VERTICAL COMPUTER SYSTEMS INC - FORM 10-Q

Attached files

file	filename
EX-32.1 - EXHIBIT 32.1 - VERTICAL COMPUTER SYSTEMS INC	s110548_ex32-1.htm
EX-31.1 - EXHIBIT 31.1 - VERTICAL COMPUTER SYSTEMS INC	s110548_ex31-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2018

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

For the transition period from _____ to _____

Commission file number 0-28685

VERTICAL COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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

101 West Renner Road, Suite 300

Richardson, TX 75082

(Address of principal executive offices)

(972) 437-5200

(Registrant’s Telephone Number)

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

Yes ☒ No ☐

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

Yes ☒ No ☐

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

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

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

As of June 8, 2018, the issuer had 1,190,915,201 shares of common stock, par value $0.00001, issued and 1,150,915,201 outstanding.

PART I

FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

	March 31,		December 31,
	2018		2017
Assets
Current assets
Cash	$	106,193	$	62,084
Accounts receivable, net of allowance for bad debts of $139,640 and $234,439		289,511		349,002
Prepaid expenses and other current assets		8,586		5,312
Total current assets		404,290		416,398

Property and equipment, net of accumulated depreciation of $1,045,597 and $1,044,936		8,422		9,211
Intangible assets, net of accumulated amortization of $319,505 and $319,504		6,690		6,690
Deposits and other assets		8,004		8,037

Total assets	$	427,406	$	440,336

Liabilities and Stockholder’s Deficit
Current liabilities:
Accounts payable and accrued liabilities	$	14,728,152	$	14,122,394
Accounts payable to related parties		168,862		148,760
Deferred revenue		1,762,327		1,752,421
Derivative liabilities		44,652		159,537
Convertible debentures, net of unamortized discounts of $47,729 and $75,705		1,192,272		1,164,295
Notes payable		5,901,919		3,775,703
Notes payable and convertible debt to related parties		308,242		308,242
Total current liabilities		24,106,426		21,431,352

Non-current portion – notes payable		—		2,158,140

Total liabilities		24,106,426		23,589,492

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

(Continued from previous page)

	March 31, 2018			December 31, 2017
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 52,800 shares issued and outstanding		10,255,185			10,255,185
Series B 10% Convertible Cumulative Preferred stock; $0.001 par value; 375,000 shares authorized; 7,200 shares issued and outstanding		246			246
Series C 4% Convertible Cumulative Preferred stock; $100.00 par value; 200,000 shares authorized; 50,000 shares issued and outstanding		200,926			200,926
Series D 15% Convertible Cumulative Preferred stock; $0.001 par value; 300,000 shares authorized; 25,000 shares issued and outstanding		852			852
		10,457,209			10,457,209

Stockholders’ Deficit
Common Stock; $.00001 par value; 2,000,000,000 shares authorized; 1,188,415,201 issued and 1,148,415,201 outstanding as of March 31, 2018 and 1,188,095,201 issued and 1,148,095,201 outstanding as of December 31, 2017		11,886			11,883
Treasury stock: 40,000,000 as of March 31, 2018 and December 31, 2017		(400	)		(400	)
Additional paid-in capital		24,668,667			24,609,424
Accumulated deficit		(58,621,340	)		(58,087,916	)
Accumulated other comprehensive income – foreign currency translation		364,794			339,051

Total Vertical Computer Systems, Inc. stockholders’ deficit		(33,576,393	)		(33,127,958	)

Non-controlling interest		(559,836	)		(478,407	)
Total stockholders’ deficit		(34,136,229	)		(33,606,365	)

Total liabilities and stockholders’ deficit	$	427,406		$	440,336

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

	Three Months Ended March 31,
	2018			2017
Revenues
Licensing and software	$	10,680		$	—
Software maintenance		803,475			807,512
Cloud-based offering		61,262			59,703
Consulting services		188,290			72,771
Other		7,821			2,757
Total revenues		1,071,528			942,743

Cost of revenues		(362,477	)		(373,552	)

Gross profit		709,051			569,191

Operating expenses:
Selling, general and administrative expenses		900,443			1,082,185
Depreciation and amortization		788			325
Bad debt recovery		(93,143	)		(51,022	)
Total operating expenses		808,088			1,031,488

Operating loss		(99,037	)		(462,297	)

Other Income (Expense):
Gain on derivative liabilities		141,532			339,467
Forbearance fees		—			(3,000	)
Interest income		3			15
Interest expense		(409,720	)		(558,011	)
Net loss before non-controlling interest and income tax expense		(367,222	)		(683,826	)
Income tax expense		188,536			35,910

Net loss before non-controlling interest		(555,758	)		(719,736	)
Net (income) loss attributable to non-controlling interest		22,334			(8,671	)
Net loss attributable to Vertical Computer Systems, Inc.		(533,424	)		(728,407	)

Dividend applicable to preferred stock		(155,600	)		(151,472	)

Net loss applicable to common stockholders	$	(689,024	)	$	(879,879	)

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

Basic weighted average of common shares outstanding		1,148,155,646			1,133,430,551
Diluted weighted average of common shares outstanding		1,204,514,127			1,216,490,286

Comprehensive loss
Net loss	$	(555,758	)	$	(719,736	)
Translation adjustments		25,743			(23,989	)
Comprehensive loss		(530,015	)		(743,725	)
Comprehensive (income) loss attributable to non-controlling interest		22,334			(8,671	)
Comprehensive loss attributable to Vertical Computer Systems, Inc.	$	(507,681	)	$	(752,396	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

(Unaudited)

											Additional Paid-in Capital						Other Comprehensive Income		Non-controlling Interest
	Common Stock				Treasure Stock									Accumulated Deficit
	Shares		Amount		Shares			Amount						Accumulated Deficit								Total
Balances at December 31, 2017		1,188,095,201	$	11,883	$	(40,000,000	)	$	(400	)	$	24,609,424		$	(58,087,916	)	$	339,051	$	(478,407	)	$	(33,606,365	)
Amortization of restricted stock awards		—		—		—			—			11,874			—			—		—			11,874
Shares issued for vested restricted stock awards		320,000		3		—			—			(3	)		—			—		—			—
Issuance of subsidiary shares for debt extensions		—		—		—			—			26,987			—			—		(1,208	)		25,779
Issuance of subsidiary shares for services		—		—		—			—			20,385			—			—		(3,046	)		17,339
Dividends declared but unpaid to non-controlling interest holders		—		—		—			—			—			—			—		(54,841	)		(54,841	)
Other comprehensive income translation adjustment		—		—		—			—			—			—			25,743		—			25,743
Net loss		—		—		—			—			—			(533,424	)		—		(22,334	)		(555,758	)
Balances at March 31, 2018		1,188,415,201	$	11,886		(40,000,000	)		(400	)	$	24,668,667		$	(58,621,340	)	$	364,794	$	(559,836	)	$	(34,136,229	)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

	Three Months Ended March 31,
	2018			2017

Cash flows from operating activities
Net loss	$	(555,758	)	$	(719,736	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		788			325
Bad debt recovery		(93,143	)		(51,022	)
Amortization of debt discounts		80,404			245,271
Gain on derivative liabilities		(141,532	)		(339,467	)
Common stock issued to an employee		—			72,000
Amortization of restricted stock awards		11,874			35,167
Amortization of subsidiary restricted stock awards		17,339			46,342
Changes in operating assets and liabilities:
Accounts receivable		147,903			(12,656	)
Prepaid expenses and other assets		(3,258	)		(34,013	)
Accounts payable to related parties		20,102			(2,014	)
Accounts payable and accrued liabilities		555,483			554,627
Deferred revenue		39,352			70,168
Net cash provided by (used in) operating activities		79,554			(135,008	)

Cash flow from investing activities:
Purchase of equipment		—			(4,745	)
Net cash used in investing activities		—			(4,745	)

Cash flows from financing activities:
Borrowings on notes payable		—			50,000
Payments of notes payable		(31,926	)		(4,716	)
Net cash provided by (used in) financing activities		(31,926	)		45,284

Effect of changes in exchange rates on cash		(3,519	)		(14,718	)
Net change in cash		44,109			(109,187	)
Cash, beginning of period		62,084			190,448
Cash, end of period	$	106,193		$	81,261

Supplemental disclosures of cash flow information:
Cash paid for interest	$	62,766		$	22,747

Non-cash investing and financing activities:
Common shares issued for vested restricted stock awards	$	3		$	5
Debt discount due to subsidiary shares issued for debt extensions		25,779			—
Derivative liability for conversion of convertible debt		—			7,245
Common shares issued for conversion of notes and accounts payable		—			10,109
Debt discounts due to derivative liabilities		26,647			17,741
Dividend accrued but unpaid to non-controlling interest holders	$	54,841		$	32,500

See accompanying notes to unaudited consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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

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

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 three months ended March 31, 2018 and 2017, $0 and $0 of internal costs were capitalized, respectively.

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.

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.

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. 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

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

Valuation of the Embedded and Warrant Derivatives

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

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

Recently Issued Accounting Pronouncements

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 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.

Results of Operations

Three Months Ended March 31, 2018 Compared To Three Months Ended March 31, 2017

Total Revenues. We had total revenues of $1,071,528 and $942,743 in the three months ended March 31, 2018 and 2017, respectively. The increase in total revenues was $128,785 for the three months ended March 31, 2018 representing a 13.7% increase compared to the total revenues for the three months ended March 31, 2017. Of the $1,071,528 and $942,743 total revenues for the three months ended March 31, 2018 and 2017, respectively, $1,070,489 and $933,517 of such amounts were related to the business operations of NOW Solutions, a 75% owned subsidiary of the Company.

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from licenses and software increased by $10,680 compared to that for the three months ended March 31, 2017 due to a licensing upgrade to an existing customer for 2018. Software maintenance in the three months ended March 31, 2018 decreased by $4,037 from the same period in the prior year. The revenue decrease in software maintenance is primarily due to the loss or reduction of customer maintenance agreements partially offset by favorable currency rate changes on our Canadian revenue. Consulting revenue, in the three months ended March 31, 2018, increased by $115,519 from the same period in the prior year, which represents an 158.7% increase. This increase was primarily due to more billable consulting services for custom applications and software upgrades in the first quarter of 2018 compared to 2017 and favorable currency rate changes on Canadian consulting revenue. Cloud-based revenues were $61,262 for the three months ended March 31, 2018 compared to $59,703 for the same period in the prior year, representing a $1,559 increase or 2.6%. The increase is primarily related to the conversion of one customer from maintenance to cloud-based services partially offset by lower cloud-based revenue in NOW Solutions Canada and SnAPPnet. Other revenue in the three months ended March 31, 2018 increased by $5,064 or 183.7% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, sales discounts, and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $362,477 for the three months ended March 31, 2018, compared to $373,552 for the three months ended March 31, 2017. The decrease in cost of revenues of $11,075 represents a 3% decrease. The decrease in direct cost of revenues was primarily due to lower payroll and benefit costs. During the three months ended March 31, 2018 and 2017, $0 and $0 of internal costs were capitalized, respectively.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $900,443 and $1,082,185 in the three months ended March 31, 2018 and 2017, respectively. The decrease of $181,742 is 16.8% less than for the same period in 2017. The decrease is primarily due to decreased stock compensation expense due to the issuance of restricted stock to consultants and employees in 2017, decreased legal fees and decreased penalties on unpaid payroll taxes.

Depreciation and Amortization. We had depreciation and amortization expense of $788 and $325 for the three months ended March 31, 2018 and 2017, respectively. The increase of $463 or 142.5% relates to depreciation on purchases of computers in the first quarter of 2018. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

Bad Debt Recovery. We had bad debt recovery of $93,143 and $51,022 for the three months ended March 31, 2018 and 2017, respectively. Bad debt recovery relates to the collection of customer accounts greater than 90 days past due previously expensed.

Operating Loss. We had an operating loss from operations of $99,037 and $462,297 for the three months ended March 31, 2018 and 2017, respectively. The change was primarily due to increase revenues, decreased cost of revenues, decreased selling, general and administrative expenses and increased bad debt recovery.

Gain/Loss on Derivative Liability. Derivative liabilities are adjusted each quarter using the Black-Scholes option pricing model. The gain on derivative liability was $141,532 for the three months ended March 31, 2018 compared to a gain of $339,467 for the same period in 2017.

Forbearance Fees. Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended March 31, 2018 and 2017 were $0 and $3,000, respectively.

Interest Expense. We had interest expense of $409,720 and $558,011 for the three months ended March 31, 2018 and 2017, respectively. Interest expense in 2018 decreased by $148,291, representing a decrease of 26.6% compared to the same expense in the three months ended March 31, 2017. The decrease is primarily due to decreased debt discount amortization for the three months ended March 31, 2018.

Net loss before non-controlling interest and income tax provision. We had a net loss before non-controlling interest and income tax provision of $367,222 and $683,826 for the three months ended March 31, 2018 and 2017, respectively. The net loss for the three months ended March 31, 2018 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 $99,037. The operating loss was decreased by the gain on derivative liability and increased by interest expense resulting in a net loss of $367,222 for the three months ended March 31, 2018. The net loss for the three months ended March 31, 2017 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 $462,297. The operating loss was decreased by the gain on derivative liability and increased by forbearance fees and interest expense resulting in a net loss of $683,826 for the three months ended March 31, 2017.

Income Tax Provision. We had an income tax provision of $188,536 for the three months ended March 31, 2018 compared to $35,910 for the three months ended March 31, 2017. The income tax provision is related to NOW Solutions, a 75% owned subsidiary of the Company. The income tax provision is related to foreign and US income tax.

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $155,600 and $151,472 for the three months ended March 31, 2018 and 2017, respectively.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $689,024 and $879,879 for the three months ended March 31, 2018 and 2017, respectively. Net loss attributed 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 three months ended March 31, 2018 and 2017, respectively.

Liquidity and Capital Resources

At March 31, 2018, we had non-restricted cash-on-hand of $106,193 compared to $62,084 at December 31, 2017.

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 increased $9,906 or 0.6% from the balance at December 31, 2017. The increase was primarily a result of the loss of US customers on a calendar year renewal basis partially offset by a decrease in the Canadian to US dollar currency exchange rate.

Our accounts receivable trade decreased from $349,002 at December 31, 2017 to $289,511 (net of allowance for bad debts) at March 31, 2018. The decrease is primarily a result of higher receivables at December 31, 2017 vs. March 31, 2018 due to a majority of customers being on calendar year renewals, partially offset by a decrease in the allowance for doubtful accounts.

The accounts payable, accrued liabilities and accounts payable to related parties went from $14,271,154 at December 31, 2017 to $14,897,014 at March 31, 2018. The resulting balance at March 31, 2018 is 51 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.

For the three months ended March 31, 2018, we repaid $31,926 to third party lenders. For the three months ended March 31, 2017, we repaid $4,716 to third party lenders.

For the three months ended March 31, 2018 and 2017, one of our subsidiaries accrued $54,841 and $32,500, respectively of dividends to non-controlling interests.

The total change in cash for the three months ended March 31, 2018 was an increase of $44,109.

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.

As of March 31, 2018, the following contractual obligations and commercial commitments were outstanding:

	Balance at		Due in Next Five Years
Contractual Obligations	March 31, 2018		2018		2019		2020		2021		2022+
Notes payable	$	6,110,162	$	6,110,162		—		—		—		—
Convertible debts		1,340,000		1,340,000		—		—		—		—
Operating lease		56,872		44,204		8,445		4,223		—		—
Total	$	7,507,034	$	7,494,366	$	8,445		4,223		—		—

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

	March 31, 2018		December 31, 2017

In default	$	5,649,662	$	3,390,190
Not in default		1,800,500		4,091,895

Total Notes Payable	$	7,450,162	$	7,482,085

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 $533,424 for the three months ended March 31, 2018 and a net loss of $728,407 for the three months ended March 31, 2017, and we 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 March 31, 2018, we had negative working capital of approximately $23.7 million (although this figure includes deferred revenue of approximately $1.8 million) and have 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. We will require additional funds to pay down our liabilities, as well as finance our expansion plans consistent with our anticipated changes in operations and infrastructure. However, there can be no assurance that we will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to us and whether we will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures

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

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2017, as filed on May 10, 2018.

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, 2017.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

Item 1A. Risk Factors

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2017, as filed on May 10, 2018.

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

During the three months ended March 31, 2018, 320,000 shares of VCSY common stock issued to employees of the Company vested.

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 $35,400 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 and became due on May 1, 2018 when VHS did not meet performance objectives.

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

The following documents are filed as part of this report:

31.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated June 8, 2018	Provided herewith

32.1	Certification of Principal Executive Officer and Principal Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated June 8, 2018	Provided herewith

101.INS	XBRL Instance Document	Provided herewith

101.SCH	XBRL Taxonomy Extension Schema	Provided herewith

101.CAL	XBRL Taxonomy Extension Calculation Linkbase	Provided herewith

101.DEF	XBRL Taxonomy Extension Definition Linkbase	Provided herewith

101.LAB	XBRL Taxonomy Extension Label Linkbase	Provided herewith

101.PRE	XBRL Taxonomy Extension Presentation Linkbase	Provided herewith

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.

June 8, 2018	By:	/s/ Richard Wade
		Richard Wade,
		President and Chief Executive Officer
		(Principal Executive Officer and
		Principal Accounting Officer)

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VERTICAL COMPUTER SYSTEMS INC Reports