Vertical Computer Systems Inc (VCSY) SEC Quarterly Report (10-Q) for Q2 2017

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2017

☐  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)

(972) 437-5200

(Registrant's Telephone Number)

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

Yes  ☒   No  ☐

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

Yes  ☒   No ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     ☐  

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

As of August 21, 2017, the issuer had 1,190,335,201 shares of common stock, par value $0.00001, issued and 1,150,335,201 outstanding.

PART I

FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

(Continued on next page)

See accompanying notes to the unaudited consolidated financial statements.

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

(Continued from previous page)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders' Deficit

December 31, 2016 through June 30, 2017

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

(Continued on next page)

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

(Continued from previous page)

See accompanying notes to unaudited consolidated financial statements.

VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we", "our", the "Company" or "Vertical") have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical's annual report on Form 10-K for the year ended December 31, 2016. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, "our", "we", the "Company" or "VCSY", as applicable). Vertical's subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. ("SnAPPnet"), an 80% owned subsidiary of Vertical. Vertical's subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. ("Taladin"), and Vertical Healthcare Solutions, Inc. ("VHS"), each of which a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. ("Priority Time") a 70% owned subsidiary, Ploinks, Inc. ("Ploinks"), a 90% owned subsidiary and Government Internet Systems, Inc. ("GIS"), an 84.5% owned subsidiary. Vertical's subsidiaries which are inactive include EnFacet, Inc. ("ENF"), Globalfare.com, Inc. ("GFI"), Pointmail.com, Inc. and Vertical Internet Solutions, Inc. ("VIS"), each of which is a wholly-owned subsidiary of Vertical.

In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported in the 2016 annual report on Form 10-K have been omitted.

Earnings per share

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

For the six months ended June 30, 2017 and 2016, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive.

Capitalized Software Costs

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

During the six months ended June 30, 2017 and 2016, the Company capitalized an aggregate of $0 and $250,184 respectively, related to software development.

Recently Issued Accounting Pronouncements

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company's financial position, operations or cash flows.

Note 2. Going Concern

The accompanying unaudited consolidated financial statements for the six months ended June 30, 2017 and 2016 have been prepared assuming that we will continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.

The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. As of June 30, 2017, we had negative working capital of approximately $21.5 million and defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

Note 3. Notes Payable

The following table reflects our third party debt activity, including our convertible debt, for the six months ended June 30, 2017:

During the six months ended June 30, 2017, the Company borrowed $180,000 from a third party lender at 10% interest per annum of which $40,000 was repaid.

During the six months ended June 30, 2017, the Company issued a convertible debenture in the principal amount of $60,000 to a third party lender for a loan made to the Company in the same amount. The debt accrues interest at 10% per annum and is due one year from the date of issuance. Beginning six months after issuance of the debenture and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company's common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued a total of 600,000 shares of common stock of the Company to the lender with the Rule 144 restrictive legend and 3-year warrants under which each lender may purchase in aggregate a total of 600,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share. In connection with the issuance of shares of common stock and warrants, the Company recorded a discount of $9,916 against the face value of the loan based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as a derivative liability. The discount is being amortized over twelve months and $54 of amortization expense was recognized for the six months ended June 30, 2017.

During the six months ended June 30, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 was converted into 1,688,762 common shares. In May 2017, the Company amended the convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000 and cancelled a $10,000 note payable issued to the third party lender. This convertible note has been paid in full.

Lakeshore Financing

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

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

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

As additional consideration for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney's fees and direct costs) from any litigation or settlement proceeds related to the SiteFlash™ technology to Lakeshore which was increased to 8% under an amendment to the Loan Agreement in 2013. In addition, until the Note is paid in full, NOW Solutions agreed to pay a Lakeshore royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management has estimated the fair value of the royalty to be nominal as of its issuance date and no royalty was owed as of September 30, 2015 or December 31, 2014.

In December 2014, the Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. Under the terms of the amendment, NOW Solutions agreed to make $2,500 weekly advance payments to Lakeshore to be applied to the 25% dividend of NOW Solutions' net income after taxes in connection with Lakeshore's 25% minority ownership interest in NOW Solutions. Within 10 business days after the Company files its periodic reports with the SEC, NOW Solutions will also make quarterly payment advances to Lakeshore based on 60% of Lakeshore's 25% share of NOW Solutions estimated quarterly net income after taxes, less any weekly payment advances received by Lakeshore during the then-applicable quarter and the weekly $2,500 payments shall be increased or decreased based only upon any increases or decreases of maintenance and cloud-based offering fees during the then-completed quarter (but will not decrease below a minimum of $2,500 per week). NOW Solutions shall pay Lakeshore the balance of Lakeshore's 25% of NOW's yearly net income after taxes (less any advances) within 10 business days after the Company files it annual 10-K report with the SEC and any payments in excess of Lakeshore's 25% of NOW yearly profit shall be credited towards future weekly advance payments. The Company also agreed to pay attorney fees of $40,000 and paid fees of $80,000 to a former consultant and employee of the Company who is a member of Lakeshore. In consideration of the extension to cure the default under the Lakeshore Note and the Loan Agreement, the Company transferred a 20% ownership interest in two subsidiaries to Lakeshore: Priority Time Systems, Inc., and in SnAPPnet, Inc.. This resulted in an additional non-controlling interest recognized in the equity of the Company of $391,920 and $99,210 for Priority Time Systems, Inc. and SnAPPnet, Inc., respectively, during 2014. The Company had an option to buy back Lakeshore's ownership interest in NOW Solutions, Priority Time and SnAPPnet, Inc. (which expired on January 31, 2015).

In July 2015, we entered into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the amendment, the Company issued 13,000,000 common shares with the Rule 144 restrictive legend, resulting in a forbearance loss of $455,000 and Ploinks agreed to issue 3,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares was determined to be nominal. Also in July 2015, the Company further amended the Lakeshore Note and the Loan Agreement with Lakeshore. Pursuant to this Agreement, the Company issued 2,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a forbearance loss of $54,200 and paid $15,000 to Lakeshore as forbearance fees.

In August 2015, we entered into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the amendment, the Company issued 7,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a forbearance loss of $175,700 and Ploinks agreed to issue 2,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares was determined to be nominal.

Under the August 2015 agreement, the Company also agreed to make a $500,000 payment for amounts due to Lakeshore under the Lakeshore Note and the Loan Agreement. In the event that the Company did not make the Lakeshore $500,000 payment on or before August 21, 2015, then Lakeshore in lieu of the $500,000 payment, would obtain a purchase option (the "2015 Purchase Option") to purchase an additional 250 shares of NOW Solutions common stock for a total purchase price of $950,000. In addition, since the Company did not make the $500,000 payment to Lakeshore on or before August 21, 2015, no further payment on the Note was due until January 1, 2016 at which time the Note plus all accrued interest were recalculated and the Note was re-amortized under the same interest rate and terms as the Note and the maturity date of the Note was extended 10 years from January 1, 2016.

The Lakeshore note is in default and the Company is currently evaluating solutions to resolve all issues with Lakeshore.

During the six months ended June 30, 2017, NOW Solutions, a subsidiary of the Company, accrued dividends to Lakeshore of $65,000.

For additional transactions after June 30, 2017 concerning notes payable, please see "Subsequent Events" in Note 9.

Note 4. Derivative liability and fair value measurements

Derivative liabilities

As of June 30, 2017, the Company has convertible notes and common stock warrants that qualify as derivative liabilities under ASC 815.

As of June 30, 2017, the aggregate fair value of the outstanding derivative liabilities was $396,674. For the six months ended June 30, 2017, the net gain on the change in fair value of derivative liabilities was $619,898.

The Company estimated the fair value of the derivative liabilities using the Black-Scholes option pricing model and the following key assumptions during 2017:

Fair value measurements

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

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

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

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

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

The following table provides a summary of the fair value of our derivative liabilities as of June 30, 2017 and December 31, 2016:

The estimated fair value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities and deferred revenue approximates their carrying value due to their short-term nature. The Company uses Level 3 inputs to estimate the fair value of its derivative liabilities.

The below table presents the change in the fair value of the derivative liabilities during the six months ended June 30, 2017:

Note 5. Common and Preferred Stock Transactions

In May 2017, the Company granted 300,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 50,000 shares of Ploinks, Inc. common stock to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company. The aggregate fair market value of the VCSY common stock grant was determined to be $4,200 based on the quoted market price of VCSY stock at date of grant and Ploinks, Inc. common stock grant was determined to be $5,400 based on a third party valuation of Ploinks stock. In addition, the Company agreed to issue up to 2,000,000 common shares of the Company and 200,000 shares of Ploinks, Inc. common stock pursuant to restricted performance stock agreements with the consultant. These shares may vest over a term of 3 years and are based upon the Consultant achieving certain performance criteria.

During the six months ended June 30, 2017, the Company issued a convertible debenture in the principal amount of $60,000 to a third party lender for a loan made to the Company in the same amount. The debt accrues interest at 10% per annum and is due one year from the date of issuance. Beginning six months after issuance of the debenture and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company's common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued a total of 600,000 shares of common stock of the Company to the lender with the Rule 144 restrictive legend and 3-year warrants under which each lender may purchase in aggregate a total of 600,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share. In connection with the issuance of shares of common stock and warrants, the Company recorded a discount of $9,916 against the face value of the loan based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as a derivative liability. The discount is being amortized over twelve months and $54 of amortization expense was recognized for the six months ended June 30, 2017.

During the six months ended June 30, 2017, the Company entered into a subscription agreement under which a third party subscriber purchased 1,000 shares of VCSY Series A Preferred Stock for $200,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 2,000,000 shares of common stock of the Company with the Rule 144 restrictive legend, 100,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2-year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $36,670. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company's common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $22,800. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $1,196. The fair market value of all warrants issued to the subscribers was $451 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the six months ended June 30, 2017, the Company granted 295,500 shares of the common stock of Ploinks, Inc. to third party lenders in connection with 3 to 6-month extensions of convertible debentures in the principal amount of $1,035,000 issued in 2015 and 2016. The aggregate fair market value of the awards was determined to be $31,914 and was recorded as debt discount, and is being amortized through the term of the convertible debenture.

During the six months ended June 30, 2017, the Company granted 3,000,000 VCSY common shares pursuant to a stock award to an employee of the Company and its subsidiaries (at a fair market value of $72,000).

During the six months ended June 30, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 was converted into 1,688,762 common shares. In May 2017, the Company had amended this convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000 and cancelled a $10,000 note payable issued to the third party lender. This convertible note has been paid in full.

During the six months ended June 30, 2017, the Company entered into a restricted stock agreement to grant 120,000 shares of the Company's common stock with the Rule 144 restrictive legend with an employee of the Company under which the shares vest in equal installments over a 30-month period. The fair value of the shares was $2,208 based on the quoted market price of VCSY stock on the grant date and $368 was amortized to expense during the six months ended June 30, 2017.

During the six months ended June 30, 2017, 550,000 VCSY common shares vested under restricted stock agreements to employees and a consultant of the Company.

During the six months ended June 30, 2017, Ploinks, Inc. entered into a restricted stock agreement to grant 60,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of the Company pursuant to a restricted stock agreement with Ploinks, Inc. These shares typically vest over a 30-month period in equal installments and the fair value of the awards is being expensed over this vesting period. The fair value of the shares was $6,480 based on a third party valuation of Ploinks stock and $1,082 was amortized to expense during the six months ended June 30, 2017.

During the six months ended June 30, 2017, the Company granted 300,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of a subsidiary of the Company's pursuant to a restricted stock agreement with the Company. 150,000 shares vested immediately upon grant of the shares (as noted below) and 150,000 shares will vest in 4 months from the date of grant. The fair value of the shares was $32,400 based on a third party valuation of Ploinks stock and $22,127 was amortized to expense during the six months ended June 30, 2017

During the six months ended June 30, 2017, 350,001 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

Stock compensation expense for the amortization of restricted stock awards was $67,494 for the six months ended June 30, 2017. As of June 30, 2017, there were 11,695,000 shares of unvested stock compensation awards to employees and 16,000,000 shares of unvested stock compensation awards to non-employees.

We have evaluated our convertible cumulative preferred stock under the guidance set out in FASB ASC 470-20 and accordingly classified these shares as temporary equity in the consolidated balance sheets.

For additional transactions after June 30, 2017 concerning stock transactions, please see "Subsequent Events" in Note 9.

Note 6. Option and Warrant Activity

Option and warrant activities during the six months ended June 30, 2017 is summarized as follows:

The weighted average remaining life of the outstanding warrants as of June 30, 2017 was 1.98. The intrinsic value of the exercisable warrants as of June 30, 2017 was $.0139.

For additional transactions after June 30, 2017 concerning warrants and stock options, please see "Subsequent Events" in Note 9.

Note 7. Related Party Transactions

Related party debt, including our convertible debt was $308,242 as of June 30, 2017 and December 31, 2016.

As of June 30, 2017 and December 31, 2016, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $162,500 and $139,546, respectively. The payables are unsecured, non-interest bearing and due on demand.

Note 8. Legal Proceedings

We are involved in the following ongoing legal matters:

On December 31, 2011, the Company and InfiniTek corporation ("InfiniTek") entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek 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 the date of this Report and each party is alleging the other party is in breach of the settlement agreement. We intend to resolve all disputes with InfiniTek.

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney's fees and court costs.  The Company has $112,985 of principal and interest accrued as of March 31, 2017. In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122 . William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney's fees and expenses. The Company has $260,286 of principal and interest accrued as of June 30, 2017. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

Note 9. Subsequent Events

In July 2017, the United States Patent and Trademark office issued a patent (Patent No. 9710425) for the invention titled "Mobile Proxy Server for Internet Server Having a Dynamic IP Address" for Claims 1-20. The term "IP" stands for "Internet Protocol," which is the principal communications protocol for the Internet. This patented technology is incorporated in the Ploinks SPC™ and the Company's core communication platform.

In July 2017, the Company granted 500,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 30,000 shares of common stock of Ploinks, Inc. to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company.

During the period that runs from July 1, 2017 through August 21, 2017, the Company issued a convertible debenture in the principal amount of $50,000 to a third party lender for a loan made to the Company in the same amount. The debt accrues interest at 10% per annum and is due one year from the date of issuance. Beginning six months after issuance of the debenture and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company's common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued a total of 500,000 shares of common stock of the Company to the lender with the Rule 144 restrictive legend and 3-year warrants under which the lender may purchase up to 500,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share.

During the period that runs from July 1, 2017 through August 21, 2017, the Company entered into a subscription agreement under which a third party subscriber purchased 300 shares of VCSY Series A Preferred Stock for $60,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscriber also received a total of 600,000 shares of common stock of the Company with the Rule 144 restrictive legend, 30,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscriber may purchase an aggregate total of 45,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2-year warrants under which the subscriber may purchase an aggregate total of 45,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share.

During the period that runs from July 1, 2017 through August 21, 2017, the Company granted 4,500 shares of common stock of Ploinks, Inc. to a third party lender in connection with a 6-month extension of a convertible debenture in the principal amount of $15,000 issued in 2016.

During the period that runs from July 1, 2017 through August 21, 2017, the Company made payments of $126,500 of principal and interest due under a convertible debenture in the principal amount of $115,000 issued by the Company to a third party lender. This convertible debenture has been paid in full.

During the period that runs from July 1, 2017 through August 21, 2017, 250,000 VCSY common shares issued under restricted stock agreements to an employee of the Company vested.

During the period that runs from July 1, 2017 through August 21, 2017, 80,000 common shares of stock of Ploinks, Inc. issued under restricted stock agreements to an employee of the Company vested.

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

Critical Accounting Policies

Capitalized Software Costs

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product's estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value. During the six months ended June 30, 2017 and 2016, $0 and $250,184 of internal costs were capitalized, respectively.

Revenue Recognition

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

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

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

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

Software licenses are generally sold as part of a multiple-element arrangement that may include maintenance and, under a separate agreement, consulting services. The consulting services are generally performed by the Company, but the customer may use a third-party to perform the consulting services. We consider these separate agreements as being negotiated as a package. The Company determines whether there is vendor specific objective evidence of fair value ('‘VSOEFV'') for each element identified in the arrangement, to determine whether the total arrangement fees can be allocated to each element. If VSOEFV exists for each element, the total arrangement fee is allocated based on the relative fair value of each element. In cases where there is not VSOEFV for each 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 third parties to provide new and existing customers with hosting facilities providing all infrastructure and allowing us to offer our currently sold software, emPath® and SnAPPnet™, on a service basis. However, a contractual right to take possession of the software license or run it on another party's hardware is not granted to the customer. We refer to the delivery method to give functionality to new customers utilizing this service as cloud-based. Since the customer is not given contractual right to take possession of the software, the scope of ASC 350-40 does not apply. A customer using cloud-based software can enter into an agreement to purchase a software license at any time. We generate revenue from cloud-based offering as the customer utilizes the software over the Internet.

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

Allowances for Doubtful Accounts

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

Deferred Taxes

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

Stock-Based Compensation Expense

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

Valuation of the Embedded and Warrant Derivatives

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

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

Recently Issued Accounting Pronouncements

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company's financial position, operations or cash flows.

Results of Operations

Three and six months ended June 30, 2017 compared to three and six months ended June 30, 2016

Total Revenues. We had total revenues of $959,606 and $969,659 for the three months ended June 30, 2017 and 2016, respectively. The decrease in total revenues was $10,053 for the three months ended June 30, 2017 representing a 1.0% decrease compared to the total revenues for the three months ended June 30, 2016. Substantially all of the revenues for the three months ended June 30, 2017 were related to the business operations of NOW Solutions.

Total revenues for the three months ended June 30, 2017 and 2016 primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. Software maintenance in the three months ended June 30, 2017 decreased by $32,549 or 4.0% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to decreases with existing customer maintenance agreements and the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the three months ended June 30, 2017 increased by $37,778 from the same period in the prior year, which represents a 57.3% increase. This increase was due to more demand for version upgrades and enhancements to existing customer accounts in our Canadian operations during the second quarter of 2017. Cloud-based revenues were $65,964 for the three months ended June 30, 2017 compared to $81,183 for the same period in the prior year, representing a $15,219 decrease or 18.7%. The decrease is primarily related to the loss of one of our SnAPPnet customers. Other revenue in the three months ended June 30, 2017 decreased by $580 or 80.6% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses and other miscellaneous revenues.

We had total revenues of $1,902,349 and $1,922,602 in the six months ended June 30, 2017 and 2016, respectively. The decrease in total revenues was $20,253 representing a 1.1% decrease. Substantially all of the revenues for the six months ended June 30, 2017 were related to the business operations of NOW Solutions.

Total revenues for the six months ended June 30, 2017 and 2016 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from new software licenses decreased $11,483 compared to that for the six months ended June 30, 2016 due to the sale of our employee self-service module to an existing customer during the six months ended June 30, 2016. Software maintenance in the six months ended June 30, 2017 decreased by $32,832 or 2.0% from the same period in the prior year. The revenue decrease in software maintenance is primarily due to the loss or reduction of customer maintenance agreements in the US and Canada and the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the six months ended June 30, 2017, increased by $28,495 or 19.3% from the same period in the prior year. This increase was primarily a result of more demand for version upgrades and enhancements to existing customer accounts in our Canadian operations during the first six months of 2016. Cloud-based revenues were $125,667 for the six months ended June 30, 2017 compared to $124,466 for the same period in the prior year, representing a $1,201 decrease or 1.0%. Other revenue in the six months ended June 30, 2017 decreased by $5,634 or 66.0% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $439,243 for the three months ended June 30, 2017, compared to $376,308 for the three months ended June 30, 2016. The increase in cost of revenues of $62,935 represents a 16.7% increase. The increase in direct cost of revenues was primarily due to an increased in payroll and related benefits. During the three months ended June 30, 2017 and 2016, $0 and $106,257 of internal costs were capitalized, respectively.

For the six months ended June 30, 2017, direct costs of revenues were $812,795 compared to $764,464 for the same period in 2016 resulting in an increase of $48,331 or 6.3%. The increase in direct cost of revenues was primarily due to increased payroll and related benefits. During the six months ended June 30, 2017 and 2016, $0 and $250,184 of internal costs were capitalized, respectively.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $897,074 and $808,832 in the three months ended June 30, 2017 and 2016, respectively. The increase of $88,242 is 10.9% more than the same period in 2016. The increase is primarily due to increased payroll and professional fees somewhat offset by decreased consulting and legal fees.

For the six months ended June 30, 2017, we had $1,979,259 compared to $1,476,648 for the six months ended June 30, 2016. The $502,611 or 34.0% increase is primarily due to increased payroll and related benefits in 2017 as the company is no longer capitalizing payroll costs related to our Ploinks, Inc. development team.

Depreciation and Amortization . We had depreciation and amortization expense of $325 and $325 for the three months ended June 30, 2017 and 2016, respectively. Depreciation expense relates to depreciation of long lived assets. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

For the six months ended June 30, 2017, we had $650 compared to $433 for the six months ended June 30, 2016. Depreciation expense relates to depreciation of long lived assets. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

Bad Debt Expense (Recovery). We had bad debt recovery for the three months ended June 30, 2017 of $13,645 compared to bad debt expense of $5,789 for the three months ended June 30, 2016. Bad debt recovery relates to the collection of customer accounts greater than 90 days past due previously expensed. Bad debt expense is related to the allowance of customer accounts greater than 90 days past due.

For the six months ended June 30, 2017, we had bad debt recovery of $64,667 compared to bad debt expense of $11,927 for the six months ended June 30, 2016. Bad debt recovery relates to the collection of customer accounts greater than 90 days past due previously expensed. Bad debt expense is related to the allowance of customer accounts greater than 90 days past due.

Gain (loss) on Derivative Liability . Derivative liabilities are adjusted each quarter using the Black-Scholes option pricing model. The gain on derivative liabilities was $280,431 for the three months ended June 30, 2017 compared to a loss of $139,747 for the three months ended June 30, 2016. The gain on derivative liabilities was $619,898 for the six months ended June 30, 2017 compared to a loss of $111,035 for the six months ended June 30, 2016.

Gain (Loss) on Debt Extinguishment . We had a $35,969 gain on debt extinguishment for the three and six months ended June 30, 2016. The 2016 gain related to the fair market value from the issuance of 5 million shares with the Rule 144 restrictive legend of VCSY common stock given as consideration for payment of $130,000 of principal on an outstanding note payable.

Forbearance Fees . Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended June 30, 2017 were $3,000 compared to $6,000 for the three months ended June 30, 2016. The fees for the three months ended June 30, 2017 and 2016 are related to forbearance of a VCSY note payable.

Forbearance fees for the six months ended June 30, 2017 were $6,000 compared to $17,100 for the six months ended June 30, 2016. The fees for the six months ended June 30, 2017 are related to forbearance of a VCSY note payable. The fees for the six months ended June 30, 2016 are related forbearance of two VCSY note payables.

Interest Expense . We had interest expense of $460,592 and $526,078 for the three months ended June 30, 2017 and 2016, respectively. Interest expense decreased in 2017 by $65,486 representing an increase of 12.4% compared to the same expense in the three months ended June 30, 2016. The decrease was primarily due to the elimination of high interest on an accounts payable balance.

For the six months ended June 30, 2017, we had interest expense of $1,018,603 compared to $903,045 for the same period in 2016, representing a $115,558 or 12.8% increase for the period. The increase is primarily due to new debt interest and amortization of debt discounts on convertible debt issued with stock and warrants.

Net Income (loss). We had a net loss before non-controlling interest and income tax expense of $546,551 and net loss before non-controlling interest and income tax expense of $857,443 for the three months ended June 30, 2017 and 2016, respectively. The net loss for the three months ended June 30, 2017 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us operating loss of $363,391. This was increased by interest expense and forbearance fees and reduced by a gain on derivative liabilities, resulting in a net loss of $546,551 for the three months ended June 30, 2017. The net loss for the three months ended June 30, 2016 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us operating loss of $221,595. This loss was increased by a loss on derivative liabilities, forbearance fees and interest expense and reduced by a gain on debt extinguishment, resulting in a net loss of $857,443 for the three months ended June 30, 2016.

We incurred net losses before non-controlling interest and income tax expense of $1,230,377and $1,326,063 for the six months ended June 30, 2017 and 2016, respectively. The changes were due to the reasons discussed above.

Income Tax Provision . We had an income tax provision of $84,289 and $120,199 for the three and six months ended June 30, 2017, respectively. The income tax provision is related to NOW Solutions, a 75% owned subsidiary of the Company. The income tax provision is related to US and foreign income tax. We had an income tax provision of $27,196 and $102,756 for the three and six months ended June 30, 2016.

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $154,933 and $147,000 for the three months ended June 30, 2017 and 2016, respectively and $306,405 and $294,000 for the six months ended June 30, 2017 and 2016, respectively.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $740,241 and $1,051,831 for the three months ended June 30, 2017 and 2016, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

We had a net loss attributed to common stockholders of $1,620,120 and $1,752,159 for the six months ended June 30, 2017 and 2016, respectively. Net loss available to common stockholders was due to the factors discussed above.

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the six months ended June 30, 2017 and 2016, respectively.

Liquidity and Capital Resources

At June 30, 2017, we had non-restricted cash-on-hand of $79,375 compared to $190,448 at December 31, 2016.

Net cash used in operating activities for the six months ended June 30, 2017 was $508,202 compared to net cash used in operating activities of $84,680 for the six months ended June 30, 2016.

A large portion of our cash (and revenue) comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. Deferred revenue decreased $171,747 or 10.1% from the balance at December 31, 2016. The decrease was due to a higher number of customers on calendar year maintenance agreements which results in higher deferred revenue in December.

Our accounts receivable trade decreased from $367,278 at December 31, 2016 to $128,161 (net of allowance for bad debts) at June 30, 2017. The decrease is a result of seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to June.

The accounts payable and accrued liabilities went from $12,075,298 at December 31, 2016 to $13,033,408 at June 30, 2017. The increase is primarily related to an increase in accrued interest and accrued payroll. The resulting balance at June 30, 2017 is 55 times more than the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

We used cash to invest in equipment and the development of software products for the six months ended June 30, 2017 and June 30, 2016 of $0 and $253,985, respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

For the six months ended June 30, 2017, we had $240,000 of new debt funding, $200,000 in equity funding and repaid $44,705 in debt funding. For the six months ended June 30, 2016, we had $696,900 of new debt funding, repaid $210,199 to lenders and paid $150,000 of dividends to non-controlling shareholders of NOW Solutions.

The total change in cash for the six months ended June 30, 2017 was a decrease of $111,073.

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

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

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We had a net loss attributable to common stock holders of $1,620,120 and $1,752,159 for the six months ended June 30, 2017 and 2016, respectively and have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at June 30, 2017, we had negative working capital of approximately $21.5 million (although this figure includes deferred revenue of approximately $1.6 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures

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

Management's annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2016, as filed on April 24, 2017.

There have been no material changes in our internal control over financial reporting since our reporting on Form 10-K for the year ended December 31, 2016.

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

On December 31, 2011, the Company and InfiniTek corporation ("InfiniTek") entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek 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 the date of this Report and each party is alleging the other party is in breach of the settlement agreement. We intend to resolve all disputes with InfiniTek.

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills. The Company has $112,985 of principal and interest accrued as of March 31, 2017. The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney's fees and court costs.  In June 2017, the court entered a default judgment against the Company. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No. BC649122 . William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney's fees and expenses.  The Company has $260,286 of principal and interest accrued as of June 30, 2017. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

Item 1A. Risk Factors

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2016, as filed on April 24, 2017.

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

In May 2017, the Company granted 300,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 50,000 shares of Ploinks, Inc. common stock to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company. The aggregate fair market value of the VCSY common stock grant was determined to be $4,200 based on the quoted market price of VCSY stock at date of grant and Ploinks, Inc. common stock grant was determined to be $5,400 based on a third party valuation of Ploinks stock. In addition, the Company agreed to issue up to 1,000,000 common shares of the Company and 100,000 shares of Ploinks, Inc. common stock pursuant to restricted performance stock agreements with the consultant. These shares may vest over a term of 3 years and are based upon the Consultant achieving certain performance criteria.

During the six months ended June 30, 2017, the Company issued a convertible debenture in the principal amount of $60,000 to a third party lender for a loan made to the Company in the same amount. The debt accrues interest at 10% per annum and is due one year from the date of issuance. Beginning six months after issuance of the debenture and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company's common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued a total of 600,000 shares of common stock of the Company to the lender with the Rule 144 restrictive legend and 3-year warrants under which each lender may purchase in aggregate a total of 600,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share. In connection with the issuance of shares of common stock and warrants, the Company recorded a discount of $9,916 against the face value of the loan based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as a derivative liability. The discount is being amortized over twelve months and $54 of amortization expense was recognized for the six months ended June 30, 2017.

During the six months ended June 30, 2017, the Company entered into a subscription agreement under which a third party subscriber purchased 1,000 shares of VCSY Series A Preferred Stock for $200,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 2,000,000 shares of common stock of the Company with the Rule 144 restrictive legend, 100,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2-year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $36,670. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company's common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $22,800. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $1,196. The fair market value of all warrants issued to the subscribers was $451 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the six months ended June 30, 2017, the Company granted 295,500 shares of the common stock of Ploinks, Inc. to third party lenders in connection with 3 to 6-month extensions of convertible debentures in the principal amount of $1,035,000 issued in 2015 and 2016. The aggregate fair market value of the awards was determined to be $31,914 and was recorded as debt discount, and is being amortized through the term of the convertible debenture.

During the six months ended June 30, 2017, the Company granted 3,000,000 VCSY common shares pursuant to a stock award to an employee of the Company and its subsidiaries (at a fair market value of $72,000).

During the six months ended June 30, 2017, $22,421 of principal, interest and legal fees under a convertible note issued in the principal amount of $90,000 was converted into 1,688,762 common shares. In May 2017, the Company had amended this convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000 and cancelled a $10,000 note payable issued to the third party lender. This convertible note has been paid in full.

During the six months ended June 30, 2017, the Company entered into a restricted stock agreement to grant 120,000 shares of the Company's common stock with the Rule 144 restrictive legend with an employee of the Company under which the shares vest in equal installments over a 30-month period. The fair value of the shares was $2,208 based on the quoted market price of VCSY stock on the grant date and $368 was amortized to expense during the six months ended June 30, 2017.

During the six months ended June 30, 2017, 550,000 VCSY common shares vested under restricted stock agreements to employees and a consultant of the Company.

During the six months ended June 30, 2017, Ploinks, Inc. entered into a restricted stock agreement to grant 60,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of the Company pursuant to a restricted stock agreement with Ploinks, Inc. These shares typically vest over a 30-month period in equal installments and the fair value of the awards is being expensed over this vesting period. The fair value of the shares was $6,480 based on a third party valuation of Ploinks stock and $1,082 was amortized to expense during the six months ended June 30, 2017.

During the six months ended June 30, 2017, the Company granted 300,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of a subsidiary of the Company's pursuant to a restricted stock agreement with the Company. 150,000 shares vested immediately upon grant of the shares (as noted below) and 150,000 shares will vest in 4 months from the date of grant. The fair value of the shares was $32,400 based on a third party valuation of Ploinks stock and $22,127 was amortized to expense during the six months ended June 30, 2017.

During the six months ended June 30, 2017, 350,001 shares of the common stock of Ploinks, Inc. issued under restricted stock agreements to consultants and employees of the Company and a subsidiary of the Company vested.

In July 2017, the Company granted 500,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 30,000 shares of common stock of Ploinks, Inc. to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company.

During the period that runs from July 1, 2017 through August 21, 2017, the Company issued a convertible debenture in the principal amount of $50,000 to a third party lender for a loan made to the Company in the same amount. The debt accrues interest at 10% per annum and is due one year from the date of issuance. Beginning six months after issuance of the debenture and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company's common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loan, the Company also issued a total of 500,000 shares of common stock of the Company to the lender with the Rule 144 restrictive legend and 3-year warrants under which the lender may purchase up to 500,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share.

During the period that runs from July 1, 2017 through August 21, 2017, the Company entered into a subscription agreement under which a third party subscriber purchased 300 shares of VCSY Series A Preferred Stock for $60,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscriber also received a total of 600,000 shares of common stock of the Company with the Rule 144 restrictive legend, 30,000 shares of common stock of Ploinks, Inc., 2-year warrants under which the subscriber may purchase an aggregate total of 45,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2-year warrants under which the subscriber may purchase an aggregate total of 45,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share.

During the period that runs from July 1, 2017 through August 21, 2017, the Company granted 4,500 shares of common stock of Ploinks, Inc. to a third party lender in connection with a 6-month extension of a convertible debenture in the principal amount of $15,000 issued in 2016.

During the period that runs from July 1, 2017 through August 21, 2017, the Company made payments of $126,500 of principal and interest due under a convertible debenture in the principal amount of $115,000 issued by the Company to a third party lender. This convertible debenture has been paid in full.

During the period that runs from July 1, 2017 through August 21, 2017, 250,000 VCSY common shares issued under restricted stock agreements to an employee of the Company vested.

During the period that runs from July 1, 2017 through August 21, 2017, 80,000 common shares of stock of Ploinks, Inc. issued under restricted stock agreements to an employee of the Company vested.

Item 3. Defaults Upon Senior Securities

Note payable of $1,759,150 issued by NOW Solutions to Lakeshore Investment, LLC, dated January 9, 2013. The note is secured with the assets of NOW Solutions, Priority Time Systems, SnAPPnet, and the SiteFlash™ assets and bears a default interest rate of 16%. As of August 21, 2017, the outstanding principle and accrued interest currently due under the note is $1,952,253.

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

The following documents are filed as part of this report:

SIGNATURES

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