owners

 

The following table sets forth certain information regarding the beneficial ownership of the shares of common stock as of May 10, 2018, by each of our directors and executive officers and any person or entity known by us to be the beneficial owner of more than 5% of the outstanding shares of common stock. The table also shows the beneficial ownership of our stock by all directors and executive officers as a group. The table includes the number of shares subject to outstanding options and warrants to purchase shares of common stock. The percentages are based on 1,194,475,201 shares of common stock outstanding as of May 10, 2018, together with options, warrants or other securities convertible or exchangeable by the beneficial owners into shares of common stock within 60 days of May 10, 2018.

 

Title of Class

   

Name and Address of Beneficial Owner (1)

 

Shares of Common
Stock Beneficially
Owned

   

Percent
of Class

 
Common     Richard Wade     80,250,190 (2)     6.72 %
Common     William K. Mills       7,333,333 (3)     *  
Common     All Directors and Executive Officers as a group (2 persons)    

87,583,523

      7.33 %

 

 

*    Less than 1%.

 

(1) The address of each director and officer is c/o Vertical Computer Systems, Inc., 101 West Renner Road, Suite 300, Richardson, TX 75082.

 

(2) Includes 74,932,543 shares owned by MRC. MRC has pledged approximately 35,000,000 common shares as collateral to secure various promissory notes issued in the aggregate principal amount of approximately $1,290,000. Mr. Wade is the President and CEO of the Company. MRC is a corporation controlled by the W5 Family Trust and Mr. Wade is the trustee of the W5 Family Trust.

 

(3) Includes 5,250,000 shares owned by Mr. Mills, 1,083,333 shares of VCSY common stock owned by Parker Mills, L.L.P. (“Parker Mills”) and 3-year warrants to purchase 1,000,000 shares of VCSY common stock at $0.05 per share granted to Parker Mills. William Mills is a Director of the Company and a partner of Parker Mills.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence

 

Certain Relationships and Related Transactions

 

In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. Mr. Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

 

38

 

 

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

 

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

 

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

 

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

 

Since payment of the Bonus is contingent upon first paying all unpaid salary and there are no foreseeable revenues to pay the twenty percent interest in these technologies, it is doubtful at the present time that any Bonus will be paid and therefore the Bonus was not accrued as of December 31, 2017 as this contingent liability is considered remote. Cumulative bonus interest through December 31, 2017 is $4,435,576.

 

As of December 31, 2017, and 2016, the Company had accounts payable to related parties and related party contractors in an aggregate amount of $148,760 and $139,546, respectively. The payables are unsecured, non-interest bearing and due on demand.

 

Director Independence; Board Leadership Structure

 

The Company’s common stock is quoted through the OTC Markets and quoted on the OTCQB under the symbol “VCSY”. For purposes of determining whether members of the Company’s Board of Directors are “independent,” the Company’s Board utilizes the standards set forth in the NASDAQ Stock Market Marketplace Rules. At present, the Company’s entire Board serves as its Audit, Compensation and Nominating Committees. The Company’s Board of Directors has determined that, of the Company’s present directors, William Mills, constituting one of the two members of the Board, is an “independent director,” as defined under NASDAQ’s Marketplace Rules, for purposes of qualifying as independent members of the Board and an Audit, Compensation and Nominating Committee of the Board, but that Richard Wade is not an “independent director” since he serves as executive officer of the Company. In reaching its conclusion, the Board determined that Mr. Mills does not have a relationship with the Company that, in the Board’s opinion, would interfere with his exercise of independent judgment in carrying out the responsibilities of a director, nor does Mr. Mills have any of the specific relationships set forth in NASDAQ’s Marketplace Rules that would disqualify him from being considered an independent director.

 

Currently, Mr. Richard Wade serves as both Chairman of the Board and Chief Executive Officer. As noted above, Mr. William Mills is the sole independent director and Mr. Mills has not taken on any supplemental role in his capacity as director. It is anticipated that additional independent directors may be added to the Board, however, the Company’s Board of Directors has not set a timetable for such action.

 

39

 

 

The Company’s Board of Directors is of the view that the current leadership structure is suitable for the Company at its present stage of development, and that the interests of the Company are best served by the combination of the roles of Chairman of the Board and Chief Executive Officer.

 

As a matter of regular practice, and as part of its oversight function, the Company’s Board of Directors undertakes a review of the significant risks in respect of the Company’s business. Such review is conducted in concert with the Company’s in-house legal staff, and is supplemented as necessary by outside legal counsel, accountants, and other professionals with expertise in substantive areas germane to the Company’s business. With the Company’s current governance structure, the Company’s Board of Directors and senior executives are, by and large, the same individuals, and consequently, there is not a significant division of oversight and operational responsibilities in managing the material risks facing the Company.

 

Item 14. Principal Accountant Fees and Services

 

Audit Fees. The aggregate fees billed for professional services rendered by our principal accounting firm of MaloneBailey were $81,000 and $75,000 for the audit of our annual financial statements for 2017 and 2016, which included the reviews of the financial statements in our Forms 10-Q for the applicable fiscal years.

 

Tax Fees . The principal accounting firm of MaloneBailey did not provide any tax services in 2017 and 2016.

 

All Other Fees . Other than the services described above, the aggregate fees billed for services rendered by our principal accountant was $228,800 and $211,200, respectively, for the fiscal years ended 2017 and 2016.

 

40

 

 

PART IV

 

Item 15. Exhibits and Financial Statement Schedules

 

The following documents are filed as part of this report:

 

a. Exhibits:

 

Exhibit No.

Description

Location

2.1 Certificate of Ownership and Merger Merging Scientific Fuel Technology, Inc. into Vertical Computer Systems, Inc. Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
3.1 Original Unamended Certificate of Incorporation of Vertical Computer Systems, Inc. (f/k/a Xenogen Technology, Inc.) Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
3.2 Certificate of Amendment of Certificate of Incorporation (changed name to Vertical Computer Systems, Inc.) Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
3.3 Certificate of Amendment of Certificate of Incorporation (2000) Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
3.4 Certificate of Amendment of Certificate of Incorporation Incorporated by reference to Exhibit 3.1 to the Company’s Form 8-K filed on February 27, 2015
3.5 Amended and Restated By-Laws of the Company Incorporated by reference to Exhibit 3.1 to the Company’s Form 8-K filed on January 13, 2015
4.1 Certificate of Designation of 4% Cumulative Redeemable Series A Preferred Stock Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
4.2 Certificate of Designation of 10% Cumulative Redeemable Series B Preferred Stock Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
4.3 Certificate of Designation of 4% Cumulative Redeemable Series C Preferred Stock Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
4.4 Certificate of Designation of 15% Cumulative Redeemable Series D Preferred Stock Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
4.5 Form of Restricted Stock Agreement Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
4.6 Form of Convertible Note Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
4.7 Form of Stock Purchase Warrant Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
10.1 Employment Agreement between the Company and Richard Wade Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
10.2 Secured Term Promissory Note in the principal amount of $1,759,150 payable by NOW Solutions to Lakeshore Investment, LLC.

Provided herewith

 

14.1 Code of Ethics Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016

 

41

 

 

21.1 Subsidiaries of the Company Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 14, 2016
31.1 Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 10, 2018 Provided herewith
32.1 Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 10, 2018 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 Linkbase Provided herewith

 

42

 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  VERTICAL COMPUTER SYSTEMS, INC.
     

May 10, 2018

By: /s/ Richard Wade   
    Richard Wade,
   

President and Chief Executive Officer

(Principal Executive Officer and Principal Accounting Officer)

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

DIRECTORS:
     
May 10, 2018 By: /s/ Richard Wade
    Richard Wade, Director
     

May 10, 2018

By: /s/ William Mills    
    William Mills, Director

 

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VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS 

 

Report of Independent Registered Public Accounting Firm F-2
   
Consolidated Financial Statements  
Consolidated Balance Sheets F-3
Consolidated Statements of Operations and Comprehensive Loss F-4
Consolidated Statements of Stockholders’ Deficit F-5
Consolidated Statements of Cash Flows F-6
   
Notes to Consolidated Financial Statements F-7

  

F- 1  

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Shareholders and Board of Directors of

Vertical Computer Systems, Inc.

 

Opinion on the Financial Statements

 

We have audited the accompanying consolidated balance sheets of Vertical Computer Systems, Inc. and its subsidiaries (collectively, the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of operations and comprehensive loss, stockholders’ deficit, and cash flows for the years then ended, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

 

Going Concern Matter

 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

Basis for Opinion

 

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

 

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

 

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

 

/s/ MaloneBailey, LLP

www.malonebailey.com

We have served as the Company’s auditor since 2008.

Houston, Texas

 

May 10, 2018

 

F- 2  

 

VERTICAL COMPUTER SYSTEMS, INC.

 

CONSOLIDATED BALANCE SHEETS  

    December 31,     December 31,  
    2017     2016  
Assets                
Current assets:                
Cash   $ 62,084     $ 190,448  
Accounts receivable, net of allowance for bad debts of $234,439 and $139,705     349,002       367,278  
Prepaid expenses and other current assets     5,312       10,355  
Total current assets     416,398       568,081  
                 
Property and equipment, net of accumulated depreciation of $1,044,936 and $1,043,397     9,211       5,097  
Intangible assets, net of accumulated amortization of $319,504 and $319,513     6,690       6,690  
Deposits and other assets     8,037       8,064  
                 
Total assets   $ 440,336     $ 587,932  
                 
Liabilities and Stockholders’ Deficit                
Current liabilities:                
Accounts payable and accrued liabilities     14,122,394       12,075,298  
Accounts payable to related parties     148,760       139,546  
Deferred revenue     1,752,421       1,794,264  
Derivative liabilities     159,537       1,014,192  
Convertible debentures, net of unamortized discounts of $75,705 and $354,785     1,164,295       899,428  
Notes payable     3,775,703       4,953,717  
Notes payable and convertible debt to related parties     308,242       308,242  
Total current liabilities     21,431,352       21,184,687  
                 
Non-current portion – notes payable     2,158,140        
                 
Total liabilities     23,589,492       21,184,687  
                 
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 52,800 shares issued and outstanding as of December 31, 2017 and 51,500 shares 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 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: $0.00001 par value, 2,000,000,000 shares authorized, 1,188,095,201 issued and 1,148,095,201 outstanding as of December 31, 2017 and 2,000,000,000 shares authorized, 1,167,841,439 issued and 1,127,841,439 outstanding as of December 31, 2016     11,883       11,679  
Treasury stock: 40,000,000 shares as of December 31, 2017 and 40,000,000 shares as of December 31, 2016     (400 )     (400 )
Additional paid-in capital     24,609,424       23,672,153  
Accumulated deficit     (58,087,916 )     (55,017,675 )
Accumulated other comprehensive income – foreign currency translation     339,051       424,996  
Total Vertical Computer Systems, Inc. stockholders’ deficit
    (33,127,958 )     (30,909,247 )
                 
Non-controlling interest     (478,407 )     43,969  
Total stockholders’ deficit     (33,606,365 )     (30,865,278 )
                 
Total liabilities and stockholders’ deficit   $ 440,336     $ 587,932  

 

See accompanying notes to consolidated financial statements.

 

F- 3  

 

VERTICAL COMPUTER SYSTEMS, INC. 

CONSOLIDATED STATEMENTS OF OPERATIONS  

AND OTHER COMPREHENSIVE LOSS  

 

    Years Ended December 31,  
    2017     2016  
Revenues:            
Licensing and software   $ 811     $ 19,290  
Software maintenance     3,137,950       3,235,281  
Consulting services     214,343       279,517  
Cloud-based offering     395,339       281,080  
Other     21,883       12,507  
Total Revenues     3,770,326       3,827,675  
                 
Cost of Revenues     (1,574,645 )     (1,524,853 )
                 
Gross Profit     2,195,681       2,302,822  
                 
Operating Expenses:                
Selling, general and administrative expenses     4,311,088       3,871,572  
Depreciation and amortization     1,453       1,083  
Bad debt expense     93,757       98,896  
Impairment of software costs           1,421,155  
Total operating expenses     4,406,298       5,392,706  
                 
Operating loss     (2,210,617 )     (3,089,884 )
                 
Other Income (Expense):                
Gain (loss) on derivative liabilities     879,780       (268,728 )
Forbearance fees     (12,000 )     (58,500 )
Gain (loss) on extinguishment of debt     (128,250 )     35,969  
Interest income     21       53  
Interest expense     (1,819,147 )     (1,998,762 )
                 
Net loss before non-controlling interest and income tax benefit     (3,290,213 )     (5,379,852 )
                 
Income tax expense     11,876       86,378  
                 
Net loss before non-controlling interest     (3,302,089 )     (5,466,230 )
                 
Net loss attributable to non-controlling interest     231,848       188,479  
Net loss attributable to Vertical Computer Systems, Inc.     (3,070,241 )     (5,277,751 )
                 
Dividends applicable to preferred stock     (616,667 )     (592,472 )
                 
Net loss available to common stockholders   $ (3,686,908 )   $ (5,870,223 )
                 
Basic and diluted loss per share   $ (0.00 )   $ (0.01 )
                 
Basic and diluted weighted average common shares outstanding     1,137,125,217       1,106,272,758  
                 
Comprehensive loss:                
Net loss   $ (3,302,089 )   $ (5,466,230 )
Translation adjustments     (85,945 )     (133,672 )
Comprehensive loss     (3,388,034 )     (5,599,902 )
                 
Comprehensive loss attributable to non-controlling interest     231,848       188,479  
Comprehensive loss attributable to Vertical Computer Systems, Inc.   $ (3,156,186 )   $ (5,411,423 )

 

See accompanying notes to consolidated financial statements.

 

F- 4  

 

VERTICAL COMPUTER SYSTEMS, INC.

C ONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT

YEARS ENDED DECEMBER 31, 2017 AND 2016

 

    Common Stock     Treasure Stock     Additional Paid-in
Capital
    Accumulated Deficit     Other Comprehensive Income     Non- controlling Interest     Total  
    Shares     Amount     Shares     Amount    
Balances at December 31, 2015     1,114,601,656     $ 11,147       (30,000,000 )     (300 )   $ 22,252,823     $ (49,739,924 )   $ 558,668     $ 566,571     $ (26,351,015 )
Amortization of restricted stock awards                             229,223                         229,223  
Forfeited restricted stock awards                             (1,145 )                       (1,145 )
Shares issued to subsidiary and held in treasury     10,000,000       100       (10,000,000 )     (100 )                              
Shares issued for vested restricted stock awards     7,175,000       72                   (72 )                        
Cancellation of shares issued for loan forbearance     (1,000,000 )     (10 )                 10                          
Shares issued for accounts payable     1,500,000       15                   37,485                         37,500  
Shares issued for services     3,000,000       30                   66,520                         66,550  
Shares issued for related party accounts payable     5,000,000       50                   99,950                         100,000  
Shares issued with convertible debt     7,150,000       71                   114,342                         114,413  
Shares issued for conversion of convertible debt     5,914,783       59                   81,942                         82,001  
Shares issued for payment of note principal     5,000,000       50                   92,450                         92,500  
Reclassification of warrants as derivative liabilities                             (50,557 )                       (50,557 )
Settlement of derivative liability upon conversion of debt                             50,681                         50,681  
Shares issued to employees and contractors     3,500,000       35                   78,715                         78,750  
Shares and subsidiary shares issued for equity subscriptions     6,000,000       60                   232,852                   (3,416 )     229,496  
Dividends paid by subsidiary to non-controlling interest                                               (295,000 )     (295,000 )
Issuance of subsidiary shares for services                             370,734                   (35,707 )     335,027  
Issuance of subsidiary shares for debt extension
                            16,200                         16,200  
Other comprehensive income translation adjustment                                         (133,672 )           (133,672 )
Net loss                                   (5,277,751 )           (188,479 )     (5,466,230 )
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                             116,180                         116,180  
Shares issued for vested restricted stock awards     6,665,000       68                   (68 )                        
Shares issued for conversion of convertible debt     1,688,762       17                   22,404                         22,421  
Shares issued for convertible debt     1,100,000       11                   12,281                         12,292  
Settlement of derivative liability upon conversion of debt                             19,566                         19,566  
Shares issued to employees     4,000,000       40                   84,760                         84,800  
Issuance of subsidiary shares for services                             306,609                   (27,127 )     279,482  
Dividends declared but unpaid to non-controlling interest holders                                               (250,000 )     (250,000 )
Shares and subsidiary shares issued for equity subscriptions     2,600,000       26                   72,284                   (1,570 )     70,740  
Other comprehensive income translation adjustment                                         (85,945 )           (85,945 )
Shares issued for debt extinguishment     2,500,000       25                   35,375                         35,400  
Subsidiary shares issued for debt extinguishment                             96,676                   (3,826 )     92,850  
Issuance of shares for services     1,700,000       17                   21,043                         21,060  
Issuance of subsidiary shares for debt extensions                             150,161                   (8,005 )     142,156  
Net loss                                   (3,070,241 )           (231,848 )     (3,302,089 )
Balances at December 31, 2017     1,188,095,201     $ 11,883     $ (40,000,000 )   $ (400 )   $ 24,609,424     $ (58,087,916 )   $ 339,051     $ (478,407 )   $ (33,606,365 )
                                                                         

See accompanying notes to consolidated financial statements.

 

F- 5

 

 

VERTICAL COMPUTER SYSTEMS, INC.

 

C ONSOLIDATED STATEMENTS OF CASH FLOWS

 

    Years Ended December 31,  
    2017     2016  
Cash flows from operating activities:                
                 
Net loss   $ (3,302,089 )   $ (5,466,230 )
Adjustments to reconcile net loss to net cash                
used in operating activities:                
Loss (gain) on extinguishment of debt and accrued interest     128,250       (35,969 )
Depreciation and amortization     1,453       1,083  
Amortization of restricted stock awards     116,180       307,973  
Amortization of subsidiary restricted stock awards     279,482       335,027  
Amortization of debt discounts     478,398       648,339  
(Gain) loss on derivatives     (879,780 )     268,728  
Common shares issued for services     21,060       66,550  
Impairment of software development costs           1,421,155  
Common shares issued to employees     84,800        
Bad debt expense     93,757       98,896  
Forfeited restricted stock awards           (1,145 )
Changes in operating assets and liabilities:                
Accounts receivable     (66,584 )     (79,856 )
Prepaid expense and other assets     4,909       47,024  
Accounts payable and accrued liabilities     2,459,144       1,665,678  
Accounts payable to related parties     9,214       131,167  
Deferred revenue     (113,871 )     104,825  
Net cash used in operating activities     (685,677 )     (486,755 )
                 
Cash flows from investing activities:                
Software development           (246,184 )
Purchase of equipment     (5,568 )     (3,805 )
Net cash used in investing activities     (5,568 )     (249,989 )
                 
Cash flows from financing activities:                
Payments of notes payable     (44,705 )     (113,699 )
Payments of convertible notes payable     (115,000 )      
Borrowings on notes payable     370,500       170,000  
Borrowings on convertible debentures     110,000       715,000  
Issuance of stock subscriptions     260,000       600,000  
Dividends paid by subsidiary to non-controlling interest           (295,000 )
Bank overdraft           (52 )
Net cash provided by financing activities     580,795       1,076,249  
                 
Effect of changes in exchange rates on cash     (17,914 )     (186,198 )
                 
Net decrease in cash     (128,364 )     153,307  
Cash, beginning of period     190,448       37,141  
Cash, end of period   $ 62,084     $ 190,448  
                 
Supplemental Disclosure of Cash Flows Information:                
Cash paid for interest   $ 34,259     $ 182,618  
Cash paid for income taxes            
                 
Non-cash Investing and Financing Activities:                
Common shares issued for vested restricted stock     68       72  
Issuance of shares for settlement of accounts payable and related party accounts payable           137,500  
Common shares issued for conversion of debt and accrued interest     22,421       82,001  
Common stock issued for settlement of derivative liabilities     19,566        
Common stock issued for settlement of note principal           130,000  
Debt discount due to derivative liabilities     44,240       741,583  
Debt discount due to subsidiary shares issued for debt extensions     142,156       16,200  
Debt discount due to shares issued with debt     12,292       114,413  
Reclassification of warrants as derivative liabilities           50,557  
Accrued interest capitalized into debt principal     414,364        
Settlement of derivative due to conversion           50,681  
Restricted stock cancelled           10  
Subsidiary dividends owed to noncontrolling interest declared and capitalized to note principal     250,000        

Promissory note modified to convertible note

    10,000        

 

See accompanying notes to consolidated financial statements.

 

F- 6

 

 

VERTICAL COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

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

 

Nature of Business

 

Vertical Computer Systems, Inc. was incorporated in Delaware in March 1992. We are a multinational provider of application software, software services, Internet core technologies, and derivative software application products through our distribution network. Our business model combines complementary, integrated software products, internet core technologies, and a multinational distribution system of partners, in order to create a distribution matrix that is capable of penetrating multiple sectors through cross selling our products and services. We operate one business segment.

 

Basis of Presentation

 

The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company,” “Vertical”, or “VCSY”, as applicable). Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), an 80% owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. (“Taladin”), and Vertical Healthcare Solutions, Inc. (“VHS”), each of which a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”), an 80% owned subsidiary, Ploinks, Inc. (“Ploinks”), an 88% owned subsidiary and Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary. Vertical’s subsidiaries which are inactive include EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary of Vertical. To date, we have generated revenues primarily from software licenses, software as a service, consulting fees and maintenance agreements from NOW Solutions and SnAPPnet and patent licenses from Vertical Computer Systems, the parent company.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its subsidiaries. Equity investments in which we exercise significant influence, but do not control and are not the primary beneficiary, are accounted for using the equity method of accounting. Investments in which we do not exercise significant influence over the investee are accounted for using the cost method of accounting. All intercompany accounts and transactions have been eliminated. We currently have no investments accounted for using the equity or cost methods of accounting.

 

Cash and Cash Equivalents

 

Cash equivalents are highly liquid investments with an original maturity of three months or less.

 

Revenue Recognition

 

Our revenue recognition policies are in accordance with standards on software revenue recognition, which includes 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.

 

F- 7

 

 

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 those. 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 a third party to provide new and existing customers with a hosting facility 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 a cloud-based offering. 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 our cloud-based offering can enter into an agreement to purchase a software license at any time. We generate revenue from our cloud-based offering as the customer utilizes the software over the Internet.

 

We will provide consulting services to customers in conjunction with our 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 our cloud-based offering, are charged a fee equal to the number of employees paid each month multiplied by an agreed-upon monthly rate per employee. The revenue is recognized as the cloud-based offering services are rendered each month.

 

F- 8

 

 

Concentration of Credit Risk

 

We maintain our cash in bank deposit accounts, which, at times, may exceed federally insured limits. We have not experienced any such losses in these accounts. Substantially all of our revenue was derived from recurring maintenance fees related to our payroll processing software. The company’s revenue consists of 63% in Canada and 37% in the US. Receivables arising from sales of the Company’s products are not collateralized. As of December 31, 2017, three customers represented approximately 91% (42%, 37%, and 12%) of accounts receivable. As of December 31, 2016, two customers represented approximately 71% (40% and 31%) of accounts receivable.

 

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.

 

For the year ended December 31, 2017 and 2016, the company capitalized $0 and $246,184, respectively of software development costs related to its Ploinks subsidiary. During 2016, the company recorded an impairment loss of $1,421,155 related to software development cost.

 

Property and Equipment

 

Property and equipment are stated at cost. Depreciation is computed primarily utilizing the straight-line method over the estimated economic life of three to five years. Maintenance, repairs and minor renewals are charged directly to expenses as incurred. Additions and betterment to property and equipment are capitalized. When assets are disposed of, the related cost and accumulated depreciation thereon are removed from the accounts and any resulting gain or loss is included in the statement of operations.

 

Impairment of Long-Lived Assets

 

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets. Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value. During 2016, the company recorded an impairment loss of $1,421,155 related to software development cost.

 

Stock-based Compensation

 

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.

 

Allowance for Doubtful Accounts

 

We establish an allowance for bad debts through a review of several factors including historical collection experience, current aging status of the customer accounts, and financial condition of our customers. We do not generally require collateral for our accounts receivable. Our allowance for doubtful accounts was $234,439 and $139,705 as of December 31, 2017 and 2016, respectively.

 

Income Taxes

 

We provide for income taxes in accordance with the asset and liability method of accounting for income taxes.

 

F- 9

 

 

Under the asset and liability method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. A valuation allowance is provided when management cannot determine whether it is more likely than not the deferred tax asset will be realized. The effect on deferred income taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

 

Since January 1, 2007, we account for uncertain tax positions in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”) on income taxes which addresses how we should recognize, measure and present in our financial statements uncertain tax positions that have been taken or are expected to be taken in a tax return. Pursuant to this guidance, we can recognize a tax benefit only if it is “more likely than not” that a particular tax position will be sustained upon examination or audit. To the extent the “more likely than not” standard has been satisfied, the benefit associated with a tax position is measured as the largest amount that is greater than 50% likely of being realized upon settlement. No asset for unrecognized tax benefits was recorded as of December 31, 2017 and 2016.

 

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.

 

The following represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share computation:

 

    Year Ended December 31, 2017     Year Ended December 31, 2016  
    Net Loss
Applicable to
Common
Stockholders
(Numerator)
    Shares
(Denominator)
    Per Share
Amount
    Net Loss
Applicable to
Common
Stockholders
(Numerator)
    Shares
(Denominator)
    Per Share
Amount
 
Basic and Diluted EPS   $ (3,686,908 )     1,137,125,217     $ (0.00 )   $ (5,870,223 )     1,106,272,758     $ (0.01 )
                                                 

As of December 31, 2017 and 2016, common stock equivalents related to the convertible debt, preferred stock and stock derivative liabilities were not included in the denominators of the diluted earnings per share as their effect would be anti-dilutive.

 

Fair Value of Financial Instruments

 

For certain of our financial instruments, including cash, accounts receivable, short term debt and accrued expenses, the carrying amounts approximate fair value due to the short maturity of these instruments. The carrying value of our long-term debt approximates its fair value based on the quoted market prices for the same or similar issues or the current rates offered to us for debt of the same remaining maturities. For additional information, please see Note 4 – Derivative Liabilities and Fair Value Measurements.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenue and expenses during the reporting period. Among the more significant estimates included in these financial statements are the estimated allowance for doubtful accounts receivable, valuation allowance for deferred tax assets, impairment of long-lived assets and intangible and the valuation of warrants and restricted stock grants. Actual results could materially differ from those estimates.

 

F- 10

 

 

Cash Reimbursements

 

We record reimbursement by our customers for out-of-pocket expense as part of consulting services revenue in accordance with the guidance related to income statement characterization of reimbursements received for out of pocket expense incurred.

 

Reclassifications

 

Certain reclassifications have been made to the prior periods to conform to the current period presentation.

 

Recently Issued Accounting Pronouncements

 

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

 

In May 2016, the FASB issued ASU No. 2016-12, “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients”, to clarify certain core recognition principles including collectability, sales tax presentation, noncash consideration, contract modifications and completed contracts at transition and disclosures no longer required if the full retrospective transition method is adopted. The effective date and transition requirements for these amendments are for annual reporting periods beginning after December 15, 2017, including interim reporting periods therein, and that would also permit public entities to elect to adopt the amendments as of the original effective date as applicable to reporting periods beginning after December 15, 2016. The new guidance allows for the amendment to be applied either retrospectively to each prior reporting period presented or retrospectively as a cumulative-effect adjustment as of the date of adoption. The Company adopted the standard on January 1, 2018 and does not anticipate this amendment will have a material impact on its consolidated financial statements.

 

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

 

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

 

Note 2. Going Concern Uncertainty

 

The accompanying consolidated financial statements for 2017 and 2016 have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of 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 December 31, 2017, the Company had negative working capital of approximately $21.0 million and defaulted on several of its debt obligations. The company also incurred net losses in 2017 and 2016. These conditions raise substantial doubt about the Company’s ability to continue as a going concern.

 

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. Related Party Transactions

 

In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed for services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. Mr. Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

 

On June 30, 2016, the Company amended an agreement (originally entered into in July 2010) with certain former and current employees of the Company, concerning the deferral of payroll claims of approximately $883,190 for salary earned from 2012 to June 30, 2016 and $1,652,113 for salary earned from 2001 to 2012. The deferral period ended on December 31, 2017 at which time payroll claims of approximately $1,118,561 for salary earned from 2012 to December 31, 2017 and $1,652,113 for salary earned from 2001 to 2012, remained unpaid and is reflected as a current liability on the Company’s consolidated financial statements.

 

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

 

F- 11

 

 

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

 

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

 

Since payment of the Bonus is contingent upon first paying all unpaid salary and there are no foreseeable revenues to pay the twenty percent interest in these technologies, it is doubtful at the present time that any Bonus will be paid and therefore the Bonus was not accrued as of December 31, 2017 as this contingent liability is considered remote. Cumulative bonus interest through December 31, 2017 is $4,435,576.

 

As of December 31, 2017 and 2016, the Company had accounts payable to related parties in an aggregate amount of $148,760 and $139,546, respectively.

 

Related Party Notes Payable

 

    December 31,  
    2017     2016  
Notes payable bearing interest at 10% to 15% per annum. Of these notes payable $208,242 and $208,242 were in default at December 31, 2017 and 2016, respectively.   $ 208,242     $ 208,242  
                 
Convertible debenture bearing interest at 10% per annum, due one year from date of issuance.   $ 100,000     $ 100,000  
Total notes payable to related parties     308,242       308,242  
                 
Current maturities     (308,242 )     (308,242 )
                 
Long-term portion of notes payable to related parties   $     $  

 

The following table reflects our related party debt activity for the years ended December 31, 2017 and 2016:

 

December 31, 2015   $ 417,445  
Common shares issued for debt principal     (130,000 )
Amortization of debt discounts due to stock and warrants issued with debt     20,797  
December 31, 2016     308,242  
December 31, 2017   $ 308,242  

 

F- 12

 

 

Note 4. Derivative Liabilities and Fair Value Measurements

 

Derivative liabilities

 

During the years ended December 31, 2017 and 2016, the Company entered into several loan agreements with third party lenders and a related party lender under which certain convertible debentures (which are convertible into shares of the Company’s common stock) and warrants to purchase shares of the Company’s common stock were issued. During the year ended December 31, 2016, the Company entered into subscription agreements with third parties to purchase shares of the Company’s Series A Preferred Stock (which are convertible the Company’s common stock) and warrants to purchase shares of the Company’s common stock.

 

For additional details regarding these transactions, please see the 2016 and 2017 summaries for convertible debentures and subscription agreements under “Common and Preferred Stock” in Note 10.

 

During 2016, certain notes issued by the Company became convertible and qualified as derivative liabilities under ASC 815. In addition, the outstanding common stock warrants associated with the notes became tainted and were required to be accounted for as derivative liabilities under ASC 815.

 

For the year ended December 31, 2017, the aggregate change in the fair value of derivative liabilities was a gain of $879,780. For the year ended December 31, 2016, the aggregate change in the fair value of derivative liabilities was a loss of $268,728.

 

The valuation of our embedded derivatives is determined by using the Black-Scholes Option Pricing Model. As such, our derivative liabilities have been classified as Level 3.

 

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 2016
Expected dividends 0% 0%
Expected terms (years) 0.08 – 2.51 0.16 – 3.04
Volatility 108% - 128% 101% - 139%
Risk-free rate 1.53% - 1.98% 0.36% - 1.61%

  

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.

 

 F- 15

 

 

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

 

      Fair value measurements on a recurring basis  
      Level 1     Level 2     Level 3  
As of December 31, 2017:                    
Liabilities                    
Derivatives     $     $     $ 159,537  
                           
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 estimated fair value of our long-term borrowings approximates carrying value since the related rates of interest approximate current market rates.

 

The below table presents the change in the fair value of the derivative liabilities during the year ended December 31, 2017 and 2016:

 

Fair value as of December 31, 2015   $  
   Additions recognized as debt discounts     741,583  
   Additions reclassified from equity     50,557  
   Additions recognized in equity financing     4,005  
   Reduction due to settlement upon conversion     (50,681 )
   Loss on change in fair value of derivatives     268,728  
Fair value as of December 31, 2016   $ 1,014,192  
   Additions recognized as debt discounts     44,240  
   Additions recognized in equity financing     451  
   Reduction due to settlement upon conversion     (19,566 )
   Gain on change in fair value of derivatives     (879,780 )
Fair value as of December 31, 2017   $ 159,537  

 

Note 5. Property and Equipment

 

Property and equipment consist of the following as of December 31, 2017 and 2016:

 

    2017     2016  
             
Equipment (3-5 year life)   $ 920,963     $ 915,280  
Leasehold improvements (5 year life)     87,714       87,714  
Furniture and fixtures (3-5 year life)     45,470       45,500  
                 
Total     1,054,147       1,048,494  
                 
Accumulated depreciation     (1,044,936 )     (1,043,397 )
    $ 9,211     $ 5,097  

 

Depreciation expense for 2017 and 2016 was $1,453 and $1,083, respectively.

 

Note 6. Intangible Assets

 

Intangible assets consisted of the following as of December 31, 2017 and 2016:

 

    2017     2016  
Acquired software (5-year life)   $ 303,994     $ 304,003  
Customer list (5-year life)     2,200       2,200  
Trademark     5,000       5,000  
Website (5-year life)     15,000       15,000  
Total     326,194       326,203  
Accumulated amortization     (319,504 )     (319,513 )
    $ 6,690     $ 6,690  

 

Amortization expense for 2017 and 2016 was $0 and $0, respectively.

 

 F- 16

 

 

During 2017, the Company did not capitalize any costs related to software development.

 

During 2016, the Company capitalized an aggregate of $246,184 related to software development and wrote off $1,421,155 of impaired software development costs related to its Ploinks™ software application, which included the $246,184.

 

Note 7. Accounts Payable and Accrued Expenses

 

Accounts payable and accrued liabilities consist of the following:

 

    2017     2016  
             
Accounts payable   $ 2,847,404     $ 2,613,942  
Accrued payroll     3,205,759       2,734,024  
Accrued payroll tax and penalties     2,911,718       2,309,970  
Accrued interest     4,236,038       3,371,112  
Accrued taxes     511,966       598,684  
Accrued liabilities - other     409,509       447,566  
    $ 14,122,394   $ 12,075,298  

 

Accrued payroll primarily consists of deferred compensation for several executives who agreed to defer a portion of their salaries due to cash flow constraints. Accrued payroll tax and penalties relate to unpaid payroll taxes, interest and penalties for NOW Solutions, Inc. and for certain non-functioning subsidiaries, The Internal Revenue Service has made a claim for payroll taxes owed of approximately $1.5 million and has garnished certain receivables from U.S. customers. Accrued taxes primarily consist of U.S. sales tax, Canadian GST, Canadian income tax and U.S. income tax. Accrued liabilities – other primarily consists of accrued rent, board of director fees, unbilled professional and consulting fees, and other accrued expenses.

 

Note 8. Notes Payable and Convertible Debts

 

The following table reflects our third-party debt activity, including our convertible debt, for the years ended December 31, 2016 and 2015:

 

December 31, 2015   $ 5,397,020  
Repayments of third party notes     (113,699 )
Borrowings from third parties     885,000  
Conversion of convertible debt principal to common stock     (74,297 )
Debt discounts due to stock and warrants issued with debt     (872,196 )
Amortization of debt discounts     627,542  
Attorney fees added to note principal     3,500  
Currency translation     275  
December 31, 2016     5,853,145  
Repayments of third party notes     (159,705 )
Borrowings from third parties     480,500  
Conversion of convertible debt principal to common stock     (19,213 )
Debt discounts due to parent stock and warrants and subsidiary stock issued with debt and derivative liabilities from convertible debt     (198,688 )
Amortization of debt discounts     478,398  
Subsidiary dividends to noncontrolling interest added to note principal     250,000  
Accrued interest added to note principal     414,364  
Currency translation     (663 )
December 31, 2017   $ 7,098,138  

 

 F- 17

 

 

During the year ended December 31, 2016, the Company issued convertible debentures in the aggregate principal amount of $715,000 to various third party lenders for loans made to the Company in the same amount. The debts accrue interest at 10% per annum and are due one year from the date of issuance. Beginning six months after issuance of the respective debentures and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company’s common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loans, the Company also issued a total of 7,150,000 shares of common stock of the Company to the lenders with the Rule 144 restrictive legend and 3 year warrants under which each lender may purchase in aggregate a total of 7,150,000 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 $186,967 against the face value of the loans based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as derivative liabilities. The discount is being amortized over twelve months and $105,597 of amortization expense was recognized for the year ended December 31, 2016.

 

During the year ended December 31, 2016, $82,001 of principal, interest and fees under a convertible note were converted into 5,914,783 unrestricted common shares of the Company.

 

During the year ended December 31, 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 year ended December 31, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 (as amended) was converted into 1,688,762 common shares. In May 2017, the Company amended this convertible note which was 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 same third-party lender. This convertible note has been paid in full.

 

During the year ended December 31, 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 lender. These convertible debentures have been paid in full.

 

During the year ended December 31, 2017, the Company granted a total of 651,700 shares of the common stock of Ploinks, Inc. to third party lenders in connection with a series of 3 and 6-month extensions of convertible debentures in the aggregated principal amount of $1,200,000 issued in 2015 and 2016. The aggregate fair market value of the awards was determined to be $142,156 and was recorded as debt discount and is being amortized through the term of the convertible debenture. Certain notes issued in the prior year(s) become convertible during 2017. Consequently, the embedded conversion feature was determined to be derivative liabilities, and the Company recognized a derivative debt discount. Amortization expense of $39,142 for this debt discount was recorded during the year ended December 31, 2017.

 

During the year ended December 31, 2017, the Company’s total amortization of debt discounts was $478,398 and was recorded as interest expense.

 

Lakeshore Financing

 

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

 

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

 

 F- 18

 

 

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

 

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

 

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

 

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

 

The 2017 Lakeshore Loan Amendment also provides that if NOW Solutions makes any advance toward net income (less Vertical’s management fee and management allocations) to Vertical, then NOW Solutions shall pay Lakeshore 25% share of such an advance no later than one business day after Vertical receives its 75% percent share.

 

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

 

During the year ended December 31, 2017, the Company, through its subsidiary, accrued dividends of $250,000 payable to Lakeshore of which $250,000 was rolled into their note payable balance. During the year ended December 31, 2016, the Company, through its subsidiary, paid $295,000 towards dividends owed.

 

 F- 19

 

 

    December 31     December 31  
    2017     2016  
             

Third Party Notes Payable

               
Unsecured notes payable issued to third party lenders bearing interest at rates between 10% and 15% per annum and are past due their original maturity dates. Of these notes, $1,555,639 and $1,570,368 were in default or non-performing as of December 31, 2017 and 2016, respectively.   $ 2,146,139     $ 1,830,377  
                 
Secured notes payable issued to third party lenders, bearing interest at 10% to 18% per annum. These notes are secured by stock pledges by MRC totaling 33,976,296 common shares. Of these notes $1,025,449 and $1,025,449 were in default or non-performing at December 31, 2017 and 2016, respectively.     1,025,449       1,025,449  
                 
Secured notes payable issued to third party lenders, bearing interest at 11% to 18% per annum. These notes are secured by certain technology owned by the Company, supporting its Emily product. Of these notes $470,860 were in default or non-performing at December 31, 2017 and 2016.
    470,860       470,860  
                 
Secured note payable issued to Lakeshore, bearing interest at 11% per annum. The note is secured by all assets of NOW Solutions and was secured by all of the assets of Priority Time, and SnAPPnet, Inc. as well as the SiteFlash™ technology until these security interests were cancelled in December 2017. This note was current at December 31, 2017 but was in default at December 31, 2016.
    2,291,395       1,627,031  
Total notes payable to third parties
    5,933,843       4,953,717  
Current maturities     3,775,703       4,953,717  
Long-term portion of notes payable to third parties   $ 2,158,140     $  

 

Certain notes payable also contain provisions requiring additional principal reductions in the event sales by NOW Solutions exceed certain financial thresholds or the Company receives “Net Proceeds” from infringement claims regarding U.S. Patent #6,826,744, U.S. Patent #7,716,629 and U.S. Patent #8,949,780 (which include the SiteFlash™ technology).

 

The company had new borrowings on third party notes of $370,500, increased note principal on the Lakeshore debt by $250,000 for unpaid dividends and made note payments of $44,705 during the year ended December 31, 2017.

 

Third Party Convertible Promissory Notes and Debentures

 

Third party convertible promissory notes and debentures consist of the following:

 

    December 31,
2017
    December 31,
2016
 
             
In December 2003, we issued a debenture in the amount of $30,000 to a third party. The debt accrues interest at 13% per annum and was due December 2005. The holder may convert the debenture into shares of common stock at 100% of the closing price.   $ 30,000     $ 30,000  
                 
Convertible debentures to various third-party lenders for loans made to the Company in the aggregate amount of $1,210,000 net of unamortized discounts of $75,705.  The debts accrue interest at 10% per annum and are due one year from the date of issuance.  Beginning six months after issuance of the respective debenture, the holder of the debenture may convert the debenture into shares of common stock at a price per share of either (a) 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.     1,134,295       869,428  
                 
Total convertible debentures     1,164,295       899,428  
Current maturities     (1,164,295 )     (899,428 )
Long-term portion of convertible debentures   $     $  

 

Future minimum payments for third party, related party, and convertible debentures for the next five years are as follows:

 

Year     Amount  
         
2018   $ 5,323,945  
2019     148,722  
2020     165,932  
2021     185,134  
2022+     1,658,352  
         
Total notes payable     7,482,085  
Unamortized discounts     (75,705 )
Notes payable, net of discounts
  $ 7,406,380  

 

 F- 20

 

 

For additional transactions involving notes payable after December 31, 2017, please see “Subsequent Events” in Note 12.

 

Note 9. Income Taxes

 

We account for income taxes using the asset and liability method of accounting for income taxes. Deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rate applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities and result primarily form differences in methods used to amortize intangible assets. A valuation allowance is provided when management cannot determine whether it is more likely than not that the deferred tax asset will be realized. The effect on deferred income taxes of the change in tax rates is recognized in income in the period that includes the enactment date. The difference between the statutory tax rate and the effective tax rate is the valuation allowance.

 

The provision of income taxes consists of the following for the years ended December 31, 2017 and 2016:

 

      Years Ended December 31,  
      2017     2016  
Current              
   Federal             73,016  
   State              
   Foreign       11,876       13,362  
        11,876       86,378  

 

During 2017 and 2016, the Company recorded an income tax provision of $11,876 and $86,378, respectively related to income taxes for NOW Solutions, a 75% owned subsidiary of the Company.

 

Temporary difference between the financial statement carrying amount and tax bases of assets and liabilities that give rise to deferred tax assets relate to the following:

 

    December 31,
2017
    December 31,
2016
 
Net operating loss carry-forward   $ 6,848,000     $ 10,255,000  
Reserves     258,000       512,000  
Accrued vacation     24,000       38,000  
Deferred compensation     649,000       892,000  
Deferred revenue     368,000       610,000  
      8,147,000       12,307,000  
Valuation allowance     (8,147,000 )     (12,307,000 )
    $     $  

 

At December 31, 2017 and December 31, 2016, VCSY had available net operating loss carry-forwards of approximately $22.6 million and $20.6 million, respectively. At December 31, 2017 and 2016, NOW Solutions had available net operating loss carry-forwards of approximately $395,000 and $281,000, respectively. These net operating loss carry-forwards expire in varying amounts through 2032.

 

 F- 21

 

 

The benefit for income taxes differs from the amount computed by applying the U.S. federal income tax rate of 34% to loss before income taxes as follows for the years ended December 31, 2017 and 2016:

 

    2017     2016  
             
U.S. federal income tax expense at statutory rates     (1,103,299 )     (1,852,199 )
Permanent differences     109,130       5,719  
Foreign income tax expense     11,876       13,362  
Change in valuation allowance     994,169       1,919,496  
      11,876       86,378  

 

As of December 31, 2016, all garnishments of NOW Solutions Canada customer receivables in order to pay debts owed to the Canada Revenue Agency for income tax and good and services taxes (“GST”) had been removed and all outstanding debts related to the GST had been paid.

 

Open tax years for U.S. federal income taxes for VCSY are 2012, 2013, 2014, 2015, 2016 and 2017. Open tax years for U.S. federal income taxes for NOW Solutions are 2013, 2014, 2015, 2016 and 2017.

 

The Tax Cuts and Jobs Act (the “Act”) was enacted on December 22, 2017. The Act reduces the US federal corporate tax rate from 35% to 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. As of December 31, 2017, the Company has not completed the accounting for the tax effects of enactment of the Act; however, as described below, it has made a reasonable estimate of the effects on existing deferred tax balances. These amounts are provisional and subject to change. The most significant impact of the legislation for the Company was a $5,046,000 reduction of the value of the Company’s net deferred tax assets (which represent future tax benefits) as a result of lowering the U.S. corporate income tax rate from 35% to 21%. The Act also includes a requirement to pay a one-time transition tax on the cumulative value of earnings and profits that were previously not repatriated for U.S. income tax purposes. The Company has not made sufficient progress on the transition tax analysis to reasonably estimate the effects, and therefore, has not recorded provisional amounts. However, based on analysis to date the one-time transition tax is not expected to be material.

 

Note 10. Common and Preferred Stock

 

Terms of Common and Preferred Stock

 

Common Stock . The authorized capital stock of the Company consists of 2,000,000,000 shares of common stock, par value $0.00001 per share, of which 1,188,095,201 were issued and 1,148,095,201 were outstanding at December 31, 2017 and 1,167,841,439 were issued and 1,127,841,439 were outstanding at December 31, 2016. Each share of our common stock entitles the holder to one vote on each matter submitted to a vote of our stockholders, including the election of directors. There is no cumulative voting and there are no redemption or sinking fund provisions related to the common stock. Stockholders of our common stock have no preemptive, conversion or other subscription rights.

 

Series A Cumulative Convertible Preferred Stock . We have authorized the issuance of 250,000 shares of Series A 4% Cumulative Convertible Preferred Stock (“Series A Preferred Stock”), of which there are 52,800 shares issued and outstanding at December 31, 2017 and 51,500 shares issued and outstanding at December 31, 2016. Holders of these shares of Series A Preferred Stock are entitled to vote on an as-converted basis with the holders of common stock, except that the holders are entitled to vote as a separate class on any matters affecting the Series A Preferred Stock stockholders, on the sale of the business, the increase in the number of directors, the payment of a dividend on any junior stock, and the issuance of any stock that is on parity or senior to the Series A Preferred Stock. Each share of Series A Preferred Stock is entitled to 500 votes per share. Dividends accrue at an annual rate of 4% of the liquidation preference and are payable quarterly subject to the board’s discretion. Each share of Series A Preferred Stock is convertible into 500 shares of common stock of the Company. In the event of liquidation, each share of Series A Preferred Stock will be entitled to a preference of $200, plus accrued but unpaid dividends, prior to the holders of any junior class of stock.

 

Series B 10% Cumulative Convertible Preferred Stock . We have authorized the issuance of 375,000 shares of Series B 10% Cumulative Convertible Redeemable Preferred Stock (“Series B Preferred Stock”), of which there are 7,200 shares outstanding at December 31, 2017 and December 31, 2016. Holders of Series B Preferred Stock are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash or stock dividends accrue cumulatively at an annual rate of 10% per annum on March 15 and September 15 of each year and are payable subject to the board’s discretion. Each share of Series B Preferred Stock is convertible into 3.788 shares of common stock of the Company. The shares of Series B Preferred Stock are redeemable at a rate of $6.25 per share, or $45,000 if all outstanding shares are redeemed. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holders of any class of common stock.

 

Series C 4% Cumulative Convertible Preferred Stock . We have authorized the issuance of 200,000 shares of Series C 4% Cumulative Convertible Preferred Stock (“Series C Preferred Stock”), of which there are 50,000 shares outstanding at December 31, 2017 and December 31, 2016. Holders of Series C Preferred Stock are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash dividends accrue at an annual rate of 4% of the liquidation preference and are payable quarterly subject to the board’s discretion. Each share of Series C Preferred Stock is convertible into 400 shares of common stock of the Company; however, of the 50,000 shares of the Company’s Series “C” Cumulative Convertible Preferred Stock that are outstanding, the holder of 37,500 shares waived the conversion rights associated with these shares pursuant to an agreement in 2010. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holder of any class of common stock.

 

 F- 22

 

 

In the event of liquidation, each share of Series C Preferred Stock will be entitled to a preference of $100, plus accrued but unpaid dividends, prior to the holders of any junior class of stock.

 

Series D 15% Cumulative Convertible Preferred Stock . We have authorized the issuance of 300,000 shares of Series D 15% Cumulative Convertible Redeemable Preferred Stock (“Series D Preferred Stock”), of which there were 25,000 shares outstanding at December 31, 2017 and December 31, 2016. Holders of these shares are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash dividends accrue cumulatively at an annual rate of 15% per annum on March 15 and September 15 of each year and are payable subject to the board’s discretion. Any aggregate deficiency shall be cumulative and shall be fully paid or set apart for payment before any dividend shall be paid or set apart for payment of any class of common stock. Each share of Series D Preferred Stock is convertible into 3.788 shares of common stock of the Company. The shares of Series D Preferred Stock are redeemable at a rate of $6.25 per share, or $156,250 if all outstanding shares are redeemed. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holders of any class of common stock.

 

2017

 

Common Stock

 

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 consisted 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.

 

In December 2017, in order to facilitate the amendment of the Lakeshore Loan Agreement and the Lakeshore Note, which resulted in the curing any existing defaults under the Lakeshore Loan Agreement and the Lakeshore Note as well as the release by Lakeshore of the security interests in the SiteFlash assets and the assets of SnAPPnet and Priority Time which secured the Lakeshore Note, the Company issued 2,500,000 VCSY common shares at a fair market value of $35,400 and 300,000 Ploinks common shares at a fair market value of $92,850 to third party purchasers of 600,000 shares of VHS Series A Preferred Stock from a member of Lakeshore. For additional details concerning the amendment of the Lakeshore Loan and the Lakeshore Note, please see the “Lakeshore Financing” subsection under “Notes Payable and Convertible Debts” of Note 8.

 

During the year ended December 31, 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 year ended December 31, 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.

 

 F- 23

 

 

During the year ended December 31, 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 year ended December 31, 2017, the Company granted a total of 651,700 shares of the common stock of Ploinks, Inc. to third party lenders in connection with a series of 3 and 6-month extensions of convertible debentures in the aggregated principal amount of $1,200,000 issued in 2015 and 2016. The aggregate fair market value of the awards was determined to be $142,156 and was recorded as debt discount and is being amortized through the term of the convertible debenture. Certain notes issued in the prior year(s) become convertible during 2017. Consequently, the embedded conversion feature was determined to be derivative liabilities, and the Company recognized a derivative debt discount.

 

During the year ended December 31, 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 year ended December 31, 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 year ended December 31, 2017.

 

During the year ended December 31, 2017, 3,665,000 VCSY common shares vested under restricted stock agreements to employees and two consultants of the Company.

 

During the year ended December 31, 2017, 3,000,000 VCSY common shares were issued to an employee of the Company. The fair market value of the shares was $72,000.

 

During the year ended December 31, 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 year ended December 31, 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 year ended December 31, 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 year ended December 31, 2017 $279,482 was amortized to expense related to the issuance of Ploinks, Inc. restricted stock.

 

During the year ended December 31, 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 $116,180 for the year ended December 31, 2017. As of December 31, 2017, there were 6,140,000 shares of unvested stock compensation awards to employees and 15,500,000 shares of unvested stock compensation awards to non-employees.

 

 F- 24

 

 

Preferred Stock

 

For the year ended December 31, 2017, total dividends applicable to Series A and Series C Preferred Stock was $616,667. The Company did not declare or pay any dividends in 2017. Although no dividends have been declared, the cumulative total of preferred stock dividends due to these stockholders upon declaration was $10,104,851 as of December 31, 2017.

 

2016

 

Common Stock

 

In March 2016, the Company cancelled 1,000,000 unregistered shares of its common stock issued during 2015 to a third party lender under an agreement to amend certain promissory notes issued by the Company and NOW Solutions in the aggregate principal amount of $715,000. Under the amendment, the Company agreed to make $22,000 monthly payments and an additional $10,000 penalty if such monthly payment is not timely made.

 

In March 2016, the Company issued 10,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to its consolidated subsidiary Ploinks, Inc. These shares are held in treasury. In exchange, Ploinks, Inc. issued 5,000,000 of its common shares to the Company.

 

In April 2016, the Company and a third-party noteholder entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend in exchange for the cancellation of $130,000 in principal owed under a note payable issued by NOW Solutions with a principal amount of $213,139. The fair market value of the shares was $92,500. A gain on debt extinguishment of $37,500 was recorded for the year ended December 31, 2016.

 

In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed for services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. Mr. Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

 

In May 2016, the Company and a third party entered into an agreement under which the Company issued 1,500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to the third party in lieu of paying $35,969 in fees, expenses, and interest owed to the third party for services rendered to the Company and its subsidiaries. The fair market value of the shares issued was $37,500. A loss on debt extinguishment of $1,531 was recorded for the year ended December 31, 2016.

 

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

 

During the year ended December 31, 2016, the Company issued 3,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to third-party consultants for services. The fair market value of the shares was $66,550 and was recorded as consulting fees for the year ended December 31, 2016.

 

During the year ended December 31, 2016, the Company issued convertible debentures in the aggregate principal amount of $715,000 to various third-party lenders for loans made to the Company in the same amount. The debts accrue interest at 10% per annum and are due one year from the date of issuance. Beginning six months after issuance of the respective debentures and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company’s common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loans, the Company also issued a total of 7,150,000 shares of common stock of the Company to the lenders with the Rule 144 restrictive legend and 3 year warrants under which each lender may purchase in aggregate a total of 7,150,000 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 $186,967 against the face value of the loans based on the relative fair market value of the common stock of $114,413 and the full fair market value of the warrants of $72,554. The warrants are accounted for as derivative liabilities. The discount is being amortized over twelve months and amortization expense was recognized for the year ended December 31, 2016.

 

 F- 25

 

 

During the year ended December 31, 2016, $82,001 of principal, interest and fees under a convertible note issued in the principal amount of $80,000 were converted into 5,914,783 unrestricted common shares of the Company.

 

During the year ended December 31, 2016, the Company entered into subscription agreements under which third party subscribers purchased 3,000 shares of VCSY Series A Preferred Stock for $600,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 6,000,000 shares of common stock of the Company with the Rule 144 restrictive legend, 300,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscribers may purchase an aggregate total of 450,000 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 450,000 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 $366,499. 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 $229,496. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $3,416. The fair market value of all warrants issued to the subscribers was $4,005 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

 

During the year ended December 31, 2016, the Company cancelled 200,000 previously awarded but unvested unregistered shares of the Company’s common stock issued to an employee of the Company when the employee resigned. This resulted in the reversal of previously recognized compensation expense of $1,145 during the year ended December 31, 2016.

 

During the year ended December 31, 2016, the Company granted 18,250,000 unregistered shares of its common stock pursuant to restricted stock agreements. Shares under restricted stock agreements typically vest over a period of 1-3 years in various installments and the fair value of the awards is being expensed over the vesting periods. The aggregate fair market value of the awards was determined to be $361,365. Stock compensation expense of $229,223 has been recorded for the year ended December 31, 2016 as additional paid-in capital.

 

Stock compensation expense for the amortization of restricted stock awards for VCSY stock was $229,223 for the year ended December 31, 2016. As of December 31, 2016, there were 13,125,000 shares of unvested VCSY common stock compensation awards to employees and consultants.

 

During the year ended December 31, 2016, 7,175,000 VCSY common shares issued under restricted stock agreements to employees of the Company were vested.

 

During the year ended December 31, 2016, the Company granted 150,000 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 $500,000 issued in 2015. The aggregate fair market value of the awards was determined to be $16,200 and was recorded as debt discount, and amortized through the term of the note.

 

During the year ended December 31, 2016, Ploinks, Inc. granted 1,000,000 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 3 years in various installments and the fair value of the awards is being expensed over this vesting period. The aggregate fair market value of the awards was determined to be $108,000. Stock compensation expense of $70,800 has been recorded for the year ended December 31, 2016.

 

During the year ended December 31, 2016, the Company granted 4,286,000 unregistered shares of the common stock of Ploinks, Inc. to employees and consultants of the Company and its subsidiaries pursuant to restricted stock agreements with the Company. These shares typically vest over 3 years in various installments and the fair value of the awards is being expensed over this vesting period. The aggregate fair market value of the awards was determined to be $462,888. Stock compensation expense of $264,227 has been recorded for the year ended December 31, 2016. These shares were issued out of shares owned by VCSY.

 

During the year ended December 31, 2016, 2,332,001 unregistered shares of the common stock of Ploinks, Inc. to employees and consultants of the Company and its subsidiaries granted under restricted stock agreement vested.

 

During the year ended December 31, 2016, 133,334 unregistered shares of the common stock of Ploinks, Inc. granted to an employee of the Company under a restricted stock agreement were cancelled.

 

 F- 26

 

 

For additional transactions concerning common and preferred stock after December 31, 2017, please see “Subsequent Events” in Note 13.

 

Preferred Stock

 

For the year ended December 31, 2016, total dividends applicable to Series A and Series C Preferred Stock was $592,472. The Company did not declare or pay any dividends in 2016. Although no dividends have been declared, the cumulative total of preferred stock dividends due to these stockholders upon declaration was $9,488,184 as of December 31, 2016.

 

Note 11. Option and Warrant Activity

 

Option and warrant activity years ended December 31, 2017 and 2016 is summarized as follows:

 

    Incentive Stock Options     Non-Statutory Stock Options     Warrants     Weighted Average Exercise Price  
Outstanding at December 31, 2015                 6,800,000     $ 0.091  
Options/Warrants granted                 8,050,000     $ 0.106  
Options/Warrants exercised                        
Options/Warrants expired/cancelled                        
Outstanding at December 31, 2016                 14,850,000     $ 0.100  
Options/Warrants granted                 1,490,000     $ 0.101  
Options/Warrants exercised                        
Options/Warrants expired/cancelled                        
Outstanding at December 31, 2017                 16,340,000     $ 0.101  

 

The weighted average remaining life of the outstanding warrants as of December 31, 2017 and 2016 was 1.60 and 2.48, respectively. The intrinsic value of the exercisable warrants as of December 31, 2017 and 2016 was $.0170 and $.0220.

 

Note 12. Commitments and Contingencies

 

Commitments

 

We lease various office spaces which leases run from July 2016 through September 2018. We have future minimum rental payments as follows:

 

Years ending December 31,     Amount  
2018       65,250  
2019       8,445  
2020       4,223  
2021        
2022        
Total     $ 77,918  

 

Rental expense for the years ended December 31, 2017 and 2016 was $105,899 and $106,208, respectively.

 

Contingencies

 

On June 30, 2016, the Company amended an agreement (originally entered into in July 2010) with certain former and current employees of the Company, concerning the deferral of payroll claims of approximately $883,190 for salary earned from 2012 to June 30, 2016 and $1,652,113 for salary earned from 2001 to 2012. The deferral period ended on December 31, 2017 at which time payroll claims of approximately $1,118,561 for salary earned from 2012 to December 31, 2017 and $1,652,113 for salary earned from 2001 to 2012, remained unpaid and is reflected as a current liability on the Company’s consolidated financial statements.

 

 F- 27

 

 

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

 

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

 

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

 

Since payment of the Bonus is contingent upon first paying all unpaid salary and there are no foreseeable revenues to pay the twenty percent interest in these technologies, it is doubtful at the present time that any Bonus will be paid and therefore the Bonus was not accrued as of December 31, 2017 as this contingent liability is considered remote. Cumulative bonus interest through December 31, 2017 is $4,435,576.

 

Royalties

 

When we acquire rights to patents, licenses, or other intellectual property, we generally agree to pay royalties on any net sales of any products utilizing these rights. There were no sales of products requiring royalties in 2017 and 2016.

 

We also have royalty agreements associated with certain notes payable that provide a royalty when revenues exceed certain thresholds in addition to royalty agreements on subsidiary revenues pursuant to the terms of an acquisition agreement. For the years ended December 31, 2017 and 2016, we accrued royalties of $4,614 and $7,405, respectively, on revenues from subsidiaries.

 

Litigation

 

We are involved in the following ongoing legal matters:

 

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

 

 F- 28

 

 

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company. The Company has $121,617 of principal and interest accrued as of December 31, 2017.

 

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 $298,016 of principal and accrued interest as of December 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 13. Subsequent Events

 

During the period that runs from January 1, 2018 through May 10, 2018, the Company extended the term of certain warrants to purchase a total of 5,400,000 shares of VCSY common stock (at $0.10 per share) for an additional 1-year period and granted 83,200 shares of the common stock of Ploinks, Inc. to third-party lenders in connection with 3 and 6-month extensions of convertible debentures in the principal amount of $540,000 that were issued in 2015 and 2016.

 

During the period that runs from January 1, 2018 through May 10, 2018, 320,000 shares of VCSY common stock issued to employees of the Company vested.

 

During the period that runs from January 1, 2018 through May 10, 2018, 209,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

 

 F- 29