UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2014

¨ 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)

101 West Renner Road, Suite 300, Richardson, TX 75082

(Address of Principal Executive Offices)

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

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

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

Common Stock, par value $0.00001 per share

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes¨   Nox

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes¨   Nox

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. Yesx      No¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such file. Yesx      No¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained in this form, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or amendment to this Form 10-K. Yesx      No¨

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes¨      Nox

Issuer’s revenues for fiscal year ended December 31, 2014: $7,435,502

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the registrant’s most recently completed second fiscal quarter: $33,066,805.

As of April 15, 2015, the issuer had 1,003,545,134 shares of common stock, par value $0.00001, issued and outstanding.

Documents incorporated by reference: None

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2014

TABLE OF CONTENTS

PART I

Item 1. Business

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

Background

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

Business Overview

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

We attempt to acquire marketing or licensing rights for products which, in our belief, are best-of-breed, are profitable or on the path to profitability, are complementary to our other software offerings, and provide cross-product distribution channels. Our business model combines complementary and integrated software products, internet core technologies, and a multinational distribution system of partners, in order to create a distribution matrix that we believe is capable of penetrating multiple sectors through cross-promotion.

We are in the process of developing and preparing to launch applications and products utilizing our Emily™ mobile platform (please refer to the “Internet Core Technologies” section for more details) as well as other related technology in the mobile market.

Administrative Software

Our main administrative application software, emPath®, which is designed to handle complex payroll and human resources challenges, is developed, marketed and maintained by NOW Solutions. emPath® is natively Web-based which means that the application can easily be accessed with a web browser. NOW Solutions, a 75% owned subsidiary, is selling emPath® in the United States and Canadian markets both as a software solution and a Software-as-a-Service (“SaaS”) offering, also known as Cloud-based offering. For a description of our cloud computing model for emPath®, please see the section entitled “Cloud-based services” below.

In 2010, we completed the workflow engine for emPath® and continued improvements for its cloud computing model. We also implemented our new strategy of developing certain HR/payroll related modules that can be sold separately from emPath® or bundled with emPath® as a comprehensive solution. These new features, when coupled with experience gained with the product by the Brazil-based development staff (over the past eight years), have substantially facilitated faster product development. In addition, we have significantly improved the scalability of emPath® to meet the needs of small businesses as well as very large enterprise clients.

Our continuous effort to improve our emPath® product and its cloud-based offering has allowed us to finalize and launch our new module-based initiative under which certain payroll/human resource modules can be marketed independently from emPath® or bundled into a comprehensive solution. A key objective of the module development initiative has been to enable new modules to be sold to a smaller customer base (companies with 25 to 500 employees) in a simple standardized version. This version will have full functionality and all the benefits of a total enterprise solution, while maintaining scalability in order to meet the needs of and to compete for the largest corporate customers and government entities, which often have complex payroll rules. We also have a global payroll initiative to launch emPath® internationally.

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

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

SnAPPnet™ is currently marketed as a best-of breed standalone solution through SnAPPnet, Inc. We are in the process of integrating this product with emPath® so it can also be sold to NOW Solutions’ customers as an emPath® module.

We have other administrative software in various stages of development which will be marketed through our subsidiaries including Priority Time, Vertical Healthcare Solutions, Inc. (“VHS”), Taladin, Inc., (“Taladin”), and Government Internet Systems Inc. (“GIS”).

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

Cloud-based services

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

A cloud-based service is a cost-effective, reliable and secure way for businesses to obtain the same benefits of commercially licensed, internally operated software, without the associated complexity and high start-up costs of deploying the software in-house or the need to dedicate IT people on staff to monitor and upgrade such a system.

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

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

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

SnAPPnet™, a physician credentialing application, is currently offered as a cloud-based solution. We are in the process of developing a registered nurse module of SnAPPnet™. In addition, we are adding some key new features to the software application as well as doing a design review to meet other potential markets for credentialing and markets in need of automated fillable forms. We are marketing SnAPPnet™ directly to hospitals and plan to offer it through VHS to physicians in the United States and to NOW Solutions’ existing customer base.

In addition, we have converted our SiteFlash™ product to offer it in a cloud-based configuration. We intend to concentrate our initial marketing efforts in the affiliate, government and publishing markets as well as utilizing SiteFlash™ for internal development projects. For a description of SiteFlash™, please see the section entitled “Internet Core Technologies” below.

Software Services

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

Internet Core Technologies

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

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

SiteFlash™ can be offered as a stand-alone product and also as a technology platform for products targeted at specific vertical markets. The SiteFlash™ technology focuses on content management, e-commerce, and workflow and has led to the development of three additional software application products: ResponseFlash™, NewsFlash™ and AffiliateFlash™. In addition to a cloud-based offering, we are in the process of using SiteFlash™ as an internal component, along with some other company technology, in a new application which will be called the Physicians Bridge, and be marketed through VHS.

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

The third patented Internet core technology we have developed is the combination of three components: the Emily™ XML Broker, the Emily™ XML Agent and the Emily™ XML Portal. This technology has been featured as an alternative to Web Services in the 4^th Edition of the XML Handbook, by Dr. Charles Goldfarb, considered the father of XML and inventor of all markup languages. We are upgrading this technology for use in a new application we are developing simultaneously.

The fourth Internet core technology is a web server software that was licensed to the Company. This technology was acquired with the intent to modify it and use it, along with the Emily™ technology and new patent pending technology, as a basis to create a new product called the Emily™ Mobile Platform (“Emily™ Mobile Platform”). We plan to launch a personal private mobile communications channel, known as Ploinks™, utilizing the Emily™ Mobile Platform through our subsidiary, Ploinks, Inc. in 2015.

In addition, in the summer of 2010, we elected to utilize a new software development platform which we used for PTS™ and also created “dashboardlets^TM” (a proprietary tool for business intelligence) allowing the scalability to meet large and/or complex customer requirements. In addition, this development platform will be used to develop other modules for the Company’s software solutions and to support SnAPPnet™ and certain portions of emPath®.

Intellectual Property Assets

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

Our Emily™ core technology allows a disparate and distributed database to be viewed and updated as if it was a single large database. This unique ability is patented under U.S. Patent No. 7,076,521.

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

We also have our fiber optic patent (for transmission of images over a single filament of fiber optic cable) under U.S Patent No. 6718103.

Finally, we have our tiny web server and other mobile technologies, which are patent-pending.

Market Segments

Our current products address the following market segments:

Business Operations and Units

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

NOW Solutions, Inc.

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

NOW Solutions has converted some of its existing customers to its cloud-based model and is in the process of developing methods to introduce its cloud-based offering (supporting MS SQL, Oracle and DB2 databases) through distributors in the United States. During the conversion of one of our large complex customers and in discussions with other similar complex customers, we determined that there was a critical need and opportunity in providing a solution we are labeling “tailored cloud-based”, which can fulfill our customers unique requirements while giving them the benefits of a cloud-based offering.

Additionally, NOW Solutions has embarked on a strategy of developing and licensing HR products complementary to its existing suite of products that can be sold separately or integrated as emPath® modules, which has been greatly facilitated by emPath®’s Web Services integration. PTS™ is the first product to be integrated within the emPath® solution. PTS™ was officially introduced at NOW Solutions’ user conference in November 2011 and was presented to a number of customers who had expressed interest in purchasing once beta testing of one of NOW Solutions’ hospitals client (which is the basis for a time and attendance solution tailored to the medical industry) is completed. NOW Solutions is currently finalizing the integration of PTS™ with emPath®. The second product is SnAPPnet™, which is in the in the process of being upgraded to expand the utility of the product beyond traditional credentialing software so that it can be used by HR departments of NOW Solutions’ existing customer to create and administer fillable forms routinely used for employees.

NOW Solutions has also finalized its business plan to expand into the global payroll market, utilizing its existing expertise gained from offering a comprehensive payroll/HR solution to customers with employees throughout the United States and Canada.

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

For the 12 months ended December 31, 2014, NOW Solutions had approximately $658,542 of total assets, revenues of approximately $4,484,923 and net income of approximately $628,621.

Taladin, Inc.

Taladin, a Texas corporation, is a wholly-owned subsidiary of the Company. In November 2005, Taladin and NOW Solutions entered into a license agreement whereby Taladin received the exclusive rights to commercially exploit emPath® for use by the United States federal, state and local governments and agencies in exchange for a license fee and royalties. Taladin has developed a module for emPath® to meet federal payroll guidelines for law enforcement and fire departments. However, the completion of this module has been delayed until final testing has been performed and the emPath®’s integration with PTS™ has been finalized.

For the 12 months ended December 31, 2014, Taladin had no material assets, no revenues and a net loss of approximately $99.

Ploinks, Inc.

Ploinks, Inc., a Texas corporation (formerly OptVision Research, Inc.), is a wholly-owned subsidiary of the Company.

Vertical has licensed its Emily Mobile Platform to Ploinks, Inc., for use by consumers as a personal private communication channel.

For the 12 months ended December 31, 2014, Ploinks, Inc. had no material assets, no revenues and a net loss of approximately $292.

Vertical Healthcare Solutions, Inc.

VHS, a Texas corporation, is a wholly-owned subsidiary of the Company. VHS will market a new platform called the “Physicians Bridge”, which will be the basis for marketing applications to physicians utilizing other Vertical technologies and products which were licensed for the physician market by Vertical to VHS in 2010.   Vertical will license its Emily Mobile Platform to VHS to be utilized as a communication channel between physicians as well as a communication channel between physicians and patients.

For the 12 months ended December 31, 2014, VHS had no material assets, no material revenues, and a net loss of approximately $163,387.

Priority Time Systems, Inc.

Priority Time, a Nevada corporation, is an 80% owned subsidiary of the Company. On June 15, 2009, we purchased 90% of the common stock of Priority Time from a shareholder of Priority Time. In addition, we entered into a shareholder agreement with the selling shareholder of Priority Time whereby we have the option to purchase the remaining 10% of the common shares of Priority Time stock at any time after 3 years from the date of our purchase of our 90% interest. The shareholder agreement also provides for the licensing terms of Priority Time products to our other subsidiaries.

Priority Time has been developing PTS™, a time and attendance product that we will offer both as a standalone product and as an integrated module within emPath®. In late spring 2010, we elected to stop development of PTS™ in its then-current form and switched to a new development platform. That new platform allowed us to create a cloud-based solution that utilizes a rule-based system, which will better meet the needs of NOW Solutions’ most complex customers and more easily create a time and attendance product for vertical markets (i.e. medical, government, casinos, and hospitality).

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

For the 12 months ended December 31, 2014, Priority Time had no material assets, no material revenues and a net loss of approximately $829,454.

SnAPPnet, Inc.

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

In 2012, we added a new feature that was requested by two of our hospital clients. That feature is presently being beta tested. A redesign is planned to create the flexibility to meet the requirements of automated fillable forms for HR departments of NOW Solutions’ customers as well as traditional credentialing needs for physicians and nurses.

For the 12 months ended December 31, 2014, SnAPPnet, Inc. had assets of approximately $56,260, revenues of approximately $128,832 and a net loss of approximately $101,004.

Government Internet Systems, Inc.

GIS, a Nevada corporation is our 84.5% owned subsidiary. Vertical licensed ResponseFlash™ to GIS in order to market and distribute this technology to government entities (excluding state universities and schools) in the United States. We are in the process of reviewing the marketing objectives and products for GIS.

For the 12 months ended December 31, 2014, GIS had no assets, no material revenue and net loss of approximately $10,766.

Vertical do Brasil

Our 100% owned subsidiary, Vertical do Brasil, a Brasilian company, houses a software development team that performs services on behalf of the Company and its subsidiaries.

For the 12 months ended December 31, 2014, Vertical do Brasil had assets of approximately $3,614, no revenues and net loss of approximately $99,250.

The following corporations are inactive:

Vertical Internet Solutions, Inc.

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

For the 12 months ended December 31, 2014, VIS had no material assets, no material revenue and no expenses.

EnFacet, Inc.

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

For the 12 months ended December 31, 2014, EnFacet had no material assets, no material revenue and no expenses.

Globalfare.com

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

For the 12 months ended December 31, 2014, Globalfare had no assets, no material revenue and no expenses.

Pointmail.com, Inc.

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

For the 12 months ended December 31, 2014, Pointmail had no assets, no revenues and no expenses.

Competition

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

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

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

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

Ploinks, Inc. competes with Facebook, Twitter, Snapchat, Viber, Tango, WhatsApp and other social media services.

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

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

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

Strategic Overview

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

The key components of our strategy are to:

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

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

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

Proprietary Rights

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

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

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

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

Together, these patents are the foundation of our SiteFlash™ platform, and form the basis of the ResponseFlash™, NewsFlash™ and AffiliateFlash™ products. 

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

The USPTO granted us a patent (No. 8,578,266) for a “Method and System for Providing a Framework for Processing Markup Language Documents” on November 5, 2013. This patent covers the Emily™ scripting language.

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

In 2010, we filed an application for a patent titled “System and Method for Running a Web Server on a Mobile Internet Device,” which is still pending.

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

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

In 2014, we filed two provisional patent applications.  

As of the date of this Report, we have filed three patent applications in 2015.

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

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

Regulatory Environment; Public Policy

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

Employees

As of April 15, 2015, we had 21 full-time and 5 part-time employees (19 are employed in the United States and 7 in Canada), and 3 full time consultants. We are not a party to any collective bargaining agreements.

Item 1A. Risk Factors

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

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

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

We had a net loss of $1,450,822 and $2,602,811 for the years ended December 31, 2014 and 2013, respectively, and have historically incurred losses. Accordingly, we have and may continue to experience significant liquidity and cash flow problems because our operations are not profitable. No assurances can be given that we will be successful in reaching or maintaining profitable operations.

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

The report of our independent registered public accounting firm included an explanatory paragraph in connection with our financial statements for the years ended December 31, 2014 and 2013. This paragraph states that our recurring net losses, negative working capital and accumulated deficit, the substantial funds used in our operations and the need to raise additional funds to accomplish our objectives raise substantial doubt about our ability to continue as a going concern. Our ability to develop our business plan and to continue as a going concern depends upon our ability to raise capital, to succeed in the licensing of our intellectual property and to achieve improved operating results. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.

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

The accompanying consolidated financial statements for the years ended December 31, 2014 and 2013 have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We have suffered significant recurring operating losses, used substantial funds in our operations, and need to raise additional funds to accomplish our objectives. Stockholders’ deficit at December 31, 2014 was $26.5 million. Additionally, at December 31, 2014, we had negative working capital of approximately $17.3 million (although it includes deferred revenue of approximately $2.3 million) and have defaulted on all of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

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

Our Success Depends On Our Ability to Obtain Additional Capital.

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

We Have a Working Capital Deficit, Which Means That Our Current Assets on December 31, 2014 Were Not Sufficient to Satisfy Our Current Liabilities on That Date.

We had a working capital deficit of approximately $17.3 million at December 31, 2014, which means that our current liabilities exceeded our current assets by approximately $17.3 million (although it includes deferred revenue of approximately $2.3 million). Current assets are assets that are expected to be converted into cash within one year and, therefore, may be used to pay current liabilities as they become due. Our working capital deficit means that our current assets on December 31, 2014 were not sufficient to satisfy all of our current liabilities on that date.

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

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

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

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

Keeping Pace with Industry Changes.  

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

Impact of Product Development Delays or Competitive Announcements.  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Security and Privacy Breaches Could Adversely Impact Our Business.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Item 2. Properties

The Company and NOW Solutions’ headquarters are currently located at 101 West Renner Road, Suite 300, Richardson, Texas, and comprise approximately 4,000 square feet. NOW Solutions has other offices at 6205 Airport Road, Building B, Suite 214, Mississauga, Ontario, Canada, which comprises 793 square feet, and Avenida N. Sra. De Copacabana, 895, Suite 901, Copacabana, Rio de Janeiro, Brazil, which comprises 1,200 square feet. All of these locations are leased from third parties and the premises are in good condition. We believe that our facilities are adequate for our present needs and near-term growth, and that additional facilities will be available at acceptable rates as we need them. Our other subsidiaries may be reached through our Richardson, Texas headquarters.

Item 3. Legal Proceedings

We are involved in the following ongoing legal matters:

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

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

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

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

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

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

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

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

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

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

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

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

On September 16, 2013, the United States District Court for the Eastern District of Texas issued a claims construction order in the Vertical Action concerning the terms found in the claims of the Patents-in-Suit. On December 12, the Company settled the patent infringement claim that the Company initiated in federal court against LG. Pursuant to the confidential settlement agreement, the Company has granted to LG a non-exclusive, fully paid-up license under the two patents (“Patents-in-Suit”) with any continuation patents of the Patents-in-Suit and any other continuation patents with the same priority claim as the Patents-in-Suit.

On December 12, 2013, the Company settled its patent infringement claim against LG Electronics. Pursuant to the confidential settlement agreement, the Company granted to LG Electronics a non-exclusive, fully paid-up license under the Patents-in-Suit which were the subject of the legal proceeding. The litigation concerning the Patents-in-Suit with LG has been resolved.

On March 20, 2014, the Company settled the patent infringement claim that the Company initiated in federal court against Samsung. Pursuant to the confidential settlement agreement, the Company has granted to Samsung a non-exclusive, fully paid-up license under the Patents-in-Suit with any continuation patents of the Patents-in-Suit and any other patents with the same priority claim as the Patents-in-Suit. The litigation concerning the Patents-in-Suit with Samsung has been resolved.

On May 8, 2014, the Company settled the patent infringement claim that the Company initiated in federal court against Interwoven. Pursuant to the confidential settlement agreement, the Company has granted to Interwoven and its subsidiaries, affiliates and parent companies (which include Autonomy Corporation PLC and Hewlett-Packard Company, Inc.), a non-exclusive, fully paid-up license to the Patents-in-Suit with any continuation patents of the Patents-in-Suit and any other patents with the same priority claim as the Patents-in-Suit. The Interwoven Action has been resolved.

On July 8, 2011, we were served with a lawsuit in the Texas State District Court in Dallas, Texas by Clark Consulting Services, Inc. (“CCS”) for breach of contract and other claims.  CCS was seeking damages from us in excess of $133,750 plus attorney’s fees and interest.  On August 8, 2011, we filed an answer denying CCS’s claims and setting forth affirmative defenses.  In December 2011, the Company and CCS entered into a settlement agreement whereby the lawsuit was dismissed. Pursuant to the terms of the settlement agreement, the Company agreed to pay CCS $134,000, which was to be paid in installment payments. Due to the Company’s failure to make timely payments, an additional $60,000 was added to the outstanding balance. On October 26, 2012, we entered into an agreement under which we agreed to make monthly payments of $5,000 and pay the outstanding balance plus attorney’s fees and costs by February 1, 2013. As of December 31, 2012, the settlement amount of $149,000 has been included in accounts payable and accrued liabilities. During 2013, the parties entered into several agreements to extend the date by which the Company has to pay off the balance of the settlement amount whereby. Under these agreements, the Company agreed to make monthly payments of $10,000 (of which $2,500 of each payment would be applied as late fees) beginning in February 2013 through November 2013 until the outstanding balance has been paid. As of November 17, 2014, all payments have been made and this matter has been resolved.

On October 11, 2012, Micro Focus (US), Inc. (“Micro Focus”) filed a lawsuit against NOW Solutions in the United States District Court for the southern division district of Maryland alleging breaches of its contractual obligations under an independent software agreement and copyright infringement. On January 28, 2013, NOW Solutions and Micro Focus entered into a settlement agreement whereby NOW Solutions agreed to pay Micro Focus $420,000, of which $70,000 in installment payments were made with the outstanding balance due on April 30, 2013. In connection with the settlement, the Company entered into a guaranty agreement with Micro Focus concerning NOW Solutions’ obligations under the promissory note. The Company did not make the $375,000 payment due to Micro Focus. On May 15, 2013, Vertical was served with a lawsuit in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning the guaranty by Vertical to Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On July 3, 2013, NOW Solutions was served with a lawsuit for a confessed judgment in the Circuit Court for Montgomery County, Maryland by Micro Focus concerning NOW Solutions’ failure to make payment of the outstanding balance due under the promissory note. On January 15, 2014, the Company and NOW Solutions consented to a judgment in the amount of $350,000, plus $36,000 in accrued interest and attorney’s fees in the amount of $80,000, plus accrued interest at the rate of 10% per annum until paid. As of December 31, 2014, all payments have been made and this matter has been resolved.

On February 4, 2014, Victor Weber filed a lawsuit against Vertical Mountain Reservoir Corporation (“MRC”), and Richard Wade in the District Court of Clark County, Nevada for failure to make payment of the outstanding balance due under a $275,000 promissory note issued by Vertical to Mr. Weber. The plaintiff seeks payment of the principal balance due under the note $275,000, default interest at the rate of 18% per annum, attorney’s fees and court costs, and punitive damages. On July 24 2014, the court granted plaintiff’s motion for summary judgment against defendants. The judgment was filed on September 18, 2014. We are currently seeking to resolve this matter with Mr. Weber. Mr. Wade is the President and CEO of Vertical and the President of MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade is the trustee of the W5 Family Trust.

On October 20, 2014, Michael T. Galvan and Michelle Bates (“Galvan & Bates”) filed a lawsuit in the Court of Chancery in the State of Delaware seeking to have the court compel the Company to hold a shareholder meeting for the purpose of electing all directors of the Company, designating the time and place of a meeting and other details reasonably necessary to hold such a meeting, attorney costs and fees (including reasonable attorney’s fees), and such other relief as the court deems proper. Galvan and Bates are stockholders of the Company. This case is styled Michael T. Galvan and Michelle Bates v. Vertical Computer Systems, Inc., No. 10234. The Company held an annual meeting of shareholders on February 25, 2015. This matter is resolved.

Item 4. Mine Safety Disclosures

Not applicable.

PART II

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

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

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

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

Number of Holders

As of April 15, 2015, there were 1,846 holders of record of VCSY common stock.

Equity Securities Under Compensation Plans

We had no securities authorized for issuance under equity compensation plans (which include individual agreements) as of December 31, 2014.

We do not have any equity compensation plans (i.e., stock option plans or restricted stock plans) that have been approved by security holders.

We did not issue any warrants to purchase VCSY common stock in 2014.

Dividends

We have outstanding shares of Series A and Series C 4% Convertible Cumulative Preferred stock that accrue dividends (if such dividends are declared) at a rate of 4% on a semi-annual basis. The total dividends applicable to Series A and Series C Preferred Stock were $588,000 for each of the years ended December 31, 2014 and 2013. Our Board of Directors did not declare any dividends on our outstanding shares of Series A or Series C Preferred Stock during 2014 or 2013, nor has the Company paid any dividends on our outstanding shares of Series A or Series C Preferred Stock since 2001. We intend to retain future earnings, if any, to provide funds for use in the operation and expansion of our businesses. Accordingly, we do not anticipate paying cash dividends on any of our capital stock, including preferred stock, in the near future. For additional information concerning dividends, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

Unregistered Sales of Securities

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

In July 2013, the Company issued 500,000 shares of VCSY common stock to a third party lender in connection with a loan of $150,000 by the lender, The fair-market value of these shares was valued at $19,700.

During the year ended December 31, 2013, the Company cancelled 1,500,000 previously issued common shares of the Company that had been granted to a third party lender.

During the year ended December 31, 2013, 1,500,000 shares of VCSY common stock were issued to consultants of the Company. The fair-market value of these shares was valued at $45,000.

During the year ended December 31, 2013, 2,050,000 shares of VCSY common stock granted to employees and consultants of the Company, valued at $55,226 vested.

During the year ended December 31, 2014, 550,000 common shares granted to employees of the Company and a consultant of the Company vested. Stock compensation that was previously accrued totaling $10,226 was reclassified from accrued liabilities to stockholders’ equity associated with these shares vested.

During the year ended December 31, 2014, the Company granted 200,000 common shares to an employee of the Company. The shares vested immediately upon grant and the fair value of the shares was determined to be $3,200. The fair value was expensed in full during the year ended December 31, 2014.

In February 2015, the Company amended its certificate of incorporation in the state of Delaware to increase the authorized number of shares of common stock to 2,000,000,000 shares of common stock.

In March 2015, the Company issued a total 3,809,983 shares of our common stock to reimburse an officer of the Company and a company controlled by another officer of the Company in connection with indemnity and reimbursement agreements entered into with the Company. The Company was obligated to reimburse these 3,809,983 shares in connection with 1,309,983 shares sold under a stock pledge agreement with a third party lender, 500,000 shares and wrongfully converted by the same lender and 2,000,000 shares transferred to two other third party lenders on the Company’s behalf.

Unless otherwise noted, the offers, sales and issuances of our unregistered securities set forth above involved no underwriter’s discounts or commissions. In engaging in the transactions described above which involved our unregistered securities, we relied upon the private offering exemption provided under Section 4(2) of the Securities Act of 1933, as amended, in that the transactions involved private offerings of our unregistered securities, we did not make a public offering or sale of our securities, the investors were either accredited or unaccredited but sophisticated, and the investors represented to us that they were acquiring the securities for investment purposes and for their own accounts, and not with an eye toward further distribution.

Item 6. Selected Financial Data

Not applicable.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is a summary of the key factors management considers necessary or useful in reviewing our results of operations, liquidity and capital resources. The following discussion and analysis should be read together with the Consolidated Financial Statements and Notes of Vertical and its subsidiaries included in Item 8 of this Report, and the cautionary statements and risk factors included in Item 1A of this Report.

Critical Accounting Policies

Capitalized Software Costs

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value. During 2014, the Company wrote off $771,251 of previously capitalized software costs related to its 70% owned subsidiary, Priority Time Systems. During the year ended December 31, 2014, $478,876 of internal costs were capitalized related to its Ploinks™ software application. During the year ended December 31, 2013, $163,367 of internal costs were capitalized.

Revenue Recognition

Our revenue recognition policies are in accordance with standards on software revenue recognition, which include guidance on revenue arrangements with multiple deliverables and arrangements that include the right to use of software stored on another entity’s hardware.

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

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

Software License. We sell concurrent perpetual software licenses to our customers. The license gives the customer the right to use the software without regard to a specific term. We recognize the license revenue upon execution of a contract and delivery of the software, provided the license fee is fixed and determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. When the software license arrangement requires the Company to provide consulting services that are essential to the functionality of the software, the product license revenue is recognized upon the acceptance by the customer and consulting fees are recognized as services are performed.

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

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

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

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

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

Allowances for Doubtful Accounts

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

Deferred Taxes

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

Stock-Based Compensation Expense

We account for share-based compensation in accordance with the provisions of share-based payments, which require measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares issued and the quoted price of our common stock. See Note 10 of the Consolidated Financial Statements for a further discussion of stock-based compensation.

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

The Company does not expect the adoption of any recently issued accounting pronouncements to have a significant impact on the Company’s consolidated financial statements.

Results of Operations

Year ended December 31, 2014 Compared To Year Ended December 31, 2013

Total Revenues. We had total revenues of $7,435,502 and $6,057,026 for the years ended December 31, 2014 and 2013, respectively. The increase in total revenue was $1,378,476 for the year ended December 31, 2014, representing a 22.8% increase compared to the total revenue for the year ended December 31, 2013. The increase in revenue was primarily due to a $2,600,000 software patent license issued in 2014 compared to $750,000 in 2013, partially offset by a $339,812 decrease in software maintenance and a $30,056 decrease in cloud-based offerings. Of the $7,435,502 and $6,057,026 total revenues for the years ended December 31, 2014 and 2013, respectively, $4,484,923 and $5,201,633 of such amounts were related to the business operations of NOW Solutions, a 75% owned subsidiary of the Company.

The revenues from licenses and software primarily consist of fees we bill for NOW Solutions’ new payroll and human resources (“PRHR”) software licenses and licenses fees for patents and technology we own. The increase in license and software revenue from 2014 to 2013 was $1,777,640 which was due to increased sales of our PRHR software and licensing fees for patents and technology in 2014 to new or existing customers.

Software maintenance revenue is generated from existing customers of our PRHR software who want the continued benefit of tax updates, customer support, and software enhancements. Software maintenance revenue decreased by $339,812 or 7.9% from the year ended December 31, 2013 to the same period in 2014. The decrease was due to the loss of customer contracts and the effect of unfavorable currency exchange rates on our Canadian maintenance revenue.

Consulting revenue for the year ended December 31, 2014 decreased by $5,463 from the same period in the prior year, representing a 1.4% decrease. This decrease was due to the effect of unfavorable currency exchange rates on our Canadian consulting revenue.

Cloud-based revenue decreased $30,056 or 7.0% for the year ended December 31, 2014 compared to the same period in 2013. The decrease was primarily related to customer user base adjustments during 2014 and the effect of unfavorable currency exchange rates on our Canadian cloud-based revenue.

Other revenues, consisting primarily of reimbursable travel expenses, decreased by $23,833 or 26.9% for the year ended December 31, 2014 compared to the same period for 2013. The decrease was mainly attributable to lower reimbursable travel in 2014 due to decreased consultant travel.

Cost of Revenues. We had direct costs associated with the above revenues of $2,159,870 for the year ended December 31, 2014 compared to $2,445,628 for the same period of 2013, representing a decrease of $285,758 or 11.7%. These direct costs are primarily related to costs providing customer support, professional services, software upgrades and enhancements. The decrease in direct costs is primarily related to a decrease in payroll costs, consultant travel and rent for the year ended December 31, 2014 compared to the same period for 2013.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $5,035,088 and $3,398,244 for the years ended December 31, 2014 and 2013, respectively. The total selling, general and administrative expenses for the year ended December 31, 2014 increased by $1,636,844 compared to the selling, general and administrative expenses for the year ended December 31, 2013, representing a 48.2% increase. The increase was primarily due to an increase in legal expenses to prosecute patent infringement on the Company’s intellectual property, increased royalties related to licensing of our patented intellectual property and increased payroll and health insurance costs.

Bad Debt Expense. We had net bad debt expense of $42,492 for 2014 compared to bad debt expense of $51,955 in 2013. The 2014 and 2013 expense were related to a reserve for several customer accounts greater than 90 days past due.

Impairment of software costs. For the year ended December 31, 2014, $771,251 of capitalized software development costs were considered impaired.

Gain on Settlement of Liabilities. For the year ended December 31, 2013, there was a $334,100 gain on settlement of liabilities as a result of our review of trade payables, accrued liabilities and notes payable for those items in which the statute of limitations had been exceeded and no legal liability existed.

Operating Income (Loss). We had an operating loss of $618,077 for the year ended December 31, 2014 compared to operating income of $441,952 for the year ended December 31, 2013, a difference of $1,060,029. The difference between 2014 and 2013 is primarily a result of higher revenues and gross profit offset by higher selling, general and administrative expense, the 2014 impairment of software development costs and a 2013 gain on settlement of trade payables.

Gain/loss on Derivative Liability. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock. In general, as our stock price increases, the derivative liability increases, resulting in a loss. As our stock price decreases, the derivative liability decreases, resulting in a gain. The gain on derivative liability was $211,621 for the year ended December 31, 2014 compared to a loss on derivative liability of $231,901 for the year ended December 31, 2013. The change of $443,522 was a result of a decrease in the Company’s stock price at December 31, 2014 compared to December 31, 2013.

Interest Expense. We had interest expense of $933,529 and $832,949 for the years ended December 31, 2014 and 2013, respectively. Interest expense increased for the year ended December 31, 2014 by $100,580, representing an increase of 12.1%, compared to interest expense for the year ended December 31, 2013. The increase was a result of interest on new borrowings, higher interest on loans in default and interest on accounts payable balances.

Interest Income. Interest income for the year ended December 31, 2014 was $19 compared to $24 for the year ended December 31, 2013.

Forbearance Fees. Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the year ended December 31, 2014 were $197,156 compared to $327,867 for the same period in 2013. The decrease in forbearance relates to our senior secured debt for NOW Solutions.

Loss on Loan Remedy Resulting From Issuance of Noncontrolling Interest. Loss on loan remedy resulting from issuance of noncontrolling interest was $1,457,240 for the year ended December 31, 2013. The expense relates to issuance of 25% of NOW Solutions, Inc. stock to our senior secured lenders.

Net Loss. We had a net loss of $1,450,822 for the year ended December 31, 2014 compared to a net loss of $2,602,811 for the year ended December 31, 2013. The net loss for 2014 was primarily due to an operating loss of $618,077 increased by $197,156 of forbearance fees and $933,529 of interest expense, partially offset by a gain on derivative liabilities. The net loss for 2013 was primarily due to operating income of $441,952 reduced by loss on derivative liabilities of $231,901, forbearance fees of $327,867, loss on non-controlling interest of $1,457,240 and interest expense of $832,949.

Income Tax Provision. We had an income tax benefit of $86,300 for the year ended December 31, 2014. The benefit is related to income tax expense of $166,675 for NOW Solutions, a 75% owned subsidiary of the Company, foreign tax expense for NOW Solutions of $14,867 offset by the settlement of foreign taxes from previous years for NOW Solutions of $267,842. Income tax expense of $194,830 for the year ended December 31, 2013 was related to foreign taxes of NOW Solutions. For 2014, since the company owns less than 80% of NOW Solutions, VCSY’s tax loss carry-forwards cannot be utilized to offset NOW Solutions, Inc.’s taxable income. Income taxes in previous years were not accrued as VCSY owned 100% and was able to utilize its tax loss carry-forwards to offset NOW Solutions’ taxable income.

Dividend Applicable to Preferred Stock. The Company has outstanding Series A 4% Convertible Cumulative Preferred Stock that accrues dividends (if such dividends are declared) at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% Convertible Cumulative Preferred Stock that accrues dividends (if such dividends are declared) at a rate of 4% on a quarterly basis. For the years ended December 31, 2014 and 2013, the total dividends applicable to Series A and Series C Preferred Stock (from prior years) were $588,000 each year. The Company did not declare or pay any dividends in 2014 or 2013.

Net Loss Applicable to Common Stockholders. We had net loss attributed to common stockholders of $2,070,836 and $3,081,614 for the years ended December 31, 2014 and 2013, respectively. Net loss applicable to common stockholders for the year ended December 31, 2014 decreased by $1,010,778 compared to December 31, 2013. The decrease in the net loss applicable to common stockholders was due to the combination of factors described above in “Net Loss.”

Net Loss Per Share. The Company had a net loss per share of $0.00 and $0.00 for the years ended December 31, 2014 and 2013, respectively.

Financial Condition, Liquidity, Capital Resources and Recent Developments

At December 31, 2014, we had non-restricted cash-on-hand of $117,866 compared to $162,709 at December 31, 2013.

Net cash used in operating activities for the year ended December 31, 2014 was $134,350 compared to net cash used in operating activities of $469,040 for the year ended December 31, 2013.

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. During 2014, our deferred maintenance revenue (a liability) increased slightly from $2,317,989 to $2,321,044.

Our accounts receivable decreased from $562,831 at December 31, 2013 to $560,879 at December 31, 2014 (net of allowance for bad debts). The decrease in receivables of $1,952 was due to faster year-end collections of NOW Solutions’ receivables.

Accounts payable and accrued liabilities increased from $9,787,515 at December 31, 2013 to $10,696,070 at December 31, 2014. The increase of $908,555 was primarily related to increases in accrued executive payroll, payroll taxes and penalties, and interest on notes payable. The balance in accounts payable and accrued liabilities is approximately 19.0 times the balance in accounts receivable. This is one of the reasons we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

.

Net cash used in investing activities for the year ended December 31, 2014 was $486,967 consisting of the purchase of equipment and software of $8,091 and the development of software products of $478,876.

Net cash provided by financing activities for the year ended December 31, 2014 was $43,267, consisting of borrowings on notes payable of $451,282 and borrowings on related party debt of $25,500. This was somewhat offset by repayments of notes payable of $418,294, payments of related party debt of $20,992 and a decrease in bank overdrafts of $5,771.

The total change in cash and cash equivalents for the year ended December 31, 2014 when compared to the year ended December 31, 2012 was a decrease of $44,843.

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

Contractual Obligations and Commercial Commitments

As of December 31, 2014, the following contractual obligations and commercial commitments were outstanding:

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

Going Concern Uncertainty

We had a net loss of $1,450,822 and $2,602,811 for the years ended December 31, 2014 and 2013, respectively, and have historically incurred losses. In addition, we had a working capital deficit of approximately $17.3 million at December 31, 2014. The foregoing raises substantial doubt about our ability to continue as a going concern.

Management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations. We will require additional funds to pay down our liabilities, as well as finance our expansion plans consistent with our anticipated changes in operations and infrastructure. However, there can be no assurance that we will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to us and whether we will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.

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

Off-Balance Sheet Arrangements.

None.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

None.

Item 8. Financial Statements and Supplementary Data

Please refer to the Audited Consolidated Financial Statements of the Company and its subsidiaries for the fiscal years ended December 31, 2014 and 2013, which are attached to this Report.

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

None

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

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

Management’s Annual Report on Internal Control over Financial Reporting

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

In order to ensure whether our internal control over financial reporting is effective, management has assessed such controls for its financial reporting as of December 31, 2014. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

In performing this assessment, management has identified the following material weaknesses as of December 31, 2014:

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

As a result of these material weaknesses in our internal control over financial reporting, our management concluded that our internal control over financial reporting as of December 31, 2014, was not effective based on the criteria set forth by COSO in Internal Control – Integrated Framework. A material weakness in internal control over financial reporting is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

Management’s Plan for Remediation of Material Weaknesses

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

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

Item 9B. Other Information

None.

PART III

Item 10. Directors, Executive Officers and Corporate Governance

Our present directors and executive officers are as follows:

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

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

William K. Mills, Secretary and Director of VCSY

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

Significant Employees of the Company

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

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

Laurent Tetard, Chief Operating Officer-SaaS

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

Harold Frazier, Jr., Director of Mobile Software Development

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

Significant Employees of NOW Solutions

Marianne M. Franklin, President and Chief Executive Officer

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

Jamie Patterson, Director of Software Development

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

Compliance with Section 16(a) of the Exchange Act

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

To the best of the Company's knowledge, based solely on review of the copies of such forms furnished to it, or written representations that no other forms were required, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% stockholders were complied with during 2011.

Code of Ethics

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

Corporate Governance

Family Relationships

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

Involvement in Legal Proceedings

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

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

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

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

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

Board of Directors Meetings and Subcommittees.

Meetings. Our Board of Directors held several meetings during the fiscal year ended December 31, 2014. All board actions were completed through unanimous written consents.

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

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

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

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

Item 11. Executive Compensation

The following table shows all the cash compensation paid by the Company, as well as certain other compensation paid or accrued, during the fiscal years ended December 31, 2014 and 2013 to our highest paid executive officers and employees, who were employed by us during 2013 and 2014. No restricted stock awards, long-term incentive plan payouts or other types of compensation, other than the compensation identified in the chart below, were paid to these executive officers during these fiscal years. Except as set forth below, no other executive officer of Vertical earned a total annual salary and bonus for any of these years in excess of $100,000.

SUMMARY COMPENSATION TABLE

The below table shows information of compensation of the named officers for fiscal years ended December 31, 2013 and December 31, 2014 :

No stock options were exercised by the named executive officers during the fiscal year ended December 31, 2014 or 2013.

No options or warrants held by executive officers or directors were granted or exercised during the fiscal years ended December 31, 2014 and 2013.

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

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

In February 2012, we executed an employment agreement with Laurent Tetard to serve as Chief Operating Officer-SaaS of the Company and its subsidiaries. The initial term of the agreement was 2 years and renews on annual basis unless terminated by either party. Under the agreement, Mr. Tetard receives an annual base salary of $165,000. In the event the employment agreement is terminated by Mr. Tetard’s death, his estate shall be entitled to compensation accrued to the time of death plus the lesser of one year’s base compensation or the compensation due for the lesser of 12 months or through the remainder of the employment term. In the event of termination by the Company without cause, Mr. Tetard would receive base compensation for no less than six months of the remainder of the employment term. Mr. Tetard may also terminate his employment for good reason and shall be entitled to continued health insurance benefits and base compensation at the rate in effect at the time of his termination for good reason through the end of twelve months after which his employment is terminated for good reason. In connection with the employment agreement, the Company issued Mr. Tetard 600,000 shares of its common stock at a fair market value of $13,500 and VHS issued 15,000 shares of Series B Preferred Stock of VHS at a fair market value which is nominal.

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

Outstanding Equity Awards

There were no outstanding equity awards of the named officers at the end of 2014

Narrative Disclosure to Outstanding Equity Awards at Fiscal Year End

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

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

COMPENSATION OF DIRECTORS

We do not pay any compensation to our employee directors for their service on the Board. However, we do pay our non-employee directors as indicated below. The below table provides compensation for all non-employee directors in 2014:

Narrative Disclosure to Director Compensation Table

Non-employee directors are entitled to receive $3,500 per month in 2014 and 2013.

Reimbursement of Expenses

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

Compensation Risks Assessment

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

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

Security Ownership By Named Executive Officers, Directors and Beneficial Owners

The following table sets forth certain information regarding the beneficial ownership of the shares of common stock as of April 15, 2015, by each of our directors and executive officers and any person or entity known by us to be the beneficial owner of more than 5% of the outstanding shares of common stock. The table also shows the beneficial ownership of our stock by all directors and executive officers as a group. The table includes the number of shares subject to outstanding options and warrants to purchase shares of common stock. The percentages are based on 1,003,545,134 shares of common stock outstanding as of April 15, 2015, together with options, warrants or other securities convertible or exchangeable by the beneficial owners into shares of common stock within 60 days of April 15, 2015.

*    Less than 1%.

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

Certain Relationships and Related Transactions

In November 2009, the obligation to reimburse MRC with 1,309,983 common shares of the Company stock became due pursuant to the Indemnity and Reimbursement Agreement between MRC and the Company. This obligation was made in connection with the sale of 1,500,000 shares of our common stock in 2008 pledged by MRC to secure a $96,946 promissory note issued to a third party lender. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust. 

In July 2011, the Company and Robert Farias, a former employee of the Company, agreed to cancel $364,679 of outstanding debt owed to Mr. Farias and in exchange for such cancellation; the Company issued two notes with principal of $274,679 and $90,000, respectively. Beginning February 1, 2012, the interest rate increased to 10% on the outstanding balance of principal and accrued interest accrued through January 31, 2012 under the respective note. Also in February 2012, NOW Solutions granted Mr. Farias a junior security interest in all of its assets to secure the obligations under the $274,679 note in consideration of a personal guarantee made by Mr. Farias to secure the obligations under a note in the principal amount of $105,300 issued to Lakeshore Investment, LLC for a loan to NOW Solutions. On January 9, 2013, the Company paid off these notes owed to Robert Farias and the security interest granted to Robert Farias was cancelled.

In August 2013, Luiz Valdetaro, on behalf of the Company, transferred 1,000,000 unrestricted shares of our common stock owned by Mr. Valdetaro to Lakeshore in exchange for an extension to having common shares of NOW Solutions returned, representing a 25% interest the Company was obligated to transfer to Lakeshore. The fair-market value of these shares was valued at $47,000. Also in August 2013, in connection with the transfer, the Company entered into an indemnity and reimbursement agreement to reimburse Mr. Valdetaro with 1,000,000 shares of our common stock within one year and pay for all costs associated with the transfer of shares to Lakeshore and the reimbursement of shares to Mr. Valdetaro. Mr. Valdetaro is the Chief Technology Officer of the Company.

In October 2013, MRC pledged 1,000,000 shares of our common stock to secure a $50,000 loan made to the Company by a third party lender. The Company is obligated to replace these shares if these shares are transferred to the lender. This note is currently in default and therefore these shares have been classified as a derivative liability as of December 31, 2014 became past due. The initial fair value of these shares was determined to be $72,000 as of December 9, 2013.

Also in October 2013, MRC transferred 1,000,000 unrestricted shares of our common stock owned by MRC to a third party lender in connection with a $100,000 loan to the Company. The fair-market value of these shares was valued at $85,000. Also in October 2013, in connection with the transfer, the Company entered into an indemnity and reimbursement agreement to reimburse MRC with 1,000,000 shares of our common stock within one year and pay for all costs associated with the transfer of shares to the lender and the reimbursement of shares to MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.

In August 2014, in connection with a $50,000 note payable issued to a third party lender by the Company, MRC amended a stock pledge agreement previously entered into with the lender under which MRC had pledged 16,976,296 common shares to secure payment of this note and another note issued to the lender.

During the year ended December 31, 2014, the Company borrowed $25,500 from an employee of the Company. The note is unsecured, bears interest at 11% per annum and is due on demand.

As of December 31, 2014 and 2013, the Company had accounts payable to two employees and one consultant in an aggregate amount of $36,333 and $23,594, respectively. The payables are unsecured, non-interest bearing and due on demand.

In March 2015, pursuant to an indemnity and reimbursement agreement executed between Mr. Valdetaro and the Company we issued 1,000,000 shares of our common stock to reimburse Mr. Valdetaro for 1,000,000 shares of common stock transferred to Lakeshore on the Company’s behalf in connection with an extension granted by Lakeshore in August 2013.

In March 2015, pursuant to two indemnity and reimbursement agreements executed between MRC and the Company, we issued a total of 2,809,983 shares of our common stock to reimburse MRC. Of these shares, the Company was obligated to reimburse MRC with, 1,309,983 shares of common stock had been pledged by MRC and sold by a third party lender in 2009 in connection with a $96,946 promissory note, 500,000 shares of common stock had been wrongfully converted by the same lender in 2014, and 1,000,000 shares of common stock had been transferred to another third party lender in October 2013 on the Company’s behalf for a $100,000 loan made by the lender to the Company. MRC has assigned its claim against the third party lender for the lender’s wrongful conversion of 500,000 common shares to the Company and we are pursuing the claim in the third party lender’s bankruptcy proceeding.

Director Independence; Board Leadership Structure

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

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

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

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

Item 14. Principal Accountant Fees and Services

Audit Fees. The aggregate fees billed for professional services rendered by our principal accounting firm of MaloneBailey were $80,000 and $82,273 for the audit of our annual financial statements for 2014 and 2013, which included the reviews of the financial statements in our Forms 10-Q for the applicable fiscal years.

Tax Fees. The principal accounting firm of MaloneBailey did not provide any tax services in 2014 and 2013.

All Other Fees. Other than the services described above, the aggregate fees billed for services rendered by our principal accountant was $0 and $0, respectively, for the fiscal years ended 2014 and 2013.

PART IV

Item 15. Exhibits and Financial Statement Schedules

The following documents are filed as part of this report:

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

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

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors

Vertical Computer Systems, Inc.

Richardson, Texas

We have audited the accompanying consolidated balance sheets of Vertical Computer Systems, Inc. and its subsidiaries (collectively, the “Company”) as of December 31, 2014 and 2013 and the related consolidated statements of operations and comprehensive income (loss), stockholders’ deficit, and cash flows for each of the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vertical Computer Systems, Inc. and its subsidiaries as of December 31, 2014 and 2013 and the consolidated results of their operations and their cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America.

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

/s/ MaloneBailey, LLP

www.malonebailey.com

Houston, Texas

April 15, 2015

VERTICAL COMPUTER SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

AND OTHER COMPREHENSIVE INCOME (LOSS)

See accompanying notes to consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT

YEARS ENDED DECEMBER 31, 2014 AND 2013

See accompanying notes to consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

Nature of Business

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

Basis of Presentation

The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable). NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), a 80% owned subsidiary of Vertical, currently maintain daily business operations, EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. (“PMI”) and Vertical Internet Solutions, Inc. (“VIS”), each of which is inactive and Vertical Healthcare Solutions, Inc. (“VHS”), Ploinks, Inc. (“Ploinks”) (formerly, OptVision Research, Inc.), Taladin, Inc. (“Taladin”), and Vertical do Brasil, each of which has minor activities, are all wholly-owned subsidiaries of Vertical. Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary, and Priority Time Systems, Inc. (“Priority Time”) a 70% owned subsidiary, are entities with minor activities. To date, we have generated revenues primarily from software licenses, software as a service, consulting fees and maintenance agreements from NOW Solutions and SnAPPnet and patent licenses from Vertical Computer Systems, the parent company.

Principles of Consolidation

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

Cash and Cash Equivalents

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

Revenue Recognition

Our revenue recognition policies are in accordance with standards on software revenue recognition, which includes guidance on revenue arrangements with multiple deliverables and arrangements that include the right to use of software stored on another entity’s hardware.

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

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

Software License. We sell concurrent perpetual software licenses to our customers. The license gives the customer the right to use the software without regard to a specific term. We recognize the license revenue upon execution of a contract and delivery of the software, provided the license fee is fixed and determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. When the software license arrangement requires the Company to provide consulting services that are essential to the functionality of the software, the product license revenue is recognized upon the acceptance by the customer and consulting fees are recognized as services are performed.

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

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

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

Software as a Service (“SaaS”). We have contracted with a third party to provide new and existing customers with a hosting facility providing all infrastructure and allowing us to offer our currently sold software, emPath® and SnAPPnet™, on a service basis. However, a contractual right to take possession of the software license or run it on another party’s hardware is not granted to the customer. We refer to the delivery method to give functionality to new customers utilizing this service as SaaS. Since the customer is not given contractual right to take possession of the software, the scope of ASC 350-40 does not apply. A customer using 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 will provide consulting services to customers in conjunction with SaaS. 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 the SaaS functionality, 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.

Concentration of Credit Risk

We maintain our cash in bank deposit accounts, which, at times, may exceed federally insured limits. We have not experienced any such losses in these accounts. Substantially all of our revenue was derived from recurring maintenance fees related to our payroll processing software.

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 2014, the Company wrote off $771,251 of previously capitalized software costs related to its 70% owned subsidiary, Priority Time Systems. 

Property and Equipment

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

Impairment of Long-Lived Assets

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets. Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value. During 2014 and 2013, there was no impairment of long-lived assets.

Stock-based Compensation

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

Allowance for Doubtful Accounts

We establish an allowance for bad debts through a review of several factors including historical collection experience, current aging status of the customer accounts, and financial condition of our customers. We do not generally require collateral for our accounts receivable. Our allowance for doubtful accounts was $97,419 and $83,326 as of December 31, 2014 and 2013, respectively.

Income Taxes

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

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

Since January 1, 2007, we account for uncertain tax positions in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”) on income taxes which addresses how we should recognize, measure and present in our financial statements uncertain tax positions that have been taken or are expected to be taken in a tax return. Pursuant to this guidance, we can recognize a tax benefit only if it is “more likely than not” that a particular tax position will be sustained upon examination or audit. To the extent the “more likely than not” standard has been satisfied, the benefit associated with a tax position is measured as the largest amount that is greater than 50% likely of being realized upon settlement. No liability for unrecognized tax benefits was recorded as of December 31, 2014 and 2013.

Earnings per Share

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

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