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”).
We presently market several software products, including the following: HRMS emPath™ 6.5 (“emPath™”) by our subsidiary, NOW Solutions, Inc. (“NOW Solutions”), a physician credentialing solution known as “SnAPPnet”™ and a time and attendance software known as PTS™ (“PTS”™) by our subsidiary Priority Time Systems, Inc. (“Priority Time”). In addition, we are upgrading a point-of-sale software solution known as “PASS”™, a content management system called SiteFlash™ (“SiteFlash”™) and an FLSA (Fair Labor Standards Act) payroll software based upon emPath™ geared to meeting requirements for city and county fire, sheriff and police departments, which will be distributed by our subsidiary Taladin, Inc. (“Taladin”). For a description of these products, please see the section entitled “Software Services” under “Business Overview”.
Business Overview
We are a multi-national provider of Internet core technologies, application software, and software services through our distribution network with operations or sales in the United States, Canada and Brazil. Our primary Internet core technologies include SiteFlash™, Emily™ XML Enabler Agent, Emily™ XML Broker, which can be an alternative to Web services, and the Emily™ XML Scripting Language, which can be used to build Web services. Our fiber optic patent (for transmission of images over a single filament of fiber optic cable (No. 6718103) is in OptVision Research, Inc. (“OptVision Research”).
Our main application software, emPath™, which is designed to handle complex Payroll and Human Resources challenges, is marketed by NOW Solutions. NOW Solutions, our wholly owned subsidiary, is selling emPath™ in the United States and Canadian markets both as a software solution as well as a Software-as-a-Service (“SaaS”) offering, also known as cloud-based (“cloud-based”) offering. For a description of our new delivery model for emPath™, please see the section entitled “Software Services” under “Business Overview”.
Our newly released 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. PTS™ will be marketed as a best-of-breed solution as well as an integrated suite with emPath™ by our subsidiary NOW Solutions. The initial marketing effort will focus on the United States and Brazil markets.
We have other application software in various stages of development which will be marketed through our subsidiaries including Priority Time, Vertical Healthcare Solutions, Inc. (“VHS”), Taladin, SnAPPnet, Inc, and Government Internet Systems Inc. (“GIS”). We are actively pursuing the licensing of our intellectual properties, including our System and Method for Generating Web sites in an Arbitrary Framework (see “Legal Proceedings” in Item 3).
In 2009, we acquired rights from Emerald Software Group (“Emerald”) to market its AllegroHR onboarding and offboarding software solutions as well as staff service requests and personnel action notices applications, including the right to market these products as a private label offering.
In 2010, our wholly owned subsidiary, SnAPPnet, Inc., a Texas corporation, purchased substantially all of the assets of Pelican Applications, LLC (“Pelican”), including a software application product known as SnAPPnet™ which is currently used for physician credentialing, as well as Pelican’s entire customer base.
In January 2011, we entered into a license agreement for a web server software with the intent to modify and use it as a basis to create a product.
Our continuous effort to develop our emPath™ product and its cloud-based offering platform has allowed us to finalize and launch our new module-based initiative whereby certain payroll/human resource modules can be marketed independently from emPath™ or bundled as a comprehensive solution. A key objective of the module development initiative is to enable new modules to be sold to a smaller customer base (25 to 500 employee companies) 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 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.
Our current products address the following market segments:
MARKET
PRODUCT
OWNERSHIP/
LICENSOR
LICENSEE
Human Resources and Payroll
emPath™
NOW Solutions
VHS (a), Taladin (b)
Pharmacies and medical practices
SiteFlash™
Vertical
VHS(a)
Government Sector- Emergency Response
ResponseFlash™
Vertical
GIS (b)
Pharmacies and medical practices
PASS™
Vertical
VHS(a)
Software development units
Emily™
Vertical
VHS(a)
Human Resources and Payroll
AllegroHR
Emerald Software Group
NOW Solutions
Time and Attendance
PTS™
Priority Time
VHS (a), NOW Solutions (c)
Healthcare Credentialing
SnAPPnet™
SnAPPnet, Inc.
VHS (a) , NOW Solutions (c)
(a)Physician market
(b)Government market
(c)Clients of NOW Solutions
Application Software
Our primary application software is emPath™, a human resources/payroll software, which is developed, marketed and maintained by our wholly-owned subsidiary, NOW Solutions. This software is Web-based, meaning that it can be accessed on the Internet, and is currently being offered as a cloud-based offering or as a software license.
In 2010, we completed the workflow engine for emPath™ and continued improvements for its cloud-based offering. 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 six years), have substantially facilitated faster product development. In addition, we have significantly improved the scalability of emPath™ to meet the needs of small businesses (“emPath™ for Small Business”) as well as very large enterprise clients. We are also continuing to upgrade emPath™ for our cloud-based 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. As a result of our initial sales to complex payroll customers, we realized the need for a “tailored cloud-based” offering which could provide these types of customers the cost benefits of a cloud-based offering while meeting their complex requirements.
In the summer of 2010, we elected to utilize a new development platform (“Platform”) for the development of PTS™ and created “dashboardletsTM” (a proprietary tool for business intelligence) allowing the scalability to meet large and/or complex customer requirements. We are currently marketing PTS™ through Priority Time as a separate product, as well as offering it as a bundled solution with NOW Solutions’ emPath™, which we are marketing to emPath™’s existing customer base.
We are marketing our SnAPPnet™ application directly to hospitals and to NOW Solutions’ existing customer base as well as through VHS to physicians in the United States. We are also in the process of developing a registered nurse module of SnAPPnet™, which we will market to NOW Solutions’ existing healthcare customers in the United States. 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 believe that our application software services provide customers with upfront cost savings and significant increases in productivity for everyday operations, including competitive set-up fees and implementation times. The new Platform will be used to develop the other modules.
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 core internet 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. This unique ability is patented (U.S. Patent number 6,826,744 and continuation patent U.S. Patent No. 7,716,629) and has many applications in the Web arena. SiteFlash™ architectural concepts enable integration with existing technological components within many organizations. SiteFlash™’s additional key features 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).
We offer SiteFlash™ 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™. Initially, GIS will focus on marketing ResponseFlash™, a Web-based emergency communication system, in the Homeland Security area to all government sectors excluding public education (i.e., schools, colleges, and universities).
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.
The second core Internet technology we have developed is the patent-pending 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 core Internet 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 allows a disparate and distributed database to be viewed and updated as if it was a single large database. This unique ability is patented (U.S. Patent number 7,076,521). This technology has been featured as an alternative to Web Services in the 4th Edition of the XML Handbook, by Dr. Charles Goldfarb, considered the father of XML and inventor of all markup languages. We are, at this time, upgrading the technology.
The fourth core Internet technology is a seventeen year-old web server software that was licensed to the Company. The technology was acquired with the intent to modify and use it as a basis to create a new product.
Software Services
In addition to its standard emPath™ offering, NOW Solutions has been providing a new delivery model: software-as-a-service, or simply “cloud-based”. Cloud-based is a software application delivery model where a software company both develops and operates/hosts the application for use by its customers over the Internet. It is a low-cost 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. The term "cloud-based" has become the industry adopted reference term, generally replacing earlier terms like "On-Demand" and "ASP" (Application Service Provider). After completing the testing of its emPath™ cloud-based model to ensure a robust and competitive solution, NOW Solutions has sold 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, NOW Solutions has created a “Tailored cloud-based” offering to meet the needs of large complex customers who have specialized requirements.
Other NOW Solutions’ software services include maintenance, custom maintenance, professional services and managed services offerings.
SnAPPnet™ and PTS™ will both be cloud-based offerings along with professional and managed services.
Business Operations and Units
Our business operations are grouped into the following units: NOW Solutions, Taladin, OptVision Research, VHS, Priority Time, SnAPPnet, Inc., GIS, Vertical Internet Solutions, Inc. (“VIS”), EnFacet, Inc. (“EnFacet”), Globalfare.com, Inc. (“Globalfare”), Pointmail.com, Inc. (“Pointmail”), and minority and other limited interests, joint ventures, and strategic partnerships. Each of these divisions is discussed below.
NOW Solutions, Inc.
NOW Solutions, a Delaware corporation, is a wholly-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 200 or more employees. NOW Solutions currently markets emPath™, which handles complex human resources and payroll situations where the clients 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 allows quick customization of payroll rules and calculations without any programming. NOW Solutions’ product suite is targeted to address the needs of management in today’s dynamic business environment and gives organizations a user friendly, multi-lingual (i.e., English, Canadian French, Spanish, Portuguese and Chinese) and flexible software solution, without the multi-million dollar implementation and support budgets of the 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 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 new strategy of developing and licensing HR products complementary to its existing suite of products and that can be sold separately or integrated with emPath™, which is greatly facilitated by emPath™’s Web Services integration. The first products which are part of this initiative consist of “onboarding” and “offboarding” software applications, which were obtained through NOW Solutions’ agreement with Emerald and resulted in an immediate sale to one of its existing customers. The second product is PTS™ which was officially presented at NOW Solutions’ user conference in November 2011.
In 2010, NOW Solutions Canada entered into a reseller and marketing agreement with Kronos Canadian Systems, Inc. (“Kronos Canadian”). Under the terms of the agreement, Kronos Canadian selected emPath™ as its exclusive HRMS and Payroll solution for use in Canada. NOW Solutions’ emPath™ application was to be rebranded and marketed to Kronos Canadian’s customers as “Kronos HR Payroll Powered by emPath™”. NOW Solutions and Kronos Canadian look to continue their business relationship and in that regard are in discussions to enter into a Referral Agreement to replace the earlier reseller agreement, to simplify the arrangement between the parties. NOW Solutions Canada will continue to directly market its product in Canada.
The revenue model of NOW Solutions is based upon five components: licensing fees, cloud-based fees, professional consulting services, managed services and renewable maintenance fees. Under the cloud-based delivery model, NOW Solutions typically collects monthly fees.
For the 12 months ended December 31, 2011, NOW Solutions had approximately $546,101 of total assets, revenues of approximately $6,136,843 and net income of approximately $1,207,576.
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 but the finalization of the module was put on hold while final testing was performed and the underlying emPath™ cloud-based platform was finalized, coupled with emPath™’s integration with PTS™.
For the 12 months ended December 31, 2011, Taladin had no material assets, no revenues and a net loss of approximately $11,007.
OptVision Research, Inc.
OptVision Research, a Texas corporation, is a wholly-owned subsidiary of the Company and was created to support the development of our fiber optic patent through either direct investment or government grants.
The United States Patent and Trademark Office (“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. We are in the process of attempting to secure funding from the Federal Government for development of the patent.
For the 12 months ended December 31, 2011, OptVision had no material assets, no revenues and a net loss of approximately $1,025.
Vertical Healthcare Solutions, Inc.
VHS, a Texas corporation, is a wholly-owned subsidiary of the Company. In May 2008, Robert Farias assigned Point-of-Sale software (“PASS” ™) technology to the Company. In addition, VHS and Mr. Farias entered into a distributor agreement for PASS™ whereby Mr. Farias would market PASS™ to his existing clients. In October 2008, VHS entered into a consulting agreement with Farias-Jett (a sole proprietorship of Mr. Farias), and an employment agreement with Mr. Farias. Significant upgrades have been completed on the PASS™ software and VHS has some pharmacies beta testing this product. PASS™ is being adapted to meet the needs for physicians for a secondary market. On December 17, 2009, Sigis (the “Special Interest Group for IIAS Standards”) certified that PASS™ met the requirements by the IRS for IIAS COMPLIANT POINT OF SALE SYSTEM. In 2010, VCSY licensed its various products and technology to VHS for the physician market. Marketing and sales were put on hold in 2011 until PTS™ and SnAPPnet ™ developments were completed.
For the 12 months ended December 31, 2011, VHS had no material assets, no material revenues, and a net loss of approximately $123,247.
Priority Time Systems, Inc.
Priority Time is a Nevada corporation. On June 15, 2009, we purchased 90% of the common stock of Priority Time from a shareholder of Priority Time. In addition, we also 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 the 90% block. 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 offer both as a standalone product and as an integrated product with emPath™. In late spring 2010, we elected to stop development and switch to a new Platform allowing us to create a new product utilizing 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. The product was officially presented at NOW Solutions’ user conference in November 2011.
For the 12 months ended December 31, 2011, Priority Time had assets of approximately $585,452, no material revenues and a net loss of approximately $257,654.
SnAPPnet, Inc.
SnAPPnet, Inc., a Texas corporation, is a wholly-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 2011, we upgraded the product, commenced adding some key new features and solidified its customer base. A redesign is underway to create the flexibility to meet the requirements of automated full fillable forms for NOW Solutions’ customer based HR departments as well as traditional credentialing needs.
For the 12 months ended December 31, 2011, SnAPPnet, Inc. had assets of approximately $152,457, revenues of approximately $136,076 and net loss of approximately $59,043.
Government Internet Systems, Inc.
Our 84.5% owned subsidiary, GIS, a Nevada corporation, was formerly named Emily™ Solutions, Inc. 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. GIS seeks to enter into agreements to distribute other non-Company products particularly in the Homeland Security sector. We are in the process of reviewing the marketing objectives and products for GIS.
For the 12 months ended December 31, 2011, GIS had no assets, no material revenue and net loss of approximately $970.
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, 2011, 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 currently inactive and we have no plans regarding this subsidiary.	
For the 12 months ended December 31, 2011, EnFacet had no material assets, no revenues and a net loss of $1,334.
Globalfare.com
Globalfare, a Nevada corporation, is a wholly-owned subsidiary of the Company. Globalfare is currently inactive and we currently have no plans regarding this subsidiary.
For the 12 months ended December 31, 2011, Globalfare had no assets, no revenues and a net loss of $99.
Pointmail.com, Inc.
Pointmail, a California corporation, is a wholly-owned subsidiary of the Company. Pointmail is currently inactive and we currently have no plans regarding this subsidiary or its technology.
For the 12 months ended December 31, 2011, Pointmail had no assets, no revenues and no expenses.
Minority Interests and Royalty Interests
iNet Purchasing, Inc.
In April 2000, we acquired a 2.5% minority interest in iNet and became entitled to a royalty on all iNet transactions for up to 40 years. iNet is a developer of Internet-based procurement services targeted at the specific needs of public sector purchasing in the state and local government arena through PublicBuy.net. In November 2001, we entered into a license agreement with iNet, pursuant to which the Emily™ software and technology were licensed for use in connection with iNet’s e-procurement system in Texas, Maine, and Idaho in exchange for a 20% commission on subscription fees. In April 2005, iNet Purchasing was acquired by SicommNet. We are in the process of enforcing our rights as a consequence of such acquisition.
As of December 31, 2011, all of the iNet investments and advances paid for royalties were fully reserved. There have been no revenues or expenses in relation to the investments for the twelve months ended December 31, 2011.
Strategic Alliances and Software Distributors
Farias-Jett. In August 2008, NOW Solutions entered into a hosted service provider agreement with Farias-Jett for emPath™. In July 2011, this agreement was cancelled and replaced with a license and service provider agreement.
Emerald Software Group. In February 2009, NOW Solutions entered into an agreement with Emerald to market its AllegroHR products in conjunction with NOW Solutions’ emPath™ Payroll/HRMS software solution and to sell it separately. AllegroHR consists of onboarding and offboarding software solutions as well as staff service request and personnel action notices applications. NOW Solutions can distribute AllegroHR under a private label version. This relationship is in the process of being renegotiated.
Competition
We have 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 competitors for cloud-based emPath™ include ADP, Ceridian, Ultimate Software and Quicken. However, while NOW Solutions competes with these companies, its payroll product is utilized in conjunction with many of these companies’ other modules.
Priority Time’s competitors include Kronos, NOVAtime Technology, ADI Time which was recently acquired by Asure Software, Galaxy Technologies which was acquired by Insperity (formerly known as Administaff), and Qqest Software Systems.
SnAPPnet 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.
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:
1.We have a number of proprietary patented technologies that can be utilized in our offerings.
2.NOW Solutions has an outstanding customer support department that has supported large complex entities for a number of years, and many of these large entities are leaders in their respective industries.
3.emPath™’s inherent strengths include its formula builder, the use of one single data base, and a strong, highly identifiable customer base it can reference.
4.emPath™ is built on a state-of-the-art Microsoft.net platform, allowing for rapid software development and interoperability with other software packages.
5.Our new development platform, including the dashboardlet™ feature, will provide a consistent business intelligence tool across our products’ line.
Strategic Overview
The Company’s product portfolio reflects a number of unique characteristics and advantages that have been developed or acquired over time. Yet we were unable to devote our full resources to maximize the benefit of our various technologies until the final resolution of the litigation with Ross Systems, Inc. (“Ross”) in the fall of 2009. Currently, we are actively pursuing the strategy of (a) further developing the technologies owned by the Company and its subsidiaries and (b) combining all the technologies owned by the Company and its subsidiaries into viable product offerings.
The key components of our strategy are:
1.A strong, profitable subsidiary, NOW Solutions, that has a highly-referenceable client base, including companies that are leaders in their industries and have been users of emPath™ and its predecessor product for over 25 years for their payroll and human resource needs.
2.A portfolio of patented technologies that can be licensed to third parties or utilized internally to strengthen our existing and projected product offerings.
3.Development of compatible partners and acquisition or licensing of products that complement our existing offerings.
4.The unique ability to market our new PTS™ and SnAPPnet™ products as well as other products to NOW Solutions’ customer base and, at the same time, have those customers assist us in development of the specifications for their own market.
5.The utilization of our patented technology and other application software in solutions for our core application software.
The software development leg of our strategy is twofold. The first lies in continuing to develop the ability to compete with the large ERP providers like SAP and Oracle in 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 a cloud-based offering 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.
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 with best-of-breed products that complement our business units. 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 the opportunity exists to cross-promote and market their respective products. We are also identifying complementary products from third parties which we can private label and sell with our existing products or sell separately.
Proprietary Rights
We rely upon a combination of contract provisions and patent, copyright, trademark and trade secret laws to protect our proprietary rights in our 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 agreements with employees and consultants. NOW Solutions’ emPath™ software technology as well as PTS™, SnAPPnet™, PASS™ are protected by copyright and trademark.
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, which has increased the scope of the original patent by adding 32 new claims to the original 53 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.
We have filed for a patent related to the Emily™ XML scripting language. This patent application was published in February 2003 and is still pending.
In 2010, we filed an application for a patent titled “System and Method for running a Web Server on a Mobile Internet Device”.
In 2011, we filed two provisional applications for patents relating to our patent application filed in 2010.
Although we intend to protect our 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 and 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. Our Company is in two lawsuits involving our patents (see “Legal Proceedings” in Item 3)
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 March 30, 2012, we had 26 full-time and 3 part-time employees (21 are employed in the United States and 8 in Canada), and 8 consultants (7 in Brazil). We are not a party to any collective bargaining agreements.
Item 1A.
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 $167,588 and $245,164 for the years ended December 31, 2011 and 2010, 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, 2011 and 2010. 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 12 months ended December 31, 2011 and 2010 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. Negative shareholders’ equity at December 31, 2011 was $21.5 million. Additionally, at December 31, 2011, we had negative working capital of approximately $9.7 million (although it includes deferred revenue of approximately $2.5 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 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 viable products, other products for which we have marketing rights, as well as increased revenues from NOW Solutions products and the successful launch of our new solutions by our subsidiaries (such as emPath™ for Small Business, PASS™, SnAPPnet™ , and PTS™), 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 ceased.
We Have a Working Capital Deficit, Which Means That Our Current Assets on December 31, 2011 Were Not Sufficient to Satisfy Our Current Liabilities on That Date
We had a working capital deficit of approximately $9.7 million at December 31, 2011, which means that our current liabilities exceeded our current assets by approximately $9.7 million (although it includes deferred revenue of approximately $2.5 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, 2011 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:
·the demand for our SiteFlash™ and Emily™ technology;
·the demand for NOW Solutions’ emPath™ product;
·the demand for VHS’ PASS™ product;
·the demand for our PTS™ product;
·the demand for our SnAPPnet™ product;
·introduction of new products and services by us and our competitors;
·costs incurred with respect to acquisitions;
·price competition or pricing changes in the industry;
·technical difficulties or system failures;
·general economic conditions and economic conditions specific to the Internet and Internet media; and
·the licensing of our intellectual property.
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.
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 the development effort, 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:
·the difficulty of assimilating the operations and personnel of the acquired companies;
·the potential disruption of our ongoing business and distraction of management;
·the difficulty of incorporating acquired technology or content and rights into our products and media properties;
·the correct assessment of the relative percentages of in-process research and development expense which needs to be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset;
·the failure to successfully develop an acquired in-process technology resulting in the impairment of amounts currently capitalized as intangible assets;
·unanticipated expenses related to technology integration;
·the maintenance of uniform standards, controls, procedures and policies;
·the impairment of relationships with employees and customers as a result of any integration of new personnel; and
·the potential unknown liabilities associated with acquired businesses.
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 our original SiteFlash™ and Emily™ technology products and Internet content, 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.
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:
·With a price of less than $5.00 per share;
·That are not traded on a recognized national exchange;
·Whose prices are not quoted on the NASDAQ automated quotation system (NASDAQ listed stock must have a price of not less than $5.00 per share); or
·In issuers with net tangible assets less than $2 million (if the issuer has been in continuous operation for at least three years) or $5 million (if in continuous operation for less than three years), or with average revenues of less than $6 million for the last three years.
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.
Item 2. Properties
The Company and NOW Solutions’ headquarters are currently located at 101 West Renner Road, Suite 300, Richardson, Texas, and comprise approximately 2,576 square feet. NOW Solutions has other offices at 6707 Brentwood Stair Rd., Suite 226, Fort Worth, Texas 76112, which comprises 1,703 square feet, 6205 Airport Road, Building A, Suite 300, Mississauga, Ontario, Canada, which comprises 710 square feet, and Avenida N. Sra. De Copacabana, 895, Suite 901, Copacabana, Rio de Janeiro, Brazil, which comprises 1,200 square feet. In addition, Priority Time has offices at 2815 Pebble Road, Suite 501, Las Vegas, NV 89123, which comprises 2,248 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.
Item 3. Legal Proceedings
We are involved in the following ongoing legal matters:
In August 2009, Parker Shumaker & Mills, LLP (“PSM”) filed a lawsuit in Los Angeles Superior Court to collect the outstanding balance of $51,238 under a promissory note issued by the Company to PSM in the principal amount of $75,000, plus interest at 6% per annum, late fees and attorneys’ fees. We issued the $75,000 note in connection with a settlement in October 2005 with PSM. In December 2009, we entered into a settlement agreement and stipulated judgment with PSM whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM. During 2011, the Company made payments of $28,140 toward the outstanding balance of the judgment amount leaving a balance of $5,066 at December 31, 2011.
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.
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 is a complaint for declaratory judgment, in which Interwoven is requesting that the court find that no valid and enforceable claim of either of the two patents referenced above has been infringed by Interwoven. The case is styled Interwoven, Inc. v Vertical Computer Systems, Inc. No. 3:10-CV-4645-RS.
On January 11, 2011, Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (“Samsung”) filed a lawsuit in the United States District Court for the Northern District of California seeking to consolidate its lawsuit with the Interwoven Action. This case is styled Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc., v. Vertical Computer Systems, Inc., No. 3:11-CV-00189-RS.
On May 2, 2011, the United States District Court for the Northern District of California denied Vertical’s renewed motion to transfer the Interwoven Action to the Eastern District of Texas and granted Vertical's motion to transfer the lawsuit filed by Samsung in the Northern District of California to the Eastern district in Texas. On May 11, 2011, the United States District Court for the Eastern District of Texas granted Interwoven’s 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 May 12, 2011, Vertical filed in the United States Court of Appeals for the Federal Circuit a petition for a writ of mandamus seeking review of that portion of the May 2, 2011 order by the Northern District of California which refused to transfer the Interwoven v. Vertical action to the Eastern District of Texas, which was denied on August 17, 2011.
On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order concerning the terms found in the claims of the Patents-in-Suit.
On March 8, 2012, the United States District Court for the Northern District of California in the Interwoven Action denied Interwoven’s motion to stay all judicial proceedings pending the outcome of an ex parte reexamination of the Patents-in-Suit by the USPTO.
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, payable in monthly installments of $5,000 through June 2012 and $10,000 monthly installments thereafter until the outstanding balance has been paid. The Company will be obligated to pay CCS an additional $60,000 in the event it does not make timely payment within 5 days of notice from CCS.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
Our common equity is quoted on the Over-The-Counter Bulletin Board (the “OTCBB”) under the symbol “VCSY”.
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 March 27, 2012, there were 1,842 holders of record of our VCSY common stock.
Equity Securities Under Compensation Plans
We had the following securities authorized for issuance under equity compensation plans (which include individual agreements) as of December 31, 2011:
(1)We do not have any equity compensation plans (i.e., stock option plans or restricted stock plans) that have been approved by security holders.
(2)Our Stock Option Plan expired on December 15, 2009.
(3)Of the 600,000 shares of restricted VCSY common stock that were issued in connection with an individual restricted stock agreement executed in 2010 with an employee of the Company and NOW Solutions, 200,000 shares had vested at December 31, 2011. No additional shares have vested through March 30, 2012.
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, 2011 and 2010. Our Board of Directors did not declare any dividends on our outstanding shares of Series A or Series C Preferred Stock during 2011 or 2010, 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 Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Unregistered Sales of Securities
During the last two years, we issued the following unregistered securities:
In January 2010, the Company and MRC amended the Indemnity and Reimbursement Agreement whereby the Company agreed to reimburse and indemnify MRC for 16,976,296 shares of VCSY common stock pledged in November 2009 as collateral in connection with a $150,000 note. 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 March 2010, the Company transferred 610,000 shares of Series A Convertible Preferred Stock of VHS (a wholly-owned subsidiary of the Company) to Mr. Robert Farias in exchange for the following: (a) an irrevocable waiver by Mr. Farias of the conversion rights in respect of 37,500 shares of the Company’s Series “C” 4% Cumulative Convertible Preferred Stock owned by Mr. Farias; (b) cancellation by Mr. Farias of $100,000 of debt owed by the Company to Mr. Farias; and (c) cancellation by Mr. Farias of three separate common stock purchase warrants held by Mr. Farias, exercisable for an aggregate of 15,000,000 shares of common stock. As a consequence of the waiver of conversion rights and the cancellation of warrants, the Company was no longer obligated to issue up to 30,000,000 shares of VCSY common stock. Mr. Farias serves as our Executive Vice-President of Business Development.
In March 2010, the Company further amended the Indemnity and Reimbursement Agreement with MRC. Pursuant to this amendment, MRC received 300,000 shares of the Series A Convertible Preferred Stock of VHS in exchange for the cancellation of the Company’s obligation to issue 10,000,000 shares of VCSY common stock to MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, our President and CEO, is the trustee of the W5 Family Trust.
In March 2010, the Company issued 90,000 shares of VHS Series A Preferred Stock to its Chief Technology Officer, Luiz Valdetaro, in exchange for the cancellation of an obligation to issue Mr. Valdetaro 3,000,000 shares of VCSY common stock.
On May 21, 2010, VHS issued 100,000 shares of its Series B Convertible Preferred Stock to members of Pelican Applications, LLC (“Pelican”), a California limited liability company, in connection with the purchase of the business and substantially all the assets of Pelican. For more details about the purchase of Pelican, please refer to “SnAPPnet™” in Note 3 of the Notes to the Consolidated Financial Statements.
On June 1, 2010, VHS issued 50,000 shares of Series B Convertible Preferred Stock to a consultant to serve as its Chief Operating Officer in consideration for services rendered on behalf of VHS and SnAPPnet, Inc. In October 2011, these shares were cancelled pursuant to an agreement with the consultant, provided that if certain payments for past services were not timely made, VHS would be obligated to issue new shares in the same amount.
During the year ended December 31, 2010, 100,000 unregistered shares of VCSY common stock were forfeited pursuant to a restricted stock agreement between the Company and an employee. These shares were not vested at the date of forfeiture.
During year ended December 31, 2010, we cancelled 1,500,000 shares of VCSY common stock that had been reserved but not delivered to a third party lender in connection with a loan in 2003 that was not fully funded.
During the year ended December 31, 2010, 583,333 shares of VCSY common stock, valued at $10,383, became vested.
During year ended December 31, 2010, we issued 600,000 shares of VCSY common stock to an employee of the Company pursuant to a restricted stock agreement, under which the shares vest in equal installments over a three year period.
During the year ended December 31, 2011, 200,000 shares of VCSY common stock issued to an employee of the Company and NOW Solutions, valued at $6,200, vested. The $6,200 vested portion is recorded as an accrued liability as of December 31, 2011.
During year ended December 31, 2011, no shares of VCSY common stock were issued.
During year ended December 31, 2011, no shares of VCSY common stock were cancelled.
In March 2012, the Company granted 1,200,000 unregistered shares of VCSY common stock to an employee of the Company and an employee of NOW Solutions pursuant to restricted stock agreements with the Company.
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.
Item 6. Selected Financial Data
Not applicable.
Item 7.
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 the year ended December 31, 2011, $295,919 of internal costs were capitalized. During the year ended December 31, 2010, $159,629 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, 2011 Compared To Year Ended December 31, 2010
Total Revenues. We had total revenues of $6,272,918 and $5,907,899 for the years ended December 31, 2011 and 2010, respectively. The increase in total revenue was $365,019 for the year ended December 31, 2011, representing a 6.2% increase compared to the total revenue for the year ended December 31, 2010. The increase in revenue was primarily due to increases in software-as-a-service and consulting for 2011. Of the $6,272,918 and $5,907,899 total revenues for the years ended December 31, 2011 and 2010, respectively, $6,136,842 and $5,840,955 of such amounts were related to the business operations of NOW Solutions, a wholly-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 decrease in license and software revenue from 2010 to 2011 was $99,648, which was due to decreased sales of licensing our PRHR software in 2011 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 $23,979 or 0.5% from the year ended December 31, 2010 to the same period in 2011. The slight revenue decrease was due to non-renewal of one customer account combined with one customer moving to our SaaS model, which was somewhat offset by contractual price increases on existing customer accounts.
Consulting revenue for the year ended December 31, 2011 increased by $115,636 from the same period in the prior year, representing a 18.5% increase. This increase was due to a one-time adjustment for unamortized service fees.
Cloud-based revenue increased $368,614 or 141.1% for the year ended December 31, 2011 compared to the same period in 2010. The increase was due to several of our existing customers switching to a SaaS model in 2011 and the inclusion of SnAPPnet revenues for the entire year in 2011 compared to a partial year in 2010 (SnAPPnet was purchased in May 2010). This revenue stream is relatively new for us and, in order to increase this business, we continue to refine our marketing and sales approach for customers who may need this type of solution.
Other revenues, consisting primarily of reimbursable travel expenses and fees related to user conferences, increased by $4,396 or 3.1% for the year ended December 31, 2011 compared to the same period for 2010. The increase was mainly attributable to an increase in attendance fees for NOW Solutions’ user conference held in 2011 but not in 2010. User conferences for NOW Solutions’ clients are held approximately every other year, and the above increase was somewhat offset by lower reimbursable travel expenses for consultants in 2011 compared to 2010.
Cost of Revenues. We had direct costs associated with the above revenues of $1,752,587 for the year ended December 31, 2011 compared to $1,620,181 for the same period of 2010, representing an increase of $132,406 or 8.2%. These direct costs are primarily related to costs associated with providing customer support, professional services and the user conference. The cost increases included a one-time catch up adjustment for third party software license fees ($75,000), increased royalty fees on subsidiary revenue ($42,000), higher costs associated with the cloud-based revenue ($16,000), NOW Solutions’ user conference held in 2011 but not in 2010 ($49,000) offset by decreased customer and technical support costs ($35,000), and decreased commissions as a result of decreased sales to new customers ($19,000).
Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $4,147,060 and $4,541,294 for the years ended December 31, 2011 and 2010, respectively. The total selling, general and administrative expenses for the year ended December 31, 2011 decreased by $394,234 compared to the selling, general and administrative expenses for the year ended December 31, 2010, representing approximately an 8.7% decrease. The decrease was primarily due to a decrease in consulting fees for software developers and other consultants ($267,000), legal fees ($9,000), employee expenses ($25,000), travel ($20,000), tax penalties ($41,000), audit fees ($11,000) and late charges ($35,000). Of the SG&A expenses for the year ended December 31, 2011, approximately $584,000 represented business development expenses for initiatives being undertaken through VHS, Priority Time and SnAPPnet.
Bad Debt Expense. We had bad debt expense of $14,646 for 2011 compared to bad debt recoveries of $10,114 in 2010. The 2011 expense was related to one customer and the 2010 recoveries were due to the collection of receivables from previous years that were originally considered doubtful.
Gain on Settlement of Liabilities. For the year ended December 31, 2011, there was a $48,532 gain on settlement of liabilities related to trade payables that had exceeded the statute of limitations. For 2010, there was a $517,532 gain on settlement of trade payables, notes payable and deferred compensation that had exceeded the statute of limitations.
Operating Income. We had operating income of $338,944 for the year ended December 31, 2011 compared to $222,902 for the year ended December 31, 2010, a difference of $116,042. Excluding the impact of the gain on settlement of liabilities for 2011 and 2010, we would have reported operating income of $290,412 and an operating loss of $294,904 for 2011 and 2010, respectively. The $585,316 increase from 2011 to 2010 is primarily a result of higher revenues in SaaS for 2011 and a reduction in selling, general and administrative costs.
Gain 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 $6,550 for the year ended December 31, 2011 compared to $97,074 for the year ended December 31, 2010. The change of $90,524 was a result of the elimination of part of the derivative liability in 2010 and a slight decrease in the Company’s stock price from 2010 to 2011.
Interest Expense. We had interest expense of $513,098 and $569,540 for the years ended December 31, 2011 and 2010, respectively. Interest expense decreased for the year ended December 31, 2011 by $56,442, representing a decrease of 9.9%, compared to interest expense for the year ended December 31, 2010. The decrease was a result of a 2011 adjustment to write back overaccrued interest from previous years.
Interest Income. Interest income for the year ended December 31, 2011 was $16 compared to $4,400 for the year ended December 31, 2010. Interest income for 2010 was related to interest on a note receivable from a former contractor.
Net Loss. We had a net loss of $167,588 for the year ended December 31, 2011 compared to $245,164 for the year ended December 31, 2010. The net loss for 2011 was primarily due to operating income of $338,944, reduced by interest expense of $513,098. The net loss for 2010 was primarily due to operating income of $222,902 reduced by interest expense of $569,540.
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, 2011 and 2010, 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 2011 or 2010.
Net Loss Applicable to Common Stockholders. We had net loss attributed to common stockholders of $654,577 and $738,316 for the years ended December 31, 2011 and 2010, respectively. Net loss applicable to common stockholders for the year ended December 31, 2011 decreased by $83,739 compared to December 31, 2010. The decrease in the net income 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, 2011 and 2010, respectively.
Financial Condition, Liquidity, Capital Resources and Recent Developments
At December 31, 2011, we had non-restricted cash-on-hand of $132,452 compared to $272,970 at December 31, 2010.
Net cash provided by operating activities for the year ended December 31, 2011 was $188,221 compared to $329,110 for the year ended December 31, 2010. We collected cash from our customers totaling $6,730,823, short and long term borrowings of $103,500 and other miscellaneous cash receipts of $34,788. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $3,950,658, attorney fees of $98,955, professional fees and third party consultants of $435,796, interest expense of $485,045, taxes (including sales tax and VAT) of $462,190, and other regular trade payables of $1,576,985.
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 2011 our deferred maintenance revenue (a liability) decreased slightly from $2,568,847 to $2,549,718.
Our accounts receivable decreased from $565,367 at December 31, 2010 to $412,293 at December 31, 2011 (net of allowance for bad debts). The decrease in receivables of $153,074 was due to increased collection efforts on our software maintenance clients before year-end.
Accounts payable and accrued liabilities decreased from $6,774,923 at December 31, 2010 to $6,566,970 at December 31, 2011. The decrease of $207,953 was net of $48,532 of trade payables which were written off based on the statute of limitations and $364,679 from the conversion of accounts payable and accrued liabilities to long-term debt. The balance in accounts payable and accrued liabilities is approximately 16 times the balance in accounts receivable. This was 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.
Net cash used in investing activities for the year ended December 31, 2011 was $327,005, consisting of the purchase of equipment and software of $31,086 and the development of software products of $295,919.
Net cash used in financing activities for the year ended December 31, 2011 was $16,518, consisting of borrowings on notes payable of $88,000, borrowings on related party debt of $15,500 and a decrease in bank overdraft of $43,339. This was offset by repayments of notes payable of $10,000 and payments of related party debt of $66,679.
The total change in cash and cash equivalents for the year ended December 31, 2011 when compared to the year ended December 31, 2010 was a decrease of $140,518.
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, 2011, 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 $167,588 and $245,164 for the years ended December 31, 2011 and 2010, respectively, and have historically incurred losses. In addition, we had a working capital deficit of approximately $9.7 million at December 31, 2011. 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.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
None.
Item 8.
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, 2011 and 2010, which are attached to this Report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, principally our chief financial officer and chief executive officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our management concluded that our disclosure controls and procedures as of the end of the period covered by this report were not effective such that the information required to be disclosed by us in reports filed under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding disclosure. In particular, we have identified the following material weakness of our internal controls:
-There is an over-reliance upon independent financial reporting consultants for review of critical accounting areas and disclosures and material non-standard transactions.
-There is a lack of sufficient accounting staff due to the size of the Company which results in a lack of segregation of duties necessary for a good system of internal control.
Management’s Annual Report on Internal Control over Financial Reporting
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, 2011. 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, 2011:
There is an absence of adequate segregation of duties relating to oversight and management of our systems. This resulted primarily from the fact that certain parts of the work of our chief financial officer are not monitored or reviewed. 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:
oAlthough we implemented a new accounting system effective January 1, 2009 that allows for the consolidation of the various entities in Vertical Computer Systems along with the translation from local currency to reporting currency, the system needs to be refined in order to perform currency translations accurately. As a result, we continue to performing our consolidation and currency translations manually. This will be remediated once funds become available to effectively implement needed system changes.
oImproving the control and oversight of the duties relating to the systems we use in the evaluation and processing of certain accounts and areas in the posting and recording of journal entries into certain accounts (in which material weaknesses have been identified as described above). This improvement should include reviews by management of the accounting processes as well as a reorganization of some of the accounting functions. In January 2010, we contracted with a consulting firm to assess our internal controls over financial reporting and propose improvements that can be implemented given our size and number of employees. The company has not yet implemented these improvements in their entirety as of the filing of this report due to employee turnover and resource limitations.
oImproving the segregation of duties relating to the processing of accounts and the recording of journal entries into certain accounts. The company has recently increased the size of its accounting staff which will allow for needed segregation of duties within the organization. As of the date of this report, the company is evaluating and reorganizing the duties of its accounting staff in order to address this internal control weakness.
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, 2011, 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:
oWe have implemented a new accounting system effective January 1, 2009 that allows for the consolidation of the various entities in Vertical Computer Systems along with the translation from local currency to reporting currency. Although the system eliminates many of the manual steps in translation and consolidation, many of the steps continue to be manual. This system also allows for some automation for recording software maintenance revenue and the recording of the deferred revenue liability account. This automation improves the accuracy of these accounts and is no longer considered a material weakness.
oImproving the control and oversight of the duties relating to the systems we use in the evaluation and processing of certain accounts and areas in the posting and recording of journal entries into certain accounts (in which material weaknesses have been identified as described above). This improvement should include reviews by management of the accounting processes as well as a reorganization of some of the accounting functions. In January 2010, we contracted with a consulting firm to assess our internal controls over financial reporting and propose improvements that can be implemented given our size and number of employees.
oImproving the segregation of duties relating to the processing of accounts and the recording of journal entries into certain accounts. This improvement is expected to come based on recommendations from the consulting firm assessing our internal controls over financial reporting.
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.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Our present directors and executive officers are as follows:
Name
Age
Position
Tenure
Richard S. Wade
President, Chief Executive Officer and Director
11 years
William K. Mills
Secretary and Director
11 years
Freddy Holder
Chief Financial Officer
1 year
Richard S. Wade, President, Chief Executive 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, 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.
Freddy Holder, Chief Financial Officer of VCSY and NOW Solutions
Mr. Holder has experience spanning all aspects of finance and accounting. He started his career with the accounting firm of Ernst and Young and has worked for both large and small multi-national public and private companies in the software, retail and services industries. Most recently, Mr. Holder was Director of Consulting for Sirius Solutions, LLLP, where he was responsible for the finance and accounting practice of the company’s North Texas region. Prior to that, he served as the Managing Director and International Controller for FedEx Office, where he directed all international finance operations and financial control management of eight countries outside the United States. Mr. Holder also served as Director of Accounting for Software Spectrum, where he was responsible for all North American accounting operations and worldwide financial reporting for this Fortune 1,000 publicly held software reseller. Previous experience also includes the position of Corporate Controller for US Data Corporation, a publicly held software development company. Mr. Holder has held a CPA license in the state of Texas since 1989 and received his degree from the University of Texas at Dallas.
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.
Significant Employees of NOW Solutions, Inc.
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.
Dorothy Spotts, Vice President of Services and Support
Ms. Spotts joined Ross Systems in April 1991 as a Support Analyst in the Customer Support Department progressing to Operations Manager. Subsequently, she attained the position of Manager of Integration Services in September 1997. In March 1999, she was promoted to Director of Integration Services and then became Director of Professional Services in July 2000. Ms. Spotts’ responsibilities include the overall management of Application Consulting, Integration Services and Customer Support. Ms. Spotts graduated with a BBA from the University of Texas at Austin.
Laurent Tetard, Executive Vice President of International Operations
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.
Robert Sterpin, Vice President of Sales, Canada & U.S. Midwest
Mr. Sterpin joined NOW Solutions in 2003. He has a varied background in sales and sales management starting his career with DEC (HP) and working for several major corporations such as IBM and Cincom Systems. Mr. Sterpin spent almost 5 years at Ross Systems where he was Vice President Canada and the U.S. Midwest for their ERP software product suite. Prior to joining NOW Solutions, he was Vice President Sales & Marketing for a systems integration/ consulting firm. Mr. Sterpin majored in Science at the University of Toronto.
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. This Code of Ethics was originally filed as an exhibit to the Form 10-KSB filed for the year ended December 31, 2003 and was updated in January 2008 with the new address of our corporate headquarters. 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, 2011. 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.
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, 2011 and 2010 to our highest paid executive officers and employees, who were employed by us during 2011. 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 the last two fiscal years:
No stock options were exercised by the named executive officers during the fiscal year ended December 31, 2011 or 2010.
(1)Mr. Wade deferred $881,688 of salary earned during the period from 2002 through 2008, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For more details, please refer to Note 4 of the Notes to the Consolidated Financial Statements.
(2)Mr. Braun served as our Chief Financial Officer, through September 30, 2010. Mr. Braun provided consulting services to us in exchange for remuneration in 2011.
(3)Mr. Holder began to serve as our Chief Financial Officer on December 6, 2010. In December 2010, we issued 600,000 shares of VCSY common stock to Mr. Holder pursuant to a restricted stock agreement whereby the shares vest in equal installments over a three year period. Of these shares, 200,000 had vested at December 31, 2011.
(4)Mr. Valdetaro deferred $467,071 of salary earned during the period from 2002 through 2007, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For more details, please refer to Note 4 of the Notes to the Consolidated Financial Statements.
(5)Mr. Salz deferred $185,914 of salary earned during the period from 2001 through 2004, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For more details, please refer to Note 4 of the Notes to the Consolidated Financial Statements.
(6)In 2010, the board of directors declared bonuses of $171,344 to be paid to certain executives and employees. The bonus amount was based primarily on 2009 operating results and the allocation of amounts has not yet been determined. This amount was accrued for the year ended December 31, 2011.
Narrative Disclosure to Summary Compensation Table
Compensation for our key executives is comprised of three main components: base salary, annual performance-based cash bonus and long-term equity awards. We do not target a specific weighting of these three components or use a prescribed formula to establish pay levels. Rather, the board of directors considers changes in the business, external market factors and our financial position each year when determining pay levels and allocating between long-term and current compensation for the named executive officers.
Cash compensation is comprised of base salary and an annual performance-based cash bonus opportunity. The board of directors generally seeks to set a named executive officer’s targeted total cash compensation opportunity within a range that is the average of the applicable peer company and/or general industry compensation survey data, adjusted as appropriate for individual performance and internal pay equity and labor market conditions.
Where we have included an equity component as part of our compensation package, we do so because we believe that equity-based compensation aligns the long-term interests of our named executive officers with those of stockholders.
These cash and equity compensation components of pay are supplemented by various benefit plans that provide health benefits, which are substantially the same as the benefits provided to all of our U.S. based employees. The Company also provides life, accident, and disability voluntary benefit plans, which are plans where employees generally make most or all of the contributions toward the respective benefit plan.
Employment Agreements with Executive Officers
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. Mr. Wade is also entitled to an annual bonus from a bonus pool for executives equal to 5% of our taxable income (without deduction for depreciation). Mr. Wade’s share of the bonus pool is equal to the percentage of his annual base compensation to the total of the combined annual base compensation of all executives in the pool. 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 December 2010, we executed an employment agreement with Freddy Holder pursuant to which Mr. Holder serves as Chief Financial Officer of the Company and its subsidiaries. The initial term of the agreement is 2 years and renews on annual basis unless terminated by either party. Under the agreement, Mr. Holder receives an annual base salary of $160,000. Mr. Holder is also 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. Mr. Holder’s share of the bonus pool is equal to the percentage of his annual base compensation to the total of the combined annual base compensation of all executives in the pool. In the event the employment agreement is terminated by Mr. Holder’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. Holder would receive base compensation for no less than six months of the remainder of the employment term. Mr. Holder 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 and Mr. Holder entered into a restricted stock agreement, whereby the Company issued Mr. Holder 600,000 shares of its common stock at a fair market value of $18,600. These shares vest over three years on the anniversary date of the restricted stock agreement in equal installments. Of these 600,000 shares, 200,000 had vested at December 31, 2011.
Outstanding Equity Awards
The below table shows information of outstanding equity awards of the named officers at the end of 2011:
(1)Pursuant to a restricted stock agreement with the Company, Mr. Holder, the CFO of the Company, was issued 600,000 unregistered shares of VCSY common stock (at a fair market value of $18,600 in December 2010, based upon the total number of shares issued and the share price on the date of the issuance), vesting over three years in three equal installments, of which 200,000 shares had vested at December 31, 2011.
Narrative Disclosure to Outstanding Equity Awards at Fiscal Year End Table
Stock Option Plan. The Stock Option Plan expired in 2009. We issued no stock options or warrants to any employees or to any other parties in 2011 and do not have any stock options outstanding.
Stock Awards. The common stock issued to Mr. Holder has been issued on the same terms as the stock issued to other employees of the Company and its subsidiaries. The 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.
For further information regarding securities authorized for issuance under Equity Compensation Plans, and the equity compensation plan information table, please see Part II, “Item 5: Market for Common Equity and Related Stockholder Matters.”
Director Compensation
The below table provides compensation for all non-employee directors in 2011:
DIRECTOR COMPENSATION
Narrative Disclosure to Director Compensation Table
Non-employee directors are entitled to receive $2,500 per month in 2011 and 2010.
Item 12.
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 March 30, 2012, 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 999,135,151 shares of common stock outstanding as of March 30, 2012, together with options, warrants or other securities convertible or exchangeable by the beneficial owners into shares of common stock within 60 days of March 30, 2012.
*	Less than 1%.
1)The address of each director and officer is c/o Vertical Computer Systems, Inc., 101 West Renner Road, Suite 300, Richardson, TX 75082.
(2)Includes 88,870,050 shares owned by MRC, a corporation controlled by the W5 Family Trust, of which Richard W. Wade is a trustee. MRC pledged 10,000,000 shares of VCSY common stock as collateral on a $25,000 note issued in August 2002. MRC pledged 4,000,000 and 3,000,000 shares of VCSY common stock as collateral on a $60,000 note and a $40,000 note, respectively, that were issued by us in November 2003. MRC pledged 5,000,000 shares of VCSY common stock as collateral on a $200,000 note issued in October 2006 to Mr. Weber. Also in October 2006, MRC pledged 5,000,000 shares of VCSY common stock as collateral on a $215,000 note issued by NOW Solutions to us and assigned to Mr. Weber in October 2005. MRC pledged 10,000,000 shares of VCSY common stock as collateral on a $300,000 note issued in March 2007 to Mr. Weber and as collateral on the interest payments due under the $200,000 note issued in October 2006. MRC pledged 3,000,000 shares of VCSY common stock as collateral on a $96,946 note issued in February 2008 to a third party lender. In November 2008, the lender sold 1,500,000 shares for $118,167, of which $103,555 was applied to outstanding debt claimed by the lender including interest, penalties & attorney’s fees and the remaining $14,612 was returned to MRC representing the amount of shares oversold by the lender. Of the 1,500,000 shares sold by the lender, we are currently obligated to reimburse MRC with 1,309,983 common shares. MRC pledged 16,976,296 shares of VCSY common stock in connection with a $150,000 loan to NOW Solutions by a third party lender in November 2009 In March 2010, the Company and MRC entered into an amendment of the Indemnity and Reimbursement Agreement whereby the obligation to reimburse MRC with 10,000,000 shares of VCSY common stock that were loaned to the Company in March 2008 was cancelled in exchange for the Company’s transfer of 300,000 shares VHS Series A Preferred Stock owned by the Company to MRC. For more details on this transaction, please refer to Note 4 of the Notes to the Consolidated Financial Statements. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, our President and CEO, is the trustee of the W5 Family Trust.
3)Includes 250,000 shares of VCSY common stock issued in February 2008 by us to Mr. Mills pursuant to a restricted stock agreement in connection with services as a director and officer of the Company. All of these shares vested in 2009.
.
(4)Includes 600,000 shares of VCSY common stock we issued in December 2010 to Mr. Holder pursuant to a restricted stock agreement in connection with services as an officer of the Company, of which 200,000 shares had vested at December 31, 2011.
Item 13.
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 December 2009, we entered into a settlement agreement and stipulated judgment with Parker, Shumaker & Mills, L.L.P. (“PSM”) in connection with a lawsuit filed in August 2009, whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. During 2011, the Company made payments of $28,140 toward the outstanding balance of the judgment amount leaving a balance of $5,066 at December 31, 2011. Bill Mills is a Director of the Company and a partner of PSM, which was formerly known as Parker Mills, LLP.
In January 2010, the Company and MRC amended the Indemnity and Reimbursement Agreement whereby the Company agreed to reimburse and indemnify MRC for 16,976,296 shares pledged in November 2009 as collateral in connection with a $150,000 note. Also in January 2010, the Company entered into an amendment of the Indemnity and Reimbursement Agreement with MRC. Pursuant to this amendment, and in consideration of the pledge by MRC, the Company agreed to pay MRC a fee as follows: (i) $3,000 for the first year of the term of the note and (ii) 2% of the unpaid principal balance of the note for each succeeding year during the term of the note. 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 March 2010, the Company further amended the Indemnity and Reimbursement Agreement with MRC. Pursuant to this amendment, MRC received 300,000 shares of the Series A Convertible Preferred Stock of VHS in exchange for the cancellation of the Company’s obligation to issue 10,000,000 shares of common stock of the Company to MRC. 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 March 2010, the Company transferred 610,000 shares of Series A Convertible Preferred Stock of VHS to Mr. Robert Farias in exchange for the following: (a) an irrevocable waiver by Mr. Farias of the conversion rights in respect of 37,500 shares of the Company’s Series “C” 4% Cumulative Convertible Preferred Stock owned by Mr. Farias; (b) cancellation by Mr. Farias of $100,000 of debt owed by the Company to Mr. Farias; and (c) cancellation by Mr. Farias of three separate common stock purchase warrants held by Mr. Farias, exercisable for an aggregate of 15,000,000 shares of common stock of the Company. As a consequence of the waiver of conversion rights and the cancellation of warrants, the Company was no longer obligated to issue up to 30,000,000 shares of its common stock. Mr. Farias serves as our Executive Vice-President of Business Development.
In March 2010, the Company issued 90,000 shares of VHS Series A Preferred Stock to its Chief Technology Officer, Luiz Valdetaro, in exchange for the cancellation of an obligation to issue Mr. Valdetaro 3,000,000 shares of the common stock of the Company.
In July 2010, we entered into an agreement with certain former and current employees of the Company, concerning the deferral of payroll claims which have a balance of $1,689,558 at December 31, 2011. The claims are for salary earned from 2001 to 2008, which remains unpaid and is reflected as a current liability on the Company’s consolidated financial statements.
Pursuant to the terms of the agreement, each current and former employee who is a party to the agreement (the “Employee”) agreed to continue the deferral of salary (“Salary Deferral”) for a period of one year following the date of the agreement. In consideration for the Salary Deferral, the Company agreed to pay each Employee a sum equal to the amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which such salary was earned, plus nine percent interest, compounded annually until such time as the unpaid salary has been paid in full. The interest will only be paid from amounts anticipated to be paid to the Company in respect of specified intellectual property assets of the Company.
In order to effect the payments due under the agreement, the Company assigned to the Employees a twenty percent interest in any net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629 (plus any continuation patents), (b) U.S. patent #7,076,521 in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent application titled “Method and System for Providing a Framework for Processing Markup Language Documents.”
In July and August 2010, we entered into agreements with an employee to borrow $48,000 on a short-term basis at 10% interest. As of December 31, 2011, we have made payment of $6,000 on this debt.
On January 18, 2011, the Company and Microidea Software Development, LLC (“Microidea”) entered into a license agreement whereby Microidea granted an exclusive license of a 17 year-old software known as “Tiny Web Server” to the Company for an initial term of thirty years with three twenty year renewal terms in consideration of a 5% royalty. During the term of the license agreement, the Company also has the right to purchase the technology for $6 million, payable in four installments of $1.5 million over a 3 year period. The President of Microidea is Mr. Luiz Valdetaro, who also serves as our Chief Technology Officer.
In July 2011, the Company and Robert Farias 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. The amended payment terms for the notes consist of monthly interest only payments through 2012 with interest and principal payments of $5,000 to be allocated between the notes commencing January 31, 2013 until the notes are fully paid. Also in February 2012, NOW Solutions granted Mr. Farias a 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. This security interest is junior to the presented indebtedness of NOW Solutions to Tara Financial Services, Inc. and Lakeshore Investment, LLC. Mr. Farias serves as our Executive Vice-President of Business Development.
In November 2011, NOW Solutions and Mr. Wade entered into an agreement concerning a personal guaranty made by Mr. Wade to induce a third party to enter into a staff services agreement. Pursuant to the agreement, NOW Solutions shall reimburse Mr. Wade for any costs or expenses incurred by Mr. Wade in connection with the guaranty with respect to certain obligations of NOW Solutions under the staff services agreement. Mr. Wade is the Chairman of NOW Solutions and the President and CEO of the Company.
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.
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 $88,000 and $128,900 for the audit of our annual financial statements for 2011 and 2010, 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 2011 and 2010. The aggregate fees billed in the fiscal years ended 2011 and 2010 for professional services rendered by Hartman, Leito, and Bolt, LLP for tax advice, tax planning and tax return preparation were $15,915 and $18,195. Dickstein Shapiro Moran & Oshinsky LLP billed $0 and $2,953 and for tax advice and tax planning for the years ended 2011 and 2010, respectively.
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 2011 and 2010.
PART IV
Item 15.
Item 15. Exhibits And Financial Statement Schedules
The following documents are filed as part of this report:
(a)Exhibits:
Exhibit No.
Description
Location
2.1
Certificate of Ownership and Merger Merging Scientific Fuel Technology, Inc. into Vertical Computer Systems, Inc.
Incorporated by reference to Exhibit 2.1 to the Company’s Form 10-K filed on April 15, 2011
3.1
Original Unamended Certificate of Incorporation of Vertical Computer Systems, Inc. (f/k/a Xenogen Technology, Inc.)
Incorporated by reference to Exhibit 3.1 to the Company’s Form 10-K filed on April 15, 2011
3.2
Certificate of Amendment of Certificate of Incorporation (change name to Vertical Computer Systems, Inc.)
Incorporated by reference to Exhibit 3.2 to the Company’s Form 10-K filed on April 15, 2011
3.3
Certificate of Amendment of Certificate of Incorporation (2000)
Incorporated by reference to Exhibit 3.3 to the Company's Form 10-K filed on April 15, 2011
3.4
Amended and Restated By-Laws of the Company
Incorporated by reference to Exhibit 3.4 to the Company's Form 10-K filed on April 15, 2011
4.1
Certificate of Designation of 4% Cumulative Redeemable Series A Preferred Stock
Incorporated by reference to Exhibit 4.1 to the Company's Form 10-K filed on April 15, 2011
4.2
Certificate of Designation of 10% Cumulative Redeemable Series B Preferred Stock
Incorporated by reference to Exhibit 4.2 to the Company's Form 10-K filed on April 15, 2011
4.3
Certificate of Designation of 4% Cumulative Redeemable Series C Preferred Stock
Incorporated by reference to Exhibit 4.3 to the Company's Form 10-K filed on April 15, 2011
4.4
Certificate of Designation of 15% Cumulative Redeemable Series D Preferred Stock
Incorporated by reference to Exhibit 4.4 to the Company's Form 10-K filed on April 15, 2011
4.5
Form of Restricted Stock Agreement
Incorporated by reference to Exhibit 4.5 to the Company's Form 10-K filed on April 15, 2011
10.1
Form of Debenture
Incorporated by reference to Exhibit 10.1 to the Company's Form 10-K filed on April 15, 2011
10.2
Employment Agreement between the Company and Richard Wade
Incorporated by reference to Exhibit 10.2 to the Company's Form 10-K filed on April 15, 2011
10.3
Secured Term Promissory Note in the principal amount of $359,559.90, payable by NOW Solutions to Tara Financial Services, Inc.
Incorporated by reference to Exhibit 10.7 to the Company's Form 10-K filed on April 15, 2011
10.4
Secured Term Promissory Note in the principal amount of $438,795.31, payable by the Company to Tara Financial Services, Inc.
Incorporated by reference to Exhibit 10.8 to the Company's Form 10-K filed on April 15, 2011;
10.5
Secured Term Promissory Note in the principal amount of $955,103.30, payable by NOW Solutions to Tara Financial Services, Inc.
Incorporated by reference to Exhibit 10.9 to the Company's Form 10-K filed on April 15, 2011
10.6
Employment Agreement between the Company and Freddy Holder
Incorporated by reference to Exhibit 10.11 to the Company's Form 10-K filed on April 15, 2011
Exhibit No.
Description
Location
10.7
License Agreement between the Company and Microidea Software Development, LLC.
Incorporated by reference to Exhibit 10.12 to the Company's Form 10-K filed on April 15, 2011
14.1
Code of Ethics
Incorporated by reference to Exhibit 14.1 to the Company's Form 10-K filed on April 15, 2011
21.1
Subsidiaries of the Company
Incorporated by reference to Exhibit 21.1 to the Company's Form 10-K filed on April 15, 2011
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated March 30, 2012
Provided herewith
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated March 30, 2012
Provided herewith
32.1
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated March 30, 2012
Provided herewith
32.2
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated March 30, 2012
Provided herewith
101.INS*
XBRL Instance Document
Provided herewith
101.SCH*
XBRL Taxonomy Extension Schema Document
Provided herewith
101.LAB*
XBRL Taxonomy Extension Label Document
Provided herewith
101.PR*
XBRL Taxonomy Extension Presentation Document
Provided herewith
101.DEF*
XBRL Taxonomy Extension Definition Document
Provided herewith
* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
SIGNATURES
Pursuant to the requirements of 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, 2011 and 2010 and the related consolidated statements of operations, 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 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, 2011 and 2010 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 Vertical Computer Systems, Inc. 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
March 30, 2012
VERTICAL COMPUTER SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
VERTICAL COMPUTER SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
VERTICAL COMPUTER SYSTEMS, INC.
STATEMENTS OF CONSOLIDATED STOCKHOLDERS’ DEFICIT
YEARS ENDED DECEMBER 31, 2011 AND 2010
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 wholly subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable), EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. (“PMI”) and Vertical Internet Solutions (“VIS”), all of which are inactive; Vertical Healthcare Solutions (“VHS”), OptVision Research, Inc. (“OVR”), Taladin, Inc. (“Taladin”), Government Internet Systems, Inc. (“GIS”), a 84.5% owned subsidiary, SnAPPnet, Inc. (“SnAPPnet”), Priority Time Systems, Inc. (“Priority Time) a 90% owned subsidiary, all entities with minor activities and NOW Solutions, Inc. (“NOW Solutions”). To date, we have generated revenues primarily from software licenses, software as a service, consulting fees and maintenance agreements from NOW Solutions, our 100% owned subsidiary, 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.
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 2011 and 2010, there was no impairment of long-lived assets due to the minimal value of such 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.
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 $12,483 and $16,700 as of December 31, 2011 and 2010, 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, 2011 and 2010.
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:
As of December 31, 2011 and 2010, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability totaling 30,681,957 were not included in the denominators of the diluted earnings per share as their effect would be anti-dilutive.
Fair Value of Financial Instruments
For certain of our financial instruments, including cash and cash equivalents, accounts receivable and accrued expenses, the carrying amounts approximate fair value due to the short maturity of these instruments. The carrying value of our long-term debt approximates its fair value based on the quoted market prices for the same or similar issues or the current rates offered to us for debt of the same remaining maturities. See Note 5 - Derivative instruments and fair value measurements for additional information.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenue and expenses during the reporting period. Among the more significant estimates included in these financial statements are the estimated allowance for doubtful accounts receivable, valuation allowance for deferred tax assets, impairment of long-lived assets and intangible and the valuation of warrants and restricted stock grants. Actual results could materially differ from those estimates.
Cash Reimbursements
We record reimbursement by our customers for out-of-pocket expense as part of consulting services revenue in accordance with the guidance related to income statement characterization of reimbursements received for out of pocket expense incurred.
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.
Reclassifications
Certain reclassifications have been made to the prior periods to conform to the current period presentation.
Note 2. Going Concern Uncertainty
The accompanying consolidated financial statements for 2011 and 2010 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 consolidated financial statements do not purport to represent realizable or settlement values. As of December 31, 2011, we had negative working capital of approximately $9.7 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. 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.
Note 3. Acquisitions
SnAPPnet
On May 21, 2010, our newly formed subsidiary, SnAPPnet, Inc., a Texas corporation, 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. The Company intends 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.
The fair value of consideration transferred in the acquisition, the assets acquired and the liabilities assumed are set forth in the following table:
(1)No value has been assigned to the Series B Convertible Preferred Stock of VHS, since VHS is deemed a development stage company with no assets, liabilities or operations at the time of the transaction. Also, it is a wholly-owned subsidiary of Vertical Computer Systems, Inc. and does not trade on any exchange independently of VCSY.
(2)The contingent consideration consists of a 5% royalty payment on sales of the SnAPPnet™ software application, and is payable to the members (equity owners) of Pelican, prorated to their respective ownership interests in Pelican. The royalty will expire 10 years following the closing date or the payment of $2.5 million, whichever occurs first.
The fair value of the contingent consideration was determined based on SnAPPnet™’s projected revenues for the next 5 years and the application of a discount rate to the future royalty payments. A probability factor was also applied to the different revenue assumptions used. At the end of each reporting period after the acquisition date, the contingent payment will be measured again to its fair value, with changes in fair value recorded in earnings.
(3)Fair values assigned to the contingent consideration as well as the assets acquired and liabilities assumed are provisional, pending receipt of a final valuation of the acquisition.
The pro forma results for the twelve months ended December 31, 2010, as though the Company had acquired SnAPPnet on the first day of the fiscal year 2010, are set forth below. The unaudited pro forma operating results are not necessarily indicative of what would have occurred had the transaction taken place on the first day of fiscal year 2010.
Note 4. Related Party 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 December 2009, we entered into a settlement agreement and stipulated judgment with Parker, Shumaker & Mills, L.L.P. (“PSM”) in connection with a lawsuit filed in August 2009, whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. During 2011, the Company made payments of $28,140 toward the outstanding balance of the judgment amount leaving a balance of $5,066 at December 31, 2011. Bill Mills is a Director of the Company and a partner of PSM, which was formerly known as Parker Mills, LLP.
In January 2010, the Company and MRC amended the Indemnity and Reimbursement Agreement whereby the Company agreed to reimburse and indemnify MRC for 16,976,296 shares pledged in November 2009 as collateral in connection with a $150,000 note. Also in January 2010, the Company entered into an amendment of the Indemnity and Reimbursement Agreement with MRC. Pursuant to this amendment, and in consideration of the pledge by MRC, the Company agreed to pay MRC a fee as follows: (i) $3,000 for the first year of the term of the note and (ii) 2% of the unpaid principal balance of the note for each succeeding year during the term of the note. 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 March 2010, the Company further amended the Indemnity and Reimbursement Agreement with MRC. Pursuant to this amendment, MRC received 300,000 shares of the Series A Convertible Preferred Stock of VHS in exchange for the cancellation of the Company’s obligation to issue 10,000,000 shares of common stock of the Company to MRC. 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 March 2010, the Company transferred 610,000 shares of Series A Convertible Preferred Stock of VHS to Mr. Robert Farias in exchange for the following: (a) an irrevocable waiver by Mr. Farias of the conversion rights in respect of 37,500 shares of the Company’s Series “C” 4% Cumulative Convertible Preferred Stock owned by Mr. Farias; (b) cancellation by Mr. Farias of $100,000 of debt owed by the Company to Mr. Farias; and (c) cancellation by Mr. Farias of three separate common stock purchase warrants held by Mr. Farias, exercisable for an aggregate of 15,000,000 shares of common stock of the Company. As a consequence of the waiver of conversion rights and the cancellation of warrants, the Company was no longer obligated to issue up to 30,000,000 shares of its common stock. Mr. Farias serves as our Executive Vice-President of Business Development.
In March 2010, the Company issued 90,000 shares of VHS Series A Preferred Stock to its Chief Technology Officer, Luiz Valdetaro, in exchange for the cancellation of an obligation to issue Mr. Valdetaro 3,000,000 shares of the common stock of the Company.
In July 2010, we entered into an agreement with certain former and current employees of the Company, concerning the deferral of payroll claims which have a balance of $1,689,558 at December 31, 2011. The claims are for salary earned from 2001 to 2008, which remains unpaid and is reflected as a current liability on the Company’s consolidated financial statements.
Pursuant to the terms of the agreement, each current and former employee who is a party to the agreement (the “Employee”) agreed to continue the deferral of salary (“Salary Deferral”) for a period of one year following the date of the agreement. In consideration for the Salary Deferral, the Company agreed to pay each Employee a sum equal to the amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which such salary was earned, plus nine percent interest, compounded annually until such time as the unpaid salary has been paid in full. The interest will only be paid from amounts anticipated to be paid to the Company in respect of specified intellectual property assets of the Company.
In order to effect the payments due under the agreement, the Company assigned to the Employees a twenty percent interest in any net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629 (plus any continuation patents), (b) U.S. patent #7,076,521 in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent application titled “Method and System for Providing a Framework for Processing Markup Language Documents.”
In July and August 2010, we entered into agreements with an employee to borrow $48,000 on a short-term basis at 10% interest. As of December 31, 2011, we have made payment of $6,000 on this debt.
On January 18, 2011, the Company and Microidea Software Development, LLC (“Microidea”) entered into a license agreement whereby Microidea granted an exclusive license of a 17 year-old software known as “Tiny Web Server” to the Company for an initial term of thirty years with three twenty year renewal terms in consideration of a 5% royalty. During the term of the license agreement, the Company also has the right to purchase the technology for $6 million, payable in four installments of $1.5 million over a 3 year period. The President of Microidea is Mr. Luiz Valdetaro, who also serves as our Chief Technology Officer.
In July 2011, the Company and Robert Farias 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. The amended payment terms for the notes consist of monthly interest only payments through 2012 with interest and principal payments of $5,000 to be allocated between the notes commencing January 31, 2013 until the notes are fully paid. Also in February 2012, NOW Solutions granted Mr. Farias a 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. This security interest is junior to the presented indebtedness of NOW Solutions to Tara Financial Services, Inc. and Lakeshore Investment, LLC. Mr. Farias serves as our Executive Vice-President of Business Development.
In November 2011, NOW Solutions and Mr. Wade entered into an agreement concerning a personal guaranty made by Mr. Wade to induce a third party to enter into a staff services agreement. Pursuant to the agreement, NOW Solutions shall reimburse Mr. Wade for any costs or expenses incurred by Mr. Wade in connection with the guaranty with respect to certain obligations of NOW Solutions under the staff services agreement. Mr. Wade is the Chairman of NOW Solutions and the President and CEO of the Company.
For additional transactions involving related parties after December 31, 2011, please see “Subsequent Events” in Note 15.
Note 5. Derivative liabilities and fair value measurements
Derivative liabilities
During 2008, one of our officers pledged 3,000,000 shares of common stock (through a company he controls) to secure the debt owed to a third party lender. In connection with the pledge of stock, we signed an agreement to replace these shares within one year. Subsequent to this agreement, 1,309,983 shares of this stock were sold to satisfy the debt owed to the lender. This contractual commitment to replace all of the pledged shares was evaluated under FASB ASC 815-40, Derivatives and Hedging and was determined to have characteristics of a liability and therefore constituted a derivative liability under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At December 31, 2011 and December 31, 2010, the aggregate derivative liability was $24,235 and $30,785.
During 2007, two of our officers loaned a total of 13 million shares of unrestricted stock to the Company (see Note 4). This stock was used to satisfy certain obligations of the Company. In connection with the loans, the Company signed agreements to replace the shares within one year. These contractual commitments were evaluated under FASB ASC 815-40, Derivatives and Hedging and were determined to have characteristics of a liability and therefore derivative liabilities under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. In March 2010, these derivative liabilities were eliminated through the issuance of preferred stock in VHS as described above in Note 4.
During 2002 and 2003, we issued convertible debentures with conversion features based on the market value of the Company’s common stock at the date of conversion. The conversion features were evaluated under FASB ASC 815-40, Derivatives and Hedging and were determined to have characteristics of a liability and therefore a derivative liability under the above guidance. The conversion prices were variable which caused the Company to conclude it was possible at some point in the future to not have available the number of common shares required to share settle all common stock equivalent instruments. This in turn caused outstanding warrants and all other convertible debt to also be classified as derivative liabilities. Each reporting period, these derivative liabilities are marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. In March 2010, the derivative liability associated with the outstanding warrants was eliminated through the issuance of preferred stock in VHS as described in Note 4 above. At December 31, 2010, the Company wrote-off the $10,000 debenture for which the statute of limitations had been exceeded and no legal liability exists.
At December 31, 2011 and 2010, the aggregate derivative liability was $24,235 and $30,785, respectively. The aggregate gain on the change in the fair value of derivative liabilities was $6,550 and $97,074 for the years ended December 31, 2011 and 2010, respectively.
The valuation of our remaining embedded derivatives is determined by using the VCSY stock price at December 31, 2011 and 2010. As such, our derivative liabilities have been classified as Level 1.
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 December 31, 2011 and 2010:
Note 6. Property and Equipment
Property and equipment consist of the following as of December 31, 2011 and 2010:
Depreciation expense for 2011 and 2010 was $22,432 and $20,943, respectively.
Note 7. Intangible Assets
Intangible assets consisted of the following as of December 31, 2011 and 2010:
Amortization expense for 2011 and 2010 was $45,781 and $30,499, respectively.
Note 8. Accounts Payable and Accrued Expenses
Accounts payable and accrued liabilities consist of the following:
Accrued payroll primarily consists of deferred compensation for several executives who agreed to defer a portion of their salaries due to cash flow constraints. Accrued liabilities - other primarily consists of accrued rent, board of director fees, unbilled professional and consulting fees, and other accrued expenses. Accrued payroll tax and penalties relate to unpaid payroll taxes, interest and penalties for prior years for non-functioning subsidiaries and employer payroll taxes on accrued payroll. Accrued taxes primarily consist of unpaid sales and use taxes, VAT and other accrued taxes.
Note 9. Notes Payable and Convertible Debts
The total amortization expense recorded on the debt discounts during the years ended December 31, 2011 and 2010 was $16,354.
Certain notes payable in the aggregate principal amount of $2,383,754 also contain provisions requiring additional principal reductions in the event sales by NOW Solutions exceed certain financial thresholds or the Company receives proceeds from infringement claims regarding U.S. patent #6,826,744 and U.S. patent #7,716,629.
Future minimum payments for the next five years are as follows:
Convertible Debentures
Convertible debentures consist of the following:
For additional transactions involving notes payable after December 31, 2011, please see “Subsequent Events” in Note 15.
Note 10. Income Taxes
We account for income taxes using the asset and liability method of accounting for income taxes. Deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rate applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities and result primarily form differences in methods used to amortize intangible assets. A valuation allowance is provided when management cannot determine whether it is more likely than not that the deferred tax asset will be realized. The effect on deferred income taxes of the change in tax rates is recognized in income in the period that includes the enactment date. The difference between the statutory tax rate and the effective tax rate is the valuation allowance.
Temporary difference between the financial statement carrying amount and tax bases of assets and liabilities that give rise to deferred tax assets relate to the following:
At December 31, 2011 and December 31, 2010, we had available net operating loss carry-forwards of approximately $15.6 million. These net operating loss carry-forwards expire in varying amounts through 2030.
Note 11. Common and Preferred Stock
Terms of Common and Preferred Stock
Common Stock. The authorized capital stock of the Company consists of 1,000,000,000 shares of common stock, par value $0.00001 per share, of which 997,335,151 were issued and outstanding at December 31, 2011 and December 31, 2010. Each share of our common stock entitles the holder to one vote on each matter submitted to a vote of our stockholders, including the election of directors. There is no cumulative voting and there are no redemption or sinking fund provisions related to the common stock. Stockholders of our common stock have no preemptive, conversion or other subscription rights.
Series A Cumulative Convertible Preferred Stock. We have authorized the issuance of 250,000 shares of Series A 4% Cumulative Convertible Preferred Stock (“Series A Preferred Stock”), of which there are 48,500 shares outstanding at December 31, 2011 and 2010. Holders of these shares of Series A Preferred Stock are entitled to vote on an as-converted basis with the holders of common stock, except that the holders are entitled to vote as a separate class on any matters affecting the Series A Preferred Stock stockholders, on the sale of the business, the increase in the number of directors, the payment of a dividend on any junior stock, and the issuance of any stock that is on parity or senior to the Series A Preferred Stock. Each share of Series A Preferred Stock is entitled to 500 votes per share. Dividends accrue at an annual rate of 4% of the liquidation preference and are payable quarterly subject to the board’s discretion. Each share of Series A Preferred Stock is convertible into 500 shares of common stock of the Company. In the event of liquidation, each share of Series A Preferred Stock will be entitled to a preference of $200, plus accrued but unpaid dividends, prior to the holders of any junior class of stock.
Series B 10% Cumulative Convertible Preferred Stock. We have authorized the issuance of 375,000 shares of Series B 10% Cumulative Convertible Redeemable Preferred Stock (“Series B Preferred Stock”), of which there are 7,200 shares outstanding at December 31, 2011 and December 31, 2010. Holders of Series B Preferred Stock are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash or stock dividends accrue cumulatively at an annual rate of 10% per annum on March 15 and September 15 of each year and are payable subject to the board’s discretion. Each share of Series B Preferred Stock is convertible into 3.788 shares of common stock of the Company. The shares of Series B Preferred Stock are redeemable at a rate of $6.25 per share, or $45,000 if all outstanding shares are redeemed. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holders of any class of common stock.
Series C 4% Cumulative Convertible Preferred Stock. We have authorized the issuance of 200,000 shares of Series C 4% Cumulative Convertible Preferred Stock (“Series C Preferred Stock”), of which there are 50,000 shares outstanding at December 31, 2011 and December 31, 2010. Holders of Series C Preferred Stock are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash dividends accrue at an annual rate of 4% of the liquidation preference and are payable quarterly subject to the board’s discretion. Each share of Series C Preferred Stock is convertible into 400 shares of common stock of the Company; however , of the 50,000 shares of the Company’s Series “C” Cumulative Convertible Preferred Stock that are outstanding, the holder of 37,500 shares waived the conversion rights associated with these shares pursuant to an agreement in 2010. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holder of any class of common stock. In the event of liquidation, each share of Series C Preferred Stock will be entitled to a preference of $100, plus accrued but unpaid dividends, prior to the holders of any junior class of stock.
Series D 15% Cumulative Convertible Preferred Stock. We have authorized the issuance of 300,000 shares of Series D 15% Cumulative Convertible Redeemable Preferred Stock (“Series D Preferred Stock”), of which there were 25,000 shares outstanding at December 31, 2011 and December 31, 2010. Holders of these shares are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash dividends accrue cumulatively at an annual rate of 15% per annum on March 15 and September 15 of each year and are payable subject to the board’s discretion. Any aggregate deficiency shall be cumulative and shall be fully paid or set apart for payment before any dividend shall be paid or set apart for payment of any class of common stock. Each share of Series D Preferred Stock is convertible into 3.788 shares of common stock of the Company. The shares of Series D Preferred Stock are redeemable at a rate of $6.25 per share, or $156,250 if all outstanding shares are redeemed. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holders of any class of common stock.
Common Stock
During the year ended December 31, 2011, 200,000 shares of the Company’s common stock vested, resulting in stock compensation expense of $6,200. The stock compensation expense was accrued as a liability during 2011. The shares will be issued when the full 600,000 common shares are earned under the award. These shares were earned by an officer of the Company and NOW Solutions pursuant to a restricted stock agreement executed in 2010. As of December 31, 2011, there was $11,958 of total unrecognized compensation costs related to these stock awards.
Preferred Stock
Although no dividends have been declared, the cumulative total of preferred stock dividends due to these stockholders upon declaration was $6,453,712 as of December 31, 2011.
Common Stock
During 2010, our obligation to issue 13,000,000 shares of our common stock to employees of the Company was cancelled pursuant to an agreement whereby we issued a total of 310,000 shares of VHS Series A Preferred Stock owned by the Company to these employees. For additional details, please see Note 4-Related Party Transactions.
During 2010, 100,000 unregistered shares of our common stock were forfeited pursuant to a restricted stock agreement between the Company and an employee. These shares were not vested at the date of forfeiture and had never been issued.
During the year ended December 31, 2010, 583,333 shares of the Company’s common stock vested, resulting in stock compensation expense of $10,855. These shares were issued to employees of the Company and NOW Solutions pursuant to restricted stock agreements executed in 2007.
During 2010, the Company granted 600,000 unregistered shares of our common stock to an employee of the Company pursuant to a restricted stock agreement, under which the shares vest in equal installments over a three year period. As of December 31, 2010, there was $18,158 of total unrecognized compensation costs related to these stock awards. These costs are expected to be recognized over a weighted average period of less than 3 years.
During 2010, the Company cancelled 1,500,000 previously issued common shares resulting in a gain of $7,351.
Preferred Stock
Although no dividends have been declared, the cumulative total of preferred stock dividends due to these stockholders upon declaration was $5,865,712 as of December 31, 2010.
Note 12. Stock Options and Warrants
Our stock option plan allowing grants of both Incentive Stock Options (within the meaning of Section 422 and the Internal Revenue Code of 1986, as amended) and non-statutory options, in an aggregate amount of 50,000,000 shares expired in 2009.
There were no non-statutory stock options, incentive stock options or warrants granted in 2011 or 2010.
In February 2009, Robert Farias, a related party, notified us of his intent to exercise warrants to purchase 15,000,000 shares of our common stock at an average exercise price of $0.02 per share. In March 2010, Robert Farias agreed to accept 610,000 shares of Series A Preferred Stock of VHS, in exchange for cancellation of his warrants, waiving waiver of the conversion rights associated with 37,500 shares of the Company’s Series “C” Cumulative Convertible Preferred Stock, and forgiveness of $100,000 of unsecured trade payables. For additional details, please see Note 4.
Option and warrant activities in 2010 and 2011 are summarized as follows:
At December 31, 2011 and 2010, there are no options or warrants outstanding.
Note 13. Gain on Settlement of Current Liabilities
In 2011, the Company recorded a gain on settlement of liabilities of $48,532 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. Our review included the determination of the dates of receipt of goods and services, the last activity with the vendor, former employee or note holder, and the applicable statute of limitations. For those payables that met all the above requirements, we have removed the liability and recorded the gain on settlement as required under the guidance on transfers and servicing of financial assets and extinguishments of liabilities.
In 2010, the Company recorded a gain on settlement of liabilities of $517,806 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. Our review included the determination of the dates of receipt of goods and services, the last activity with the vendor, former employee or note holder, the applicable statute of limitations, and a search for applicable liens and judgments. For those payables that met all the above requirements, we have removed the liability and recorded the gain on settlement as required under the guidance on transfers and servicing of financial assets and extinguishments of liabilities.
Note 14. Commitments and Contingencies
Commitments
We lease various office spaces which leases run from October 2010 through May 2015. We have future minimum rental payments as follows:
Rental expense for the years ended December 31, 2011 and 2010 was $186,878 and $160,788, respectively.
Royalties
When we acquire rights to patents, licenses, or other intellectual property, we generally agree to pay royalties on any net sales of any products utilizing these rights. There were no sales of products requiring royalties in 2011 and 2010.
We also have royalty agreements associated with certain notes payable that provide a royalty when revenues exceed certain thresholds in addition to royalty agreements on subsidiary revenues pursuant to the terms of an acquisition agreement. For the years ended December 31, 2011 and 2010, we had royalties of $92,672 and $50,457, respectively, on revenues from subsidiaries.
Litigation
We are involved in the following ongoing legal matters:
In August 2009, Parker Shumaker & Mills, LLP (“PSM”) filed a lawsuit in Los Angeles Superior Court to collect the outstanding balance of $51,238 under a promissory note issued by the Company to PSM in the principal amount of $75,000, plus interest at 6% per annum, late fees and attorneys’ fees. We issued the $75,000 note in connection with a settlement in October 2005 with PSM. In December 2009, we entered into a settlement agreement and stipulated judgment with PSM whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM. During 2011, the Company made payments of $28,140 toward the outstanding balance of the judgment amount leaving a balance of $5,066 at December 31, 2011.
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.
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 is a complaint for declaratory judgment, in which Interwoven is requesting that the court find that no valid and enforceable claim of either of the two patents referenced above has been infringed by Interwoven. The case is styled Interwoven, Inc. v Vertical Computer Systems, Inc. No. 3:10-CV-4645-RS.
On January 11, 2011, Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc. (“Samsung”) filed a lawsuit in the United States District Court for the Northern District of California seeking to consolidate its lawsuit with the Interwoven Action. This case is styled Samsung Electronics Co., Ltd. and Samsung Electronics America, Inc., v. Vertical Computer Systems, Inc., No. 3:11-CV-00189-RS.
On May 2, 2011, the United States District Court for the Northern District of California denied Vertical’s renewed motion to transfer the Interwoven Action to the Eastern District of Texas and granted Vertical's motion to transfer the lawsuit filed by Samsung in the Northern District of California to the Eastern district in Texas. On May 11, 2011, the United States District Court for the Eastern District of Texas granted Interwoven’s 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 May 12, 2011, Vertical filed in the United States Court of Appeals for the Federal Circuit a petition for a writ of mandamus seeking review of that portion of the May 2, 2011 order by the Northern District of California which refused to transfer the Interwoven v. Vertical action to the Eastern District of Texas, which was denied on August 17, 2011.
On December 30, 2011, the United States District Court for the Northern District of California issued a claims construction order concerning the terms found in the claims of the Patents-in-Suit.
On March 8, 2012, the United States District Court for the Northern District of California in the Interwoven Action denied Interwoven’s motion to stay all judicial proceedings pending the outcome of an ex parte reexamination of the Patents-in-Suit by the USPTO.
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, payable in monthly installments of $5,000 through June 2012 and $10,000 monthly installments thereafter until the outstanding balance has been paid. The Company will be obligated to pay CCS an additional $60,000 in the event it does not make timely payment within 5 days of notice from CCS.
Note 15. Subsequent Events
In February 2012, NOW Solutions issued a promissory note in the principal amount of $105,300 to Lakeshore Investments, LLC (“Lakershore”) in connection an $80,000 loan from Lakeshore. NOW Solutions granted Lakeshore a security interest in all of its assets to secure the obligations under the note, which is junior to the presented indebtedness of NOW Solutions to Tara Financial.
In February 2012, the Company and Robert Farias amended the terms of two notes in the principal amounts of $274,679 and $90,000, that were issued by NOW Solutions and VHS in July 2011 in connection with the cancellation of $364,679 of outstanding debt owed to Mr. Farias. Pursuant to the terms of the agreement, 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. The amended payment terms for the notes consist of monthly interest only payments through 2012 with interest and principal payments of $5,000 to be allocated between the notes commencing January 31, 2013 until the notes are fully paid. Also in February 2012, NOW Solutions granted Mr. Farias a 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. This security interest is junior to the presented indebtedness of NOW Solutions to Tara Financial and Lakeshore Investment, LLC. Mr. Farias serves as our Executive Vice-President of Business Development.
In March 2012, the Company issued a promissory note in the principal amount of $100,000 to a third party lender in connection to a $100,000 loan from the lender, bearing interest at 12% per annum, payable in monthly installments. To secure the loan, SnAPPnet, Inc. granted the third party lender a security interest in all of its assets to secure the obligations in the original aggregate principal amount of $304,000 which includes this note and other notes issued by the Company and NOW Solutions for loans made by this lender.
In March 2012, the Company granted 1,200,000 unregistered shares of our common stock to an employee of the Company and an employee of NOW Solutions pursuant to restricted stock agreements with the Company.
In March 2012, we issued a 12% $275,000 note to a third party due in 90 days.
Stockholders’ Equity
For the period from January 1, 2011 to March 30, 2012, no shares of our common stock have vested pursuant to any restricted stock agreement.
As of the Date of this Report for the year ended December 31, 2011, we have determined that we currently have (i) the following shares of common stock issued, and (ii) outstanding instruments which are convertible into the shares of common stock indicated below in connection with stock options, warrants, and preferred shares previously issued by the Company or agreements with the Company:
In addition, the Company has $30,000 in an outstanding convertible debenture that had been issued to a third party.
Accordingly, given the fact that the Company currently has 1,000,000,000 shares of common stock authorized, the Company could exceed its authorized shares of common stock by approximately 30,000,000 shares if all of the financial instruments described in the table above were exercised or converted into shares of common stock (excluding the $30,000 from the outstanding debenture noted above).
We have evaluated our convertible cumulative preferred stock under the guidance set out in FASB ASC 470-20 and have accordingly classified these shares as temporary equity in the consolidated balance sheets.