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, 2008





[  ]  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: (817)
348-8717





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 
o      No
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





Check
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





Check if
there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-K (§ 229.405 of this chapter) 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  x     No
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 Exchange Act).    Yes o        No
x





Issuer’s
revenues for fiscal year ended December 31,
2008:  $8,257,987





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 March 31,
2009:  $25,172,966.





As of
April 15, 2009, the issuer had 998,935,151 shares of common stock, par value
$.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, 2008





TABLE OF
CONTENTS


PART
      I
              
              2ITEM
      1.  BUSINESS
              
              2ITEM
      1A. RISK FACTORS
              
              9ITEM
      2.  PROPERTIES
              
              12ITEM
      3.  LEGAL PROCEEDINGS
              
              12ITEM
      4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
              
              13PART
      II
              
              14ITEM
      5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
      MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
              
              14ITEM
      7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS
              
              18ITEM
      8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
              
              24ITEM
      9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
      FINANCIAL DISCLOSURE
              
              24ITEM
      9A (T).  CONTROLS AND PROCEDURES
              
              24ITEM
      9B.  OTHER INFORMATION
              
              26PART
      III
              
              27ITEM
      10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
    GOVERNANCE
              
              27ITEM
      11. EXECUTIVE COMPENSATION
              
              30ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
      RELATED STOCKHOLDER MATTERS
              
              33ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE
              
              33ITEM
      14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES
              
              35PART
      IV
              
              36ITEM
      15.  EXHIBITS AND FINANCIAL STATEMENT
    SCHEDULES
              
              36SIGNATURES
              
              39




CONSOLIDATED
FINANCIAL STATEMENTS





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





1




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, (f) our lack of
operational experience, and (g) 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 the 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 the following software products: HRMS emPath® 6.4 (“emPath®”),
ResponseFlashTM, SiteFlashTM, and a point-of-sale software solution known as
“PASS”.  Until very recently, we licensed, as a value added
distributor, the rights to market IA (formerly ImmuneApp) and StatePointPlus®,
and was marketing these products individually and collectively as a managed
baseline solution (“Managed Baseline
Solution”).  There is a dispute concerning our licensing rights
with CW International LLC (“CWI”) and the licensor of these
products.  We are  negotiating possible solutions with the
respective licensor.  For a description of these products, please see
the section entitled “Software Services” under “Business
Overview”.  We are actively pursuing licensing our intellectual
properties, including SiteFlashTM.  NOW Solutions, Inc. (“NOW Solutions”), a
wholly owned subsidiary of the Company, is selling emPath® in the United States
and Canadian markets and is preparing to launch an international payroll
product.  For a description of our new delivery model for emPath®,
please see the section entitled “Software Services” under “Business
Overview.”  We intend to market our other software products
internationally commencing in Canada, Italy and Brazil -- either directly
through our company and our subsidiaries, or through agreements with national
and regional distributors.




Business
Overview




We are
a multi-national provider of Internet core technologies, administrative
software, and software services through our distribution network with operations
or sales in the United States, Canada, Japan, and Brazil and also are in active
negotiations in Italy and the UK to establish a business
presence.  Our primary Internet core technologies include SiteFlashTM,
ResponseFlashTM, Emily® XML enabler agent, Emily® XML broker, and the Emily® XML
Scripting Language, which can be used to build Web services.  Our main
administrative software product is emPath®, which is designed to handle complex
Payroll and Human Resources challenges. Software services currently provided by
our company include emPath®, delivered as a Software-as-a-Service
(SaaS).




In 2008,
Robert Farias, a related party, assigned Point-of-Sale software (“PASS”) technology to
us for use by pharmacies and medical practices.  In 2009, we acquired
rights from Emerald Software Group to market AllegroHR onboarding and
offboarding software solutions as well as staff service request and personnel
action notices applications, including the right to market these products as a
private label offering.




2







We
attempt to acquire marketing or licensing rights for products which, in our
belief, are proven and 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
      SolutionsLarge
      Corporations and Universities
            
            SiteFlashTM
            
            VerticalGovernment
      Sector- Emergency Response
            
            ResponseFlashTM
            
            Vertical
            
            GISPharmacies
      and medical practices
            
            PASS
            
            VerticalSoftware
      development units
            
            Emily®
            
            VerticalHuman
      Resources and Payroll
            
            AllegroHR
            
            Emerald
      Software Group
            
            NOW
      Solutions




Administrative
Software




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




We
recently released a new version of emPath® (emPath® 6.4) which encompasses
ASP.net and a new user interface which has increased customization
capabilities.  These new features, when coupled with experience gained
with the product by the Brazil-based development staff (over three years), has
substantially facilitated faster development. We are also exploring
opportunities to utilize emPath®’s powerful payroll component to provide private
label contracting as well as existing payroll providers in localized
markets.




We
believe that our administrative software services provide customers with upfront
cost savings and productivity increases for everyday operations, including
competitive set-up charges and implementation times.




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 another software product 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, which permits 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 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 (any output device including
wireless devices such as PDAs and cellular phones) framework.





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, Government Internet Systems
(“GIS”), a
majority-owned subsidiary of the Company, 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). NewsFlashTM is used by newspapers (e.g. La
Opinion and Japan’s Sports Hochi) and AffiliateFlashTM is used by companies with
an affiliate/franchise structure.




3





Currently,
we are converting our SiteFlashTM product to be able to offer it in a SaaS
configuration.  We intend to concentrate our initial marketing efforts
in the affiliate, government and publishing markets.




We are
actively pursuing licensing opportunities for our SiteFlashTM patent. Please
refer to “Legal Proceedings” regarding the settlement of an infringement claim
that we had initiated in federal court against Microsoft.




The
second core Internet technology we have developed is the patent-pending Emily®
XML scripting language, 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® work platform, also known
as “the Emily® Framework”, consists of executable programs, files, configuration
data and documentation needed 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 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 Markup Language Executive (MLE), a programming language that runs on
Windows®, Linux and several UNIX platforms.




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 the
earlier terms "On-Demand" and "ASP" (Application Service Provider). After
completing testing its emPath® SaaS model to ensure a robust and competitive
solution, NOW Solutions is now marketing its SaaS offering of emPath® 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 its current market of mid to large sized customers but also increase
its 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 is completing its new “emPath® for Small
Business” offering.




Until
very recently, the Company was marketing IA (formerly ImmuneApp) and
StatePointPlus®, presenting these products individually or collectively as a
Managed Baseline Solution. IA is a security software program that allows a
system administrator to stop the use of unauthorized programs, including
unlicensed software, viruses, Trojans, spyware, adware and malicious code.
StatePointPlus® is an intelligent System Baseline Management patented technology
that improves information technology management by providing a highly
cost-effective complete inventory of network hardware, giving a complete picture
of all existing workstations, servers, and software on a network.  The
technology also provides a self-healing function to reverse unauthorized changes
to systems, ensuring that IT systems are in compliance with company policies and
standards as well as government regulations, including HIPAA, Sarbanes-Oxley and
ISO. The Company is in negotiations concerning its licensing rights for these
products.




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
Inc. (“Taladin”), OptVision
Research, Inc. (“OptVision Research”),
Vertical Healthcare Solutions, Inc. (“VHS”), 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 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.  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.




4




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,
particularly its “emPath® for Small Business” SaaS through distributors.
Additionally, NOW Solutions has embarked on a new strategy of 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’s agreement with Emerald Software Group and
resulted in an immediate sale to one of its existing
customers.




The
existing revenue model of NOW Solutions is based primarily upon four components:
licensing fees, SaaS fees, professional consulting services, and renewable
maintenance fees.  Under the SaaS delivery model, NOW Solutions
typically collects monthly fees.





For the
12 months ended December 31, 2008, NOW Solutions had approximately $577,106 of
total assets, revenues of approximately $5,325,605 and a net loss of
approximately $200,137.




Government
Internet Systems, Inc.




Our 81.5%
owned subsidiary, GIS, a Nevada corporation, was formerly named Emily®
Solutions, Inc.  Vertical will license ResponseFlashTM to GIS 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 have submitted proposals to various city, county
and state governments.  We are currently seeking funding for
GIS.




For the
12 months ended December 31, 2008, GIS had no assets and no material revenue or
expenses.




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, 2008, VIS had no material assets and no material
revenue or expenses.




EnFacet,
Inc.




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





For the 12 months ended December 31,
2008, EnFacet had no material assets, no revenues and a net loss of
approximately $14,622.




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, 2008, Globalfare.com had no assets, no revenue and
no expenses.




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.




5




For the
12 months ended December 31, 2008, Pointmail.com had no assets, no revenues and
no expenses.




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 and is pursuing a patent for the module.  We are
currently seeking funding for Taladin and have commenced marketing the product
on a SaaS platform to sheriff’s departments.




For an
update of transactions concerning Taladin at fiscal year-end, please see the
notes payable issued by Taladin in “Notes Payable” under Note 7 of the Notes to
Consolidated Financial Statements.




For the
12 months ended December 31, 2008, Taladin had no material assets, revenues of
approximately $17,099 and a net loss of approximately $56,038.




OptVision
Research, Inc




OptVision
Research, Inc., 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 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, 2008, OptVision had no material assets and no
material revenue or expenses.




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 commenced selling to pharmacies with initial
success. PASS is being adapted to meet the needs for physicians for a secondary
market.




For the
12 months ended December 31, 2008, VHS had no material assets and no material
revenue or expenses.




Minority
Interests and Royalty Interests




iNet Purchasing,
Inc.




In April
2000, we acquired a 2.5% minority interest in iNet and were 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 pursuant to the SicommNet ownership of iNet
Purchasing, Inc.




As of
December 31, 2008, 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,
2008.




6




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 15, 2009.





Strategic
Alliances and Software Distributors




InfiniTek
Corporation.In July 2008,
InfiniTek Corporation entered into consulting and distribution agreements with
the Company and its subsidiaries.  Under the consulting agreements,
InfiniTek will provide software application and development services to Vertical
and marketing services on behalf of Taladin for the FLSA (Fair Labor Standards
Act) compliant payroll product that is integrated with the emPath® HRMS software
solution.  In addition, NOW Solutions and InfiniTek entered into a
distribution agreement whereby InfiniTek is authorized on a non-exclusive basis
to market NOW Solutions’ emPath® HR/Payroll products in the United
States.




Farias-Jett.In August 2008, NOW
Solutions entered into a hosted service provider agreement with Farias-Jett for
emPath® so that they can market it to their existing customer
base.





Emerald Software
Group.In February 2009, NOW Solutions entered into an
agreement with Emerald Software Group to market its AllegroHR products with NOW
Solutions’ emPath® Payroll/HRMS software solution and 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.





Infotec,
Inc.In
April 2003, the Company and Infotec, a Japanese corporation, entered into a
software reseller agreement whereby Infotec agreed to market, distribute,
provide maintenance and technical support for our SiteFlashTM software in Japan
and pay us a fee on all sales and maintenance fees.We currently plan to
discuss future prospects with Infotec.




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 administrative software, NOW Solutions’ competitors include
Oracle, Lawson, Cyborg/Hewitt, Kronos, DLGL, Ultimate and SAP. Our competitors
in the network security sector include Tripwire, McAfee, Symantec, Cisco and
Computer Associates. Our competitors have longer operating histories, greater
name recognition, larger customer bases and significantly greater financial,
technical and marketing resources than we do. We cannot guarantee that we will
be able to compete successfully against current or future competitors or that
competitive pressures 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 because of our
proprietary software.





Strategic
Overview




We
believe that each of our business units, as described above, has distinct
marketing advantages for the niche markets it serves.  We plan to find
national and regional marketers and international resellers who can commercially
exploit our products in these niche markets.  By utilizing the
strategic advantages each individual business unit possesses, we plan to
leverage our strengths and exploit the network of customers, vendors, and
support agencies that we have built.We currently seek to use
a combination of direct marketing and strategic partnerships to commercially
exploit our products derived from SiteFlashTM, namely NewsFlashTM, and
AffiliateFlashTM.  In this way, we hope to define the best potential
markets for our SiteFlashTM products, and then license the product to one of our
subsidiaries to exploit.  At this time, we have placed our Emily®
software on hold while we concentrate on immediate opportunities within our
existing business units.




7




One of
our strategies is to enter into co-marketing agreements with other companies,
particularly those with best-of-breed products that complement our business
units.  The existing strategy with potential co-marketing partners is
to segregate the co-marketing agreements whereby each business unit will have a
separate agreement with the co-marketing partner for its particular target
market. Additionally, the business units will enter into agreements with each
other where the opportunity exists to cross-promote/market their products. We
are also identifying products where we can private label and sell with our
existing products or sell separately.  We are exploring various
opportunities to exploit our proprietary software, which includes the
possibility of licensing the software to major companies in non-competitive
niche markets.




Although
our current marketing effort focuses upon several sectors, we have recently
concentrated on the United States federal, state and local government for the
following reasons: (i) affiliated companies have government clients, which has
created the potential to cross-promote/market our products and Web services;
(ii) we offer products which are well-suited to the current governmental
environment, in particular, the demand for cross-agency and federal, state and
local interface, like ResponseFlashTM; and (iii) the increased security
environment necessitates improvements in secure communications and
agency-to-agency contacts that can be facilitated by
ResponseFlashTM.




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.





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. We
have filed for a Continuation for this patent to increase its scope.  This
patent is the foundation of our product, SiteFlashTM, and forms 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.  In addition, we have also filed for a patent related to the Emily®
programming language. This patent application was published in February 2003 and
is 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 our products as a
trade secret and as an unpublished copyright work.  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 contents of services or products
or that any such assertion may not result in litigation or require us to enter
into royalty arrangements.




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, 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.




8






Employees




As of
April 15, 2009, we have 29 full-time employees, of which 26 are employed at NOW
Solutions (17 are employed in the United States and 9 in Canada), and 16
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 small profit of $195,333 for the year ended December 31, 2008, we have
historically incurred losses.  For the year ended December 31, 2007,
we had a net loss of $1,566,345. 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, 2008 and 2007.  This paragraph states that our
recurring operating losses, negative working capital and accumulated deficit,
the substantial funds used in our operations and the need to raise additional
funds to accomplish our objectives raise substantial doubt about our ability to
continue as a going concern.  Our ability to develop our business plan
and to continue as a going concern depends upon our ability to raise capital and
to achieve improved operating results.  Our financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.





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, 2008 and 2007 have been prepared assuming that we will continue as a going
concern, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business.




The
carrying amounts of assets and liabilities presented in the financial statements
do not purport to represent realizable or settlement values.  We have
suffered significant recurring operating losses, used substantial funds in our
operations, and need to raise additional funds to accomplish our
objectives.  Negative shareholders’ equity at December 31, 2008 was
$14.9 million.  Additionally, at December 31, 2008, we had negative
working capital of approximately $13.2 million (although it includes
deferred revenue of approximately $2.4 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 and other products for which we
have marketing rights, as well as increased revenues from NOW Solutions
products, none of which can be assured.  Our ability to generate
revenues is subject to substantial uncertainty and our inability to generate
sufficient revenues to support our operations and debt repayment could require
us to curtail or suspend operations.  Such an event would likely
result in a decline in our stock price.




9





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.  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, 2008 Were Not Sufficient to Satisfy Our Current Liabilities on That
Date




We had
a working capital deficit of approximately $13.2 million at December 31, 2008, which means that our current liabilities
exceeded our current assets by approximately $13.2 million (although it includes
deferred revenue of approximately $2.4 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, 2008 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
      level of usage of the Internet;


·
            the
      level of user traffic on our Websites;


·
            seasonal
      trends and budgeting cycles in sponsorship;


·
            incurrence
      of costs relating to the development, operation and expansion of our
      Internet operations;


·
            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; and


·
            general
      economic conditions and economic conditions specific to the Internet and
      Internet media.





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





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





Keeping pace with
industry changes.  We must enhance and expand our product
offerings to reflect industry trends, new technologies and new operating
environments as they become increasingly important to customer
deployments.   We must continue to expand our business models
beyond traditional software licensing and subscription models, specifically,
software-as-a-service is becoming 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.
  10





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 has placed a significant strain on our managerial, operational,
and financial resources.  To manage our growth, we must continue to
implement and improve our operational and financial systems and to expand,
train, and manage our employee base. Any inability to manage growth effectively
could have a material adverse effect on our business, operating results, and
financial condition.  Acquisition transactions are accompanied by a
number of risks, including 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 management 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 these acquisitions.  Our failure to address these
risks could negatively affect our business operations through lost
opportunities, revenues or profits, any of which would likely result in a lower
stock price.





Our
Success Depends On Our Ability to Protect Our Proprietary
Technology





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





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.




11





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 still 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 Solution’s headquarters are currently located at 101 West Renner
Road, Suite 300, Richardson, Texas, and comprises approximately 2,576 square
feet.  In addition, NOW Solutions has offices at 201 Main Street,
Suite 1175, Fort Worth, Texas, which comprises 3,450 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 leasedfrom 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 Texas
headquarters.




Item
3.  Legal Proceedings




We are
involved in the following ongoing legal matters:




In
February 2003, we sued Ross Systems Inc. (“Ross”) on behalf of
our subsidiary NOW Solutions in New York Supreme Court (the “Vertical Action”) in
connection with the acquisition of certain assets of Ross for the recovery of
unpaid maintenance fees due to NOW Solutions pursuant to an asset purchase
agreement.  Accordingly, NOW Solutions gave notice to Ross in February
2003 of NOW Solutions’ claim of offset.  NOW Solutions claimed a total
amount of approximately $3,562,000 and an offset against the $750,000 remaining
on the purchase money note, plus other damages.  In conjunction with
our claim, NOW Solutions withheld payment on the remaining $750,000 note, due in
February 2003. For information concerning the decision regarding this action and
the trial regarding the action between NOW Solutions and Ross, please see Ross’
action against NOW Solutions below.





In March 2004, Ross sued NOW Solutions
in the New York Supreme Court (the “Ross Action”) to collect the $750,000 note
payable plus interest and attorneys fees.  A joint trial of the Ross
Action and Vertical Action commenced on March 20, 2007. On April 13, 2007, the
court rendered decisions in both Actions as follows:  (1) In the
action of Ross Systems, Inc. v. NOW Solutions, Inc. a directed verdict was
granted (a) to Ross Systems on its claim for payment of the promissory note, net
of certain offsets that the court found due to NOW Solutions on its first,
second and fifth counterclaims, other than for the amount claimed due by NOW for
maintenance fee adjustments due at the closing of the sale transaction between
the parties, in the amount of $664,000; (b) to NOW Solutions on its first
counterclaim for maintenance fee adjustments in the amount of $1,943,482;
accordingly, NOW Solutions was awarded the net amount of $1,279,482, plus
statutory (simple) interest at 9% per annum from the date the claim accrued; and
(c) to Ross Systems, dismissing NOW’s fourth counterclaim against Ross for
failure to deliver certain assets at closing;  (2) In the action of
Vertical Computer Systems, Inc. v. Ross Systems, Inc., et. al., the court
dismissed Vertical’s claim on behalf of NOW Solutions for maintenance fee
adjustments, as moot in light of its directed verdict in the Ross Action, and
dismissed Ross’ defenses to the Vertical Action and Ross’ claim for attorney
fees therein.  On October 11, 2007 a judgment was entered for NOW
Solutions (the “Judgment”) in the amount of $3,151,216, which consisted of
$1,279,483 for NOW Solutions’ claims (after deducting $664,000 for Ross’ claim),
$912,464 in attorneys’ fees and expenses, and $865,361 for accrued
interest.  Ross appealed the Judgment.




12





On
February 10, 2009, the Appellate Division, First Department of the New York
Supreme Court unanimously affirmed the Judgment of the trial
court.  On March 12, 2009 Ross moved before the Appellate Division of
the Supreme Court, First Department, for re-argument of the appeal, or in the
alternative, for leave to appeal the Court of Appeals.





On March
24, 2009, NOW Solutions applied for and received the Ross’ cash deposit that was
held by the New York City Department of Finance.  These funds had been
deposited by Ross to stay enforcement of the Judgment.  The stay was
vacated by operation of law five (5) days after notice that the Judgment was
affirmed by the Appellate Division.





As of
March 24, 2009, the cash deposit of $3,151,216 had accrued $133,424 in interest
since the Judgment was entered on October 11, 2007.  The net proceeds
of the cash deposit collected by NOW Solutions was $873,444, after deducting
$2,345,502 in outstanding attorney’s fees and costs and $65,693 in fees and
interest charged by New York City Department of Finance on the cash
deposit.





NOW
Solutions is entitled to an additional amount of approximately $335,000 plus
accrued interest that remains unsatisfied on the Judgment. In addition, NOW
Solutions intends to move for an award of additional attorney fees and expenses
incurred in defense of the appeal.   Ross has moved before the
Appellate Division of the Supreme Court, First Department, for re-argument
of the appeal, or in the alternative, for leave to appeal the Court of
Appeals.  This motion was submitted on April 9, 2009 and a decision is
pending.





The IRS
has a claim for unpaid Employment (Form 941) taxes and Federal Unemployment
(Form 940) taxes for the period December 31, 2001 through December 31, 2005. On
March 9, 2007, we filed an appeal with the United States Tax Court, seeking an
installment payout agreement.   The Tax Court case has been
resolved and the IRS position was sustained.   We paid $200,000 of the
principal amount of the unpaid payroll taxes in September 2008.  As of
December 31, 2008, the total tax, penalties and interest due was
$177,093.





On April
18, 2007, we filed suit for patent infringement against Microsoft Corp. in the
United States District Court for the Eastern District of Texas. We claimed that
the Microsoft .Net System infringes U.S. Patent No. 6,826,744.  In
July 2008, we settled our patent infringement claim against Microsoft
Corporation.  Pursuant to the confidential settlement agreement, we
granted to Microsoft a non-exclusive, fully paid-up license under the patent
which was the subject of the legal proceeding.





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.  Also, we in the future may become involved in other legal
actions that may have a significant effect on our financial position, operations
or cash flows.




Item
4.  Submission Of Matters To A Vote Of Security Holders




None.




13




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, 2008
            
            $
            0.1050
            
            
            $
            0.0220Quarter
      Ended September 30, 2008
            
            $
            0.0830
            
            
            $
            0.0140Quarter
      Ended June 30, 2008
            
            $
            0.0200
            
            
            $
            0.0130Quarter
      Ended March 31, 2008
            
            $
            0.0200
            
            
            $
            0.0120Quarter
      Ended December 31, 2007
            
            $
            0.0200
            
            
            $
            0.0110Quarter
      Ended September 30, 2007
            
            $
            0.0260
            
            
            $
            0.0180Quarter
      Ended June 30, 2007
            
            $
            0.0300
            
            
            $
            0.0200Quarter
      Ended March 31, 2007
            
            $
            0.0260
            
            
            $
            0.0130







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 15, 2009, there were approximately 1,733 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, 2008:




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
            
            
            2,500,000
            
            
            $
            0.014
            
            
            
            47,500,000
            (2)Warrants
            
            
            250,000
            
            
            $
            0.025
            
            
            
            
            -(3)Unvested
      Restricted Stock Awards
            
            
            4,066,669
            
            
            $
            0.028
            
            
            
            
            -(
      4)Total
            
            
            6,816,669
            
            
            $
            0.023
            
            
            
            47,500,000




(1)
            Other
      than individual agreements with employees, directors and third party
      consultants, we do not have any equity compensation plans (i.e., stock
      option plans or restricted stock plans) that have been approved by
      security holders.




14




(2)
            Under
      the Stock Option Plan, we have the right to issue up to 50,000,000 stock
      options.  The Stock Option Plan expires December 15,
      2009.  The Company does not anticipate issuing any options under
      the stock option plan in the near
future.




(3)
            Warrants
      to purchase 250,000 shares of our common stock were issued under an
      individual warrant agreement to a third party consultant.  Other
      than individual agreements, we have not approved any equity compensation
      plan with regard to warrants.




(4)
            The
      4,066,669 shares of restricted stock that had not vested at December 31,
      2008 were issued in connection with individual restricted stock agreements
      with employees, directors and consultants of the Company and NOW Solutions
      executed in 2005 through 2008.  Of these 4,066,669 unvested
      shares at December 31, 2008, 1,433,333 have vested and 800,000 have been
      cancelled through April 15, 2009.




Dividends




We have
outstanding 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 and $588,000 for the years ended December
31, 2008 and 2007, respectively.  Our Board of Directors did not
declare and did not pay any dividends on our outstanding shares of Series A
Preferred Stock or Series C Preferred Stock during 2008 or 2007 and has not
declared or paid any dividends 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 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 March
2007, MRC and Victor Weber entered into a pledge agreement, whereby the MRC
pledged 10,000,000 shares of our common stock to secure the principal payments
and interest payments on the $300,000 Note and interest payments on the $200,000
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.  Mr. Weber is the President and a Director of
Government Internet Systems, Inc., a subsidiary of the Company, and a member of
CWI.





In April
2007, Luiz Valdetaro, on behalf of the Company, transferred 2,000,000
unrestricted shares of our common stock owned by Mr. Valdetaro to an officer of
Tara Financial in exchange for waiving the defaults and extending the payment
terms on notes payable in the amounts of $438,795, $350,560, $955,103 and
$450,000 issued to Tara Financial by the Company, NOW Solutions, and Taladin in
February 2006.  Mr. Valdetaro is the Chief Technology Officer of the
Company.  Also in April 2007, in connection with the transfer, the
Company entered into an indemnity and reimbursement agreement to reimburse Mr.
Valdetaro with 2,000,000 shares of our common stock within one year and pay for
all costs associated with the transfer of shares to Tara Financial and the
reimbursement of shares to Mr. Valdetaro.





In April
2007, Mr. Valdetaro, on behalf of the Company, transferred 1,000,000
unrestricted shares of our common stock owned by Mr. Valdetaro to CCS in
connection with a $40,000 loan made by CCS to the Company.  The
Company is also obligated to arrange for a pledge of 1,000,000 shares of our
common stock to secure the loan.  Mr. Valdetaro is the Chief
Technology Officer of the Company.  Also in April 2007, in connection
with the transfer of shares to CCS, the Company entered into an indemnity and
reimbursement agreement to reimburse Mr. Valdetaro with 1,000,000 shares of our
common stock within one year and pay for all costs associated with the transfer
of shares to CCS and the reimbursement of shares to Mr. Valdetaro.





In April 2007, the Company and MRC
entered into an indemnity and reimbursement agreement for transfer and pledges
of shares of common stock of the Company.  Pursuant to the agreement,
MRC loaned the Company 10,000,000 shares of common stock of the Company in order
for the Company to meet current obligations concerning stock the Company has
been obligated to issue and deliver.  In connection with the loan of
shares to the Company, the Company agreed to reimburse MRC with up to 10,000,000
shares of common stock of the Company and pay for all costs associated with such
transfer and the reimbursement of shares to MRC within one year.  In
addition, in the event that any of the shares of common stock of the Company
pledged by MRC on behalf of the Company in connection with promissory notes
issued by the Company (or its subsidiaries, as applicable) are sold to cover a
default under the respective note, the Company agreed to reimburse MRC with a
number of shares equal to the number of shares sold to cover the default under
the respective note within 1 year, and to reimburse MRC for all costs associated
with such sales and the reimbursement of shares to MRC related to such
sales.




15





In April
2007, we issued 4,250,000 shares of our common stock in connection with the
exercise of warrants and an agreement executed in 2006.  All of the
foregoing shares were previously accounted for in the 10-KSB Report for the
period ended December 31, 2006.





During
the year ended December 31, 2007, warrants to purchase 6,894,444 shares of our
common stock at an exercise price of $0.010 to $0.10 per share
expired.




During
the year ended December 31, 2007, we issued 4,550,000 unregistered shares of our
common stock to employees and a consultant of the Company and NOW Solutions
pursuant to restricted stock agreements executed in 2007 that provide for the
shares to vest upon issuance or up to three years in equal installments at the
anniversary date of the agreement.




During
the year ended December 31, 2007, 4,589,292 unregistered shares of our common
stock vested.  These shares were issued pursuant to restricted stock
agreements with employees and consultants of the Company and NOW Solutions
executed in 2005, 2006 and 2007.





During
the year ended December 31, 2007, 1,369,042 unregistered shares of our common
stock were cancelled.  These shares had been issued pursuant to
restricted stock agreements with employees of NOW Solutions executed in 2005 and
2006.





During
the year ended December 31, 2007, 31,000 shares of our common stock were
cancelled by a third party.





In
January 2008, we issued 250,000 unregistered shares of our common
stock  (at a fair-market value of $3,750) to a third party lender in
connection with extending the maturity dates of two promissory notes issued by
GIS in November 2002 in the amounts of $40,000 and $60,000,
respectively.




In
February 2008, we issued 500,000 unregistered shares of our common stock (at a
fair market value of $9,000) to a third party lender in connection with
refinancing a $50,000 promissory note issued in June 2002 as well as accrued
interest, fees, and expenses incurred in connection with the
refinancing.




In
February 2008, 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.  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 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.  Of the
1,500,000 shares sold by the lender, the Company is obligated to reimburse MRC
with 1,309,983 shares within 1 year of the sales of the pledged
shares.





In March
2008, MRC pledged 2,000,000 shares of our common stock to secure a $75,000
promissory note payable to Parker Mills in connection with extending the
maturity date until June 2009.   MRC is a corporation controlled
by the W5 Family Trust.  Mr. Wade, the President and CEO of the
Company, is the trustee of the W5 Family Trust.  Bill Mills is a
Director of the Company and a partner of Parker Mills, LLP.





In March 2008, the Company and MRC
amended the indemnity and reimbursement agreement (entered into in April 2007)
whereby the Company agreed to reimburse and indemnify MRC for additional shares
pledged as collateral in connection with a $96,946 and a $75,000
notes.  MRC is a corporation controlled by the W5 Family
Trust.  Mr. Wade, the President and CEO of the Company, is the trustee
of the W5 Family Trust.




16





In May
2008, we issued 1,000,000 shares of our common stock to Victor Weber that were
granted in connection with a $100,000 loan made by Mr. Weber to NOW Solutions in
October 2006.  These shares were accounted for in our 10-KSB for the
year ended December 31, 2006.




In
September 2008, we issued 250,000 shares of our common stock (at a fair-market
value of $3,500) to a third party consultant in connection with a services
agreement.





In
November 2008, we issued 750,000 shares of our common stock to a third party
consultant whereby all of the shares will vest in 6 months from the date of
execution of the restricted stock agreement.





During
the year ended December 31, 2008, warrants to purchase 6,250,000 shares of our
common stock at an exercise price of $0.0075 to $0.010 per share
expired.





During
the year ended December 31, 2008, 3,183,333 shares of our common stock vested.
These shares were issued pursuant to a stock agreement with employees of NOW
Solutions executed from 2005 through 2007.





During
the year ended December 31, 2008, we issued 250,000 unregistered shares of our
common stock to a director of the Company pursuant to a restricted stock
agreement that provides for the shares to vest on the 1-year anniversary date of
the agreement.





During
the year ended December 31, 2008, 500,000 shares of our common stock were
cancelled pursuant to the terms of a restricted stock agreement with an employee
of NOW Solutions who resigned.





On
February 11, 2009, Robert Farias notified us  of his intent to
exercise his warrants to purchase 15,000,000 shares of our common stock at an
exercise price of $0.020 per share.  Robert Farias is an employee of
VHS.  For additional details on related party transaction concerning
Mr. Farias, please see “Certain Relationships and Related Transactions” under
Part II, Item 13 of this Report.  We have not issued these shares
since we currently do not have sufficient shares authorized to meet this
obligation.





For the
period from January 1, 2009 to April 15, 2009, 1,433,333 unregistered shares of
our common stock vested.  These shares were issued pursuant to
restricted stock agreements with employees of the Company and NOW Solutions
executed in 2006, 2007 and 2008.





For the
period from January 1, 2009 to April 15, 2009, 800,000 shares of our common
stock were cancelled pursuant to the terms of a restricted stock agreement with
employees of NOW Solutions who resigned.





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.  With regard to the unaccredited investors, all
information required to be delivered to them concerning the Company, including
financial statements, was in fact delivered to them.




17




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 the Report.




Critical
Accounting Policies




Capitalized Software Costs




Software costs incurred internally in
creating computer software products are expensed until technological feasibility
has been established upon completion of a detailed program
design.  Thereafter, all software development costs are capitalized
until the point that the product is ready for sale and 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, 2008 and 2007, no costs
were capitalized.




Revenue Recognition




Our revenue recognition policies are in
accordance with Statement of Position (‘‘SOP’’) 97-2, ‘‘Software Revenue Recognition,’’as amended by SOP 98-9, ‘‘Modification of SOP 97-2, Software
Revenue Recognition with Respect to Certain Transactions,’’Staff
Accounting Bulletin (‘‘SAB’’) No. 104, ‘‘Revenue Recognition,’’Emerging Issues Task Force (‘‘EITF’’) No. 00-21, ‘‘Revenue Arrangements with Multiple
Deliverable,’’and EITF No. 00-3 “Application of AICPA Statement of
Position 97-2 to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.”





In the
case of non-software arrangements, we apply EITF No. 00-21 and revenues related
to arrangements with 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 training and implementation services, to our
clients using a time and materials pricing methodology. The Company prices its
delivery of consulting services on a time and material 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, on a separate agreement, consulting services. The
consulting services are generally performed by the Company, but the customer can
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 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.




18





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 term the
delivery method to give functionality to new customers utilizing this service as
Software as a Service (“SaaS”). Since the customer is not given contractual
right to take position of the software, the scope of SOP 97-2 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 this service. 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 hardware to access the 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 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 estimates 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 we 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 we will be able to realize our deferred tax assets in
the future in excess of our net recorded asset, an adjustment to reduce the
valuation allowance would increase income in the period such determination is
made.




19




Stock-Based Compensation
Expense




We account for share-based compensation
in accordance with the provisions of SFAS 123(R) 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.       The Company uses the Black
Scholes option valuation model to estimate the fair value of its stock options
at the date of grant.  Historical data is used to estimate the
expected price volatility, the expected option life and the expected forfeiture
rate.  The risk-free rate is based on the U.S. Treasury yield curve in
effect at the time of grant for the estimated life of the
option.  Determining the appropriate fair value model and calculating
the fair value of share-based payment awards requires the input of subjective
assumptions.  The assumptions used in calculating the fair value of
share-based payment awards represent management’s best estimates, but these
estimates involve inherent uncertainties and the application of management
judgment.  As a result, if factors change and the Company uses
different assumptions, the stock-based compensation expense could be materially
different in the future.  See Note 10 to the Consolidated Financial
Statements for a further discussion of stock-based compensation.




Valuation
of the Embedded and Warrant Derivatives





The
valuation of our embedded derivatives and warrant derivatives are determined
primarily by the Black-Scholes option pricing model. An embedded derivative is a
derivative instrument that is embedded within another contract, which under the
convertible note (the host contract) includes the right to convert the note by
the holder, certain default redemption right premiums and a change of control
premium (payable in cash if a fundamental change occurs). In accordance with
FASB Statement No. 133, as amended, Accounting for Derivative Instruments and
Hedging Activities, these embedded derivatives are marked-to-market each
reporting period, with a corresponding non-cash gain or loss charged to the
current period. A warrant derivative liability is determined in accordance with
Emerging Issues Task Force (“EITF”) Issue No. 00-19,
“Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company’s Own Stock” (“EITF00-19”). Based
on EITF00-19, warrants which are determined to be
classified as derivative liabilities are marked-to-market each reporting period,
with a corresponding non-cash gain or loss charged to the current period. The
practical effect of this has been that when our stock price increases so does
our derivative liability, resulting in a non-cash loss charge that reduces our
earnings and earnings per share. When our stock price declines, we record a
non-cash gain, increasing our earnings and earnings per share.





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
June 2008, FASB ratified EITF No. 07-05, Determining Whether an Instrument
(or an Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF
07-05”).  EITF 07-05 provides that an entity should use a
two-step approach to evaluate whether an equity-linked financial instrument (or
embedded feature) is indexed to its own stock, including evaluating the
instrument’s contingent exercise and settlement provisions.  EITF
07-05 is effective January 1, 2009 and we are currently evaluating the impact of
the adoption of EITF 07-05 on our financial results.
 
 In May
2008, the FASB issued FASB Staff Position APB No. 14-1, “Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement)” (“APB 14-1”), which applies to convertible
debt that includes a cash conversion feature. Under APB 14-1, the liability and
equity components of convertible debt instruments within the scope of this
pronouncement shall be separately accounted for in a manner that will reflect
the entity’s nonconvertible debt borrowing rate when interest cost is recognized
in subsequent periods. APB 14-1 is effective for fiscal years beginning after
December 15, 2008. We are currently evaluating the impact of the adoption of
APB14-1 on our financial results.
 
 In
March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments
and Hedging Activities. SFAS 161 is effective beginning January 1, 2009 and
required entities to provide expanded disclosures about derivative instruments
and hedging activities including (1) the ways in which an entity uses
derivatives, (2) the accounting for derivatives and hedging activities, and (3)
the impact that derivatives have (or could have) on an entity’s financial
position, financial performance, and cash flows. SFAS 161 requires expanded
disclosures and does not change the accounting for derivatives. We are currently
evaluating the impact of SFAS 161, but we do not expect the adoption of this
standard to have a material impact on our financial results.
 
 In
February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial
Assets and Financial Liabilities Including an Amendment of FASB Statement No.
115 (SFAS 159), which permits entities to choose to measure many financial
instruments and certain other items at fair value (Fair Value Option). Election
of the Fair Value Option is made on an instrument-by-instrument basis and is
irrevocable. At the adoption date, unrealized gains and losses on financial
assets and liabilities for which the Fair Value Option has been elected would be
reported as a cumulative adjustment to beginning retained earnings. Following
the election of the Fair Value Option for certain financial assets and
liabilities, the Company would report unrealized gains and losses due to changes
in fair value in earnings at each subsequent reporting date. We adopted SFAS 159
effective January 1, 2008 which did not have a material impact on our operating
results, financial position or cash flows as we did not elect the Fair Value
Option for any of our financial assets or liabilities.
 
 In
September 2006, the FASB issued SFAS 157, Fair Value Measurements(SFAS
157), which defines fair value, establishes a framework for measuring fair
value, and expands disclosures about fair value measurements. This pronouncement
applies to other standards that require or permit fair value measurements.
Accordingly, this statement does not require any new fair value measurement. The
provisions of SFAS 157 are effective for the Company on January 1, 2008. We
have partially adopted FAS 157 as of January 1, 2008 except for those
non-recurring measurements for non-financial assets and non-financial
liabilities subject to the partial deferral in FASB Statement of Position No.
157-2, Partial Deferral of the
Effective Date of Statement 157,” (“FSP 157-2”).  The adoption
of FAS 157 did not have an impact on our consolidated financial position or
operating results.   FSP 157-2 delays the effective date of FAS
157 from fiscal years beginning after November 15, 2007 to fiscal years
beginning after November 15, 2008 for all nonfinancial assets and nonfinancial
liabilities, except those that are recognized or disclosed at fair value in the
financial statements on a recurring basis (at least
annually).




Results
of Operations





Year
ended December 31, 2008 Compared To Year Ended December 31, 2007





Total
Revenues.  We had total revenues of $8,257,987 and $5,895,726
for the years ended December 31, 2008 and 2007, respectively.  The
increase in total revenue was $2,362,261 for the year ended December 31, 2008,
representing a 40.1% increase compared to the total revenue for the year ended
December 31, 2007.  Of the $8,257,987 and $5,895,726 for the years
ended December 31, 2008 and 2007, respectively, $5,325,605 and $5,895,726,
respectively, 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 2007 to 2008 was $2,805,453, primarily from licensing some of our
patents for a one-time license fee of $2,900,000.  Our software
license revenue dropped slightly in 2008 compared to 2007.  We had no
new significant software sales in either year, but in 2007, we did sell a
perpetual software license to a current customer whose license had
expired.  This revenue did not recur in 2008.





The
software maintenance revenue is generated from existing customers of our payroll
and HR software who continue to need or want tax updates, customer support, and
software enhancements and fixes.  This revenue declined by $163,239 or
3.3% from the year ended December 31, 2007 to the same period in
2008.  The revenue decline is due to customers who no longer renew
their maintenance, partially offset by increases in the maintenance fees we bill
our customers.




20





Consulting
revenue for the year ended December 31, 2008 decreased by $158,624 from the same
period in the prior year, representing approximately a 27.8%
decrease.  This decrease was due to the completion of two significant
implementation projects in 2007 without being able to replace that business in
2008 due to a lack of new software licenses sold.  Consulting revenues
traditionally lag behind software license revenues as the implementation of new
software sales takes several months.





Hosting
and SaaS revenue increased $10,964 or 13.6% for the year ended December 31, 2008
compared to the same period in 2007.  This revenue stream is
relatively new for us and we continue to refine our marketing and sales approach
for customers who need this type of solution to their payroll and HR needs to
increase this business.





Other
revenues, consisting primarily of reimbursable travel expenses and fees related
to user conferences for the years ended December 31, 2008 and 2007, decreased by
$132,293 or 73.9% from the prior year.  This decrease was the result
of not generating revenue from the NOW Solutions’ user conference which occurs
approximately every other year, as well as a decline in reimbursable travel
expenses as a result of the lower consulting activity in 2008 compared to 2007
as described above.





Cost of
Revenues.We had direct costs associated with the above
revenues of $1,159,319 for the year ended December 31, 2008 compared to
$1,298,071 for the same period of 2007, representing a decline of $138,752 or
10.7%.  These direct costs are primarily related to costs associated
with providing customer support, professional services and the user
conference.  Almost all of the decline in cost of revenues from 2007
to 2008 is a result of not hosting a users conference in 2008.  The
remaining reduction was due to lower consulting costs (primarily travel costs)
as a result of reduced consulting activity.  Higher costs for customer
support related to hiring additional employees and providing salary increases in
2008 offset part of the reduction in costs.




Selling, General
and Administrative Expenses. We had selling, general and
administrative expenses of $6,435,651 and $5,339,777 for the years ended
December 31, 2008 and 2007, respectively.  The total selling, general
and administrative expenses for the year ended December 31, 2008 increased by
$1,095,874 compared to the selling, general and administrative expenses for the
year ended December 31, 2007, representing approximately a 20.5%
increase.  The increase was primarily due to attorney fees of
approximately $1,390,000 attributed to the Microsoft litigation settlement and
consulting fees related to potential new sources of revenue.  Other
attorney fees primarily related to the Ross lawsuit were lower by approximately
$200,000, salaries and benefits for US salespeople were lower by approximately
$72,000 due to the full year impact of layoffs in 2007, and lower advertising
costs of approximately $29,000.  Also, commitment fees associated with
rights to patents and software declined approximately $193,000 from the prior
year.





Operating Income
(Loss).  We had operating income of $591,422 for the year ended
December 31, 2008 compared to an operating loss of $985,113 for the year ended
December 31, 2007 which is an improvement of $1,576,535.  The
improvement in operating results is due to the increase in revenues (primarily
license revenues of $2,805,453) and the lower cost of
revenues.  Higher selling, general and administrative expenses
primarily related to the attorney fees associated with the litigation settlement
of approximately $1,390,000 offsets part of the improvement.




Interest
Expense. We
had interest expense of 874,635 and $1,005,325 for the years ended December 31,
2008 and 2007, respectively.  Interest expense decreased for the year
ended December 31, 2008 by $130,690, representing a decline of approximately
13.0%, compared to interest expense for the year ended December 31,
2007.  The decrease was the result of paying down the principal on
some loans and lower amounts of default interest on debt in technical
default.





Net Income
(Loss).We had net income of $195,333 for the year ended December
31, 2008 compared to a net loss of $1,566,345 for the year ended December 31,
2007.  Net income for the year ended December 31, 2008 increased by
$1,761,678 representing an increase of approximately 112.5%.  The
increase from a net loss to net income for the year ended December 31, 2008 was
attributable to the combination of an increase in revenues of $2,362,261, the
reduction in cost of revenues of $138,752 and lower interest expense of
$130,690.  Higher selling, general and administrative costs of
$1,095,874 offset part of the improvement.  In addition, we had a
one-time adjustment to our trade payables of $514,518 that positively impacted
net income.  This adjustment was done to reduce payables for items
where the statute of limitations precludes the vendor from collecting
the amounts we had originally recorded.  Without this adjustment,
we would have had a net loss of $319,185 for the year ended December 31,
2008.




21




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, 2008 and 2007, the total
dividends applicable to Series A and Series C Preferred Stock (from prior years)
were $588,000.  The Company did not declare or pay any dividends in
2008 or 2007.




Net Loss
Applicable to Common
Stockholders.  We had a net loss attributed to common
stockholders of $392,667 and $2,154,345 for the years ended December 31, 2008
and 2007, respectively. Net loss applicable to common stockholders for the year
ended December 31, 2008 decreased by $1,761,678 representing a decrease of
approximately 81.8%, compared to the net loss applicable to common stockholders
for the year ended December 31, 2007. The decrease in the net loss applicable to
common stockholders was due to the combination of factors described above in
“Net Income (Loss).”




Net Loss Per
Share.  The Company had a net loss per share of $0.00 and $0.00
for the years ended December 31, 2008 and 2007, respectively.





Financial
Condition, Liquidity, Capital Resources And Recent Developments





At
December 31, 2008, we had non-restricted cash-on-hand of $255,774 compared to
$131,420 at December 31, 2007.




Net
cash provided by operating activities for the year ended December 31, 2008 was
$445,379.  We collected cash from our customers of $6,098,579 and
one-time license fees of $2,900,000.  We used this cash to pay for
salaries, benefits, payroll taxes and payroll fees of $3,764,451, attorney fees
of $1,579,722, professional fees and consultants of $634,772, interest expense
of $537,854, taxes (including sales tax, VAT, and IRS past due taxes) of
$478,634 and regular trade payables of $1,468,097.


Net cash
used in investing activities for the year ended December 31, 2008 was $36,378,
consisting of the purchase of equipment and software.





Net cash
used in financing activities for the year ended December 31, 2008 was $374,317,
consisting of repayments of notes payable of $411,477 and issuance of new notes
payable of $37,160.





The total
change in cash and cash equivalents for the year ended December 31, 2008 when
compared to year ended December 31, 2007 was an increase of
$124,354.





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





Contractual
Obligations and Commercial Commitments





As of
December 31, 2008, the following contractual obligations and commercial
commitments were outstanding:





Balance
      at
            
            
            Due
      in Next Five YearsContractual
      Obligations
            
            12/31/08
            
            
            2009
            
            
            2010
            
            
            2011
            
            
            2012
            
            
            
            2013+Notes
      payable
            
            
            5,355,409
            
            
            
            3,573,871
            
            
            
            313,040
            
            
            
            188,224
            
            
            
            127,115
            
            
            
            1,153,159Convertible
      debts
            
            
            40,000
            
            
            
            40,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Operating
      lease
            
            
            129,677
            
            
            
            109,805
            
            
            
            19,872
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            
            5,525,086
            
            
            
            3,723,676
            
            
            
            332,912
            
            
            
            188,224
            
            
            
            127,115
            
            
            
            1,153,159




22




Of the
above notes payable of $5,355,409, the default status is as
follows:





Notes
      Payable
            
            2008
            
            
            2007In
      default
            
            $
            3,039,754
            
            
            $
            3,344,196Current
            
            
            2,315,655
            
            
            
            2,386,116Total
      Notes Payable
            
            $
            5,355,409
            
            
            $
            5,730,312





For an update on the refinancing of the
notes payable since fiscal year-end, please refer to “Subsequent Events” under
Note 14 of the Notes to Consolidated Financial Statements.





Going
Concern Uncertainty




While we
had a small profit for the year ended December 31, 2008, we have historically
incurred losses.  For the year ended December 31, 2007, we had a net
loss of $1,566,345. In addition, we had a working capital deficit of
approximately $13.1 million at December 31, 2008.  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 condensed
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.  In July 2008, the Company and
Microsoft settled our lawsuit for patent infringement (for more details, see
Item 3, “Legal Proceedings”). The exact results of our opportunities to license
our intellectual to other parties are unknown at this time.




Off-Balance
Sheet Arrangements.





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, 2008 and 2007, which are attached to this
Report.





Item
9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure




In December 2007, Weaver & Tidwell,
LLP (“Weaver &
Tidwell”) resigned as the independent certified public accountants of the
Company with no disagreements on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedures,
which disagreements, if not resolved to Weaver & Tidwell’s satisfaction,
would have caused it to make reference to the subject matter of the
disagreements in connection with its reports for our fiscal year ended December
31, 2006.  On January 16, 2008, we engaged Malone & Bailey, P.C.
(“Malone &
Bailey”) as our principal accountant to audit our financial
statements.




23




Item 9A
(T).  CONTROLSANDPROCEDURES




Evaluation of Disclosure Controls and
Procedures





Our
management, principally our chief financial officer and chief executive officer,
evaluated the effectiveness of our disclosure controls and procedures as of the
end of the period covered by this report.  Based on that evaluation,
our management concluded that our disclosure controls and procedures as of the
end of the period covered by this report were not effective such that the
information required to be disclosed by us in reports filed under the Securities
Exchange Act of 1934 is (i) recorded, processed, summarized and reported within
the time periods specified in the SEC’s rules and forms and (ii) accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate to allow timely decisions regarding
disclosure.  In particular, we have identified the following material
weakness of our internal controls:




·
            There
      is an over-reliance upon independent financial reporting consultants for
      review of critical accounting areas and disclosures and material
      non-standard transactions.


·
            There
      is a lack of sufficient accounting staff which results in a lack of
      segregation of duties necessary for a good system of internal
      control.





Management’s Annual Report on Internal
Control over Financial Reporting





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 Securities
and Exchange Act of 1934, as amended) 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, 2008.  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, 2008:





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:





·
            Revenue
      and deferred revenue process – There was a material weakness in the
      process of recognizing revenue for the software maintenance contracts in
      effect during the year which resulted from the fact that there are certain
      calculations made by our chief financial officer which are not reviewed or
      approved by anyone else.


·
            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 work of our chief financial officer in this process
      (starting with processing the trial balance, through the evaluation and
      implementation of policies and accounting issues, until the complete
      production of consolidated financial statements) is not reviewed 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 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 as directed in EITF 00-19.  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,
2008, 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.




24





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:





·
            Implementing
      a new accounting system that will allow for the consolidation of the
      various entities in Vertical Computer Systems along with the translation
      from local currency to reporting currency.  The system will
      eliminate many of the manual steps in translation and
      consolidation.  This accounting system was put in place
      effective January 1, 2009.


·
            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.


·
            The
      segregation of duties relating to the processing of accounts and the
      recording of journal entries into certain
  accounts.





We will begin implementing additional
oversight and review of certain accounts and postings.




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.




25




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
            
            65
            
            President,
      Chief Executive Officer and Director
            
            9
      yearsWilliam
      K. Mills
            
            50
            
            Secretary
      and Director
            
            9
      yearsDavid
      Braun
            
            51
            
            Chief
      Financial Officer
            
            2
      years




Richard
S. Wade, President, Chief Executive Officer and Director, Chairman and Director
of NOW Solutions




Richard
S. Wade is President and CEO 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.  In March 1998, Struthers Industries, Inc. filed a
petition for bankruptcy under the United States Bankruptcy Act.  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.  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 Mills, LLP (formerly Parker, Mills Morin,
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.




David
Braun, Chief Financial Officer of VCSY and NOW Solutions





David
Braun is an accountant with over 25 years experience in a wide variety of
accounting and finance roles.  His career includes public accounting,
large company internal audit, financial analysis, mergers and acquisitions, SEC
reporting, general accounting and consolidations of both domestic and
international companies.  Most recently he was the Corporate
Controller for a plastics injection molding company with plants in the United
States, Mexico and Ireland.  Prior to that, he worked for a healthcare
provider where he was responsible for managing 24 employees with accounting
responsibility for over 200 clinics.  Previous experience includes
working for a large chemicals manufacturing company where he assisted in
implementing a worldwide version of SAP and created a finance shared services
group for the US and Canada.  He is a CPA and a graduate of the
University of Texas at Austin.




26





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.





Carmelina
Uggenti, Vice President of Customer Development





Prior to
her current position, Ms. Uggenti joined Ross Systems, Inc. in January 1994 as a
Senior Consultant/Project Manager in the Human Resources/Payroll Professional
Services Department.  In 1998, Ms. Uggenti became responsible for the
pre-sales organization. Ms. Uggenti has overall responsibility for NOW
Solutions' global sales, pre-sales, professional services pre-sales and
marketing.





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.





27





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 2008 with the following exceptions: Richard Wade did not
timely file Form 5 in 2008, William Mills did not timely file Form 5 in 2008 or
Form 4 in 2008, and David Braun did not timely file Form 3, Form 4 or Form 5 in
2008.




Code
of Ethics





We have
adopted a Code of Ethics that applies to our Principal Executive Officer,
Principal Accounting Officer and other persons performing similar functions, as
well as all of our other employees and directors.  This Code of Ethics
was filed as Exhibit 14.1 to the Form 10-KSB filed for the year ended
December 31, 2003 and was updated in January 2008 with the new address for 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; and





(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, 2008. 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.




28





Compensation
Committee.  As all our executive officers are currently under
employment agreements or are at-will employees, we do not have a separate
compensation committee. At this point, we do not intend to establish a separate
compensation committee as this function will be performed by our full Board of
Directors.





Nominating
Committee.  We do not currently have a separate nominating
committee as this function is performed by our full Board of
Directors.





Shareholder
Communication.  We communicate regularly with shareholders
through press releases, as well as annual and quarterly 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, 2008 and 2007 to our highest paid executive officers and employees,
who were employed by us during 2008.  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 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
            
            
            Other
                Annual
                Compensation
            
            
            Restricted
                Stock
                Award(s)
            
            
            Options/
                SARs
            
            
            LTIP
                Payouts
            
            
            All
      Other
                Compen-sation($)
            
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            
            (#
            )
            
            ($)
            
            
            ($)Richard
      Wade,(1)
            
            2008
            
            $
            300,000
            (1)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -President
      and Chief
            
            2007
            
            $
            300,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Executive
      Officer-
            
            
            
            -
            
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -David
      Braun(2)
            
            2008
            
            $
            130,000
            
            
            
            -
            
            
            
            -
            
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -Chief
      Financial Officer
            
            2007
            
            $
            94,615
            
            
            
            -
            
            
            
            -
            
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -Luiz
      Valdetaro, (3)
            
            2008
            
            $
            150,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Chief
      Technology
            
            2007
            
            $
            150,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -OfficerJames
      Salz (4)
            
            2008
            
            $
            107,500
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Corporate
      Counsel
            
            2007
            
            $
            100,000
            
            
            
            -
            
            
            
            -
            
            
            
            9,000
            
            
            
            -
            
            
            
            -
            
            
            
            -







No stock
options were exercised by the named executive officers during the fiscal year
ended December 31, 2008 or 2007.




(1)
            Mr.
      Wade deferred $25,000, $150,000, $150,000, $154,097, $47,218, $155,270 and
      $300,000 of his salary in 2008, 2007, 2006, 2005, 2004, 2003 and 2002,
      respectively.  Pursuant to his employment agreement, dated
      December 1, 2001, Mr. Wade, as President and CEO, was entitled to purchase
      up to 20,600,000 shares of common stock for three years at a strike price
      of $0.10, vesting in equal monthly amounts over a 36-month
      period.  All of these warrants had expired at December 31,
      2007.




(2)
            In
      March 2007, Mr. Braun was issued  800,000 shares of our common
      stock (at a fair market value of $16,800) pursuant to a restricted stock
      agreement with the Company which provides for the stock to vest over three
      years in three equal installments, of which 266,666 shares had vested at
      December 31, 2008.  Also includes 200,000 share of our common
      stock that were issued pursuant to a restricted stock agreement that
      vested in 2007.




29




(3)
            Mr.
      Valdetaro deferred $23,750, $25,000, $50,269, $86,766, $150,000, and
      $137,500 of his salary in 2007, 2006, 2005, 2004 2003, and 2002,
      respectively.




(4)
            Mr.
      Salz deferred $48,345, $55,000 and $58,333 of his salary in 2004, 2003,
      and 2002 respectively.  In January 2006, Mr. Salz was issued
      1,500,000 unregistered shares of our common stock (at a fair market value
      of $9,000) pursuant to a restricted stock agreement with the Company which
      provides for the stock to vest over one year in three equal installments
      at four month intervals, of which all shares had vested at December 31,
      2007.




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, and was issued 5-year warrants to purchase
20,000,000 shares of our common stock at an exercise price of $0.10 per share
and 5-year warrants to purchase 600,000 shares of our common stock at an
exercise price of $0.10 per share.  These warrants vested over a
36-month period and all had expired at December 1, 2007.  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.  Mr. Wade
deferred $25,000 and $150,000 of his salary in 2008 and 2007.





Outstanding
Equity Awards




The below
table shows information of outstanding equity awards of the named officers at
the end of 2008:


OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-END (2008)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  ($)David
      Braun
                Chief
      Financial Officer (2)
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              
              533,333
              
              
              
              -
              
              
              
              -







(1)
            In
      December 1999, we established a stock option plan (the “Stock Option
      Plan”) whereby we  may grant both Incentive Stock Options
      (within the meaning of Section 422 and the Internal Revenue Code of 1986,
      as amended) and non-statutory
options.




30






(2)
            Pursuant
      to a restricted stock agreement with the Company, Mr. Braun, the CFO of
      the Company, was issued 800,000 unregistered shares of our common stock
      (at a fair market value of $16,800 in March 2007, vesting over three years
      in three equal installments, of which 266,667 shares had vested at
      December 31, 2008.  As of April 15, 2009, 533,333 shares have
      vested.  In addition, 200,000 unregistered shares of our common
      stock (at a fair market value of $1,400), which had been issued to Mr.
      Braun pursuant to a prior restricted stock agreement executed in 2006, had
      vested at December 31, 2007.





Narrative
Disclosure to Outstanding Equity Awards at Fiscal Year End Table





Stock Option Plan.Under the
Stock Option Plan, we may issue up to 50,000,000 shares (adjusted post stock
split).  Most options issued are non-assignable, non-transferable,
vest on the date of grant, and expire between three and five years from the date
of grant.  The Stock Option Plan expires on December 15,
2009.  We issued no stock options to any employees or any other
parties in 2008.





Stock Awards.  The
common stock issued to Mr. Braun is granted 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 2008:





DIRECTOR
      COMPENSATIONName
            
            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
            
            
            
            4,750
            (1)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            34,750







(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.  None of the 250,000 shares had vested at December 31,
      2008.  As of April 15, 2009, all of these shares had
      vested.





Narrative
Disclosure to Director Compensation Table





No
options or warrants were granted as director compensation during the fiscal
years ended 2007 or 2008.  Non-employee directors are entitled to
receive $2,500 per month in 2007 and 2008.  Mr. Mills was issued
250,000 shares of our common stock in February 2008.  All of these
shares have vested.





31




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 15, 2009, 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
998,935,151shares of common stock outstanding as of April 15, 2009, together
with options, warrants or other securities convertible or exchangeable by the
beneficial owners into shares of common stock within 60 days of April 15,
2009.





Title
      of Class
            
            Name
      and Address of Beneficial Owner(1)
            
            Shares
                of
      Common Stock Beneficially Owned
            
            
            Percent
                of
      ClassCommon
            
            Richard
      Wade
            
            
            95,190,206
            (2)
            
            
            9.53
            %Common
            
            William
      K. Mills
            
            
            283,333
            (3)
            
            
            *Common
            
            David
      Braun
            
            
            1,000,000
            (4)
            
            
            *Common
            
            All
      Directors and Executive Officers as a group
              (3
      persons)
            
            
            96,473,539
            
            
            
            9.66
            %







*
            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
      Mountain Reservoir Corporation (“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
      obligated to reimburse MRC with 1,309,983 shares within 1 year of the
      sales of the pledged shares.  MRC pledged 2,000,000 shares of
      our common stock as collateral on a $75,000 note issued to Parker Mills
      LLP in October 2005.  In addition, the Company is obligated to
      reimburse MRC for 10,000,000 shares of our common stock pursuant to an
      indemnity and reimbursement agreement for the 10,000,000 shares loaned by
      MRC to the Company in April 2007 as well as the 1,309,983 pledged shares
      sold on the Company’s behalf to secure the debt under the $96,946
      note.


(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 which have vested at
      April 15, 2009.


(4)
            Includes
      800,000 shares of our common stock issued in March 2007 by us to Mr. Braun
      pursuant to a restricted stock agreement in connection with services as an
      officer of the Company which vest in equal installments over 3
      years.  Of these 800,000 shares, 533,333 shares have vested at
      April 15, 2009.  Also includes 200,000 shares of our common
      stock that were issued pursuant to a restricted stock agreement that
      vested in 2007.




Item
13. Certain Relationships and Related Transactions, and Director
Independence





Certain
Relationships and Related Transactions





In April
2007, we paid Mr. Rossetti 3,000,000 shares of our common stock (at a fair
market value of $48,000) in connection with an agreement entered into concerning
loans and monies owed to Mr. Rossetti and Markquest.  Mr. Rossetti is
Executive Vice-President of Government Affairs, Chairman, CEO and Director of
GIS, Director of NOW Solutions and an officer of Markquest, Inc.




32




In March
2007, we borrowed $300,000 under a promissory note, bearing interest at 12% per
annum and due in September 2007, from Mr. Weber. In connection with the note,
MRC pledged 10,000,000 shares of our common stock.   The note is
in default.




In April
2007, Luiz Valdetaro, on behalf of the Company, transferred 2,000,000 shares of
our common stock owned by him to Tara Financial in exchange for waiving the
defaults and extending the payment terms on notes payable to Tara of $438,795,
$350,560, $955,103 and $450,000. Mr. Valdetaro is our Chief Technology
Officer.  We agreed to reimburse Mr. Valdetaro with 2,000,000 shares
within one year and pay for any related costs. This obligation is currently owed
to Mr. Valdetaro.




In April 2007, Mr. Valdetaro, on behalf
of the Company, transferred 1,000,000 shares of our common stock owned by him to
CCS in connection with a $40,000 loan from CCS. Also in April 2007, in
connection with the transfer of shares to CCS, the Company entered into an
indemnity and reimbursement agreement to reimburse Mr. Valdetaro with 1,000,000
shares within one year and pay for all costs associated with the transfer of
shares to CCS.  This obligation is currently owed to Mr.
Valdetaro.




In
April 2007, the Company and MRC entered into an indemnity and reimbursement
agreement for transfer and pledges of shares of our common stock. Pursuant to
the agreement, MRC loaned the Company 10,000,000 shares of our common stock in
order for the Company to meet current obligations concerning stock the Company
has been obligated to issue and deliver to various parties.  In
connection with a loan of 10,000,000 shares by MRC to the Company, we agreed to
reimburse MRC with up to 10,000,000 shares of our common stock within one year
and pay for all costs associated with such transfer.




In July
2007, we borrowed $46,586 from Stephen Rossetti with interest of 10% per annum
and due on demand. In December 2007, we reached an agreement with Markquest and
Stephen Rossetti related to the $113,734 note issued in December 2006, the
$46,586 loan by Mr. Rossetti in July 2007, and $36,000 in fees owed to
Markquest.  The agreement canceled the $113,734 note and we issued a
$213,139 promissory note to Markquest, bearing interest at 10% per annum which
incorporated all of the amounts plus accrued interest. The note is to be paid in
monthly interest payments of accrued interest beginning in February 2008 and
monthly accrued interest and principal payments of $4,500 beginning in August
2008. Mr. Rossetti is Executive Vice-President of Government Affairs, Chairman,
CEO and Director of GIS, Director of NOW Solutions and an officer of
Markquest.  We engaged Mr. Rossetti
(through Markquest) to provide consulting services regarding government markets
for our products in the United States.  As of December 31, 2008, we
have an outstanding liability associated with a consulting agreement with
Markquest of $33,720.For additional details on this note,
please see “Notes Payable” under Note 7 in the Notes to Consolidated Financial
Statements.





In August 2007, we borrowed $30,400
from Victor Weber with interest of 12% per annum and principal and interest due
on demand. Mr. Weber is the President and a Director of GIS, and a member of
CWI.





In March
2008, MRC pledged 2,000,000 shares of our common stock to secure a $75,000
promissory note issued to Parker Mills. William Mills is a director of the
Company and also a partner of the law firm Parker Mills.   For
additional details on this note, please see “Notes Payable” under Note 7 in the
Notes to Consolidated Financial Statements.





In
February 2008, MRC pledged 3,000,000 shares of our common stock 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.  Of the 1,500,000 shares sold by the lender, the
Company is obligated to reimburse MRC with 1,309,983 shares within 1 year of the
sales of the pledged shares.  For additional details on the $96,946
note and the pledge of stock, please see “Notes Payable” under Note 7 in
the Notes to Consolidated Financial Statements.





In May 2008, Robert Farias assigned the
rights to a “point-of-sale” software technology to the Company pursuant to an
agreement, which was sublicensed to VHS. VHS and Farias-Jett, sole
proprietorship of Mr. Farias, entered into a distributor agreement for PASS
whereby Mr. Farias would market PASS to his existing clients.  In
September 2008, VHS entered into a consulting agreement with Farias-Jett and an
employment agreement with Mr. Farias.  Also in September 2008, NOW
Solutions entered into a hosted service provider agreement with Farias-Jett for
emPath®.  Robert Farias is a director of InfiniTek Corporation with
whom the Company and its subsidiaries have entered into consulting and referral
agreements.




33





For
additional related transactions with certain parties, please see “Subsequent
Events” under Note 14 in the Notes to Consolidated Financial
Statements.





Director
Independence





The
Company applies the definition of independent director as set forth in NASDAQ
Stock Market Rule 4200 (a)(15), as well as Rule 10A-3 under the
Securities Exchange Act of 1934, as amended.  In accordance with this
guidance, the Board considers Mr. William Mills to be
independent.   Mr. Wade would not be deemed an independent
director since he is employed by the Company as its President and
CEO.




Item
14.  Principal Accountant Fees and Services





Audit
Fees.The aggregate fees billed for professional services
rendered by our principal accounting firm of Malone & Bailey, PC were
$167,815 and $99,500 for the audit of our annual financial statements for 2008
and 2007, which included the reviews of the financial statements in our
Forms 10-QSB for the applicable fiscal years.




Tax
Fees.  The principal accounting firm of Malone and Bailey, PC
did not provide any tax services in 2008 and 2007.  The aggregate fees
billed in the fiscal years ended 2008 and 2007 for professional services
rendered by Hartman, Leito, and Bolt, LLP for tax advice, tax planning and tax
return preparation were $22,100 and $12,500. In addition, BDO Dunwoody LLP in
Toronto billed $12,592 and $8,758 in Canadian dollars for tax advice, tax
planning and tax return preparation for the years ended 2008 and 2007,
respectively.  Dickstein Shapiro Moran & Oshinsky LLP billed
$28,842 and $11,955 and for tax advice and tax planning for the years ended 2008
and 2007, respectively




All Other
Fees.Other than the
services described above, the aggregate fees billed for services rendered
by  either principal accountant was $0 and $0, respectively, for the
fiscal years ended 2008 and 2007.




34




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.
            
            Incorporated
      by reference to Exhibit 2.1 to the Company’s Form 10-KSB filed on April
      14, 20063.1
            
            Original
      Unamended Certificate of Incorporation of Vertical Computer Systems, Inc.
      (f/k/a Xenogen Technology, Inc.)
            
            Incorporated
      by reference to Exhibit 3.1 to the Company’s Form 10-KSB filed on April
      14, 20063.2
            
            Certificate
      of Amendment of Certificate of Incorporation (change name to Vertical
      Computer Systems, Inc.)
            
            Incorporated
      by reference to Exhibit 3.2 to the Company’s Form 10-KSB filed on April
      14, 20063.3
            
            Certificate
      of Amendment of Certificate of Incorporation (2000)
            
            Incorporated
      by reference to Exhibit 3.3 to the Company’s Form 10-KSB filed on April
      14, 20063.4
            
            Amended
      and Restated By-Laws of the Company
            
            Incorporated
      by reference to Exhibit 3.4 to the Company’s Form 10-KSB filed on April
      14, 20064.1
            
            Certificate
      of Designation of 4% Cumulative Redeemable Series A Preferred
      Stock
            
            Incorporated
      by reference to Exhibit 4.1 to the Company’s Form 10-KSB filed on April
      14, 20064.2
            
            Certificate
      of Designation of 10% Cumulative Redeemable Series B Preferred
      Stock
            
            Incorporated
      by reference to Exhibit 4.2 to the Company’s Form 10-KSB filed on April
      14, 20064.3
            
            Certificate
      of Designation of 4% Cumulative Redeemable Series C Preferred
      Stock
            
            Incorporated
      by reference to Exhibit 4.3 to the Company’s Form 10-KSB filed on April
      14, 20064.4
            
            Certificate
      of Designation of 15% Cumulative Redeemable Series D Preferred
      Stock
            
            Incorporated
      by reference to Exhibit 4.4 to the Company’s Form 10-KSB filed on April
      14, 20064.5
            
            Form
      of Warrant
            
            Incorporated
      by reference to Exhibit 10.96 to the Company’s Form 10-KSB filed on August
      7, 20034.6
            
            Form
      of Restricted Stock Agreement
            
            Incorporated
      by reference to Exhibit 4.7 to the Company’s Form 10-KSB filed on April
      14, 200610.1
            
            1999
      Stock Option Plan of the Company
            
            Incorporated
      by reference to Exhibit 10.1 to the Company’s Form 10-KSB filed on April
      14, 200610.2
            
            Promissory
      Note, dated August 30, 2002, between the Company and a third party
      lender
            
            Incorporated
      by reference to Exhibit  10.2 to the Company’s Form 10-KSB filed
      on April 17, 200710.3
            
            Form
      of Debenture
            
            Incorporated
      by reference to Exhibit  10.3 to the Company’s Form 10-KSB filed
      on April 17, 2007




35




Exhibit
      No.
            
            Description
            
            Location10.4
            
            Employment
      Agreement as of December 1, 2001 between the Company and Richard
      Wade
            
            Incorporated
      by reference to Exhibit  10.6 to the Company’s Form 10-KSB filed
      on April 17, 200710.5
            
            Warrant
      Agreement as of December 19, 2001 between the Company and Richard
      Wade
            
            Incorporated
      by reference to Exhibit  10.7 to the Company’s Form 10-KSB filed
      on April 17, 200710.6
            
            Warrant
      Agreement as of December 19, 2001 between the Company and Richard
      Wade
            
            Incorporated
      by reference to Exhibit  10.8 to the Company’s Form 10-KSB filed
      on April 17, 200710.7
            
            Letter
      Payout Agreement, dated August 24, 2004 entered into by the
      Company.
            
            Incorporated
      by reference to Exhibit 99.1 to the Company’s Form 8-K filed on August 31,
      200510.8
            
            Form
      of Agreed Judgment
            
            Incorporated
      by reference to Exhibit 99.2 to the Company’s Form 8-K filed on August 31,
      200510.9
            
            Settlement
      Agreement and Promissory Note, dated October 19, 2005 between the Company
      and Parker Mills Morin, LLP
            
            Incorporated
      by reference to Exhibit 10.41 to the Company’s Form 10-KSB filed on April
      14, 200610.10
            
            Amended
      and Restated Term Secured Promissory Note in the principal amount of
      $600,000.00, payable by NOW Solutions to Taladin, Inc.
            
            Incorporated
      by reference to Exhibit 10.1 to the Company’s Form 8-K filed on February
      24, 200610.11
            
            Secured
      Term Promissory Note in the principal amount of $450,000.00, payable by
      Taladin, Inc. to Tara Financial Services, Inc.
            
            Incorporated
      by reference to Exhibit 10.2 to the Company’s Form 8-K filed on February
      24, 200610.12
            
            Secured
      Term Promissory Note in the principal amount of $150,000.00, payable by
      Taladin, Inc. to Strategic Growth Partners, Inc.
            
            Incorporated
      by reference to Exhibit 10.3 to the Company’s Form 8-K filed on February
      24, 200610.13
            
            Agreement
      dated as of February 13, 2006 among Tara Financial Services, Inc., as
      lender, NOW Solutions, the Company, Robert Farias, and Robert
      Mokhtarian
            
            Incorporated
      by reference to Exhibit 10.4 to the Company’s Form 8-K filed on February
      24, 2006




10.14
            
            Secured
      Term Promissory Note in the principal amount of  $359,559.90,
      payable by NOW Solutions to Tara Financial Services, Inc.
            
            Incorporated
      by reference to Exhibit 10.5 to the Company’s Form 8-K filed on February
      24, 200610.15
            
            Secured
      Term Promissory Note in the principal amount of  $438,795.31,
      payable by the Company to Tara Financial Services, Inc.
            
            Incorporated
      by reference to Exhibit 10.6 to the Company’s Form 8-K filed on February
      24, 200610.16
            
            Secured
      Term Promissory Note in the principal amount of  $955,103.30,
      payable by NOW Solutions to Tara Financial Services, Inc.
            
            Incorporated
      by reference to Exhibit 10.7 to the Company’s Form 8-K filed on February
      24, 2006




36




Exhibit
      No.
            
            Description
            
            Location10.17
            
            Secured
      Term Promissory Note, dated October 27, 2006, in the principal amount of
      $100,000, payable by Taladin to Victor T. Weber.
            
            Incorporated
      by reference to Exhibit  10.46 to the Company’s Form 10-KSB
      filed on April 17, 200714.1
            
            Code
      of Ethics
            
            Incorporated
      by reference to Exhibit  21.1 to the Company’s Form 10-KSB filed
      on April 22, 200821.1
            
            Subsidiaries
      of the Company
            
            Incorporated
      by reference to Exhibit  21.1 to the Company’s Form 10-KSB filed
      on April 17, 200731.1
            
            Certification
      of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002, dated April 15, 2009
            
            Provided
      herewith31.2
            
            Certification
      of Chief Financial OfficerPursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002, dated April 15,
      2009
            
            Provided
      herewith32.1
            
            Certification
      of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002, dated April 15, 2009
            
            Provided
      herewith32.2
            
            Certification
      of Chief Financial OfficerPursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002, dated April 15,
      2009
            
            Provided
      herewith





37




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
      15, 2009
              By:
              /s/   Richard
      WadeRichard
      Wade, President andChief
      Executive Officer
  April
      15, 2009
              By:
              /s/
      David
      BraunDavid
      BraunChief
      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
      15, 2009
              By:
              /s/
      Richard
      WadeRichard
      Wade, Director






April
      15, 2009
              By:
              /s/
      William
      MillsWilliam
      Mills, Director




38


VERTICAL
COMPUTER SYSTEMS, INC. AND SUBSIDIARIES





INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS





Report of Independent Registered Public Accounting
      Firms
            
            F-2Consolidated
      Financial StatementsConsolidated
      Balance Sheets
            
            F-3Consolidated
      Statements of Operations
            
            F-4Consolidated
      Statements of Stockholders’ Deficit
            
            F-5Consolidated
      Statements of Cash Flows
            
            F-7Notes
      to Consolidated Financial Statements
            
            F-8





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. as of December 31, 2008 and December 31, 2007 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 financial position of Vertical Computer Systems, Inc. as
of December 31, 2008 and December 31, 2007 and the results of operations and
cash flows for the years then ended, in conformity with accounting principles
generally accepted in the United States of America.





The
accompanying financial statements have been prepared assuming that Vertical
Computer Systems, Inc. will continue as a going concern. As discussed in Note 2
to the 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 financial statements
do not include any adjustments that might result from the outcome of this
uncertainty.




Malone
& Bailey, PC


www.malone-bailey.com


Houston,
Texas





April 15,
2009




F-2




VERTICAL
COMPUTER SYSTEMS, INC.





CONSOLIDATED
BALANCE SHEETS


December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007AssetsCurrent
      assets:Cash
                        
                        $
                        255,774
                        
                        
                        $
                        131,420Accounts
      receivable, net of allowance for bad debts of $313,281 and
      $349,009
                        
                        
                        277,592
                        
                        
                        
                        962,772Employee
      receivables, net of allowance for doubtful accounts of $13,820 in
      2008
                        
                        
                        9,183
                        
                        
                        
                        25,414Prepaid
      expenses and other current assets
                        
                        
                        59,551
                        
                        
                        
                        25,439Total
      current assets
                        
                        
                        602,100
                        
                        
                        
                        1,145,045Property
      and equipment, net of accumulated depreciation of $1,024,064 and
      $970,867
                        
                        
                        59,311
                        
                        
                        
                        80,708Deposits
      and other assets
                        
                        
                        19,705
                        
                        
                        
                        10,416Total
      assets
                        
                        $
                        681,116
                        
                        
                        $
                        1,236,169Liabilities
      and Stockholder’s DeficitCurrent
      liabilities:Accounts
      payable and accrued liabilities
                        
                        $
                        7,354,544
                        
                        
                        $
                        7,604,988Deferred
      revenue
                        
                        
                        2,359,394
                        
                        
                        
                        2,777,604Derivative
      liabilities
                        
                        
                        433,669
                        
                        
                        
                        291,584Current
      portion-convertible debentures
                        
                        
                        40,000
                        
                        
                        
                        40,000Current
      portion-notes payable
                        
                        
                        2,516,157
                        
                        
                        
                        2,661,543Current
      portion-notes payable to related parties
                        
                        
                        1,057,714
                        
                        
                        
                        847,050Total
      current liabilities
                        
                        
                        13,761,478
                        
                        
                        
                        14,222,769Non-current
      portion – notes payable
                        
                        
                        1,742,996
                        
                        
                        
                        1,948,913Non-current
      portion – notes payable to related parties
                        
                        
                        38,542
                        
                        
                        
                        272,806Total
      liabilities
                        
                        
                        15,543,016
                        
                        
                        
                        16,444,488Stockholders’
      DeficitSeries
      A 4% Convertible Cumulative Preferred stock; $0.001 par value; 250,000
      shares authorized; 48,500 shares issued and
    outstanding;
                        
                        
                        49
                        
                        
                        
                        49Series
      B 10% Convertible CumulativePreferred stock; $0.001 par value; 375,000 shares authorized; 7,200
      shares issued and outstanding;
                        
                        
                        45,000
                        
                        
                        
                        45,000Series
      C 4% Convertible CumulativePreferred stock; $100 par value; 200,000 shares authorized; 50,000
      shares issued and outstanding;
                        
                        
                        350,000
                        
                        
                        
                        350,000Series
      D 15% Convertible CumulativePreferred stock; $0.001 par value; 300,000 shares authorized;
      25,000 shares issued and outstanding;
                        
                        
                        156,250
                        
                        
                        
                        156,250Common
      stock: $.00001 par value, 1,000,000,000 shares authorized 995,668,482 and
      991,485,149 shares issued and outstanding
                        
                        
                        9,957
                        
                        
                        
                        9,915Additional
      paid-in capital
                        
                        
                        28,035,764
                        
                        
                        
                        27,974,390Accumulated
      deficit
                        
                        
                        (43,660,257
                        )
                        
                        
                        (43,855,590
                        )Accumulated
      other comprehensive income – foreign currency
    translation
                        
                        
                        201,337
                        
                        
                        
                        111,667Total
      stockholders’ deficit
                        
                        
                        (14,861,900
                        )
                        
                        
                        (15,208,319
                        )Total
      liabilities and stockholders’ deficit
                        
                        $
                        681,116
                        
                        
                        $
                        1,236,169





See
accompanying notes to consolidated financial statements




F-3




VERTICAL
COMPUTER SYSTEMS, INC.





CONSOLIDATED
STATEMENTS OF OPERATIONS





Years
      ended December 31,2008
            
            
            2007RevenuesLicensing
      and software
            
            $
            2,955,219
            
            
            $
            149,766Software
      maintenance
            
            
            4,752,090
            
            
            
            4,915,329Consulting
      services
              Hosting
      and Software as a Service
            
            
            412,552
      91,441
            
            
            
            571,176
      80,477Other
            
            
            46,685
            
            
            
            178,978Total
      Revenues
            
            
            8,257,987
            
            
            
            5,895,726Cost
      of Revenues
            
            
            1,159,319
            
            
            
            1,298,071Gross
      Margin
            
            
            7,098,668
            
            
            
            4,597,655Selling
      , general and administrative expenses
            
            
            6,435,651
            
            
            
            5,339,777Depreciation
      and amortization
            
            
            57,775
            
            
            
            61,962Bad
      debt expense
            
            
            13,820
            
            
            
            181,029Operating
      expenses
            
            
            6,507,246
            
            
            
            5,582,768Operating
      income (loss)
            
            
            591,422
            
            
            
            (985,113
            )(Loss)
      gain on derivative
            
            
            (38,530
            )
            
            
            51,416Gain
      on settlement of debt
            
            
            -
            
            
            
            370,749Gain
      on settlement of trade payables
            
            
            514,518
            
            
            
            -Interest
      income
            
            
            2,558
            
            
            
            1,928Interest
      expense
            
            
            (874,635
            )
            
            
            (1,005,325
            )Net
      income (loss)
            
            
            195,333
            
            
            
            (1,566,345
            )Dividend
      applicable to preferred stock
            
            
            (588,000
            )
            
            
            (588,000
            )Net
      loss applicable to common stockholders
            
            $
            (392,667
            )
            
            $
            (2,154,345
            )Basic
      and diluted loss per share
            
            $
            (0.00
            )
            
            $
            (0.00
            )Basic
      and diluted weighted averageof common shares outstanding
            
            
            994,476,951
            
            
            
            990,378,049Comprehensive
      loss and its components consist
      of the following:Net
      income (loss)
            
            $
            195,333
            
            
            $
            (1,566,345
            )Translation
      adjustments
            
            
            89,670
            
            
            
            (10,276
            )Comprehensive
      income (loss)
            
            $
            285,003
            
            
            $
            (1,576,621
            )





See
accompanying notes to consolidated financial statements




F-4





VERTICAL
COMPUTER SYSTEMS, INC.


STATEMENTS
OF STOCKHOLDERS’ DEFICIT


TWO
YEARS ENDED DECEMBER 31, 2008





Additional
            
            
            
            
            
            OtherCommon
      Stock
            
            
            Preferred
      Stock
            
            
            Paid-in
            
            
            Accumulated
            
            
            ComprehensiveShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            Income
            
            
            TotalBalances
      at 12/31/06 (restated)
            
            
            996,926,857
            
            
            $
            9,970
            
            
            
            130,700
            
            
            $
            551,299
            
            
            $
            28,208,434
            
            
            $
            (42,289,245
            )
            
            $
            121,943
            
            
            $
            (13,397,599
            )Issuance
      of restricted stock for services, net
      of cancellations
            
            
            4,589,292
            
            
            
            45
            
            
            
            
            
            
            
            
            
            
            
            49,662
            
            
            
            
            
            
            
            
            
            
            
            49,707Shares
      loaned to the company by officer
            
            
            (13,000,000
            )
            
            
            (130
            )
            
            
            
            
            
            
            
            
            
            
            (342,870
            )
            
            
            
            
            
            
            
            
            
            
            (343,000
            )Shares
      issued to note holder for extension of maturity of debt
            
            
            2,000,000
            
            
            
            20
            
            
            
            
            
            
            
            
            
            
            
            44,980
            
            
            
            
            
            
            
            
            
            
            
            45,000Shares
      issued to note holder in consideration of note payable
            
            
            1,000,000
            
            
            
            10
            
            
            
            
            
            
            
            
            
            
            
            14,184
            
            
            
            
            
            
            
            
            
            
            
            14,194Abandoned
      shares returned
            
            
            (31,000
            )
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            -Other
      comprehensive income translation
      adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (10,276
            )
            
            
            (10,276
            )Net
      loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,566,345
            )
            
            
            
            
            
            
            (1,566,345
            )Balances
      12/31/07
            
            
            991,485,149
            
            
            $
            9,915
            
            
            
            130,700
            
            
            $
            551,299
            
            
            $
            27,974,390
            
            
            $
            (43,855,590
            )
            
            $
            111,667
            
            
            $
            (15,208,319
            )




See
accompanying notes to consolidated financial statements




F-5


VERTICAL
COMPUTER SYSTEMS, INC.
 STATEMENTS
OF STOCKHOLDERS’ DEFICIT
 TWO
YEARS ENDED DECEMBER 31, 2008


Additional
            
            
            
            
            
            OtherCommon
      Stock
            
            
            Preferred
      Stock
            
            
            Paid-in
            
            
            Accumulated
            
            
            ComprehensiveShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            Income
            
            
            TotalBalances
      at 12/31/07
            
            
            991,485,149
            
            
            $
            9,915
            
            
            
            130,700
            
            
            $
            551,299
            
            
            $
            27,974,390
            
            
            $
            (43,855,590
            )
            
            $
            111,667
            
            
            $
            (15,208,319
            )Issuance
      of restricted stock for services, net
      of cancellations
            
            
            3,183,333
            
            
            
            32
            
            
            
            
            
            
            
            
            
            
            
            45,134
            
            
            
            
            
            
            
            
            
            
            
            45,166Shares
      issued in association with renegotiated notes payable
            
            
            750,000
            
            
            
            7
            
            
            
            
            
            
            
            
            
            
            
            12,743
            
            
            
            
            
            
            
            
            
            
            
            12,750Shares
      issued for services
            
            
            250,000
            
            
            
            3
            
            
            
            
            
            
            
            
            
            
            
            3,497
            
            
            
            
            
            
            
            
            
            
            
            3,500Other
      comprehensive income translation
      adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            89,670
            
            
            
            89,670Net
      income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            195,333
            
            
            
            
            
            
            
            195,333Balances
      12/31/08
            
            
            995,668,482
            
            
            $
            9,957
            
            
            
            130,700
            
            
            $
            551,299
            
            
            $
            28,035,764
            
            
            $
            (43,660,257
            )
            
            $
            201,337
            
            
            $
            (14,861,900
            )




See
accompanying notes to consolidated financial statements




F-6




VERTICAL
COMPUTER SYSTEMS, INC.





CONSOLIDATED
STATEMENTS OF CASH FLOWS





Years
      ended December 31,2008
            
            
            2007Cash
      flows from operating activities:Net
      income (loss)
            
            $
            195,333
            
            
            $
            (1,566,345
            )Adjustments
      to reconcile net loss to net cash provided by operating
      activities:Depreciation
      and amortization
            
            
            57,775
            
            
            
            61,962Amortization
      of debt discount
            
            
            22,416
            
            
            
            96,867Stock
      compensation
            
            
            59,370
            
            
            
            49,707Shares
      issued for extension of debt
            
            
            12,750
            
            
            
            45,000Loss
      (gain) on derivatives
            
            
            38,530
            
            
            
            (51,416
            )Bad
      debt expense
            
            
            13,820
            
            
            
            181,029Loan
      origination costs included in notes payable
            
            
            -
            
            
            
            11,586Gain
      on settlement of trade payables
            
            
            (514,518
            )
            
            
            -Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            685,180
            
            
            
            (292,517
            )Receivable
      from officers and employees
            
            
            2,411
            
            
            
            86,010Prepaid
      expense and other assets
            
            
            (43,401
            )
            
            
            15,853Accounts
      payable and accrued liabilities
            
            
            333,923
            
            
            
            1,375,187Deferred
      revenue
            
            
            (418,210
            )
            
            
            118,082Net
      cash provided by operating activities
            
            
            445,379
            
            
            
            131,005Cash
      flows from investing activities:Proceeds
      from sale of investment
            
            
            -
            
            
            
            2,760Purchase
      of equipment
            
            
            (36,378
            )
            
            
            (59,059
            )Net
      cash used in investing activities
            
            
            (36,378
            )
            
            
            (56,299
            )Cash
      flows from financing activities:Payment
      of notes payable
            
            
            (411,477
            )
            
            
            (441,892
            )Proceeds
      from issuance of notes payable
            
            
            37,160
            
            
            
            425,400Net
      cash used in financing activities
            
            
            (374,317
            )
            
            
            (16,492
            )Effect
      of changes in exchange rates on cash
            
            
            89,670
            
            
            
            (10,276
            )Net
      increase in cash and cash equivalents,
            
            
            124,354
            
            
            
            47,938Cash
      and cash equivalents,beginning of
      period
            
            
            131,420
            
            
            
            83,482Cash
      and cash equivalents, end of period
            
            $
            255,774
            
            
            $
            131,420





See
accompanying notes to consolidated financial statements




F-7




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 administrative 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, EnFacet, Inc. (“ENF”),Globalfare.com, Inc.
(“GFI”),
Pointmail.com, Inc. (“PMI”), Vertical
Internet Solutions (“VIS”), and Vertical
Healthcare Solutions (“VHS”), all of which
are inactive; OptVision Research, Inc. (“OVR”),Taladin, Inc.
(“Taladin”),
Government Internet Systems, Inc. (“GIS”), 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 Statement of Position
(‘‘SOP’’) 97-2, ‘‘Software
Revenue Recognition,’’as amended by SOP 98-9, ‘‘Modification of SOP 97-2, Software
Revenue Recognition with Respect to Certain Transactions,’’Staff
Accounting Bulletin (‘‘SAB’’) No. 104, ‘‘Revenue Recognition,’’Emerging Issues Task Force (‘‘EITF’’) No. 00-21, ‘‘Revenue Arrangements with Multiple
Deliverable,’’and EITF No. 00-3 “Application of AICPA Statement of
Position 97-2 to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.”





In the
case of non-software arrangements, we apply EITF No. 00-21 and revenues related
to arrangements with 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 training and implementation services, to our
clients using a time and materials pricing methodology. The Company prices its
delivery of consulting services on a time and material 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-8


VERTICAL
COMPUTER SYSTEMS, INC.


Software
licenses are generally sold as part of a multiple element arrangement that may
include maintenance and, on a separate agreement, consulting services. The
consulting services are generally performed by the Company, but the customer can
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 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 term the
delivery method to give functionality to new customers utilizing this service as
Software as a Service (“SaaS”). Since the customer is not given contractual
right to take position of the software, the scope of SOP 97-2 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 this service. 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 desktop to access the 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 services are rendered each
month.





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 the convertible note (the host contract) includes the
right to convert the note by the holder, certain default redemption right
premiums and a change of control premium (payable in cash if a fundamental
change occurs). In accordance with FASB Statement No. 133, as amended,
Accounting for Derivative Instruments and Hedging Activities, these embedded
derivatives are marked-to-market each reporting period, with a corresponding
non-cash gain or loss charged to the current period. A warrant derivative
liability is determined in accordance with Emerging Issues Task Force Issue No.
00-19, “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company’s Own Stock.”  Based
on EITF00-19, warrants which are determined to be
classified as derivative liabilities are marked-to-market each reporting period,
with a corresponding non-cash gain or loss charged to the current period. The
practical effect of this has been that when our stock price increases so does
our derivative liability, resulting in a non-cash loss 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.




F-9


VERTICAL
COMPUTER SYSTEMS, INC.


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.





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





Statement
of Financial Accounting Standard (SFAS) No. 144, “Accounting for the Impairment
or Disposal of Long-Lived Assets” requires that long-lived assets be reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable through the estimated
undiscounted cash flows expected to result from the use and eventual disposition
of the assets. Whenever any such impairment exists, an impairment loss will be
recognized for the amount by which the carrying value exceeds the fair value.
During 2008 and 2007, 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 SFAS
123(R) 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.





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
$313,281 and $349,009 as of December 31, 2008 and 2007,
respectively.





Included
in our allowance for doubtful accounts, we have fully reserved for a $110,085
receivable related to an amount due from Ross (see the litigation section under
Note 13).




F-10


VERTICAL
COMPUTER SYSTEMS, INC.


Income
Taxes





We
provide for income taxes in accordance with Statements of Financial Accounting
Standards No. 109, “Accounting for Income Taxes.” SFAS 109 requires a
company to use 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. Under SFAS 109,
the effect on deferred income taxes of a change in tax rates is recognized in
income in the period that includes the enactment date.





On
July 13, 2006, the FASB issued Interpretation No. 48, “Accounting for
Uncertainty in Income Taxes—an Interpretation of FASB Statement 109.” FIN 48
prescribes 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 FIN 48, 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. We adopted FIN 48 on January 1, 2007. The adoption of FIN 48 did not
require any restatement of our financial statements.





Earnings
Per Share





Statement
of Financial Accounting Standards FASB No. 128, “Earnings per Share”, which
replaces the calculation of primary and fully diluted earnings (loss) per share
with basic and diluted earnings (loss) per share, is used to calculate earnings
per share. Basic earnings (loss) per share includes no dilution and is computed
by dividing income (loss) available to common stockholders by the weighted
average number of shares outstanding during the period. Diluted earnings (loss)
per share reflect the potential dilution of securities that could share in the
earnings of an entity, similar to fully diluted earnings (loss) per share. As of
December 31, 2008, all outstanding convertible debts and warrants and options
outstanding were excluded in the calculation of diluted loss per share because
they were 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. The fair value of the note payable to stockholder
cannot be estimated due to its related party nature.





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 Emerging Issues Task Force Issue No.
01-14 “Income Statement Characterization of Reimbursements Received for Out of
Pocket Expense Incurred.”





Recently
Issued Accounting Pronouncements




In June
2008, FASB ratified EITF No. 07-05, Determining Whether an Instrument
(or an Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF
07-05”).  EITF 07-05 provides that an entity should use a
two-step approach to evaluate whether an equity-linked financial instrument (or
embedded feature) is indexed to its own stock, including evaluating the
instrument’s contingent exercise and settlement provisions.  EITF
07-05 is effective January 1, 2009 and we are currently evaluating the impact of
the adoption of EITF 07-05 on our financial results.




F-11


VERTICAL
COMPUTER SYSTEMS, INC.


In May
2008, the FASB issued FASB Staff Position APB No. 14-1, “Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement)” (“APB 14-1”), which applies to convertible
debt that includes a cash conversion feature. Under APB 14-1, the liability and
equity components of convertible debt instruments within the scope of this
pronouncement shall be separately accounted for in a manner that will reflect
the entity’s nonconvertible debt borrowing rate when interest cost is recognized
in subsequent periods. APB 14-1 is effective for fiscal years beginning after
December 15, 2008. We are currently evaluating the impact of the adoption of
APB14-1 on our financial results.





In March
2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and
Hedging Activities. SFAS 161 is effective beginning January 1, 2009 and required
entities to provide expanded disclosures about derivative instruments and
hedging activities including (1) the ways in which an entity uses derivatives,
(2) the accounting for derivatives and hedging activities, and (3) the impact
that derivatives have (or could have) on an entity’s financial position,
financial performance, and cash flows. SFAS 161 requires expanded disclosures
and does not change the accounting for derivatives. We are currently evaluating
the impact of SFAS 161, but we do not expect the adoption of this standard to
have a material impact on our financial results.





In
February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial
Assets and Financial Liabilities Including an Amendment of FASB Statement No.
115 (SFAS 159), which permits entities to choose to measure many financial
instruments and certain other items at fair value (Fair Value Option). Election
of the Fair Value Option is made on an instrument-by-instrument basis and is
irrevocable. At the adoption date, unrealized gains and losses on financial
assets and liabilities for which the Fair Value Option has been elected would be
reported as a cumulative adjustment to beginning retained earnings. Following
the election of the Fair Value Option for certain financial assets and
liabilities, the Company would report unrealized gains and losses due to changes
in fair value in earnings at each subsequent reporting date. We adopted SFAS 159
effective January 1, 2008 which did not have a material impact on our operating
results, financial position or cash flows as we did not elect the Fair Value
Option for any of our financial assets or liabilities.





In
September 2006, the FASB issued SFAS 157, Fair Value Measurements(SFAS
157), which defines fair value, establishes a framework for measuring fair
value, and expands disclosures about fair value measurements. This pronouncement
applies to other standards that require or permit fair value measurements.
Accordingly, this statement does not require any new fair value measurement. The
provisions of SFAS 157 are effective for the Company on January 1, 2008. We
have partially adopted FAS 157 as of January 1, 2008 except for those
non-recurring measurements for non-financial assets and non-financial
liabilities subject to the partial deferral in FASB Statement of Position No.
157-2, Partial Deferral of the
Effective Date of Statement 157,” (“FSP 157-2”).  The adoption
of FAS 157 did not have an impact on our consolidated financial position or
operating results.   FSP 157-2 delays the effective date of FAS
157 from fiscal years beginning after November 15, 2007 to fiscal years
beginning after November 15, 2008 for all nonfinancial assets and nonfinancial
liabilities, except those that are recognized or disclosed at fair value in the
financial statements on a recurring basis (at least
annually).




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 2008 and 2007 have been
prepared assuming that we will continue as a going concern which contemplates
the realization of assets and the satisfaction of liabilities in the normal
course of business.





The
carrying amounts of assets and liabilities presented in the financial statements
do not purport to represent realizable or settlement values. We have suffered
significant recurring operating losses, used substantial funds in our
operations, and we need to raise additional funds to accomplish our objectives.
Negative stockholders’ equity at December 31, 2008 was $14.9 million.
Additionally, at December 31, 2008, we had negative working capital of
approximately $13.1 million (although it includes deferred revenue of
approximately $2.4 million) and defaulted on several of our debt obligations.
These conditions raise substantial doubt about our ability to continue as a
going concern.




F-12


VERTICAL
COMPUTER SYSTEMS, INC.


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 for our operations and to pay down our liabilities, as well as
finance our expansion plans consistent with the anticipated changes in
operations and infrastructure. The consolidated financial statements contain no
adjustment for the outcome of this uncertainty.





Note
3. Related Party Transactions





In March
2007, we borrowed $300,000 under a promissory note, bearing interest at 12% per
annum and due in September 2007, from Mr. Victor Weber. Mr. Victor Weber is a
Director and President of GIS and an equity owner of CWI.  In
connection with the note, MRC pledged 10,000,000 shares of our common
stock.   MRC is a corporation controlled by the W5 Family Trust.
Mr. Wade, our President and CEO, is the trustee of the W5 Family Trust. The note
is in default.





In April
2007, we issued Mr. Rossetti 3,000,000 shares of our common stock (at a fair
market value of $48,000) in connection with an agreement entered into concerning
loans and monies owed to Mr. Rossetti and Markquest, Inc. (“Markquest”). Mr.
Rossetti is Executive Vice-President of Government Affairs, Chairman, CEO and
Director of GIS, Director of NOW Solutions and an officer of
Markquest.





In April
2007, Luiz Valdetaro, on behalf of the Company, transferred 2,000,000 shares of
our common stock owned by him to Tara Financial in exchange for waiving the
defaults and extending the payment terms on notes payable to Tara of $438,795,
$350,560, $955,103 and $450,000. Mr. Valdetaro is our Chief Technology
Officer.  We agreed to reimburse Mr. Valdetaro with 2,000,000 shares
within one year and pay for any related costs. This obligation is currently owed
to Mr. Valdetaro.





In April
2007, Mr. Valdetaro, on behalf of the Company, transferred 1,000,000 shares of
our common stock owned by him to CCS in connection with a $40,000 loan
from CCS. Also in April 2007, in connection with the transfer of shares to
CCS, we entered into an indemnity and reimbursement agreement to reimburse Mr.
Valdetaro with 1,000,000 shares within one year and pay for all costs associated
with the transfer of shares to CCS.  This obligation is currently owed
to Mr. Valdetaro.





In April
2007, we and MRC entered into an indemnity and reimbursement agreement for
transfer and pledges of shares of our common stock. Pursuant to the agreement,
MRC loaned us 10,000,000 shares of our common stock in order for us to meet
current obligations concerning stock we have been obligated to issue and deliver
to various parties.





In
connection with a loan of 10,000,000 shares by MRC to us, we agreed to reimburse
MRC with up to 10,000,000 shares of our common stock within one year and pay for
all costs associated with such transfer. This obligation is currently owed to
MRC.





In July
2007, we borrowed $46,586 from Stephen Rossetti with interest of 10% per annum
and due on demand. In December 2007, we reached an agreement with Markquest and
Stephen Rossetti related to the $113,734 note issued in December 2006, the
$46,586 loan by Mr. Rossetti in July 2007, and $36,000 in fees owed to
Markquest.  The agreement canceled the $113,734 note and we issued a
$213,139 promissory note to Markquest, bearing interest at 10% per annum which
incorporated all of the amounts plus accrued interest. The note is to be paid in
monthly interest payments of accrued interest beginning in February 2008 and
monthly accrued interest and principal payments of $4,500 beginning in August
2008. Mr. Rossetti is Executive Vice-President of Government Affairs, Chairman,
CEO and Director of GIS, Director of NOW Solutions and an officer of Markquest.
We engaged Mr.
Rossetti (through Markquest) to provide consulting services regarding government
markets for our products in the United States.  As of December 31,
2008, we have an outstanding liability associated with a consulting agreement
with Markquest of $33,720.For additional details on the note,
please see “Notes Payable” under Note 7.





In August
2007, we borrowed $30,400 from Victor Weber with interest of 12% per annum and
principal and interest due on demand. Mr. Weber is the President and a Director
of GIS and a member of CWI.





In March
2008, MRC pledged 2,000,000 shares of our common stock to secure a $75,000
promissory note issued to Parker Mills. William Mills is a director of the
Company and also a partner of the law firm Parker Mills.   For
additional details on this note, please see “Notes Payable” under Note
7.




In March
2008, MRC pledged 3,000,000 shares of our common stock 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.  Of the 1,500,000 shares sold by the lender, we are obligated
to reimburse MRC with 1,309,983 shares within 1 year of the sales of the pledged
shares.  For additional details on this $96,946 note and the pledge of
stock, please see “Notes Payable” under Note 7.




F-13


VERTICAL
COMPUTER SYSTEMS, INC.


In May
2008, Robert Farias assigned the rights to a “point-of-sale” software technology
(“PASS”) to us
pursuant to an agreement, which was sublicensed to VHS. VHS and Farias-Jett, a
sole proprietorship of 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 and an
employment agreement with Mr. Farias.  Also in October 2008, NOW
Solutions entered into a hosted service provider agreement with Robert Farias
for emPath®.  Robert Farias is a director of InfiniTek Corporation
with whom the Company and its subsidiaries have entered into consulting and
referral agreements.  As of December 31, 2008, we have an outstanding
liability related to the consulting agreement of $28,000.





For
additional related party transactions subsequent to December 31, 2008, please
see “Subsequent Events” under Note 14.





Note
4. Fair value of financial instruments





Effective
January 1, 2008, we adopted the provisions of SFAS No. 157, Fair Value
measurements, for all financial instruments. SFAS 157 establishes a three-level
valuation hierarchy for disclosure of fair value measurements. The valuation
hierarchy is based upon the transparency of inputs to the valuation of an asset
or liability as of the measurement date. The three levels are defined as
follows:


●
              Level
      1 — Quoted prices (unadjusted) for identical assets or liabilities in
      active markets●
              Level
      2 — Quoted prices for similar assets or liabilities in active markets;
      quoted prices for identical or similar assets or liabilities in markets
      that are not active; and model-derived valuations whose inputs or
      significant value drivers are observable●
              Level
      3 — Significant inputs to the valuation model are
    unobservable




The
following describes the valuation methodologies we use to measure financial
instruments at fair value.





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 (see Note
3).  1,309,983 shares of this stock were sold to satisfy the debt owed
to the lender.  In connection with the pledge of stock, we signed an
agreement to replace these shares within one year. These loans were evaluated
under FAS 133 and EITF 00-19 and were determined under EITF 00-19 to have
characteristics of a liability and therefore derivative liabilities under FAS
133. Each reporting period, this derivative liability is marked-to-market with
the non-cash gain or loss recorded in the period as a gain or loss on
derivatives.





During
2007, two of our officers loaned a total of 13 million shares of unrestricted
stock to the Company (see Note 3). This stock was used to satisfy certain
obligations of the Company. In connection with the loans, the Company signed an
agreement to replace the shares within one year. These loans were evaluated
under FAS 133 and EITF 00-19 and were determined under EITF 00-19 to have
characteristics of a liability and therefore derivative liabilities under FAS
133. Each reporting period, this derivative liability is marked-to-market with
the non-cash gain or loss recorded in the period as a gain or loss on
derivatives.





During
2002 and 2003, we issued convertible debentures with a conversion features based
on the market value of the stock at the date of conversion. The conversion
features were evaluated under FAS 133 and EITF 00-19 and were determined under
EITF 00-19 to have characteristics of a liability and therefore a derivative
liability under FAS 133.  The conversion prices were variable which
caused the Company to conclude it was possible at some point in the future to
not have available the number of common shares required to share settle all
common stock equivalent instruments.  This caused warrants not subject
to FAS 123 and all other convertible debt to also be classified as derivative
liabilities under FAS 133. 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.





The
valuation of our embedded derivatives and warrant derivatives are determined
primarily by the Black-Scholes option pricing model and the Lattice model. As
such, our derivative liabilities have been classified as Level 2.




F-14


VERTICAL
COMPUTER SYSTEMS, INC.


The
following table provides a summary of the fair value of our derivative
liabilities measured on a recurring basis under SFAS 157:





Fair
      value measurements on a recurring basis
              December
      31, 2008Level
      1
            
            
            Level
      2
            
            
            Level
      3LiabilitiesWarrants
      and convertible debentures
            
            $
            -
            
            
            $
            111,694
            
            
            $
            -Stock
      derivative – 13,000,000 shares
            
            
            -
            
            
            
            292,500
            
            
            
            -Stock
      derivative – 1,309,983 shares
            
            
            -
            
            
            
            29,475
            
            
            
            -




Note
5. Property and Equipment





Property
and equipment consist of the following:




2008
            
            
            2007Equipment  (3-5
      year life)
            
            $
            952,403
            
            
            $
            923,060Leasehold
      improvements  (5 year life)
            
            
            87,712
            
            
            
            87,712Furniture
      and fixtures  (3-5 year life)
            
            
            43,260
            
            
            
            40,803Total
            
            
            1,083,375
            
            
            
            1,051,575Accumulated
      depreciation
            
            
            (1,024,064
            )
            
            
            (970,867
            )$
            59,311
            
            
            $
            80,708





Depreciation
expense for 2008 and 2007 was $57,775 and $61,962, respectively.





Note
6. Accounts Payable and Accrued Expenses





Accounts
payable and accrued liabilities consist of the following:




2008
            
            
            2007Accounts
      payable
            
            $
            2,004,944
            
            
            $
            2,441,543Accrued
      payroll
            
            
            2,153,786
            
            
            
            2,179,853Accrued
      payroll tax and penalties
            
            
            571,005
            
            
            
            769,374Accrued
      interest
            
            
            1,631,062
            
            
            
            1,294,281Accrued
      liabilities - Other
            
            
            993,747
            
            
            
            919,937$
            7,354,544
            
            
            $
            7,604,988





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 sales and other taxes,
and other accrued expenses. Accrued payroll tax and penalties relate to unpaid
payroll taxes, interest and penalties for prior years.




F-15


VERTICAL
COMPUTER SYSTEMS, INC.


Note
7. Notes Payable and Convertible Debts





December
      31
            
            
            December
      312008
            
            
            2007Note
      payable to Ross, unsecured and bearing interest at 10%. In September 2007,
      the court awarded a judgment against Ross that exceeds this amount. Refer
      to “Litigation” under Note 13.
            
            $
            750,000
            
            
            $
            750,000Note
      payable to a third-party lender, unsecured, bearing interest at 10%,
      principal and interest due on demand.
            
            
            31,859
            
            
            
            31,859Notes
      payable to a third-party, unsecured and non-interest
      bearing.
            
            
            42,000
            
            
            
            27,000Note
      payable bearing interest at 13% per annum and unsecured. The note is in
      default.
            
            
            161,504
            
            
            
            161,504Note
      payable of $50,000 to a third-party lender, bearing interest at 12% per
      annum. The note was in default. The note is secured by 3,000,000 common
      shares pledged by MRC. 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.
            
            
            -
            
            
            
            35,568Note
      payable of $50,000 to a third-party lender, bearing interest at 12% per
      annum. The note has been in default since April 1, 2003 and
      is unsecured.
            
            
            50,000
            
            
            
            50,000Note
      payable of $25,000 to a third-party lender, bearing interest at 12% per
      annum, secured by 10,000,000 common shares owned by MRC due in December
      2002. 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.  The note has been in default since April 1,
      2003.
            
            
            12,583
            
            
            
            12,583Note
      payable of $215,000 owed Victor Weber. The note bears interest at
      12%.  In connection with the note, MRC pledged 5,000,000 common
      shares. 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. Mr. Weber is the President and a Director of GIS, a subsidiary of
      the Company, and a member of CWI. The note is in
    default.
            
            
            215,000
            
            
            
            215,000Note
      payable of $25,000, bearing interest at 10% per annum, dated April 2003.
      The note is unsecured
      andin default.
            
            
            25,000
            
            
            
            25,000Note
      payable of $17,500, bearing interest at 10%. This note is unsecured
      and in default.
            
            
            11,000
            
            
            
            11,000Note
      payable of $17,500, bearing interest at 10%.  This note is unsecured
      and in default.
            
            
            11,000
            
            
            
            11,000Note
      payable of $10,000 bearing interest at 8% per annum, unsecured, and due on
      June 1, 2002. This note is in default.
            
            
            10,000
            
            
            
            10,000Note
      payable of $10,365 dated January 17, 2003 bearing interest at 10% per
      annum, due on December 5, 2003. This note is unsecured
      and in default.
            
            
            7,365
            
            
            
            7,365Note
      payable of $23,030 dated March 21, 2003 bearing interest at 12% per annum,
      due on April 21, 2004.  The note is unsecured
      andin default.
            
            
            23,030
            
            
            
            23,030Note
      payable of $60,000 dated November 5, 2003, bearing interest at 10% per
      annum, due on November 5, 2004. The note is secured by 4,000,000 shares of
      our common stock owned by MRC. 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. This note is
      in default.
            
            
            60,006
            
            
            
            60,006Note
      payable of $40,000 dated November 19, 2003, bearing interest at 10% per
      annum, and due on November 19, 2004. The note is secured by 3,000,000
      shares of our common stock owned by MRC. 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. This note is
      in default.
            
            
            40,000
            
            
            
            40,000




F-16


VERTICAL
COMPUTER SYSTEMS, INC.


Note
      payable of $5,000 to Mr. James Salz, unsecured, bearing interest at 10%
      per annum and due on demand. Mr. Salz is the Company’s corporate
      counsel.
            
            
            5,000
            
            
            
            5,000Note
      payable of $10,000 to Mr. James Salz, unsecured, bearing interest at 10%
      per annum. Mr. Salz is the Company’s corporate counsel. The note is in
      default.
            
            
            10,000
            
            
            
            10,000Note
      payable originally for $600,000 issued to Arglen Acquisitions,
      LLC.  In August 2005, the Company agreed to pay Arglen a total
      of $713,489 unsecured, which includes unpaid interest and various fees.
      Pursuant to the terms of the Payout Agreement, the Company is currently
      obligated to make monthly payments on the amount specified above of
      $25,000 or 10% of the Company's new sales, whichever is greater, until the
      remainder of the $713,489 is paid. For additional details, see Note 13,
      “Litigation” and Note 14, “Subsequent Events” for subsequent events
      concerning this note.
            
            
            -
            
            
            
            148,489Note
      payable of $75,000 bearing interest at 6% to the law firm Parker Mills
      dated October 2005. The note was due January 31, 2008 and shall be paid in
      equal monthly installments of $3,125, beginning February 1, 2006 for a
      period of 24 months. Bill Mills is a company director and also a partner
      of Parker Mills. After December 31, 2007, MRC agreed to pledge 2,000,000
      shares of our common stock to secure the note.  The note is in
      default.
            
            
            56,217
            
            
            
            58,318Note
      payable of $992,723 to Wolman Blair, PLLC dated November 30, 2005. The
      note is secured with the assets of NOW Solutions and bears a default
      interest rate of 18%. The note is payable as follows: equal monthly
      installments of $40,000, each, commencing March 1, 2006, and continuing on
      the first day of each month thereafter, until March 1, 2008, upon which
      date all outstanding principal and interest shall be due. In April 2007,
      the Company prevailed in a lawsuit against Ross and the Company is
      entitled to collect attorney fees from Ross, which will be applied to a
      portion of this note. For more details on legal proceedings between the
      Company, NOW Solutions and Ross, please refer to “Litigation” under Note
      13. The note was in default.  Please see “Subsequent Events”
      under Note 14 for subsequent events concerning this
    note.
            
            
            992,723
            
            
            
            992,723Note
      payable of $450,000 to Tara Financial, dated February 13, 2006. The note
      bears interest at 12% per annum. The note is currently payable as follows:
      (a) unpaid principal balance and interest payments of $7,000, beginning on
      January 1, 2007 and continuing through February 1, 2008; and (b) monthly
      payments increased to $12,700, beginning on March 1, 2008 and continuing
      until February 1, 2011. 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. For additional details on the
      Ross litigation, please see “Litigation” under Note 13. 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.  Please see “Subsequent Events” under Note 14 for
      subsequent events concerning this note.
            
            
            300,471
            
            
            
            384,914




F-17


VERTICAL
COMPUTER SYSTEMS, INC.




Note
      payable of $150,000 owed to SGP, dated February 13, 2006. The note bears
      interest at 12% per annum. The note is payable as follows: (a) unpaid
      principal balance and interest payments of $2,334, beginning on January 1,
      2007 and continuing through February 1, 2008; and (b) monthly payments
      increased $4,233, beginning on March 1, 2008 and continuing until March 1,
      2011. The $150,000 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. For additional details on the Ross
      litigation, please see “Litigation” under Note 13. The note is in
      default.  Please see “Subsequent Events” under Note 14 for
      subsequent events concerning this note.
            
            
            95,388
            
            
            
            121,062Note
      payable of $438,795 to Tara Financial, dated February 13, 2006. The note
      bears interest at 12% per annum. The note is payable as follows: unpaid
      principal balance and interest payments of $5,763, beginning on January 1,
      2007 and continuing until February 1, 2018. The new note is secured by an
      interest in certain technology developed by Adhesive Software and owned by
      the Company, commonly known as “SiteFlashTM”.
            
            
            391,143
            
            
            
            404,360Note
      payable of $359,560 to Tara Financial, dated February 13, 2006. The note
      bears interest at 12% per annum And is payable as follows: unpaid
      principal balance and interest of $4,723, beginning on January 1, 2007 and
      continuing until February 1, 2018 (the maturity date). The note is secured
      by all of the assets of NOW Solutions. This note payable also contains
      provisions requiring additional principal reductions in the event sales by
      NOW Solutions exceed certain financial thresholds.
            
            
            328,122
            
            
            
            335,666Note
      payable of $955,103 to Tara Financial, dated February 13, 2006. The note
      bears interest at 12% per annum, due in 2018 and payable in monthly
      installments of $12,544, beginning on January 1, 2007, and continuing
      until February 1, 2018 (the maturity date). The note is secured by all of
      the assets of NOW Solutions. This note payable also contains provisions
      requiring additional principal reductions in the event sales by NOW
      Solutions exceed certain financial thresholds.
            
            
            870,611
            
            
            
            890,543Note
      payable of $51,000 unsecured,dated September 2006 to a third party lender, bearing interest at
      10% per annum. In connection with the loan, the Company issued 1,000,000
      common shares (at a fair-market value of $18,000). The note is in
      default.
            
            
            15,605
            
            
            
            28,357Note
      payable of $200,000 issued to Mr. Weber, dated October 24, 2006. The note
      bears interest at 12% per annum. The Company shall pay accrued interest
      from the previous month on a monthly basis and make minimum payments on
      the balance of the note as follows: (a) $60,000 is due 6 months from the
      date of the note, (b) $30,000 is due 7 months from the date of the note,
      (c) $30,000 is due 8 months from the date of the note; (d) $30,000 is due
      9 months from the date of the note; and (e) all outstanding principal and
      interest then outstanding is due 11 months from the date of the note. In
      March 2007, the payment dates for this note were extended by sixty (60)
      days. The note may be paid from gross revenues derived from
      StatePointPlus® after the payment of license and exclusivity fees to
      TrueBaseline for StatePoinPlus® to the extent such funds become available.
      In connection with the note, MRC pledged 5,000,000 shares of common stock
      of the Company to secure the note to the Company. In addition, to secure
      the principal payments and interest payments on a $300,000 note issued to
      Mr. Weber and the interest payments on this note payable, MRC pledged
      10,000,000 shares of common stock of the Company. 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. Mr. Weber is the President
      and a Director of GIS and a member of CWI. The note is in
      default.
            
            
            200,000
            
            
            
            200,000




F-18


VERTICAL
COMPUTER SYSTEMS, INC.


Note
      payable of $100,000 issued by Taladin to Mr. Weber, dated October 27,
      2006. The note bears interest at 12% per annum. The note is secured by
      Taladin’s first lien position on the assets of NOW Solutions. Tara
      Financial, SGP and Mr. Weber share the first lien position, senior to all
      other security interests in the assets of NOW Solutions. The $100,000 note
      payable is currently payable as follows: (a) unpaid principal balance and
      interest payments of $1,556, beginning on January 1, 2007 and continuing
      through February 1, 2008; and (b) monthly payments increased $2,822,
      beginning on March 1, 2008 and continuing until March 1, 2011 (the “Maturity Date”). The $100,000 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. For
      additional details on the Ross litigation, please see “Litigation” under
      Note 13. Mr. Weber is the President and a Director of GIS and a member of
      CWI. Please see “Subsequent Events” under Note 14 for subsequent events
      concerning this note.
            
            
            60,630
            
            
            
            76,426Note
      payable of $300,000 due to Mr. Weber, bearing interest at 12% per annum
      and due in March 2008. The note may be paid from gross revenues derived
      from StatePointPlus® after the payment of license and exclusivity fees to
      TrueBaseline for StatePointPlus® to the extent such funds become
      available. In addition, to secure the principal payments and interest
      payments on this note and the interest payments on the $200,000 note
      issued to Mr. Weber, MRC pledged 10,000,000 shares of common stock of the
      Company. 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. Mr. Weber is the President and a Director of GIS and a member of
      CWI.
            
            
            300,000
            
            
            
            300,000Note
      payable of $40,000 due to CCS, bearing interest at 12% per annum, and due
      in July 2007. The Company or a party acting on the Company’s behalf is
      also obligated to arrange for a pledge of 1,000,000 shares of our common
      stock to secure the loan.  The note is in
      default.
            
            
            26,804
            
            
            
            40,000Note
      payable, dated August 2007, for $20,000 to a third party lender,
      unsecured, bearing interest at 12% per annum, due on
      demand.
            
            
            8,809
            
            
            
            20,000Note
      payable, dated August 2007, for $30,400,
      unsecured to Victor Weber, bearing interest at 12% per annum,
      due on demand. . Mr. Weber is the President and a Director of GIS and a
      member of CWI.
            
            
            30,400
            
            
            
            30,400Note
      payable, dated December 2007, for $213,139 unsecured,
      issued to Markquest, bearing interest at 10% per annum, payable with
      accrued interest beginning in February 2008 and monthly accrued interest
      and principal payments of $4,500 beginning in August 2008. This note
      consists of amounts due under a $113,734 note issued to Stephen Rossetti
      in December 2006, which was cancelled, and $46,586 owed under a loan by
      Mr. Rossetti in July 2007 and $36,000 in fees owed to Markquest, plus
      accrued interest. Mr. Rossetti is Executive Vice-President of Government
      Affairs, Chairman, CEO and Director of GIS, Director of NOW Solutions and
      an officer of Markquest.
            
            
            213,139
            
            
            
            213,139Total
      notes payable
            
            
            5,355,409
            
            
            
            5,730,312Current
      maturities
            
            
            (3,573,871
            )
            
            
            (3,508,593
            )Long-Term
      portion of notes payable
            
            $
            1,781,538
            
            
            $
            2,221,719




F-19


VERTICAL
COMPUTER SYSTEMS, INC.


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





Year
            
            
            Amount2009
            
            
            $
            3,573,8712010
            
            
            
            313,0402011
            
            
            
            188,2242012
            
            
            
            127,1152013
            
            
            
            143,9332014+
            
            
            
            1,009,226Total
      notes payable
            
            
            $
            5,355,409





Notes
payable to related parties at December 31, 2008 total $1,096,256.  The
current portion of notes payable to related parties totals $1,057,714 at
December 31, 2008.





Convertible
Debentures





Convertible
debentures consist of the following:





December
      31,
              2008
            
            
            December
      31,
              2007Convertible
      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.
            
            $
            10,000
            
            
            $
            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
            
            
            40,000
            
            
            
            40,000Current
      maturities
            
            
            40,000
            
            
            
            40,000Long-term
      portion of convertible debentures
            
            $
            -
            
            
            $
            -




Note
8. Income Taxes





We
account for income taxes in accordance with Statement of Financial Standards No.
109, “Accounting for Income Taxes,” which uses 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.




F-20


VERTICAL
COMPUTER SYSTEMS, INC.


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,
                2008
              
              
              December
      31,
                2007Net
      operating loss carry-forward
              
              $
              8,537,000
              
              
              $
              8,640,000Reserves
              
              
              674,500
              
              
              
              683,000Accrued
      vacation
              
              
              64,000
              
              
              
              70,000Deferred
      compensation
              
              
              770,000
              
              
              
              774,000Deferred
      revenue
              
              
              800,000
              
              
              
              782,000Derivatives
              
              
              173,000
              
              
              
              116,00011,018,000
              
              
              
              11,065,000Valuation
      allowance
              
              
              (11,018,000
              )
              
              
              (11,065,000
              )$
              -
              
              
              $
              -




At
December 31, 2008 and December 31, 2007, we had available net operating loss
carry-forwards of approximately $21.4 million for federal tax purposes and $15.4
million for state tax purposes, which expire in varying amounts through 2027 and
2012, respectively.





Note
9. Stockholders’ Equity




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
$.00001 per share, of which 995,668,482 and 991,485,149 were issued and
outstanding at December 31, 2008 and December 31, 2007,
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.  Shareholders 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,
2008 and December 31, 2007.  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 effecting the Series A Preferred Stock shareholders, 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, 2008 and December 31, 2007.  Holders of Series B
Preferred Stock are not entitled to vote on matters presented to the
shareholders, 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,
2008 and December 31, 2007.  Holders of Series C Preferred Stock are
not entitled to vote on matters presented to the shareholders, 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-21


VERTICAL
COMPUTER SYSTEMS, INC.


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, 2008 and December 31, 2007.  Holders of these shares are
not entitled to vote on matters presented to the shareholders, 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.  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.





2008





Common
Stock





During
2008, one of the officers of the Company pledged 3,000,000 shares of common
stock (through a company he controls) to secure the debt owed to a third party
lender (see Note 4). 1,309,983 shares of this stock were sold to satisfy the
debt owed to the lender.  In connection with the pledge of stock, the
Company signed an agreement to replace these shares within one
year.





During
2008, the Company granted 1,250,000 unregistered shares of common stock of the
company to employees and consultants of the Company and NOW Solutions pursuant
to restricted stock agreements. 250,000 of these unrestricted shares vested
immediately with the remaining shares vesting over a period from six months to
one year, as provided.





During
2008, 500,000 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.




During
2008, 3,183,333 unregistered shares of common stock issued to employees and
consultants of the Company and NOW Solutions vested resulting in stock
compensation expense of $45,166. These shares were issued pursuant to restricted
stock agreements executed in 2005-2008. As of December 31, 2008, there was
$71,186 of total unrecognized compensation costs related to these stock
awards.  These costs are expected to be recognized over a weighted
average period of .57 years.




Preferred
Stock





Although
no dividends have been declared, the cumulative total of preferred stock
dividends due to these shareholders upon declaration was $4,689,712 as of
December 31, 2008.





2007





Common
Stock





In April
2007, Luiz Valdetaro, on behalf of the Company, transferred 2,000,000
unrestricted shares of our common stock owned by Mr. Valdetaro to an officer of
Tara Financial in exchange for waiving the defaults and extending the payment
terms on several notes payable in the amounts of $438,795, $350,560, $955,103
and $450,000 issued to Tara Financial by the Company, NOW Solutions, and Taladin
in February 2006. Also in April 2007, in connection with the transfer, we
entered into an indemnity and reimbursement agreement to reimburse Mr. Valdetaro
with 2,000,000 shares within one year and pay for all costs associated with the
transfer of shares to Tara Financial and the reimbursement of shares to Mr.
Valdetaro. Mr. Valdetaro is the Chief Technology Officer of the Company. This
transaction was evaluated under FAS 133 and EITF 00-19 and was determined under
EITF 00-19 to have characteristics of a liability and therefore a derivative
liability under FAS 133.




F-22


VERTICAL
COMPUTER SYSTEMS, INC.


Also in
April 2007, Mr. Valdetaro, on behalf of the Company, transferred 1,000,000
unrestricted shares of common stock owned by Mr. Valdetaro to CCS in connection
with a $40,000 loan made by CCS to us. We are also obligated to arrange for a
pledge of 1,000,000 shares of common stock to secure the loan. Also in April
2007, in connection with the transfer of shares to CCS, the Company entered into
an indemnity and reimbursement agreement to reimburse Mr. Valdetaro with
1,000,000 shares within one year and pay for all costs associated with the
transfer of shares to CCS and the reimbursement of shares to Mr. Valdetaro. Mr.
Valdetaro is the Chief Technology Officer of the Company. This transaction was
evaluated under FAS 133 and EITF 00-19 and was determined under EITF 00-19 to
have characteristics of a liability and therefore a derivative liability under
FAS 133.





In April
2007, we entered into an indemnity and reimbursement agreement with MRC for the
transfer and pledge of shares of common stock of the Company. Pursuant to the
agreement, MRC loaned us 10,000,000 shares of common stock of the Company in
order for the Company to meet current obligations concerning stock the Company
has been obligated to issue and deliver. In connection with the loan of shares
to the Company, the Company agreed to reimburse MRC with up to 10,000,000 shares
of common stock of the Company and pay for all costs associated with such
transfer and the reimbursement of shares to MRC within one year. In addition, in
the event that any of the shares of common stock of the Company pledged by MRC
on behalf of the Company in connection with promissory notes issued by the
Company (or its subsidiaries, as applicable) are sold to cover a default under
the respective note, the Company agreed to reimburse MRC with a number of shares
equal to the number of shares sold to cover the default under the respective
note within 1 year, and to reimburse MRC for all costs associated with such
sales and the reimbursement of shares to MRC related to such sales. This
transaction was evaluated under FAS 133 and EITF 00-19 and was determined under
EITF 00-19 to have characteristics of a liability and therefore a derivative
liability under FAS 133.





During
2007, the Company granted 4,550,000 unregistered shares of our common stock to
employees and consultants of the Company and NOW Solutions pursuant to
restricted stock agreements. 500,000 of these unrestricted shares vested
immediately with the remaining shares vesting over a period from one to three
years, as provided.





During
2007, 1,369,042 unregistered shares of our common stock were cancelled pursuant
to restricted stock agreements between the Company and employees of NOW
Solutions. These shares were not vested at the date of cancellation and had
never been issued.





During
2007, 4,589,292 unregistered shares of our common stock issued to employees and
consultants of the Company and NOW Solutions vested. These shares were issued
pursuant to restricted stock agreements executed in 2005-2007.





Preferred
Stock





Although
no dividends have been declared, the cumulative total of preferred stock
dividends due to these shareholders upon declaration was $4,101,712 as of
December 31, 2007.





Note
10. 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. We can issue up to
50,000,000 shares. Most options issued are non-assignable, non-transferable,
vested on the date of grant, and expire three to five years from the date of
grant. The plan expires December 15, 2009.





2008





There
were no non-statutory stock options, incentive stock options or warrants granted
in 2008.





During
2008, warrants to purchase 6,250,000 common shares at $0.0075 to $0.01 per share
expired.





2007





There
were no non-statutory stock options, incentive stock options or warrants granted
in 2007.





During
2007, warrants to purchase 6,894,444 common shares at $0.01 to $0.10 per share
expired.




F-23


VERTICAL
COMPUTER SYSTEMS, INC.


Option
and warrant activities in 2007 and 2008 are summarized as follows:





Incentive
      Stock Options
            
            
            Non-Statutory
      Stock Options
            
            
            Warrants
            
            
            Weighted
      Average Exercise PriceOutstanding
      at 12/31/06
            
            
            2,500,000
            
            
            
            -
            
            
            
            28,394,444
            
            
            
            0.034Options/Warrants
      granted
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Options/Warrants
      exercised
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Options/Warrants
      expired/cancelled
            
            
            -
            
            
            
            -
            
            
            
            (6,894,444)
            
            
            
            0.092Outstanding
      at 12/31/07
            
            
            2,500,000
            
            
            
            -
            
            
            
            21,500,000
            
            
            
            0.017Options/Warrants
      granted
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Options/Warrants
      exercised
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Options/Warrants
      expired/cancelled
            
            
            -
            
            
            
            -
            
            
            
            (
      6,250,000
            )
            
            
            0.010Outstanding
      at 12/31/08
            
            
            2,500,000
            
            
            
            -
            
            
            
            15,250,000
            
            
            
            0.019




Information
relating to stock options/warrants at December 31, 2008, summarized by exercise
price, is as follows:





Warrants/Options
      Outstanding
            
            
            ExercisableWeightedAverage
            
            
            Weighted
            
            
            
            
            
            WeightedRemaining
            
            
            Average
            
            
            
            
            
            AverageNumber
            
            
            Contractual
            
            
            Exercise
            
            
            Number
            
            
            ExerciseExercise
      Price Per Share
            
            
            Outstanding
            
            
            Life
      (Months)
            
            
            Price
            
            
            Exercisable
            
            
            PriceIncentive
      Stock Options$0.01
      - $0.09
            
            
            
            2,500,000
            
            
            
            1.97
            
            
            $
            0.014
            
            
            
            2,500,000
            
            
            $
            0.0142,500,000
            
            
            
            1.97
            
            
            $
            0.014
            
            
            
            2,500,000
            
            
            $
            0.014Warrants$0.003
      - $0.100
            
            
            
            15,250,000
            
            
            
            1.51
            
            
            $
            0.020
            
            
            
            15,250,000
            
            
            $
            0.02015,250,000
            
            
            
            1.51
            
            
            $
            0.020
            
            
            
            15,250,000
            
            
            $
            0.020Grand
      total
            
            
            
            17,750,000
            
            
            
            1.58
            
            
            $
            0.019
            
            
            
            17,750,000
            
            
            $
            0.019




As of
December 31, 2008, the options and the warrants have an intrinsic value of
$90,000 and $75,000, respectively.




Note
11. Gain on Settlement of Current Liabilities





In June
2008, we recorded a gain on settlement of trade payables of $514,518 as a result
of our review of trade payables for those items in which the statute of
limitations has been exceeded and no legal liability exists.  Our
review included the determination of the dates of receipt of goods and services,
the last activity with the vendor, the applicable statute of limitations, and a
search for applicable liens or judgments.  For those payables that met
all the above requirements, we have removed the liability and recorded the gain
on settlement as required under SFAS 140 Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities as we are relieved from
these liabilities as a matter of law.





In
December 2007, we recorded a gain on settlement of debt related to agreements we
entered into with several vendors in 2001 whereby we issued these vendors shares
of our common stock. Under the terms of our agreement, these vendors agreed to
take our shares, sell such shares in the market, and apply the proceeds against
our indebtedness. The vendors also agreed to periodically update us on the
number of shares sold and the amount of any shortfall or overage, compared to
the original liability. For several years, many of these vendors updated us
periodically and we adjusted our liability accordingly. However, we did not
receive any update subsequent to 2004. From that time until 2007, these
liabilities were carried on our books as accrued liabilities.




F-24


VERTICAL
COMPUTER SYSTEMS, INC.


At the
end of 2007, management and corporate counsel of the company assessed these
liabilities and determined that the Company was judicially released from the
liability due to the expiration of the statutes of limitations. Generally, the
statute of limitation is four to six years, depending on State laws. Because
these vendors operated in multiple states, including states with a six-year
statute of limitations, we concluded that the first appropriate period to write
off this liability was 2007.





Note
12. Supplemental Disclosure of Cash Flow Information





Supplemental
cash flow information for the years ended December 31, 2008 and 2007 are as
follows:





December
      31,2008
                
                
                2007Cash
      paid for interest
                
                $
                537,854
                
                
                $
                440,565Cash
      paid for income taxes
                
                $
                -
                
                
                $
                -




Non-cash
activities for the years ended December 31, 2008 and 2007 were as
follows:





December
      31,2008
            
            
            2007Conversion
      of accounts payable and accrued liabilities to notes
    payable
            
            
            64,372
            
            
            
            52,811Shares
      loaned to the Company by stockholder to settle note
payable
            
            
            103,555
            
            
            
            343,000$
            167,927
            
            
            $
            395,811





Note
13. Commitments and Contingencies





Commitments





We lease
various office spaces which leases run from February 2004 through February 2010.
We have future minimum rental payments as follows:





Years
      ending December 31,
            
            Amount2009
            
            $
            109,8052010
            
            
            19,872Total
            
            $
            129,677





Rental
expense for the years ended December 31, 2008 and 2007 was $191,263 and
$211,564, respectively.





Commitments
Related to NOW Solutions





Effective
on October 1, 2005, NOW Solutions began paying the Company a monthly management
fee of $20,000, plus all direct costs associated with the NOW Solutions’
management and operations incurred by the Company.





Royalties





On
December 16, 1999, we acquired the software rights to Emily®, an XML
computer language, for $5,000. As part of the agreement, we agreed to pay
royalties every six months, based on the net sales of products sold that
were developed using the Emily® computer language. Royalties range from 1% to 5%
of net sales. There were no sales for the years ended December 31, 2008 and
2007, respectively.




F-25


VERTICAL
COMPUTER SYSTEMS, INC.


Payroll
Taxes





We have
filed all payroll tax returns but have not made all related tax payments since
2003. We have accrued the payroll tax payments and approximately $125,000 for
any related penalties and interest that may be assessed by the Internal Revenue
Service. Management believes that the $125,000 is sufficient to cover the
penalties and interest that may be assessed. NOW Solutions has filed all payroll
tax returns and made all payroll tax payments. For Vertical Computer Systems,
the IRS has a claim for unpaid payroll taxes of $313,839 from
2001-2005.  We have paid $200,000 of the IRS claim during
2008.  As of December 31, 2008, the total payroll taxes, penalties and
interest due for VCSY was $177,093. For additional details, please see
“Litigation” below.





Litigation





We are
involved in the following ongoing legal matters:




In
February 2003, we sued Ross Systems Inc. (“Ross”), Arglen,
Tinley, and Gyselen.  We then stopped payments on the remaining
$750,000 note that was due in February 2003 in connection with the acquisition
of certain assets of Ross.  The actions against Tinley, Arglen and
Gyselen were dismissed or settled in December 2003. In September 2007, the court
awarded us a judgment of $3,151,216.  In November 2007, Ross gave
notice of its intention to appeal the decision and posted a bond in the amount
of the judgment.  The $750,000 note payable and accrued interest are
still shown on our books until Ross’s appeal is settled.  Please see
Note 14 for Subsequent Event on the status of the appeal and our collection
efforts on the judgment award.





In August
2004, Arglen obtained a default judgment in a court for a past due $600,000
promissory note, plus fees and interest.  We agreed to pay Arglen
$713,489.  As of December 31, 2008, we had paid all principal due
under the payout agreement.  Please see Note 14 for Subsequent Event
on the settlement of the dispute with Arglen regarding interest on the above
payout agreement.





The IRS
has a claim for unpaid payroll taxes of $313,839 from 2001-2005. On March 9,
2007, we filed an appeal with the United States Tax Court, seeking an
installment payout agreement. .  The Tax Court case has been resolved
and the IRS position was sustained.   We have paid $200,000 of the IRS
claim during 2008.  As of December 31, 2008, the total payroll taxes,
penalties and interest due was $177,093.





On April 18, 2007, we filed suit for
patent infringement against Microsoft Corp. in the United States District Court
for the Eastern District of Texas. We claimed that the Microsoft .Net System
infringes U.S. Patent No. 6,826,744.  In July 2008, we settled our
patent infringement claim against Microsoft Corporation.  Pursuant to
the confidential settlement agreement, we granted to Microsoft a non-exclusive,
fully paid-up license under the patent which was the subject of the legal
proceeding. The proceeds from the license was
included in revenue.




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
14. Subsequent Events





Arglen
Litigation





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, the Company agreed to pay Arglen $60,000 in $10,000 installments
over a six month period.  We have the amount accrued in interest on
the original note payable as of December 31, 2008.





Ross
Litigation





In
February 2009, the Appellate Division of the Supreme Court of New York, First
Department, affirmed the trial court’s judgment entered on October 11, 2007 for
Now Solutions, our wholly-owned subsidiary in the action of Ross Systems, Inc.
v. NOW Solutions, Inc.





On March
24, 2009, NOW Solutions, Inc. applied for and received the cash deposit of Ross
Systems, Inc. (“Ross”) that was held
by the New York City Department of Finance.  These funds had been
deposited by Ross to stay enforcement of the judgment awarded to NOW Solutions
in the action of Ross Systems, Inc. v. NOW Solutions, Inc.  The stay
was vacated by operation of law after the judgment was affirmed by the New York,
Appellate Division on February 11, 2009.   As of March 24, 2009,
the cash deposit of $3,151,216 had accrued $133,424 in interest since the
judgment was entered on October 11, 2007.




F-26


VERTICAL
COMPUTER SYSTEMS, INC.


The net
proceeds of the cash deposit collected by Now Solutions after deducting
$2,345,502 in attorney’s fees (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 cash deposit, was $873,444. NOW Solutions is
entitled to an additional amount of approximately $335,000 plus accrued interest
that remains unsatisfied on the judgment, In addition, NOW Solutions intends to
move for an award of additional attorney fees and expenses incurred in defense
of the appeal.





In the
above action, Ross has moved before the Appellate Division of the Supreme Court,
First Department, for re-argument of the appeal, or in the
alternative, for leave to appeal the Court of Appeals.  This motion was
submitted on April 9, 2009 and a decision is pending.





Notes
Payable





For the
period from January 1, 2009 to April 15, 2009, the Company made payments of
$325,659 that NOW Solutions was obligated to pay toward the outstanding balances
on certain notes payable issued by Taladin from the net proceeds collected on
the judgment awarded to NOW Solutions in the Ross litigation (after deducting
attorney’s fees and costs).





Stock
Holders Equity, Stock Options and Warrants





On
February 11, 2009, Robert Farias 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.





For the
period from January 1, 2009 to April 15, 2009, 1,433,333 unregistered shares of
our common stock vested. These shares were issued pursuant to restricted stock
agreements with employees of the Company and NOW Solutions executed in 2006 and
2007.





As of the
Date of this Report for the year ended December 31, 2008, the Company has also
determined that it currently has (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:





998,935,151
            
            Common
      Stock Issued250,000
            
            Common
      Shares that may be purchased from outstanding Warrants15,000,000
            
            Common
      Shares to be issued pursuant to exercised Warrants2,500,000
            
            Common
      Shares convertible from Outstanding Options24,250,000
            
            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)20,000,000
            
            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 Shares13,000,000
            
            Common
      Shares that the Company has agreed to issue within 1 year to an employee
      of the Company and an entity beneficially owned by an Executive of the
      Company pursuant to agreements1,075,367,108
            
            Total
      Common Shares Outstanding and Accounted
  For/Reserved





In
addition, the Company has $40,000 in outstanding debentures that it has issued
to third parties.





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 75,000,000 shares if all of the financial instruments described
in the table above were exercised or converted into shares of common stock
(excluding the $40,000 of outstanding debentures noted above).




F-27