VERTICAL COMPUTER SYSTEMS INC - FORM 10-Q

Attached files

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EX-31.1 - EXHIBIT 31.1 - VERTICAL COMPUTER SYSTEMS INC	v360639_ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - VERTICAL COMPUTER SYSTEMS INC	v360639_ex32-1.htm
EXCEL - IDEA: XBRL DOCUMENT - VERTICAL COMPUTER SYSTEMS INC	Financial_Report.xls

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2013

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

For the transition period from _____ to _____

_________________________

Commission file number 0-28685

_________________________

VERTICAL COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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

101 West Renner Road, Suite 300

Richardson, TX 75082

(Address of principal executive offices)

(972) 437-5200

(Registrant’s Telephone Number)

________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

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

Yes x No ¨

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

Large accelerated filer ¨		Accelerated filer	¨
Non-accelerated filer ¨	(Do not check if a smaller reporting company)	Smaller reporting company	x

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

As of November 18, 2013, the issuer had 999,535,151 shares of common stock, par value $0.00001, issued and outstanding.

PART I

FINANCIAL INFORMATION

Item1. Consolidated Financial Statements

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

	September 30,		December 31,
	2013		2012
Assets
Current assets
Cash	$	26,255	$	111,851
Accounts receivable, net of allowance for bad debts of $45,285 and $52,100		188,889		440,195
Prepaid expenses and other current assets		113,331		115,777
Total current assets		328,475		667,823

Property and equipment, net of accumulated depreciation of $1,027,403 and $1,021,595		24,943		27,062
Intangible assets, net of accumulated amortization of $249,305 and $217,670		935,990		871,721
Deposits and other		31,719		15,346

Total assets	$	1,321,127	$	1,581,952

Liabilities and Stockholders’ Deficit
Current liabilities:
Accounts payable and accrued liabilities	$	8,633,641	$	7,466,957
Bank overdraft		20,496		9,624
Deferred revenue		1,823,815		2,614,714
Derivative liability		114,345		31,440
Convertible debenture		30,000		30,000
Current portion - notes payable, net of debt discount		2,768,628		2,486,810
Current portion - notes payable to related parties		343,207		724,790
Total current liabilities		13,734,132		13,364,335

Non-current portion – notes payable		1,492,015		1,188,868

Total liabilities		15,226,147		14,553,203

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

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Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

(Continued from previous page)

	September 30,		December 31,
	2013		2012
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 48,500 shares issued and outstanding		9,700,000		9,700,000
Series B 10% Convertible Cumulative Preferred stock; $0.001 par value; 375,000 shares authorized; 7,200 shares issued and outstanding		246		246
Series C 4% Convertible Cumulative Preferred stock; $100.00 par value; 200,000 shares authorized; 50,000 shares issued and outstanding		200,926		200,926
Series D 15% Convertible Cumulative Preferred stock; $0.001 par value; 300,000 shares authorized; 25,000 shares issued and outstanding		852		852
		9,902,024		9,902,024

Stockholders' Deficit
Common Stock; $.00001 par value; 1,000,000,000 shares authorized 997,485,151 and 997,935,151 issued and outstanding as of September 30, 2013 and December 31, 2012		9,975		9,979
Additional paid-in-capital		19,331,084		19,254,154
Accumulated deficit		(42,599,461)		(41,621,437)
Accumulated other comprehensive income – foreign currency translation		(185,915)		(251,848)

Total Vertical Computer Systems, Inc. stockholders’ deficit		(23,444,317)		(22,609,152)

Noncontrolling interest		(362,727)		(264,123)
Total stockholders’ deficit		(23,807,044)		(22,873,275)

Total liabilities and stockholders' deficit	$	1,321,127	$	1,581,952

See accompanying notes to the unaudited consolidated financial statements.

	3

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Revenues
Licensing and software	$	-	$	-	$	72,720	$	1,000
Software maintenance		1,069,785		1,127,348		3,285,985		3,417,471
Cloud-based offering		83,418		95,702		305,229		352,469
Consulting services		72,191		44,944		310,959		248,864
Other		13,485		17,620		62,425		60,602
Total revenues		1,238,879		1,285,614		4,037,318		4,080,406

Cost of revenues		585,905		583,433		1,883,179		1,970,223

Gross profit		652,974		702,181		2,154,139		2,110,183

Operating expenses:
Selling, general and administrative expenses		902,021		844,697		2,454,731		2,294,221
Depreciation and amortization		13,130		14,804		40,403		46,698
Bad debt expense		-		-		-		20,872
Total operating expenses		915,151		859,501		2,495,134		2,361,791

Operating loss		(262,177)		(157,320)		(340,995)		(251,608)

Other income (expense):
Interest Income		35		-		46		15
Loss on derivative liability		(76,355)		(11,790)		(82,905)		(655)
Forbearance fees		(109,500)		-		(129,825)		-
Loss on extinguishment of debt		-		(5,000)		-		(20,000)
Interest expense		(217,186)		(174,636)		(522,949)		(494,501)

Net loss		(665,183)		(348,746)		(1,076,628)		(766,749)
Net loss attributable to noncontrolling interest		50,987		18,832		98,604		58,177
Net loss attributable to Vertical Computer Systems, Inc.		(614,196)		(329,914)		(978,024)		(708,572)
Dividends applicable to preferred stock		(147,000)		(147,000)		(441,000)		(441,000)

Net loss available to common stockholders	$	(761,196)	$	(476,914)	$	(1,419,024)	$	(1,149,572)

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

Basic and diluted weighted average common shares outstanding		997,843,847		997,935,151		998,116,835		997,715,443

Comprehensive loss
Net loss	$	(665,183)	$	(348,746)	$	(1,076,628)	$	(766,749)
Translation adjustments		(46,906)		(103,619)		65,933		(108,871)
Comprehensive loss		(712,089)		(452,365)		(1,010,695)		(875,620)
Comprehensive loss attributable to noncontrolling interest		50,987		18,832		98,604		58,177
Comprehensive loss attributable to Vertical Computer Systems, Inc.	$	(661,102)	$	(433,533)	$	(912,091)	$	(817,443)

See accompanying notes to the unaudited consolidated financial statements.

	4

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

(Unaudited)

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

Balances at December 31, 2012		997,935,151	$	9,979	$	19,254,154	$	(41,621,437)	$	(251,848)	$	(264,123)	$	(22,873,275)

Shares issued with debt		500,000		5		19,695		-		-		-		19,700

Shares issued for accrued stock compensation related to restricted stock awards		550,000		6		10,220		-		-		-		10,226

Shares issued for forbearance fees		1,000,000		10		46,990		-		-		-		47,000

Cancellation of stock		(2,500,000)		(25)		25		-		-		-		-

Other comprehensive income translation adjustment		-		-		-		-		65,933		-		65,933

Net loss		-		-		-		(978,024)		-		(98,604)		(1,076,628)

Balances at September 30, 2013		997,485,151	$	9,975	$	19,331,084	$	(42,599,461)	$	(185,915)	$	(362,727)	$	(23,807,044)

See accompanying notes to the unaudited consolidated financial statements.

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Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
	2013		2012
Cash flows from operating activities
Net loss	$	(1,076,628)	$	(766,749)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		40,403		46,698
Amortization of debt discounts		16,646		50,300
Forbearance fees paid with common stock		47,000		-
Bad debt expense		-		20,872
Loss on derivatives		82,905		655
Changes in operating assets and liabilities:
Accounts receivable		228,846		236,422
Prepaid expenses and other assets		8,533		(15,568)
Accounts payable and accrued liabilities		1,175,970		615,160
Deferred revenue		(790,899)		(521,058)
Net cash used in operating activities		(267,224)		(333,268)

Cash flow from investing activities:
Software development		(95,978)		(240,029)
Purchase of property and equipment		(6,573)		(8,481)
Net cash used in investing activities		(102,551)		(248,510)

Cash flows from financing activities: Borrowings on notes payable		2,059,150		742,405
Payments of notes payable		(1,470,192)		(185,434)
Borrowings on related party debt		-		36,000
Payments on related party debt		(381,583)		(5,066)
Payments made on extinguishment of debt		-		(20,000)
Bank overdraft		10,871		940
Net cash provided by financing activities		218,246		568,845

Effect of changes in exchange rates on cash		65,933		(108,872)

Net change in cash and cash equivalents		(85,596)		(121,805)
Cash and cash equivalents, beginning of period		111,851		132,452
Cash and cash equivalents, end of period	$	26,255	$	10,647

Supplemental disclosures of cash flow information:
Cash paid for interest	$	223,624	$	246,263

Non-cash investing and financing activities:
Adjustment to debt principal due to reapplication of payments	$	4,061	$	9,353
Common shares issued for accrued stock compensation		10,226		14,100
Common shares cancelled		25		-
Common shares issued with debt		19,700		-
Loan commitment fees accrued		5,000		-

See accompanying notes to unaudited consolidated financial statements.

	6

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 2012. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable). NOW Solutions, a wholly-owned subsidiary of Vertical currently maintains daily business operations, EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. (“PMI”) and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary and is inactive and Vertical Healthcare Solutions, Inc. (“VHS”), SnAPPnet, Inc. (“SnAPPnet”), OptVision Research, Inc. (“OVR”), Taladin, Inc. (“Taladin”), and Vertical do Brasil, each of which has minor activities, are all wholly-owned subsidiaries of Vertical. Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary, and Priority Time Systems, Inc. (“Priority Time”), a 90% owned subsidiary, are entities with minor activities. 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 2012 annual report on Form 10-K have been omitted.

Earnings per share

Basic earnings per share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of shares of the Company’s common stock outstanding during the period. “Diluted earnings per share” reflects the potential dilution that could occur if our share-based awards and convertible securities were exercised or converted into common stock. The dilutive effect of our share-based awards is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. The dilutive effect of our convertible preferred stock and convertible debentures is computed using the if-converted method, which assumes conversion at the beginning of the year.

For the nine months ended September 30, 2013 and 2012, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive.

Reclassifications

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

Recently Issued Accounting Pronouncements

In February 2013, the FASB issued ASU 2013-02 "Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income" (ASU 2013-02). ASU 2013-02 amends ASU 2011-05 and requires that entities disclose additional information about amounts reclassified out of Accumulated Other Comprehensive Income (AOCI) by component. Significant amounts reclassified out of AOCI are required to be presented either on the face of the Consolidated Statements of Income and Comprehensive Income or in the notes to the financial statements. The requirements of ASU 2013-02 are effective for fiscal years and interim periods in those years beginning after December 15, 2012. The Company does not expect the adoption of ASU 2013-02 to have a material impact on the Company’s consolidated financial statements.

Note 2. Going Concern

The accompanying unaudited consolidated financial statements for the nine months ended September 30, 2013 and 2012 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.

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The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. As of September 30, 2013, we had negative working capital of approximately $13.4 million and defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

Our management is continuing its efforts to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations as well as to generate additional revenue through our existing businesses, including the licensing of our intellectual property. 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 this uncertainty.

Note 3. Notes Payable

The following table reflects our third party debt activity, including our convertible debt, for the nine months ended September 30, 2013:

Total debt as of December 31, 2012	$	3,705,678
Repayments of third party notes		(1,470,192)
Borrowings from third parties		2,059,150
Adjustment for reapplication of payments		4,061
Total debt as of September 30, 2013	$	4,298,697
Unamortized discounts		(8,054)
Total debt, net of unamortized discounts as of September 30, 2013	$	4,290,643

In July 2013, a third party lender loaned VHS $150,000. Pursuant to the loan agreement, VHS issued a promissory note bearing interest at 10% per annum to the lender in the amount of $150,000 payable in 90 days from the date VHS received funds. Under the terms of the agreement, VHS is obligated to pay a $5,000 commitment fee no later than the date the note becomes due. In consideration of the loan, the Company issued 5,000 shares of VHS Series B Preferred Stock (fair value determined to be nominal) and granted 500,000 shares of VCSY common stock (fair value determined to be $19,700) to the lender. The value of the common shares of $19,700 and the accrued $5,000 commitment fee was recorded as a debt discount that is being amortized over the life of the note using the effective interest rate method. During the nine months ended September 30, 2013, $16,646 of the debt discount has been amortized into interest expense.

During nine months ended September 30, 3013, in addition to the loans set forth above, the Company borrowed $150,000 from third party lenders. These notes are unsecured, bear interest at 10%- 11% per annum and are due on demand.

During the nine months ended September 30, 2013 and 2012, the Company made interest payments of $223,624 and $246,263, respectively.

During the nine months ended September 30, 2013 and 2012, the Company made principal payments of $1,470,192 and $185,434, respectively.

Lakeshore Financing

On January 9, 2013, NOW Solutions completed a financing transaction in the aggregate amount of $1,759,150, which amount was utilized to pay off existing indebtedness of the Company and NOW Solutions to Tara Financial Services and Robert Farias, an employee of the Company, and all security interests granted to Tara Financial Services and Robert Farias were cancelled.

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

The Lakeshore Note is secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“SnAPPnet”) and the Company’s SiteFlash technology and cross-collateralized. Upon the aggregate principal payment of $290,000 toward the Lakeshore Note, the Company has the option to have Lakeshore release either the Priority Time collateral or the SiteFlash collateral. Upon payment of the aggregate principal $590,000 toward the Lakeshore Note, Lakeshore shall release either the Priority Time collateral or the SiteFlash collateral (whichever is remaining). Upon payment of the aggregate principal $890,000 toward the Lakeshore Note, Lakeshore shall release the SnAPPnet collateral and upon full payment of the Lakeshore Note, Lakeshore shall release the NOW Solutions collateral.

	8

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. In addition, until the Note is paid in full, NOW Solutions agreed to pay a Lakeshore royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management has estimated the fair value of the royalty to be nominal. The Company has accrued $27,000 for the nine months ended September 30, 2013 related to this royalty based upon the estimated annual revenues expected to be generated during the year ended December 31, 2013.

Pursuant to the Loan Agreement, as amended, the Company also agreed to make certain principal payments toward the Lakeshore Note of (a) $90,000 by February 15, 2013, which was secured by 15% interest in the Company’s ownership of Priority Time and this payment was timely made to Lakeshore and (b) $600,000 by March 15, 2013, which was secured by 25% of the Company’s ownership interest in NOW Solutions and this payment was not made to Lakeshore. As of September 30, 2013, the common shares of NOW Solutions representing a 25% ownership interest in NOW Solutions were in Lakeshore’s possession, but Lakeshore had not taken action to transfer the shares in Lakeshore’s name due to forbearance agreements that have been entered into. The Company and Lakeshore made further amendments to the Loan Agreement concerning the return of these common shares on October 3, 2013 (see “Subsequent Events” in Note 9 for further details). The Company has determined a noncontrolling interest in NOW Solutions did not exist as of September 30, 2013 as the shares representing a 25% ownership interest in NOW Solutions have not been transferred to Lakeshore’s name.

Option for the Return of Common Shares of NOW Solutions and Forbearance Agreement

Between January and August 2013, the Company and Lakeshore entered into multiple amendments to the loan agreement with Lakeshore. Pursuant to these amendments, the Company had an option to pay Lakeshore $750,000 by September 30, 2013 for the return of shares of common stock of NOW Solutions in Lakeshore’s possession representing 25% ownership of NOW Solutions by September 30, 2013. In consideration of this option and Lakeshore’s extension to make payment, the Company paid Lakeshore forbearance fees aggregating $82,825 during the nine months ended September 30, 2013 and agreed to pay Lakeshore a bonus of 25% of NOW Solutions’ profits for the period that runs from March 15, 2013 through September 30, 2013 which will be due no later than December 31, 2013.As additional consideration, the Company increased the interest payable to Lakeshore from Net Claim Proceeds (less any attorney’s fees and direct costs) from any litigation or settlement proceeds related to the SiteFlash technology from 5% to 8% and an officer of the Company transferred 1,000,000 shares of VCSY common stock (valued at $47,000) owned by him to Lakeshore on behalf of the Company. Management has estimated the fair value of the profits royalty and the right to the net claim proceeds to be nominal. The aggregate forbearance fees paid during the nine months ended September 30, 2013 were $129,825 consisting of cash payments of $82,825 and 1,000,000 common shares valued at $47,000. The Company and Lakeshore made further amendments to the Loan Agreement on October 3, 2013 (see “Subsequent Events” in Note 9 for further details).

Note 4. Derivative Liability and Fair Value Measurements

Derivative liability

During 2008, an officer of the Company pledged 3,000,000 shares of common stock (through a company he controls) to secure the debt owed to a third party lender. In connection with the pledge of stock, we signed an agreement to replace these shares within one year. As of September 30, 2013 1,309,983 shares of stock were owed under this agreement.

In August 2013, an officer of the Company transferred 1,000,000 shares of common stock owned by him to Lakeshore in connection with the Lakeshore option and forbearance agreement related to the shares of common stock of NOW Solutions in possession of Lakeshore representing a 25% ownership of NOW Solutions (see Note 3). In connection with the transfer of the stock, we signed an agreement to replace these 1,000,000 shares.

These commitments to replace all of the pledged shares were evaluated under FASB ASC 815-40, Derivatives and Hedging and were determined to have characteristics of a liability and therefore constituted a derivative liability under the above guidance. Each reporting period, these derivative liabilities are marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At September 30, 2013 and December 31, 2012, the aggregate fair value of these derivative liabilities was $114,345 and $31,440.

The aggregate change in the fair value of derivative liabilities was a loss of $35,905 and a loss of $655 for the nine months ended September 30, 2013 and 2012, respectively. A loss on derivative liabilities of $47,000 was recorded in August 2013 to recognize the initial value of the derivative related to the 1,000,000 shares of common stock.

The valuation of our embedded derivatives is determined by using the VCSY stock price at September 30, 2013. As such, our derivative liabilities have been classified as Level 1.

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Fair value measurements

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

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

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

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

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

The following table provides a summary of the fair value of our derivative liabilities as of September 30, 2013 and December 31, 2012:

	Fair value measurements on a recurring basis
	Level 1		Level 2		Level 3
As of September 30, 2013:
Liabilities
Stock derivative – 1,309,983 shares	$	64,844	$	-	$	-
Stock derivative – 1,000,000 shares	$	49,501	$	-	$	-

As of December 31, 2012:
Liabilities
Stock derivative – 1,309,983 shares	$	31,440	$	-	$	-

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.

Note 5. Common and Preferred Stock Transactions

In July 2013, the Company issued 500,000 shares of VCSY common stock (valued at $19,700) to a third party lender in connection with a $150,000 loan to the Company. The fair value of the shares was recorded as a debt discount that is being amortized to interest expense over the life of the loan.

In August 2013, Luiz Valdetaro, the Chief Technology Officer of the Company, transferred 1,000,000 shares of VCSY common stock owned by him to Lakeshore (valued at $47,000) in connection with an option for Lakeshore to return shares of common stock of NOW Solutions in Lakeshore’s possession representing a 25% ownership interest in NOW Solutions (see “Option for the Return of Common Shares of NOW Solutions and Forbearance Agreement” in Note 3). The Company has recognized this transaction as a 1,000,000 share cancellation by Luiz Valdetaro, and a 1,000,000 share issuance to Lakeshore, valued at $47,000.

Also, in August 2013, the Company and Luiz Valdetaro, the Chief Technology Officer of the Company, entered into an indemnity and reimbursement agreement whereby the Company agreed to reimburse and indemnify an officer of the Company for 1,000,000 shares of VCSY common stock owned by him that he transferred to Lakeshore on the Company’s behalf. Under the agreement, the Company is obligated to reimburse the officer with 1,000,000 shares of VCSY common stock within 1 year (see Note 4).

During the nine months ended September 30, 2013, the Company cancelled 1,500,000 previously issued common shares of the Company that had been granted to a third party lender.

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During the nine months ended September 30, 2013, 550,000 common shares granted to employees of the Company and a consultant of the Company vested. Stock compensation that was previously accrued totaling $10,226 was reclassed from accrued liabilities to stockholders’ equity associated with these shares vesting.

As of the date of this report, we have determined that we currently have (i) the following shares of common stock issued, and (ii) outstanding shares of preferred stock which are convertible into the shares of common stock indicated below and a contractual commitment to issue the shares of common stock indicated below:

997,485,151		Common Stock Granted and Outstanding
2,050,000		Common Stock Granted and Outstanding, but not vested
2,309,983		Common Shares Company Is Obligated to Reimburse to officers of the Company for pledged shares sold and transferred on the Company’s behalf)
24,250,000		Common Shares convertible from Preferred Series A Stock (48,500 shares outstanding)
27,274		Common Shares convertible from Preferred Series B Stock (7,200 shares outstanding)
5,000,000		Common Shares convertible from Preferred Series C Stock (50,000 shares outstanding)
94,700		Common Shares convertible from Preferred Series D Stock (25,000 shares outstanding)
1,031,217,108		Total Common Shares Outstanding and Accounted For/Reserved

In addition, the Company has $30,000 in an outstanding convertible debenture that had been issued to a third party.

Accordingly, given the fact that the Company currently has 1,000,000,000 shares of common stock authorized, the Company could exceed its authorized shares of common stock by approximately 31,000,000 shares if all of the financial instruments described in the table above were exercised or converted into shares of common stock (excluding the $30,000 from the outstanding debenture noted above).

We have evaluated our convertible cumulative preferred stock under the guidance set out in FASB ASC 480 and have accordingly classified these shares as temporary equity in the consolidated balance sheets.

Note 6. Stock Options, Warrants and Restricted Stock Awards

Stock Options and Warrants

There are currently no outstanding common stock options or warrants.

Restricted Stock

A summary of the activity of the restricted stock for the nine months ended September 30, 2013 is shown below.

			Weighted
			Average Grant-
	Shares		Date Fair Value
Non Vested Balance at December 31, 2012		1,100,000	$	0.0186
Granted		1,500,000		0.0300
Vested		(550,000)		0.0186
Forfeited/Cancelled		-		-
Non Vested Balance at September 30, 2013		2,050,000	$	0.0269

As of September 30, 2013, there was $26,902 of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of less than 2 years.

During the nine months ended September 30, 2013, the Company granted 1,500,000 common shares (valued at $45,000) for services to consultants of the Company that vest on December 31, 2013.

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Note 7. Related Party Transactions

In January 2013, the Company paid off all existing indebtedness of the Company and the underlying security interest granted to Mr. Farias, an employee of the Company, was cancelled, including two promissory notes bearing interest at 10% per annum that were issued in the principal amount of $274,679 and $90,000, respectively.

The following table reflects our related party debt activity for the nine months ended September 30, 2013:

December 31, 2012	$	724,790
Repayments of related party notes		(381,583)
September 30, 2013	$	343,207

Note 8. Legal Proceedings

We are involved in the following ongoing legal matters:

On November 18, 2009, we sued InfiniTek Corporation (“InfiniTek”) in the Texas State District Court in Fort Worth, Texas for breach of contract and other claims (the “Texas Action”) seeking equitable relief and unspecified damages when a dispute between the Company and InfiniTek was not resolved. All agreements with InfiniTek have been cancelled. On January 15, 2010, InfiniTek filed a counter-claim for non-payment of amounts billed. InfiniTek claimed it was owed $195,000 plus lost opportunity costs of not less than $220,000.

On April 7, 2010, we were served with a lawsuit filed by InfiniTek in the California Superior Court in Riverside, California seeking damages in excess of $76,303 for breach of contract and lost profit (the “California Action”). This lawsuit related to one of the causes of action and the same set of underlying facts, as those in the Texas legal action. On May 7, 2010, we filed a motion to dismiss this action. On July 14, 2010, the court denied our motion. On August 13, 2010, we filed an answer to InfiniTek’s complaint, including a denial and affirmative defenses.

On December 31, 2011, the Company and InfiniTek entered into a settlement agreement whereby the Texas Action and the California Action were both dismissed. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments due under the settlement agreement as of November 16, 2012 and each party is alleging the other party is in breach of the settlement agreement. We are currently seeking to resolve all disputes with InfiniTek.

On November 15, 2010, we filed a lawsuit in the Federal District Court for the Eastern District of Texas (the “Vertical Action”) against Interwoven, Inc. ("Interwoven"), LG Electronics MobileComm U.S.A., Inc., LG Electronics, Inc., Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (collectively, the "Defendants"). We sued the Defendants for patent infringement claims under United States Patent No. 6,826,744 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) and United States Patent No. 7,716,629 (“System and Method for Generating Web Sites in an Arbitrary Object Framework”) (collectively the “the Patents-in-Suit”), both of which are owned by the Company. We seek an award of monetary damages and other relief. The case is styled Vertical Computer Systems, Inc. v Interwoven, Inc., LG Electronics Mobilecomm U.S.A., Inc., No. 2:10-CV-00490.

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On November 17, 2010, we were served with a lawsuit filed on October 14, 2010 by Interwoven in the United States District Court for the Northern District of California (the “Interwoven Action”). This lawsuit was instituted as a complaint for declaratory judgment, in which Interwoven requested that the court find that no valid and enforceable claim of either of the two patents referenced above has been infringed by Interwoven. The case is styled Interwoven, Inc. v Vertical Computer Systems, Inc. No. 3:10-CV-4645-RS.

On January 11, 2011, Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (“Samsung”) filed a lawsuit in the United States District Court for the Northern District of California seeking to consolidate its lawsuit with the Interwoven Action. This case is styled Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc., v. Vertical Computer Systems, Inc., No. 3:11-CV-00189-RS.

On May 2, 2011, the United States District Court for the Northern District of California denied Vertical’s renewed motion to transfer the Interwoven Action to the Eastern District of Texas and granted Vertical's motion to transfer the lawsuit filed by Samsung in the Northern District of California to the Eastern district in Texas. On May 11, 2011, the United States District Court for the Eastern District of Texas granted Interwoven’s motion to transfer the case to the Northern District of California with respect to Interwoven and denied Samsung’s motion to transfer its case to the Northern district.

On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order in the Interwoven Action concerning the terms found in the claims of the Patents-in-Suit.

On October 12, 2012, the United States Patent and Trademark Office (“USPTO”) issued an ex parte reexamination certificate of United States Patent No. 7,716,629. In the ex parte reexamination certificate, Claims 21-36, 29, 30, and 32 were confirmed; Claims 1, 8, 11, 13, 28 and 31 were determined to be patentable as amended, Claims 2-6, 9, 10, 12, 14-17, 19 and 20, which were dependent on an amended claim, were determined to be patentable, and claims 7, 18 and 27 were not reexamined.

On October 25, 2012, the USPTO notified the Company of its intent to issue an ex parte reexamination certificate concerning the ex parte reexamination of United States Patent No. 6,826,744. In the notice of intent to issue ex parte reexamination certificate, the USPTO notified that the prosecution on the merits is closed in this ex parte reexamination proceeding and indicated that Claims 6, 8, 19, 22, 30, 32, 41, 44, 50, 51 were confirmed; Claims 1 and 26 were cancelled; Claims 12-17, 20, 34-39, 42 and 43 are not subject to reexamination; newly presented Claims 54-57 are patentable and continuation of patent claims amended: 2-5, 7, 9-11, 18, 21, 23-25, 27-29, 31, 33, 40, 45-49, 52 and 53.

On January 4, 2013, the United States District Court for the Northern District of California in the Interwoven Action denied Interwoven’s motion for summary judgment for unenforceability and invalidity of the Patents-in-Suit in its entirety.

On July 17, 2013, the United States District Court for the Northern District of California in the Interwoven Action ruled on Interwoven’s motion for summary judgment with respect to infringement and damages concerning the Patents-in-Suit. The court denied Interwoven’s motion for summary judgment on the issue of direct infringement and granted summary judgment in favor of Interwoven with respect to infringement on the doctrine of equivalents and with respect to indirect infringement. The court also granted in part and denied in part Interwoven’s motion to exclude certain expert witness testimony.

Discovery for the Interwoven Action has been completed. The trial date has been set for March 10, 2014.

On September 16, 2013, the United States District Court for the Eastern District of Texas issued a claims construction order in the Vertical Action concerning the terms found in the claims of the Patents-in-Suit. Discovery is ongoing. The trial date has been set for May 7, 2014.

On July 8, 2011, we were served with a lawsuit in the Texas State District Court in Dallas, Texas by Clark Consulting Services, Inc. (“CCS”) for breach of contract and other claims. CCS was seeking damages from us in excess of $133,750 plus attorney’s fees and interest. On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses. In December 2011, the Company and CCS entered into a settlement agreement whereby the lawsuit was dismissed. Pursuant to the terms of the settlement agreement, the Company agreed to pay CCS $134,000, which was to be paid in installment payments. Due to the Company’s failure to make timely payments, an additional $60,000 was added to the outstanding balance. On October 26, 2012, we entered into an agreement under which we agreed to make monthly payments of $5,000 and pay the outstanding balance plus attorney’s fees and costs by February 1, 2013. As of December 31, 2012, the settlement amount of $149,000 has been included in accounts payable and accrued liabilities. During 2013, the parties entered into several agreements to extend the date by which the Company has to pay off the balance of the settlement amount whereby. Under these agreements, the Company agreed to make monthly payments of $10,000 (of which $2,500 of each payment would be applied as late fees) beginning in February 2013 through November 2013 until the outstanding balance has been paid. As of November 18, 2013, the Company has made payments of $105,000 and the outstanding settlement balance is $89,000.

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On October 11 2012, Micro Focus (US), Inc. (“Micro Focus”) filed a lawsuit against NOW Solutions in the United States District Court for the southern division district of Maryland alleging breaches of its contractual obligations under an independent software agreement and copyright infringement. On January 28, 2013, NOW Solutions and Micro Focus entered into a settlement agreement whereby NOW Solutions agreed to pay Micro Focus $420,000, of which $25,000 was paid in January and the remaining $375,000 balance is to be paid under a promissory note bearing no interest and payable in three monthly installments of $15,000 beginning in February with the outstanding balance due on April 30, 2013. In connection with the settlement, the Company entered into a guaranty agreement with Micro Focus concerning NOW Solutions’ obligations under the promissory note. The Company did not make the $375,000 payment due to Micro Focus. On May 1, 2013, NOW Solutions received a notice of default concerning its failure to pay the $375,000 balance due under the promissory note. Micro Focus has a confession of judgment by NOW Solutions in connection with the promissory note for the outstanding balance due under the note, plus interest at 15% and reasonable attorney’s fees. On May 15, 2013, Vertical was served with a lawsuit in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning the guaranty by Vertical to Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On July 3, 2013, NOW Solutions was served with a lawsuit for a confessed judgment in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. Micro Focus is seeking damages of $375,000, plus attorneys’ fees of $40,000, plus interest at 15% per annum from the date the lawsuit was filed. On August 13, 2013 the court entered an order to open, modify, and vacate Micro Focus' confessed judgment in the NOW Solutions action. On October 25, 2013, the court entered an order to consolidate Micro Focus’ lawsuits against Vertical and NOW Solutions into one lawsuit. Discovery is ongoing. We intend to resolve this matter with Micro Focus. The Company has accrued $420,000 related to this suit as of December 31, 2012 of which $339,190 is outstanding as of September 30, 2013.

Note 9. Subsequent Events

On October 3, 2013, the Company and Lakeshore further amended the Loan Agreement (see Note 3). Pursuant to this amendment, Lakeshore agreed to return shares of common stock of NOW Solutions in Lakeshore’s possession representing a 25% ownership interest in NOW Solutions (the “NOW Shares”). To pay for the return of the NOW Shares, the Company issued a promissory note (the “NOW Shares Note”) in the principal amount of $1,050,000, bearing interest at 9% and due on October 1, 2014 and paid a $100,000 transaction fee to Lakeshore. As additional consideration for the return of the NOW Shares, the Company is obligated to pay Lakeshore a bonus of 25% of NOW Solutions’ profits for the period that runs from March 15, 2013 through the earlier of the date the NOW Shares Note is paid or October 1, 2014, during which period the Company shall make $5,000 weekly payments to be applied to the foregoing bonus. In the event the NOW Shares Note is not timely paid, then the Company is obligated to transfer common stock representing a 20% ownership interest in NOW Solutions, SnAPPnet, Inc., VHS, and Priority Time to Lakeshore in lieu of paying the then-outstanding balance due under the NOW Shares Note. The Company has paid the transaction fee and made other payments to Lakeshore pursuant to the terms of the amendment and is in the process of clarifying ancillary terms of the amendment to the Loan Agreement with Lakeshore.

In October 2013, a third party lender loaned the Company $100,000. In connection with the loan, the Company has pledged to issue 1,000,000 common shares of the Company’s stock to the lender.

In October 2013, a third party lender loaned the Company $50,000. In connection with the loan, the Company has pledged to issue 1,000,000 common shares of the Company’s stock to the lender to secure the loan.

On November 5, 2013, the United States Patent and Trademark Office granted us a patent (No. 8,578,266.) for an invention for a “Method and System for Providing a Framework for Processing Markup Language Documents.” The patent is related to the Emily™ XML scripting language.

For subsequent events involving litigation, please see “Legal Proceedings” in Note 8.

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

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

Critical Accounting Policies

Capitalized Software Costs

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

During the nine months ended September 30, 2013 and 2012, $95,978 and $240,029 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.

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

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

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

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

Allowances for Doubtful Accounts

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

Deferred Taxes

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

Stock-Based Compensation Expense

We account for share-based compensation in accordance with the provisions of share-based payments, which 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 6 of the Consolidated Financial Statements for a further discussion of stock-based compensation.

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Valuation of the Embedded and Warrant Derivatives

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

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

Recently Issued Accounting Pronouncements

In February 2013, the FASB issued ASU 2013-02 "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income" (ASU 2013-02). ASU 2013-02 amends ASU 2011-05 and requires that entities disclose additional information about amounts reclassified out of Accumulated Other Comprehensive Income (AOCI) by component. Significant amounts reclassified out of AOCI are required to be presented either on the face of the Consolidated Statements of Income and Comprehensive Income or in the notes to the financial statements. The requirements of ASU 2013-02 are effective for fiscal years and interim periods in those years beginning after December 15, 2012. The Company does not expect the adoption of ASU 2013-02 to have a material impact on the Company’s financial statements.

Results of Operations

Three and Nine months ended September 30, 2013 Compared To Three and Nine months ended September 30, 2012

Total Revenues. We had total revenues of $1,238,879 and $1,285,614 for the three months ended September 30, 2013 and 2012, respectively. The decrease in total revenues was $46,735 for the three months ended September 30, 2013 representing a 3.6% decrease compared to the total revenues for the three months ended September 30, 2012. Substantially all of the revenues for the three months ended September 30, 2013 and 2012 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $21,587 or 1.7% of total revenues for the three months ended September 30, 2013 and $17,572 or 1.4% of total revenues for the three months ended September 30, 2012.

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. There were no new licensing sales of our emPath® product during the third quarter of 2013 or 2012. Software maintenance in the three months ended September 30, 2013 decreased by $57,563 or 5.1% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to non-renewal of maintenance agreements by customers and the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the three months ended September 30, 2013 increased by $27,247 from the same period in the prior year, which represents a 60.6% increase. This increase was due to additional consulting services for version upgrades and enhancements to existing accounts during the third quarter of 2013. Cloud-based revenues were $83,418 for the three months ended September 30, 2013 compared to $95,702 for the same period in the prior year, representing a $12,284 decrease or 12.8%. The decrease is primarily related to a customer rate adjustment and a customer user base adjustment during 2013. Other revenue in the three months ended September 30, 2013 decreased by $4,135 or 23.5% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

We had total revenues of $4,037,318 and $4,080,406 in the nine months ended September 30, 2013 and 2012, respectively. The decrease in total revenues was $43,088 for the nine months ended September 30, 2013 representing a 1.1% decrease compared to the total revenues for the nine months ended September 30, 2012. Substantially all of the revenues for the nine months ended September 30, 2013 and 2012 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $89,274 or 2.2% of total revenues for the nine months ended September 30, 2013 and $75,695 or 1.9% of total revenues for the nine months ended September 30, 2012.

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The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. The revenue from new software licenses increased by $71,720 compared to that for the nine months ended September 30, 2012 due to new licensing sales of our emPath® product during 2013. Software maintenance in the nine months ended September 30, 2013 decreased by $131,486 or 3.8% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to primarily due to non-renewal of maintenance agreements by customers and the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the nine months ended September 30, 2013 increased by $62,095 from the same period in the prior year, which represents a 25% increase. This increase was due to additional consulting services for version upgrades and enhancements to existing accounts during the nine months ended September 30, 2013. Cloud-based revenues were $305,229 for the nine months ended September 30, 2013 compared to $352,469 for the same period in the prior year, representing a $47,240 decrease or 13.4%. The decrease is primarily related to a customer rate adjustment and a customer user base adjustment during 2013. Other revenue in the nine months ended September 30, 2013 increased by $1,823 or 3.0% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $585,905 for the three months ended September 30, 2013, compared to $583,433 for the three months ended September 30, 2012. The increase in cost of revenues of $2,472 represents a 0.4% increase. The increase in direct cost of revenues was primarily due to increased royalties on third party software licensing and increased costs of third party hosting partially offset by lower travel expenses for consultants and lower payroll and commissions. During the three months ended September 30, 2013 and 2012, $51,461 and $75,568 of internal costs were capitalized, respectively.

For the nine months ended September 30, 2013, direct costs of revenues were $1,883,179 compared to $1,970,223 for the same period in 2012 resulting in a decrease of $87,044 or 4.4%. The decrease in direct cost of revenues was primarily due to lower travel expenses for consultants and lower commissions. During the nine months ended September 30, 2013 and 2012, $95,978 and $240,029 of internal costs were capitalized, respectively.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $902,021 and $844,697 in the three months ended September 30, 2013 and 2012, respectively. The increase of $57,324 is 6.8% more than the same period in 2012. We had increased legal expenses to prosecute patent infringement on the Company’s intellectual property and increased loan fees on senior secured debt. Of the selling, general and administrative expenses for the three months ended September 30, 2013 and 2012, $78,000 and $119,000 respectively, represented business development expenses for various initiatives being undertaken through VHS, PTS, SnAPPnet, Inc. and VCSY.

For the nine months ended September 30, 2013 we had $2,454,731 compared to $2,294,221 for the nine months ended September 30, 2012. The increase of $160,510 was 7.0% higher than the same period in 2012. We had increased legal expenses to prosecute patent infringement on the Company’s intellectual property and increased loan fees on senior secured debt. Of the selling, general and administrative expenses for the nine months ended September 30, 2013 and 2012, $346,000 and $455,000, respectively, represented business development expenses for various initiatives being undertaken including Vertical Healthcare Solutions, Inc., Priority Time Systems, Inc., SnAPPnet, Inc. and VCSY.

Bad Debt Expense. We had bad debt expense of $20,872 for the nine months ended September 30, 2012 and $0 in 2013. The expense related to non-payment of a portion of one of NOW Solutions’ customer invoices.

Gain (Loss) on Derivative Liability. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock. The loss on derivative liabilities was $76,355 for the three months ended September 30, 2013 compared to a loss of $11,790 for the same period in 2012. The loss on derivative liabilities was $82,905 for the nine months ended September 30, 2013 compared to a loss of $655 for the nine months ended September 30, 2012. The increase in losses for the three months ended and nine months ended September 30, 2013 are related to an increase in the Company’s stock price and adding an additional derivative liability in the third quarter of 2013

Interest Expense. We had interest expense of $217,186 and $174,636 for the three months ended September 30, 2013 and 2012, respectively. Interest expense increased by $42,550 representing an increase of 24.4% compared to the same expense in the three months ended September 30, 2012. The increase was primarily due to increased borrowings in 2013 and higher interest rates on debts in default.

For the nine months ended September 30, 2013, we had interest expense of $522,949 compared to $494,501 for the same period in 2012, representing a $28,448 or 5.8% increase for the period. The increase was primarily due to increased borrowings in 2013 and higher interest rates on debts in default.

Loss on extinguishment of debt. We had loss on debt extinguishment of $5,000 and $20,000 for the three and nine months ended September 30, 2013, respectively. The expense related to payments made to extend the maturity date of a note payable.

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Net Income (loss). We had a net loss of $665,183 and $348,746 for the three months ended September 30, 2013 and 2012, respectively. The net loss for the three months ended September 30, 2013 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $262,177. This loss was increased by interest expense and a loss on derivative liability. The net loss for the three months ended September 30, 2012 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $157,320. The operating loss was increased by interest expense and a loss on derivative liability.

We incurred net losses of $1,076,628 and $766,749 for the nine months ended September 30, 2013 and 2012, respectively. The changes were due to the reasons discussed above.

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $147,000 for both the three months ended September 30, 2013 and 2012 and $441,000 for both the nine months ended September 30, 2013 and 2012.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $761,196 and $476,914 for the three months ended September 30, 2013 and 2012, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

We had a net loss attributed to common stockholders of $1,419,024 and $1,149,572 for the nine months ended September 30, 2013 and 2012, respectively. Net loss available to common stockholders was due to the factors discussed above.

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the nine months ended September 30, 2013 and 2012, respectively.

Liquidity and Capital Resources

At September 30, 2013, we had non-restricted cash-on-hand of $26,255 compared to $111,851 at December 31, 2012.

Net cash used in operating activities for the nine months ended September 30, 2013 was $267,224 compared to net cash used in operating activities of $333,268 for the nine months ended September 30, 2012. For the nine months ended September 30, 2013, we collected cash from our customers of $3,414,505. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $1,541,523, attorney fees of $82,046, professional fees and consulting fees of $265,376, interest payments of $223,624, taxes (including sales tax and VAT) of $185,216, and other regular trade payables of $1,383,944. For the nine months ended September 30, 2012, we collected cash from our customers of $3,507,852. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $2,504,358, attorney fees of $40,453, professional fees and consulting fees of $214,559, interest payments of $246,263, taxes (including sales tax and VAT) of $356,203, and other regular trade payables of $484,284.

A large portion of our cash (and revenue) comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. Deferred revenue decreased $790,899 or 30.2% from the balance at December 31, 2012. The decrease was due to a higher number of customers on calendar year maintenance agreements which results in higher deferred revenue in December.

Our accounts receivable trade decreased from $440,195 at December 31, 2012 to $188,889 (net of allowance for bad debts) at September 30, 2013. The decrease is a result of seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to September.

The accounts payable and accrued liabilities went from $7,466,957 at December 31, 2012 to $8,633,641 at September 30, 2013. The increase is primarily related to unpaid executive payroll and payroll taxes. As described above, we utilized some of the cash we received from collections on customer accounts receivable to pay current expenses and to pay down some of the accounts payable. The resulting balance at September 30, 2013 is 46 times more than the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

We used cash to invest in equipment and the development of software products for the nine months ended September 30, 2013 and September 30, 2012 of $102,551 and $248,510, respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers, and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

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For the nine months ended September 30, 2013, we paid $1,851,775 of principal on notes payable and notes payable to related parties and had $2,059,150 of new debt funding in the same period. For the nine months ended September 30, 2012, we paid $190,500 of principal on notes payable and notes payable to related parties and had $778,405 of new debt funding in the same period. We also paid $20,000 to a lender in order to extend the maturity date of a loan

The total change in cash for the nine months ended September 30, 2013 was a decrease of $85,596.

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

	Balance at
	September 30,		Due in Next Five Years
Contractual Obligations	2013		2013			2014	2015		2016		2017+
Notes payable	$	4,611,904	$	3,119,889	$	108,262	$	120,790	$	134,768	$	1,128,195
Convertible debenture		30,000		30,000		-		-		-		-
Operating lease		146,371		23,189		93,330		29,852		-		-
Total	$	4,788,275	$	3,173,078	$	201,592	$	150,642	$	134,768	$	1,128,195

Following is the status of notes payable:

	September 30,
	2013		December 31, 2012

In default	$	2,901,989	$	2,276,994
Not in default		1,739,915		2,123,474

Total Notes Payable	$	4,641,904	$	4,400,468

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We had a net loss of $1,076,628 and $766,749 for the nine months ended September 30, 2013 and 2012, respectively and have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at September 30, 2013, we had negative working capital of approximately $13.4 million (although this figure includes deferred revenue of approximately $1.8 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

Our management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations as well as to generate additional revenue through our existing businesses, including the licensing of our intellectual property. 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 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 unaudited consolidated financial statements contain no adjustment for the outcome of this uncertainty.

Related Party Transactions

The following table reflects our related party debt activity for the nine months ended September 30, 2013:

December 31, 2012	$	724,790
Repayments of related party notes		(381,583)
September 30, 2013	$	343,207

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures

Our management, principally our chief financial officer and chief executive 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 following material weakness of our internal controls:

	·	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.

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2012, as filed on April 16, 2013.

There have been no material changes in our internal control over financial reporting since our reporting on Form 10-K for the year ended December 31, 2012.

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PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

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Discovery for the Interwoven Action has been completed. The trial date has been set for March 10, 2014.

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Item 1A. Risk Factors

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2012, as filed on April 16, 2013.

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

In July 2013, the Company and granted 500,000 shares of VCSY common stock (valued at $19,700) to a third party lender in consideration of a $150,000 loan to the Company..

During the nine months ended September 30, 2013, the Company cancelled 1,500,000 previously issued common shares of the Company that had been granted to a third party lender.

During the nine months ended September 30, 2013, the Company granted 1,500,000 common shares (valued at $45,000) for services to consultants of the Company that vest on December 31, 2013.

During the nine months ended September 30, 2013, 550,000 common shares granted to employees of the Company and a consultant of the Company, valued at $10,226, vested.

During the period from October 1, 2013 to November 18, 2013, the Company became obligated to cause 1,000,000 common shares of the Company’s stock to be transferred to a third party lender in consideration of a $100,000 loan.

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

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Item 6. Exhibits

The following documents are filed as part of this report:

Exhibit No.	Description	Location
31.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 18, 2013	Provided herewith
32.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated November 18, 2013	Provided herewith
101.INS*	XBRL Instance Document	Provided herewith
101.SCH*	XBRL Taxonomy Extension Schema	Provided herewith
101.CAL *	XBRL Taxonomy Extension Calculation Linkbase	Provided herewith
101.DEF*	XBRL Taxonomy Extension Definition Linkbase	Provided herewith
101.LAB*	XBRL Taxonomy Extension Label Linkbase	Provided herewith
101.PRE*	XBRL Taxonomy Extension Presentation Document	Provided herewith

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

SIGNATURES

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

	VERTICAL COMPUTER SYSTEMS, INC.

November 18, 2013	By:	/s/ Richard Wade
		Richard Wade
		President and Chief Executive Officer
		(Principal Executive Officer and
		Principal Accounting Officer)

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