UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549







FORM 10-K





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





For the fiscal year ended December 31, 2010





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





For the transition period from _____ to _____










Commission file number 0-28685







VERTICAL COMPUTER SYSTEMS, INC.


(Exact Name of Small Business Issuer as Specified in its Charter)





Delaware
65-0393635(State of Incorporation)
(I.R.S. Employer Identification No)





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


(Address of Principal Executive Offices)




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





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





Title of each class
Name of each exchange on which registeredNone
None





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





Common Stock, par value $0.00001 per share


(Title of Class)





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





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


Yes o No x





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





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




Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained in this form, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or amendment to this Form 10-K. Yes xNo o





Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





Large accelerated filer o

Accelerated filer oNon-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company x





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





Issuer’s revenues for fiscal year ended December 31, 2010: $5,907,899





Aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of June 30, 2010: $23,779,295.





As of April 14, 2011, the issuer had 997,935,151 shares of common stock, par value $0.00001, issued and outstanding.





Documents incorporated by reference: None











VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES


FORM 10-K


FOR THE FISCAL YEAR ENDED DECEMBER 31, 2010





TABLE OF CONTENTS




PART I
2Item 1. Business
2Item 1A. Risk Factors
11Item 2. Properties
14Item 3. Legal Proceedings
14item 4. Reserved
16PART II
17Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
17Item 6. Selected Financial Data
19Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
19Item 7A. Quantitative and Qualitative Disclosures About Market Risk
26Item 8. Financial Statements and Supplementary Data
26Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
26Item 9A (T). Controls and Procedures
26Item 9B. Other Information
28PART III
29Item 10. Directors, Executive Officers and Corporate Governance
29Item 11. Executive Compensation
32Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
35Item 13. Certain Relationships and Related Transactions, and Director Independence
36Item 14. Principal Accountant Fees and Services
38PART IV
39Item 15. Exhibits And Financial Statement Schedules
39SIGNATURES
41CONSOLIDATED FINANCIAL STATEMENTS
F-1





Exhibit 31.1
Section 302 Certification by Chief Executive OfficerExhibit 31.2
Section 302 Certification by Chief Financial OfficerExhibit 32.1
Section 906 Certification by Chief Executive OfficerExhibit 32.2
Section 906 Certification by Chief Financial Officer




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PART I





Item 1. Business





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





Background





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




We presently market several software products, including the following: HRMS emPath® 6.5 (“emPath®”), a physician credentialing solution known as “SnAPPnet” and ResponseFlashTM. In addition, we are upgrading a point-of-sale software solution known as “PASS”, a time and attendance software by our subsidiary Priority Times Systems, Inc. (“PTS”), and an FLSA (Fair Labor Standards Act) payroll software based upon emPath® geared to meeting requirements for city and county fire, sheriff and police departments that will be distributed by our subsidiary Taladin, Inc. (“Taladin”). For a description of these products, please see the section entitled “Software Services” under “Business Overview”.




Business Overview




We are a multi-national provider of Internet core technologies, application software, and software services through our distribution network with operations or sales in the United States, Canada and Brazil. Our primary Internet core technologies include SiteFlashTM, Emily® XML Enabler Agent, Emily® XML Broker, which can be an alternative to Web services, and the Emily® XML Scripting Language, which can be used to build Web services. Our fiber optic patent (for transmission of images over a single filament of fiber optic cable [No. 6718103]) is in OptVision Research, Inc. (“OptVision Research”).





Our main application software, emPath®, which is designed to handle complex Payroll and Human Resources challenges, is marketed by NOW Solutions. NOW Solutions, Inc. (“NOW Solutions”), a wholly owned subsidiary of the Company, is selling emPath® in the United States and Canadian markets both as a software solution as well as a new Software-as-a-Service (“SaaS”) offering, also known as “cloud-based” offering. For a description of our new delivery model for emPath®, please see the section entitled “Software Services” under “Business Overview”.




We have other application software in various stages of developments which will be marketed through different Company subsidiaries including PTS, Vertical Healthcare Solutions, Inc. (“VHS”), Taladin, SnAPPnet, Inc, and Government Internet Systems Inc. (“GIS”). We are actively pursuing the licensing of our intellectual properties, including SiteFlashTM.




In 2009, we acquired rights from Emerald Software Group (“Emerald”) to market that company’s AllegroHR onboarding and offboarding software solutions as well as staff service requests and personnel action notices applications, including the right to market these products as a private label offering. Also in 2009, we acquired PTS, a software company that was completing the development of a time and attendance software solution known as “Priority Time” for use by employers to improve efficiency of their workforce.





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In 2010, our wholly owned subsidiary, SnAPPnet, Inc., a Texas corporation, purchased substantially all of the assets of Pelican Applications, LLC (“Pelican”), including a software application product known as SnAPPnet which is currently used for physician credentialing, as well as Pelican’s entire customer base. Also in 2010, NOW Solutions Canada, Inc., our wholly owned subsidiary, entered into a reseller and marketing agreement with Kronos Canadian Systems, Inc.





In January 2011, we entered into an assignment agreement for a sixteen year-old web server software with the intent to modify and use it as a basis to create a product.





A substantial effort has been made to develop our emPath® product and its SaaS offering platform, which will allow us to finalize and launch our new module-based initiative whereby certain payroll/human resource modules can be marketed independently from emPath® or bundled as a comprehensive solution. A key objective of the module development initiative is to enable new modules to be sold to a smaller customer base (25 to 500 employee companies) in a simple standardized version. This version will have full functionality and all the benefits of a total enterprise solution, while maintaining scalability in order to meet the needs of and to compete for the largest corporate customers and government entities, which often have complex payroll rules.





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




Our current products address the following market segments:




MARKET

PRODUCT

OWNERSHIP/

LICENSOR

LICENSEEHuman Resources and Payroll

emPath®

NOW Solutions

VHS (a), Taladin (b)Pharmacies and medical practices

SiteFlashTM

Vertical

VHSGovernment Sector- Emergency Response

ResponseFlashTM

Vertical

GIS (b)Pharmacies and medical practices

PASS

Vertical

VHSSoftware development units

Emily®

Vertical

VHSHuman Resources and Payroll

AllegroHR

Emerald Software Group

NOW SolutionsTime and Attendance

Priority Time

Priority Time Systems

VHS (a), NOW Solutions (c)Physician Credentialing

SnAPPnet

SnAPPnet, Inc.

VHS (a)


(a)
Physician market


(b)
Government market


(c)
Clients




Application Software




Our primary application software is emPath®, a human resources/payroll software, which is developed, marketed and maintained by our wholly-owned subsidiary, NOW Solutions. This software is Web-based, meaning that it can be accessed on the Internet, and is currently being offered as a SaaS (aka cloud-based) or as a software license.




In 2010, we completed the workflow engine for emPath® and continued improvements for its SaaS offering. We also implemented our new strategy of developing certain HR/payroll related modules that can be sold separately from emPath® or bundled with emPath® as a comprehensive solution. These new features, when coupled with experience gained with the product by the Brazil-based development staff (over the past five years), have substantially facilitated faster product development. In addition, we have significantly improved the scalability of emPath® to meet the needs of small businesses as well as very large enterprise clients. We are also continuing to upgrade emPath® for our SaaS offering utilizing emPath®’s powerful payroll component to provide private label contracting as well as distribution opportunities through existing payroll providers in their local markets. As a result of our initial sales to complex payroll customers, we realized the need for a “Tailored SaaS” allowing these types of customers to receive the cost benefits of a SaaS offering while meeting their complex requirements.




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In the summer of 2010, we elected to utilize a new development platform (“Platform”) and created “dashboardletsTM” (a proprietary tool for business intelligence) allowing the scalability to meet large and/or complex customer requirements. We currently anticipate marketing Priority Time through PTS as a separate module in May 2011, as well as bundling it with NOW Solutions’ emPath®, which we intend to market to emPath®’s existing customer base.




We are marketing our SnAPPnet application to NOW Solutions’ existing customer base as well as through VHS to physicians in the United States. We are also in the process to developing a registered nurse module of SnAPPnet, which we will market NOW Solutions’ existing healthcare customers in the United States. In addition, we are adding some key new features to the software application as well as doing a design review to meet other potential markets for credentialing.




We believe that our application software services provide customers with upfront cost savings and significant increases in productivity for everyday operations, including competitive set-up fees and implementation times. The new Platform will be used to develop the other modules.




Internet Core Technologies




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




Our primary core internet technology is SiteFlashTM. The SiteFlashTM technology utilizes XML and publishes content on the Web, enabling the user to build and efficiently operate Websites with the unique ability to separate form, function, and content. SiteFlashTM uses an advanced component-based structure to separate, parse, and store the various components of even the most complex Web pages, permitting these components to be named, organized, filed and eventually redeployed onto the Web pages of a Website. Once all of the components of a Web page are converted into “objects,” they can be grouped, as required by the user, into the three main types of web page components: content, form and function. Content includes text, pictures or multimedia. Form includes graphics and Website colors, layout and design. Functionincludes the activities performed by or actions executed on the Website. In this way, each element of a Website created using SiteFlashTM is interchangeable with any other similar element, and these elements may be grouped together in almost any combination to create complex Websites. This separation of form, function, and content also allows for the rapid creation of affiliated Websites. This unique ability is patented (U.S. Patent number 6,826,744 and continuation patent U.S. Patent No. 7,716,629) and has many applications in the Web arena. SiteFlashTM architectural concepts enable integration with existing technological components within many organizations. Additional key features that differentiate SiteFlashTM from other products are its affiliation/syndication capability, its multi-lingual capability and its multi-modal framework (enabling use on any output device, including wireless devices such as smart phones, as well as cellular phones and other devices with Internet capability).





We offer SiteFlashTM as a stand-alone product and also as a technology platform for products targeted at specific vertical markets. The SiteFlashTM technology focuses on content management, e-commerce, and workflow and has led to the development of three additional software application products: ResponseFlashTM, NewsFlashTM and AffiliateFlashTM. Initially, GIS will focus on marketing ResponseFlashTM, a Web-based emergency communication system, in the Homeland Security area to all government sectors excluding public education (i.e., schools, colleges, and universities).





We have converted our SiteFlashTM product to offer it in a SaaS configuration. We intend to concentrate our initial marketing efforts in the affiliate, government and publishing markets.




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




The third core Internet technology we have developed is the combination of three components: the Emily® XML Broker, the Emily® XML Agent and the Emily® XML Portal. This technology allows a disparate and distributed database to be viewed and updated as if it was a single large database. This unique ability is patented (U.S. Patent number 7,076,521).





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This technology has been featured as an alternative to Web Services in the 4th Edition of the XML Handbook, by Dr. Charles Goldfarb, considered the father of XML and inventor of all markup languages. We are, at this time, pursuing opportunities to deploy the technology in industries such as the government and health insurance markets.




The fourth core Internet technology is a sixteen year-old web server software that was assigned to the Company. The technology was acquired with the intent to modify and use it as a basis to create a new product.




Software Services




In addition to its standard emPath® offering, NOW Solutions has been providing a new delivery model: software-as-a-service, or simply “SaaS”. SaaS is a software application delivery model where a software company both develops and operates/hosts the application for use by its customers over the Internet. It is a low-cost way for businesses to obtain the same benefits of commercially licensed, internally operated software, without the associated complexity and high start-up costs. The term “SaaS” has become the industry adopted reference term, generally replacing “cloud based” or earlier terms like “On-Demand” and “ASP” (Application Service Provider). After completing the testing of its emPath® SaaS model to ensure a robust and competitive solution, NOW Solutions has sold that offering to existing and new clients. This delivery model provides a highly reliable, secure and scalable infrastructure, enabling us not only to continue servicing and expanding our current market of mid to large sized customers but also to increase our market reach by offering a solution to smaller sized customers, which otherwise may not be able to afford an in-house solution. As an expanded product, NOW Solutions has created a “Tailored SaaS” offering to meet the needs of large complex customers who have specialized requirements.




Other NOW Solutions’ software services include maintenance, custom maintenance, professional services and a new managed services offering.




SnAPPnet and Priority Time will both be SaaS offerings along with professional and managed services.




Business Operations and Units




Our business operations are grouped into the following units: NOW Solutions, GIS, Vertical Internet Solutions, Inc. (“VIS”), EnFacet, Inc. (“EnFacet”), Globalfare.com, Inc. (“Globalfare”), Pointmail.com, Inc. (“Pointmail”), Taladin, OptVision Research, VHS, PTS, SnAPPnet, Inc., and minority and other limited interests, joint ventures, and strategic partnerships. Each of these divisions is discussed below.




NOW Solutions, Inc.




NOW Solutions, a Delaware corporation, is a wholly-owned subsidiary of the Company. NOW Solutions specializes in end-to-end, fully integrated human resources and payroll solutions. NOW Solutions has clients in the United States and Canada ranging from private businesses to government agencies, who typically employ 200 or more employees. NOW Solutions currently markets emPath®, which handles complex human resources and payroll situations where the clients may have employees from different unions, multiple state locations, and intricate compensation structures. We believe that the competitive advantage of emPath® is its speed of implementation through a formula-builder technology, which allows quick customization of payroll rules and calculations without any programming. NOW Solutions’ product suite is targeted to address the needs of management in today’s dynamic business environment and gives organizations a user friendly, multi-lingual (i.e., English, Canadian French, Spanish, Portuguese and Chinese) and flexible software solution, without the multi-million dollar implementation and support budgets of the major competitors.





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





Additionally, NOW Solutions has embarked on a new strategy of developing and licensing HR products complementary to its existing suite of products that can be sold as a separate product or integrated with emPath®, which is greatly facilitated by emPath®’s Web Services integration. The first products which are part of this initiative consist of “onboarding” and “offboarding” software, which were obtained through NOW Solutions’ agreement with Emerald and resulted in an immediate sale to one of its existing customers. The second product is Priority Time which we anticipate launching as a separate product in May 2011, offering it to our existing customer base.




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In 2010, NOW Solutions Canada entered into a reseller and marketing agreement with Kronos Canadian Systems, Inc.. Under the terms of the agreement, Kronos Canadian Systems, Inc. selected emPath® as its exclusive HRMS and Payroll solution for use in Canada. NOW Solutions’ emPath® application will be rebranded and marketed to Kronos Canadian’s customers as “Kronos HR Payroll Powered by emPath®”. NOW Solutions Canada will continue to directly market its product in Canada.





The traditional revenue model of NOW Solutions was based primarily upon four components: licensing fees, SaaS fees, professional consulting services, and renewable maintenance fees. We are now offering Managed Services. Under the SaaS delivery model, NOW Solutions typically collects monthly fees.





For the 12 months ended December 31, 2010, NOW Solutions had approximately $677,771 of total assets, revenues of approximately $5,840,955 and net income of approximately $1,372,738.




Taladin, Inc.




Taladin, a Texas corporation, is a wholly-owned subsidiary of the Company. In November 2005, Taladin and NOW Solutions entered into a license agreement whereby Taladin received the exclusive rights to commercially exploit emPath® for use by the United States federal, state and local governments and agencies in exchange for a license fee and royalties. Taladin has developed a module for emPath® to meet federal payroll guidelines for law enforcement and fire departments but the finalization of the module was put on hold while final testing was performed and the underlying emPath® SaaS platform was finalized.




For the 12 months ended December 31, 2010, Taladin had no material assets, no revenues and a net loss of approximately $7,409.




OptVision Research, Inc.




OptVision Research, a Texas corporation, is a wholly-owned subsidiary of the Company and was created to support the development of our fiber optic patent through either direct investment or government grants.





The United States Patent and Trademark Office (“USPTO”) granted us a patent (No. 6,718,103) for an invention for “Transmission of Images over a Single Filament Fiber Optic Cable” in April 2004. This patent is in a theoretical stage only and is intended to be used for transmitting images on fiber optics that might improve in orders of magnitude today’s capacity of fiber optics to transmit images and data. We are in the process of attempting to secure funding from the Federal Government for development of the patent.





For the 12 months ended December 31, 2010, OptVision had no material assets, no revenues and a net loss of approximately $3,913.




Vertical Healthcare Solutions, Inc.




VHS, a Texas corporation, is a wholly-owned subsidiary of the Company. In May 2008, Robert Farias assigned Point-of-Sale software (“PASS”) technology to the Company. In addition, VHS and Mr. Farias entered into a distributor agreement for PASS whereby Mr. Farias would market PASS to his existing clients. In October 2008, VHS entered into a consulting agreement with Farias-Jett (a sole proprietorship of Mr. Farias), and an employment agreement with Mr. Farias. Significant upgrades have been completed on the PASS software and VHS has some pharmacies beta testing this product. PASS is being adapted to meet the needs for physicians for a secondary market. On December 17, 2009, Sigis (the “Special Interest Group for IIAS Standards”) certified that PASS met the requirements by the IRS for IIAS COMPLIANT POINT OF SALE SYSTEM. In 2010, VCSY licensed its various products and technology to VHS for the physician market. A comprehensive package is being finalized for that market.





For the 12 months ended December 31, 2010, VHS had no material assets, no material revenues, and a net loss of approximately $132,154.




Priority Time Systems, Inc.




PTS is a Nevada corporation. On June 15, 2009, we purchased 90% of the common stock of PTS from a shareholder of PTS. The purchase price was $63,000, of which $25,000 was paid at execution and the balance paid in equal monthly installments over a 12-month period beginning in August 2009. In connection with this purchase, we also agreed to retain the selling shareholder as a consultant of PTS beginning in July 2009. In addition, we also entered into a shareholder agreement with the selling shareholder of PTS whereby we have the option to purchase the remaining 10% of the common shares of PTS stock at any time after 3 years from the date of our purchase of the 90% block. The shareholder agreement also provides for the licensing terms of PTS products to our other subsidiaries.





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PTS has been developing Priority Time, a time and attendance product that we intend to offer both as a standalone product and as an integrated product with emPath®. In late spring 2010, we elected to stop the development and switch to a new Platform allowing us to create a new product utilizing a rule based system, which will better meet the needs of NOW Solutions’ most complex customers and more easily create a time and attendance product for vertical markets. Additionally, we are utilizing an in-house tool to create dashboardletsTM. We are finalizing the completion of the Priority Time product, which we anticipate launching in May 2011.





In connection with the PTS acquisition, the Company continues to retain two highly experienced executives within PTS with years of experience and success in the independent marketing and sales of time and attendance software solutions.





For the 12 months ended December 31, 2010, PTS had assets of approximately $249,527, no material revenues and a net loss of approximately $153,975.





SnAPPnet, Inc.





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





In 2010 we were able to retain the existing customers and complete an installation for a new large customer, all while consolidating the operations with those of the Company. We are finalizing the specifications of the software to better meet the existing needs of physicians with improved features as well as supporting other credentialing opportunities we have identified, utilizing the new Platform mentioned earlier.





As part of the acquisition of Pelican, we retained an experienced executive in the healthcare industry with years of experience and success in the marketing and sales of physician credentialing and healthcare software solutions.





For the 12 months ended December 31, 2010, SnAPPnet, Inc. had assets of approximately $260,699, revenues of approximately $66,942 and net loss of approximately $48,309.





Government Internet Systems, Inc.




Our 81.5% owned subsidiary, GIS, a Nevada corporation, was formerly named Emily® Solutions, Inc. Vertical licensed ResponseFlashTM to GIS, in order to market and distribute this technology to government entities (excluding state universities and schools) in the United States. GIS seeks to enter into agreements to distribute other non-Company products particularly in the Homeland Security sector. We are in the process of submitting proposals to various city, county and state governments. We are currently seeking funding through grants.




For the 12 months ended December 31, 2010, GIS had no assets, no material revenue and net loss of approximately $8,302.




Vertical Internet Solutions, Inc.





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





For the 12 months ended December 31, 2010, VIS had no material assets, no material revenue and $239,284 of expenses related to tax liens on prior years payroll tax liabilities.




7




EnFacet, Inc.




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





For the 12 months ended December 31, 2010, EnFacet had no material assets, no revenues and net income of $106,076 primarily related to the write off of liabilities on which the statute of limitation has been met.




Globalfare.com




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




For the 12 months ended December 31, 2010, Globalfare had no assets, no revenues and net income of $8,952 primarily related to the write off of liabilities on which the statute of limitation has been met.




Pointmail.com, Inc.




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




For the 12 months ended December 31, 2010, Pointmail had no assets, no revenues and no expenses.




Minority Interests and Royalty Interests




iNet Purchasing, Inc.




In April 2000, we acquired a 2.5% minority interest in iNet and became entitled to a royalty on all iNet transactions for up to 40 years. iNet is a developer of Internet-based procurement services targeted at the specific needs of public sector purchasing in the state and local government arena through PublicBuy.net. In November 2001, we entered into a license agreement with iNet, pursuant to which the Emily® software and technology were licensed for use in connection with iNet’s e-procurement system in Texas, Maine, and Idaho in exchange for a 20% commission on subscription fees. In April 2005, iNet Purchasing was acquired by SicommNet. We are in the process of reviewing our rights as a consequence of such acquisition.




As of December 31, 2010, all of the iNet investments and advances paid for royalties were fully reserved. There have been no revenues or expenses in relation to the investments for the twelve months ended December 31, 2010.




TranStar Systems, Inc.




TranStar Systems, Inc. (“TranStar”), based in Claremont, California, is a systems integrator and consulting firm that is establishing an e-business platform. That platform is mainly focused on multiple-application smart card based solutions for credit, debit, payroll debit cards and other high volume informational transactions with a large customer base. We are entitled to receive 3% of any transaction fees and any other revenues generated by TranStar in perpetuity, although no royalties have been received from TranStar as of April 14, 2011. Although TranStar put its smart card and payroll debit card business on hold in 2009, we have a distribution agreement with the President of TranStar to market our products, including emPath®.




Strategic Alliances and Software Distributors




Farias-Jett.In August 2008, NOW Solutions entered into a hosted service provider agreement with Farias-Jett for emPath® so that Farias-Jett can market emPath® for Small Business SaaS product to its existing customer base. In 2010, Farias-Jett was active in providing input and beta testing for this offering.





Emerald Software Group.In February 2009, NOW Solutions entered into an agreement with Emerald to market its AllegroHR products with NOW Solutions’ emPath® Payroll/HRMS software solution and to sell it separately. AllegroHR consists of onboarding and offboarding software solutions as well as staff service request and personnel action notices applications. NOW Solutions can distribute AllegroHR under a private label version. Throughout 2009 and 2010, Emerald worked closely with the Company in utilizing emPath®’s web services to provide an integrated solution for emPath®’s first on-boarding customer.




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Competition




We have substantial competition from software and hardware vendors, system integrators, and multinational corporations focused upon information technology and security. In the realm of application software, NOW Solutions’ competitors include Oracle, Lawson, Cyborg /Hewitt, Kronos, DLGL, Ultimate and SAP. Our competitors for emPath® for SaaS include ADP, Ceridian, Ultimate and Quicken. However, while NOW Solutions competes with these companies, its payroll product is utilized in conjunction with many of these companies’ other modules.





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





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





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





1.
We have a number of proprietary patented technologies that can be utilized in our offerings.


2.
NOW Solutions has an outstanding customer support department that has supported large complex entities for a number of years, and many of these large entities are leaders in their respective industries.


3.
emPath®’s inherent strengths include its formula builder, the use of one single data base, and a strong, highly identifiable customer base it can reference.


4.
emPath® is built on a state-of-the-art Microsoft.net platform, allowing for rapid software development and interoperability with other software packages.





Strategic Overview




The Company’s product portfolio reflects a number of unique characteristics and advantages that have been developed or acquired over time. Yet we were unable to devote our full resources to maximize the benefit of our various technologies until the final resolution of the litigation with Ross Systems, Inc. (“Ross”) in the fall of 2009. Currently, we are actively pursuing the strategy of (a) further developing the technologies owned by the Company and its subsidiaries and (b) combining all the technologies owned by the Company and its subsidiaries into viable product offerings.




The key components of our strategy are:




1.
A strong, profitable subsidiary, NOW Solutions, that has a highly-referenceable client base, including companies that are leaders in their industries and users of emPath® for over 10 years for their payroll and human resource needs.




2.
A portfolio of patented technologies that can be licensed to third parties or utilized internally to strengthen our existing and projected product offerings.




3.
Development of compatible partners and acquisition or licensing of products that complement our existing offerings.




4.
The unique ability to market our new Priority Time product as well as other products to NOW Solutions’ customer base and, at the same time, have those customers assist us in development of the specifications for their own market.




5.
The utilization of our patented technology and other application software in solutions for our core application software.




9





The software development leg of our strategy is twofold. The first lies in continuing to develop the ability to compete with the large ERP providers like SAP and Oracle in providing complex best-of-breed alternatives offerings that are more cost effective solutions. The second is to continue developing our intellectual property internally for mass market, best-of-breed solutions offered as a SaaS offering that incorporate the advantages of our complex solutions. In each such instance, the software development leg of our strategy will be augmented by exploring solutions that can be linked to federal and state government programs for cost savings.




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




Proprietary Rights




We rely upon a combination of contract provisions and patent, copyright, trademark and trade secret laws to protect our proprietary rights in our products and services. We distribute our products and services under agreements that grant users or customers a license to use our products and services and rely upon the protections afforded by the copyright laws to protect against the unauthorized reproduction of our products. In addition, we protect our trade secrets and other proprietary information through agreements with employees and consultants. NOW Solutions’ emPath® software technology is protected by copyright and trademark. Priority Time, SnAPPnet , PASS are also protected by copyright.





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





The USPTO granted us a patent (No. 6,826,744) for an invention for “System and Method for Generating Web Sites in an Arbitrary Object Framework” on November 30, 2004. On May 11, 2010, we were granted a continuation patent (U.S. Patent No. 7,716,629) of U.S. Patent No. 6,826,744 by the USPTO. All pending new claims were granted in the continuation patent, which has increased the scope of the original patent by adding 32 new claims to the original 53 claims. Together, these patents are the foundation of our product, SiteFlashTM, and form the basis of the ResponseFlashTM, NewsFlashTM and AffiliateFlashTM products.





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





We have filed for a patent related to the Emily® XML scripting language. This patent application was published in February 2003 and is still pending.





On December 13, 2010, we filed an application for a patent, serial number 12/966741, titled “System and Method for running a Web Server on a Mobile Internet Device”. This patent application is not yet published and still pending.





On March 31, 2011, we filed a provisional application for a patent, serial number 61/470474, titled “Mobile Web Proxy”. This provisional patent application is not yet published and still pending.





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




10




Regulatory Environment; Public Policy




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




Employees




As of April 14, 2011, we had 26 full-time and 5 part-time employees, of which 26 are employed at NOW Solutions (17 are employed in the United States and 9 in Canada), and 11 consultants (6 in Brazil). We are not a party to any collective bargaining agreements.




Item 1A. Risk Factors




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





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





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





While we had a loss of $150,316 for the year ended December 31, 2010 and a profit of $3,504,538 for the year ended December 31, 2009, we have historically incurred losses. Our loss for the year ended December 31, 2010 was primarily due to losses in startup and developing subsidiaries. Our profit for the year ended December 31, 2009 was primarily due to our collecting the judgment awarded to us against Ross. Accordingly, we have and may continue to experience significant liquidity and cash flow problems because our operations are not profitable. No assurances can be given that we will be successful in reaching or maintaining profitable operations.





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





The report of our independent registered public accounting firm included an explanatory paragraph in connection with our financial statements for the years ended December 31, 2010 and 2009. 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, to succeed in the licensing of our intellectual property and to achieve improved operating results. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.





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





The accompanying consolidated financial statements for the 12 months ended December 31, 2010 and 2009 have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.





11





The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We have suffered significant recurring operating losses, used substantial funds in our operations, and need to raise additional funds to accomplish our objectives. Negative shareholders’ equity at December 31, 2010 was $21.3 million. Additionally, at December 31, 2010, we had negative working capital of approximately $11.9 million (although it includes deferred revenue of approximately $2.6 million) and have defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.





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





We believe that our success will depend upon our ability to generate revenues from our SiteFlashTM and Emily® technology products through licensing and development of viable products, other products for which we have marketing rights, as well as increased revenues from NOW Solutions products and the successful launch of our new solutions by our subsidiaries (such as emPath® for Small Business, PASS, SnAPPnet, and Priority Time), none of which can be assured. Our ability to generate revenues is subject to substantial uncertainty and our inability to generate sufficient revenues to support our operations and debt repayment could require us to curtail or suspend operations. Such an event would likely result in a decline in our stock price.





Our Success Depends On Our Ability to Obtain Additional Capital





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





We Have a Working Capital Deficit, Which Means That Our Current Assets on December 31, 2010 Were Not Sufficient to Satisfy Our Current Liabilities on That Date





We had a working capital deficit of approximately $11.9 million at December 31, 2010, which means that our current liabilities exceeded our current assets by approximately $11.9 million (although it includes deferred revenue of approximately $2.6 million). Current assets are assets that are expected to be converted into cash within one year and, therefore, may be used to pay current liabilities as they become due. Our working capital deficit means that our current assets on December 31, 2010 were not sufficient to satisfy all of our current liabilities on that date.





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





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




·
the demand for our SiteFlashTM and Emily® technology;
 ·
the demand for NOW Solutions’ emPath® product;
 ·
the demand for VHS’ PASS product;
 ·
the demand for PTS’ Time and Attendance product;
 ·
the demand for our SnAPPnet product;
 ·
introduction of new products and services by us and our competitors;
 ·
costs incurred with respect to acquisitions;
 ·
price competition or pricing changes in the industry;
 ·
technical difficulties or system failures;
 ·
general economic conditions and economic conditions specific to the Internet and Internet media; and
 ·
the licensing of our intellectual property.




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


12


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


Keeping Pace with Industry Changes.





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





Impact of Product Development Delays or Competitive Announcements.





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





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





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





·
the difficulty of assimilating the operations and personnel of the acquired companies;


·
the potential disruption of our ongoing business and distraction of management;


·
the difficulty of incorporating acquired technology or content and rights into our products and media properties;


·
the correct assessment of the relative percentages of in-process research and development expense which needs to be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset;


·
the failure to successfully develop an acquired in-process technology resulting in the impairment of amounts currently capitalized as intangible assets;


·
unanticipated expenses related to technology integration;


·
the maintenance of uniform standards, controls, procedures and policies;


·
the impairment of relationships with employees and customers as a result of any integration of new personnel; and


·
the potential unknown liabilities associated with acquired businesses.





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





Our Success Depends On Our Ability to Protect Our Proprietary Technology





Our success is dependent, in part, upon our ability to protect and leverage the value of our original SiteFlashTM 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.




13





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





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





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





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





·
With a price of less than $5.00 per share;


·
That are not traded on a recognized national exchange;


·
Whose prices are not quoted on the NASDAQ automated quotation system (NASDAQ listed stock must have a price of not less than $5.00 per share); or


·
In issuers with net tangible assets less than $2 million (if the issuer has been in continuous operation for at least three years) or $5 million (if in continuous operation for less than three years), or with average revenues of less than $6 million for the last three years.





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





Item 2. Properties




The Company and NOW Solutions’ headquarters are currently located at 101 West Renner Road, Suite 300, Richardson, Texas, and comprise approximately 2,576 square feet. In addition, NOW Solutions has offices at 6707 Brentwood Stair Rd., Suite 226, Fort Worth, Texas 76112, which comprises 1,703 square feet, 6205 Airport Road, Building A, Suite 300, Mississauga, Ontario, Canada, which comprises 710 square feet, and Avenida N. Sra. De Copacabana, 895, Suite 901, Copacabana, Rio de Janeiro, Brazil, which comprises 1,200 square feet. All of these locations are leased from third parties and the premises are in good condition. We believe that our facilities are adequate for our present needs and near-term growth, and that additional facilities will be available at acceptable rates as we need them. Our other subsidiaries may be reached through our Richardson, Texas headquarters.




Item 3. Legal Proceedings




We are involved in the following ongoing legal matters:




On October 11, 2007 a judgment in the amount of $3,151,216 was entered for NOW Solutions (the “Judgment”) against Ross in New York state court. The amount of the Judgment consisted of $1,279,483 for NOW Solutions’ claims (after deducting $664,000 for Ross’ claim), $912,464 in attorneys’ fees and expenses, and $865,361 for accrued interest. Ross appealed the Judgment, which was affirmed by the appellate court. On March 24, 2009, the New York City Department of Finance released Ross’ cash deposit of $3,151,216 (which had accrued $133,424 in interest) to NOW Solutions. The net proceeds of the deposit collected by NOW Solutions totaled $873,444, after deducting $2,345,502 in attorneys’ fees and costs (including a $992,723 promissory note issued to Wolman Blair PLLC) and $65,693 in fees and interest charged by New York City Department of Finance on the deposit.





14





On September 15, 2009, NOW Solutions executed a settlement agreement with Ross in connection with the outstanding monies (accrued interest, attorney fees and expenses) owed by Ross to NOW Solutions. Pursuant to the terms of the settlement agreement, Ross made a $390,468 payment to NOW Solutions and a $144,532 payment to the Internal Revenue Service (“IRS”) on behalf of the Company which is reported as part of the “Gain on settlement of litigation” in the consolidated statements of operations. All litigation with Ross has been resolved.





In August 2004, Arglen obtained a default judgment against the Company for a past due $600,000 promissory note, plus fees and interest. We agreed to pay Arglen $713,489. As of December 31, 2008, we had paid all principal due under the payout agreement. In February 2009, the Company and Arglen agreed to settle a dispute concerning accrued interest regarding the payout agreement. Under the terms of the settlement, we paid Arglen $60,000. This matter has been resolved.





The IRS had a claim for unpaid Employment (Form 941) taxes and Federal Unemployment (Form 940) taxes for the period December 31, 2001 through December 31, 2005. We paid $200,000 of the principal amount of the unpaid payroll taxes in September 2008. In September 2009, the lien held by the IRS against us in the amount of $144,532 was satisfied. This matter has been resolved.





In August 2009, Parker Shumaker & Mills, LLP (“PSM”) filed a lawsuit in Los Angeles Superior Court to collect the outstanding balance of $51,238 under a promissory note issued by the Company to PSM in the principal amount of $75,000, plus interest at 6% per annum, late fees and attorneys’ fees. We issued the $75,000 note in connection with a settlement in October 2005 with PSM. In December 2009, we entered into a settlement agreement and stipulated judgment with PSM whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM. During 2010, the Company made timely payments of $40,000 of this note leaving a balance of $33,371 at December 31, 2010.





On November 18, 2009, we sued InfiniTek Corporation (“InfiniTek”) in the Texas State District Court in Fort Worth, Texas for breach of contract and other claims (the “Texas Action”) seeking equitable relief and unspecified damages when a dispute between the Company and InfiniTek was not resolved. All agreements with InfiniTek have been cancelled. On January 15, 2010, InfiniTek filed a counter-claim for non-payment of amounts billed. InfiniTek claims it is owed $195,000, and has incurred alleged lost opportunity cost of not less than $220,000. We attempted unsuccessfully to resolve our dispute with InfiniTek via mediation. Our lawsuit was amended on March 30, 2010. Discovery is ongoing.





On April 7, 2010, we were served with a lawsuit filed by InfiniTek in the California Superior Court in Riverside, California seeking damages in excess of $76,303 for breach of contract and lost profit. This lawsuit relates to one of the causes of action, and the same set of underlying facts, as those in the Texas legal action mentioned above. On May 7, 2010, we filed a motion to dismiss this action. On July 14, 2010, the court denied our motion. On August 13, 2010, we filed an answer to InfiniTek’s complaint, including a denial and affirmative defenses. We continue to litigate the claims made by InfiniTek in this action as well as our other claims against InfiniTek in the Texas case. The amounts in dispute are included in our accounts payable and accrued liabilities pending the outcome of this litigation.





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





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





15





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





Motions filed by the parties in the Eastern District of Texas and the Northern District of California concerning the Vertical Action, the Interwoven Action, and the Samsung lawsuit are pending decisions by the respective courts.





In the opinion of management, the ultimate resolution of any pending matters may have a significant effect on our financial position, operations or cash flows.




Item 4. Reserved





16





PART II




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




Our common equity is quoted on the Over-The-Counter Bulletin Board (the “OTCBB”) under the symbol “VCSY”.





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




High


LowQuarter Ended December 31, 2010

$
0.0327


$
0.0190Quarter Ended September 30, 2010

$
0.0330


$
0.0230Quarter Ended June 30, 2010

$
0.0390


$
0.0260Quarter Ended March 31, 2010

$
0.0330


$
0.0210Quarter Ended December 31, 2009

$
0.0290


$
0.0160Quarter Ended September 30, 2009

$
0.0410


$
0.0190Quarter Ended June 30, 2009

$
0.0260


$
0.0180Quarter Ended March 31, 2009

$
0.0400


$
0.0210








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




Number of Holders




As of April 12, 2011, there were 1,843 holders of record of our common stock.




Equity Securities Under Compensation Plans




We had the following securities authorized for issuance under equity compensation plans (which include individual agreements) as of December 31, 2010:




Plan category

Number of securities to be issued upon exercise of outstanding options, warrants and rights


Weighted-average exercise price of outstanding options, warrants and rights


Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))(a)


(b)


(c)Equity compensation plans approved by security holders(1)


-



-



-Equity compensation plans not approved by security holdersStock Options (2)


-



-



-Warrants (3)


-



-



-Unvested Restricted Stock Awards (4)


600,000


$
0.031



-Total


600,000


$
0.031



-




17





(1)
We do not have any equity compensation plans (i.e., stock option plans or restricted stock plans) that have been approved by security holders.




(2)
The Stock Option Plan expired December 15, 2009.




(3)
Warrants issued to Robert Farias to purchase 15,000,000 shares of our common stock under three separate warrant agreements were cancelled pursuant to an agreement with Robert Farias in March 2010. For additional details, please refer to Note 4 of the Notes to the Financial Statements.





(4)
The 600,000 shares of restricted stock that had not vested at December 31, 2010 were issued in connection with an individual restricted stock agreement executed in 2010 with an employee of the Company and NOW Solutions. Of the 600,000 unvested shares at December 31, 2010, no shares have vested through April 14, 2011.




Dividends




We have outstanding shares of Series A and Series C 4% Convertible Cumulative Preferred stock that accrue dividends (if such dividends are declared) at a rate of 4% on a semi-annual basis. The total dividends applicable to Series A and Series C Preferred Stock were $588,000 for each of the years ended December 31, 2010 and 2009. Our Board of Directors did not declare any dividends on our outstanding shares of Series A or Series C Preferred Stock during 2010 or 2009, nor has the Company paid any dividends on our outstanding shares of Series A or Series C Preferred Stock since 2001. We intend to retain future earnings, if any, to provide funds for use in the operation and expansion of our businesses. Accordingly, we do not anticipate paying cash dividends on any of our capital stock, including preferred stock, in the near future. For additional information concerning dividends, please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.




Unregistered Sales of Securities





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




In November 2009, the obligation to reimburse Mountain Reservoir Corporation (“MRC”) with 1,309,983 common shares of the Company stock became due pursuant to the Indemnity and Reimbursement agreement between MRC and the Company. This obligation was made in connection with the sale of 1,500,000 common shares of our stock pledged by MRC to secure a $96,946 promissory note issued to a third party lender. In November 2008, the lender sold 1,500,000 shares of the pledged stock for $118,167, of which $103,555 was applied to outstanding debt claimed by the lender including interest, penalties & attorney’s fees. The remaining $14,612 was returned to MRC representing the amount of shares oversold by the lender. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.





During 2009, 2,583,336 unregistered shares of common stock issued to employees and consultants of both the Company and NOW Solutions became vested, resulting in stock compensation expense of $94,533.





During 2009, 800,000 unregistered shares of common stock of the Company were forfeited pursuant to restricted stock agreements between the Company and employees of NOW Solutions. These shares were not vested at the date of forfeiture.




In January 2010, the Company and MRC amended the indemnity and reimbursement agreement (originally entered into in April 2007) whereby the Company agreed to reimburse and indemnify MRC for 16,976,296 shares pledged in November 2009 as collateral in connection with a $150,000 note. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.





In March 2010, the Company transferred 610,000 shares of Series A Convertible Preferred Stock of VHS (a wholly-owned subsidiary of the Company) to Mr. Robert Farias in exchange for the following: (a) an irrevocable waiver by Mr. Farias of the conversion rights in respect of 37,500 shares of the Company’s Series “C” 4% Cumulative Convertible Preferred Stock owned by Mr. Farias; (b) cancellation by Mr. Farias of $100,000 of debt owed by the Company to Mr. Farias; and (c) cancellation by Mr. Farias of three separate common stock purchase warrants held by Mr. Farias, exercisable for an aggregate of 15,000,000 shares of common stock of the Company. As a consequence of the waiver of conversion rights and the cancellation of warrants, the Company was no longer obligated to issue up to 30,000,000 shares of its common stock. Mr. Farias is an employee of VHS, a director of NOW Solutions, and a director of PTS.




18




In March 2010, the Company further amended the Transfer and Indemnity Agreement (amendment originally entered into in January 2010) with MRC. Pursuant to this amendment, MRC received 300,000 shares of the Series A Convertible Preferred Stock of VHS in exchange for the cancellation of the Company’s obligation to issue 10,000,000 shares of common stock of the Company to MRC. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, our President and CEO, is the trustee of the W5 Family Trust.





In March 2010, the Company issued 90,000 shares of VHS Series A Preferred Stock to its Chief Technology Officer, Luiz Valdetaro, in exchange for the cancellation of an obligation to issue Mr. Valdetaro 3,000,000 shares of the common stock of the Company.





On May 21, 2010, VHS issued 100,000 shares of Series B Convertible Preferred Stock to members of Pelican Applications, LLC (“Pelican”), a California limited liability company, in connection with the purchase of the business and substantially all the assets of Pelican. For more details about the purchase of Pelican, please refer to “SnAPPnet” in Note 3 of the Notes to the Consolidated Financial Statements.




On June 1, 2010, VHS issued 50,000 shares of Series B Convertible Preferred Stock to a consultant to serve as its Chief Operating Officer in consideration for services rendered on behalf of VHS and SnAPPnet, Inc..





During the year ended December 31, 2010, 100,000 unregistered shares of our common stock were forfeited pursuant to a restricted stock agreement between the Company and an employee. These shares were not vested at the date of forfeiture.





During year ended December 31, 2010, we cancelled 1,500,000 shares of our common stock that had been reserved but not delivered to a third party lender in connection with a loan in 2003 that was not fully funded.





During the year ended December 31, 2010, 583,333 shares of the Company’s common stock, valued at $10,383, became vested.





During year ended December 31, 2010, we issued 600,000 shares of our common stock to an employee of the Company pursuant to a restricted stock agreement, under which the shares vest in equal installments over a three year period.





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




Item 6. Selected Financial Data





Not applicable.




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





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




19




Critical Accounting Policies




Capitalized Software Costs




Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design. Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value. The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years. The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value. During the year ended December 31, 2010, $159,629 of internal costs were capitalized. During the year ended December 31, 2009, $30,870 of internal costs were capitalized.




Revenue Recognition




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





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





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





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





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





20





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





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





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





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





Allowances for Doubtful Accounts




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




Deferred Taxes




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




Stock-Based Compensation Expense




We account for share-based compensation in accordance with the provisions of share-based payments, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares issued and the quoted price of our common stock. The Company uses the Black-Scholes option valuation model to estimate the fair value of its stock options at the date of grant. Historical data is used to estimate the expected price volatility, the expected option life and the expected forfeiture rate. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of subjective assumptions. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and the Company uses different assumptions, the stock-based compensation expense could be materially different in the future. See Note 10 of the Consolidated Financial Statements for a further discussion of stock-based compensation.




21


Valuation of the Embedded and Warrant Derivatives
  The valuation of our embedded derivatives and warrant derivatives are determined primarily by the Black-Scholes option pricing model and the Lattice model. An embedded derivative is a derivative instrument that is embedded within another contract, which under a convertible note (the host contract) includes the right to convert the note by the holder, certain default redemption right premiums and a change of control premium (payable in cash if a fundamental change occurs). In accordance with the guidance on derivative instruments, embedded derivatives are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. A warrant derivative liability is determined in accordance with the guidance on derivative financial instruments indexed to, and potentially settled in, a company’s own stock. Based on this guidance, warrants which are determined to be classified as derivative liabilities are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. The practical effect of this has been that when our stock price increases so does our derivative liability, resulting in a non-cash loss that reduces our earnings and earnings per share. When our stock price declines, we record a non-cash gain, increasing our earnings and earnings per share.
  To determine the fair value of our embedded derivatives, management evaluates assumptions regarding the probability of certain future events. Other factors used to determine fair value include our period end stock price, historical stock volatility, risk free interest rate and derivative term. The fair value recorded for the derivative liability varies from period to period. This variability may result in the actual derivative liability for a period either above or below the estimates recorded on our consolidated financial statements, resulting in significant fluctuations in other income (expense) because of the corresponding non-cash gain or loss recorded.
  Recently Issued Accounting Pronouncements
  In January 2010, the FASB issued authoritative guidance that requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements, and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. The guidance was effective for the Company beginning with its first quarter of 2010, except for Level 3 reconciliation disclosures, which are effective for annual periods beginning after December 15, 2010. The adoption of this authoritative guidance did not have a significant impact on the Company’s consolidated financial statements.
  In October 2009, the FASB issued authoritative guidance related to the recognition of revenue for multiple-deliverable arrangements. Under the authoritative guidance, revenue may be allocated to the different elements in an arrangement based on relative selling price using the best estimate of selling price if vendor-specific or other third-party evidence of value is not available. This authoritative guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is still assessing the potential impact of adopting the new authoritative guidance.
  In October 2009, the FASB issued authoritative guidance altering the scope of revenue recognition guidance for software deliverables to exclude items sold that include hardware with software that is essential to the hardware’s functionality. This authoritative guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is still assessing the potential impact of adopting the new authoritative guidance.
  Results of Operations
  Year ended December 31, 2010 Compared To Year Ended December 31, 2009
  Total Revenues. We had total revenues of $5,907,899 and $5,399,812 for the years ended December 31, 2010 and 2009, respectively. The increase in total revenue was $508,087 for the year ended December 31, 2010, representing a 9.4% increase compared to the total revenue for the year ended December 31, 2009. The increase in revenue was due to increases in all products and services for 2010. Of the $5,907,899 and $5,399,812 total revenues for the years ended December 31, 2010 and 2009, respectively, $5,840,955 and $5,399,812 of such amounts was related to the business operations of NOW Solutions, a wholly-owned subsidiary of the Company.
  The revenues from licenses and software primarily consist of fees we bill for new payroll and human resources (“HR”) software licenses and licenses fees for patents and technology we own. The increase in license and software revenue from 2009 to 2010 was $159,308, primarily due to increased licensing of our payroll and HR software in 2010 by adding new customers and selling additional licenses and modules to existing customers.
  22
  Software maintenance revenue is generated from existing customers of our payroll and HR software who want the continued benefit of tax updates, customer support, and software enhancements and fixes. Software maintenance revenue increased by $35,186 or 0.8% from the year ended December 31, 2009 to the same period in 2010. The revenue increase is due to new customers adding maintenance with new licensing agreements, an increased number of users and price increases to existing customers. The revenue increase was partially offset by customers who did not renew their maintenance agreements and pricing pressure we experienced with customers experiencing financial difficulties.
  Consulting revenue for the year ended December 31, 2010 increased by $172,785 from the same period in the prior year, representing a 38.1% increase. This increase was due to the sale of payroll and HR software in 2010 for which the customer requested consulting support for implementation and training. We also had more consulting work in 2010 due to the sale of additional modules and upgrades of our payroll and HR software to existing customers who also requested consulting support for implementation. Consulting revenues traditionally lag (in time) behind software license revenues, as the implementation of new software takes several months.
  Hosting and SaaS revenue increased $123,265 or 89.4% for the year ended December 31, 2010 compared to the same period in 2009. The increase is due to the effect of having existing customers from 2009 for a full year in 2010,the effect of two additional customers and a fee increase on an existing customer. This revenue stream is relatively new for us and, in order to increase this business, we continue to refine our marketing and sales approach for customers who need this type of solution to their payroll and HR needs.
  Other revenues, consisting primarily of reimbursable travel expenses and fees related to user conferences, increased by $17,543 or 14.0% for the year ended December 31, 2010 compared to the same period for 2009. The increase is mainly attributable to an increase in travel expenses as a result of increased consulting activities. The revenue increase was offset by a decrease in attendance fees for NOW Solutions’ user conference held in 2009, but not in 2010. User conferences for NOW Solutions’ clients are held approximately every other year.
  Cost of Revenues.We had direct costs associated with the above revenues of $1,620,181 for the year ended December 31, 2010 compared to $1,565,372 for the same period of 2009, representing an increase of $54,809 or 3.5%. These direct costs are primarily related to costs associated with providing customer support, professional services and the user conference. The cost increases included higher costs associated with the SaaS revenue ($32,181), increased commissions as a result of increased licensing and maintenance revenue ($14,843), higher travel costs due to increased consulting revenue ($91,564), and additional costs related to SnAPPnet ($28,914) partially offset by the NOW Solutions’ user conference held in 2009 but not in 2010 ($73,119), and one-time fees in 2009 for third party maintenance, commissions and royalties ($39,574).
  Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $4,541,294 and $4,886,583 for the years ended December 31, 2010 and 2009, respectively. The total selling, general and administrative expenses for the year ended December 31, 2010 decreased by $345,289 compared to the selling, general and administrative expenses for the year ended December 31, 2009, representing approximately a 7.1% decrease. The decrease was primarily due to a decrease in consulting fees for software developers and other consultants ($305,468) and a decrease in legal fees ($133,878) offset by an increase in employee expenses ($122,884) primarily related to increased benefit expenses and bonus pay. Of the SG&A expenses for the year ended December 31, 2010, approximately $600,000 represented business development expenses for initiatives being undertaken through VHS, PTS and SnAPPnet.
  Bad Debt Expense. We had bad debt recoveries for 2010 of $10,114 compared to bad debt recoveries of $124,642 in 2009. The recoveries were due to the collections of receivables from previous years that were originally considered doubtful.
  Gain on Settlement of Liabilities. For the year ended December 31, 2010, there was a $517,806 gain on settlement of liabilities related to trade payables, notes payable and deferred compensation that had reach the statute of limitations. In July 2009, we settled an outstanding trade payable with a law firm by purchasing all the outstanding uncollected receivables of the firm from the bankruptcy trustee. The $121,020 gain on the settlement in 2009 was the net of the open outstanding payable, less the purchase price. A third party law firm represented us in this matter.
  Operating Income (Loss). We had operating income of $222,902 for the year ended December 31, 2010 compared to operating loss of $848,104 for the year ended December 31, 2009, a difference of $1,071,006. Excluding the impact of the gain on settlement of liabilities for 2010 and 2009, we would have reported an operating loss of $294,904 and $969,124 for 2010 and 2009, respectively. The $674,220 reduction in loss from 2010 to 2009 is a result of higher revenues in all products and services for 2010 and a reduction in selling, general and administrative costs.
  23
  Loss on Derivative Liability. In 2009 we had derivative liabilities related to common stock loaned to the Company by two executives and embedded derivative liabilities on convertible debt and outstanding options and warrants. In March 2010, we negotiated agreements with the two executives and one of the holders of warrants and some of our outstanding Series C 4% Convertible Cumulative Preferred stock. These agreements eliminated the associated derivative liabilities for these financial instruments. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock and other items that impact the valuation of the derivatives. In general, as our stock price increases, the derivative liability increases, resulting in a loss. As our stock price decreases, the derivative liability decreases, resulting in a gain. The gain on derivative liability was $97,074 for the year ended December 31, 2010 compared to the loss on derivative liability of $51,190 for the year ended December 31, 2009. The change of $148,264 is a result of the elimination of part of the derivative liability in 2010 and a decrease in the Company’s stock price from 2009 to 2010 resulting in a loss on the remaining portion of the derivative liability.
  Interest Expense. We had interest expense of $569,540 and $538,683 for the years ended December 31, 2010 and 2009, respectively. Interest expense increased for the year ended December 31, 2010 by $30,857, representing an increase of 5.7%, compared to interest expense for the year ended December 31, 2009. The increase was the result of interest on debt in technical default, interest on sales tax liabilities and interest on legal claims for 2010.
  Gain on Settlement of Litigation. On March 24, 2009, NOW Solutions received the cash deposit of Ross, held by the New York City Department of Finance, to stay enforcement of the judgment awarded to NOW Solutions in the action of Ross Systems, Inc. v. NOW Solutions. The stay was vacated by operation of law after the judgment was affirmed by the New York Appellate Division on February 11, 2009. On September 24, 2009, we received the final settlement from Ross of $535,000 for additional interest and legal fees incurred to respond to their appeal. The gain is the total of the gross proceeds from the judgment (excluding interest income) plus the note payable to Ross and interest that had been accrued on the note. We also had a receivable from Ross for certain funds due us after the acquisition was completed that was written off. That receivable had been fully reserved, so there was no income impact from the write-off of the receivable.
  Interest Income. Interest income for the year ended December 31, 2010 was $4,400, and was related to interest on a note receivable from a former contractor. In 2009, as a result of the award from Ross described above, we received $133,424 of interest income on the funds deposited by Ross with the New York Appellate Court system, which was reflected as interest income for the year ended December 31, 2009.
  Net Income.We had a net loss of $150,316 for the year ended December 31, 2010 compared to a net income of $3,504,538 for the year ended December 31, 2009. The net loss for 2010 was primarily due to operating income of $222,902, reduced by interest expense of $569,540. The net income for 2009 was due to the factors discussed above, but the primary drivers for the income were the gain on settlement of the Ross litigation of $4,799,093 and the associated interest income of $133,424. Excluding the impact of one-time items for settlement of liabilities for 2010 and settlement of litigation and liabilities for 2009, we would have had a net loss of $668,122 for 2010 and $1,415,575 for 2009. The recurring improvement is related to the items discussed above, but is essentially the impact of higher revenues, and lower selling general and administrative expenses.
  Dividend Applicable to Preferred Stock. The Company has outstanding Series A 4% Convertible Cumulative Preferred Stock that accrues dividends (if such dividends are declared) at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% Convertible Cumulative Preferred Stock that accrues dividends (if such dividends are declared) at a rate of 4% on a quarterly basis. For the years ended December 31, 2010 and 2009, the total dividends applicable to Series A and Series C Preferred Stock (from prior years) were $588,000 each year. The Company did not declare or pay any dividends in 2010 or 2009.
  Net Income (Loss) Applicable to Common Stockholders. We had net loss attributed to common stockholders of $738,316 and a net income applicable to common stockholders of $2,916,538 for the years ended December 31, 2010 and 2009, respectively. Net income applicable to common stockholders for the year ended December 31, 2010 decreased by $3,654,854 compared to the net income applicable to common stockholders for the year ended December 31, 2009. The decrease in the net income applicable to common stockholders was due to the combination of factors described above in “Net Income.”
  Net Income (Loss) Per Share. The Company had a net income per share of $0.00 and a net loss per share of $0.00 for the years ended December 31, 2010 and 2009, respectively.
  24
  Financial Condition, Liquidity, Capital Resources and Recent Developments
  At December 31, 2010, we had non-restricted cash-on-hand of $272,970 compared to $229,738 at December 31, 2009.
  Net cash provided by operating activities for the year ended December 31, 2010 was $329,110 compared to $1,651,116 for the year ended December 31, 2009. We collected cash from our customers totaling $6,589,753. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $3,741,227, attorney fees of $105,161, professional fees and third party consultants of $742,405, interest expense of $331,586, taxes (including sales tax and VAT) of $432,611, and other regular trade payables of $907,653.
 
 A large portion of our cash and revenue comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. During 2010 we were able to increase pricing on maintenance contracts, keep our existing maintenance clients and add new clients, allowing our deferred maintenance revenue (a liability) to increase slightly from $2,404,681 to $2,568,847.
  Our accounts receivable decreased from $783,219 at December 31, 2009 to $565,367 at December 31, 2010 (net of allowance for bad debts). The decrease in receivables of $217,852 was due to our ability to collect from software maintenance clients before year-end,
  Accounts payable and accrued liabilities increased from $6,397,575 at December 31, 2009 to $6,774,923 at December 31, 2010. The increase of $377,348 is net of $474,776 of trade payables which were written off based on the statute of limitations and $100,000 from the conversion of accounts payable and accrued liabilities to Preferred Stock. The increase also included the assumption of $79,158 of trade payables and accrued liabilities from the acquisition of SnAPPnet. The balance in accounts payable and accrued liabilities is approximately 13 times the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.
 
 Net cash used in investing activities for the year ended December 31, 2010 was $173,620, consisting of the purchase of equipment and software and a 100% interest in SnAPPnet, a software application product used for physician credentialing.
  Net cash provided by financing activities for the year ended December 31, 2010 was $17,727, consisting of borrowings on notes payable of $133,195, borrowings on related party debt of $48,000 and an increase in bank overdraft of $63,740. This was offset by repayments of notes payable of $129,884 and payments of related party debt of $97,324.
  The total change in cash and cash equivalents for the year ended December 31, 2010 when compared to the year ended December 31, 2009 was an increase of $43,232.
  As of the date of the filing of this Report, we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms. Therefore, we need to raise additional funds through selling securities, obtaining loans, renegotiating the terms of our existing debt, increasing sales of our products and services and/or succeed in licensing our intellectual property. Our inability to raise such funds or renegotiate the terms of our existing debt will significantly jeopardize our ability to continue operations.
  Contractual Obligations and Commercial Commitments
  As of December 31, 2010, the following contractual obligations and commercial commitments were outstanding:
  Balance at


Due in Next Five YearsContractual Obligations

12/31/10


2011


2012


2013


2014


2015+Notes payable

$
3,399,408


$
3,399,408


$
-


$
-


$
-


$
-Convertible debts


30,000



30,000



-



-



-



-Operating lease


431,904



115,591



99,862



93,269



93,330



29,852Total

$
3,861,312


$
3,544,999


$
99,862


$
93,269


$
93,330


$
29,852
  25
  Of the above notes payable of $3,399,408, the default status is as follows:
  2010


2009In default

$
3,299,543


$
2,670,051Current


99,865



751,790Total Notes Payable

$
3,399,408


$
3,421,841
  Going Concern Uncertainty
  While we had a loss of $150,316 for the year ended December 31, 2010 and a profit of $3,504,538 for the year ended December 31, 2009, we have historically incurred losses. In addition, we had a working capital deficit of approximately $11.9 million at December 31, 2010. The foregoing raises substantial doubt about our ability to continue as a going concern.
  Management is continuing its efforts to attempt to secure funds through equity and/or debt instruments for our operations, expansion and possible acquisitions, mergers, joint ventures, and/or other business combinations. We will require additional funds to pay down our liabilities, as well as finance our expansion plans consistent with our anticipated changes in operations and infrastructure. However, there can be no assurance that we will be able to secure additional funds and that if such funds are available, whether the terms or conditions would be acceptable to us and whether we will be able to turn into a profitable position and generate positive operating cash flow. The consolidated financial statements contain no adjustment for the outcome of this uncertainty.
  Furthermore, we are exploring certain opportunities with a number of companies to participate in co-marketing of each other’s products. We are proceeding to license our intellectual property to third parties. The exact results of our opportunities to license our intellectual property to other parties are unknown at this time.
   Off-Balance Sheet Arrangements.
  None.
  Item 7A.Quantitative and Qualitative Disclosures About Market Risk
  None.
   Item 8. Financial Statements and Supplementary Data
  Please refer to the Audited Consolidated Financial Statements of the Company and its subsidiaries for the fiscal years ended December 31, 2010 and 2009, which are attached to this Report.
   Item 9. Changes in and Disagreementswith Accountants on Accounting and Financial Disclosure
  None
   Item 9A (T). Controls and Procedures
  Evaluation of Disclosure Controls and Procedures
  26
  Our management, principally our chief financial officer and chief executive officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our management concluded that our disclosure controls and procedures as of the end of the period covered by this report were not effective such that the information required to be disclosed by us in reports filed under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding disclosure. In particular, we have identified the following material weakness of our internal controls:
  -
There is an over-reliance upon independent financial reporting consultants for review of critical accounting areas and disclosures and material non-standard transactions.
  -
There is a lack of sufficient accounting staff due to the size of the Company which results in a lack of segregation of duties necessary for a good system of internal control.
  Management’s Annual Report on Internal Control over Financial Reporting
  Our management is responsible for establishing and maintaining disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act for the Company.
  In order to ensure whether our internal control over financial reporting is effective, management has assessed such controls for its financial reporting as of December 31, 2010. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
  In performing this assessment, management has identified the following material weaknesses as of December 31, 2010:
  There is an absence of adequate segregation of duties relating to oversight and management of our systems. This resulted primarily from the fact that certain parts of the work of our chief financial officer are not monitored or reviewed. The absence of adequate segregation of duties may have an effect on the systems which we use in the evaluating and processing of certain accounts and areas and in the posting and recording of journal entries into certain accounts, as described below:
  ●
Financial statements closing process – There was a material weakness in the process of closing and consolidating our financial statements which resulted from the fact that the process is manual and two of our entities have functional currencies that are not the US Dollar. This translation to US Dollars is also manual and does not have reporting that allows for detailed review of each account. Although our chief financial officer performs much of this process (starting with processing the trial balance, through the evaluation and implementation of policies and accounting issues), the complete production of consolidated financial statements is not reviewed in detail by anyone else.
  ●
Treasury and cash process – There was a material weakness in the sub-process of debt management which resulted from the fact that our chief financial officer manages, evaluates, records and discloses all matters which relate to debts, debt issuance and renegotiation expenses, interest, etc., and the work of our chief financial officer is not reviewed in detail by anyone else. Further, our chief financial officer relied upon financial reporting consultants as it relates to the accounting for loan renegotiation and loan termination costs.
  ●
Equity instruments – There was a material weakness in the sub-process related to evaluating debt and equity instruments with conversion privileges to determine whether or not the instruments had embedded derivative components. There was a material weakness in the sub-process related to evaluating certain equity instrument transactions and the accounting treatment for these non-standard transactions. Both of these resulted from the fact that our chief financial officer relies heavily upon financial reporting consultants as it relates to derivative and non-standard equity transactions.
  As a result of these material weaknesses in our internal control over financial reporting, our management concluded that our internal control over financial reporting as of December 31, 2010, was not effective based on the criteria set forth by COSO in Internal Control – Integrated Framework. A material weakness in internal control over financial reporting is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
  27
  Management’s Plan for Remediation of Material Weaknesses
  In light of the conclusion that our internal control over financial reporting was not effective, our management is in the process of implementing a plan intended to remediate such ineffectiveness and to strengthen our internal controls over financial reporting through the implementation of certain remedial measures, which include:
  ●
We have implemented a new accounting system effective January 1, 2009 that allows for the consolidation of the various entities in Vertical Computer Systems along with the translation from local currency to reporting currency. Although the system eliminates many of the manual steps in translation and consolidation, many of the steps continue to be manual. This system also allows for some automation for recording software maintenance revenue and the recording of the deferred revenue liability account. This automation improves the accuracy of these accounts and is no longer considered a material weakness.
  ●
Improving the control and oversight of the duties relating to the systems we use in the evaluation and processing of certain accounts and areas in the posting and recording of journal entries into certain accounts (in which material weaknesses have been identified as described above). This improvement should include reviews by management of the accounting processes as well as a reorganization of some of the accounting functions. In January 2010, we contracted with a consulting firm to assess our internal controls over financial reporting and propose improvements that can be implemented given our size and number of employees.
  ●
Improving the segregation of duties relating to the processing of accounts and the recording of journal entries into certain accounts. This improvement is expected to come based on recommendations from the consulting firm assessing our internal controls over financial reporting.
  This annual report does not include an attestation report of our public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.
  Item 9B. Other Information
  None.
  28
  PART III
   Item 10. Directors, Executive Officers and Corporate Governance
  Our present directors and executive officers are as follows:
  Name

Age

Position

TenureRichard S. Wade

67

President, Chief Executive Officer and Director

10 yearsWilliam K. Mills

52

Secretary and Director

10 yearsFreddy Holder

46

Chief Financial Officer

< 1 year
  Richard S. Wade, President, Chief Executive Officer and Director, Chairman and Director of NOW Solutions
  Richard S. Wade is President, CEO and Chairman of the Board of the Company and has been a director since October 1999. Before coming to Externet World, Inc. in mid-1999, and then transitioning to what is now the Company in late 1999, Mr. Wade held a number of executive positions with companies in the Pacific Rim from 1983 through early 1999, including the position of Chief Operating Officer of Struthers Industries, Inc., a public company in the business of wireless applications. Prior to these executive positions, Mr. Wade spent over 10 years with Duty Free Shoppers, Inc., culminating in his attaining the positions of president of their Mid-Pacific Division and then president of their U.S. Division. Prior to that, Mr. Wade was a CPA and staff auditor with Peat, Marwick & Mitchell. Over the course of his career, Mr. Wade has accumulated experience in retail operations, distribution, and financial matters. The breadth of Mr. Wade’s managerial and operational experience led the Board of Directors to believe this individual is qualified to serve as a director of the Company. Mr. Wade earned his Bachelor of Science in Accounting at Brigham Young University, a Master of Science in Business Policy from Columbia University Business School and received a certificate of recognition from the government of Guam.
  William K. Mills, Secretary and Director
  William K. Mills has been a director since December 2000. Mr. Mills is a founding partner of Parker Shumaker Mills, LLP (formerly Parker Mills, LLP) where he specializes in complex commercial business representations, including transactional and litigation matters, such as legal malpractice, intellectual property and general corporate and governmental representations since 1995. Between 1991 and 1994, Mr. Mills was a senior attorney and partner with Lewis, D’Amato, Brisbois & Bisgaard, prior to which he was a senior attorney with Radcliff & West from 1989 to 1991, senior associate with Buchalter, Nemer Fields & Younger from 1987 to 1991 and an attorney with Daniels, Baratta & Fine from 1982 to 1987. Mr. Mills holds a J.D. from UCLA Law School and an A.B. in American Government from Harvard College. Active in professional and community organizations, Mr. Mills has served as General Counsel to the California Association of Black Lawyers, a member of the Los Angeles County Bar Judicial Appointments Committee, and a Board Member of the John M. Langston Bar Association. Mr. Mills has also served on the boards of the Didi Hirsch Mental Health Foundation, the United Way’s Los Angeles Metropolitan Region Board, the Los Angeles City Ethics Commission, and the Los Angeles County Judicial Procedures Commission. The breadth of Mr. Mills’ professional and legal experience led the Board of Directors to believe this individual is qualified to serve as a director of the Company.
  Freddy Holder, Chief Financial Officer of VCSY and NOW Solutions
  Mr. Holder has over 23 years experience spanning all aspects of finance and accounting. He started his career with the accounting firm of Ernst and Young and has worked for both large and small multi-national public and private companies in the software, retail and services industries. Most recently, Mr. Holder was Director of Consulting for Sirius Solutions, LLLP, where he was responsible for the finance and accounting practice of the company’s North Texas region. Prior to that, he served as the Managing Director and International Controller for FedEx Office, where he directed all international finance operations and financial control management of eight countries outside the United States. Mr. Holder also served as Director of Accounting for Software Spectrum, where he was responsible for all North American accounting operations and worldwide financial reporting for this Fortune 1,000 publicly held software reseller. Previous experience also includes the position of Corporate Controller for US Data Corporation, a publicly held software development company. Mr. Holder has held a CPA license in the state of Texas since 1989 and received his degree from the University of Texas at Dallas.
  29
  Significant Employees of the Company
  Luiz Valdetaro, Chief Technology Officer, Director of NOW Solutions
  Prior to joining the Company, Mr. Valdetaro was previously a consultant (1993-1997) and Chief Technology Officer (1997-1999) of Diversified Data Resources, a software company. Prior to that, Mr. Valdetaro was a Senior Systems Engineer for System/One and EDS, after System/One was acquired by EDS. Prior to that, Mr. Valdetaro was a senior systems engineer for Bank of America. Mr. Valdetaro is a graduate of Pontific Catholic University, Rio de Janeiro, Brazil with a B.S. in Electronic Engineering and a M.S. in Systems Engineering.
  Significant Employees of NOW Solutions, Inc.
  Marianne M. Franklin, President and Chief Executive Officer
  Marianne M. Franklin is President and Chief Executive Officer of NOW Solutions. Ms. Franklin brings her experience in the payroll and human resources industry, which included over eight years working at Ross Systems, most recently as Vice President of North American sales. Prior to this function, Ms. Franklin was Director of Ross’ HR/Payroll Canadian Sales. Ms. Franklin’s background also includes two years with ADP and 13 years in the banking industry, working with payroll products.
  Dorothy Spotts, Vice President of Services and Support
  Ms. Spotts joined Ross Systems in April 1991 as a Support Analyst in the Customer Support Department progressing to Operations Manager. Subsequently, she attained the position of Manager of Integration Services in September 1997. In March 1999, she was promoted to Director of Integration Services and then became Director of Professional Services in July 2000. Ms. Spotts’ responsibilities include the overall management of Application Consulting, Integration Services and Customer Support. Ms. Spotts graduated with a BBA from the University of Texas at Austin.
  Laurent Tetard, Executive Vice President of International Operations
  Mr. Tetard joined the Company in 1999, where he oversaw business development, managed software design projects and handled daily operations. His responsibilities included working with clients and strategic partners to develop business plans, implement strategies and methodologies to support software development. Combining his education and experience, Mr. Tetard has specialized in managing design, implementation, documentation and installation of Internet compatible applications. From 1994 to 1996, Mr. Tetard was a Public Relations Officer with the French Air Force, in Toulouse, France. Earlier in his career, he completed a thesis in collaboration with the French Aeronautics and Space Research Center (“ONERA”) and served engineering internships at Aerospatiale, France. Mr. Tetard is an honor’s graduate of the noted French Ecole Nationale Superieure D’arts et Metiers (“ENSAM”), with a BS in Engineering and a MS in Multidisciplinary Engineering.
  Robert Sterpin, Vice President of Sales, Canada & U.S. Midwest
  Mr. Sterpin joined NOW Solutions in 2003. He has a varied background in sales and sales management starting his career with DEC (HP) and working for several major corporations such as IBM and Cincom Systems. Mr. Sterpin spent almost 5 years at Ross Systems where he was Vice President Canada and the U.S. Mid West for their ERP software product suite. Prior to joining NOW Solutions, he was Vice President Sales & Marketing for a systems integration/ consulting firm. Mr. Sterpin majored in Science at the University of Toronto.
  Jamie Patterson, Director of Software Development
  Mr. Patterson joined the Company in 2006, originally as the Quality Assurance Manager, after working as an independent contractor for the company for three years. In 2000, he joined the Hewlett-Packard Company as a Research and Development Software Engineer. From 1992 to 2000 he worked for Ross Systems starting as a Support Analyst in the Customer Support Department. In 1993 he began developing software in the Integration Services department and Product Development department. Prior to Ross Systems, he worked as an IT engineer and software developer supporting a payroll application. Mr. Patterson is a graduate of University of Texas at Arlington with a Masters of Computer Science and Engineering degree and from the University of Washington with a B.S. in Civil Engineering.
  30
  Compliance with Section 16(a) of the Exchange Act
  Section 16(a) of the Exchange Act requires the Company’s officers and directors, and persons who own more than 10% of a registered class of the Company’s equity securities, to file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file.
  To the best of the Company’s knowledge, based solely on review of the copies of such forms furnished to it, or written representations that no other forms were required, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% stockholders were complied with during 2010.
  Code of Ethics
  We have adopted a Code of Ethics that applies to our Principal Executive Officer, Principal Accounting Officer and other persons performing executive functions, as well as all other employees and directors of the Company and its subsidiaries. This Code of Ethics was originally filed as an exhibit to the Form 10-KSB filed for the year ended December 31, 2003 and was updated in January 2008 with the new address of our corporate headquarters. Our Code of Ethics is filed as Exhibit 14.1 to this Report, and is available at our Internet website located at http://www.vcsy.com/investor.
  Corporate Governance
  Family Relationships
  There are no family relationships between or among the directors, executive officers or persons nominated or charged by us to become directors or executive officers.
  Involvement in Legal Proceedings
  To the best of our knowledge, during the past five years, none of the following occurred with respect to a present or former director or executive officer of the Company:
  (1) any bankruptcy petition filed by or against such person or any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time;
  (2) any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses);
  (3) being subject to any order, judgment or decree, not subsequently reversed, suspended or vacated, of any court of any competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; or
  (4) being found by a court of competent jurisdiction (in a civil action), the SEC or the Commodities Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended or vacated.
  Board of Directors Meetings and Subcommittees.
  Meetings. Our Board of Directors held several meetings during the fiscal year ended December 31, 2010. All board actions were completed through unanimous written consents.
  Audit Committee and Financial Expert. Our Board of Directors (the “Board”) does not have a separate audit committee. Although Mr. Wade (a member of the Board) has the qualifications of an “audit committee financial expert” as defined in Item 407(d)(5), Mr. Wade would not be deemed independent since he is an employee of the Company. At this point, we do not intend to establish a separate audit committee as this function will be performed by our full Board of Directors.
  Compensation Committee. As all our executive officers are currently under employment agreements or are at-will employees, we do not have a separate compensation committee. At this point, we do not intend to establish a separate compensation committee as this function will be performed by our full Board of Directors.
  31
  Nominating Committee. We do not currently have a separate nominating committee as this function is performed by our full Board of Directors.
  Shareholder Communication. We communicate regularly with shareholders through press releases, as well as annual, quarterly, and current (Form 8-K) reports. Our Chief Executive Officer addresses investor concerns on an on-going basis. Interested parties, including shareholders and other security holders, may communicate directly with our Board of Directors or with individual directors by writing to our Chief Executive Officer at 101 W. Renner Road, Suite 300, Richardson, TX 75082.
   Item 11. Executive Compensation
  The following table shows all the cash compensation paid by the Company, as well as certain other compensation paid or accrued, during the fiscal years ended December 31, 2010 and 2009 to our highest paid executive officers and employees, who were employed by us during 2010. No restricted stock awards, long-term incentive plan payouts or other types of compensation, other than the compensation identified in the chart below, were paid to these executive officers during these fiscal years. Except as set forth below, no other executive officer of Vertical earned a total annual salary and bonus for any of these years in excess of $100,000.
  SUMMARY COMPENSATION TABLE
  The below table shows information of compensation of the named officers for the last two fiscal years:
  Annual Compensation

Long-Term CompensationAwards

PayoutsName and

Principal Position

Year

Salary

Bonus (6)

Other

Annual

Compensation

Restricted

Stock

Award(s)

Options/

SARs

LTIP

Payouts

All Other

Compen-sation($)

($)

($)

($)

(#)

($)

($)Richard Wade,(1)

2010

$
300,000
(1)

-


-


-


-


-


-President and Chief

2009

$
300,000


-


-


-


-


-


-Executive Officer-


-





-


-


-David Braun(2)

2010

$
97,500


-


-


-


-


-


-Chief Financial Officer

2009

$
130,000


-


-


-


-


-


-Freddy Holder(3)

2010

$
11,590


-


-


18,600


-


-


-Chief Financial Officer

2009


-


-


-


-


-


-


-Luiz Valdetaro, (4)

2010

$
150,000


-


-


-


-


-


-Chief Technology

2009

$
150,000


-


-


-


-


-


-OfficerJames Salz (5)

2010

$
110,000


-


-


-


-


-


-Corporate Counsel

2009

$
110,000


-


-


-


-


-


-
 
 
 No stock options were exercised by the named executive officers during the fiscal year ended December 31, 2010 or 2009.
  (1)
Mr. Wade deferred $881,688 of salary earned during the period from 2002 through 2008, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For more details, please refer to Note 4 of the Notes to the Consolidated Financial Statements.
  (2)
Mr. Braun served as our Chief Financial Officer, through September 30, 2010. Mr. Braun continues to provide consulting services to us in exchange for remuneration as of the date of this report.
  32
  (3)
Mr. Holder began to serve as our Chief Financial Officer on December 6, 2010. In December 2010, we issued 600,000 shares of our common stock to Mr. Holder pursuant to a restricted stock agreement whereby the shares vest in equal installments over a three year period.
  (4)
Mr. Valdetaro deferred $467,071 of salary earned during the period from 2002 through 2007, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For more details, please refer to Note 4 of the Notes to the Consolidated Financial Statements.
  (5)
Mr. Salz deferred $185,914 of salary earned during the period from 2001 through 2004, as adjusted in connection with an agreement to defer payroll claims between the Company and certain employees of the Company executed in 2010. For more details, please refer to Note 4 of the Notes to the Consolidated Financial Statements.
  (6)
In 2010, the board of directors declared bonuses of $171,344 to be paid to certain executives and employees. The bonus amount was based primarily on 2009 operating results and the allocation of amounts has not yet been determined. This amount was accrued for the year ended December 31, 2010.
  Narrative Disclosure to Summary Compensation Table
  Compensation for our key executives is comprised of three main components: base salary, annual performance-based cash bonus and long-term equity awards. We do not target a specific weighting of these three components or use a prescribed formula to establish pay levels. Rather, the board of directors considers changes in the business, external market factors and our financial position each year when determining pay levels and allocating between long-term and current compensation for the named executive officers.
  Cash compensation is comprised of base salary and an annual performance-based cash bonus opportunity. The board of directors generally seeks to set a named executive officer’s targeted total cash compensation opportunity within a range that is the average of the applicable peer company and/or general industry compensation survey data, adjusted as appropriate for individual performance and internal pay equity and labor market conditions.
  Where we have included an equity component as part of our compensation package, we do so because we believe that equity-based compensation aligns the long-term interests of our named executive officers with those of stockholders.
  These cash and equity compensation components of pay are supplemented by various benefit plans that provide health benefits, which are substantially the same as the benefits provided to all of our U.S. based employees. The Company also provides life, accident, and disability voluntary benefit plans, which are plans where employees generally make most or all of the contributions toward the respective benefit plan.
  Employment Agreements with Executive Officers
  In December 2001, we executed an employment agreement with Richard Wade pursuant to which Mr. Wade serves as Chief Executive Officer and President of the Company. The agreement currently renews on annual basis unless terminated by either party. Under the agreement, Mr. Wade receives an annual base salary of $300,000. Mr. Wade is also entitled to an annual bonus from a bonus pool for executives equal to 5% of our taxable income (without deduction for depreciation). Mr. Wade’s share of the bonus pool is equal to the percentage of his annual base compensation to the total of the combined annual base compensation of all executives in the pool. In the event the agreement is terminated by Mr. Wade’s death, his estate shall be entitled to compensation accrued to the time of death plus the lesser of one year’s base compensation or the compensation due through the remainder of the employment term. In the event of termination by the Company without cause, Mr. Wade would receive base compensation for the remainder of the employment term.
  In December 2010, we executed an employment agreement with Freddy Holder pursuant to which Mr. Holder serves as Chief Financial Officer of the Company and its subsidiaries. The initial term of the agreement is 2 years and renews on annual basis unless terminated by either party. Under the agreement, Mr. Holder receives an annual base salary of $160,000. Mr. Holder is also entitled to an annual bonus from a bonus pool for executives equal to 5% of the Company taxable income before net operating loss deduction and special deductions from the federal tax return filed. Mr. Holder’s share of the bonus pool is equal to the percentage of his annual base compensation to the total of the combined annual base compensation of all executives in the pool. In the event the employment agreement is terminated by Mr. Holder’s death, his estate shall be entitled to compensation accrued to the time of death plus the lesser of one year’s base compensation or the compensation due for the lesser of 12 months or through the remainder of the employment term. In the event of termination by the Company without cause, Mr. Holder would receive base compensation for no less than six months of the remainder of the employment term. Mr. Holder may also terminate his employment for Good Reason and shall be entitled to continued health insurance benefits and base compensation at the rate in effect at the time of his termination for Good Reason through the end of twelve months after which his employment is terminated for Good Reason. In connection with the employment agreement, the Company and Mr. Holder entered into a restricted stock agreement, whereby the Company issued Mr. Holder 600,000 shares of its common stock at a fair market value of $18,600. These shares vest over three years on the anniversary date of the restricted stock agreement in equal installments.
  33
  Outstanding Equity Awards
  The below table shows information of outstanding equity awards of the named officers at the end of 2010:
  OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END (2010)
  Option Awards(1)

Stock AwardsName

Number of
Securities
Underlying
Unexercised
Options (#)
Exercisable

Number of
Securities
Underlying
Unexercised
Options (#)
non-exercisable

Equity
Incentive
Plan
Awards:
Number of
Securities
Underlying
Unexercised
Unearned
Options (#)

Option
Exercise
Price ($)

Option
Expiration
Date

Number of
Shares or
Units of
Stock That
Have Not
Vested (#)

Market
Value of
Shares or
Units of
Stock That
Have Not
Vested ($)

Equity
Incentive
Plan
Awards:
Number of
Unearned
Shares,
Units or
Other
Rights That
Have Not
Vested (#)

Equity
Incentive
Plan
Awards:
Market or
Payout
Value of
Unearned
Shares,
Units or
Other
Rights That
Have Not
Vested ($)Freddy HolderChief Financial Officer (1)

-

-

-

-



600,000

18,600

-
 
 
 (1)
Pursuant to a restricted stock agreement with the Company, Mr. Holder, the CFO of the Company, was issued 800,000 unregistered shares of our common stock (at a fair market value of $18,600 in December 2010, based upon the total number of shares issued and the share price on the date of the issuance), vesting over three years in three equal installments, of which no shares had vested at December 31, 2010.
  Narrative Disclosure to Outstanding Equity Awards at Fiscal Year End Table
  Stock Option Plan.The Stock Option Plan, whereby we were able to issue up to 50,000,000 shares (adjusted post stock split) expired in 2009. We issued no stock options to any employees or to any other parties in 2010 and do not have any stock options outstanding.
  Stock Awards. The common stock issued to Mr. Holder has been issued on the same terms as the stock issued to other employees of the Company and its subsidiaries. The restricted stock agreements generally provide for the stock to vest over a 1 or 3 year period. In the event the employee is terminated without cause, a portion of the remaining unvested stock will vest on a pro-rata basis.
  For further information regarding securities authorized for issuance under Equity Compensation Plans, and the equity compensation plan information table, please see Part II, “Item 5: Market for Common Equity and Related Stockholder Matters.”
  Director Compensation
  The below table provides compensation for all non-employee directors in 2010:
  34
  DIRECTOR COMPENSATION
  Name

Fees Earned
or Paid in
Cash


Stock
Awards


Option
Awards


Non-Equity
Incentive Plan Compensation


Nonqualified
Deferred Compensation Earnings


All Other Compensation


Total($)


($)


($)


($)


($)


(#)


($)William Mills


30,000




(1)


-



-



-



-



30,000
  
 (1)
In February 2008, we issued 250,000 shares of our common stock to Mr. Mills pursuant to a restricted stock agreement which provided for vesting at 1 year. All of these shares had vested at December 31, 2009.
  Narrative Disclosure to Director Compensation Table
  Non-employee directors are entitled to receive $2,500 per month in 2010 and 2009. No options or warrants were granted as director compensation during the fiscal years ended 2010 or 2009. Mr. Mills was issued 250,000 shares of our common stock in February 2008. All of these shares have vested.
  Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
  Security Ownership By Named Executive Officers, Directors and Beneficial Owners
  The following table sets forth certain information regarding the beneficial ownership of the shares of common stock as of April 14, 2011, by each of our directors and executive officers and any person or entity, known by us to be the beneficial owner of more than 5% of the outstanding shares of common stock. The table also shows the beneficial ownership of our stock by all directors and executive officers as a group. The table includes the number of shares subject to outstanding options and warrants to purchase shares of common stock. The percentages are based on 997,935,151 shares of common stock outstanding as of April 14, 2011, together with options, warrants or other securities convertible or exchangeable by the beneficial owners into shares of common stock within 60 days of April 14, 2011.
  Title of Class

Name and Address of Beneficial Owner(1)

Sharesof Common Stock
Beneficially Owned

Percentof ClassCommon

Richard Wade

94,190,206 (2)

9.44%Common

William K. Mills

283,333 (3)

*Common

Freddy Holder

600,000 (4)

*Common

All Directors and Executive Officers as a group

(3 persons)

95,073,539

9.53%
  
 *
Less than 1%.
  (1)
The address of each director and officer is c/o Vertical Computer Systems, Inc., 101 West Renner Road, Suite 300, Richardson, TX 75082.
  (2)
Includes 88,870,050shares owned by MRC, a corporation controlled by the W5 Family Trust, of which Richard W. Wade is a trustee. MRC pledged 10,000,000 shares of our common stock as collateral on a $25,000 note issued in August 2002. MRC pledged 4,000,000 and 3,000,000 shares of our common stock as collateral on a $60,000 note and a $40,000 note, respectively, that were issued by us in November 2003. MRC pledged 5,000,000 shares of our common stock as collateral on a $200,000 note issued in October 2006 to Mr. Weber. Also in October 2006, MRC pledged 5,000,000 shares of our common stock as collateral on a $215,000 note issued by NOW Solutions to us and assigned to Mr. Weber in October 2005. MRC pledged 10,000,000 shares of our common stock as collateral on a $300,000 note issued in March 2007 to Mr. Weber and as collateral on the interest payments due under the $200,000 note issued in October 2006. MRC pledged 3,000,000 shares of our common stock as collateral on a $96,946 note issued in February 2008 to a third party lender. In November 2008, the lender sold 1,500,000 shares for $118,167, of which $103,555 was applied to outstanding debt claimed by the lender including interest, penalties & attorney’s fees and the remaining $14,612 was returned to MRC representing the amount of shares oversold by the lender. Of the 1,500,000 shares sold by the lender, we are currently obligated to reimburse MRC with 1,309,983 common shares. MRC pledged 16,976,296shares of our common stock in connection with a $150,000 loan to NOW Solutions by a third party lender in November 2009 In March 2010, the Company and MRC entered into an amendment of an indemnity and reimbursement agreement whereby the obligation to reimburse MRC with 10,000,000 common shares that were loaned to the Company in March 2008 was cancelled in exchange for the Company’s transfer of 300,000 shares VHS Series A Preferred Stock owned by the Company to MRC. For more details on this transaction, please refer to Note 4 of the Notes to the Financial Statements. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, our President and CEO, is the trustee of the W5 Family Trust.
  35
  (3)
Includes 250,000 shares of our common stock issued in February 2008 by us to Mr. Mills pursuant to a restricted stock agreement in connection with services as a director and officer of the Company. All of these shares vested in 2009
 .
 (4)
Includes 600,000 shares of our common stock we issued in December 2010 to Mr. Holder pursuant to a restricted stock agreement in connection with services as an officer of the Company.
   Item 13. Certain Relationships and Related Transactions, and Director Independence
  Certain Relationships and Related Transactions
  In November 2009, the obligation to reimburse MRC with 1,309,983 common shares of the Company stock became due pursuant to the Indemnity and Reimbursement agreement between MRC and the Company. This obligation was made in connection with the sale of 1,500,000 common shares of our stock pledged by MRC to secure a $96,946 promissory note issued to a third party lender. In November 2008, the lender sold 1,500,000 shares of the pledged stock for $118,167, of which $103,555 was applied to outstanding debt claimed by the lender including interest, penalties & attorney’s fees. The remaining $14,612 was returned to MRC representing the amount of shares oversold by the lender. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.
  In November 2009, MRC pledged 16,976,296 shares of Company common stock owned by MRC as collateral in connection with a $150,000 note payable by the Company. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.
  In December 2009, we entered into a settlement agreement and stipulated judgment with Parker, Shumaker & Mills, L.L.P. (“PSM”) in connection with a lawsuit filed in August 2009, whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM, which was formerly known as Parker Mills, LLP (the successor entity to Parker Mills Morin, LLP and Parker Mills & Patel, LLP).
  In January 2010, the Company and MRC amended the indemnity and reimbursement agreement (originally entered into in April 2007) whereby the Company agreed to reimburse and indemnify MRC for 16,976,296 shares pledged in November 2009 as collateral in connection with a $150,000 note. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.
  In January 2010, the Company entered into an amendment of the Transfer and Indemnity Agreement with MRC. Pursuant to this amendment, and in consideration of the pledge by MRC, the Company agreed to pay MRC a fee as follows: (i) $3,000 for the first year of the term of the note and (ii) 2% of the unpaid principal balance of the note for each succeeding year during the term of the note. In March 2010, the Company further amended the Transfer and Indemnity Agreement with MRC. Pursuant to this amendment, MRC received 300,000 shares of the Series A Convertible Preferred Stock of VHS in exchange for the cancellation of the Company’s obligation to issue 10,000,000 shares of common stock of the Company to MRC. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.
  In March 2010, the Company transferred 610,000 shares of Series A Convertible Preferred Stock of VHS to Mr. Robert Farias in exchange for the following: (a) an irrevocable waiver by Mr. Farias of the conversion rights in respect of 37,500 shares of the Company’s Series “C” 4% Cumulative Convertible Preferred Stock owned by Mr. Farias; (b) cancellation by Mr. Farias of $100,000 of debt owed by the Company to Mr. Farias; and (c) cancellation by Mr. Farias of three separate common stock purchase warrants held by Mr. Farias, exercisable for an aggregate of 15,000,000 shares of common stock of the Company. As a consequence of the waiver of conversion rights and the cancellation of warrants, the Company was no longer obligated to issue up to 30,000,000 shares of its common stock. Mr. Farias is an employee of VHS, a Director of NOW Solutions, and a Director of PTS.
  In March 2010, the Company issued 90,000 shares of VHS Series A Preferred Stock to its Chief Technology Officer, Luiz Valdetaro, in exchange for the cancellation of an obligation to issue Mr. Valdetaro 3,000,000 shares of the common stock of the Company.
  36
  On July 23, 2010, we entered into an agreement with certain former and current employees of the Company, concerning the deferral of payroll claims of $1,696,111 at December 31, 2010. The claims are for salary earned from 2001 to 2008, which remains unpaid and is reflected as a current liability on the Company’s audited financial statements.
  Pursuant to the terms of the agreement, each current and former employee who is a party to the agreement (the “Employee”) agreed to continue the deferral of salary (“Salary Deferral”) for a period of one year following the date of the agreement. In consideration for the Salary Deferral, the Company agreed to pay each Employee a sum equal to the amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which such salary was earned, plus nine percent interest, compounded annually until such time as the unpaid salary has been paid in full. The Company and the Employees have agreed that the deferred salary plus interest will be paid from amounts anticipated to be paid to the Company in respect of specified intellectual property assets of the Company.
  In order to effect the payments due under the agreement, the Company assigned to the Employees a twenty percent interest in any net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629 (plus any continuation patents) on Adhesive Software’s SiteFlashTM Technology, (b) U.S. patent #7,076,521 in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent application #09/888,329 in respect of “Method and System for Providing a Framework for Processing Markup Language Documents.”
  In July and August 2010, we entered into agreements with an employee to borrow $48,000 on a short-term basis at 10% interest. As of March 31, 2011, we have made payment of $8,000 on this debt.
  On January 18, 2011, the Company and Microidea Software Development, LLC (“Microidea”) entered into an assignment agreement whereby Microidea assigned its ownership of a 16 year-old software known as “Tiny Web Server” to the Company for an initial term of thirty years with three twenty year renewal terms in consideration of a 5% royalty. The Company also has the right to purchase the technology for $6 million, payable in four installments of $1.5 million over a 3 year period. Mr. Valdetaro is our Chief Technology Officer and the President of Microidea.
   Director Independence; Board Leadership Structure
  The Company’s common stock is quoted through the OTC Bulletin Board System. For purposes of determining whether members of the Company’s Board of Directors are “independent,” the Company’s Board utilizes the standards set forth in the NASDAQ Stock Market Marketplace Rules. At present, the Company’s entire Board serves as its Audit, Compensation and Nominating Committees. The Company’s Board of Directors has determined that, of the Company’s present directors, William Mills, constituting one of the two members of the Board, is an “independent director,” as defined under NASDAQ’s Marketplace Rules, for purposes of qualifying as independent members of the Board and an Audit, Compensation and Nominating Committee of the Board, but that Richard Wade is not an “independent director” since he serves as executive officer of the Company. In reaching its conclusion, the Board determined that Mr. Mills does not have a relationship with the Company that, in the Board’s opinion, would interfere with his exercise of independent judgment in carrying out the responsibilities of a director, nor does Mr. Mills have any of the specific relationships set forth in NASDAQ’s Marketplace Rules that would disqualify him from being considered an independent director.
  Currently, Mr. Richard Wade serves as both Chairman of the Board and Chief Executive Officer. As noted above, Mr. William Mills is the sole independent director and Mr. Mills has not taken on any supplemental role in his capacity as director. It is anticipated that additional independent directors may be added to the Board, however, the Company’s Board of Directors has not set a timetable for such action.
  The Company’s Board of Directors is of the view that the current leadership structure is suitable for the Company at its present stage of development, and that the interests of the Company are best served by the combination of the roles of Chairman of the Board and Chief Executive Officer.
  As a matter of regular practice, and as part of its oversight function, the Company’s Board of Directors undertakes a review of the significant risks in respect of the Company’s business. Such review is conducted in concert with the Company’s in-house legal staff, and is supplemented as necessary by outside professionals with expertise in substantive areas germane to the Company’s business. With the Company’s current governance structure, the Company’s Board of Directors and senior executives are, by and large, the same individuals, and consequently, there is not a significant division of oversight and operational responsibilities in managing the material risks facing the Company.
  37
  Item 14. Principal Accountant Fees and Services
  Audit Fees.The aggregate fees billed for professional services rendered by our principal accounting firm of MaloneBailey were $128,900 and $123,750 for the audit of our annual financial statements for 2010 and 2009, which included the reviews of the financial statements in our Forms 10-Q for the applicable fiscal years.
  Tax Fees. The principal accounting firm of Malone & Bailey did not provide any tax services in 2010 and 2009. The aggregate fees billed in the fiscal years ended 2010 and 2009 for professional services rendered by Hartman, Leito, and Bolt, LLP for tax advice, tax planning and tax return preparation were $18,195 and $18,872. In addition, BDO Dunwoody LLP in Toronto billed $0 and $8,851 in Canadian dollars for tax advice, tax planning and tax return preparation for the years ended 2010 and 2009, respectively. Dickstein Shapiro Moran & Oshinsky LLP billed $2,953 and $26,482 and for tax advice and tax planning for the years ended 2010 and 2009, respectively.
  All Other Fees.Other than the services described above, the aggregate fees billed for services rendered by our principal accountant was $0 and $0, respectively, for the fiscal years ended 2010 and 2009.
  38
  PART IV
   Item 15. Exhibits AndFinancial Statement Schedules
  The following documents are filed as part of this report:
  (a)
Exhibits:
  Exhibit No.

Description

Location2.1

Certificate of Ownership and Merger Merging Scientific Fuel Technology, Inc. into Vertical Computer Systems, Inc.

Provided herewith3.1

Original Unamended Certificate of Incorporation of Vertical Computer Systems, Inc. (f/k/a Xenogen Technology, Inc.)

Provided herewith3.2

Certificate of Amendment of Certificate of Incorporation (change name to Vertical Computer Systems, Inc.)

Provided herewith3.3

Certificate of Amendment of Certificate of Incorporation (2000)

Provided herewith3.4

Amended and Restated By-Laws of the Company

Provided herewith4.1

Certificate of Designation of 4% Cumulative Redeemable Series A Preferred Stock

Provided herewith4.2

Certificate of Designation of 10% Cumulative Redeemable Series B Preferred Stock

Provided herewith4.3

Certificate of Designation of 4% Cumulative Redeemable Series C Preferred Stock

Provided herewith4.4

Certificate of Designation of 15% Cumulative Redeemable Series D Preferred Stock

Provided herewith4.5

Form of Restricted Stock Agreement

Provided herewith10.1

Form of Debenture

Provided herewith10.2

Employment Agreement between the Company and Richard Wade

Provided herewith10.3

Amended and Restated Term Secured Promissory Note in the principal amount of $600,000.00, payable by NOW Solutions to Taladin, Inc.

Provided herewith10.4

Secured Term Promissory Note in the principal amount of $450,000.00, payable by Taladin, Inc. to Tara Financial Services, Inc.

Provided herewith10.5

Secured Term Promissory Note in the principal amount of $150,000.00, payable by Taladin, Inc. to Strategic Growth Partners, Inc.

Provided herewith10.6

Agreement among Tara Financial Services, Inc., as lender, NOW Solutions, the Company, Robert Farias, and Robert Mokhtarian

Provided herewith
  39
  Exhibit No.

Description

Location10.7

Secured Term Promissory Note in the principal amount of $359,559.90, payable by NOW Solutions to Tara Financial Services, Inc.

Provided herewith10.8

Secured Term Promissory Note in the principal amount of $438,795.31, payable by the Company to Tara Financial Services, Inc.

Provided herewith10.9

Secured Term Promissory Note in the principal amount of $955,103.30, payable by NOW Solutions to Tara Financial Services, Inc.

Provided herewith10.10

Secured Term Promissory Note in the principal amount of $100,000, payable by Taladin to Victor T. Weber.

Provided herewith10.11

Employment Agreement between the Company and Freddy Holder

Provided herewith10.12

Assignment Agreement between the Company and Microidea Software Development, LLC.

Provided herewith14.1

Code of Ethics

Provided herewith21.1

Subsidiaries of the Company

Provided herewith31.1

Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated April 14, 2011

Provided herewith31.2

Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated April 14, 2011

Provided herewith32.1

Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated April 14, 2011

Provided herewith32.2

Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated April 14, 2011

Provided herewith
  40
  SIGNATURES
  Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
  VERTICAL COMPUTER SYSTEMS, INC.April 14, 2011
By:
/s/ Richard WadeRichard Wade, President andChief Executive Officer
 April 14, 2011
By:
/s/ Freddy HolderFreddy HolderChief Financial Officer
  Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
  DIRECTORS:April 14, 2011
By:
/s/ Richard WadeRichard Wade, Director
 April 14, 2011
By:
/s/ William MillsWilliam MillsWilliam Mills, Director
  41


VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES
  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


Report of Independent Registered Public Accounting Firm
F-2Consolidated Financial StatementsConsolidated Balance Sheets
F-3Consolidated Statements of Operations
F-4Consolidated Statements of Stockholders’ Deficit
F-5Consolidated Statements of Cash Flows
F-6Notes to Consolidated Financial Statements
F-7




F-1




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  Board of Directors
 Vertical Computer Systems, Inc.
 Richardson, Texas
  We have audited the accompanying consolidated balance sheets of Vertical Computer Systems, Inc. (the “Company”)as of December 31, 2010 and 2009 and the related consolidated statements of operations, stockholders’ deficit, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
  We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
  In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vertical Computer Systems, Inc. as of December 31, 2010 and 2009 and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
  The accompanying consolidated financial statements have been prepared assuming that Vertical Computer Systems, Inc. will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, Vertical Computer Systems, Inc. suffered losses from operations and has a working capital deficiency, which raises substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters also are described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
  /s/ MaloneBailey, LLP
 www.malonebailey.com
 Houston, Texas
  April 15, 2011
  F-2




VERTICAL COMPUTER SYSTEMS, INC.
  CONSOLIDATED BALANCE SHEETS




December 31,

2010


December 31,

2009AssetsCurrent assets:Cash

$
272,970


$
229,738Accounts receivable, net of allowance for bad debts of $16,700 and $30,594


565,367



783,219Employee receivables, net of allowance for doubtful accounts of $13,820 in 2009


3,480



7,380Prepaid expenses and other current assets


113,025



67,830Total current assets


954,842



1,088,167Property and equipment, net of accumulated depreciation of $988,361 and $967,520


35,120



30,973Intangible assets, net of accumulated amortization of $129,770 and $99,271


441,432



109,731Deposits and other assets


14,113



12,533Total assets

$
1,445,507


$
1,241,404Liabilities and Stockholders’ DeficitCurrent liabilities:Accounts payable and accrued liabilities


6,774,923



6,397,575Bank overdraft


63,740



-Deferred revenue


2,568,847



2,404,680Derivative liabilities


30,785



484,859Convertible debentures


30,000



40,000Current portion-notes payable, net of unamortized discounts of $16,354 and $6,304


3,029,046



1,596,853Current portion-notes payable to related parties


370,362



359,903Total current liabilities


12,867,703



11,283,870Non-current portion – notes payable


-



1,405,302Non-current portion – notes payable to related parties


-



59,783Total liabilities


12,867,703



12,748,955
 Series A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000 shares authorized; 48,500 shares issued and outstanding;


9,700,000



9,700,000Series B 10% Convertible Cumulative Preferred stock; $0.001 par value; 375,000 shares authorized; 7,200 shares issued and outstanding;


246



246Series C 4% Convertible Cumulative Preferred stock; $100 par value; 200,000 shares authorized; 50,000 shares issued and outstanding;


200,926



350,000Series D 15% Convertible Cumulative Preferred stock; $0.001 par value; 300,000 shares authorized; 25,000 shares issued and outstanding;


852



8529,902,024



10,051,098Stockholders’ DeficitCommon stock: $0.00001 par value, 1,000,000,000 shares authorized 997,335,151 and 998,251,818 shares issued and outstanding as of December 31, 2010 and 2009, respectively


9,973



9,983Additional paid-in capital


19,240,060



18,630,472Accumulated deficit


(40,306,035
)


(40,155,719
)Accumulated other comprehensive income – foreign currency translation


(170,522
)


(40,537
)Total Vertical Computer Systems, Inc. stockholders’ deficit


(21,226,524
)


(21,555,801
)Noncontrolling interest


(97,696
)


(2,848
)Total stockholders’ deficit


(21,324,220
)


(21,558,649
)Total liabilities and stockholders’ deficit

$
1,445,507


$
1,241,404


See accompanying notes to consolidated financial statements
  F-3




VERTICAL COMPUTER SYSTEMS, INC.
  CONSOLIDATED STATEMENTS OF OPERATIONS




Years Ended December 31,2010


2009Revenues:Licensing and software

$
373,221


$
213,913Software maintenance


4,505,177



4,469,991Consulting services


625,812



453,027Hosting and Software as a Service


261,158



137,893Other


142,531



124,988Total Revenues


5,907,899



5,399,812Cost of Revenues


(1,620,181
)


(1,565,372
)Gross Profit


4,287,718



3,834,440Operating Expenses:Selling, general and administrative expenses


4,541,294



4,886,583Depreciation and amortization


51,442



41,623Bad debt recovery


(10,114
)


(124,642
)Gain on settlement of liabilities


(517,806
)


(121,020
)Total operating expenses


4,064,816



4,682,544Operating income (loss)


222,902



(848,104
)Other Income (Expense):Gain (loss) on derivative


97,074



(51,190
)Gain on settlement of litigation


-



4,799,093Interest income


4,400



133,574Interest expense


(569,540
)


(538,683
)Net income (loss)


(245,164
)


3,494,690Net loss attributable to noncontrolling interest


94,848



9,848Net income (loss) attributable to Vertical Computer Systems, Inc.


(150,316
)


3,504,538Dividend applicable to preferred stock


(588,000
)


(588,000
)Net income (loss) applicable to common stockholders

$
(738,316
)

$
2,916,538Basic and diluted income (loss) per share

$
(0.00
)

$
0.00Basic weighted average common shares outstanding


998,571,270



997,572,824Diluted weighted average common shares outstanding


-



1,003,039,623Comprehensive income:Net income (loss)

$
(150,316
)

$
3,494,690Translation adjustments


(129,985
)


(241,874
)Comprehensive income


(280,301
)


3,252,816Comprehensive loss attributable to noncontrolling interest


94,848



9,848Comprehensive income (loss) attributable to Vertical Computer Systems, Inc.

$
(185,453
)

$
3,262,664




See accompanying notes to consolidated financial statements.
  F-4




VERTICAL COMPUTER SYSTEMS, INC.
  STATEMENTS OF CONSOLIDATED STOCKHOLDERS’ DEFICIT
 YEARS ENDED DECEMBER 31, 2010 AND 2009




Additional





Other


Non-Common Stock


Paid-in


Accumulated


Comprehensive


controllingShares


Amount


Capital


Deficit


Interest


Interest


TotalBalances at December 31, 2008


995,668,482


$
9,957


$
18,535,965


$
(43,660,257
)

$
201,337


$
-


$
(24,912,998
)Issuance of restricted stock for services,net of forfeitures


2,583,336



26



94,507



-



-



-



94,533Noncontrolling interest from acquisition ofPriority Time Systems, Inc.


-



-



-



-



-



7,000



7,000Other comprehensive incomeTranslation adjustment


-



-



-



-



(241,874
)


-



(241,874
)Net income


-



-



-



3,504,538



-



(9,848
)


3,494,690Balances at December 31, 2009


998,251,818


$
9,983


$
18,630,472


$
(40,155,719
)

$
(40,537
)

$
(2,848
)

$
(21,558,649
)Issuance of restricted stock for services,net of forfeitures


583,333



6



10,849



-



-



-



10,855Stock cancellations


(1,500,000
)


(16
)


(7,335
)


-



-



-



(7,351
)Cancellation of warrants and obligation to delivercommon stock to related party


-



-



357,000



-



-



-



357,000Forgiveness of related party liabilitycharged to additional paid in capital


-



-



100,000



-



-



-



100,000Cancellation of conversion option in SeriesC  preferred stock


-



-



149,074



-



-



-



149,074Other comprehensive incomeTranslation adjustment


-



-



-



-



(129,985
)


-



(129,985
)Net loss


-



-



-



(150,316
)


-



(94,848
)


(245,164
)Balances at December 31, 2010


997,335,151


$
9,973


$
19,240,060


$
(40,306,035
)

$
(170,522
)

$
(97,696
)

$
(21,324,220
)




See accompanying notes to consolidated financial statements.




F-5




VERTICAL COMPUTER SYSTEMS, INC.
  CONSOLIDATED STATEMENTS OF CASH FLOWS




Years Ended December 31,2010


2009Cash flows from operating activities:Net income (loss)

$
(245,164
)

$
3,494,690Adjustments to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization


51,442



41,623Amortization of debt discounts


22,658



16,812Stock compensation


10,855



94,533Cancellation of common stock


(7,351
)


-Non-cash portion of gain on settlement of litigation


-



(1,112,877
)(Gain) loss on derivatives


(97,074
)


51,190Bad debt (recovery) expense


(10,114
)


(124,642
)Gain on settlement of liabilities


(517,806
)


(121,020
)Changes in operating assets and liabilities:Accounts receivable


227,966



(380,985
)Employee receivables


3,900



1,803Prepaid expense and other assets


(46,775
)


(1,107
)Accounts payable and accrued liabilities


840,258



(352,387
)Deferred revenue


96,315



45,286Net cash provided by operating activities


329,110



1,651,116Cash flows from investing activities:Acquisition of Priority Time Systems, Inc., net of cash received


(5,335
)


(24,999
)Software development


(145,799
)


-Purchase of equipment


(22,486
)


(53,017
)Net cash used in investing activities


(173,620
)


(78,016
)Cash flows from financing activities:Payments on notes payable


(129,884
)


(1,677,262
)Borrowings on notes payable


133,195



320,000Payments on related party debt


(97,324
)Borrowings on related party debt


48,000Bank overdraft


63,740



-Net cash provided by (used in) financing activities


17,727



(1,357,262
)Effect of changes in exchange rates on cash


(129,985
)


(241,874
)Net increase (decrease) in cash and cash equivalents,


43,232



(26,036
)Cash and cash equivalents,beginning of period


229,738



255,774Cash and cash equivalents, end of period

$
272,970


$
229,738Supplemental Disclosure of Cash Flows Information:Cash paid for interest

$
331,586


$
1,071,381Cash paid for income taxes


-



-Non-cash Investing and Financing Activities:Forgiveness of related party liability

$
100,000


$
-Cancellation of derivative liability and warrants


357,000



-Cancellation of conversion option in Series C preferred stock


149,074



-Debt discount due to royalty given


32,708



-Conversion of accounts payable and accrued liabilities to notes payable


-



100,881Issuance of note for acquisition of PTS


-



38,000




See accompanying notes to consolidated financial statements.
  F-6





VERTICAL COMPUTER SYSTEMS, INC.




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





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





Nature of Business





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





Basis of Presentation





The consolidated financial statements include the accounts of the Company and its wholly subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable), EnFacet, Inc. (“ENF”),Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. (“PMI”) and Vertical Internet Solutions (“VIS”), all of which are inactive; Vertical Healthcare Solutions (“VHS”), OptVision Research, Inc. (“OVR”),Taladin, Inc. (“Taladin”), Government Internet Systems, Inc. (“GIS”), SnAPPnet, Inc. (“SnAPPnet”), Priority Time Systems, Inc. (“PTS”) a 90% owned subsidiary, all entities with minor activities and NOW Solutions, Inc. (“NOW Solutions”). To date, we have generated revenues primarily from software licenses, consulting fees and maintenance agreements from NOW Solutions, our 100% owned subsidiary, and patent licenses from Vertical Computer Systems, the parent company.





Principles of Consolidation





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





Cash and Cash Equivalents





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




Revenue Recognition





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





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





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





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




F-7




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





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





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





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





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




F-8




Valuation of the Embedded and Warrant Derivatives





The valuation of our embedded derivatives and warrant derivatives is determined primarily by the Black-Scholes option pricing model and the Lattice model. An embedded derivative is a derivative instrument that is embedded within another contract, which under the convertible note (the host contract) includes the right to convert the note by the holder, certain default redemption right premiums and a change of control premium (payable in cash if a fundamental change occurs). In accordance with the guidance on derivative instruments, these embedded derivatives are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. A warrant derivative liability is determined in accordance with the guidance on derivative financial instruments indexed to, and potentially settled in, a company’s own stock. Based on this guidance, warrants which are determined to be classified as derivative liabilities are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. The practical effect of this has been that when our stock price increases so does our derivative liability, resulting in a non-cash loss that reduces our earnings and earnings per share. When our stock price declines, we record a non-cash gain, increasing our earnings and earnings per share.





To determine the fair value of our embedded derivatives, management evaluates assumptions regarding the probability of certain future events. Other factors used to determine fair value include our period end stock price, historical stock volatility, risk free interest rate and derivative term. The fair value recorded for the derivative liability varies from period to period. This variability may result in the actual derivative liability for a period either above or below the estimates recorded on our consolidated financial statements, resulting in significant fluctuations in other income (expense) because of the corresponding non-cash gain or loss recorded.





Concentration of Credit Risk





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





Capitalized Software Costs





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





Property and Equipment





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





Impairment of Long-Lived Assets





Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets. Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value. During 2010 and 2009, there was no impairment of long-lived assets due to the minimal value of such assets.





Stock-based Compensation





We account for share-based compensation in accordance with the provisions of share-based payments, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock, and the fair value of stock options is determined using the Black-Scholes valuation model.




F-9





Allowance for Doubtful Accounts





We establish an allowance for bad debts through a review of several factors including historical collection experience, current aging status of the customer accounts, and financial condition of our customers. We do not generally require collateral for our accounts receivable. Our allowance for doubtful accounts was $16,700 and $30,594 as of December 31, 2010 and 2009, respectively.





Income Taxes





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





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





Since January 1, 2007, we account for uncertain tax positions in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”) on income taxes which addresses how we should recognize, measure and present in our financial statements uncertain tax positions that have been taken or are expected to be taken in a tax return. Pursuant to this guidance, we can recognize a tax benefit only if it is “more likely than not” that a particular tax position will be sustained upon examination or audit. To the extent the “more likely than not” standard has been satisfied, the benefit associated with a tax position is measured as the largest amount that is greater than 50% likely of being realized upon settlement. No liability for unrecognized tax benefits was recorded as of December 31, 2010 and 2009.





Earnings per Share





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





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





Year Ended

December 31, 2010





Year Ended

December 31, 2009Net Income (Numerator)


Shares (Denominator)


Per Share Amount


Net (Loss) (Numerator)


Shares (Denominator)


Per Share AmountBasic EPS

$
(738,316
)


998,571,270


$
0.00


$
2,916,538



997,572,824


$
0.00Effect of dilutive securitiesWarrants & Restricted Stock






-



0.00



-



5,466,799



0.00Diluted EPS

$
(738,316
)


998,571,270


$
0.00


$
2,916,538



1,003,039,623


$
0.00





As of December 31, 2009, common stock equivalents related to the convertible debentures, convertible debt and preferred stock and stock derivative liability totaling 73,976,565 were not included in the denominators of the diluted earnings per share as their effect would be anti-dilutive.





Fair Value of Financial Instruments





For certain of our financial instruments, including cash and cash equivalents, accounts receivable and accrued expenses, the carrying amounts approximate fair value due to the short maturity of these instruments. The carrying value of our long-term debt approximates its fair value based on the quoted market prices for the same or similar issues or the current rates offered to us for debt of the same remaining maturities. See Note 5 – Derivative instruments and fair value measurements for additional information.




F-10




Use of Estimates





The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenue and expenses during the reporting period. Among the more significant estimates included in these financial statements are the estimated allowance for doubtful accounts receivable, valuation allowance for deferred tax assets, impairment of long-lived assets and intangible and the valuation of warrants and restricted stock grants. Actual results could materially differ from those estimates.





Cash Reimbursements





We record reimbursement by our customers for out-of-pocket expense as part of consulting services revenue in accordance with the guidance related to income statement characterization of reimbursements received for out of pocket expense incurred.





Recently Issued Accounting Pronouncements




In January 2010, the FASB issued authoritative guidance that requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements, and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. The guidance was effective for the Company beginning with its first quarter of 2010, except for Level 3 reconciliation disclosures, which are effective for annual periods beginning after December 15, 2010. The adoption of this authoritative guidance did not have a significant impact on the Company’s consolidated financial statements.





In October 2009, the FASB issued authoritative guidance related to the recognition of revenue for multiple-deliverable arrangements. Under the authoritative guidance, revenue may be allocated to the different elements in an arrangement based on relative selling price using the best estimate of selling price if vendor-specific or other third-party evidence of value is not available. This authoritative guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is still assessing the potential impact of adopting the new authoritative guidance.





In October 2009, the FASB issued authoritative guidance altering the scope of revenue recognition guidance for software deliverables to exclude items sold that include hardware with software that is essential to the hardware’s functionality. This authoritative guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is still assessing the potential impact of adopting the new authoritative guidance.





Reclassifications




Certain reclassifications have been made to the prior periods to conform to the current period presentation.





Note 2. Going Concern Uncertainty





The accompanying consolidated financial statements for 2010 and 2009 have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.





The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. We have suffered significant recurring operating losses, used substantial funds in our operations, and we need to raise additional funds to accomplish our objectives. Stockholders’ deficit at December 31, 2010 was $21.3 million. Additionally, at December 31, 2010, we had negative working capital of approximately $11.9 million (although it includes deferred revenue of approximately $2.6 million) and defaulted on several of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.




F-11




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




Note 3. Acquisitions





2010





SnAPPnet





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





The fair value of consideration transferred in the acquisition, the assets acquired and the liabilities assumed are set forth in the following table:





Consideration:Cash

$
5,335Series B Convertible Preferred Stock (1)


-Contingent consideration (2) (3)


12,256Total consideration

$
17,591
  Below is the preliminary purchase price allocation:
  Recognized amount of identifiable assets acquired and liabilities assumed (3):
 Software

$
189,201Property and equipment


7,604Intangibles


22,200Accounts payable


(9,274
)Notes payable


(66,660
)Deferred revenue


(119,352
)Royalty payable


(6,128
)$
17,591







(1)
No value has been assigned to the Series B Convertible Preferred Stock of VHS, since VHS is deemed a development stage company with no assets, liabilities or operations at the time of the transaction. Also, it is a wholly-owned subsidiary of Vertical Computer Systems, Inc. and does not trade on any exchange independently of VCSY.





(2)
The contingent consideration consists of a 5% royalty payment on sales of the SnAPPnet software application, and is payable to the members (equity owners) of Pelican, prorated to their respective ownership interests in Pelican. The royalty will expire 10 years following the closing date or the payment of $2.5 million, whichever occurs first.




The fair value of the contingent consideration was determined based on SnAPPnet’s projected revenues for the next 5 years and the application of a discount rate to the future royalty payments. A probability factor was also applied to the different revenue assumptions used. At the end of each reporting period after the acquisition date, the contingent payment will be measured again to its fair value, with changes in fair value recorded in earnings.


(3)
Fair values assigned to the contingent consideration as well as the assets acquired and liabilities assumed are provisional, pending receipt of a final valuation of the acquisition.


F-12





The pro forma results for the twelve months ended December 31, 2010 and 2009, as though the Company had acquired SnAPPnet on the first day of fiscal year 2010 and 2009, are set forth below. The unaudited pro forma operating results are not necessarily indicative of what would have occurred had the transaction taken place on the first day of fiscal year 2010 and 2009.





Unaudited Pro Forma Combined

For the Years Ended, December 31,2010


2009Revenues

$
5,932,076


$
5,442,077Net Income (Loss)


(248,393
)


3,462,614Earnings (Loss) per share - Basic

$
-


$
-Basic weighted average of common shares outstanding


998,571,270



997,572,824Diluted weighted average of common shares outstanding


998,571,270



1,003,039,623





2009





Priority Time Systems





On June 15, 2009, we purchased 90% of the common stock of PTS, a Nevada corporation, from a stockholder of PTS. The purchase price was $63,000, of which $25,000 was paid at execution with the balance of the purchase price as a note payable to be paid in equal monthly installments over a 12-month period beginning in August 2009. In connection with the agreement, we also agreed to retain the selling stockholder as a consultant of PTS beginning in July 2009. To secure our purchase of the PTS stock, we pledged these shares of PTS stock purchased to the selling stockholder. In addition, we also entered into a stockholder agreement with the other stockholder of PTS whereby we have the option to purchase the remaining 10% of the common shares of PTS stock at any time after 3 years from the date of our purchase of the shares representing 90% of the common stock of PTS. Under the terms of the stockholder agreement, the purchase price will consist of a cash payment equal to the pro-rata number of shares of stock owned by the other stockholder (relative to the total number of shares of common stock issued by PTS) multiplied by 300% of PTS’s gross revenues for the previous 12 calendar months prior to the date that we provide written notice of our intention to purchase these shares from the other stockholder. The stockholder agreement also provides for the licensing terms of PTS products to our other subsidiaries.





The related purchase price was allocated to identifiable assets acquired and liabilities assumed as follows:





Software in development

$
70,000Noncontrolling interest


(7,000
)Total net assets acquired

$
63,000


Note 4. Related Party Transactions





In November 2009, the obligation to reimburse Mountain Reservoir Corporation (“MRC”) with 1,309,983 common shares of the Company stock became due pursuant to the Indemnity and Reimbursement agreement between MRC and the Company. This obligation was made in connection with the sale of 1,500,000 common shares of our stock pledged by MRC to secure a $96,946 promissory note issued to a third party lender. In November 2008, the lender sold 1,500,000 shares of the pledged stock for $118,167, of which $103,555 was applied to outstanding debt claimed by the lender including interest, penalties & attorney’s fees. The remaining $14,612 was returned to MRC representing the amount of shares oversold by the lender. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.





In November 2009, MRC pledged 16,976,296 shares of Company common stock owned by MRC as collateral in connection with a $150,000 note payable by the Company. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.





In December 2009, we entered into a settlement agreement and stipulated judgment with Parker, Shumaker & Mills, L.L.P. (“PSM”) in connection with a lawsuit filed in August 2009, whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM, which was formerly known as Parker Mills, LLP (the successor entity to Parker Mills Morin, LLP and Parker Mills & Patel, LLP). During 2010, the Company made timely payments of $40,000 on this note leaving a balance of $33,371 at December 31, 2010.




F-13




In January 2010, the Company and MRC amended the indemnity and reimbursement agreement (originally entered into in April 2007) whereby the Company agreed to reimburse and indemnify MRC for 16,976,296 shares pledged in November 2009 as collateral in connection with a $150,000 note. MRC is a corporation controlled by the W5 Family Trust. Mr. Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.





In January 2010, the Company also entered into an amendment of the Transfer and Indemnity Agreement with MRC. Pursuant to this amendment, and in consideration of the pledge by MRC, the Company agreed to pay MRC a fee as follows: (i) $3,000 for the first year of the term of the note and (ii) 2% of the unpaid principal balance of the note for each succeeding year during the term of the note. In March 2010, the Company further amended the Transfer and Indemnity Agreement with MRC. Pursuant to this amendment, MRC received 300,000 shares of the Series A Convertible Preferred Stock of VHS in exchange for the cancellation of the Company’s obligation to issue 10,000,000 shares of common stock of the Company to MRC. MRC is controlled by the W5 Family Trust, and Mr. Richard Wade, the President and CEO of the Company, is the trustee of the W5 Family Trust.




In March 2010, the Company transferred 610,000 shares of Series A Convertible Preferred Stock of VHS to Mr. Robert Farias in exchange for the following: (a) an irrevocable waiver by Mr. Farias of the conversion rights in respect of 37,500 shares of the Company’s Series “C” 4% Cumulative Convertible Preferred Stock owned by Mr. Farias; (b) cancellation by Mr. Farias of $100,000 of debt owed by the Company to Mr. Farias; and (c) cancellation by Mr. Farias of three separate common stock purchase warrants held by Mr. Farias, exercisable for an aggregate of 15,000,000 shares of common stock of the Company. As a consequence of the waiver of conversion rights and the cancellation of warrants, the Company was no longer obligated to issue up to 30,000,000 shares of its common stock. Mr. Farias is an employee of VHS, a Director of NOW Solutions, and a Director of PTS.




In March 2010, the Company issued 90,000 shares of VHS Series A Preferred Stock to its Chief Technology Officer, Luiz Valdetaro, in exchange for the cancellation of an obligation to issue Mr. Valdetaro 3,000,000 shares of the common stock of the Company.





On July 23, 2010, we entered into an agreement with certain former and current employees of the Company, concerning the deferral of payroll claims of $1,696,111 at December 31, 2010. The claims are for salary earned from 2001 to 2008, which remains unpaid and is reflected as a current liability on the Company’s audited financial statements.




Pursuant to the terms of the agreement, each current and former employee who is a party to the agreement (the “Employee”) agreed to continue the deferral of salary (“Salary Deferral”) for a period of one year following the date of the agreement. In consideration for the Salary Deferral, the Company agreed to pay each Employee a sum equal to the amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which such salary was earned, plus nine percent interest, compounded annually until such time as the unpaid salary has been paid in full. The Company and the Employees have agreed that the deferred salary plus interest will be paid from amounts anticipated to be paid to the Company in respect of specified intellectual property assets of the Company.




In order to effect the payments due under the agreement, the Company assigned to the Employees a twenty percent interest in any net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629 (plus any continuation patents) on Adhesive Software’s SiteFlashTM Technology, (b) U.S. patent #7,076,521 in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent application #09/888,329 in respect of “Method and System for Providing a Framework for Processing Markup Language Documents.”




In July and August 2010, we entered into agreements with an employee to borrow $48,000 on a short-term basis at 10% interest.  As of March 31, 2011, we have made payment of $8,000 on this debt.




F-14




Note 5. Derivative liabilities and fair value measurements





Derivative liabilities





During 2008, one of our officers pledged 3,000,000 shares of common stock (through a company he controls) to secure the debt owed to a third party lender.  In connection with the pledge of stock, we signed an agreement to replace these shares within one year. Subsequent to this agreement, 1,309,983 shares of this stock were sold to satisfy the debt owed to the lender. This contractual commitment to replace all of the pledged shares was evaluated under FASB ASC 815-40, Derivatives and Hedging and was determined to have characteristics of a liability and therefore constituted a derivative liability under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At December 31, 2010 and December 31, 2009, the aggregate derivative liability was $30,785 and $31,440.





During 2007, two of our officers loaned a total of 13 million shares of unrestricted stock to the Company (see Note 4). This stock was used to satisfy certain obligations of the Company. In connection with the loans, the Company signed agreements to replace the shares within one year. These contractual commitments were evaluated under FASB ASC 815-40, Derivatives and Hedging and were determined to have characteristics of a liability and therefore derivative liabilities under the above guidance. Each reporting period, this derivative liability is marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. At December 31, 2009, the aggregate derivative liability was $312,000. In March 2010, these derivative liabilities were eliminated through the issuance of preferred stock in VHS as described above in Note 4.





During 2002 and 2003, we issued convertible debentures with conversion features based on the market value of the Company’s common stock at the date of conversion. The conversion features were evaluated under FASB ASC 815-40, Derivatives and Hedging and were determined to have characteristics of a liability and therefore a derivative liability under the above guidance. The conversion prices were variable which caused the Company to conclude it was possible at some point in the future to not have available the number of common shares required to share settle all common stock equivalent instruments. This in turn caused outstanding warrants and all other convertible debt to also be classified as derivative liabilities. Each reporting period, these derivative liabilities are marked-to-market with the non-cash gain or loss recorded in the period as a gain or loss on derivatives. In March 2010, the derivative liability associated with the outstanding warrants was eliminated through the issuance of preferred stock in VHS as described in Note 4 above. At December 31, 2010, the Company wrote-off the $10,000 debenture (see Note 8) for which the statute of limitations had been exceeded and no legal liability exists. At December 31, 2009, the aggregate derivative liability was $141,419.





The aggregate gain or loss on the change in the fair value of derivative liabilities was a gain of $97,074 and a loss of $51,190 for the years ended December 31, 2010 and 2009, respectively.





The valuation of our remaining embedded derivatives is determined by using the VCSY stock price at December 31, 2010. As such, our derivative liabilities have been classified as Level 1 as of December 31, 2010. The valuation of our convertible debenture and warrant derivatives are determined primarily by the Black-Scholes option pricing model and the Lattice model. As such, these derivative liabilities have been classified as Level 3 as of December 31, 2009. To determine the fair value of our derivatives, management evaluates assumptions regarding the probability of certain future events. Other factors used to determine fair value include our period end stock price ($0.024), historical stock volatility (129%), risk free interest rate (1.14%) and derivative term (generally 0.25 years). The valuation of our embedded derivatives is determined by using the VCSY stock price at December 31, 2009. As such, our embedded derivative liabilities have been classified as Level 1 as of December 31, 2009.





Fair value measurements





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





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





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




F-15




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





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


The following table provides a summary of the fair value of our derivative liabilities as of December 31, 2010 and 2009:





Fair value measurements on a

recurring basis

December 31, 2010Level 1


Level 2


Level 3LiabilitiesStock derivative – 1,309,983 shares

$
30,785



-



-




Fair value measurements on a

recurring basis

December 31, 2009Level 1


Level 2


Level 3LiabilitiesWarrants and convertible debentures

$
-


$
-


$
141,419Stock derivative – 13,000,000 shares


312,000



-



-Stock derivative – 1,309,983 shares


31,440



-



-





The derivative liabilities associated with the warrants and the 13,000,000 shares were settled during the year ended December 31, 2010. The change in value of the derivative liability associated with the 1,309,983 shares relates to a mark-to-market adjustment of $655, which is reflected in the statement of operations.





Note 6. Property and Equipment





Property and equipment consist of the following as of December 31, 2010 and 2009:





2010


2009Equipment (3-5 year life)

$
893,954


$
869,640Leasehold improvements (5 year life)


87,712



87,712Furniture and fixtures (3-5 year life)


41,815



41,141Total


1,023,481



998,493Accumulated depreciation


(988,361
)


(967,520
)$
35,120


$
30,973





Depreciation expense for 2010 and 2009 was $20,943 and $41,623, respectively.





Note 7. Intangible Assets





Intangible assets consisted of the following as of December 31, 2010 and 2009:




2010


2009Capitalized software development

$
247,228


$
100,869Acquired software (5 year life)


301,774



-Customer list (5 year life)


2,200



108,133Trademark (5 year life)


5,000



-Website (5 year life)


15,000



-Total


571,202



209,002Accumulated amortization


(129,770
)


(99,271
)$
441,432


$
109,731




F-16




Amortization expense for 2010 and 2009 was $30,499 and $0, respectively.





Note 8. Accounts Payable and Accrued Expenses





Accounts payable and accrued liabilities consist of the following:





2010


2009Accounts payable

$
2,295,361


$
1,559,937Accrued payroll


1,991,607



2,117,394Accrued payroll tax and penalties


523,907



387,651Accrued interest


849,769



735,487Accrued taxes


455,953



609,540Accrued liabilities - Other


658,326



987,566$
6,774,923


$
6,397,575





Accrued payroll primarily consists of deferred compensation for several executives who agreed to defer a portion of their salaries due to cash flow constraints. Accrued liabilities – other primarily consists of accrued rent, board of director fees, unbilled professional and consulting fees, and other accrued expenses. Accrued payroll tax and penalties relate to unpaid payroll taxes, interest and penalties for prior years for non-functioning subsidiaries and employer payroll taxes on accrued payroll. Accrued taxes primarily consist of unpaid sales and use taxes, VAT and other accrued taxes.





Note 9. Notes Payable and Convertible Debts





December 31


December 312010


2009Third Party Notes PayableNotes payable issued to third parties unsecured and non-interest bearing. Of these notes, $58,000 was non-performing as of December 31, 2010 and 2009, respectively.


58,000



88,000Notes payable issued to third parties in the aggregate principal amount of $548,158 and $448,158 as of December 31, 2010 and 2009, respectively, bearing interest at rates between 10% and 13% per annum and unsecured. In December 2010 the statue of limitations was exceeded on two of the note payables in the amounts of $10,000 and $23,030 and no legal liability existed. The balances were removed and recorded as a gain on settlement as required under the guidance on transfers and servicing of financial assets and extinguishments of liabilities. These notes are in default or non-performing at December 31, 2010 and 2009. Net of unamortized discount of $6,304 as of December 31, 2009.


340,297



370,218Notes payable issued to third party lenders, bearing interest at 10% to 12% per annum, in an aggregate principal amount of $990,000. These notes are secured by stock pledges by MRC totaling 53,976,296 common shares. Of these notes $970,088 and $827,589 were in default or non-performing at December 31, 2010 and 2009, respectively.


970,088



977,589Note payable of $450,000 to Tara Financial, dated February 13, 2006, bearing interest at 12% per annum and is due on February 1, 2011 (the maturity date). The $450,000 note payable by Taladin contains provisions requiring additional principal reductions in the event sales by NOW Solutions exceed certain financial thresholds or from net proceeds collected from any judgment, settlement, or decree in favor of the Company with respect to the pending Ross litigation. During 2009, pursuant to the terms of this note, we paid $212,111 from net proceeds of the Ross litigation toward this note. For additional details on the Ross litigation, please refer to the Litigation section under Note 14. The $450,000 note also contains a conversion option pursuant to which all or any portion of the unpaid principal, plus interest, may be converted at the option of Tara Financial, into shares of common stock of Taladin equal to a maximum of 2.5% of Taladin’s outstanding common stock at the time of conversion. The note was secured by all of the assets of NOW Solutions.


-



55,993Note payable of $438,795 to Tara Financial, dated February 13, 2006, bearing interest at 12% per annum and is due on February 1, 2018 (the maturity date). The new note is secured by an interest in certain technology developed by Adhesive Software and owned by the Company, commonly known as “SiteFlashTM”. These notes were in default at December 31, 2010.


371,541



371,541Note payable acquired in the purchase of SnAPPnet. For additional details on the purchase of SnAPPnet, please see Note 3.


66,660



-Note payable, net of unamortized discount, to a third party dated July 13, 2010 bearing interest at 10% per annum, maturing on July 13, 2011. Quarterly payments of accrued interest in addition to a 5% royalty on gross revenues of a subsidiary company up to $50,000. The note was in default at December 31, 2010. The fair value of the royalty was determined to be $32,708 which was recorded as a discount on the debt. The discount is being amortized over the life of the loan using the effective interest rate method. The unamortized discount at December 31, 2010 was $16,354.


83,646



-Notes payable of $359,560 and $955,103 to Tara Financial, dated February 13, 2006, bearing interest at 12% per annum. The notes are due on February 1, 2018 (the maturity date). These notes payable also contains provisions requiring additional principal reductions in the event sales by NOW Solutions exceed certain financial thresholds. The notes are secured by all of the assets of NOW Solutions and were in default at December 31, 2010.


1,138,814



1,138,814Total notes payable to third parties


3,029,046



3,002,155Current maturities


3,029,046



1,596,853Long-term portion of notes payable to third parties

$
-


$
1,405,302
  F-17
   December 31


December 312010


2009Related Party Notes PayableUnsecured notes payable issued to related parties in the aggregate principal amount of $427,519. These notes bear interest at a rate of 10% to 12% per annum. Of these notes payable, $337,157 and $213,139 were in default at December 31, 2010 and 2009, respectively.

$
370,362


$
397,519Note payable of $63,000, non-interest bearing to a related party in connection with the purchase of 90% of the common stock of PTS. The Company pledged its 90% ownership in PTS to secure the note. For additional details on the purchase of PTS, please see Note 3.


-



22,167Total notes payable to related parties


370,362



419,686Current maturities


370,362



359,903Long-term portion of notes payable to related parties

$
-


$
59,783




F-18




The total amortization expense recorded on the debt discounts during the years ended December 31, 2010 and 2009 was $22,658 and $0, respectively.





Future minimum payments for the next five years are as follows:





Year

Amount2011

$
3,399,4082012


-2013


-2014


-2015


-2016+


-Total notes payable

$
3,399,408





Convertible Debentures





Convertible debentures consist of the following:


December 31,
2010


December 31,
2009Convertible debentures dated March 29, 2002, bearing interest at 5%, convertible into shares of the Company’s common stock at the debt holder’s choice of either 120% of the closing bid price on the date of agreement or 80% of the lowest closing bid price five days prior to the conversion. The debenture is convertible at the option of the holder at any time after purchase. Principal and interest were due at maturity on March 28, 2004. This debenture was originally issued in the principal amount of $100,000. In December 2010, the statute of limitations had been exceeded and no legal liability existed, and therefore the balance was removed and recorded as a gain on settlement as required under the guidance on transfers and servicing of financial assets and extinguishments of liabilities.

$
-


$
10,000In December 2003, we issued a debenture in the amount of $30,000 to a third party. We received net proceeds of $26,000 for the debenture. The debt accrues interest at 5% per annum and was due December 2005. The holder may convert the debenture into shares of common stock at 100% of the closing price for the preceding trading day after we receive notice of conversion.


30,000



30,000Total convertible debentures


30,000



40,000Current maturities


30,000



40,000Long-term portion of convertible debentures

$
-


$
-




F-19




Note 10. Income Taxes





We account for income taxes using the asset and liability method of accounting for income taxes. Deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rate applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities and result primarily form differences in methods used to amortize intangible assets. A valuation allowance is provided when management cannot determine whether it is more likely than not that the deferred tax asset will be realized. The effect on deferred income taxes of the change in tax rates is recognized in income in the period that includes the enactment date. The difference between the statutory tax rate and the effective tax rate is the valuation allowance.





Temporary difference between the financial statement carrying amount and tax bases of assets and liabilities that give rise to deferred tax assets relate to the following:




December 31,
2010


December 31,

2009Net operating loss carry-forward

$
6,775,000


$
6,789,000Reserves


600,000



611,600Accrued vacation


54,000



68,000Deferred compensation


737,000



826,000Deferred revenue


970,000



778,000Derivatives


13,000



211,0009,149,000



9,283,600Valuation allowance


(9,149,000
)


(9,283,600
)$
-


$
-





At December 31, 2010 and December 31, 2009, we had available net operating loss carry-forwards of approximately $15.6 million. These net operating loss carry-forwards expire in varying amounts through 2030.





Note 11. Common and Preferred Stock




Terms of Common and Preferred Stock




Common Stock.The authorized capital stock of the Company consists of 1,000,000,000 shares of common stock, par value $0.00001 per share, of which 997,335,151and 998,251,818were issued and outstanding at December 31, 2010 and December 31, 2009, respectively. Each share of our common stock entitles the holder to one vote on each matter submitted to a vote of our stockholders, including the election of directors. There is no cumulative voting and there are no redemption or sinking fund provisions related to the common stock. Stockholders of our common stock have no preemptive, conversion or other subscription rights.





Series A Cumulative Convertible Preferred Stock. We have authorized the issuance of 250,000 shares of Series A 4% Cumulative Convertible Preferred Stock (“Series A Preferred Stock”), of which there are 48,500 shares outstanding at December 31, 2010 and 2009. Holders of these shares of Series A Preferred Stock are entitled to vote on an as-converted basis with the holders of common stock, except that the holders are entitled to vote as a separate class on any matters affecting the Series A Preferred Stock stockholders, on the sale of the business, the increase in the number of directors, the payment of a dividend on any junior stock, and the issuance of any stock that is on parity or senior to the Series A Preferred Stock. Each share of Series A Preferred Stock is entitled to 500 votes per share. Dividends accrue at an annual rate of 4% of the liquidation preference and are payable quarterly subject to the board’s discretion. Each share of Series A Preferred Stock is convertible into 500 shares of common stock of the Company. In the event of liquidation, each share of Series A Preferred Stock will be entitled to a preference of $200, plus accrued but unpaid dividends, prior to the holders of any junior class of stock.





Series B 10% Cumulative Convertible Preferred Stock. We have authorized the issuance of 375,000 shares of Series B 10% Cumulative Convertible Redeemable Preferred Stock (“Series B Preferred Stock”), of which there are 7,200 shares outstanding at December 31, 2010 and December 31, 2009. Holders of Series B Preferred Stock are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash or stock dividends accrue cumulatively at an annual rate of 10% per annum on March 15 and September 15 of each year and are payable subject to the board’s discretion. Each share of Series B Preferred Stock is convertible into 3.788 shares of common stock of the Company. The shares of Series B Preferred Stock are redeemable at a rate of $6.25 per share, or $45,000 if all outstanding shares are redeemed. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holders of any class of common stock.





Series C 4% Cumulative Convertible Preferred Stock. We have authorized the issuance of 200,000 shares of Series C 4% Cumulative Convertible Preferred Stock (“Series C Preferred Stock”), of which there are 50,000 shares outstanding at December 31, 2010 and December 31, 2009. Holders of Series C Preferred Stock are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash dividends accrue at an annual rate of 4% of the liquidation preference and are payable quarterly subject to the board’s discretion.  Each share of Series C Preferred Stock is convertible into 400 shares of common stock of the Company. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holder of any class of common stock. In the event of liquidation, each share of Series C Preferred Stock will be entitled to a preference of $100, plus accrued but unpaid dividends, prior to the holders of any junior class of stock.




F-20




Series D 15% Cumulative Convertible Preferred Stock. We have authorized the issuance of 300,000 shares of Series D 15% Cumulative Convertible Redeemable Preferred Stock (“Series D Preferred Stock”), of which there were 25,000 shares outstanding at December 31, 2010 and December 31, 2009. Holders of these shares are not entitled to vote on matters presented to the stockholders, except as otherwise required by law. Cash dividends accrue cumulatively at an annual rate of 15% per annum on March 15 and September 15 of each year and are payable subject to the board’s discretion. Any aggregate deficiency shall be cumulative and shall be fully paid or set apart for payment before any dividend shall be paid or set apart for payment of any class of common stock. Each share of Series D Preferred Stock is convertible into 3.788 shares of common stock of the Company. The shares of Series D Preferred Stock are redeemable at a rate of $6.25 per share, or $156,250 if all outstanding shares are redeemed. In the event of liquidation, each share will be entitled to a preference of all dividends accrued and unpaid on each share up to the date fixed for distribution to any holders of any class of common stock.





2010





Common Stock





During 2010, our obligation to issue 13,000,000 shares of our common stock to employees of the Company was cancelled pursuant to an agreement whereby we issued a total of 310,000 shares of VHS Series A Preferred Stock owned by the Company to these employees. For additional details, please see Note 4–Related Party Transactions.





During 2010, 100,000 unregistered shares of our common stock were forfeited pursuant to a restricted stock agreement between the Company and an employee. These shares were not vested at the date of forfeiture and had never been issued.





During the year ended December 31, 2010, 583,333 shares of the Company’s common stock vested, resulting in stock compensation expense of $10,855. These shares were issued to employees of the Company and Now Solutions pursuant to restricted stock agreements executed in 2007.





During 2010, the Company granted 600,000 unregistered shares of our common stock to an employee of the Company pursuant to a restricted stock agreement, under which the shares vest in equal installments over a three year period. As of December 31, 2010, there was $11,520 of total unrecognized compensation costs related to these stock awards. These costs are expected to be recognized over a weighted average period of less than 3 years.





During 2010, the Company cancelled 1,500,000 previously issued common shares resulting in a gain of $7,351.





Preferred Stock





Although no dividends have been declared, the cumulative total of preferred stock dividends due to these stockholders upon declaration was $5,865,712 as of December 31, 2010.





2009





Common Stock





During 2009, 2,583,336 unregistered shares of common stock which had been issued to employees and consultants of the Company and NOW Solutions became vested resulting in stock compensation expense of $94,533. These shares were issued pursuant to restricted stock agreements executed in 2006 – 2008. As of December 31, 2009, there was $4,777 of total unrecognized compensation costs related to these stock awards. These costs were expected to be recognized over a weighted average period of less than 1 year.





During 2009, 800,000 unregistered shares of common stock of the Company were forfeited pursuant to restricted stock agreements between the Company and employees of NOW Solutions. These shares were not vested at the date of forfeiture and had never been issued.




F-21




Preferred Stock





Although no dividends have been declared, the cumulative total of preferred stock dividends due to preferred stockholders upon declaration was $5,277,712 as of December 31, 2009.





Note 12. Stock Options and Warrants





In December 1999, we established a stock option plan allowing grants of both Incentive Stock Options (within the meaning of Section 422 and the Internal Revenue Code of 1986, as amended) and non-statutory options, in an aggregate amount of 50,000,000 shares. The stock option plan expired December 15, 2009.





There were no non-statutory stock options, incentive stock options or warrants granted in 2010 or 2009.





Warrants to purchase 250,000 common shares at $0.015 per share expired during 2009.





In February 2009, Robert Farias, a related party, notified us of his intent to exercise warrants to purchase 15,000,000 shares of our common stock at an average exercise price of $0.02 per share.  In March 2010, Robert Farias agreed to accept 610,000 shares of Series A Preferred Stock of VHS, in exchange for cancellation of his warrants, waiving waiver of the conversion rights associated with 37,500 shares of the Company’s Series “C” Cumulative Convertible Preferred Stock, and forgiveness of $100,000 of unsecured trade payables.  For additional details, please see Note 4.





Option and warrant activities in 2009 and 2010 are summarized as follows:





Incentive Stock Options


Non-Statutory Stock Options


Warrants


Weighted Average Exercise PriceOutstanding at 12/31/08


2,500,000



-



15,250,000



0.019Options/Warrants granted


-



-



-



-Options/Warrants exercised


-



-



-



-Options/Warrants expired/cancelled


(2,500,000
)


-



(250,000)



0.015Outstanding at 12/31/09


-



-



15,000,000



0.020Options/Warrants granted


-



-



-



-Options/Warrants exercised


-



-



-



-Options/Warrants expired/cancelled


-



-



(15,000,000
)


0.020Outstanding at 12/31/10


-



-



-



-





At December 31, 2010, there are no warrants outstanding.





Note 13. Gain on Settlement of Current Liabilities





In 2010, the company recorded a gain on settlement of liabilities of $517,806 as a result of our review of trade payables accrued liabilities and notes payable for those items in which the statute of limitations had been exceeded and no legal liability existed. Our review included the determination of the dates of receipt of goods and services, the last activity with the vendor, former employee or note holder, the applicable statute of limitations, and a search for applicable liens and judgments. For those payables that met all the above requirements, we have removed the liability and recorded the gain on settlement as required under the guidance on transfers and servicing of financial assets and extinguishments of liabilities.





In 2009, we recorded a gain on settlement of trade payables of $121,020 as a result of purchasing the trade receivables of one of our vendors from the bankruptcy trustee.




F-22




Note 14. Commitments and Contingencies





Commitments





We lease various office spaces which leases run from October 2009 through May 2015. We have future minimum rental payments as follows:





Years ending December 31,

Amount2011

$
115,5912012


99,8622013


93,2692014


93,3302015


29,852Total

$
431,904





Rental expense for the years ended December 31, 2010 and 2009 was $160,788 and $178,077, respectively.





Royalties





When we acquire rights to patents, licenses, or other intellectual property, we generally agree to pay royalties on any net sales of any products utilizing these rights. There were no sales of products requiring royalties in 2010 and 2009.





We also have royalty agreements associated with certain notes payable that provide a royalty when revenues exceed certain thresholds. These royalties are generally provided as an incentive for making the loans. For the years ended December 31, 2010 and 2009, we had royalties of $50,457 and $23,748, respectively, on revenues from subsidiaries.





Payroll Taxes





For VCSY, the IRS had a claim for unpaid payroll taxes of $313,839 from 2001-2005. We paid $200,000 of the IRS claim during 2008 and $144,532 was paid in 2009. As of December 31, 2009, the total payroll taxes, penalties and interest that were due for VCSY had been satisfied. NOW Solutions has filed all payroll tax returns and made all payroll tax payments. For additional details, please see “Litigation” below.





Litigation





We are involved in the following ongoing legal matters:




On October 11, 2007 a judgment in the amount of $3,151,216 was entered for NOW Solutions (the “Judgment”) against Ross in New York state court.  The amount of the Judgment consisted of $1,279,483 for NOW Solutions’ claims (after deducting $664,000 for Ross’ claim), $912,464 in attorneys’ fees and expenses, and $865,361 for accrued interest.  Ross appealed the Judgment, which was affirmed by the appellate court.  On March 24, 2009, the New York City Department of Finance released Ross’ cash deposit of $3,151,216 (which had accrued $133,424 in interest) to NOW Solutions.  The net proceeds of the deposit collected by NOW Solutions totaled $873,444, after deducting $2,345,502 in attorneys’ fees and costs (including a $992,723 promissory note issued to Wolman Blair PLLC) and $65,693 in fees and interest charged by New York City Department of Finance on the deposit.





On September 15, 2009, NOW Solutions executed a settlement agreement with Ross in connection with the outstanding monies (accrued interest, attorney fees and expenses) owed by Ross to NOW Solutions. Pursuant to the terms of the settlement agreement, Ross made a $390,468 payment to NOW Solutions and a $144,532 payment to the Internal Revenue Service (“IRS”) on behalf of the Company which is reported as part of the “Gain on settlement of litigation” in the consolidated statements of operations. All litigation with Ross has been resolved.





In August 2004, Arglen obtained a default judgment against the Company for a past due $600,000 promissory note, plus fees and interest. We agreed to pay Arglen $713,489. As of December 31, 2008, we had paid all principal due under the payout agreement. In February 2009, the Company and Arglen agreed to settle a dispute concerning accrued interest regarding the payout agreement. Under the terms of the settlement, we paid Arglen $60,000. This matter has been resolved.





The IRS had a claim for unpaid Employment (Form 941) taxes and Federal Unemployment (Form 940) taxes for the period December 31, 2001 through December 31, 2005. We paid $200,000 of the principal amount of the unpaid payroll taxes in September 2008. In September 2009, the lien held by the IRS against us in the amount of $144,532 was satisfied. This matter has been resolved.





F-23





In August 2009, PSM filed a lawsuit in Los Angeles Superior Court to collect the outstanding balance of $51,238 under a promissory note issued by the Company to PSM in the principal amount of $75,000, plus interest at 6% per annum, late fees and attorneys’ fees. We issued the $75,000 note in connection with a settlement in October 2005 with PSM. In December 2009, we entered into a settlement agreement and stipulated judgment with PSM whereby the parties agreed to a judgment balance of $68,500, which included principal, accrued interest, late fees and attorneys’ fees, and we agreed to make monthly installment payments. Bill Mills is a Director of the Company and a partner of PSM. During 2010, the company made timely payments of $40,000 of this note leaving a balance of $33,371.48 at December 31, 2010.





On November 18, 2009, we sued InfiniTek Corporation (“InfiniTek”) in the Texas State District Court in Fort Worth, Texas for breach of contract and other claims (the “Texas Action”) seeking equitable relief and unspecified damages when a dispute between the Company and InfiniTek was not resolved. All agreements with InfiniTek have been cancelled. On January 15, 2010, InfiniTek filed a counter-claim for non-payment of amounts billed. InfiniTek claims it is owed $195,000, and has incurred alleged lost opportunity cost of not less than $220,000. We attempted unsuccessfully to resolve our dispute with InfiniTek via mediation. Our lawsuit was amended on March 30, 2010. Discovery is ongoing.





On April 7, 2010, we were served with a lawsuit filed by InfiniTek in the California Superior Court in Riverside, California seeking damages in excess of $76,303 for breach of contract and lost profit. This lawsuit relates to one of the causes of action, and the same set of underlying facts, as those in the Texas legal action mentioned above. On May 7, 2010, we filed a motion to dismiss this action. On July 14, 2010, the court denied our motion. On August 13, 2010, we filed an answer to InfiniTek’s complaint, including a denial and affirmative defenses. We continue to litigate the claims made by InfiniTek in this action as well as our other claims against InfiniTek in the Texas case. The amounts in dispute are included in our accounts payable and accrued liabilities pending the outcome of this litigation.





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





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





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





Motions filed by the parties in the Eastern District of Texas and the Northern District of California concerning the Vertical Action, the Interwoven Action, and the Samsung lawsuit are pending decisions by the respective courts.





In the opinion of management, the ultimate resolution of any pending matters may have a significant effect on our financial position, operations or cash flows.





Note 15. Subsequent Events





On January 18, 2011, the Company and Microidea Software Development, LLC (“Microidea”) entered into an assignment agreement whereby Microidea assigned its ownership of the 16 year-old software application known as “Tiny Web Server” to the Company for an initial term of thirty years with three twenty year renewal terms in consideration of a 5% royalty. The Company also has the right to purchase the technology for $6 million, payable in four installments of $1.5 million over a 3 year period. Mr. Valdetaro is our Chief Technology Officer and the President of Microidea.





On March 31, 2011, we filed a provisional application for a patent, serial number 61/470474, titled “Mobile Web Proxy”. This provisional patent application is not yet published and still pending.




F-24




Stock Holders Equity





For the period from January 1, 2010 to April 14, 2011, no shares of our common stock have vested,  pursuant to any restricted stick agreement.




As of the Date of this Report for the year ended December 31, 2010, we have determined that we currently have (i) the following shares of common stock issued, and (ii) outstanding instruments which are convertible into the shares of common stock indicated below in connection with stock options, warrants, and preferred shares previously issued by the Company or agreements with the Company:





997,935,151

Common Stock Issued and Outstanding24,250,000

Common Shares convertible from Preferred Series A stock (48,500 shares outstanding)27,274

Common Shares convertible from Preferred Series B stock (7,200 shares outstanding)5,000,000

Common Shares convertible from Preferred Series C (50,000 shares outstanding)94,700

Common Shares convertible from Preferred Series D (25,000 shares outstanding)1,309,983

Common Shares Company Is Obligated to Reimburse to officer of Company within 1 year for Pledged Shares1,028,617,108

Total Common Shares Outstanding and Accounted For/Reserved





In addition, the Company has $30,000 in an outstanding convertible debenture that had been issued to a third party.





Accordingly, given the fact that the Company currently has 1,000,000,000 shares of common stock authorized, the Company could exceed its authorized shares of common stock by approximately 30,000,000 shares if all of the financial instruments described in the table above were exercised or converted into shares of common stock (excluding the $30,000 from the outstanding debenture noted above).





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




F-25