10-Q 1 v240204_10q.htm 10-Q Unassociated Document
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, 2011
   
o
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 Small Business Issuer 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) (Zip Code)
 
(972) 437-5200
(Issuer’s Telephone Number)
________________

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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 o

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  o

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  o
 
Accelerated filer      o
 
Non-accelerated filer  o
(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

As of November 14, 2011, the issuer had 997,935,151 shares of common stock, par value $0.00001, issued and outstanding.
 
 
 

 
 
PART I
FINANCIAL INFORMATION


Item 1. Consolidated Financial Statements
 
Vertical Computer Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
(Unaudited)
 
   
September 30,
   
December 31,
 
   
2011
   
2010
 
Assets
           
Current assets
           
Cash
  $ 124,738     $ 272,970  
Accounts receivable, net of allowance for bad debts of $16,660  and $16,700
    207,757       565,367  
Prepaid expenses and other current assets
    103,112       116,505  
Total current assets
    435,607       954,842  
                 
Property and equipment, net of accumulated depreciation of $1,001,646 and
  $988,361
    45,651       35,120  
Intangible assets, net of accumulated amortization of $164,440 and $129,770
    636,659       441,432  
Deposits and other
    15,667       14,113  
                 
Total assets
  $ 1,133,584     $ 1,445,507  
                 
Liabilities and Stockholders’ Deficit
               
Current liabilities:
               
Accounts payable and accrued liabilities
  $ 6,624,314     $ 6,774,923  
Bank overdraft
    31,971       63,740  
Deferred revenue
    2,257,342       2,568,847  
Derivative liability
    24,890       30,785  
Convertible debenture
    30,000       30,000  
Current portion - notes payable, net of unamortized discounts of $16,354 for 2010
    3,102,900       3,029,046  
Current portion - notes payable to related parties
    717,140       370,362  
Total current liabilities
    12,788,557       12,867,703  
                 
Total liabilities
    12,788,557       12,867,703  
 
See accompanying notes to the unaudited consolidated financial statements.
 
(Continued on next page)
 
 

 
 
(Continued from previous page)
           
   
September 30,
   
December 31,
 
   
2011
   
2010
 
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
               
 997,335,151 issued and outstanding
    9,973       9,973  
Additional paid-in-capital
    19,240,060       19,240,060  
Accumulated deficit
    (40,521,716 )     (40,306,035 )
Accumulated other comprehensive income – foreign currency translation
    (116,149 )     (170,522 )
                 
Total Vertical Computer Systems, Inc. stockholders’ deficit
    (21,387,832 )     (21,226,524 )
                 
Noncontrolling interest
    (169,165 )     (97,696 )
Total stockholders’ deficit
    (21,556,997 )     (21,324,220 )
                 
Total liabilities and stockholders' deficit
  $ 1,133,584       1,445,507  
                 
                 

 
See accompanying notes to unaudited consolidated financial statements.
 
 
 

 
 
Vertical Computer Systems, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
 
   
Three Months Ended
September 30,
   
Nine Months Ended
 September 30,
 
    2011    
2010
   
2011
   
2010
 
Revenues
                       
Licensing and software
  $ -     $ 93,212     $ 199,103     $ 266,309  
Software maintenance
    1,113,012       1,114,469       3,375,132       3,332,997  
Software-as-a-service
    148,631       113,597       463,336       205,184  
Consulting services
    149,105       174,650       472,585       440,811  
Other
    30,716       44,825       78,728       100,212  
Total revenues
    1,441,464       1,540,753       4,588,884       4,345,513  
                                 
Cost of revenues
    474,165       400,683       1,237,806       1,155,862  
                                 
Gross profit
    967,299       1,140,070       3,351,078       3,189,651  
 
Operating expenses (income):
                               
Selling, general and administrative expenses
    1,067,906       1,067,952       3,138,963       3,109,313  
Depreciation and amortization
    16,616       7,231       49,813       21,327  
Gain on settlement of trade payables
    -       (22,438 )     -       (22,438 )
Total operating expenses
    1,084,522       1,052,745       3,188,776       3,108,202  
Income (loss) from operations
    (117,223 )     87,325       162,302       81,449  
                                 
Other income (expense):
                               
Interest expense, net
    (162,720 )     (131,573 )     (455,347 )     (356,752 )
Gain on derivative liability
    5,895       8,970       5,895       85,534  
                                 
Net loss
    (274,048 )     (35,278 )     (287,150 )     (189,769 )
                                 
Net loss attributable to noncontrolling interest
    31,262       36,158       71,469       70,310  
Net income (loss) attributable to VCSY
    (242,786 )     880       (215,681 )     (119,459 )
Dividends applicable to preferred stock
    (147,000 )     (147,000 )     (441,000 )     (441,000 )
                                 
Net loss available to common stockholders
  $ (389,786 )   $ (146,120 )   $ (656,681 )   $ (560,459 )
                                 
Basic and diluted loss per share
  $ (0.00 )   $ (0.00 )   $ (0.00 )   $ (0.00 )
                                 
Basic and diluted weighted average of common shares outstanding
    997,335,151       998,668,484       997,335,151       998,587,349  
                                 
Comprehensive loss
                               
Net income (loss)
  $ (242,786 )   $ 880     $ (215,681 )   $ (119,459 )
Translation adjustments
    195,818       (42,342 )     54,373       (63,041 )
Comprehensive loss
    (46,968 )     (41,462 )     (161,308 )     (182,500 )
Comprehensive loss attributable to noncontrolling interest
    31,262       36,158       71,469       70,310  
Comprehensive loss attributable to VCSY
  $ (15,706 )   $ (5,304 )     (89,839 )     (112,190 )
 
See accompanying notes to unaudited consolidated financial statements.
 
 
 

 
 
Vertical Computer Systems, Inc. and Subsidiaries
Consolidated Statement of Stockholders’ Deficit
For the nine months ended September 30, 2011
 (Unaudited)





               
Additional
         
Other
   
Non-controlling
       
   
Common Stock
   
Paid-in
   
Accumulated
   
Comprehensive
   
Controlling
       
   
Shares
   
Amount
   
Capital
   
Deficit
   
Interest
   
Interest
   
Total
 
 Balances at December 31, 2010
    997,335,151     $ 9,973     $ 19,240,060     $ (40,306,035 )   $ (170,522 )   $ (97,696 )   $ (21,324,220 )
                                                         
Other comprehensive income
      translation adjustment
    -       -       -       -       54,373       -       54,373  
                                                         
 Net  loss
    -       -       -       (215,681 )     -       (71,469 )     (287,150 )
                                                         
 Balances at  September 30, 2011
    997,335,151     $ 9,973     $ 19,240,060     $ (40,521,716 )   $ (116,149 )   $ (169,165 )   $ (21,556,997 )

 
See accompanying notes to unaudited consolidated financial statements.
 
 
 

 
 
Consolidated  Statements of Cash Flows
(Unaudited)
Vertical Computer Systems, Inc. and Subsidiaries
 
 
   
Nine Months Ended September 30,
 
   
2011
   
2010
 
Cash flows from operating activities
           
Net loss
  $ (287,150 )   $ (189,769 )
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation and amortization
    49,813       21,328  
Amortization of debt discounts
    16,354       -  
Gain on settlement of trade payables
    -       (22,438 )
Stock compensation
    -       7,550  
Gain on derivatives
    (5,895 )     (85,534 )
Changes in operating assets and liabilities:
               
Accounts receivable
    357,610       593,970  
Employee receivables
    1,481       (10,352 )
Prepaid expenses and other assets
    10,360       (83,925 )
Accounts payable and accrued liabilities
    223,568       163,938  
Deferred revenue
    (311,505 )     (418,454 )
Net cash (used in) provided by operating activities
    54,636       (23,686 )
                 
Cash flow from investing activities:
               
Acquisition of SnAPPnet, Inc,  net of cash received
    -       (5,335 )
Software development
    (228,154 )     (120,715 )
Purchase of property and equipment
    (27,417 )     -  
Net cash used in investing activities
 
    (255,571 )     (126,050 )
Cash flows from financing activities:
               
Borrowings from related parties
    8,000       54,195  
Borrowings from third party debt
    50,000       137,816  
Payments of third party notes payable
    -       (87,767 )
Payments of related party notes payable
    (27,901 )     (107,528 )
Bank overdraft
    (31,769 )     -  
Net cash used in financing activities
    (1,670 )     (3,284 )
                 
Effect of changes in exchange rates on cash
    54,373       (63,041 )
Net change in cash and cash equivalents
    (148,232 )     (216,062 )
Cash and cash equivalents, beginning of period
    272,970       229,738  
Cash and cash equivalents, end of period
  $ 124,738     $ 13,676  
                 
Supplemental disclosures of cash flow information:
               
Cash paid for interest
  $ 166,896     $ 154,000  
                 
Non-cash investing and financing activities:
               
Conversion of accounts payable to debt
  $ 364,679     $ -  
Adjustment to debt principal due to reapplication of payments
    9,500       -  
Noncash consideration for acquisition of SnAPPnet, Inc.
    -       75,825  
Cancellation of derivative liability and warrants
    -       357,000  
Forgiveness of related party liability charged to additional paid in capital
    -       100,000  
Cancellation of conversion option in Series C preferred stock
    -       149,074  
 
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, 2010. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, EnFacet, Inc., Globalfare.com, Inc., Pointmail.com, Inc. and Vertical Internet Solutions, all of which are inactive; Vertical Healthcare Solutions (“VHS”), OptVision Research, Inc., Taladin, Inc., Government Internet Systems, Inc., Priority Time Systems, Inc. (“PTS”), a 90% owned subsidiary, SnAPPnet, Inc., all entities with minor activities and NOW Solutions, Inc.(“NOW Solutions”). 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 2010 annual report on Form 10-K have been omitted.

Earnings per share

Basic earnings per share is calculated by dividing net income 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.

As of September 30, 2011 and 2010, 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 period to conform to the current period presentation.

Recently Issued Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (FASB) or other standard setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, we believe that the impact of recently issued accounting pronouncements that are not yet effective will not have a material impact on our financial position or results of operations upon adoption.

Fair value measurement

In May 2011, the FASB issued amended guidance to develop common requirements for fair value measurement and for disclosure of information about fair value measurements under US GAAP and International Financial Reporting Standards. This amended guidance provides clarification about the application of existing fair value measurement and disclosure requirements, and expands certain other disclosure requirements. We are required to adopt this amended guidance for our annual and interim periods beginning January 1, 2012. We do not expect the adoption of this amended guidance to have a material impact on our financial statements.
          
 
 

 
 
Presentation of comprehensive income

In June 2011, the FASB issued amended guidance requiring an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This amended guidance eliminates the option to present the components of other comprehensive income as part of the statement of stockholders’ equity. In addition, this amended guidance requires retrospective application. We are required to adopt this amended guidance for our annual and interim periods beginning January 1, 2012. We do not expect the adoption of this amended guidance to have a material impact on our financial statements.

Note 2. Going Concern

The accompanying unaudited consolidated financial statements for the nine months ended September 30, 2011 and 2010 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.

At September 30, 2011, we had a working capital deficit of approximately $12.4 million and have defaulted on the majority of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern. The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values.  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.

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 debt activity, including our convertible debt, for the nine months ended September 30, 2011:

December 31, 2010
    $ 3,429,408  
 
Repayments of related party notes
    (27,901 )
 
New borrowings
    58,000  
 
Amortization of debt discount
    16,354  
 
Adjustment to debt principal due to reapplication of payments
    9,500  
 
Conversion of accounts payable to debt
    364,679  
September 30, 2011
    $ 3,850,040  

In July 2011, the Company and a related party agreed to cancel $364,679 of outstanding debt owed to the related party and in consideration of such cancellation the Company issued two notes with principal of $274,679 and $90,000, respectively, each bearing interest at 8%. The payment terms for the notes are as follows: (a) aggregate principal payments in the amount of $25,000 due on December 20, 2011, to be allocated between the notes, (b) interest only payments beginning July 31, 2011 through January 31, 2012 and (c) monthly payments of interest plus monthly principal payments of $5,000 to be allocated between the notes beginning January 31, 2012 until the notes are fully paid.

During the nine months ended September 30, 2011, the Company borrowed $50,000 for working capital purposes from a third party and $8,000 from a related party. The debts are unsecured, bear interest at a fixed amount of $2,000 and $1,000, respectively and are due on demand. The $8,000 related party debt was repaid in November, 2011.

During the nine months ended September 30, 2011 and 2010, the Company made interest payments of $166,896 and $154,000, respectively.

 
 

 

Note 4. Derivative liability and fair value measurements
 
Derivative liability                                

During 2008, one of our officers 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. Subsequent to this agreement, 1,309,983 shares of this stock were sold to satisfy the debt owed to the lender. This contractual commitment to replace all of the pledged shares was evaluated under FASB ASC 815-40, Derivatives and Hedging and was determined to have characteristics of a liability and therefore constituted a derivative liability under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At September 30, 2011 and December 31, 2010, the aggregate derivative liability was $24,890 and $30,785, respectively.

For the nine months ended September 30, 2011 there was a $5,895 gain related to the change in the fair value of derivative liabilities. The aggregate gain or loss on the change in the fair value of derivative liabilities was a gain of $85,534 for the nine months ended September 30, 2010.

The valuation of our remaining embedded derivatives is determined by using the VCSY stock price at September 30, 2011. As such, our derivative liability has been classified as Level 1 as of September 30, 2011.

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 measured on a recurring basis:


   
Fair value measurements on a recurring basis
 
   
Level 1
   
Level 2
   
Level 3
 
As of September 30, 2011:
                 
Liabilities
 
 
   
 
   
 
 
  Stock derivative – 1,309,983 shares
  $ 24,890     $ -     $ -  
    $ 24,890     $ -     $ -  
                         
As of December 31, 2010:
                       
Liabilities
                       
  Stock derivative – 1,309,983 shares
  $ 30,785     $ -     $ -  
    $ 30,785     $ -     $ -  

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

During the three months ended September 30, 2011, there were no unregistered sales of common stock of the Company.

As of the Date of this Report (for the nine months ended September 30, 2011), 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:
 
997,335,151
 
Common Stock Issued
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 of which 12,500 shares are convertible)
94,700
 
Common Shares convertible from Preferred Series D stock (25,000 shares outstanding)
1,309,983
 
Common Shares Company Is Obligated to Reimburse to officer of Company for Pledged Shares
1,028,017,108
 
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 28,000,000 shares if all of the shares of preferred stock described in the table above were converted into shares of common stock and the Company met its contractual obligation to issue additional 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 470-20 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 of common shares of the Company for the nine months ended September 30, 2011 is shown below.

   
Shares
   
Weighted
Average
Grant-Date Fair Value
 
             
Non Vested Balance at December 31, 2010
    600,000     $ 0.031  
  Granted
    -       -  
  Vested
    -       -  
  Forfeited/Cancelled
    -       -  
Non Vested Balance at September 30, 2011
    600,000     $ 0.031  

As of September 30, 2011, there was $13,521 of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of less than 3 years.

 
 

 
 
Note 7. Related Party Transactions
 
On January 18, 2011, the Company and Microidea Software Development, LLC (“Microidea”) entered into a license agreement whereby Microidea granted an exclusive license of  a 16 year-old software known as “Tiny Web Server” to the Company for an initial term of thirty years with three twenty year renewal terms in consideration of a 5% royalty.  During the term, the Company also has the right to purchase the technology for $6 million, payable in four installments of $1.5 million over a 3 year period. The President of Microidea is Mr. Luiz Valdetaro, who also serves as our Chief Technology Officer.

In July 2011, the Company and a related party agreed to cancel $364,679 of outstanding debt owed to the related party and in consideration of such cancellation the Company issued two notes with principal of $274,679 and $90,000, respectively, each bearing interest at 8%. The payment terms for the notes are as follows: (a) aggregate principal payments in the amount of $25,000 due on December 20, 2011, to be allocated between the notes, (b) interest only payments beginning July 31, 2011 through January 31, 2012 and (c) monthly payments of interest plus monthly principal payments of $5,000 to be allocated between the notes beginning January 31, 2012 until the notes are fully paid.

Note 8. Legal Proceedings
 
We have been or 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 claims it is owed $195,000, and has incurred alleged lost opportunity cost of not less than $220,000. We attempted unsuccessfully to resolve our dispute with InfiniTek via mediation. Our lawsuit was amended on March 30, 2010. Discovery is ongoing.

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. This lawsuit relates to one of the causes of action, and the same set of underlying facts, as those in the Texas legal action mentioned above. 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. We continue to litigate the claims made by InfiniTek in this action as well as our other claims against InfiniTek in the Texas case. The amounts in dispute are included in our accounts payable and accrued liabilities pending the outcome of this litigation.

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”), 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., LG Electronics Inc., Samsung Electronics Co., Ltd., Samsung Electronics America, Inc., No. 2:10-CV-00490.

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 is a complaint for declaratory judgment, in which Interwoven is requesting 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 motions 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 May 12, 2011, Vertical filed in the United States Court of Appeals for the Federal Circuit a petition for a writ of mandamus seeking review of that portion of the May 2, 2011 order by the Northern District of California which refused to transfer the Interwoven v. Vertical action to the Eastern District of Texas, which was denied on August 17, 2011.
 
 
 

 
 
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 is seeking damages from us in excess of $133,750 plus attorney’s fees and interest.  The amounts in dispute are included in our accounts payable and accrued liabilities pending the outcome of this litigation. On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses.  Discovery is ongoing.

In the opinion of management, the ultimate resolution of any pending matters may have a significant effect on our financial position, operations or cash flows. Also, in the future, we may become involved in other legal actions that may have a significant effect on our financial position, operations or cash flows.
 
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, 2011 and 2010, $228,154 and $107,435 of internal costs were capitalized, respectively.
 
Revenue Recognition
 
Our revenue recognition policies are in accordance with standards on software revenue recognition, which includes guidance on revenue arrangements with multiple deliverables and arrangements that include the right to use of software stored on another entity’s hardware.

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

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

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

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

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

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

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

Allowances for Doubtful Accounts
 
We maintain allowances for doubtful accounts, for estimated losses resulting from the inability of our 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
 
We record 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 accounting provisions governing 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 granted and the quoted price of our common stock. The Company uses the Black-Scholes option valuation model to estimate the fair value of its stock options at the date of grant.  Historical data is used to estimate the expected price volatility, the expected option life and the expected forfeiture rate.  The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option.  Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of subjective assumptions.  The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment.  As a result, if factors change and the Company uses different assumptions, the stock-based compensation expense could be materially different in the future.
 
Valuation of the Embedded Derivatives

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

To determine the fair value of our embedded derivatives, management evaluates assumptions regarding the probability of certain future events. Other factors used to determine fair value include our period end stock price, historical stock volatility, risk free interest rate and derivative term. 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.
 
Results of Operations
 
Three and Nine Month Periods Ended September 30, 2011 Compared To Three and Nine Month Periods Ended September 30, 2010

Total Revenues.  We had total revenues of $1,441,464 and $1,540,753 in the three months ended September 30, 2011 and 2010, respectively.  The decrease in total revenues was $99,289 for the three months ended September 30, 2011 representing a 6.4% decrease compared to the total revenues for the three months ended September 30, 2010.  Substantially all of the revenues for the three months ended September 30, 2011 and September 30, 2010 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $32,578 or 2.3% of total revenues for the three months ended September 30, 2011 and $27,905 or 1.8% of total revenues for the three months ended September 30, 2010.

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and Software as a Service (“SaaS”).  The revenue from new software licenses decreased by $93,212 compared to that for the three months ended September 30, 2010 as there were no new sales for the third quarter of 2011.  Software maintenance in the three months ended September 30, 2011 decreased by $1,457 or .1% from the same period in the prior year.  The revenue decrease in software maintenance is due to non-renewal of customer accounts combined with customers moving to our SaaS model offset by contractual price increases and the effects of favorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the three months ended September 30, 2011 decreased by $25,545 from the same period in the prior year representing a 14.6% decrease.  This decrease was due to near completion of version upgrades for existing customers in Canada partially offset by new consulting projects in the US and the effects of favorable currency exchange rates.  SaaS revenues were $148,631 for the three months ended September 30, 2011 compared to $113,597 for the same period in the prior year, representing a $35,034 increase or 30.8%. The increase is related to existing customers converting to a SaaS model and incremental revenue of $4,673 related to SnAPPnet, Inc. SnAPPnet, Inc. revenue represented 17.6% of our SaaS revenue for the three months ended September 30, 2011. Other revenue in the three months ended September 30, 2011 decreased by $14,109 or 31.5% 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 $4,588,884 and $4,345,513 in the nine months ended September 30, 2011 and 2010, respectively.  The increase in total revenue was $243,371 for the nine months ended September 30, 2011 representing a 5.6% increase compared to the same period in 2010.  Substantially all revenues for the nine months ended September 30, 2011 and September 30, 2010 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $103,084 or 2.2% of total revenues for the nine months ended September 30, 2011 and $27,905 or .6% of total revenues for the nine months ended September 30, 2010. SnAPPnet, Inc. was purchased in May, 2010.
.
The total revenues consist of software licenses, consulting, software maintenance, SaaS fees and other revenues.  The revenue from licensing fees for the nine months ended September 30, 2011 decreased $67,206 or 25.2% from the same period in 2010.  The decrease was primarily due to no new sales in the third quarter of 2011. Software maintenance fees for the nine months ended September 30, 2011 increased $42,135 or 1.3%.  The revenue increase in software maintenance is due to the impact of the exchange rate of the Canadian dollar to the US dollar, partially offset by the loss of maintenance from one of our existing customers converting to a SaaS model. Consulting fees increased $31,774 or 7.2% for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010.  The increase  in consulting fees in 2011 is primarily due to consulting services related to version upgrades and new consulting projects in the US, partially offset by near completion of version upgrades for existing customers in Canada. SaaS revenues for the nine months ended September 30, 2011 were $258,152 higher than for the nine months ended September 30, 2010, a 125.8% increase.  This increase is due to converting existing customers to our SaaS offering and incremental revenue of $63,051 related to SnAPPnet, Inc. in 2011.  SnAPPnet, Inc. revenue represented 19.6% of our SaaS revenue for the nine months ended September 30, 2011. There was a $21,484 decrease in other revenue for the nine months ended September 30, 2011 compared to the same period of 2010.  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 $474,165 for the three months ended September 30, 2011, compared to $400,683 for the three months ended September 30, 2010.  The increase in cost of revenues of $73,482 represents a 18.3% increase.  The increase in direct cost of revenues was primarily due to recording a royalty expense for 2009, 2010 and 2011 in the third quarter of this year. During the three months ended September 30, 2011 and 2010, $82,770 and $43,511 of internal costs were capitalized, respectively.

For the nine months ended September 30, 2011, direct costs of revenues were $1,237,806 compared to $1,155,862 for the same period in 2010 representing an increase of $81,944 or 7.1%.  The increase in direct cost of revenues was primarily due to recording a royalty expense for 2009, 2010 and 2011 in the third quarter of this year.  During the nine months ended September 30, 2011 and 2010, $228,154 and $107,435 of internal costs were capitalized, respectively.

Selling, General and Administrative Expenses.  We had selling, general and administrative expenses of $1,067,906 and $1,067,952 in the three months ended September 30, 2011 and 2010, respectively.  We had higher salaries and consulting fees due to incremental expenses related to PTS and SnAPPnet, Inc. offset by decreased consulting services, travel and more capitalized software development costs for products in development. Of the SG&A expenses for the three months ended September 30, 2011 $102,000  represented business development expenses for various initiatives being undertaken through VHS, PTS and SnAPPnet, Inc.

For the nine months ended September 30, 2011 we had selling, general and administrative expenses of $3,138,963 compared to $3,109,313 for the nine months ended September 30, 2010.   The $29,650 increase was due to higher salaries, benefits and consulting fees due to incremental expenses related to PTS and SnAPPnet, Inc., higher legal and professional fees due to patent applications, partially offset by decreased consulting services, travel and more capitalized software development costs for products in development. Of the SG&A expenses for the nine months ended September 30, 2011, $528,000 represented business development expenses for initiatives being undertaken through VCSY, VHS, PTS and SnAPPnet, Inc.
 
Depreciation and Amortization. We had depreciation and amortization expense of $16,616 and $7,231 for the three months ended September 30, 2011 and 2010, respectively. The increase of $9,385 or 130% primarily relates to amortization of intangible assets acquired in the 2010 SnAPPnet, Inc. acquisition.

For the nine months ended September 30, 2011 we had $49,813 of depreciation and amortization compared to $21,327 for the nine months ended September 30, 2010. The $28,486 or 134% increase primarily relates to amortization of intangible assets acquired in the 2010 SnAPPnet, Inc. acquisition.

 
 

 
 
Gain on Settlement of Trade Payables.  For the three months ended September 30, 2011, we had no gain on settlement of trade payables.  In August 2010, we performed a review of open accounts payable for EnFacet, Inc., a non-operating wholly owned subsidiary of the Company, and determined that these payables no longer represented a true liability to the Company and wrote them off.
 
For the nine months ended September 30, 2011, we had no gain on settlement of trade payables.For the nine months ended September 30, 2010, we had gains on settlement of trade payables of $22,438 for the reasons discussed above for the three month period.

Gain on Derivative Liability.  The existing derivative liability is adjusted each quarter for changes in the market value of the Company’s common stock. The gain on derivative liability was $5,895 for the three months ended September 30, 2011 compared to a gain of $8,970 for the same period in 2010.  For the nine months ended September 30, 2011, there was a gain of $5,895 compared to a gain of $85,534 for September 30, 2010. The 2010 gain of $85,534 was primarily related to derivative liabilities eliminated during the third quarter of 2010.

Interest Expense, net.  We had net interest expense of $162,720 and $131,573 for the three months ended September 30, 2011 and 2010, respectively.  Interest expense increased by $31,146 or 23.7% compared to the same expense in the three months ended September 30, 2010.  This increase was primarily due to the amortization of a debt discount for 2011 on debt acquired in the second quarter of 2010 and additional default interest for 2011.

For the nine months ended September 30, 2011, we had net interest expense of $455,347 compared to $356,752  for the same period in 2010, representing a $98,585 or 27.6% increase for the period.  The increase was primarily due to amortization of a debt discount for 2011 on debt acquired in the second quarter of 2010 and additional default interest for 2011.

Net Income (Loss).  We incurred a net loss of $242,786 for the three months ended September 30, 2011 and net income of $880 for the three months ended September 30, 2010.  The net loss for the three months ended September 30, 2011 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 $117,223. The operating loss was increased by interest expense and slightly reduced by the gain on derivative liability. The net income for the three months ended September 30, 2010 was due to operating income of $87,325 increased by a gain on derivative liability and decreased by interest expense.
 

We incurred a net loss of $215,681 for the nine months ended September 30, 2011 and $119,459 for the nine months ended September 30, 2010. The net loss for the nine months ended September 30, 2011 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us operating income of $162,302. Operating income was reduced by interest expense and slightly increased by the gain on derivative liability. The net loss for the nine months ended September 30, 2010 was due to operating income $81,449, increased by a gain on derivative liability and decreased by interest expense.
 

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, 2011 and 2010 and $441,000  for both the nine months ended September 30, 2011 and 2010.
 

Net Loss Available to Common Stockholders.  We had a net loss attributed to common stockholders of $389,786 and $146,120 for the three months ended September 30, 2011 and 2010, respectively.  Net loss attributed to common stockholders was due to the factors discussed above.
 
We had a net loss available to common stockholders of $656,681 and $560,459  for the nine months ended September 30, 2011 and 2010, 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 for the three and nine month periods ended September 30, 2011 and 2010.
 
 
Liquidity and Capital Resources
 
At September 30, 2011, we had non-restricted cash-on-hand of $124,738 compared to $272,970 at December 31, 2010 and $13,676 at September 30, 2010.
 
 
 

 
 
Net cash provided by operating activities for the nine months ended September 30, 2011 was $54,636 compared to net cash used in operating activities of $23,686 for the nine months ended September 30, 2010.  For the nine months ended September 30, 2011, we collected cash from our customers of $4,699,370 and other miscellaneous receipts of $74,441.  We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $2,985,401, attorney fees of $62,542, professional fees and consulting fees of $419,225, interest expense of $166,896, taxes (sales tax and VAT) of $317,309, and trade payables of $767,802.  For the nine months ended September 30, 2010, we collected cash from our customers of $4,578,424.  We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $2,932,919, attorney fees of $74,762, professional fees and fees to consultants of $552,588, interest expense of $154,000, taxes (sales tax and VAT) of $326,601, and trade payables of $586,867.

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 $311,505 or 12.1% from the balance at December 31, 2010.  The decrease is due to a higher number of customers on calendar year maintenance agreements which results in an increase in deferred revenue in December.

Our accounts receivable trade decreased from $565,367 at December 31, 2010 to $207,757 (net of allowance for doubtful accounts) at September 30, 2011.  The decrease is a result of seasonal fluctuations in the timing of billings for software maintenance which typically yields higher receivables in December compared to September.

The accounts payable and accrued liabilities went from $6,774,923 at December 31, 2010 to $6,624,314 at September 30, 2011.  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, 2011 is over 30 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, 2011 and September 30, 2010 of $255,571 and $120,715 (of which $228,154 and $107,435 were for self-developed software),  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 employees. Software development relates to the development of new products.

For the nine months ended September 30, 2011, we paid $27,901 of principal on notes payable and notes payable to related parties and had $58,000 of new debt funding in the same period.  For the nine months ended September 30, 2010, we paid $195,295 of principal on notes payable.

As of the date of the filing of this Report, we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms.  Therefore, we need to raise additional funds through selling securities, obtaining loans, renegotiating the terms of our existing debt and/or increasing sales with our new products.  Our inability to raise such funds or renegotiate the terms of our existing debt will significantly jeopardize our ability to continue operations.
   
Balance at
   
Due in Next Five Years
 
Contractual Obligations
 
September 30,
2011
   
2011
   
 2012
   
2013
   
2014
      2015+  
Notes payable
  $ 3,820,040     $ 3,820,040     $ -     $ -     $ -     $ -  
Convertible debenture
    30,000       30,000       -       -       -       -  
Operating lease
    366,575       25,046        99,862       93,269       93,330       29,852  
Total
  $ 4,216,615     $ 3,875,086     $ 99,862     $ 93,269     $ 93,330     $ 29,852  
 
Following is the status of notes payable:

   
September 30,
2011
   
December 31,
2010
 
             
Default or non-performing
  $ 3,801,197     $ 3,299,543  
Current
    18,843       99,865  
                 
Total Notes Payable
  $ 3,820,040     $ 3,399,408  
 
 
 

 
 
At September 30, 2011, we had a working capital deficit of approximately $12.4 million and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.  The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values.  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.

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
 
On January 18, 2011, the Company and Microidea Software Development, LLC (“Microidea”) entered into a license agreement whereby Microidea granted an exclusive license of  a 16 year-old software known as “Tiny Web Server” to the Company for an initial term of thirty years with three twenty year renewal terms in consideration of a 5% royalty.  During the term, the Company also has the right to purchase the technology for $6 million, payable in four installments of $1.5 million over a 3 year period. The President of Microidea is Mr. Luiz Valdetaro, who also serves as our Chief Technology Officer.

In July 2011, the Company and a related party agreed to cancel $364,679 of outstanding debt owed to the related party and in consideration of such cancellation the Company issued two notes with principal of $274,679 and $90,000, respectively, each bearing interest at 8%. The payment terms for the notes are as follows: (a) aggregate principal payments in the amount of $25,000 due on December 20, 2011, to be allocated between the notes, (b) interest only payments beginning July 31, 2011 through January 31, 2012 and (c) monthly payments of interest plus monthly principal payments of $5,000 to be allocated between the notes beginning January 31, 2012 until the notes are fully paid.
 
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:


-  
We did not maintain sufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP commensurate with our complexity and our financial accounting and reporting requirements.  We have limited experience in the areas of financial reporting and disclosure controls and procedures.  Also, we do not have an independent audit committee.  As a result, there is a lack of monitoring of the financial reporting process and there is a reasonable possibility that material misstatements of the consolidated financial statements, including disclosures, will not be prevented or detected on a timely basis.

-  
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, 2010, as filed on April 15, 2011.

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, 2010.


PART II
OTHER INFORMATION

Item 1. Legal Proceedings

We have been or 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 claims it is owed $195,000, and has incurred alleged lost opportunity cost of not less than $220,000. We attempted unsuccessfully to resolve our dispute with InfiniTek via mediation. Our lawsuit was amended on March 30, 2010. Discovery is ongoing.

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. This lawsuit relates to one of the causes of action, and the same set of underlying facts, as those in the Texas legal action mentioned above. 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. We continue to litigate the claims made by InfiniTek in this action as well as our other claims against InfiniTek in the Texas case. The amounts in dispute are included in our accounts payable and accrued liabilities pending the outcome of this litigation.

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”), 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., LG Electronics Inc., Samsung Electronics Co., Ltd., Samsung Electronics America, Inc., No. 2:10-CV-00490.

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 is a complaint for declaratory judgment, in which Interwoven is requesting 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 motions 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 May 12, 2011, Vertical filed in the United States Court of Appeals for the Federal Circuit a petition for a writ of mandamus seeking review of that portion of the May 2, 2011 order by the Northern District of California which refused to transfer the Interwoven v. Vertical action to the Eastern District of Texas, which was denied on August 17, 2011.
 
 
 

 
 
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 is seeking damages from us in excess of $133,750 plus attorney’s fees and interest.  The amounts in dispute are included in our accounts payable and accrued liabilities pending the outcome of this litigation. On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses.  Discovery is ongoing.

In the opinion of management, the ultimate resolution of any pending matters may have a significant effect on our financial position, operations or cash flows. Also, in the future, we may become involved in other legal actions that may have a significant effect on our financial position, operations or cash flows.

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, 2010, as filed on April 15, 2011.
 
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds

None

Item 3.  Defaults Upon Senior Securities

None

Item 4.  Reserved
 
Item 5.  Other Information

None
 
Item 6.  Exhibits

The following documents are filed as part of this report:
 
Exhibit No.
Description
Location
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 14, 2011
Provided herewith
     
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 14, 2011
Provided herewith
     
32.1
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated November 14, 2011
Provided herewith
     
32.2
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated November 14, 2011
Provided herewith
     
101.INS*
XBRL Instance Document
Provided herewith
     
101.SCH*
XBRL Taxonomy Extension Schema Document
Provided herewith
     
101.LAB*
XBRL Taxonomy Extension Label Document
Provided herewith
     
101.PR*
XBRL Taxonomy Extension Presentation Document
Provided herewith
     
101.DEF*
XBRL Taxonomy Extension Definition 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 14, 2011
By:
/s/ Richard Wade             
   
Richard Wade
   
President and Chief Executive Officer
     
     
November 14, 2011
By:
/s/ Freddy Holder                          
   
Freddy Holder
   
Chief Financial Officer