NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note
1. Organization, Basis of Presentation and Significant Accounting Policies
The
accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”,
the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted
in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with
the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the
year ended December 31, 2017. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively,
“our”, “we”, the “Company,” “Vertical”, or “VCSY”, as applicable).
Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and
SnAPPnet, Inc. (“SnAPPnet”), an 80% owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal
operations are Vertical do Brasil, Taladin, Inc. (“Taladin”), and Vertical Healthcare Solutions, Inc. (“VHS”),
each of which a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”), an
80% owned subsidiary, Ploinks, Inc. (“Ploinks”), an 88% owned subsidiary and Government Internet Systems, Inc. (“GIS”),
an 84.5% owned subsidiary. Vertical’s subsidiaries which are inactive include EnFacet, Inc. (“ENF”), Globalfare.com,
Inc. (“GFI”), Pointmail.com, Inc. and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned
subsidiary of Vertical.
In
the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial
position and the results of operations for the interim periods presented have been reflected herein. The results of operations
for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated
financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported
in the 2017 annual report on Form 10-K have been omitted.
Revenue
Recognition
On
January 1, 2018, the company adopted ASU No. 2016-12, "Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements
and Practical Expedients” using the modified retrospective method applied to those contracts which were not completed as
of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period
amounts are not adjusted and continue to be reported in accordance with our historic accounting under Topic 605. There was no
impact to the opening balance of accumulated deficit or revenues for the quarter ended March 31, 2018 as a result of applying
Topic 606.
The
Company applies a five-step approach in determining the amount and timing of revenue to be recognized: (1) identifying the contract
with a customer, (2) identifying the performance obligations in the contract, (3) determining the transaction price, (4) allocating
the transaction price to the performance obligations in the contract and (5) recognizing revenue when the performance obligation
is satisfied. Substantially all of the Company’s revenue is recognized at the time control of the products transfers to
the customer.
ASC
606-10-50-5 requires that entities disclose disaggregated revenue information in categories (such as type of good or service,
geography, market, type of contract, etc..). ASC 606-10-55-89 explains that the extent to which an entity’s revenue is disaggregated
depends on the facts and circumstances that pertain to the entity’s contracts with customers and that some entities may
need to use more than one type of category to meet the objective for disaggregating revenue.
The
Company disaggregates revenue by industry as well as by country to depict the nature and economic characteristics affecting revenue.
The following table presents our revenue disaggregated by industry for the three months ended:
Industry
|
|
March
31, 2018
|
|
|
March
31, 2017
|
|
|
|
|
|
|
|
|
Agriculture
|
|
$
|
72,120
|
|
|
$
|
97,451
|
|
Automotive
|
|
|
7,341
|
|
|
|
7,053
|
|
Distribution
|
|
|
22,535
|
|
|
|
17,118
|
|
Education
|
|
|
243,306
|
|
|
|
143,398
|
|
Financial
Services
|
|
|
23,046
|
|
|
|
18,863
|
|
Government
|
|
|
150,428
|
|
|
|
117,926
|
|
Healthcare
|
|
|
290,539
|
|
|
|
303,602
|
|
Manufacturing
|
|
|
57,770
|
|
|
|
53,307
|
|
|
|
|
|
|
|
|
|
|
Manufacturing
Services
|
|
|
10,856
|
|
|
|
7,140
|
|
Media
|
|
|
29,027
|
|
|
|
26,788
|
|
Oil
and Gas
|
|
|
50,936
|
|
|
|
46,335
|
|
Pulp
and Paper Distribution
|
|
|
23,913
|
|
|
|
32,517
|
|
Pulp
and Paper Manufacturing
|
|
|
5,186
|
|
|
|
4,586
|
|
Engineering
|
|
|
34,777
|
|
|
|
33,588
|
|
Food
Services
|
|
|
4,246
|
|
|
|
3,932
|
|
Government
Contractor
|
|
|
45,502
|
|
|
|
29,139
|
|
|
|
|
|
|
|
|
|
|
Total
Revenue
|
|
$
|
1,071,528
|
|
|
$
|
942,743
|
|
The
following table presents our revenue disaggregated by country for the three months ended:
Country
|
|
March
31, 2018
|
|
|
March
31, 2017
|
|
|
|
|
|
|
|
|
Canada
|
|
$
|
666,471
|
|
|
$
|
560,257
|
|
United
States
|
|
|
405,057
|
|
|
|
382,486
|
|
|
|
|
|
|
|
|
|
|
Total
Revenue
|
|
$
|
1,071,528
|
|
|
$
|
942,743
|
|
Earnings
per share
Basic
earnings per share is calculated by dividing net income (loss) available to common stockholders by the weighted average number
of shares of the Company’s common stock outstanding during the period. “Diluted earnings per share” reflects
the potential dilution that could occur if our share-based awards and convertible securities were exercised or converted into
common stock. The dilutive effect of our share-based awards is computed using the treasury stock method, which assumes all share-based
awards are exercised and the hypothetical proceeds from exercise are used to purchase common stock at the average market price
during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they
would have been dilutive, are included in the denominator of the diluted EPS calculation. The dilutive effect of our convertible
preferred stock and convertible debentures is computed using the if-converted method, which assumes conversion at the beginning
of the year.
For the three months
ended March 31, 2018 and 2017, common stock equivalents related to warrants
and
preferred stock were not included in the calculation of the diluted loss per share as their effect would be anti-dilutive. For
the three months ended March 31, 2018 and 2017, the Company had 56,358,481 and 83,059,735 potential common shares under convertible
notes which were included in the calculation of diluted loss per share.
Recently
Issued Accounting Pronouncements
In
February 2016, the FASB issued ASU No. 2016-02,” Leases” (Topic 842) which includes a lessee accounting model that recognizes
two types of leases - finance leases and operating leases. The standard requires that a lessee recognize on the balance sheet
assets and liabilities for leases with lease terms of more than 12 months. The recognition, measurement, and presentation of expenses
and cash flows arising from a lease by a lessee will depend on its classification as a finance or an operating lease. New disclosures
to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising
from leases are also required. These disclosures include qualitative and quantitative requirements, providing information about
the amounts recorded in the financial statements. ASU 2016-02 will be effective for fiscal years beginning after December 15,
2018, including interim periods within those fiscal years. The Company is currently evaluating the effect its adoption of this
standard, if any, on our consolidated financial position, results of operations or cash flows.
In
May 2017, the FASB issued ASU No. 2017-09, “Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting”,
to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718,
Compensation—Stock Compensation, to a change to the terms or conditions of a share-based payment award. The ASU provides
guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification
accounting in ASC 718. The amendments are effective for fiscal years beginning after December15, 2017 and should be applied prospectively
to an award modified on or after the adoption date. Early adoption is permitted, including adoption in an interim period. The
Company adopted the standard on January 1, 2018 and the amendment did not have a material impact on its consolidated financial
statements.
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
The
accompanying unaudited consolidated financial statements for the three months ended March 31, 2018 and 2017 have been prepared
assuming that we will continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal
course of business.
The
carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable
or settlement values. As of March 31, 2018, we had negative working capital of approximately $23.7 million and defaulted on substantially
all of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.
Our
management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion
and possible acquisitions, mergers, joint ventures, and/or other business combinations. The Company will require additional funds
to pay down its liabilities, as well as finance its expansion plans consistent with anticipated changes in operations and infrastructure.
However, there can be no assurance that the Company will be able to secure additional funds and that if such funds are available,
whether the terms or conditions would be acceptable to the Company and whether the Company will be able to turn into a profitable
position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome
of this uncertainty.
Note
3. Notes Payable
The
following table reflects our third-party debt activity, including our convertible debt, for the three months ended March 31, 2018:
December
31, 2017
|
|
$
|
7,098,138
|
|
Repayments
of third party notes
|
|
|
(31,926
|
)
|
Debt
discounts due to parent stock and warrants and subsidiary stock issued with debt and derivative liabilities from convertible
debt
|
|
|
(52,426
|
)
|
Amortization
of debt discounts
|
|
|
80,404
|
|
Effect
of currency exchange
|
|
|
1
|
|
March
31, 2018
|
|
$
|
7,094,191
|
|
During
the three months ended March 31, 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 83,300 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. The aggregate fair market value of the Ploinks shares was determined to be $25,779 and was
recorded as debt discount and is being amortized through the term of the convertible debenture. The incremental change in the
fair value of the extended warrants was immaterial and did not change the conclusion of the debt modification.
For
additional transactions after March 31, 2018, please see “Subsequent Events” in Note 9.
Lakeshore
Financing
On
January 9, 2013, the Company and several of its subsidiaries entered into a loan agreement (the “
Loan Agreement
"),
dated as of January 9, 2013 with Lakeshore Investment, LLC ("
Lakeshore
") under which NOW Solutions issued a secured 10-year
promissory note (the “
Lakeshore Note
") bearing interest at 11% per annum to Lakeshore in the original amount of $1,759,150
and payable in equal monthly installments of $24,232 until January 31, 2022. Upon the payment of any prepayment principal amounts,
the monthly installment payments will be adjusted proportionately on an amortized rata basis.
The
Lakeshore Note was originally secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet,
Inc. ("
SnAPPnet
") and the Company’s SiteFlash™ technology, which were all cross-collateralized. Upon full payment
of the Lakeshore Note, Lakeshore will be obligated to release the NOW Solutions collateral.
As
additional consideration for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees
and direct costs) from any litigation or settlement proceeds related to the SiteFlash™ technology to Lakeshore which was
increased to 8% under an amendment to the Loan Agreement in 2013. In addition, until the Note is paid in full, NOW Solutions agreed
to pay Lakeshore a royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management
has estimated the fair value of the royalty to be nominal as of its issuance date and no royalty was owed as of December 31, 2017
or December 31, 2016.
Under
an amendment of the Lakeshore Note and the Loan Agreement executed on January 31, 2013, Vertical was obligated to transfer 25%
of its ownership interest in NOW Solutions in the event certain principal payments were not timely made to Lakeshore. When the
last forbearance agreement with Lakeshore expired, Lakeshore became a 25% minority owner of NOW Solutions on October 1, 2013.
In
December 2014, the Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. In consideration
of an extension Lakeshore granted to NOW Solutions to cure the default under the Lakeshore Note and the Loan Agreement, the Company
transferred a 20% ownership interest in two subsidiaries to Lakeshore: Priority Time Systems, Inc., and SnAPPnet, Inc.
In
December 2017, the Vertical and NOW Solutions and Lakeshore entered into an amendment (the “2017 Lakeshore Loan Amendment
“) to the Loan Agreement and the Lakeshore Note issued to Lakeshore. Pursuant to the terms of this amendment, the principal
balance of the Note was amended to $2,291,395, which included (a) all unpaid dividends and outstanding attorneys’ fees in
the amount of $250,000 and (b) all outstanding accrued interest in the amount of $414,364. Under the 2017 Lakeshore Loan Amendment,
any existing defaults under the Lakeshore Note and related security agreements were cured, the interest rate reverted to the non-default
rate of 11% interest per annum, the Lakeshore Note was re-amortized and the term of the Lakeshore Note was extended for an additional
10 years, with monthly installment payments consisting of $31,564 due on the 10
th
day of each month, beginning on January
10, 2018. In addition, the security agreements for the SiteFlash assets, the assets of Priority Time, and the assets of SnAPPnet
were cancelled and Lakeshore agreed to file notices of termination of all UCC lien statements in connection with these assets.
The security agreement concerning the assets of NOW Solutions remain in effect and upon full payment of the Lakeshore Note, Lakeshore
will release the NOW Solutions collateral. Furthermore, the interest in “Net Claim Proceeds” from the SiteFlash Assets
was increased from 8% to 20% under this amendment.
The
2017 Lakeshore Loan Amendment also provides that if NOW Solutions makes any advance toward net income (less Vertical’s management
fee and management allocations) to Vertical, then NOW Solutions shall pay Lakeshore 25% share of such an advance no later than
one business day after Vertical receives its 75% percent share. In the event NOW Solutions does not make payment to Lakeshore,
the loan will be in default and NOW Solutions has five business days from discovery and notice by Lakeshore to make payment plus
a penalty in the amount of 20% of the unpaid 25% share amount.
In
order to facilitate the execution of the 2017 Lakeshore Loan Amendment which resulted in the cure of any existing defaults under
the Loan Agreement and the Note, as well as the release by Lakeshore of the security interests in the SiteFlash assets and the
assets of SnAPPnet and Priority Time, the Company issued 2,500,000 VCSY common shares at a fair market value of $35,400 and 300,000
Ploinks common shares at a fair market value of $92,850 to certain third party purchasers of 600,000 shares of VHS Series A Preferred
Stock from a member of Lakeshore. The company recorded a loss on debt extinguishment of $128,250 during the year ended December
31, 2017.
During
the three months ended March 31, 2018 and 2017, the Company, through its subsidiary, accrued dividends of $54,841 and $32,500,
respectively, payable to Lakeshore.
Note
4. Derivative Liabilities and Fair Value Measurements
Derivative
liabilities
As
of March 31, 2018, the Company has convertible notes and common stock warrants associated with the notes that qualify as derivative
liabilities under ASC 815.
As
of March 31, 2018, the aggregate fair value of the outstanding derivative liabilities was $44,652. For the three months ended
March 31, 2018, the net gain on the change in fair value of derivative liabilities was $141,532.
The
Company estimated the fair value of the derivative liabilities using the Black-Scholes option pricing model and the following
key assumptions during 2018:
|
2018
|
Expected dividends
|
0%
|
Expected terms (years)
|
0.10 - 2.26
|
Volatility
|
94% - 110%
|
Risk-free rate
|
1.93% - 2.39%
|
Fair
value measurements
FASB
ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset
or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an
orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy
which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair
value. FASB ASC 820 describes three levels of inputs that may be used to measure fair value:
Level
1
– Quoted prices in active markets for identical assets or liabilities.
Level
2
– Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs
that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level
3
– Unobservable inputs that are supported by little or no market activity and that are financial instruments whose
values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments
for which the determination of fair value requires significant judgment or estimation.
If
the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization
is based on the lowest level of input that is significant to the fair value measurement of the instrument.
The
following table provides a summary of the fair value of our derivative liabilities as of March 31, 2018 and December 31, 2017:
|
|
Fair value measurements on a recurring basis
|
|
|
|
|
Level
1
|
|
|
|
Level
2
|
|
|
|
Level
3
|
|
As of March 31, 2018:
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivative liabilities – convertible debt
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
44,652
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2017:
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivatives
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
159,537
|
|
The
estimated fair value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities
and deferred revenue approximates their carrying value due to their short-term nature. The Company uses Level 3 inputs to estimate
the fair value of its derivative liabilities.
The
below table presents the change in the fair value of the derivative liabilities during the three months ended March 31, 2018:
Fair value as of December 31, 2017
|
|
$
|
159,537
|
|
Additions recognized as debt discounts
|
|
|
26,647
|
|
Gain on change in fair value of derivatives
|
|
|
(141,532
|
)
|
Fair value as of March 31, 2018
|
|
$
|
44,652
|
|
Note
5. Common and Preferred Stock Transactions
During
the three months ended March 31, 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 83,300 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. The incremental change in the fair value of the extended warrants was immaterial and did not
change the conclusion of the debt modification.
During
the three months ended March 31, 2018, 320,000 shares of VCSY common stock issued to employees of the Company vested.
During
the three months ended March 31, 2018, 209,998 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements
to consultants and employees of the Company and a subsidiary of the Company vested.
Stock
compensation expense for the amortization of restricted stock awards was $11,874 for the three months ended March 31, 2018. As
of March 31, 2018, there were 5,740,000 shares of unvested stock compensation awards to employees and 15,500,000 shares of unvested
stock compensation awards to non-employees.
Stock
compensation expense for the amortization of subsidiary’s restricted stock awards was $17,339 for the three months ended
March 31, 2018.
We
have evaluated our convertible cumulative preferred stock under the guidance set out in FASB ASC 470-20 and accordingly classified
these shares as temporary equity in the consolidated balance sheets.
For
additional transactions after March 31, 2018 concerning stock transactions, please see “Subsequent Events” in Note
9.
Note
6. Option and Warrant Activity
During
the three months ended March 31, 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 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.
Option
and warrant activities during the three months ended March 31, 2018 is summarized as follows:
|
|
Incentive Stock
Options
|
|
|
Non-Statutory
Stock Options
|
|
|
Warrants
|
|
|
Weighted
Average Exercise
Price
|
|
Outstanding at December 31, 2017
|
|
|
—
|
|
|
|
—
|
|
|
|
16,340,000
|
|
|
$
|
0.101
|
|
Options/Warrants granted
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Options/Warrants exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Options/Warrants expired/cancelled
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Outstanding at March 31, 2018
|
|
|
—
|
|
|
|
—
|
|
|
|
16,340,000
|
|
|
$
|
0.101
|
|
The
weighted average remaining life of the outstanding warrants as of March 31, 2018 was 1.35. The intrinsic value of the exercisable
warrants as of March 31, 2018 was $.013.
Note
7. Related Party Transactions
.
The
following table reflects our related party debt activity, including our convertible debt, for the three months ended March 31,
2018:
December 31, 2017
|
|
$
|
308,242
|
|
Amortization of debt discounts
|
|
|
—
|
|
March 31, 2018
|
|
$
|
308,242
|
|
As
of March 31, 2018, and December 31, 2017, the Company had accounts payable to employees for unreimbursed expenses and related
party contractors in an aggregate amount of $168,862 and $148,760, respectively. The payables are unsecured, non-interest bearing
and due on demand.
As
of March 31, 2018, and December 31, 2017, the Company has accrued payroll to certain current and former employees of $2,839,301
and $2,770,684, respectively.
On
June 30, 2016, the Company amended an agreement (originally entered into in July 2010) with certain former and current employees
of the Company, concerning the deferral of payroll claims of approximately $883,190 for salary earned from 2012 to June 30, 2016
and $1,652,113 for salary earned from 2001 to 2012. The deferral period ended on December 31, 2016 at which time payroll claims
of approximately $878,099 for salary earned from 2012 to December 31, 2016 and $1,652,113 for salary earned from 2001 to 2012,
remained unpaid and is reflected as a current liability on the Company’s consolidated financial statements.
Pursuant
to the terms of the amended agreement, each current and former employee who is a party to the agreement (the “Employee(s)”)
agreed to defer payment of salary from the date of the agreement (“Salary Deferral”) for a period of three months
for salary earned from July 1, 2012 to June 30, 2016 and for a period of six months for salary earned from 2001 to June 30, 2012.
In consideration for the Salary Deferral, the Company issued a total 3,500,000 shares of the Company’s common stock during
2016 with the Rule 144 restrictive legend (at a fair market value of $78,750) and agreed to pay each Employee a sum equal to the
amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which
such salary was earned, plus a bonus (the “Bonus”) of nine percent interest, compounded annually until such time as
the unpaid salary has been paid in full. The Company and the Employees have agreed that the Bonus will be paid from amounts anticipated
to be paid to the Company in respect of specified intellectual property assets of the Company.
In
order to effect the payments due under this agreement, the Company assigned to the Employees a twenty percent interest in any
net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims and any license fees
paid by a subsidiary of the Company or third party to the Company regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629
(plus any continuation patents) on Adhesive Software’s SiteFlash™ Technology, (b) U.S. patent #7,076,521 (plus any
continuation patents) in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent U.S. Patent
No. #8,578,266 and #9,405,736 (plus any continuation patents) in respect to “Method and System for Automatically Downloading
and Storing Markup Language Documents into a Folder Based Data Structure,” and (d) any license payments made (i) by a subsidiary
of the Company to the Company in connection with a licensing or distribution agreement between the Company and such subsidiary
or (ii) by third party to the Company in connection with a licensing or distribution agreement between the Company and a third
party.
Under
the terms of this agreement, the Bonus is contingent on payment of unpaid wages. In addition, the Bonus is contingent upon generating
revenues from the sources of the twenty percent interests in net proceeds assigned to the current and former employees. The interests
that were assigned under the agreement for net proceeds consist of the underlying patents of the SiteFlash™ and Emily™
technologies and licensing under distribution and licensing agreements between the Company and subsidiaries and between the Company
and third parties. Currently, there is no foreseeable income to be generated from these sources to which a twenty percent interest
can reasonably be projected or otherwise applies to. There is no pending litigation regarding any of these patents. In addition,
with respect to any licenses from Vertical to its subsidiaries, the licenses of technology underlying these patents were for a
three percent royalty on gross revenues. If there were income, any payments under this agreement would likely be minimal. Currently,
there is no income being generated from licensing. No subsidiary is currently offering a product to the market using these licensed
technologies nor does Vertical have any agreement to license these technologies to a third party.
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 March 31, 2018 and December 31, 2017 as this contingent liability is considered remote. Cumulative bonus
interest through March 31, 2018 is $4,718,235.
Note
8. Legal Proceedings
We
are involved in the following ongoing legal matters:
On
December 31, 2011, the Company and InfiniTek corporation (“InfiniTek”) entered into a settlement agreement to dismiss
an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract
and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to
InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking
damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek
$82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek had agreed
to transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software
application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The Company made $37,500 in payments due
under the settlement agreement through May 7, 2012 and each party had alleged the other party was in breach of the settlement
agreement.
On
February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California,
County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible
debenture issued by the Company to Parker Mills. The plaintiff seeks payment of the principal balance due under the convertible
debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs. In June 2017, the court
entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker
Mills, LLP v. Vertical Computer Systems, Inc., No.
BC649122
. William Mills is a partner of
Parker Mills and the Secretary and a Director of the Company. The Company has $124,583 of principal and interest accrued as of
March 31, 2018.
On
April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint, which
was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding
payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17,
2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW
Solutions to Mr. Wolman. The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest),
plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses. On September 8, 2017,
the court awarded Mr. Wolman a judgment in the amount of $282,299, which accrues interest at the rate of 16% per annum plus attorney’s
fees as to be determined by the court. The Company has $311,517 of principal and accrued interest as of March 31, 2018. We
intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.
Note
9. Subsequent Events
During
the period than runs from April 1, 2018 through June 8, 2018, the Company issued an additional 2,500,000 VCSY common shares at
a fair market value of $33,000 and an additional 300,000 Ploinks common shares at a fair market value of $92,850 to certain third
party purchasers of 600,000 shares of VHS Series A Preferred Stock from a member of Lakeshore 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. These additional shares were issued 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, when VHS did not meet performance standards
As of the filing date, June
8, 2018, the Company is in negotiations to extend the term of certain warrants to purchase VCSY common stock (at $0.10 per share)
by granting shares of Ploinks, Inc. common stock to third-party lenders in connection with 3 and 6-month extensions of convertible
debentures that were issued in 2015 and 2016.