U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2008
o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-28685
VERTICAL COMPUTER SYSTEMS, INC.
(Exact Name of Small Business Issuer as Specified in its Charter)
Delaware | 65-0393635 | |
(State of Incorporation) | (I.R.S. Employer Identification No) |
101 West Renner Road, Suite 300
Richardson, TX 75082
(Address of Principal Executive Offices)
(817) 348-8717
(Issuer’s Telephone Number)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o | Accelerated filer o | ||
Non-accelerated filer o | (Do not check if a smaller reporting company) | Smaller reporting company x |
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes o No x
As of May 20, 2008, the issuer had 999,235,151 shares of common stock, par value $.00001, issued and outstanding.
PART I
FINANCIAL INFORMATION
Item 1. Condensed consolidated Financial Statements
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(unaudited)
March 31, | December 31, | ||||||
2008 | 2007 | ||||||
Assets | |||||||
Current assets | |||||||
Cash | $ | 255,509 | $ | 131,420 | |||
Accounts receivable, net of allowance for bad debts of $344,752 | 790,510 | 962,772 | |||||
Employee receivables | 36,398 | 25,414 | |||||
Prepaid expenses and other current assets | 25,639 | 25,439 | |||||
Total current assets | 1,108,056 | 1,145,045 | |||||
Property and equipment, net of accumulated depreciation of $987,113 and $970,867 | 92,452 | 80,708 | |||||
Deposits and other | 10,439 | 10,416 | |||||
Total assets | $ | 1,210,947 | $ | 1,236,169 | |||
Liabilities and Stockholder's Deficit | |||||||
Current liabilities: | |||||||
Accounts payable and accrued liabilities | $ | 7,636,968 | $ | 7,604,988 | |||
Deferred revenue | 2,923,525 | 2,777,604 | |||||
Derivative liabilities | 389,557 | 291,584 | |||||
Convertible debenture | 40,000 | 40,000 | |||||
Current portion - notes payable | 3,436,631 | 3,508,593 | |||||
Total current liabilities | 14,426,681 | 14,222,769 | |||||
Non-current portion - notes payable | 2,274,918 | 2,221,719 | |||||
Total liabilities | 16,701,599 | 16,444,488 |
See accompanying notes to the condensed consolidated financial statements
(Continued on next page)
1
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(unaudited)
(Continued from previous page)
March 31, | December 31, | ||||||
2008 | 2007 | ||||||
Stockholders' Deficit | |||||||
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 48,500 shares issued and outstanding | 49 | 49 | |||||
Series B 10% Convertible Preferred stock; $0.001 Par Value; 375,000 Shares authorized; 7,200 shares issued and outstanding | 45,000 | 45,000 | |||||
Series C 4% Convertible Preferred stock; $100.00 par value; 200,000 shares authorized; 50,000 shares issued and outstanding | 350,000 | 350,000 | |||||
Series D 15% Convertible Preferred stock; $0.001 Par Value; 300,000 Shares authorized; 25,000 shares issued and outstanding | 156,250 | 156,250 | |||||
Common Stock; $.00001 par value; 1,000,000,000 shares authorized 993,918,482 and 991,485,149 issued and outstanding | 9,939 | 9,915 | |||||
Additional paid-in-capital | 28,009,684 | 27,974,390 | |||||
Accumulated deficit | (44,118,003 | ) | (43,855,590 | ) | |||
Accumulated other comprehensive income – foreign currency translation | 56,429 | 111,667 | |||||
Total stockholders' deficit | (15,490,652 | ) | (15,208,319 | ) | |||
Total liabilities and stockholders' deficit | $ | 1,210,947 | $ | 1,236,169 |
See accompanying notes to the condensed consolidated financial statements
2
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(Unaudited)
Three Months ended March 31, | |||||||
2008 | 2007 | ||||||
Revenues | |||||||
Licensing and maintenance | $ | 1,305,499 | $ | 1,209,167 | |||
Consulting Services | 253,583 | 99,184 | |||||
Other | 50,768 | 22,412 | |||||
Total Revenues | 1,609,850 | 1,330,763 | |||||
Selling, general and administrative expenses | 1,560,626 | 2,049,134 | |||||
Operating income (loss) | 49,224 | (718,371 | ) | ||||
Interest income | 1,107 | 990 | |||||
Gain / (Loss) on Derivative Liability | (97,973 | ) | - | ||||
Interest expense | (214,771 | ) | (181,813 | ) | |||
Net loss | (262,413 | ) | (899,194 | ) | |||
Dividend applicable to preferred stock | (147,000 | ) | (147,000 | ) | |||
Net loss applicable to common stockholders' | $ | (409,413 | ) | $ | (1,046,194 | ) | |
Basic and diluted loss per share | $ | (0.00 | ) | $ | (0.00 | ) | |
Basic and diluted weighted average of common shares outstanding | 993,232,951 | 999,333,390 | |||||
Comprehensive loss and its components consist of the following: | |||||||
Net loss | $ | (262,413 | ) | $ | (899,194 | ) | |
Unrealized gain (loss) on securities available for sale | - | (3,603 | ) | ||||
Translation adjustments | 55,238 | 5,585 | |||||
Comprehensive loss | $ | (207,175 | ) | $ | (897,212 | ) |
See accompanying notes to the condensed consolidated financial statements
3
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
Three months ended March 31, | |||||||
2008 | 2007 | ||||||
Cash flows from operating activities | |||||||
Net loss | $ | (262,413 | ) | $ | (899,194 | ) | |
Adjustments to reconcile net loss to net cash provided by operating activities: | |||||||
Depreciation and amortization | 16,031 | 15,182 | |||||
Amortization of debt discount | 5,604 | ||||||
Stock compensation | 22,568 | 11,079 | |||||
Shares issued for extension of debt | 3,750 | - | |||||
Shares issued for renegotiated debt | 9,000 | - | |||||
(Gain) / Loss on derivative | 97,973 | - | |||||
Changes in operating assets and liabilities: | |||||||
Accounts receivable | 172,262 | 364,906 | |||||
Receivable from officers and employees | (10,984 | ) | (31,199 | ) | |||
Prepaid expenses and other assets | (223 | ) | (2,266 | ) | |||
Accounts payable and accrued liabilities | 96,351 | 378,173 | |||||
Deferred revenue | 145,921 | 37,884 | |||||
Net cash provided by operating activities | 295,840 | (125,435 | ) | ||||
Cash flow from investing activities: | |||||||
Write-off of investment | - | 2,760 | |||||
Purchase of equipment | (27,774 | ) | (51,568 | ) | |||
Net cash used in investing activities | (27,774 | ) | (48,808 | ) | |||
Cash flow from financing activities: | |||||||
Payment of notes payable | (110,899 | ) | (108,416 | ) | |||
Proceeds from issuance of notes payable | 22,160 | 300,000 | |||||
Net cash used in financing activities | (88,739 | ) | 191,584 | ||||
Effect of changes in exchange rates on cash | (55,238 | ) | (5,638 | ) | |||
Net change in cash and cash equivalents | 124,089 | 11,703 | |||||
Cash and cash equivalents, beginning of period | 131,420 | 83,482 | |||||
Cash and cash equivalents, end of period | $ | 255,509 | $ | 95,185 | |||
Supplemental disclosures of cash flow information: | |||||||
Cash paid during the year period: | |||||||
Interest | $ | 218,580 | $ | 93,405 | |||
Noncash supplemental cash flow disclosures: | |||||||
Reclass of accrued interest to notes payable | 27,194 | - | |||||
Reclass of accounts payable to notes payable | 37,178 | - |
See accompanying notes to condensed consolidated financial statements
4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Organization, Basis of Presentation and Significant Accounting Policies
The accompanying unaudited interim financial statements of Vertical Computer Systems have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited financial statements and notes thereto contained in Vertical Computer Systems' annual report on Form 10-KSB for the year ended December 31, 2007 filed with the SEC on April 22, 2008. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported in the 2007 annual report on Form 10-KSB have been omitted.
Certain prior year balances have been reclassified to conform to current year presentation.
Recently issued accounting pronouncements
In March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 161, Disclosures about Derivative Instruments and Hedging Activities –an amendment of SFAS 133. SFAS 161 seeks to improve financial reporting for derivative instruments and hedging activities by requiring enhanced disclosures regarding the impact on financial position, financial performance, and cash flows. To achieve this increased transparency, SFAS 161 requires: (1) the disclosure of the fair value of derivative instruments and gains and losses in a tabular format; (2) the disclosure of derivative features that are credit risk-related; and (3) cross-referencing within the footnotes. SFAS 161 is effective for us on January 1, 2009. We are in the process of evaluating the new disclosure requirements under SFAS 161.
In September 2006, the FASB issued SFAS 157, Fair Value Measurements, as amended in February 2008 by FASB Staff Position (“FSP”) FAS 157-2, Effective Date of FASB Statement No. 157. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FSP FAS 157-2 defers the effective date of SFAS 157 for all nonfinancial assets and liabilities, except those items recognized or disclosed at fair value on an annual or more frequently recurring basis, until January 1, 2009. As such, we partially adopted the provisions of SFAS 157 effective January 1, 2008. The partial adoption of this statement did not have a material impact on our financial statements. We expect to adopt the remaining provisions of SFAS 157 beginning in 2009. We do not expect this adoption to have a material impact on our financial statements.
In February 2007, FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities–including an Amendment of FASB Statement No. 115. This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS 159 are elective; however the amendment to SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale securities. The fair value option established by SFAS 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. We have adopted this statement as of January 1, 2008. The adoption created no impact to our financial statements.
Note 2. Going Concern Uncertainty
The accompanying condensed consolidated financial statements for the three months ended March 31, 2008 and 2007 have been prepared assuming that the Company 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. The Company has suffered significant recurring operating losses, used substantial funds in its operations, and needs to raise additional funds to accomplish its objectives. Negative stockholders’ equity at March 31, 2008 was $15.5 million. Additionally, at March 31, 2008, the Company had negative working capital of approximately $13.3 million and has defaulted on several of its debt obligations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern.
Management of the Company is continuing its efforts to attempt to secure funds through equity and/or debt instruments for its operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations. The Company will require additional funds for its operations and to pay down its liabilities, as well as finance its expansion plans consistent with the Company’s anticipated changes in operations and infrastructure. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.
5
Note 3. Common and Preferred Stock Transactions
In January 2008, the Company issued 250,000 shares of common stock of the Company valued at $3,750 to a third party lender in connection with extending the maturity dates of two promissory notes issued by GIS in November 2003 in the amounts of $40,000 and $60,000, respectively.
In February 2008, the Company issued 500,000 shares of common stock of the Company valued at $9,000 to a third party lender in connection with refinancing a $50,000 promissory note issued in June 2002 as well as accrued interest, fees, and expenses incurred in connection with the refinancing.
During the three months ended March 31, 2008, 1,683,333 shares of the common stock of the Company valued at $22,568 vested. These shares were issued pursuant to restricted stock agreements with employees of the Company and NOW Solutions executed in 2006 and 2007.
During the three months ended March 31, 2008, warrants to purchase 1,000,000 shares of common stock of the Company at an exercise price of $0.010 per share expired.
The Company currently has 1,000,000,000 shares of common stock authorized and could exceed its authorized shares of common stock by approximately 75,000,000 shares if all of the warrants, options, convertible preferred stock and convertible debt were exercised or converted into shares of common stock (excluding the $40,000 of outstanding debentures).
For additional common and preferred stock transactions subsequent to the period covered by this report, please see “Subsequent Events” under Note 8.
Note 4. Notes Payable
The following table reflects our debt activity, including our convertible debt, for the three months ended March 31, 2008:
December 31, 2007 | $ | 5,770,312 | ||
Repayment | (110,899 | ) | ||
New borrowings | 22,160 | |||
Combine accrued interest into new debt | 27,194 | |||
Combine accounts payable into new debt | 37,178 | |||
Amortization of debt discount | 5,604 | |||
March 31, 2008 | $ | 5,751,549 |
In January 2008, the maturity dates of two promissory notes issued by GIS in the amounts of $60,000 and $40,000 were extended until June 2008 in consideration of issuing 250,000 common shares of the Company’s stock to the third party lender.
In February 2008, the Company refinanced a $50,000 note issued in June 2002 by issuing 500,000 common shares and replacing that old note with a new $96,946 promissory note, bearing interest at 12% per annum and due in September 2008. The new note includes accrued interest, late fees, and attorney’s fees. The old note for $50,000 is cancelled. In connection with the refinancing, MRC pledged 3,000,000 Company common shares as collateral. 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 2008, Parker Mills and the Company amended the payment terms of a $75,000 note issued in October 2005 by extending the maturity date to June 2009. In connection with the amendment, MRC pledged 2,000,000 shares of common stock of the Company as collateral on 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. Bill Mills is a Director of the Company and a partner of Parker Mills.
In March 2008, the Company and MRC amended the indemnity and reimbursement agreement (entered into in April 2007) whereby the Company agreed to reimburse and indemnify MRC for additional shares pledged as collateral in connection with a $96,946 and a $75,000 notes. 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.
During the three months ended March 31, 2008, the Company made the interest payments of $218,580 and principal payments of $110,899.
Note 5. Legal Proceedings
The Company is involved in the following ongoing legal matters:
In February 2003, we sued Ross Systems Inc. (“Ross”), Arglen Acquisitions (“Arglen”), Tinley, and Gyselen. We then stopped payments on the remaining $750,000 note that was due in February 2003 in connection with the acquisition of certain assets of Ross. The actions against Tinley, Arglen and Gyselen were dismissed or settled in December 2003. In September 2007, the court awarded us a judgment of $3,151,216, which we are seeking to collect. In November 2007, Ross gave notice of its intention to appeal the decision and posted a bond in the amount of the judgment. The $750,000 note payable and accrued interest are still shown on our books until Ross’s appeal is settled.
In August 2004, Arglen obtained a default judgment in a court for a past due $600,000 promissory note, plus fees and interest. We agreed to pay Arglen $713,489 and we began making monthly interest payments on the amounts specified above of $5,945, beginning on September 15, 2005, which was replaced by monthly payments of $25,000 or 10% of the Company's new sales, whichever is greater, beginning on February 15, 2006 until the remainder of the $713,489 is paid.
The IRS has a claim for unpaid payroll taxes of $313,839 from 2001 - 2005. On March 9, 2007, we filed an appeal with the United States Tax Court, seeking an installment payout agreement. This action is still pending.
In the opinion of management, the ultimate resolution of any pending matters may have a significant effect on our financial position, operations or cash flows.
6
Note 6 –Stock Options, Warrants and Restricted Stock Awards
Stock Option Plan
In December 1999, the Company established a stock option plan (the “Plan”) whereby the Company may grant both Incentive Stock Options (within the meaning of Section 422 and the Internal Revenue Code of 1986, as amended) and non-statutory options. Under the Plan, the Company may issue up to 50,000,000 shares (adjusted post stock split). Most options issued are non-assignable, non-transferable, vest on the date of grant, and expire between 3-5 years from the date of grant.
Summary of Outstanding Employee Stock Options and Warrants
Below is a summary of outstanding stock options and warrants issued to employees and former employees of the Company through March 31, 2008.
In March 2004, the Company issued 5-year incentive stock options to a former executive of the Company to purchase 2,500,000 shares of common stock of the Company at a strike price of $0.014 per share in connection with an employment agreement. The options are vested and will expire in March 2009.
For an update on warrants and stock options subsequent to March 31, 2008, please see “Subsequent Events” in Note 8.
Incentive Stock Options | Non-Statutory Stock Options | Warrants | Weighted Average Exercise Price | ||||||||||
Outstanding at 12/31/07 | 2,500,000 | - | 21,500,000 | 0.017 | |||||||||
Options/Warrants granted | - | - | - | - | |||||||||
Options/Warrants exercised | - | - | - | - | |||||||||
Options/Warrants expired/cancelled | - | - | 1,000,000 | 0.01 | |||||||||
Outstanding at 3/31/08 | 2,500,000 | - | 20,500,000 | 0.017 |
Information relating to stock options/warrants at March 31, 2008, summarized by exercise price, is as follows:
Warrants/Options Outstanding | Exercisable | |||||||||||||||
Weighted | ||||||||||||||||
Average | Weighted | Weighted | ||||||||||||||
Remaining | Average | Average | ||||||||||||||
Number | Contractual | Exercise | Number | Exercise | ||||||||||||
Exercise Price Per Share | Outstanding | Life (Months) | Price | Exercisable | Price | |||||||||||
Incentive Stock Options | ||||||||||||||||
$0.01 - $0.09 | 2,500,000 | 11.13 | $ | 0.014 | 2,500,000 | $ | 0.014 | |||||||||
2,500,000 | 11.13 | $ | 0.014 | 2,500,000 | $ | 0.014 | ||||||||||
Warrants | ||||||||||||||||
$0.003 - $0.100 | 20,500,000 | 8.065 | $ | 0.017 | 20,500,000 | $ | 0.017 | |||||||||
20,500,000 | 8.065 | $ | 0.017 | 20,500,000 | $ | 0.017 | ||||||||||
Grand total | 23,000,000 | 8.40 | $ | 0.0171 | 23,000,000 | $ | 0.017 |
7
Restricted Stock
Summary of Employee and Consultants Restricted Stock Awards
The Company has not established a restricted stock award plan for employees or consultants. The following is a summary of the terms of restricted stock awards issued to employees of the Company and NOW Solutions for the period that runs from January 1, 2005 through March 31, 2008.
During 2005, the Company granted 5,100,000 unregistered shares of common stock of the Company to employees of NOW Solutions pursuant to restricted stock agreements. The shares vest in equal amounts each year over a 3-year period. Of these shares, 2,565,480 have vested and 1,634,520 have been cancelled through March 31, 2008.
During 2006, the Company granted 12,525,000 shares of common stock of the Company to employees and consultants of NOW Solutions and the Company pursuant to restricted stock agreements. Of the 12,525,000 shares the Company agreed to issue, 1,000,000 shares had no vesting period, 6,200,000 shares vested over a 1-year period and 5,325,000 shares vest in equal amounts each year over a 3-year period. Of these 12,525,000 shares, 7,740,476 have vested and 3,751,188 shares have been cancelled though March 31, 2008.
During 2007, the Company granted 4,550,000 shares of common stock of the Company to employees and a consultant of the Company and NOW Solutions pursuant to restricted stock agreements. The shares are to vest in equal amounts each year over a 3-year period. Of those shares, 1,416,667 have vested through March 31, 2008.
During the three months ended March 31, 2008, the Company granted 250,000 shares of common stock of the Company to a director of the Company. These shares were issued pursuant to a restricted stock agreements executed in 2008 with the Company that provide for the shares to vest at the 1-year anniversary date of the agreement.
For issuances, vesting, and cancellations of restricted stock subsequent to March 31, 2008, please see “Subsequent Events” in Note 8.
The following activity has occurred through March 31, 2008:
Shares | Weighted Average Grant-Date Fair Value | ||||||
Non Vested Balance at December 31, 2007 | 6,750,002 | $ | 0.0126 | ||||
Granted | 250,000 | 0.0190 | |||||
Vested | (1,683,332 | ) | 0.0134 | ||||
Forfeited/Cancelled | - | - | |||||
Non Vested Balance at March 31, 2008 | 5,316,670 | $ | 0.0132 |
As of March 31, 2008, there was $79,833 of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of 2.08 years.
Note 7. Derivative liabilities
During 2007, two officers of the Company 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 an agreement to replace the shares within one year. These loans were evaluated under FAS 133 and EITF 00-19 and were determined under EITF 00-19 to have characteristics of a liability and therefore derivative liabilities under FAS 133. Each reporting period, this derivative liability is fair valued with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At March 31, 2008 and December 31, 2007, the aggregate derivative liability was $227,500 and $169,000.
8
During 2002 and 2003, the Company issued convertible debentures with a conversion features based on the market value of the stock at the date of conversion. The conversion features were evaluated under FAS 133 and EITF 00-19 and were determined under EITF 00-19 to have characteristics of a liability and therefore a derivative liability under FAS 133. 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 caused warrants not subject to FAS 123R and all other convertible debt to also be classified as derivative liabilities under FAS 133. Each reporting period, this derivative liability is fair valued with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At March 31, 2008 and December 31, 2007, the aggregate derivative liability was $162,057 and $122,584.
The valuation of our embedded derivatives and warrant derivatives are determined primarily by the Black-Scholes option pricing model. To determine the fair value of our embedded derivatives, management evaluates assumptions regarding the probability of certain future events. Other factors used to determine fair value include our period end stock price of $0.0175, historical stock volatility of 129%, risk free interest rates from 1.22% to 1.55% and the remaining term of the instrument.
Effective January 1, 2008, the Company adopted the provisions of SFAS No. 157, Fair Value measurements, for all financial instruments. SFAS 157 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
Level 1 — | Quoted prices (unadjusted) for identical assets or liabilities in active markets. |
Level 2 — | Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and model-derived valuations whose inputs or significant value drivers are observable. |
Level 3 — | Significant inputs to the valuation model are unobservable. |
Level 1 | Level 2 | Level 3 | Total | ||||||||||
Liabilities | |||||||||||||
Derivative liabilities | - | $ | 389,557 | - | $ | 389,557 |
Note 8. Subsequent Events
In May 2008, the Company issued 1,000,000 shares of the Company’s common stock to Victor Weber that were granted in connection with a $100,000 loan made by Mr. Weber to Now Solutions in October 2006. These shares were accounted for in the Company’s 10-KSB for the year ended December 31, 2006.
For the period from April 1, 2008 to May 20, 2008, warrants to purchase 5,250,000 shares of common stock of the Company at an exercise price of $0.075 to $0.010 per share expired.
For the period from April 1, 2008 to May 20, 2008, 500,000 shares of the common stock of the Company vested. These shares were issued pursuant to a restricted stock agreement with an employee of NOW Solutions executed in 2007.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion is a summary of the key factors management considers necessary or useful in reviewing the Company’s results of operations, liquidity and capital resources. The following discussion and analysis should be read together with the accompanying Condensed Consolidated Financial Statements, and the cautionary statements and risk factors included below in the item 3 of the Report.
Critical Accounting Policies
Revenue Recognition
Service revenue generated from professional consulting and training services are recognized as the services are performed. Maintenance revenue, including revenues bundled with original software product license revenues, are deferred and recognized over the related contract period, generally twelve months. The Company’s revenue recognition policies are designed to comply with American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”) and with Emerging Issues Task Force (“EITF”) issued No 00-21, “Revenue Arrangement with Multiple Deliverables.”
Deferred revenue on maintenance contracts represent cash received in advance or accounts receivable from systems, maintenance services, and consulting sales, which is recognized over the life of the contract.
In accordance with SEC Staff Accounting Bulletin No. 104 “Revenue Recognition”, the Company recognizes revenue from license of computer software up-front provided that a non-cancelable license agreement has been signed, the software and related documentation have been shipped, there are no material uncertainties regarding customer acceptance, collection of resulting receivables is deemed probable, and no significant other vendor obligations exist.
Stock-Based Compensation Expense
Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method and therefore has not restated results for prior periods. Under this transition method, we recognize compensation expense for all stock options granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company uses the Black Scholes option valuation model to estimate the fair value of its stock options at the date of grant. Historical data is used to estimate the expected price volatility, the expected option life and the expected forfeiture rate. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of subjective assumptions. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and the Company uses different assumptions, the stock-based compensation expense could be materially different in the future. See Note 10 to 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 and warrant derivatives are determined primarily by the Black-Scholes option pricing model. An embedded derivative is a derivative instrument that is embedded within another contract, which under the 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 FASB Statement No. 133, as amended, Accounting for Derivative Instruments and Hedging Activities, these embedded derivatives are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. A warrant derivative liability is determined in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”). Based on EITF 00-19, warrants which are determined to be classified as derivative liabilities 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 charge 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.
9
To determine the fair value of our embedded derivatives and warrant derivatives, management evaluates assumptions regarding the probability of certain future events. Other factors used to determine fair value include our period end stock price, historical stock volatility, risk free interest rate and derivative term. The fair value recorded for the derivative liability varies from period to period. This variability may result in the actual derivative liability for a period either above or below the estimates recorded on our consolidated financial statements, resulting in significant fluctuations in other income (expense) because of the corresponding non-cash gain or loss recorded.
New Accounting Pronouncements
In March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 161, Disclosures about Derivative Instruments and Hedging Activities –an amendment of SFAS 133. SFAS 161 seeks to improve financial reporting for derivative instruments and hedging activities by requiring enhanced disclosures regarding the impact on financial position, financial performance, and cash flows. To achieve this increased transparency, SFAS 161 requires: (1) the disclosure of the fair value of derivative instruments and gains and losses in a tabular format; (2) the disclosure of derivative features that are credit risk-related; and (3) cross-referencing within the footnotes. SFAS 161 is effective for us on January 1, 2009. We are in the process of evaluating the new disclosure requirements under SFAS 161.
In September 2006, the FASB issued SFAS 157, Fair Value Measurements, as amended in February 2008 by FASB Staff Position (“FSP”) FAS 157-2, Effective Date of FASB Statement No. 157. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FSP FAS 157-2 defers the effective date of SFAS 157 for all nonfinancial assets and liabilities, except those items recognized or disclosed at fair value on an annual or more frequently recurring basis, until January 1, 2009. As such, we partially adopted the provisions of SFAS 157 effective January 1, 2008. The partial adoption of this statement did not have a material impact on our financial statements. We expect to adopt the remaining provisions of SFAS 157 beginning in 2009. We do not expect this adoption to have a material impact on our financial statements.
In February 2007, FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities–including an Amendment of FASB Statement No. 115. This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS 159 are elective; however the amendment to SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale securities. The fair value option established by SFAS 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. We have adopted this statement as of January 1, 2008. The adoption created no impact to our financial statements.
Results of Operations
Three Months Ended March 31, 2008 Compared To Three Months Ended March 31, 2007
Total Revenues. The Company had total revenues of $1,609,850 and $1,330,763 in the three months ended March 31, 2008 and 2007, respectively. The increase in total revenues was $279,087 for the three months ended March 31, 2008 representing a 21.0% increase compared to the total revenues for the three months ended March 31, 2007. Of the $1,609,850 in revenues for the three months ended March 31, 2008 and the $1,330,763 in revenues for the three months ended March 31, 2007, $1,609,850 and $1,330,763, respectively, was related to the business operations of Now Solutions.
The total revenues primarily consist of software licenses, consulting, maintenance and hosting fees. The revenue from license and maintenance in the three months ended March 31, 2008 increased by $96,332 from the same period in the prior year, representing a 7.2% increase. Consulting revenue, in the three months ended March 31, 2008, increased by $154,399 from the same period in the prior year, which represents a 155.7% increase, due to consulting work done as a result of releasing emPath 6.4 in the third quarter of 2007. Other revenue in the three months ended March 31, 2008 increased by $28,356 or 126.5% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expense and hosting revenues. Hosting revenues generated almost all the increase for the period compared to 2007.
Selling, General and Administrative Expenses. The Company had selling, general and administrative expenses of $1,560,626 and $2,049,134 in the three months ended March 31, 2008 and 2007, respectively. The total operating expenses in the three months ended March 31, 2008 decreased by $488,508 compared to the operating expenses in the three months ended March 31, 2007, representing a 23.8% decrease. Of the $1,560,626 in expenses for the three months ended March 31, 2008 and the $2,049,134 in expenses for the three months ended March 31, 2007, Now Solutions accounted for $1,162,418 and $1,529,500, respectively.
The decrease is due to the write-off of the value of exclusivity agreements in 2007 which did not recur in 2008 and the decreased cost for attorneys as the Ross litigation activity was reduced from the first quarter of 2007.
10
Loss on Derivative Liability. The Company recognized derivative liabilities in 2007 related to common stock loaned to the company by two executives and embedded derivative liabilities on convertible debt and outstanding options and warrants. This liability is adjusted each quarter for changes in the market value of the company stock and other items that impact the valuation of the derivatives. The loss on derivative liability was $97,973 for the period ended March 31, 2008 compared to $0 for the same period in 2007.
Interest Expense. The Company had interest expense of $214,771 and $181,813 for the three months ended March 31, 2008 and 2007, respectively. Interest expense increased in 2008 by $33,958, representing an increase of 18.1% compared to the same expense in the three months ended March 31, 2007. This increase was due to the new financing and higher interest rates being paid on the refinanced debt.
Net Loss. The Company had a net loss of $262,413 and $899,194 as of March 31, 2008 and 2007, respectively. Net loss decreased by $636,781, representing a decrease of 70.8%. The decrease was primarily attributable to the combination of an increase in revenues of $279,089, a decrease in selling, general and administrative expenses of $488,508 partially offset by an increase in the loss on derivative liability of $97,973 and by an increase in interest expense of $32,958.
Dividends Applicable to Preferred Stock. The Company has outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $147,000 and $147,000 for the three months ended March 31, 2008 and 2007, respectively.
Net Loss Available to Common Stockholders. The Company had a net loss attributed to common stockholders of $409,413 and $1,046,194 for the three months ended March 31, 2008 and 2007, respectively. Net loss attributed to common stockholders decreased by $636,781, representing a decrease of 60.9%, compared to the net loss attributed to common stockholders in the three months ended March 31, 2007.
Net Loss Per Share. The Company had a net loss per share of $0.00 and $0.00 for the three months ended March 31, 2008 and 2007, respectively.
Liquidity And Capital Resources
At March 31, 2008, the Company had non-restricted cash-on-hand of $255,509.
Net cash provided by operating activities for the three months ended March 31, 2008 was $295,840. This positive cash flow was primarily related to a net loss of $262,413 adjusted by total non-cash items of $142,176 (including depreciation of $16,031, stock compensation of $22,568 and loss on the derivative liability of $97,973), decreases in all receivables items of $161,278, an increase in deferred revenue of $145,921, and an increase in accounts payable and accrued liabilities of $96,351
Net cash used in investing activities for the three months ended March 31, 2008 was $27,774 which was for the purchase of equipment.
Net cash used in financing activities for the three months ended March 31, 2008 was $88,739. New notes of $22,160 were issued in the quarter and $110,899 of notes payable were repaid.
The total change in cash for the three months ended March 31, 2008 when compared to three months ended March 31, 2007 was an increase of $124,089.
As of the date of this filing, the Company does not have sufficient funds available to fund its operations and repay its debt obligations under their existing terms. Therefore, the Company needs to raise additional funds through selling securities, obtaining loans, renegotiating the terms of its existing debt and/or increase sales. The Company’s inability to raise such funds and/or renegotiate the terms of its existing debt will significantly jeopardize its ability to continue operations.
Balance at | Due in Next Five Years | ||||||||||||||||||
Contractual Obligations | 03/31/08 | 2008 | 2009 | 2010 | 2011 | 2012+ | |||||||||||||
Notes payable | $ | 5,711,549 | $ | 3,436,631 | $ | 329,158 | $ | 345,967 | $ | 268,053 | $ | 1,331,740 | |||||||
Convertible debts | 40,000 | 40,000 | - | - | - | ||||||||||||||
Operating lease | 111,031 | 84,253 | 26,778 | - | - | - | |||||||||||||
Total | $ | 5,862,580 | $ | 3,560,884 | $ | 355,936 | $ | 345,967 | $ | 268,053 | $ | 1,331,740 |
Of the above notes payable of $5,711,549, the default situation is as follows:
11
Notes Payable | 03/31/08 | 12/31/07 | |||||
In default | $ | 3,142,126 | $ | 3,344,196 | |||
Current | 2,569,423 | 2,386,116 | |||||
Total Notes Payable | $ | 5,711,549 | $ | 5,730,312 |
Related Party Transactions
In April 2007, the Company issued Mr. Rossetti 3,000,000 common shares (at a fair market value of $48,000) in connection with a December 2006 agreement entered into concerning loans and monies owed to Mr. Rossetti and Markquest. Mr. Rossetti is Executive Vice-President of Government Affairs, Chairman, CEO and Director of GIS, Director of NOW Solutions and an officer of Markquest, Inc.
In March 2007, the Company borrowed $300,000 under a promissory note, bearing interest at 12% per annum and due in September 2007, from Mr. Weber. In connection with the note, MRC pledged 10,000,000 shares of common stock of the Company. The note is in default.
In April 2007, Luiz Valdetaro, on behalf of the Company, transferred 2,000,000 common shares owned by him to Tara Financial in exchange for waiving the defaults and extending the payment terms on notes payable to Tara of $438,795, $350,560, $955,103 and $450,000. Mr. Valdetaro is our Chief Technology Officer. The Company also agreed to reimburse Mr. Valdetaro with 2,000,000 shares within one year and pay for any related costs. This obligation is currently owed to Mr. Valdetaro.
In April 2007, Mr. Valdetaro, on behalf of the Company, transferred 1,000,000 common shares owned by him to CCS in connection with a $40,000 loan from CCS. Also in April 2007, in connection with the transfer of shares to CCS, the Company entered into an indemnity and reimbursement agreement to reimburse Mr. Valdetaro with 1,000,000 shares within one year and pay for all costs associated with the transfer of shares to CCS. This obligation is currently owed to Mr. Valdetaro.
In April 2007, the Company and MRC entered into an indemnity and reimbursement agreement for transfer and pledges of shares of common stock of the Company. Pursuant to the agreement, MRC loaned the Company 10,000,000 shares of common stock of the Company in order for the Company to meet current obligations concerning stock the Company has been obligated to issue and deliver to various parties. In connection with a loan of 10,000,000 shares by MRC to the Company, the Company agreed to reimburse MRC with up to 10,000,000 shares of common stock of the Company within one year and pay for all costs associated with such transfer. This obligation is currently owed to Mr. Wade. In March 2008, the Company and MRC amended their indemnity and reimbursement agreement whereby the Company agreed to reimburse and indemnify MRC for additional shares pledged as collateral in connection with two promissory notes of $96,946 and $75,000. For additional details on these notes, please see “Notes Payable” under Note 4.
In July 2007, the Company borrowed $46,586 from Stephen Rossetti with interest of 10% per annum and due on demand. In December 2007, the Company reached an agreement with Markquest and Stephen Rossetti related to the $113,734 note issued in December 2006, the $46,586 loan by Mr. Rossetti in July 2007, and $36,000 in fees owed to Markquest. The agreement canceled the $113,734 note and the Company issued a $213,139 promissory note to Markquest, bearing interest at 10% per annum which incorporated all of the amounts plus accrued interest. The note is to be paid in monthly interest payments of accrued interest beginning in February 2008 and monthly accrued interest and principal payments of $4,500 beginning in August 2008. Mr. Rossetti is Executive Vice-President of Government Affairs, Chairman, CEO and Director of GIS, Director of NOW Solutions and an officer of Markquest. For additional details on this note, please see “Notes Payable” under Note 5.
In August 2007, the Company borrowed $30,400 from Victor Weber with interest of 12% per annum and principal and interest due on demand. Mr. Weber is the President and a Director of GIS and a member of CWI.
In March 2008, MRC pledged 2,000,000 common shares of the Company’s stock to secure a $75,000 promissory note issued to Parker Mills. William Mills Bill is a company director and also a partner of the law firm Parker Mills. For additional details on this note, please see “Notes Payable” under Note 4.
In March 2008, MRC pledged 3,000,000 common shares of the Company’s stock to secure a $96,946 promissory note issued to a third party lender. For additional details on this note, please see “Notes Payable” under Note 5.
For additional related party transactions subsequent to the period covered by this report, please see “Subsequent Events” under Note 9.
12
Item 3. Quantitative and Qualitative Disclosures About Market Risk
A description of the risks associated with the Company’s business, financial condition, and results of operations is set forth on Form 10-KSB for the year ended December 31, 2007 filed on April 22, 2008.
Item 4T. 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 Securities Exchange Act of 1934 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 which results in a lack of segregation of duties necessary for a good system of internal control. |
Management’s annual report on internal control over financial reporting associated with the Company’s business are set forth on Form 10-KSB for the year ended December 31, 2007 filed on April 22, 2008.
The Company has commenced implementing a new accounting system and has begun implementing additional oversight and review of certain accounts and postings. We added a degreed accountant to our staff in the first quarter of 2008.
13
PART II
OTHER INFORMATION
Item 1. Legal Proceedings
The Company is involved in the following ongoing legal matters:
In February 2003, the Company filed a lawsuit and a derivative action (the “Derivative Action”) on behalf of its subsidiary Now Solutions in New York Supreme Court Case against defendants Ross Systems Inc. (“Ross”), Arglen, Tinley, and Gyselen. In conjunction with the Company’s claim, NOW Solutions withheld its payments on the remaining $750,000 note that was due in February 2003 in connection with the acquisition of certain assets of Ross against the unpaid maintenance fees and gave notice in February 2003 to Ross of NOW Solutions’ claim of offset. NOW Solutions claimed a total amount of approximately $3,562,000 to offset against the note, plus other damages. In November 2003, the New York Supreme Court dismissed the claims against Ross and Tinley. The portion of the lawsuit involving Arglen and Gyselen was settled in December 2003 and dismissed in February 2004. In November 2004, Ross filed an answer containing affirmative defenses in the Derivative Action. For information concerning the decision regarding this action and the Ross’ action against NOW Solutions, please see below.
In March 2004, Ross commenced an action in the New York Supreme Court (the “Court”) by filing a motion for summary judgment in lieu of complaint against NOW Solutions to collect the note payable in the amount of $750,000 plus 10% interest and attorneys fees. On October 7, 2004, the Court ruled in favor of NOW Solutions on its opposition to Ross’ motion and denied the motion for summary judgment, and pursuant to New York State law, the action continued and the pleadings supporting the motion were deemed to constitute the complaint. Accordingly, NOW Solutions filed an answer containing affirmative defenses and nine counterclaims against Ross. The affirmative defenses asserted by NOW Solutions included the same grounds which comprise the causes of action against Ross in the Derivative Action, namely Ross’ breach of the Asset Purchase Agreement as a result of its failure to credit NOW Solutions with adjustments at closing in an amount not less than $3,562,201. All of the counterclaims asserted by NOW Solutions against Ross related to the Asset Purchase Agreement and Ross’ breaches thereof Trial commenced on the Derivative Action and this action on March 20, 2007. On April 13, 2007, the court rendered decisions in both actions as follows: (1) In the action of Ross Systems, Inc. v. NOW Solutions, Inc. a directed verdict was granted (a) to Ross Systems on its claim for payment of the promissory note, net of certain offsets that the court found due to NOW Solutions on its first, second and fifth counterclaims, other than for the amount claimed due by NOW for maintenance fee adjustments due at the closing of the sale transaction between the parties, in the amount of $664,000; (b) to NOW Solutions on its first counterclaim for maintenance fee adjustments in the amount of $1,943,482; accordingly, NOW Solutions was awarded the net amount of $1,279,482 ($1,943,482-$664,000), plus statutory (simple) interest at 9% per annum from the date the claim accrued; and (c) to Ross Systems dismissing NOW’s fourth counterclaim against Ross for failure to deliver certain assets at closing. (2) In the action of Vertical Computer Systems, Inc. v. Ross Systems, Inc., et. al., the court dismissed the Company’s claim on behalf of NOW Solutions for maintenance fee adjustments, as moot in light of its directed verdict on this issue in the Ross Systems v. NOW Solutions action, and dismissed Ross’ defenses to the Vertical action and Ross’ claim for attorney fees therein. In the action of Ross Systems, Inc. v. NOW Solutions, Inc., NOW Solutions and Ross each filed motions for attorney's fees with the court in August 2007. In September 2007, the court awarded NOW Solutions a judgment in the amount of $3,151,216, which consisted of $1,279,483 for NOW Solutions’ claims (after deducting $664,000 for Ross’ claim), $912,464 in attorneys’ fees and expenses, and $865,361 of accrued interest. NOW Solutions is currently seeking to collect the amounts due under the judgment. The judgment was entered on October 11, 2007. In November 2007, Ross gave notice of its intention to appeal the decision and posted a bond in the amount of the judgment. The Company is currently preparing for the appeal.
In March 2004, Ross commenced an action in the Court of Chancery, State of Delaware by filing a summons and complaint against the Company, NOW Solutions and Arglen alleging a fraudulent transfer in connection with the Company’s payment of monies to Arglen pursuant to the settlement between the Company and Arlgen dated December 2003 (the “2003 Settlement”). The Company and NOW Solutions filed a motion to stay the Delaware action pending the resolution of the parties’ rights in Supreme Court, New York County and Appellate Division. Specifically, Ross seeks a judgment against the Company: (i) attaching the assets transferred to Arglen pursuant to the 2003 Settlement; (ii) enjoining the Company and NOW Solutions from making further transfers to Arglen pursuant to the Arglen Note; (iii) avoiding the transfers to the Company and Arglen or for judgment in the amount equivalent to the value of the assets transferred to them pursuant to the 2003 Settlement; and (iv) appointing a receiver to take possession of the assets transferred to the Company and Arglen pursuant to the 2003 Settlement. In July 2004, the Company and NOW Solutions filed a motion to stay the Delaware Action pending the resolution of the parties’ rights in the Derivative Action and Ross Action. In October 2004, the motion was granted and the Delaware action has been stayed. This action is subject to dismissal; however, it has been further stayed, since Ross has filed notice of its intention to appeal the above decision and has posted bond for the appeal.
14
In August 2005, the Company entered into a Payout Agreement with Arglen allowing payout terms to the Company and pursuant to which the Company agreed to enter into the Agreed Judgment. The Agreed Judgment and Payout Agreement were entered into concerning a California judgment and Arglen's notice of Filing a Foreign Judgment in Tarrant County, Texas, which were obtained in connection with the 2003 Settlement. Pursuant to the terms of the Agreed Judgment and the Payout Agreement, the Company agreed to pay Arglen a total of $713,489, which includes the following amounts: (a) $600,000 in principal on the promissory note issued by the Company pursuant to the settlement of litigation between the parties in 2003, (b) the accrued post-judgment interest on the California judgment from September 4, 2004 through September 15, 2005, at the rate of 10% per annum, which equals $61,989, and (c) attorney's fees incurred for the California and Texas judgment actions which were approximately $51,500. Pursuant to the terms of the Payout Agreement, the Company began making monthly interest payments on the amounts specified above of $5,945, beginning on September 15, 2005, which will be replaced by monthly payments of $25,000 or 10% of the Company's new sales, whichever is greater, beginning on February 15, 2006 until the remainder of the $713,489 is paid. In accordance with the Payout Agreement, Arglen shall not execute the Agreed Judgment so long as the Company continues to make its payments as agreed.
The IRS has a claim for unpaid Employment (Form 941) taxes and Federal Unemployment (Form 940) taxes for the period December 31, 2001 through December 31, 2005. As of August 27, 2006 the total tax, penalties and interest due was $313,839. In that matter, the Company appealed from a Notice of Intent to Levy served to collect this tax and on February 8, 2007, following a Due Process Hearing, the IRS determined that its decision to seek collection of the tax by levy was proper. On March 9, 2007, the Company filed an appeal of the IRS’s determination to the United States Tax Court. The Company hopes that the Court will hold that the IRS’s refusal to consider an Installment Agreement to pay the liability over several years was erroneous. There is no guarantee, however, that the Court will not sustain the IRS determination and will allow it to collect the tax, penalties and interest by levy.
On April 18, 2007, the Company filed suit for patent infringement against Microsoft Corp. in the United States District Court for the Eastern District of Texas. The Company claims that the Microsoft .Net System infringes U.S. Patent No. 6,826,744. On July 13, 2007, Microsoft filed an answer to the Company’s complaint, alleging various defenses and counterclaims. On August 2, 2007, the Company filed a reply to Microsoft’s defenses and counterclaims. The court has set trial for March 2009. The parties are in the process of discovery. The court has set the claim construction hearing for July 10, 2007.
In the opinion of management, the ultimate resolution of any pending matters may have a significant effect on the financial position, operations or cash flows of the Company. Also, the Company in the future may become involved in other legal actions that may have a significant effect on the financial position, operations or cash flows of the Company.
Item 1A. Risk Factors
A description of the risks associated with the Company’s business, financial condition, and results of operations is set forth on Form 10-KSB for the year ended December 31, 2007 filed on April 22, 2008.
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds
In January 2008, the Company issued 250,000 unregistered shares of common stock of the Company to a third party lender in connection with extending the maturity dates of two promissory notes issued by GIS in November 2002 in the amounts of $40,000 and $60,000, respectively.
In February 2008, the Company issued 500,000 unregistered shares of common stock of the Company to a third party lender in connection with refinancing a $50,000 promissory note issued in June 2002 as well as accrued interest, fees, and expenses incurred in connection with the refinancing.
In February 2008, MRC pledged 3,000,000 shares of common stock of the Company as collateral on a $96,946 note issued in February 2008 to a third party lender. 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 2008, MRC pledged 2,000,000 shares of common stock of the Company to secure a $75,000 promissory note payable to Parker Mills in connection with extending the maturity date until June 2009. 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. Bill Mills is a Director of the Company and a partner of Parker Mills, LLP.
In March 2008, the Company and MRC amended the indemnity and reimbursement agreement (entered into in April 2007) whereby the Company agreed to reimburse and indemnify MRC for additional shares pledged as collateral in connection with a $96,946 and a $75,000 notes. 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.
During the three months ended March 31, 2008, the Company issued 250,000 unregistered shares of common stock of the Company to a director of the Company pursuant to a restricted stock agreement that provides for the shares to vest on the 1-year anniversary date of the agreement.
During the three months ended March 31, 2008, warrants to purchase 1,000,000 shares of common stock of the Company at an exercise price of $0.010 per share expired.
During the three months ended March 31, 2008, 1,683,332 unregistered shares of the common stock of the Company vested. These shares were issued pursuant to restricted stock agreements with employees of the Company and NOW Solutions executed in 2006 and 2007.
15
In May 2008, the Company issued 1,000,000 shares of the Company’s common stock to Victor Weber that were granted in connection with a $100,000 loan made by Mr. Weber to Now Solutions in October 2006. These shares were accounted for in the Company’s 10-KSB for the year ended December 31, 2006.
For the period from April 1, 2008 to May 20, 2008, warrants to purchase 5,250,000 shares of common stock of the Company at an exercise price of $0.075 to $0.010 per share expired.
For the period from April 1, 2008 to May 20, 2008, 500,000 unregistered shares of the common stock of the Company vested. These shares were issued pursuant to a restricted stock agreements with an employees of NOW Solutions executed in 2007.
Item 3. Defaults Upon Senior Securities
Note payable of $992,723 to Wolman Blair, PLLC, dated November 30, 2005. The note is secured with the assets of NOW Solutions and bears a default interest rate of 18%. As of the date of this report, the Company is in arrears in the amount of $37,500.
Note payable of $239,004 to a third party lender, dated August 30, 2002, bearing interest at 13% per annum, and unsecured. As of the date of this report, the Company is in arrears in the amount of $282,679.
Note payable of $96,946 to a third party, bearing interest at 12% per annum. As of the date of this report, the Company is in arrears in the amount of $5,200.
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
The following documents are filed as part of this report:
(A) Exhibits:
Exhibit No. | Description | Location | ||
31.1 | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 20, 2008 | Provided herewith | ||
31.2 | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 20, 2008 | Provided herewith | ||
32.1 | Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 20, 2008 | Provided herewith | ||
32.2 | Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 20, 2008 | Provided herewith |
(B) Reports on Form 8-K:
On January 16, 2008, Vertical Computer Systems, Inc. engaged Malone & Bailey, P.C. as its principal accountant to audit its financial statements. The Company did not consult Malone & Bailey on any matters described in paragraph (a)(2)(i) or (ii) of Item 304 of Regulation S-B during the Company’s two most recent fiscal years or any subsequent interim period prior to engaging Malone & Bailey.
Also in January 2008, the Company relocated its corporate headquarters to 101 W. Renner Road, Suite 300, Richardson, Texas 75082. The Company and its subsidiary, NOW Solutions, Inc., will continue to utilize the office located at 201 Main Street, Suite 1175, Fort Worth, TX 76102.
16
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
VERTICAL COMPUTER SYSTEMS, INC. | ||
May 20, 2008 | By: | /s/ Richard Wade |
Richard Wade, President and | ||
Chief Executive Officer | ||
May 20, 2008 | By: | /s/ David Braun |
David Braun | ||
Chief Financial Officer |
17