UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-------------------------
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934:
For the quarterly period ended March 31, 2005.
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934:
For the transition period from _____ to _____
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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)
201 Main Street, Suite 1175
Fort Worth, Texas 76102
(Address of Principal Executive Offices)
(817) 348-8717
(Issuer's Telephone Number)
Securities registered pursuant to section 12 (b) of the Act:
Title of each class Name of each exchange on which registered
None None
---- ----
Securities registered pursuant to section 12 (g) of the Act:
Common Stock, par value $0.00001 per share
------------------------------------------
(Title of Class)
Check whether the Issuer (1) filed all reports required to be filed by
section 13 or 15(d) of the Securities Exchange Act of 1934, as amended during
the past 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.
(1) Yes |X| No |_| (2) Yes |X| No |_|
As of May 13, 2005, the issuer had 877,268,895 shares of common stock, par
value $.00001, issued and outstanding.
Documents incorporated by reference: None
Transitional Small Business Disclosure Format: No
1
VERTICAL COMPUTERS SYSTEMS, INC. AND SUBSIDIARIES
INDEX TO FORM 10-QSB
PART I FINANCIAL INFORMATION Page
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheet (unaudited) as of March 31, 2005 3
Condensed Consolidated Statements of Operations (unaudited) for the Three Months Ended 5
March 31, 2005 and 2004
Condensed Consolidated Statements of Cash Flows (unaudited) for the Three Months Ended 6
March 31, 2005 and 2004
Notes to Condensed Consolidated Financial Statements 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20
Item 3. Controls and Procedures 31
PART II OTHER INFORMATION
Item 1. Legal Proceedings 31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 34
Item 3. Defaults Under Senior Securities 35
Item 4. Submission of Matters To A Vote Of Security Holders 36
Item 5. Other Information 36
Item 6. Exhibits and Reports on Form 8-K 36
Signatures 38
Certifications 39
2
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheet
March 31, December 31,
2005 2004
------------ ------------
(UNAUDITED)
Assets
Current Assets
Cash $ 705,876 $ 330,780
Restricted cash -- --
Securities available for sale 9,128 9,128
Accounts receivable, net of allowance for bad debts of $144,973 and $137,473 966,992 1,325,114
Other receivable 75,085 75,085
Employee receivables 14,497 17,138
Prepaid expenses and other assets 13,449 13,789
------------ ------------
Total Current Assets 1,785,028 1,781,034
Property and equipment, net of accumulated depreciation 51,047 82,824
Other intangibles, net 745,188 944,298
Deposits and other 10,372 10,373
------------ ------------
Total Assets $ 2,591,635 $ 2,818,529
------------ ------------
Liabilities and Stockholder's Equity/ (Deficit)
Current Liabilities
Accounts payable and accrued liabilities $ 6,078,693 $ 6,078,310
Deferred revenue 2,933,487 2,679,484
Accrued income taxes 18,000 18,000
Current portion - convertible debenture 40,000 40,000
Current portion-notes payable 4,439,283 4,580,899
------------ ------------
Total Current Liabilities 13,509,463 13,396,693
Convertible debenture 390,000 390,000
Accrued dividends 2,463,712 2,313,712
------------ ------------
Total Liabilities $ 16,363,175 $ 16,100,405
------------ ------------
See accompanying notes to the condensed consolidated financial statements
(Continued on next page)
3
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheet
(Continued from previous page)
March 31, December 31,
2005 2004
------------ ------------
(UNAUDITED)
Minority interest -- --
Stockholders' Equity (Deficit)
Series A 4% Convertible Cumulative Preferred stock; $0.001 par value;
250,000 shares authorized; 50,000 shares issued and outstanding 50 50
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
861,268,895 and 799,272,301 issued and outstanding 8,749 8,678
Additional paid-in-capital 27,477,394 27,385,191
Accumulated deficit (41,944,794) (41,367,483)
Accumulated other comprehensive income 135,812 140,438
------------ ------------
Total Stockholders' deficit (13,771,540) (13,281,876)
------------ ------------
Total liabilities and stockholders' deficit $ 2,591,635 $ 2,818,529
============ ============
See accompanying notes to the condensed consolidated financial statements
4
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(Unaudited)
Three months ended March 31,
2005 2004
-------------- --------------
Revenues
Licensing and maintenance $ 1,269,996 $ 1,261,905
Consulting Services 277,690 231,836
Other 31,911 35,476
-------------- --------------
Total Revenues 1,579,597 1,529,217
Selling , general and administrative expenses 1,885,295 2,920,928
Goodwill Impairment -- 1,760,000
-------------- --------------
Operating loss (305,698) (3,151,711)
Interest income 687 926
Interest expense (122,300) (110,990)
-------------- --------------
Loss before minority interest and income taxes (427,311) (3,261,775)
-------------- --------------
Income Tax Provision (benefit) -- --
-------------- --------------
Loss before minority interest $ (427,311) $ (3,261,775)
-------------- --------------
Minority interest in (income) loss of subsidiary -- --
-------------- --------------
Net loss (427,311) (3,261,775)
-------------- --------------
Dividend applicable to preferred stock (150,000) (150,000)
Net loss applicable to common stockholders' (557,311) (3,411,776)
-------------- --------------
Basic and diluted loss per share 0 0
-------------- --------------
Basic and diluted weighted average
of common shares outstanding 870,968,895 831,915,161
-------------- --------------
Comprehensive loss and its components
consist of the following:
Net loss $ (427,311) $ (3,261,776)
Translation adjustments 4,203 24,294
-------------- --------------
Comprehensive loss $ (423,107) $ (3,237,482)
============== ==============
See accompanying notes to the condensed consolidated financial statements
5
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
Three Months Ended March 31,
2005 2004
------------ ------------
Cash flows from operating activities
Net loss $ (427,311) $ (3,261,776)
Adjustments to reconcile net loss to net cash
Provided by operating activities:
Depreciation and amortization 230,887 405,782
Goodwill Impairment -- 1,760,000
Write-off of MedData Solutions Investment -- 135,000
Non employee stock compensation 92,273 486,581
Employee stock compensation expense -- 83,494
Allowance for bad debts 7,500 (6,031)
Changes in operating assets and liabilities:
Accounts receivable 350,622 (48,897)
Receivable from officers and employees 2,641 (5,487)
Prepaid expenses 10,339 (104,752)
Accounts payable and accrued liabilities 383 6,148
Deferred Revenue 254,003 387,778
------------ ------------
Net cash provided by operating activities 521,338 47,344
See accompanying notes to condensed consolidated financial statements
(Continued on next page)
6
Vertical Computer Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Continued from previous page)
Three Months Ended March 31,
2005 2004
------------ ------------
Cash flow from investing activities:
Acquisition of minority interest in Now Solutions -- (877,000)
Purchase of equipment -- (17,242)
------------ ------------
Net cash used in investing activities -- (894,242)
Cash flow from financing activities:
Payment of convertible debentures -- (10,000)
Payment of Note Payable (141,616) (265,000)
Proceeds from issuance of Notes Payable -- 500,000
------------ ------------
Net cash provided by (used in) financing activities (141,616) 225,000
Effect of changes in exchange rates on cash (4,626) (24,294)
------------ ------------
Net increase (decrease) in cash and cash equivalents, 375,095 (646,192)
Cash and cash equivalents, beginning of period 330,780 962,454
------------ ------------
Cash and cash equivalents, end of period $ 705,876 $ 316,262
============ ============
Supplemental disclosures of cash flow information:
Cash paid during the year period:
Interest $ 44,322 $ 48,088
============ ============
Non-cash investing and financing activities:
Common stock and debt issued for acquisitions $ -- $ 1,018,000
============ ============
See accompanying notes to condensed consolidated financial statements
7
VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note 1 - Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-QSB and
Item 310 of Regulation S-B. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The accompanying unaudited condensed
consolidated financial statements reflect all adjustments that, in the opinion
of the management of Vertical Computer Systems, Inc. and subsidiaries
(collectively, the "Company"), are considered necessary for a fair presentation
of the financial position, results of operations, and cash flows for the periods
presented. The results of operations for such periods are not necessarily
indicative of the results expected for the full fiscal year or for any future
period. The accompanying financial statements should be read in conjunction with
the audited consolidated financial statements of the Company included in the
Company's Form 10-KSB for the year ended December 31, 2004.
Stock-Based Compensation
Effective January 1, 2004 the Company adopted the fair value provisions of
Statement of Financial Accounting Standards ("SFAS") No. 123 for share based
payments to employees. In accordance with transition provisions under SFAS No.
148, the Company has adopted the prospective method for transitional
recognition.
Going Concern Uncertainty
The accompanying condensed consolidated financial statements for the three
months ended March 31, 2005 and 2004, 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, 2005 was $13.8 million.
Additionally, at March 31, 2005, the Company had negative working capital of
approximately $11.7 million (although it includes deferred revenue of
approximately $2.9 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.
However, there can be no assurance that the Company will be able to secure
additional funds and that if such funds are available, whether the terms or
conditions would be acceptable to the Company and whether the Company will be
able to turn into a profitable position and generate positive operating cash
flow. The condensed consolidated financial statements contain no adjustment for
the outcome of this uncertainty.
Furthermore, the Company is exploring certain opportunities with a number
of companies to participate in marketing of its products. The exact results of
these opportunities are unknown at this time.
Note 2 - Common and Preferred Stock Transactions
In January 2005, warrants to purchase 3,000,000 shares of common stock at
an exercise price of $0.0165 per share at a fair market value at the date of
issuance of $49,385 (valued using the Black-Scholes Option Valuation Model) that
were issued to Grant Consultants of America ("GCA") were automatically cancelled
pursuant to the terms of the warrants. These warrants were issued in connection
with an October 2004 consulting agreement between the Company's subsidiary,
Government Internet Systems, Inc. ("GIS") and GCA.
8
In January 2005, the Company issued an additional 2,000,000 unregistered
shares of common stock to Victor Weber pursuant to the September 2004 amendment
of the terms of the $215,000 note issued by Now Solutions, Inc. ("Now
Solutions") to the Company and assigned to Mr. Weber. In December 2004, the
Company recorded an expense of issuing the 2,000,000 unregistered shares to Mr.
Weber at a fair market value of $10,000. Mr. Weber is the President and a
Director of GIS and a member of CW International, LLC ("CW International").
In March 2005, the Company issued 5,000,000 shares to Arglen Acquisitions,
LLC ("Arglen"). In December 2004, the Company recorded the expense of issuing
5,000,000 unregistered shares to Arglen at a fair market value of $82,273, which
was based on an average share price during 11 days of August 2004. These shares
were issued pursuant to the settlement agreement with Arglen whereby the Company
was obligated to issue 5,000,000 unregistered shares of common stock of the
Company to Arglen, due to its failure to file a registration statement on Form
SB-2 within 180 days from the closing date of the settlement in February 2004.
During the three months ended March 31, 2005, warrants to purchase
5,554,977 shares of common stock of the Company at a price of $0.011 to $0.35
per share expired.
Note 3 - Notes Payable
---------------------------------
March31, December 31,
2005 2004
------------ ------------
The $5.5 million note payable, issued by Now Solutions to Coast Business Credit
("Coast") and purchased by WAMCO 32, Ltd. (`WAMCO") was amended in June 2004.
Pursuant to the amendment, the interest was changed to 9% per annum and the
$1,304,766 outstanding principal balance shall be payable as follows: (a)
$91,667 principal per month, plus interest commencing on June 30, 2004 and
continuing on each succeeding month through September 30, 2004; (b) $7,500
principal per month, plus interest, commencing on October 31, 2004 and
continuing on each succeeding month through January 31, 2005; (c) providing that
Now Solutions has achieved revenues of $7.5 million and earnings before
interest, taxes, depreciation & amortization ("EBITDA") of not less than
$2,200,000 for the fiscal year 2004, $7,500 principal per month, plus interest,
commencing on February 28, 2005 and continuing on the last day of each
succeeding month until June 30, 2005; and (d) $91,667 principal per month plus
interest, commencing on July 31, 2005 and continuing on each succeeding month
until the note is paid. In the event Now Solutions does not qualify for reduced
payments, the note will be payable in the amount of $91,667 principal per month,
plus interest, commencing on February 28, 2005 and continuing on the last day of
each succeeding month until the note is paid. Now Solutions has made all
interest payments as of May 13, 2005. As of May 13, 2005, Now Solutions
owed $1,067,793 of which $518,860 is delinquent. The note is in default. $ 1,140,485 $ 1,190,601
Note payable to Ross Systems, Inc. ("Ross") issued by Now Solutions in the
amount of $1,000,000. The note is unsecured and non-interest bearing. The note
was recorded at a discount (which will be amortized over the life of the note),
payments of $250,000 and $750,000 to be due in February 2002 and 2003,
respectively. If a payment is not received within three days from the due date,
the note will begin to bear interest at 10% per annum. In 2002, Now Solutions
offset $250,000 payment through its receivable from Ross in terms of the
agreement between Now Solutions and Ross. See also Note 4 for information
concerning the legal proceedings between the Company, Now Solutions and Ross. 750,000 750,000
9
---------------------------------
March31, December 31,
2005 2004
------------ ------------
Note payable in the amount of $27,558 to a law firm, a related party, bearing
interest at 6% per annum, unsecured, principal and interest due at January 2002.
The note is in default. In January 2005, Parker, Mills, and Patel filed a
lawsuit in Los Angeles Superior Court to collect the outstanding balance of
$23,974 due under the promissory note issued to them by the Company and for
failure to pay fees for professional services in the amount of $89,930 rendered
to the Company, plus interest. In March 2005, the Company filed a demurrer. In
April 2005, the Company answered the complaint, asserting various legal defenses. 23,974 23,974
Note payable in the amount of $31,859 to a third-party lender, bearing interest at
an amount to be negotiated, principal and interest due on demand. 31,859 31,859
Note payable in the amount of $27,000 to a third-party, payable upon demand. 27,000 27,000
Note payable to a third-party lender in the amount of a $239,004 bearing
interest at 13% per annum and unsecured, with a $65,000 payment made in December
2002, commencing with monthly payment of $7,500 beginning in March 2003. This
note was issued in 2002 to replace the note of $211,137 issued in August 2001 to
a third-party lender, bearing interest at 12% per annum. In March 2003, the note
was amended that the Company agreed to pay the interest and expenses responsible
by the lender for a third-party loan secured on the lender's behalf instead of
paying to the lender and the Company agreed to begin making monthly payment of
$7,500, beginning on June 1, 2003. Pursuant to the extension in December 2003,
the Company was required to make monthly installment payments of $7,500,
beginning on February 1, 2004, until the balance under the note has been paid.
The note has been in default since February 1, 2004. 167,141 167,141
Note payable in the amount of $50,000 to a third-party lender, bearing no
interest. In March 2003, the parties entered into an amendment, whereby the
parties agreed to accrue interest beginning in October 2002 at 12% per annum.
The parties also agreed that the Company would make monthly payments of accrued
interests beginning in April 2003 and monthly principal payment of $5,000
beginning in July 2003. In connection with the note, the Company issued
three-year warrants to purchase 1,200,000 shares of its common stock at a price
of $0.003 per share. The note has been in default since April 1, 2003. 47,180 47,180
Note payable in the amount of $50,000 to a third-party lender, bearing interest
at the rate of 12% per annum. In March 2003, the parties entered into an
amendment, whereby the parties agreed to pay accrued interest in the amount of
$4,200 for this note and to extend the maturity date to June 1, 2004. Beginning
in July 2003, the above interest payments were to be replaced with a monthly
installment payment of $5,000, with the initial payments applied first to the
$25,000 note (issued below) and then to the $50,000 note. In connection with the
amendment, the Company issued three-year warrants to purchase 1,500,000 shares
of its common stock at a price of $0.004 per share. The note has been in default
since April 1, 2003. 50,000 50,000
Note payable in the amount of $25,000 to a third-party lender, bearing interest
at 12% per annum, secured by 10,000,000 shares of the Company's common stock
that are owned by Mountain Reservoir Corporation ("Mountain Reservoir"),
controlled by W5 Family Trust, of which Richard Wade, the President and CEO of
the Company, is trustee, due in December 2002. In March 2003, the parties
entered into an amendment. Pursuant to the amendment, the Company agreed to pay
accrued interest in the amount of $1,170 for this $25,000 note and amend the due
date to July 1, 2005. Beginning in July 2003, the above interest payments shall
be replaced with monthly payments of $5,000 with the initial payments applied
first to the $25,000 note and then to the $50,000 (the above) note issued. The
note has been in default since April 1, 2003. 12,583 12,583
10
---------------------------------
March31, December 31,
2005 2004
------------ ------------
Note payable in the amount of $280,000, bearing interest at 4% per annum and
issued to Robert Farias on October 31, 2001, was amended by the parties in March
2003. Pursuant to the amendment, the payment of principal was to be paid in
monthly installments in the amount of $5,000, which was to be replaced with
monthly payments of $10,000 beginning in January 2004. All interest was due on
the day the principal is paid in full. In exchange for the extensions, the
interest rate will accrue at the rate of 12% from the date the note was issued.
In February 2004, the Company and Mr. Farias amended the $280,000 note issued to
Mr. Farias on October 31, 2001 and the $181,583 note issued to Mr. Farias on
October 17, 2002. Any default on these notes was waived, and the Company agreed
to make the following payments on these notes: (i) $20,000, which was paid
toward the $181,583 note on February 20, 2004; (ii) fifty percent (50%) of the
remaining past-due amounts by March 20, 2004; and (iii) the all remaining
past-due amounts to bring the notes current by April 20, 2004. In the event the
Company does not pay the amounts in a timely manner, then all amounts still
owing under these notes will be considered in default and the following shall
apply: (i) all such remaining amounts will be added to the secured loan amounts
and will be subject to the security interest and pledge agreements under the
$84,000 promissory note issued by the Company's subsidiary, EnFacet, to Mr.
Farias on June 1, 2001; (ii) the $14,640 monthly payments to be made under the
$84,000 note will be applied to the $280,000 and $181,583 notes until these
notes are paid in full; and (iii) with respect to cash proceeds Now Solutions
receives due to a capital infusion or upfront licensing fees from a reseller
that is outside its normal scope of business (i.e., not part of software sales
in the regular course of business), Now Solutions is required to pay 50% of such
proceeds remaining after the $500,000 note payable issued by Now Solutions to
Mr. Farias on February 13, 2004 has been paid in full toward the $280,000 and
$181,583 notes if the Company is not current in its payments. The $280,000 note
is also secured by SiteFlash technology owned by the Company. Robert Farias is a
director of Now Solutions, a 100% owned subsidiary of the Company. The note is
in default. 237,626 237,626
Note payable in the amount of $181,583 issued to Robert Farias, bearing interest
at 12% per annum, payable as follows: (i) an initial installment of $10,000
payable upon execution; (ii) monthly payment of $5,000 beginning November 5,
2002 and (iii) monthly $10,000 payment beginning May 15, 2003 until all amounts
under the note have been paid in full. This note was issued to replace two notes
previously issued; each had outstanding balance of $100,000 at December 31,
2001. In February 2004, the Company and Mr. Farias amended the $280,000 note
issued to Mr. Farias on October 31, 2001 and the $181,583 note issued to Mr.
Farias on October 17, 2002. Any default on these notes was waived, and the
Company agreed to make the following payments on these notes: (i) $20,000, which
was paid toward the $181,583 note on February 20, 2004; (ii) fifty percent (50%)
of the remaining past-due amounts by March 20, 2004; and (iii) the all remaining
past-due amounts to bring the notes current by April 20, 2004. In the event the
Company does not pay the amounts in a timely manner, then all amounts still
owing under these notes will be considered in default and the following shall
apply: (i) all such remaining amounts will be added to the secured loan amounts
and will be subject to the security interest and pledge agreements under the
$84,000 promissory note issued by the Company's subsidiary, EnFacet, to Mr.
Farias on June 1, 2001; (ii) the $14,640 monthly payments to be made under the
$84,000 note will be applied to the $280,000 and $181,583 notes until these
notes are paid in full; and (iii) with respect to cash proceeds Now Solutions
receives due to a capital infusion or upfront licensing fees from a reseller
that is outside its normal scope of business (i.e., not part of software sales
in the regular course of business), Now Solutions is required to pay 50% of such
proceeds remaining after the $500,000 note payable issued by Now Solutions to
Mr. Farias on February 13, 2004 has been paid in full toward the $280,000 and
$181,583 notes if the Company is not current in its payments. The note is
secured by 10,450,000 shares of the Company's common stock that are owned by
Mountain Reservoir to cover any shortfall. Mountain Reservoir 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. Robert Farias is a director of
Now Solutions, a 100% owned subsidiary of the Company. The note is in default. 108,034 108,034
11
---------------------------------
March31, December 31,
2005 2004
------------ ------------
The Company pledged its interest in a $215,000 note issued by Now Solutions to
the Company to secure this note and the $100,000, $40,000, and $50,000 notes
issued to Victor Weber and $25,000 in expense paid by Weber on behalf of the
Company that were included in trade accounts payable, who had the option to have
the Company assign the $215,000 note to Weber provided that Weber cancels all
three notes and the outstanding $25,000 in accounts payable. Weber elected to
make this assignment in January 2004. At that time, all other notes and debt
owed to Weber were cancelled. Mr. Weber is the President and a Director of GIS
and a member of CW International. The note is in default. 215,000 215,000
Note payable in the amount of $350,000 issued by EnFacet to a third-party
lender, bearing interest at 8% per annum, unsecured, and due on February 28,
2003. EnFacet is in default subsequent to December 31, 2002. In February 2004,
the parties amended the terms of the notes. Pursuant to the amendment, the
parties waived any defaults on the notes and agreed that the notes will be
payable as follows: once the Company's subsidiary, Now Solutions, has paid off
the entire balance due under the $500,000 Note issued by Now Solutions to Farias
on February 13, 2004, 84% of any remaining amounts from the final $91,500
installment payment on the $500,000 note issued by Now Solutions to Robert
Farias on February 13, 2004, shall be applied to the $350,000 and $90,000 notes
on a pro-rata basis. Thereafter, the Company was to make monthly principal
payments of $76,860 applied on a pro-rata basis to the $350,000 and $90,000
notes until all monies due under these notes have been paid. In connection with
the amendment, Now Solutions entered into a security agreement with the lender
to guarantee the note. The security interest of Now Solutions' assets on the
secured promissory note will be junior to Now Solutions' present indebtedness to
WAMCO, Arglen, and Robert Farias in connection with the $500,000 note. This note
is in default. 350,000 350,000
Note payable in the amount $25,000 promissory note, bearing interest at 10% per
annum, was issued in April 2003 to a consultant of the Company's subsidiary,
EnFacet, Inc., for past services rendered. The note is payable in monthly $1,000
installments beginning in May 2003 to be replaced by $2,000 monthly installments
beginning in October 2003. The note is in default. 25,000 25,000
Note payable in the amount of $17,500, bearing no interest to a third-party
lender in consideration of a loan in the amount of $15,000, was due in June
2003. In connection with the note, the Company paid a commitment fee of $2,500
and issued five-year warrants to purchase 250,000 shares of common stock of the
Company at an exercise price of $0.0075 per share to the lender. In connection
with this and another loan for $15,000 (see below), the Company also issued
five-year warrants to purchase 250,000 shares of common stock of the Company at
an exercise price of $0.0075 per share to a third-party consultant. In February
2004, the parties amended the terms of the loan. The lender waived any default
on the note and in exchange the Company issued 500,000 unregistered shares of
the Company common stock to each lender (at a total fair market value of
$7,000), and to pay $8,750 by March 31, 2004 and $8,750 plus all accrued
interest by April 30, 2004 under the note. This note is in default. 11,000 11,000
12
---------------------------------
March31, December 31,
2005 2004
------------ ------------
Note payable in the amount of $17,500, bearing no interest to a third-party
lender in consideration of a loan in the amount of $15,000, was due in June
2003. In connection with the note, the Company paid a commitment fee of $2,500
and issued five-year warrants to purchase 250,000 shares of common stock of the
Company at an exercise price of $0.0075 per share to the lender. In connection
with this and another loan for $15,000 (see above), the Company also issued
five-year warrants to purchase 250,000 shares of common stock of the Company at
an exercise price of $0.0075 per share to a third-party consultant. In February
2004, the parties amended the terms of the loan. The lender waived any default
on the note and in exchange the Company issued 500,000 unregistered shares of
the Company common stock to each lender (at a total fair market value of
$7,000), and to pay $8,750 by March 31, 2004 and $8,750 plus all accrued
interest by April 30, 2004 under the note. This note is in default. 11,000 11,000
Note payable in the amount of $10,000 issued by EnFacet to a third-party lender,
bearing interest at 8% per annum, unsecured, with principal and interest due on
June 1, 2002. EnFacet has been in default since December 31, 2002. 10,000 10,000
Note payable in the amount of $84,000 issued by EnFacet to Robert Farias, dated
June 1, 2001, bearing interest at 8% per annum, unsecured, with principal and
interest due on June 1, 2002. EnFacet was in default at December 31, 2002. In
March 2003, both parties entered into an amendment. Pursuant to the amendment,
the due date was extended to March 17, 2004 in exchange for increasing the
interest rate from 8% to 12% at which interest will be accrued from the date the
note was issued. In addition, EnFacet shall make monthly payments of $1,000
commencing in April 2003. In February 2004, the Company and Robert Farias waived
any defaults on the note and agreed that the note will be payable as follows:
once the Company's subsidiary, Now Solutions, has paid off the entire balance
due under the $500,000 note issued by Now Solutions to Farias on February 13,
2004, 16% of any remaining amounts from the final $91,500 installment payment on
the $500,000 note shall be applied to the $84,000 note. Thereafter, the Company
or, at the Company's option, Now Solutions, was to make monthly principal
payments of $14,640 beginning on the first day of the following month until all
monies due under the $84,000 note has been paid. In connection with the
amendment, Now Solutions entered into a security agreement with the lender to
guarantee the note. The security interest of Now Solutions' assets on the
secured promissory note will be junior to Now Solutions' present indebtedness to
WAMCO, Arglen, and Robert Farias in connection with the $500,000 note. Robert
Farias is a director of Now Solutions, a 100% owned subsidiary of the Company.
The note is in default. 84,000 84,000
Note payable in the amount of $10,365 dated January 17, 2003 bearing an interest
of 10% per annum, with principal and interest due on December 5, 2003. $3,000 in
payments was made on this note in 2003. This note is in default. 7,365 7,365
Note payable in the amount of $23,030 dated March 21, 2003 bearing an interest
of 12% per annum, with principal and interest due on April 21, 2004. This note
is in default. 23,030 23,030
13
---------------------------------
March31, December 31,
2005 2004
------------ ------------
Note payable in the amount of $90,000 dated June 26, 2003 to a third-party
bearing an interest of 10% annum, with principal and interest due on March 28,
2004. This note is in default. In February 2004, the parties amended the terms
of the notes. Pursuant to the amendment, the parties waived any defaults on the
notes and agreed that the notes will be payable as follows: Once the Company's
subsidiary, Now Solutions, has paid off the entire balance due under the
$500,000 Note issued by Now Solutions to Farias on February 13, 2004, 84% of any
remaining amounts from the final $91,500 installment payment on the $500,000
note issued by Now Solutions to Robert Farias on February 13, 2004, shall be
applied to the $350,000 and $90,000 notes on a pro-rata basis. Thereafter, the
Company shall continue to make monthly principal payments of $76,860 applied on
a pro-rata basis to the $350,000 and $90,000 notes until all monies due under
these notes have been paid. In connection with the amendment, Now Solutions
entered into a security agreement with the lender to guarantee the note. The
security interest of Now Solutions' assets on the secured promissory note will
be junior to Now Solutions' present indebtedness to WAMCO, Arglen, and Robert
Farias in connection with the $500,000 note. This note is in default. 90,000 90,000
Note payable in the amount of $60,000 issued by GIS to a third-party dated
November 5, 2003, bearing an interest of 10% per annum, with principal and
interest due on November 5, 2004. The Company agreed to issue a 2% ownership
interest of its subsidiary, GIS to the third-party in connection with this note.
In addition, the lender will be entitled to receive a 2% royalty on net sales of
products by GIS in the United States up to $300,000 and the Company issued
1,000,000 unregistered shares of Company's common stock (with a fair market
value of $5,000). The Note is secured by 4,000,000 shares of common stock of the
Company that were owned by Mountain Reservoir. Mountain Reservoir 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. The Company currently
owns 85% of GIS, and will issue a 2% ownership interest from its share of stock
in GIS. This note is in default. 60,006 60,006
Note Payable in the amount of $40,000 issued by GIS to a third-party dated
November 19, 2003, bearing an interest of 10% per annum, with principal and
interest due on November 19, 2004. The Company agreed to issue a 1.5% ownership
interest of its subsidiary, GIS to the third-party in connection with this note.
In addition, the lender will be entitled to receive a 1.5% royalty on net sales
of products by GIS in the United States up to $200,000 and the Company issued
1,000,000 unregistered shares of Company's common stock (with a fair market
value of $4,000). The Note is secured by 3,000,000 shares of common stock of the
Company that were owned by Mountain Reservoir. Mountain Reservoir 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. The Company currently
owns 85% of GIS, and will issue a 1.5% ownership interest from share of stock in
GIS. $5,000 of this note was not funded until January 2004. This note is in default. 40,000 40,000
14
---------------------------------
March31, December 31,
2005 2004
------------ ------------
Note Payable in the amount of $500,000 issued by Now Solutions, the Company's
wholly-owned subsidiary to Robert Farias. This note is secured by Now Solutions'
assets. In addition Farias is entitled to a 5% royalty on any sales by Now
Solution of over $8,000,000 up to $500,000. The note bears interest at 10% per
annum and Now Solutions is required to make monthly interest payments for all
interest accrued in the previous month on the first day of each month beginning
April 1, 2004 and beginning on October 1, 2004 and continuing on the first day
of every month thereafter, monthly principal payments of $91,500 plus interest
until the note has been paid in full. In the event Now Solutions receives cash
proceeds due to a capital infusion or upfront licensing fees from a reseller
that is outside its normal scope of business (i.e., not part of software sales
in the regular course of business), Now Solutions is required to pay 50% of such
proceeds remaining toward payment of the $500,000 note. In connection with the
loan, the Company issued (i) five-year warrants to purchase 5,000,000
unregistered shares of common stock at $0.01 per share at a fair market value at
the date of issuance of $74,538 (valued using the Black-Scholes Valuation
Model); (ii) five-year warrants to purchase 5,000,000 unregistered shares of
common stock of the Company at $0.02 per share at a fair market value at the
date of issuance of $74,344 (valued using the Black-Scholes Valuation Model);
(iii) five-year warrants to purchase 5,000,000 unregistered shares of common
stock of the Company at $0.03 per share at a fair market value at the date of
issuance of $74,200 (valued using the Black-Scholes Valuation Model); (iv)
5,000,000 unregistered shares of common stock of the Company (at a fair market
value of $75,000); and (v) an additional 5,000,000 unregistered shares of common
stock of the Company in the event that $250,000 was not paid toward the loan on
or before March 15, 2004, which were issued (at a fair market value of
$125,000). All of the foregoing warrants and stock are subject to "piggy-back"
registration rights. In connection with the loan, Now Solutions entered into a
security agreement with the lender to guarantee the note. The security interest
of Now Solutions' assets on the secured promissory note is junior to Now
Solutions' present indebtedness to WAMCO and Arglen. In addition, the Company
also pledged a 30% ownership interest in Now Solutions to ensure the making of
the $500,000 loan to Now Solutions. The note is in default. As of May 13, 2005,
Now Solutions had made principal payments totaling $183,000 to Robert Farias. In
January 2005, WAMCO notified Mr. Farias that pursuant to the subordination
agreement executed between WAMCO and Mr. Farias, Mr. Farias was no longer to
accept payments from or to take any collection actions against Now Solutions for
the repayment of junior debt. Robert Farias is a director of Now Solutions, a
100% owned subsidiary of the Company. 317,000 408,500
Note Payable in the amount of $600,000 issued to Arglen by the Company pursuant
to the Company's acquisition of Arglen's 35% interest in Now Solutions. The
Company's purchase of Arglen's interest resulted in the Company recognizing
$1,680,000 of goodwill, which was written-off in 2004. The note is a no-interest
bearing secured promissory note providing for payments of $200,000 in April
2004, $100,000 in June 2004, and $300,000 in September 2004, which was issued at
closing. When the Company did not make the April 2004 payment, the Company began
accruing interest at the rate of 10% from the inception of the note. The note is
in default. In August 2004, Arglen obtained a default judgment in Los Angeles
court for the outstanding principal, plus attorney's fees and interest at the
rate of 10% per annum. The Company has filed a motion in the Delaware court to
stay the enforcement of the judgment pending resolution of the Delaware action.
In April 2005, Arglen filed a Notice of Filing a Foreign Judgment in Tarrant
County, Texas. The security interest of Now Solutions' assets on the secured
promissory note is junior to Now Solutions' present indebtedness to WAMCO. In
addition, at closing, the Company cancelled 80,763,943 warrants held by Arglen
and issued to Arglen 20,000,000 unregistered shares of the common stock of the
Company (at a fair market value of $280,000), which is subject to a "lock-up"
provision. Pursuant to the settlement agreement, the Company also cancelled
warrants to purchase 80,763,943 common shares of the Company that were
originally granted to Arglen in connection with the Company's acquisition 60% of
equity interest in Now Solutions. In December 2004, the Company recorded the
expense of issuing 5,000,000 unregistered shares to Arglen at a fair market
value of $82,273, which was based on an average share price during 11 days of
August 2004. These shares were due pursuant to the settlement agreement whereby
the Company was obligated to issue 5,000,000 unregistered shares of common stock
of the Company to Arglen, due to its failure to file a registration statement on
Form SB-2 within 180 days from the closing date of the settlement. In March
2005, the Company issued these 5,000,000 shares to Arglen. 600,000 600,000
------------ ------------
15
---------------------------------
March31, December 31,
2005 2004
------------ ------------
Total notes payable 4,439,283 4,580,899
Current maturities (4,439,283) (4,580,899)
------------ ------------
Long-Term portion of notes payable $ -- $ --
------------ ------------
Note 4 - Legal Proceedings
The Company is involved in the following ongoing legal matters:
In February 2003, the Company filed a lawsuit and a derivative action in
New York Supreme Court Case against defendants Ross, Arglen, James Patrick
Tinley ("Tinley"), and Garry Gyselen ("Gyselen"). The Company filed a derivative
action on behalf of its subsidiary Now Solutions when Arglen refused to
authorize a lawsuit against any parties who were alleged to have acted against
the best interest of Now Solutions. 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. The
Company's original claims sought damages and equitable relief arising out of
actions of the defendants constituting breach of contract, fraud, conspiracy and
breach of fiduciary duty in connection with certain transactions entered into
between Ross and Now Solutions; Ross and Arglen; Arglen and Now Solutions;
Gyselen and Now Solutions; and the Company and Arglen. This action concerns
claims of breach of contract and indemnification for failure to pay adjustments
at the closing on the sale of assets of Ross to Now Solutions for prepaid
maintenance fees and for related relief. 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, pursuant to the
settlement, dismissed in February 2004. The Company appealed the decision with
regard to its claim for breach of contract for Ross' failure to give the proper
maintenance fee adjustment and related claims for offset and attorney's fees. On
June 1, 2004, the appeal of the dismissal of the action against Ross was
submitted to the court for decision. On appeal, the claims against Ross were
reinstated pursuant to the order of the Appellate Division, dated October 26,
2004. In November 2004, Ross filed an answer containing affirmative defenses in
the Derivative Action.
In March 2003, Ross commenced an action in New York Supreme 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. In
August 2003, the New York Supreme Court denied the motion and dismissed Ross's
action without prejudice. In October 2003, the motion of Ross for re-argument
was denied. Ross appealed the August 2003 court order, but subsequently
abandoned its appeal.
In December 2003, the Company settled its arbitration and litigation with
Arglen, a minority partner of Now Solutions, regarding issues related to Now
Solutions. The settlement resolved various allegations by the Company and Arglen
concerning violations of Now Solutions' Operating Agreement. The arbitration has
been dismissed and any actions with respect to Arglen and Gary Gyselen and the
Company and its related parties, including Now Solutions, were also dismissed,
except that the California Superior Court, Los Angeles County retained
jurisdiction regarding the terms of the settlement between the parties. In
February 2004, the Company completed the settlement with Arglen. Pursuant to the
terms of the settlement, the Company purchased Arglen's interest in Now
Solutions for $1.4 million as follows: (a) $800,000, which was paid at the
closing and (b) $600,000, pursuant to a non-interest bearing secured promissory
note providing for payments of $200,000 in April 2004, $100,000 in June 2004,
and $300,000 in September 2004, which was issued at closing. When the Company
did not make the April 2004 payment, the Company began accruing interest at the
rate of 10% from the inception of the note. The security interest of Now
Solutions' assets on the secured promissory note is junior to Now Solutions'
present indebtedness to WAMCO. In addition, at closing, the Company cancelled
80,763,943 warrants held by Arglen and issued to Arglen 20,000,000 unregistered
shares of the common stock of the Company (at a fair market value of $280,000),
which is subject to a "lock-up" provision. The Company's purchase of Arglen's
interest resulted in the Company recognizing $1,680,000 of goodwill, which was
written-off in 2004. In December 2004, the Company recorded the expense of
issuing 5,000,000 unregistered shares to Arglen at a fair market value of
$82,273, which was based on an average share price during 11 days of August
2004. These shares were issued pursuant to the settlement agreement with Arglen
whereby the Company was obligated to issue 5,000,000 unregistered shares of
common stock of the Company to Arglen, due to its failure to file a registration
statement on Form SB-2 within 180 days from the closing date of the settlement
in February 2004. In March 2005, the Company issued these 5,000,000 shares to
Arglen. The note is in default. In August 2004, Arglen obtained a default
judgment in Los Angeles court for the outstanding principal, plus attorney's
fees and interest at the rate of 10% per annum. In April 2005, Arglen filed a
Notice of Filing a Foreign Judgment in Tarrant County, Texas.
16
In March 2004, Ross commenced an action in the New York Supreme 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. Now Solutions filed its opposition to Ross' motion, which was
submitted to the court for decision on May 20, 2004. Now Solutions opposed the
Ross motion and, on October 7, 2004, the Court ruled in favor of Now Solutions
and denied the motion for summary judgment. Pursuant to New York State law, in
the event a motion for summary judgment in lieu of complaint is denied, the
action continues and the pleadings supporting the motion are deemed to
constitute the complaint. Accordingly, Now Solutions filed an answer containing
affirmative defenses and nine (9) counterclaims against Ross. The affirmative
defenses asserted by Now Solutions include 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 relate to the Asset
Purchase Agreement and Ross' breaches thereof. The counterclaims include: (i)
breach of the covenant not to compete, whereby Now Solutions seeks damages in
excess of $10,000,000; (ii) breach of the covenant to deliver all assets to Now
Solutions at closing, whereby Now Solutions seeks damages in an amount not less
than $300,000; (iii) breach of a certain Transitional Services Agreement
(executed in conjunction with the Asset Purchase Agreement), whereby Now
Solutions seeks damages in an amount not less than $73,129; and (iv) reasonable
attorney's fees. In December 2004, Ross filed a motion to dismiss two of Now
Solutions' nine counterclaims: one which alleges that Ross and Chinadotcom used
Ross to breach a covenant not to compete and the second which requested that
Ross be enjoined from further competition with Now Solutions in violation of the
covenant. In February 2005, Ross' motion was granted based upon a procedural
default. Thereafter, Now Solutions filed a motion to vacate the default, which
motion was denied over the objections of Now Solutions. Now Solutions intends to
appeal this decision. Now Solutions' remaining seven counterclaims remain
unaffected.
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 dated December 2003. The
Company and Now Solutions have 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 Settlement
Agreement; (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 asserts transferred to them pursuant to the Settlement Agreement; and (iv)
appointing a receiver to take possession of the assets transferred to the
Company and Arglen pursuant to the Settlement Agreement. 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.
In January 2005, Parker, Mills, and Patel filed a lawsuit in Los Angeles
Superior Court to collect the outstanding balance of $23,974 due under the
promissory note issued to them by the Company and for failure to pay fees for
professional services in the amount of $89,930 rendered to the Company, plus
interest. In March 2005, the Company filed a demurrer. In April 2005, the
Company answered the complaint, asserting various legal defenses.
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 there is no assurance that 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.
17
Matters Involving the United States Securities and Exchange Commission
In December 2004, the Company was notified by the United States Securities
and Exchange Commission (the "SEC") that the SEC had suspended trading of VCSY
common stock for the period of December 1, 2004 through December 14, 2004
pursuant to an Order filed by the SEC because the Company had been delinquent in
its periodic filing obligations under Section 13(a) of the Securities and
Exchange Act of 1934, as amended (the "Exchange Act"), since the period ending
September 30, 2003.
Also in December 2004, the Company was notified by the SEC of an
administrative proceeding In the Matter of Asset Equity Group, Inc. et al.,
Admin. Proc. File No. 3-11761 ("Administrative Proceeding"), pursuant to the
filing of an "Order Instituting Administrative Proceedings and Notice of Hearing
Pursuant to Section 12(j) of the Exchange Act of 1934" that alleged that the
Company was delinquent with respect to the filing of the Form 10-KSB for the
year ended 2003 and the Form 10-QSB for the first three quarters of 2004. The
Company filed its Form 10-KSB for the year ended 2003 on January 19, 2005. The
Company filed its Form 10-QSB for the three months ended March 31, 2004 and its
Form 10-QSB for the three months ended June 30, 2004 on March 7, 2005. The
Company filed its Form 10-QSB for the three months ended September 30, 2004 on
March 8, 2005. Thus, since commencement of the Administrative Proceeding, the
Company has filed each of the delinquent reports.
On April 1, 2005, the SEC entered two orders in connection with accepting
the terms of an Offer of Settlement of Vertical Computer Systems, Inc. to settle
the Administrative Proceeding. As part of the terms of settlement, the SEC
entered in the Administrative Proceeding its Order Accepting Settlement Offer of
Vertical Computer Systems, Inc., Implementing Settlement and Staying Proceedings
to Implement Settlement ("Settlement Order"). The Settlement Order provided that
the Company must file its Form 10-KSB for the fiscal year ended December 31,
2004 ("2004 Form 10-KSB") no later than March 31, 2005. The Company filed its
2004 Form 10-KSB on March 31, 2005.
Pursuant to the Company's Offer of Settlement, the SEC also entered on
April 1, 2005, an Order Instituting Cease-and-Desist Proceedings, Making
Findings and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the
Exchange Act ("Cease-and-Desist Order" in the case captioned In the Matter of
Vertical Computer Systems, Inc., Admin. Proc. File No. 3-11879). The
Cease-and-Desist Order ordered that the Company cease and desist from committing
or causing any violations or future violations of Section 13(a) of the Exchange
Act and SEC Rules 13a-1 and 13a-13 thereunder. The Company consented to the
entry of the Cease-and-Desist Order without admitting or denying the findings in
that Order.
On April 15, 2005, the SEC dismissed without prejudice the previously
disclosed Administrative Proceeding as to the Company. The SEC's dismissal was
entered by its Order Dismissing Proceedings Without Prejudice as to the Company.
The SEC Order provided that it was entered pursuant to the previously entered
Order Accepting Settlement and Staying Proceedings to Implement Settlement,
dated April 1, 2005, and for good cause shown. Consequently, the Administrative
Proceeding has concluded with respect to the Company and is no longer pending as
to the Company.
Note 6 - Stock Options & Warrants
Incentive Stock Non-Statutory Weighted Average
Options Stock Options Warrants Exercise Price
------------------------------------------------------------
Outstanding at 12/31/04 4,000,000 -- 84,932,758 0.92
============================================================
Options/Warrants granted with an
exercise price of $0.01 to $0.03 -- -- -- --
Options/Warrants exercised -- -- -- --
Options/Warrants expired/cancelled -- -- 5,054,978 0.161
------------------------------------------------------------
Outstanding at 03/31/05 4,000,000 -- 79,877,780 0.073
18
Information relating to stock options/warrants as of March 31, 2005, 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 4,000,000 49.98 $ 0.013 -- $ --
----------------------------------------------------------------------------------
4,000,000 49.98 $ 0.013 -- $ --
==================================================================================
Non-statutory Stock Options
$0.01-- $0.09 -- -- $ -- -- $ --
----------------------------------------------------------------------------------
-- -- $ -- -- $ --
==================================================================================
Warrants
$0.003 - $0.100 76,711,111 25.14 $ 0.063 76,711,111 $ 0.063
$0.100 - $0.350 3,166,669 3.34 0.335 3,166,669 0.335
----------------------------------------------------------------------------------
79,877,780 24.27 $ 0.074 79,877,780 $ 0.074
==================================================================================
----------------------------------------------------------------------------------
Grant total 83,877,780 25.50 $0.0712 79,877,780 $ 0.074
==================================================================================
The range of assumptions used in Black-Scholes Options Pricing Model in 2005 and
2004 were as follows
March 31, December 31,
2005 2004
------------------------------
Discount rate - bond yield rate -- 2.98 - 3.90%
Volatility -- 226 - 270.1%
Expected life -- five-years
Expected dividend yield -- --
Note 7 - Subsequent Events
On April 1, 2005, the SEC entered two orders in connection with accepting
the terms of an Offer of Settlement of Vertical Computer Systems, Inc. to settle
the Administrative Proceeding, which, with respect to the Company, concerned the
delinquency of filing of certain of the Company's periodic reports required
under the Exchange Act. Since commencement of the Administrative Proceeding, the
Company has filed each of the delinquent reports. As part of the terms of
settlement, the SEC entered in the Administrative Proceeding its Order Accepting
Settlement Offer of Vertical Computer Systems, Inc., Implementing Settlement and
Staying Proceedings to Implement Settlement ("Settlement Order"). The Settlement
Order provided that the Company must file its 2004 Form 10-KSB no later than
March 31, 2005. The Company filed its 2004 Form 10-KSB on March 31, 2005.
Pursuant to the Company's Offer of Settlement, the SEC also entered on
April 1, 2005, an Order Instituting Cease-and-Desist Proceedings, Making
Findings and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the
Exchange Act ("Cease-and-Desist Order" in the case captioned In the Matter of
Vertical Computer Systems, Inc., Admin. Proc. File No. 3-11879). The
Cease-and-Desist Order ordered that the Company cease and desist from committing
or causing any violations or future violations of Section 13(a) of the Exchange
Act and SEC Rules 13a-1 and 13a-13 thereunder. The Company consented to the
entry of the Cease-and-Desist Order without admitting or denying the findings in
that Order.
19
On April 15, 2005, the SEC dismissed without prejudice the previously
disclosed Administrative Proceeding as to Vertical Computer Systems, Inc The
SEC's dismissal was entered by its Order Dismissing Proceedings Without
Prejudice as to Vertical Computer Systems, Inc. The SEC Order provided that it
was entered pursuant to the previously entered Order Accepting Settlement and
Staying Proceedings to Implement Settlement, dated April 1, 2005, and for good
cause shown. Consequently, the Administrative Proceeding has concluded with
respect to the Company and is no longer pending as to the Company.
In April 2005, $10,000 worth of principal under certain debentures were
converted into 2,500,000 shares of the Company's common stock in connection with
a $100,000 debenture issued by the Company to a third-party in March 2002.
During the period of April 1 to May 13, 2005, warrants to purchase
1,727,777 shares of common stock of the Company at a price of $0.10 to $0.35 per
share expired.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements.
This Form 10-QSB contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Exchange Act. Such statements include the Company's beliefs, expectations,
hopes, goals and plans regarding the future, including but not limited to
statements regarding the Company's strategy, competition, development plans,
financing, revenue and operations. Forward-looking statements often can be
identified by the use of terms such as "may," "will," "expect," "anticipate",
"estimate," or "continue," or the negative thereof. Such forward-looking
statements speak only as of the date made. Any forward-looking statements
represent management's best judgment as to what may occur in the future.
However, forward-looking statements are subject to risks, uncertainties, and
important factors beyond the control of the Company that could cause actual
results and events to differ materially from historical results of operations
and events and those presently anticipated or projected. The Company disclaims
any obligation subsequently to revise any forward-looking statements to reflect
events or circumstances after the date of such statement or to reflect the
occurrence of anticipated or unanticipated events.
Management's Discussion and Analysis or Plan of Operation
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
of the Company, and the cautionary statements and risk factors included below in
this item of the report.
Business Overview
The Company is a multinational provider of administrative software,
Internet core technologies, and derivative software application products through
its distribution network. The Company's main administrative software product is
emPath 6.3, which is developed and distributed by Now Solutions, the Company's
subsidiary. The Company's primary Internet core technologies include SiteFlash
and the Emily XML Scripting Language, which can be used to build web services.
The Company attempts to acquire and operate companies whose products, in the
Company's belief: are proven and best of the breed; are profitable or on the
path to profitability; complement each other; and provide cross-product
distribution channels. The Company's ownership interest is typically a
controlling interest. The Company's 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
the Company believes is capable of penetrating multiple sectors through cross
promotion.
20
The Company's current products address the following market segments:
MARKET PRODUCT OWNERSHIP LICENSEE
--------------------------------------------------------------------------------------------------------
Human Resources and Payroll emPath 6.3 Now Solutions Now Solutions
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Large Corporations and Universities SiteFlash Vertical Computer Vertical Computer
--------------------------------------------------------------------------------------------------------
Government Sector- Emergency Response ResponseFlash Vertical Computer GIS
--------------------------------------------------------------------------------------------------------
Publishing Content NewsFlash Vertical Computer EnFacet
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Emily XML Scripting Language Emily Vertical Computer VIS
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Results of Operations
Three Months Ended March 31, 2005 Compared To Three Months Ended March 31,
2004
Total Revenues. The Company had total revenues of $1,579,597 and
$1,529,217 in the three months ended March 31, 2005 and 2004, respectively. The
increase in total revenues were $50,380 for the three months ended March 31,
2005 representing approximately a 3.3% increase compared to the total revenues
for the three months ended March 31, 2004. Of the $1,579,597 in revenues for the
three months ended March 31, 2005 and the $1,529,217 in revenues for the three
months ended March 31, 2004, $1,550,352 and $1,527,717, respectively, was
related to the business operations of Now Solutions, a wholly-owned subsidiary
of the Company. The Company acquired a 60% interest in Now Solutions in February
2001, 5% in January 2004, and the remaining 35% interest in February 2004.
The total revenues primarily consist of software licenses, consulting and
maintenance fees. The revenue from license and maintenance in the three months
ended March 31, 2005 increased by $8,091 from the same period in the prior year,
representing a .6% increase. Consulting revenue in the three months ended March
31, 2005, increased by $45,854, from the same period in the prior year, which
represented approximately 19.8% increase, due to increased installations at
customers that signed license agreements the second half of 2004. Other revenue
in the three months ended March 31, 2004 decreased by $3,565 from the same
period in the prior year.
Selling, General and Administrative Expenses. The Company had selling,
general and administrative expenses of $1,885,295 and $2,920,928 in the three
months ended March 31, 2005 and 2004, respectively. The total operating expenses
in the three months ended March 31, 2005 decreased by $1,035,633 compared to the
operating expenses in the three months ended March 31, 2004, representing a
35.5% decrease. Of the $1,885,295 in expenses for the three months ended March
31, 2005 and the $2,920,928 in expenses for the three months ended March 31,
2004, Now Solutions accounted for $1,434,498 and $1,685,331, respectively.
In the first quarter of 2004, the Company paid approximately $440,000 in
fees for a $500,000 note payable issued to Now Solutions in February of 2004 by
Robert Farias and for various loan extensions. These fees were all paid in the
form of common stock or warrants. In addition, in the first quarter of 2004, the
Company acquired Robert Farias's interest in MedData Solutions for 9 million
shares of common stock. At the time of the transaction, the common stock had a
value of $135,000. The Company wrote-off its investment in MedData Solutions in
the first quarter of 2004. The Company did not have these types of transactions
in the first quarter of 2005 resulting in a reduction in selling, general and
administrative expenses. Also, Now Solutions reduced its payroll and related
costs by $119,000, depreciation and amortization by $112,000, and travel costs
by $37,000.
Goodwill Impairment. In the first quarter of 2004 the Company acquired
Stephen Parnes' 5% interest and Arglen's 30% interest in Now Solutions. These
transactions resulting in the recognition of $1,760,000 of goodwill. The Company
assessed the carrying value of this goodwill for impairment as of March 31, 2004
in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS
No. 142") and in connection with this assessment determined its goodwill was
fully impaired. As a result, the Company wrote-off the entire carrying value of
this goodwill in March 2004.
Interest Expense. The Company had an interest expense of $122,300 and
$110,990 for the three months ended March 31, 2005 and 2004, respectively.
Interest expense increased in 2005 by $11,310, representing an increase of
approximately 10.2%, compared to the same type of expense in three months ended
March 31, 2004. This increase was due to interest on the Robert Farias and
Arglen notes.
21
Net Loss. The Company had a net loss of $427,311 and $3,261,775 as of
March 31, 2005 and 2004, respectively. Net loss as of March 31, 2005 decreased
by $2,834,464, representing a decrease of 86.9%. The decrease of $2,834,464 was
primarily attributable to the combination of an increase in revenues by $50,380
and a decrease of selling, general and administrative expenses by $1,035,633 and
no goodwill write-off in 2005 versus a write-off of goodwill of $1,760,000 in
the first quarter of 2004.
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 $150,000 and $150,000 for the three months ended March 31,
2005 and 2004, respectively.
Net Loss Available to Common Stockholders. The Company had a net loss
attributed to common stockholders of $557,311 and $3,411,776 for the three
months ended March 31, 2005 and 2004, respectively. Net loss attributed to
common stockholders decreased by $2,854,465, representing a decrease of 83.7%,
compared to the net loss attributed to common stockholders in the three months
ended March 31, 2004.
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, 2005 and 2004, respectively.
Liquidity And Capital Resources
At March 31, 2005, the Company had non-restricted cash-on-hand of
$705,876. The Company did not have any restricted cash-on-hand as of March 31,
2004.
Net cash generated from operating activities for the three months ended
March 31, 2005 was $521,338. This positive cash flow was primarily related to a
net loss of $427,311 adjusted by total non-cash items of $323,160 (including
depreciation and amortization of $230,887 and expenses paid by the issuance of
common stock, warrants and stock options totaling $92,273), decreases in all
receivables items of $353,263, an increase in deferred revenue of $254,003, and
a decrease in prepaid expenses of $10,339.
For the three months ended March 31, 2005, the Company did not use any
cash for investing activities.
Net cash used for financing activities for the three months ended March
31, 2005 was $141,616. This cash was used for the repayment of notes payable.
The total change in restricted and non-restricted cash and cash
equivalents for the three months ended March 31, 2005 when compared to three
months ended March 31, 2004 was an increase of $286,959.
From 1999 to the acquisition of the minority owners of Now Solutions in
February 2004, the Company had been primarily dependent on external cash to
support its operations. Until February 2004, the Company had financed its
operations through the sale of securities, including common and preferred stock,
convertible debts, and notes payable. Since the Company became the 100% owner of
Now Solutions, it has been able to fund a substantial portion of its operations
internally.
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 and/or renegotiating the terms of its
existing debt. 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.
22
Contractual Obligations Balance at Due in Next Five Years
03/31/05 2005 2006 2007 2008 2009
- --------------------------------------------------------------------------------------------------------------
Notes payable 4,439,283 4,439,283
Convertible debts 430,000 40,000 390,000
Operating lease 407,440 105,269 147,050 61,398 53,556 40,167
---------------------------------------------------------------------------------
Total 5,276,723 4,584,552 537,050 61,398 53,556 40,167
=================================================================================
Of the above notes payable of $4,439,283, the default situation is as
follows:
Notes Payable 03/31/05 12/31/04
---------- ----------
In default $4,412,283 $4,338,899
Current 27,000 242,000
---------- ----------
Total Notes Payable $4,439,283 $4,580,899
========== ==========
Going Concern Uncertainty
The accompanying condensed consolidated financial statements for the three
months ended March 31, 2005 and 2004, 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, 2005 was $13.8 million.
Additionally, at March 31, 2005, the Company had negative working capital of
approximately $11.7 million (although it includes deferred revenue of
approximately $2.9 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.
However, there can be no assurance that the Company will be able to secure
additional funds and that if such funds are available, whether the terms or
conditions would be acceptable to the Company and whether the Company will be
able to turn into a profitable position and generate positive operating cash
flow. The condensed consolidated financial statements contain no adjustment for
the outcome of this uncertainty.
Market Risks
The Company anticipates that it will have activities in foreign countries
in future periods. These operations will expose the Company to a variety of
financial and market risks, including the effects of changes in foreign currency
exchange rates and interest rates. As of March 31, 2005, there are no material
gains or losses requiring separate disclosure.
23
Dividends
The Company has outstanding Series A and Series C 4% Convertible
Cumulative Preferred stock that accrue dividends at a rate of 4% on a
semi-annual basis.
Related Party Transactions
In November 2003, Mountain Reservoir pledged 4,000,000 shares of common
stock to secure a loan of $60,000 to GIS, which issued a $60,000 note payable on
November 5, 2003 bearing interest at 10% per annum, and was due November 5,
2004. Mountain Reservoir 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 November 2003, Mountain Reservoir pledged 3,000,000 shares of common
stock to secure a loan of $40,000 to GIS, which issued a $40,000 note payable on
November 19, 2003 bearing interest at 10% per annum, and was due November 19,
2004. Mountain Reservoir 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 January 2004, the Company agreed to issue 1,000,000 unregistered shares
of the Company's common stock (at a fair market value of $3,000), subject to
"piggy-back" registration rights, in connection with a $10,000 loan made by Jim
Salz to the Company in June 2003. In addition, the Company issued a promissory
note for $10,000 bearing interest at 10%, which was due in April 30, 2004. In
April 2004, the due date on the note was extended to August 1, 2004. In January
2005, the due date on the note was extended to April 30, 2005. Mr. Salz is the
Company's corporate counsel. The note is in default.
In January 2004, Victor Weber elected to make the assignment of a $215,000
promissory note due December 31, 2004, issued by Now Solutions to the Company in
September 2003. In connection with the assignment, the notes payable for
$100,000, $50,000 and $40,000 issued to Mr. Weber as well as $25,000 of trade
accounts payable to Mr. Weber were cancelled. The interest on the $215,000 note
for each month is the highest Prime Rate in effect during said month, but in no
event shall the rate of interest charged on the balance due under the notes in
any month be less than 8.5% per annum. In September 2004, the Company and Victor
Weber agreed to amend the terms of the $215,000 note issued by Now Solutions to
the Company and assigned to Mr. Weber. Pursuant to the terms of the amendment,
the Company agreed to issue 2,000,000 unregistered shares of common stock of the
Company (at a fair market value of $24,000), in exchange for amending the note.
In connection with the amendment, since the Company did not make full payment of
the note by December 31, 2004, the Company issued, in January 2005, an
additional 2,000,000 unregistered shares of common stock at a fair market value
of $10,000 and the note has been amended as follows: (a) the maturity date of
the note shall be extended to December 31, 2005; (b) the payment terms of the
note shall be amended so that, beginning in 2005, Now Solutions shall make (i)
monthly interest payments for all accrued interest during the previous month,
(ii) $50,000 in principal payments which will be due the end of each quarter
beginning March 31, 2005 and (iii) a final payment of all accrued interest and
principal which will be due no later than December 31, 2005. In addition, Mr.
Weber shall receive 2.5% royalty of sales by Now Solutions of its software that
exceed $8,000,000 per year up to $200,000. Mr. Weber is the President and a
Director of GIS and a member of CW International. As of May 13, 2005, the note
is in default but the Company has made all interest payments.
In February 2004, Robert Farias loaned $500,000 to Now Solutions, the
Company's wholly-owned subsidiary and received a $500,000 promissory note from
Now Solutions, secured by its assets and a 5% royalty on any sales by Now
Solutions of over $8,000,000 up to $500,000. The note bears interest at 10% per
annum and Now Solutions is required to make monthly interest payments for all
interest accrued in the previous month on the first day of each month beginning
April 1, 2004 and beginning on October 1, 2004 and continuing on the first day
of every month thereafter, monthly principal payments of $91,500 plus interest
until the note has been paid in full. In the event Now Solutions receives cash
proceeds due to a capital infusion or upfront licensing fees from a reseller
that is outside its normal scope of business (i.e., not part of software sales
in the regular course of business), Now Solutions is required to pay 50% of such
proceeds remaining toward payment of the $500,000 note. In connection with the
loan, the Company issued (i) five-year warrants to purchase 5,000,000 shares of
common stock at a $0.01 per share at a fair market value at the date of issuance
of $74,538 (valued using the Black-Scholes Valuation Model); (ii) five-year
warrants to purchase 5,000,000 shares of common stock of the Company at a $0.02
per share at a fair market value at the date of issuance of $74,344 (valued
using the Black-Scholes Valuation Model); (iii) five-year warrants to purchase
5,000,000 shares of common stock of the Company at $0.03 per share at a fair
market value at the date of issuance of $74,200 (valued using the Black-Scholes
Valuation Model); (iv) 5,000,000 unregistered shares of common stock of the
Company (at a fair market value of $75,000); and (v) an additional 5,000,000
shares of common stock of the Company in the event that $250,000 was not paid
toward the loan on or before March 15, 2004, which were issued (at a fair market
value of $120,000). All of the foregoing warrants and stock are subject to
"piggy-back" registration rights. In connection with the amendment, Now
Solutions entered into a security agreement with the lender to guarantee the
note. The security interest of Now Solutions' assets on the secured promissory
note is junior to Now Solutions' present indebtedness to WAMCO and Arglen. In
addition, the Company also pledged a 30% ownership interest in Now Solutions to
ensure the making of the $500,000 loan to Now Solutions. Robert Farias is a
director of Now Solutions, a 100% owned subsidiary of the Company. The note is
in default. As of May 13, 2005, Now Solutions had made principal payments
totaling $183,000 to Robert Farias. In January 2005, WAMCO notified Mr. Farias
that pursuant to the subordination agreement executed between WAMCO and Mr.
Farias, Mr. Farias was no longer to accept payments from or to take any
collection actions against Now Solutions for the repayment of junior debt.
24
In February 2004, the note payable in the amount of $84,000 issued by
EnFacet to Robert Farias, dated June 1, 2001, bearing interest at 12% per annum,
unsecured, with principal and interest due on June 1, 2002 was amended by the
parties. Pursuant to the amendment Robert Farias waived any defaults on the note
and the note was amended as follows: once the Company's subsidiary, Now
Solutions, has paid off the entire balance due under the $500,000 note issued by
Now Solutions to Mr. Farias on February 13, 2004, sixteen percent (16%) of any
remaining amounts from the final $91,500 installment payment on the $500,000
note shall be applied to the $84,000 note. Thereafter, the Company or, at the
Company's option, Now Solutions, shall continue to make monthly principal
payments of $14,640 beginning on the first day of the following month until all
monies due under the $84,000 note have been paid. In connection with the
amendment, Now Solutions entered into a security agreement with the lender to
guarantee the note. The security interest of Now Solutions' assets on the
secured promissory note is junior to Now Solutions' present indebtedness to
WAMCO, Arglen, and Robert Farias in connection with the $500,000 note. In an
amendment between the parties in March 2003, the interest rate was increased
from 8% to 12% and accrued from the date the note was issued in exchange for
extending the note. Robert Farias is a director of Now Solutions, a 100% owned
subsidiary of the Company. This note is in default.
In February 2004, the note payable in the amount of $280,000, bearing
interest at 4% per annum and issued to Robert Farias on October 31, 2001, was
amended by the parties. In connection with the amendment, the Company and Robert
Farias also amended the $181,583 note issued to Mr. Farias on October 17, 2002.
Pursuant to the amendment, any default on these notes was waived, and the
Company agreed to make the following payments on these notes: (i) $20,000, which
was paid toward the $181,583 note on February 20, 2004; (ii) 50% of the
remaining past-due amounts by March 20, 2004; and (iii) the all remaining
past-due amounts to bring the notes current by April 20, 2004. In the event the
Company does not pay the amounts in a timely manner, all amounts still owing
under these notes will be considered in default and the following shall apply:
(i) all such remaining amounts will be added to the secured loan amounts and
will be subject to the security interest and pledge agreements under the $84,000
promissory note issued by the Company's subsidiary, Enfacet, to Mr. Farias on
June 1, 2001; (ii) the $14,640 monthly payments to be made under the $84,000
note will be applied to the $280,000 and $181,583 notes until these notes are
paid in full; and (iii) with respect to cash proceeds Now Solutions receives due
to a capital infusion or upfront licensing fees from a reseller that is outside
its normal scope of business (i.e., not part of software sales in the regular
course of business), Now Solutions is required to pay 50% of such proceeds
remaining after the $500,000 note payable issued by Now Solutions to Mr. Farias
on February 13, 2004 has been paid in full toward the $280,000 and $181,583
notes if the Company is not current in its payments. The $280,000 note is also
secured by SiteFlash technology owned by the Company. Robert Farias is a
director of Now Solutions, a 100% owned subsidiary of the Company. The note is
in default.
In February 2004, the note payable in the amount of $181,583 issued to
Robert Farias in October 2003, bearing interest at 12% per annum was amended. In
connection with the amendment, the Company and Mr. Farias also amended the
$280,000 note issued to Mr. Farias on October 31, 2001. Pursuant to the
amendment, any default on these notes was waived, and the Company agreed to make
the following payments on these notes: (i) $20,000, which was paid toward the
$181,583 note on February 20, 2004; (ii) 50% of the remaining past-due amounts
by March 20, 2004; and (iii) the all remaining past-due amounts to bring the
notes current by April 20, 2004. In the event the Company does not pay the
amounts in a timely manner, all amounts still owing under these notes will be
considered in default and the following shall apply: (i) all such remaining
amounts will be added to the secured loan amounts and will be subject to the
security interest and pledge agreements under the $84,000 promissory note issued
by the Company's subsidiary, Enfacet, to Mr. Farias on June 1, 2001; (ii) the
$14,640 monthly payments to be made under the $84,000 note will be applied to
the $280,000 and $181,583 notes until these notes are paid in full; and (iii)
with respect to cash proceeds Now Solutions receives due to a capital infusion
or upfront licensing fees from a reseller that is outside its normal scope of
business (i.e., not part of software sales in the regular course of business),
Now Solutions is required to pay 50% of such proceeds remaining after the
$500,000 note payable issued by Now Solutions to Mr. Farias on February 13, 2004
has been paid in full toward the $280,000 and $181,583 notes if the Company is
not current in its payments. The note is also secured by 10,450,000 shares of
the Company's common stock that are owned by Mountain Reservoir to cover any
shortfall. Mountain Reservoir 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. Robert Farias is a director of Now Solutions, a 100% owned
subsidiary of the Company. The note is in default.
25
In February 2004, the Company purchased a 21% ownership interest in
MedData Solutions, Inc. from Robert Farias. In exchange, the Company issued
9,000,000 unregistered shares of the common stock of the Company (at a fair
market value of $135,000), which are subject to "piggy-back" registration
rights. As of March 31, 2004, the transaction was fully reserved. Robert Farias
is a director of Now Solutions, a 100% owned subsidiary of the Company.
In August 2004, the Company licensed the use of the Forums and calendar
applications of the Company's SiteFlash technology to Basix1 for use in Basix1's
EKG software. Pursuant to the terms of the license, Basix1 is obligated to pay
the Company 10% of all license fees generated from the exploitation Basix1's EKG
software. Also in August 2004, the Company and its subsidiaries have entered
into various marketing and co-marketing agreements with Basix1. Charles
Kensicki, the President of Basix1, is currently a Director of GIS and of Now
Solutions.
In October 2004, the Company and Stephen Rossetti agreed to amend the
terms of a consulting agreement and the $7,500 promissory note issued in May
2003. Pursuant to the terms of the amendment, the Company issued 6,500,000
unregistered shares of common stock of the Company (at a fair market value of
$84,500), as full payment for services rendered under the consulting agreement
and the $7,500 note, which has been cancelled. As of May 13, 2005, 2,900,145 of
the 4,150,145 warrants issued for consulting services for the Company and GIS
expired. Mr. Rossetti is the CEO and a Director of GIS and Now Solutions.
In January 2005, the Company entered into a marketing agreement with CW
International whereby CW International will be entitled to receive a percentage
of fees for new customers of the Company generated by CW International's
efforts. Mr. Weber is a Director and President of GIS and a member of CW
International.
Critical Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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 and the deferred income tax asset allowance. Actual results could
materially differ from those estimates.
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
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 three months ended March
31, 2005 and 2004, no costs were capitalized.
Impairment of Long-Lived Assets
Effective January 1, 2002, the Company began applying the provisions of
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("SFAS No. 144"). SFAS No. 144 requires that long-lived assets be 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.
For the three months ended March 31, 2004, the Company determined that there was
a $1,760,000 of impairment in goodwill, all of which located in the Company.
During three months ended March 31, 2005, the Company determined that there was
no impairment in goodwill, since all goodwill in the Company had been
written-off by December 31, 2004.
26
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 contact.
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
Effective January 1, 2004, the Company adopted the fair value provisions
of SFAS 123 for share based payments to employees. In accordance with transition
provisions under SFAS 148, the Company has adopted the prospective method for
transitional recognition.
Investments
Investments in entities in which the Company exercises significant
influence, but does not control, are accounted for using the equity method of
accounting in accordance with Accounting Principles Board ("APB") Opinion No. 18
"The Equity Method of Accounting for Investments in Common Stock". Investments
in securities with a readily determinable market value in which the Company does
not exercise significant influence, does not have control, and does not plan on
selling in the near term are accounted for as available for sale securities in
accordance with SFAS No. 115 "Accounting for Certain Investments in Debt and
Equity Securities".
New Accounting Pronouncements
In January 2003, the Financial Accounting Standard Board (the "FASB")
issued FASB Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest
Entities." FIN 46, as amended by FIN 46(R), issued in January 2003, requires an
investor with a majority of the variable interests in a variable interest entity
to consolidate the entity and also requires majority and significant variable
interest investors to provide certain disclosures. A variable interest entity is
an entity in which the equity investors do not have a controlling financial
interest or the equity investment at risk is insufficient to finance the
entity's activities without receiving additional subordinated financial support
from other parties. The provisions of FIN 46(R) are applicable for fiscal years
ending after December 15, 2004. The Company does not have any variable interest
entities that must be consolidated.
New Accounting Announcements Not Adopted Yet
In December 2004, the FASB announced that SFAS No. 123R (revised December
2004), "Share-Based Payment," sets accounting requirements for "share-based"
compensation to employees, including employee-stock-purchase-plans (ESPPs) and
provides guidance on accounting for awards to non-employees. This statement will
require the Company to recognize in the income statement the grant-date fair
value of stock options and other equity-based compensation issued to employees,
but expresses no preference for a type of valuation model. For public entities,
this Statement is effective for the first interim period beginning after June
15, 2005. The Company will adopt this Statement in the beginning of 2006 and is
evaluating this pronouncement's effect on the Company's financial position and
net income.
27
Factors Affecting the Company's 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 review the
risks and uncertainties described below and the other information in this
report. 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 Are in Default Under Substantially All Of Our Notes Payable, Certain Of
Which Are Secured By Pledges Of Our Assets
As noted above under Note 3 to our Condensed Consolidated Financial
Statements, the Company is currently in default under the terms of substantially
all of its notes payable. While the terms of these notes vary, they typically
permit the holder thereof to call the entire principal amount, plus accrued
interest thereunder, due and payable upon the occurrence of an event of default.
Further, certain of these notes are secured by different assets of the Company,
including Now Solutions' assets which secure the WAMCO note payable.
Notwithstanding the foregoing, it is uncertain at this time what action, if any,
will be taken by the holders of these notes in light of these defaults. While
the Company is attempting to cure these defaults, it can offer no assurances
that such attempts will be successful. These conditions raise substantial doubt
about the Company's ability to continue as a going concern.
We Have Historically Incurred Losses And May Continue To Do So In The
Future
We have historically incurred losses. In the three months ended March 31,
2005 and the year ended December 31, 2004, the Company had net losses applicable
to common shareholders of $557,311 and $5,302,210, respectively. Future losses
are likely to occur. 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
year ended December 31, 2004. This paragraph states that our recurring operating
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 and to achieve improved
operating results. Our financial statements do not include any adjustments that
might result from the outcome of this uncertainty.
The Company's ability to continue as a going concern is dependent on its
ability to raise additional funds and to establish profitable operations.
The accompanying condensed consolidated financial statements for the three
months ended March 31, 2005 and 2004 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, 2005 was $13.8 million.
Additionally, at March 31, 2005, the Company negative working capital of
approximately $11.7 million (although it includes deferred revenue of
approximately $2.9 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.
28
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.
However, there can be no assurance that the Company will be able to secure
additional funds and that if such funds are available, whether the terms or
conditions would be acceptable to the Company and whether the Company will be
able to turn into a profitable position and generate positive operating cash
flow. The condensed consolidated financial statements contain no adjustment for
the outcome of this uncertainty.
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 sales of our SiteFlash and Emily technology products and
sponsorship and e-commerce fees from our Internet sites and increased revenues
from Now Solutions products, 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 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
The Company has funding that is expected to be sufficient to fund its
present operations for one month. After one month, the Company's operations may
need to be curtailed or suspended if additional funding is not received. The
Company, however, will need significant additional funding in order to complete
its business plan objectives. Accordingly, the Company will have to rely upon
additional external financing sources to meet its cash requirements. Management
will continue to seek additional funding in the form of equity or debt to meet
its cash requirements. However, there is no guarantee the Company will raise
sufficient capital to execute its business plan. In the event that the Company
is unable to raise sufficient capital, our business plan will have to be
substantially modified and our operations curtailed or suspended.
We Have A Working Capital Deficit, Which Means That Our Current Assets On
December 31, 2004 Were Not Sufficient To Satisfy Our Current Liabilities
On That Date
We had a working capital deficit of approximately $11.7 million at March
31, 2005, which means that our current liabilities exceeded our current assets
by approximately $11.7 million (although it includes deferred revenue of
approximately $2.9 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 March 31, 2005 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:
o the demand for our SiteFlash and Emily technology;
o the demands for Now Solutions' emPath product;
o the level of usage of the Internet;
o the level of user traffic on our Websites;
o seasonal trends and budgeting cycles in sponsorship;
o incurrence of costs relating to the development, operation and
expansion of our Internet operations;
o introduction of new products and services by us and our competitors;
o costs incurred with respect to acquisitions;
o price competition or pricing changes in the industry;
o technical difficulties or system failures; and
o general economic conditions and economic conditions specific to the
Internet and Internet media.
29
We May Have Difficulty Managing Our Growth And Integrating Recently
Acquired Companies
Our recent growth 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. Acquisition transactions are accompanied by a number of
risks, including:
o the difficulty of assimilating the operations and personnel of the
acquired companies;
o the potential disruption of our ongoing business and distraction of
management;
o the difficulty of incorporating acquired technology or content and
rights into our products and media properties;
o 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;
o the failure to successfully develop an acquired in-process
technology resulting in the impairment of amounts currently
capitalized as intangible assets;
o unanticipated expenses related to technology integration;
o the maintenance of uniform standards, controls, procedures and
policies;
o the impairment of relationships with employees and customers as a
result of any integration of new management personnel; and
o 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 these 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 Their 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 stock:
o With a price of less than $5.00 per share;
30
o That are not traded on a "recognized" national exchange;
o Whose prices are not quoted on the NASDAQ automated quotation system
(NASDAQ listed stock must still have a price of not less than $5.00
per share); or
o In issuers with net tangible assets less than $2.0 million (if the
issuer has been in continuous operation for at least three years) or
$5.0 million (if in continuous operation for less than three years),
or with average revenues of less than $6.0 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.
The Company Will Likely Experience Losses For the Foreseeable Future
Our lack of an extensive operating history makes prediction of future
operating results difficult. We believe that a comparison of our quarterly
results is not meaningful. As a result, you should not rely on the results for
any period as an indication of our future performance. Accordingly, there can be
no assurance that we will generate significant revenues or that we will attain a
level of profitability in the future. We currently intend to expand and improve
our Internet operations, fund increased advertising and marketing efforts,
expand and improve our Internet user support capabilities and develop new
Internet technologies, products and services. As a result, we may experience
significant losses on a quarterly and annual basis.
ITEM 3. CONTROLS AND PROCEDURES
(A) Evaluation Of Disclosure Controls And Procedures
The Company's Principal Executive Officer and Principal Financial Officer,
after evaluating the effectiveness of the Company's disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)
as of the end of the period covered by this report, have concluded that as of
such date, the Company's disclosure controls and procedures were adequate and
effective to ensure that material information relating to the Company that is
required to be disclosed by the Company in reports that it files or submits
under the Exchange Act, is recorded, processed, summarized and reported within
the time periods specified in SEC rules and accumulated and communicated to the
Company's management, including its Principal Executive Officer and Principal
Financial Officer, to allow timely decisions regarding required disclosure.
(B) Changes In Internal Controls Over Financial Reporting
In connection with the evaluation of the Company's internal controls
during the Company's last fiscal quarter, the Company's Principal Executive
Officer and Principal Financial Officer have determined that there are no
changes to the Company's internal controls over financial reporting that have
materially affected, or are reasonably likely to materially effect, the
Company's internal controls over financial reporting.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is involved in the following ongoing legal matters:
31
In February 2003, the Company filed a lawsuit and a derivative action in
New York Supreme Court Case against defendants Ross, Arglen, Tinley, and
Gyselen. The Company filed a derivative action on behalf of its subsidiary Now
Solutions when Arglen refused to authorize a lawsuit against any parties who
were alleged to have acted against the best interest of Now Solutions. 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. The Company's original claims sought damages and
equitable relief arising out of actions of the defendants constituting breach of
contract, fraud, conspiracy and breach of fiduciary duty in connection with
certain transactions entered into between Ross and Now Solutions; Ross and
Arglen; Arglen and Now Solutions; Gyselen and Now Solutions; and the Company and
Arglen. This action concerns claims of breach of contract and indemnification
for failure to pay adjustments at the closing on the sale of assets of Ross to
Now Solutions for prepaid maintenance fees and for related relief. 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, pursuant to the settlement, dismissed in February 2004. The Company
appealed the decision with regard to its claim for breach of contract for Ross'
failure to give the proper maintenance fee adjustment and related claims for
offset and attorney's fees. On June 1, 2004, the appeal of the dismissal of the
action against Ross was submitted to the court for decision. On appeal, the
claims against Ross were reinstated pursuant to the order of the Appellate
Division, dated October 26, 2004. In November 2004, Ross filed an answer
containing affirmative defenses in the Derivative Action.
In March 2003, Ross commenced an action in New York Supreme 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. In
August 2003, the New York Supreme Court denied the motion and dismissed Ross's
action without prejudice. In October 2003, the motion of Ross for re-argument
was denied. Ross appealed the August 2003 court order, but subsequently
abandoned its appeal.
In December 2003, the Company settled its arbitration and litigation with
Arglen, a minority partner of Now Solutions, regarding issues related to Now
Solutions. The settlement resolved various allegations by the Company and Arglen
concerning violations of Now Solutions' Operating Agreement. The arbitration has
been dismissed and any actions with respect to Arglen and Gary Gyselen and the
Company and its related parties, including Now Solutions, were also dismissed,
except that the California Superior Court, Los Angeles County retained
jurisdiction regarding the terms of the settlement between the parties. In
February 2004, the Company completed the settlement with Arglen. Pursuant to the
terms of the settlement, the Company purchased Arglen's interest in Now
Solutions for $1.4 million as follows: (a) $800,000, which was paid at the
closing and (b) $600,000, pursuant to a non-interest bearing secured promissory
note providing for payments of $200,000 in April 2004, $100,000 in June 2004,
and $300,000 in September 2004, which was issued at closing. When the Company
did not make the April 2004 payment, the Company began accruing interest at the
rate of 10% from the inception of the note. The security interest of Now
Solutions' assets on the secured promissory note is junior to Now Solutions'
present indebtedness to WAMCO. In addition, at closing, the Company cancelled
80,763,943 warrants held by Arglen and issued to Arglen 20,000,000 unregistered
shares of the common stock of the Company (at a fair market value of $280,000),
which is subject to a "lock-up" provision. The Company's purchase of Arglen's
interest resulted in the Company recognizing $1,680,000 of goodwill, which was
written-off in 2004. In December 2004, the Company recorded the expense of
issuing 5,000,000 unregistered shares to Arglen at a fair market value of
$82,273, which was based on an average share price during 11 days of August
2004. These shares were issued pursuant to the settlement agreement with Arglen
whereby the Company was obligated to issue 5,000,000 unregistered shares of
common stock of the Company to Arglen, due to its failure to file a registration
statement on Form SB-2 within 180 days from the closing date of the settlement
in February 2004. In March 2005, the Company issued these 5,000,000 shares to
Arglen. The note is in default. In August 2004, Arglen obtained a default
judgment in Los Angeles court for the outstanding principal, plus attorney's
fees and interest at the rate of 10% per annum. In April 2005, Arglen filed a
Notice of Filing a Foreign Judgment in Tarrant County, Texas.
In March 2004, Ross commenced an action in the New York Supreme 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. Now Solutions filed its opposition to Ross' motion, which was
submitted to the court for decision on May 20, 2004. Now Solutions opposed the
Ross motion and, on October 7, 2004, the Court ruled in favor of Now Solutions
and denied the motion for summary judgment. Pursuant to New York State law, in
the event a motion for summary judgment in lieu of complaint is denied, the
action continues and the pleadings supporting the motion are deemed to
constitute the complaint. Accordingly, Now Solutions filed an answer containing
affirmative defenses and nine (9) counterclaims against Ross. The affirmative
defenses asserted by Now Solutions include 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 relate to the Asset
Purchase Agreement and Ross' breaches thereof. The counterclaims include: (i)
breach of the covenant not to compete, whereby Now Solutions seeks damages in
excess of $10,000,000; (ii) breach of the covenant to deliver all assets to Now
Solutions at closing, whereby Now Solutions seeks damages in an amount not less
than $300,000; (iii) breach of a certain Transitional Services Agreement
(executed in conjunction with the Asset Purchase Agreement), whereby Now
Solutions seeks damages in an amount not less than $73,129; and (iv) reasonable
attorney's fees. In December 2004, Ross filed a motion to dismiss two of Now
Solutions' nine counterclaims: one which alleges that Ross and Chinadotcom used
Ross to breach a covenant not to compete and the second which requested that
Ross be enjoined from further competition with Now Solutions in violation of the
covenant. In February 2005, Ross' motion was granted based upon a procedural
default. Thereafter, Now Solutions filed a motion to vacate the default, which
motion was deined over the objections of Now Solutions. Now Solutions intends to
appeal this decision. Now Solutions' remaining seven counterclaims remain
unaffected.
32
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 dated December 2003. The
Company and Now Solutions have 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 Settlement
Agreement; (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 asserts transferred to them pursuant to the Settlement Agreement; and (iv)
appointing a receiver to take possession of the assets transferred to the
Company and Arglen pursuant to the Settlement Agreement. 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.
In January 2005, Parker, Mills, and Patel filed a lawsuit in Los Angeles
Superior Court to collect the outstanding balance of $23,974 due under the
promissory note issued to them by the Company and for failure to pay fees for
professional services in the amount of $89,930 rendered to the Company, plus
interest. In March 2005, the Company filed a demurrer. In April 2005, the
Company answered the complaint, asserting various legal defenses.
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 there is no assurance that 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.
Matters Involving the United States Securities and Exchange Commission
In December 2004, the Company was notified by the SEC that the SEC had
suspended trading of the Company's common stock for the period of December 1,
2004 through December 14, 2004 pursuant to an Order filed by the SEC because the
Company had been delinquent in its periodic filing obligations under Section
13(a) of the Exchange Act since the period ending September 30, 2003.
Also in December 2004, the Company was notified by the SEC of the
Administrative Proceeding, pursuant to the filing of an "Order Instituting
Administrative Proceedings and Notice of Hearing Pursuant to Section 12(j) of
the Exchange Act" that alleged that the Company was delinquent with respect to
the filing of the Form 10-KSB for the year ended 2003 and the Form 10-QSB for
the first three quarters of 2004. The Company filed its Form 10-KSB for the year
ended 2003 on January 19, 2005. The Company filed its Form 10-QSB for the three
months ended March 31, 2004 and its Form 10-QSB for the three months ended June
30, 2004 on March 7, 2005. The Company filed its Form 10-QSB for the three
months ended September 30, 2004 on March 8, 2005. Thus, since commencement of
the Administrative Proceeding, the Company has filed each of the delinquent
reports.
On April 1, 2005, the SEC entered two orders in connection with accepting
the terms of an Offer of Settlement of Vertical Computer Systems, Inc. to settle
the Administrative Proceeding. As part of the terms of settlement, the SEC
entered in the Administrative Proceeding its Order Accepting Settlement Offer of
Vertical Computer Systems, Inc., Implementing Settlement and Staying Proceedings
to Implement Settlement ("Settlement Order"). The Settlement Order provided that
the Company must file its Form 10-KSB for the fiscal year ended December 31,
2004 ("2004 Form 10-KSB") no later than March 31, 2005. The Company filed its
2004 Form 10-KSB on March 31, 2005.
33
Pursuant to the Company's Offer of Settlement, the SEC also entered on
April 1, 2005, an Order Instituting Cease-and-Desist Proceedings, Making
Findings and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the
Exchange Act ("Cease-and-Desist Order" in the case captioned In the Matter of
Vertical Computer Systems, Inc., Admin. Proc. File No. 3-11879. The
Cease-and-Desist Order ordered that the Company cease and desist from committing
or causing any violations or future violations of Section 13(a) of the Exchange
Act and SEC Rules 13a-1 and 13a-13 thereunder. The Company consented to the
entry of the Cease-and-Desist Order without admitting or denying the findings in
that Order.
On April 15, 2005, the SEC dismissed without prejudice the previously
disclosed Administrative Proceeding as to the Company. The SEC's dismissal was
entered by its Order Dismissing Proceedings Without Prejudice as to the Company.
The SEC Order provided that it was entered pursuant to the previously entered
Order Accepting Settlement and Staying Proceedings to Implement Settlement,
dated April 1, 2005, and for good cause shown. Consequently, the Administrative
Proceeding has concluded with respect to the Company and is no longer pending as
to the Company.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In January 2005, warrants to purchase 3,000,000 shares of common stock at
an exercise price of $0.0165 per share at a fair market value at the date of
issuance of $49,385 (valued using the Black-Scholes Valuation Model) that were
issued to Grant Consultants of America ("GCA") were automatically cancelled
pursuant to the terms of the warrants. These warrants were issued in connection
with an October 2004 consulting agreement between the Company's subsidiary, GIS
and GCA.
In January 2005, the Company issued an additional 2,000,000 unregistered
shares of common stock to Victor Weber pursuant to the September 2004 amendment
of the terms of the $215,000 note issued by Now Solutions to the Company and
assigned to Mr. Weber. In December 2004, the Company recorded an expense of
issuing the 2,000,000 unregistered shares to Mr. Weber at a fair market value of
$10,000. Mr. Weber is a Director and President of GIS, and a member of CW
International.
In March 2005, the Company issued 5,000,000 shares to Arglen. In December
2004, the Company recorded the expense of issuing 5,000,000 unregistered shares
to Arglen at a fair market value of $82,273, which was based on an average share
price during 11 days of August 2004. These shares were issued pursuant to the
settlement agreement with Arglen whereby the Company was obligated to issue
5,000,000 unregistered shares of common stock of the Company to Arglen, due to
its failure to file a registration statement on Form SB-2 within 180 days from
the closing date of the settlement in February 2004.
During the three months ended March 31, 2005, warrants to purchase
5,554,977 shares of common stock of the Company at a price of $0.011 to $0.35
per share expired.
In April 2005, $10,000 worth of principal under certain debentures were
converted into 2,500,000 shares of the Company's common stock in connection with
a $100,000 debenture issued by the Company to a third-party in March 2002.
During the period of April 1 to May 13, 2005, warrants to purchase
1,727,777 shares of common stock of the Company at a price of $0.10 to $0.35 per
share expired.
Unless otherwise noted, the offers, sales and issuances of the Company's
unregistered securities set forth above involved no underwriter's discounts or
commissions. In engaging in the transactions described above which involved the
Company's unregistered securities, the Company 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 the Company's
unregistered securities, the Company did not make a public offering or sale of
its securities, the investors were either accredited or unaccredited but
sophisticated, and the investors represented to the Company that they were
acquiring the securities for investment purposes and for their own accounts, and
not with an eye toward further distribution. With regard to the unaccredited
investors, all information required to be delivered to them concerning the
Company, including financial statements, was in fact delivered to them.
34
ITEM 3. DEFAULTS UNDER SENIOR SECURITIES
The $5.5 million secured promissory note, bearing interest at 9% per
annum, issued by Now Solutions to Coast and purchased by WAMCO, as amended in
June 2004, is currently delinquent. The security interest of Now Solutions'
assets on the secured promissory note is senior to Now Solutions' present
indebtedness to Arglen and Robert Farias. Now Solutions has made all interest
payments as of May 13, 2005 but it is $518,860 delinquent in principle payments.
The note is in default.
The non-interest bearing secured promissory note providing for payments of
$200,000 in April 2004, $100,000 in June 2004, and $300,000 in September 2004,
issued by the Company and Now Solutions to Arglen in connection with the
settlement of litigation and the purchase by the Company of Arglen's interest in
Now Solutions is in default. The security interest of Now Solutions' assets on
the secured promissory note is junior to Now Solutions' present indebtedness to
WAMCO. The note is in default. In August 2004, Arglen obtained a default
judgment in Los Angeles court. The Company and Now Solutions owe interest and
legal fees in addition to the principal outstanding on the note. The Company has
filed a motion in the Delaware court to stay the enforcement of the judgment
pending resolution of the Delaware action. In April 2005, Arglen filed a Notice
of Filing a Foreign Judgment in Tarrant County, Texas.
The interest bearing secured promissory note in the amount of $500,000
providing for payments of $91,500 beginning in October 2004, issued by Now
Solutions to Mr. Farias in connection with the loan to Now Solutions is in
default. The security interest of Now Solutions' assets on the secured
promissory note is junior to Now Solutions' present indebtedness to WAMCO and
Arglen. In addition, the Company also pledged a 30% ownership interest in Now
Solutions to ensure the making of the $500,000 loan to Now Solutions. As of May
13, 2005, Now Solutions had made principal payments totaling $183,000 to Robert
Farias. In January 2005, WAMCO notified Mr. Farias that pursuant to the
subordination agreement executed between WAMCO and Mr. Farias, Mr. Farias was no
longer to accept payments from or to take any collection actions against Now
Solutions for the repayment of junior debt. Mr. Farias is a director of Now
Solutions, a 100% owned subsidiary of the Company.
The $84,000 promissory note, bearing interest at 12% per annum, as
amended, issued by Enfacet, Inc. to Robert Farias in June 2001 is in default.
The security interest of Now Solutions' assets on the secured promissory note is
junior to Now Solutions' present indebtedness to WAMCO, and Arglen and the
Robert Farias $500,000 promissory note. Mr. Farias is a director of Now
Solutions, a 100% owned subsidiary of the Company.
The $350,000 promissory note, bearing interest at 8% per annum, as
amended, issued by Enfacet, Inc. to a third-party in August 2001 is in default.
The security interest of Now Solutions' assets on the secured promissory note is
junior to Now Solutions' present indebtedness to WAMCO, Arglen, and the Robert
Farias $500,000 promissory note.
The $90,000 promissory note, bearing interest at 10% per annum, as
amended, issued by the Company to a third-party in June 2003 is in default. The
security interest of Now Solutions' assets on the secured promissory note is
junior to Now Solutions' present indebtedness to WAMCO, Arglen, and the Robert
Farias $500,000 promissory note.
The $280,000 promissory note, bearing interest at 12% per annum and issued
to Robert Farias on October 31, 2001, as amended by the parties, is in default.
The security interest of Now Solutions' assets on the secured promissory note is
junior to Now Solutions' present indebtedness to WAMCO and Arglen, the Robert
Farias $500,000 promissory note, and the $84,000, $350,000, and $90,000
promissory notes. The note is also secured by SiteFlash technology owned by the
Company.Mr. Farias is a director of Now Solutions, a 100% owned subsidiary of
the Company.
The $181,583 promissory note, bearing interest at 12% per annum, as
amended, issued by the Company to Robert Farias in October 2003 is in default.
The security interest of Now Solutions' assets on the secured promissory note is
junior to Now Solutions' present indebtedness to WAMCO, Arglen, the Robert
Farias $500,000 promissory note, and the $84,000, $350,000, and $90,000
promissory notes. Mr. Farias is a director of Now Solutions, a 100% owned
subsidiary of the Company. The note is also secured by 10,450,000 shares of the
Company's common stock that are owned by MRC to cover any shortfall. 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.
35
In April 2003, a new Equity Line of Credit Agreement was executed between
the Company and Cornell Capital Partners, L.P. ("Cornell"), whereby up to
$10,000,000 worth of the Company's common stock could have been purchased. The
Company is in default of this agreement. The Equity Line of Credit Agreement
contained a commitment fee of $190,000, payable in a convertible debenture,
which was issued to Cornell, and contained a placement fee of $10,000, payable
to the third-party placement agent. In July 2003, the Company issued 2,049,180
shares of common stock as payment of the $10,000 placement fee. As of May 13,
2005, no debentures have been converted.
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 Attached herewith
Section 302 of the Sarbanes-Oxley Act of 2002, dated
May 13, 2005
31.2 Certification of Chief Financial Officer Pursuant to Attached herewith
Section 302 of the Sarbanes-Oxley Act of 2002, dated
May 13, 2005
32.1 Certification of Chief Executive Officer Pursuant to Attached herewith
Section 906 of the Sarbanes-Oxley Act of 2002, dated
May 13, 2005
32.2 Certification of Chief Financial Officer Pursuant to Attached herewith
Section 906 of the Sarbanes-Oxley Act of 2002, dated
May 13, 2005
(b) Reports on Form 8-K:
On January 28, 2005, the Company filed a report on Form 8-K that BDO Seidman,
LLP, the Company's auditor, had resigned.
On January 28, 2005, the Company filed an amended report on Form 8-K/A that BDO
Seidman, LLP, the Company's auditor, had resigned.
36
On February 4, 2005, the Company filed an amended report on Form 8-K/A that BDO
Seidman, LLP, the Company's auditor, had resigned.
On February 4, 2005, the Company filed a report on Form 8-K that the Company
engaged Weaver and Tidwell, L.L.P. as its principal accountant to audit the
Company's financial statements.
On April 1, 2005, the SEC entered two orders in connection with accepting the
terms of an Offer of Settlement of the Company to settle the Administrative
Proceeding, which, with respect to the Company, concerned the delinquency of
filing of certain of the Company's periodic reports required under the Exchange
Act.
On April 15, 2005, the SEC commission dismissed without prejudice the
Administrative Proceeding, as to the Company. The SEC's dismissal was entered by
its Order Dismissing Proceedings Without Prejudice as to the Company. The SEC
Order provided that it was entered pursuant to the previously entered and
disclosed Order Accepting Settlement and Staying Proceedings to Implement
Settlement, dated April 1, 2005, and for good cause shown. Consequently, the
Administrative Proceeding has concluded with respect to the Company.
37
SIGNATURES
Pursuant to the requirements of the Exchange Act, the Company has duly
caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.
Date: May 13, 2005
VERTICAL COMPUTER SYSTEMS, INC.
By: /s/ Richard Wade
-------------------------------------
Richard Wade
President and Chief Executive Officer
By: /s/ Sheri Pantermuehl
-------------------------------------
Sheri Pantermuehl
Chief Financial Officer
38