See accompanying notes to the unaudited consolidated financial statements.

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Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

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See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

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Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

December 31, 2015 through September 30, 2016

(Unaudited)

Consolidated Statements of Cash Flows

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Vertical Computer Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

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VERTICAL COMPUTER SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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

The accompanying unaudited interim consolidated financial statements of Vertical Computer Systems, Inc. (‘we”, “our”, the “Company” or “Vertical”) have been prepared in accordance with accounting principles generally accepted in the United States of America and rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Vertical’s annual report on Form 10-K for the year ended December 31, 2015.2016. The consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “our”, “we”, the “Company” or “VCSY”, as applicable). Vertical’s subsidiaries which currently maintain daily business operations are NOW Solutions, a 75% owned subsidiary, and SnAPPnet, Inc. (“SnAPPnet”), an 80% owned subsidiary of Vertical. Vertical’s subsidiaries which have minimal operations are Vertical do Brasil, Taladin, Inc. (“Taladin"Taladin”), and Vertical Healthcare Solutions, Inc. (“VHS”), each of which a wholly-owned subsidiary of Vertical, as well as Priority Time Systems, Inc. (“Priority Time”) a 70% owned subsidiary, Ploinks, Inc. (“Ploinks”) (formerly, OptVision Research, Inc.), a 93%91% owned subsidiary and Government Internet Systems, Inc. (“GIS”), an 84.5% owned subsidiary. Vertical’s subsidiaries which are inactive include EnFacet, Inc. (“ENF”), Globalfare.com, Inc. (“GFI”), Pointmail.com, Inc. and Vertical Internet Solutions, Inc. (“VIS”), each of which is a wholly-owned subsidiary of Vertical.

In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the consolidated financial statements which would substantially duplicate the disclosure contained in the audited financial statements as reported in the 20152016 annual report on Form 10-K have been omitted.

Earnings per share

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

For the ninethree months ended September 30,March 31, 2017 and 2016, and 2015, common stock equivalents related to the convertible debentures, convertible debt, and preferred stock and stock derivative liabilityliabilities were not included in the calculation of the diluted earnings per share as their effect would be anti-dilutive.

Reclassifications

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

Capitalized Software Costs

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

During the ninethree months ended September 30,March 31, 2017 and 2016, the Company capitalized an aggregate of $246,184 related to software development$0 and wrote off $1,421,155 of impaired software development costs.

During the nine months ended September 30, 2015, the Company capitalized an aggregate of $489,148$143,927 respectively, related to software development.

Recently Issued Accounting Pronouncements

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial position, operations or cash flows.

Note 2. Going Concern

The accompanying unaudited consolidated financial statements for the ninethree months ended September 30,March 31, 2017 and 2016 and 2015 have been prepared assuming that we will continue as a going concern, and accordingly realize our assets and satisfy our liabilities in the normal course of business.

The carrying amounts of assets and liabilities presented in the consolidated financial statements do not purport to represent realizable or settlement values. As of September 30, 2016,March 31, 2017, we had negative working capital of approximately $19.6$21.2 million and defaulted on severalsubstantially all of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

Note 3. Notes Payable

The following table reflects our third-partythird party debt activity, including our convertible debt, for the ninethree months ended September 30, 2016:

March 31, 2017:

During the nine months ended September 30, 2016, the Company entered into subscription agreements under which third party subscribers purchased 750 shares of Series A 4% Convertible Cumulative Preferred Stock of the Company (“VCSY Series A Preferred Stock”) for $150,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 1,500,000 shares of common stock of the Company with the Rule 144 restrictive legend, 75,000 shares of common stock of Ploinks, Inc., 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $24,810. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company’s common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $99,238. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $24,861. The fair market value of all warrants issued to the subscribers was $1,091 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the ninethree months ended September 30, 2016, $74,000March 31, 2017, $10,109 of principal, interest and legal fees under a convertible note issued in the principal amount of $80,000 werewas converted into 5,311,465 unrestricted723,089 common shares.

For additional transactions after March 31, 2017 concerning the amendment of the $80,000 convertible note, conversion of the outstanding balance of that note into common shares and the extension of the Company.due date of other convertible debentures, please see “Subsequent Events” in Note 9.

Lakeshore Financing

On January 9, 2013, NOW Solutions completed a financing transaction in the aggregate amount of $1,759,150, which amount was utilized to pay off existing indebtedness of the Company and NOW Solutions to Tara Financial Services and Robert Farias, a former employee of the Company, and all security interests granted to Tara Financial Services and Mr. Farias were cancelled.

In connection with this financing, the Company and several of its subsidiaries entered into a loan agreement (the “Loan Agreement”), dated as of January 9, 2013 with Lakeshore Investment, LLC (“Lakeshore”) under which NOW Solutions issued a secured 10-year promissory note (the “Lakeshore Note”) bearing interest at 11% per annum to Lakeshore in the amount of $1,759,150 payable in equal monthly installments of $24,232 until January 31, 2022. Upon the payment of any prepayment principal amounts, the monthly installment payments shall be proportionately adjusted proportionately on an amortized rata basis. 

The Lakeshore Note is secured by the assets of the Company’s subsidiaries, NOW Solutions, Priority Time, SnAPPnet, Inc. (“SnAPPnet”) and the Company’s SiteFlash™ technology and cross-collateralized. Upon the aggregate principal payment of $290,000 toward the Lakeshore Note, the Company has the option to have Lakeshore release either the Priority Time collateral or the SiteFlash™ collateral. Upon payment of the aggregate principal of $590,000 toward the Lakeshore Note, Lakeshore shall release either the Priority Time collateral or the SiteFlash™ collateral (whichever is remaining). Upon payment of the aggregate principal of $890,000 toward the Lakeshore Note, Lakeshore shall release the SnAPPnet collateral and upon full payment of the Lakeshore Note, Lakeshore shall release the NOW Solutions collateral.

As additional consideration for the loan, the Company granted a 5% interest in Net Claim Proceeds (less any attorney’s fees and direct costs) from any litigation or settlement proceeds related to the SiteFlash™ technology to Lakeshore which was increased to 8% under an amendment to the Loan Agreement in 2013. In addition, until the Note is paid in full, NOW Solutions agreed to pay a Lakeshore royalty of 6% of its annual gross revenues in excess of $5 million dollars up to a maximum of $1,759,150. Management has estimated the fair value of the royalty to be nominal as of its issuance date and no royalty was owed as of September 30, 2015 or December 31, 2014.

In December 2014, the Company and Lakeshore entered into an amendment of the Lakeshore Note and the Loan Agreement. Under the terms of the amendment, NOW Solutions agreed to make $2,500 weekly advance payments to Lakeshore to be applied to the 25% dividend of NOW Solutions’ net income after taxes in connection with Lakeshore’s 25% minority ownership interest in NOW Solutions. Within 10 business days after the Company files its periodic reports with the SEC, NOW Solutions is required towill also make quarterly payment advances to Lakeshore based on 60% of Lakeshore’s 25% share of NOW Solutions estimated quarterly net income after taxes, less any weekly payment advances received by Lakeshore during the then-applicable quarter and the weekly $2,500 payments shall be increased or decreased based only upon any increases or decreases of maintenance and cloud-based offering fees during the then-completed quarter (but will not decrease below a minimum of $2,500 per week). NOW Solutions shall pay Lakeshore the balance of Lakeshore’s 25% of NOW’s yearly net income after taxes (less any advances) within 10 business days after the Company files it annual 10-K report with the SEC and any payments in excess of Lakeshore’s 25% of NOW yearly profit shall be credited towards future weekly advance payments. The Company also agreed to pay attorney fees of $40,000 and paid fees of $80,000 to a former consultant and employee of the Company who is a member of Lakeshore. In consideration of the extension to cure the default under the Lakeshore Note and the Loan Agreement, the Company transferred a 20% ownership interest in two subsidiaries to Lakeshore: Priority Time Systems, Inc., a 90% owned subsidiary of VCSY, and in SnAPPnet, Inc., a 100% owned subsidiary of VCSY, to Lakeshore.Inc.. This resulted in an additional non-controlling interest recognized in the equity of the Company of $391,920 and $99,210 for Priority Time Systems, Inc. and SnAPPnet, Inc., respectively, during 2014. The Company had an option to buy back Lakeshore’s ownership interest in NOW Solutions, Priority Time and SnAPPnet, Inc. (which expired on January 31, 2015).

In July 2015, we entered into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the amendment, the Company issued 13,000,000 common shares with the Rule 144 restrictive legend, resulting in a forbearance loss of $455,000 and Ploinks agreed to issue 3,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares was determined to be nominal. Also in July 2015, the Company further amended the Lakeshore Note and the Loan Agreement with Lakeshore. Pursuant to this Agreement, the Company issued 2,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a forbearance loss of $54,200 and paid $15,000 to Lakeshore as forbearance fees.

In August 2015, we entered into an agreement with Lakeshore to amend the terms of the Loan Agreement and the Lakeshore Note. Under the terms of the amendment, the Company issued 7,000,000 shares of its common stock with the Rule 144 restrictive legend resulting in a forbearance loss of $175,700 and Ploinks agreed to issue 2,000,000 common shares of its stock to Lakeshore. The fair value of the Ploinks shares was determined to be nominal.

In January 2016,Under the August 2015 agreement, the Company re-amortizedalso agreed to make a $500,000 payment for amounts due to Lakeshore under the Lakeshore Note at 11% interest per annum pursuant toand the amendmentLoan Agreement. In the event that the Company did not make the Lakeshore $500,000 payment on or before August 21, 2015, then Lakeshore in lieu of the Loan Agreement$500,000 payment, would obtain a purchase option (the “2015 Purchase Option”) to purchase an additional 250 shares of NOW Solutions common stock for a total purchase price of $950,000. In addition, since the Company did not make the $500,000 payment to Lakeshore on or before August 21, 2015, no further payment on the Note was due until January 1, 2016 at which time the Note plus all accrued interest were recalculated and the Note executed on August 6, 2015.  The Company has made all monthly installment payments towardswas re-amortized under the same interest rate and terms as the Note and the $2,500 weekly payments which will be applied toward Lakeshore’s share of dividends through thematurity date of this Report.the Note was extended 10 years from January 1, 2016.

The Lakeshore note is currently in default and the Company is currently in discussions with Lakeshoreevaluating solutions to resolve all outstanding issues including the reconciliation payment due on January 15, 2016.with Lakeshore.

During the ninethree months ended September 30, 2016, NOW Solutions, a subsidiary ofMarch 31, 2017, the Company, paidthrough its subsidiary, accrued dividends to Lakeshore of $222,500.$32,500.

Note 4. Derivative LiabilityLiabilities and Fair Value Measurements

Derivative liabilityliabilities

During 2016, certain notes issued byAs of March 31, 2017, the Company becamehas convertible notes and qualified as derivative liabilities under ASC 815. In addition, the outstanding common stock warrants associated with the notes became tainted and were required to be accounted forthat qualify as derivative liabilities under ASC 815.

As of September 30, 2016,March 31, 2017, the aggregate fair value of the outstanding derivative liabilities was $425,740.$685,221. For the ninethree months ended September 30, 2016,March 31, 2017, the net gain on the change in fair value of derivative liabilities was $49,291.$339,467.

The Company estimated the fair value of the derivative liabilities using the Black-Scholes option pricing model and the following key assumptions during 2016:2017:

Fair value measurements

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

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

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

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

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

The following table provides a summary of the fair value of our derivative liabilities as of September 30, 2016March 31, 2017 and December 31, 2015:2016:

The estimated fair value of short-term financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities and deferred revenue approximates their carrying value due to their short-term nature. The Company uses Level 3 inputs to estimate the fair value of its derivative liabilities.

The below table presents the change in the fair value of the derivative liabilities during the ninethree months ended September 30, 2016:March 31, 2017:

Note 5. Common and Preferred Stock Transactions

In January 2016, the Company granted 2,000,000 unregistered shares of its common stock with the Rule 144 restrictive legend and 200,000 shares of Ploinks common stock to a consultant of the Company and its subsidiaries pursuant to a consulting agreement with the Company. The aggregate fair market value of the 2,000,000 share award was determined to be $44,000. In addition, the Company agreed to issue up to 15,000,000 common shares of the Company and 1,500,000 shares of Ploinks common stock pursuant to restricted performance stock agreements with the consultant. These shares may vest over a term of 3 years and are based upon the Consultant achieving certain performance criteria.

In March 2016, the Company cancelled 1,000,000 unregistered shares of its common stock issued during 2015 to a third party lender under an agreement to amend certain promissory notes issued by the Company and NOW Solutions in the aggregate principal amount of $715,000. Under the amendment, the Company agreed to make $22,000 monthly payments and an additional $10,000 penalty if such monthly payment is not timely made. The cancellation resulted in the reversal of forbearance fees expense of $28,900 duringDuring the three months ended March 31, 2016.

In March 2016,2017, the Company issued 10,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to its consolidated subsidiary Ploinks. These shares are held in treasury.  In exchange, Ploinks issued 5,000,000 of itsgranted 3,000,000 VCSY common shares to the Company.

In April 2016, the Company and a third party noteholder entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend in exchange for the cancellation of $130,000 in principal owed under a note payable issued by NOW Solutions with a principal amount of $213,139. The fair market value of the shares was $92,500. A gain on debt extinguishment of $37,500 was recorded for the period ended September 30, 2016.

In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed for services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

In May 2016, the Company and a third party entered into an agreement under which the Company issued 1,500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to the third party in lieu of paying $35,969 in fees, expenses, and interest owed to the third party for services rendered to the Company and its subsidiaries.  The fair market value of the shares issued was $37,500.  A loss on debt extinguishment of $1,531 was recorded for the period ended September 30, 2016.

In May 2016, the Company issued 500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to a third party for services rendered. The fair market value of the shares was $11,550 and was recorded as legal fees for the period ended September 30, 2016.

Also in May 2016, the Company issued 500,000 shares of the Company’s common stock with the Rule 144 restrictive legend to another third party for services rendered. The fair market value of the shares was $11,000 and was recorded as tax consulting fees for the period ended September 30, 2016.

In June 2016, theCompany granted 1,500,000 unregistered shares of the Company’s common stock with the Rule 144 restrictive legend to a consultant of the Company and its subsidiaries pursuant to a restricted stock agreement with the Company under which the shares vest in equal installments over a 6 monthaward to 30-month period. The fair market value of the shares was $33,750 and is being amortized to expense over the vesting period. For the period ended September 30, 2016, $15,288 was amortized to stock compensation expense.

In June 2016, the Company granted 3,500,000 unregistered shares of the Company’s common stock with the Rule 144 restrictive legend to employees and a formeran employee of the Company and its subsidiaries pursuant to an amended agreement to defer payroll. For additional details, please see “Related Party Transactions” in Note 6. The(at a fair market value of the shares was $78,750.$72,000).

During the ninethree months ended September 30, 2016, the Company issued convertible debentures in the aggregate principal amount of $665,000 to various third party lenders for loans made to the Company in the same amount. The debts accrue interest at 10% per annum and are due one year from the date of issuance. Beginning six months after issuance of the respective debentures and provided that the lowest closing price of the common stock for each of the 5 trading days immediately preceding the conversion date has been $0.03 or higher, the holder of the respective debenture may convert the debenture into shares of common stock at a price per share of 80% of the average per share price of the Company’s common stock for the 5 trading days preceding the notice of conversion date using the 3 lowest closing prices. In connection with the loans, the Company also issued a total of 6,650,000 shares of common stock of the Company to the lenders with the Rule 144 restrictive legend and 3 year warrants under which each lender may purchase in aggregate a total of 6,650,000 unregistered shares of common stock of the Company at a purchase price of $0.10 per share. In connection with the issuance of shares of common stock and warrants, the Company recorded a discount of $385,779 against the face value of the loans based on the relative fair market value of the common stock and full fair market value of the warrants. The warrants are accounted for as derivative liabilities. The discount is being amortized over twelve months and $141,885 of amortization expense was recognized for the nine months ended September 30, 2016.

During the nine months ended, September 30, 2016, $74,000March 31, 2017, $10,109 of principal, interest and legal fees under a convertible note issued in the principal amount of $80,000 werewas converted into 5,311,465 unrestricted723,089 common shares.

During the three months ended March 31, 2017, 550,000 VCSY common shares vested under restricted stock agreements to employees and a consultant of the Company.

During the ninethree months ended September 30, 2016, the Company entered into subscription agreements under which third party subscribers purchased 750March 31, 2017, 200,001 shares of VCSY Series A Preferred Stock for $150,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 1,500,000 shares of common stock of the Company with the Rule 144 restrictive legend, 75,000 shares of common stock of Ploinks, Inc., 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.10 per share and 2 year warrants under which the subscribers may purchase an aggregate total of 112,500 unregistered shares of common stock of the Company at a purchase price of $0.20 per share. The allocated fair market value of the VCSY Series A Preferred Stock issued to the subscribers was $24,810. Each share of VCSY Series A Preferred Stock is convertible into 500 shares of the Company’s common stock. The allocated fair market value of all common shares of the Company issued to the subscribers was $99,238. The allocated fair market value of all common shares of Ploinks, Inc. issued to the subscribers was $8,100. The fair market value of all warrants issued to the subscribers was $24,861 (which was calculated using the Black-Sholes model). The warrants were accounted for as derivative liabilities (see Note 4).

During the nine months ended September 30, 2016, 1,175,000 VCSY common shares issued under restricted stock agreements to consultants and employees of the Company vested.

During the nine months ended September 30, 2016, theCompany cancelled 200,000 previously awarded but unvested unregistered shares of the Company’s common stock issued to an employee of the Company when the employee resigned. This resulted in the reversal of previously recognized compensation expense of $1,145 during the nine months ended September 30, 2016.

Stock compensation expense for the amortization of restricted stock awards for Ploinks, Inc. and VCSY stock was $429,577$35,167 for the ninethree months ended September 30, 2016.March 31, 2017. As of September 30, 2016,March 31, 2017, there were 19,305,00011,575,000 shares of unvested stock compensation awards to employees and 16,600,00016,000,000 shares of unvested stock compensation awards to non-employeesnon-employees.

Stock compensation expense for VCSY stock. Asthe amortization of September 30, 2016, there were 5,225,999 shares of unvestedsubsidiary’s restricted stock compensation awards to employeeswas $46,342 for Ploinks, Inc. stock.

the three months ended March 31, 2017.

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

For additional transactions after March 31, 2017 concerning stock transactions, please see “Subsequent Events” in Note 9.

Note 6. Option and Warrant Activity

Option and warrant activities during the ninethree months ended September 30, 2016March 31, 2017 is summarized as follows:

The weighted average remaining life of the outstanding warrants as of September 30, 2016March 31, 2017 was 2.295.2.23. The intrinsic value of the exercisable warrants as of September 30, 2016March 31, 2017 was $.022.$.0195.

Note 6.7. Related Party Transactions.

The following table reflects our related party debt activity, including our convertible debt, for the ninethree months ended September 30, 2016:March 31, 2017:

As of September 30, 2016,March 31, 2017 and December 31, 2015,2016, the Company had accounts payable to employees for unreimbursed expenses and related party contractors in an aggregate amount of $140,877$137,532 and $108,379,$139,546, respectively. The payables are unsecured, non-interest bearing and due on demand.

In May 2016, the Company and William Mills entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend to Mr. Mills in exchange for the cancellation of $100,000 in fees owed services rendered by Mr. Mills as a Director and Secretary of the Company. The fair market value of the shares was $100,000. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

On June 30, 2016, the Company amended an agreement (originally entered into in July 2010) with certain former and current employees of the Company, concerning the deferral of payroll claims of approximately $883,190 for salary earned from 2012 to June 30, 2016 and $1,652,113 for salary earned from 2001 to 2012, which remain unpaid and is reflected as a current liability on the Company’s consolidated financial statements.

Pursuant to the terms of the amended agreement, each current and former employee who is a party to the agreement (the “Employee(s)”) agreed to defer payment of salary from the date of the agreement (“Salary Deferral”) for a period of three months for salary earned from July 1, 2012 to June 30, 2016 and for a period of six months for salary earned from 2001 to June 30, 2012. In consideration for the Salary Deferral, the Company issued a total 3,500,000 shares of the Company’s common stock with the Rule 144 restrictive legend (at a fair market value of $78,750) and agreed to pay each Employee a sum equal to the amount of unpaid salary at December 31, 2003 plus the amount of unpaid salary at the end of any calendar year after 2003 in which such salary was earned, plus nine percent interest, compounded annually until such time as the unpaid salary has been paid in full. The Company and the Employees have agreed that the deferred salary plus the Bonus will be paid from amounts anticipated to be paid to the Company in respect of specified intellectual property assets of the Company.

In order to effect the payments due under the agreement, the Company assigned to the Employees a twenty percent interest in any net proceeds (gross proceeds less attorney’s fees and direct costs) derived from infringement claims and any license fees paid by a subsidiary of the Company or third party to the Company regarding (a) U.S. patent #6,826,744 and U.S. patent #7,716,629 (plus any continuation patents) on Adhesive Software’s SiteFlash™ Technology, (b) U.S. patent #7,076,521 (plus any continuation patents) in respect of “Web-Based Collaborative Data Collection System”, and (c) U.S. patent U.S. Patent No. #8,578,266 and #9,405,736 (plus any continuation patents) in respect to “Method and System for Automatically Downloading and Storing Markup Language Documents into a Folder Based Data Structure.”

Note 7.8. Legal Proceedings

We are involved in the following ongoing legal matters:

On December 31, 2011, the Company and InfiniTek corporation (“InfiniTek”) entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments due under the settlement agreement as of the date of this Report and each party is alleging the other party is in breach of the settlement agreement. We intend to resolve all disputes with InfiniTek.

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills.  The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  The Company has $112,985 of principal and interest accrued as of March 31, 2017. We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No.BC649122. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman.  The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses. The Company has $260,286 of principal and interest accrued as of March 31, 2017. We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

Note 8.9. Subsequent Events

During the period that runs from OctoberApril 1 2016 through November 21, 2016,to May 22, 2017, the Company amended a convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000, cancelled a $10,000 note payable issued to the third party lender, and converted the $12,312 in outstanding principal and interest of the amended convertible note into 965,673 shares of the Company’s common stock.

During the period from April 1 to May 22, 2017, the Company entered into subscription agreements under which third party subscribers purchased 1,000a restricted stock agreement for 120,000 shares of VCSY Series A Preferred Stock for $200,000. In connection with the purchase of the VCSY Series A Preferred Stock, the subscribers also received a total of 2,000,000 shares ofCompany’s common stock of the Company with the Rule 144 restrictive legend 100,000 shares of common stockwith an employee of the Company’s subsidiary, Ploinks, Inc., 2 year warrantsCompany under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company atvest in equal installments over a purchase price of $0.10 per share and 2 year warrants under which the subscribers may purchase an aggregate total of 150,000 unregistered shares of common stock of the Company at a purchase price of $0.20 per share.30-month period.

During the period that runs from OctoberApril 1 2016 through November 21, 2016, 4,500,000 VCSYto May 22, 2017, the Company granted 250,500 shares of the common stock of Ploinks, Inc. to third party lenders in connection with 3 to 6-month extensions of convertible debentures in the principal amount of $885,000 issued in 2015 and 2016.

During the period from April 1 to May 22, 2017, the Company granted 300,000 unregistered shares issued underof the common stock of Ploinks, Inc. to an employee of a subsidiary of the Company’s pursuant to a restricted stock agreementsagreement with the Company. 150,000 shares vested immediately upon grant of the shares and 150,000 shares will vest in 4 months from the date of grant.

During the period from April 1 to consultants and employeesMay 22, 2017, Ploinks, Inc. granted 60,000 unregistered shares of the common stock of Ploinks, Inc. to an employee of the Company vested.pursuant to a restricted stock agreement with Ploinks, Inc. These shares typically vest over a 30 month period in equal installments and the fair value of the awards is being expensed over this vesting period.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion is a summary of the key factors management considers necessary or useful in reviewing the Company’s results of operations, liquidity and capital resources. The following discussion and analysis should be read together with the accompanying Unaudited Consolidated Financial Statements, and the cautionary statements and risk factors included below in Item 1A of Part II of this Report.

Critical Accounting Policies

Capitalized Software Costs

Software costs incurred internally in creating computer software products are expensed until technological feasibility has been established upon completion of a detailed program design.  Thereafter, all software development costs are capitalized until the point that the product is ready for sale, and are subsequently reported at the lower of unamortized cost or net realizable value.  The Company considers annual amortization of capitalized software costs based on the ratio of current year revenues by product to the total estimated revenues by the product, subject to an annual minimum based on straight-line amortization over the product’s estimated economic useful life, not to exceed five years.  The Company periodically reviews capitalized software costs for impairment where the fair value is less than the carrying value.  During the ninethree months ended September 30,March 31, 2017 and 2016, $0 and 2015, $246,184 and $489,148$143,927 of internal costs were capitalized, respectively. During the nine months ended September 30, 2016, $1,421,155 of software development costs was written off as impaired.

Revenue Recognition

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

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

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

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

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

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

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

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

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

Allowances for Doubtful Accounts

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

Deferred Taxes

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

Stock-Based Compensation Expense

We account for share-based compensation in accordance with the provisions of share-based payments, which 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. Equity instruments issued to other than employees are valued at the earlier of a commitment date or upon completion of the services, based on the fair value of the equity instruments, and are recognized as expense over the service period.

Valuation of the Embedded and Warrant Derivatives

The valuation of our embedded derivatives is determined by using the Company’s quoted stock price. An embedded derivative is a derivative instrument that is embedded within another contract, which under a convertible note (the host contract) includes the right to convert the note by the holder, certain default redemption right premiums and a change of control premium (payable in cash if a fundamental change occurs). In accordance with the guidance on derivative instruments, embedded derivatives are marked-to-market each reporting period, with a corresponding non-cash gain or loss charged to the current period. The practical effect of this has been that when our stock price increases so does our derivative liability, resulting in a non-cash loss that reduces our earnings and earnings per share. When our stock price declines, we record a non-cash gain, increasing our earnings and earnings per share.

The fair value recorded for the derivative liability varies from period to period. This variability may result in the actual derivative liability for a period either above or below the estimates recorded on our consolidated financial statements, resulting in significant fluctuations in other income (expense) because of the corresponding non-cash gain or loss recorded.

Recently Issued Accounting Pronouncements

The Company does not expect the adoption of any recently issued accounting pronouncements to have a material impact on the Company’s financial position, operations or cash flows.

Results of Operations

Three and Nine Months Ended September 30, 2016March 31, 2017 Compared To Three and Nine Months Ended September 30, 2015March 31, 2016

Total Revenues. We had total revenues of $953,261$942,743 and $1,025,194 for$952,943 in the three months ended September 30,March 31, 2017 and 2016, and 2015, respectively. The decrease in total revenues was $71,933$10,200 for the three months ended September 30, 2016March 31, 2017 representing a 7.0%1.1% decrease compared to the total revenues for the three months ended September 30, 2015. Substantially allMarch 31, 2016. Of the $942,743 and $952,943 total revenues for the three months ended September 30,March 31, 2017 and 2016, respectively, $933,517 and 2015$945,270 of such amounts were related to the business operations of NOW Solutions. Revenue from SnAPPnet, Inc. was $12,440 or 1.3%Solutions, a 75% owned subsidiary of total revenues for the three months ended September 30, 2016 and $22,528 or 2.2%of total revenues for the three months ended September 30, 2015.Company.

Revenues for the three months ended September 30, 2016 and 2015 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. There were $7,290 of new licensing sales of our emPath® product during the third quarter of 2016 as compared to $22,500 for the same period in 2015. Software maintenance in the three months ended September 30, 2016 decreased by $30,837or 3.6% from the same period in the prior year. The revenue decrease in software maintenance is related to the loss of US maintenance revenue. Consulting revenue, in the three months ended September 30, 2016 decreased by $5,564 from the same period in the prior year, which represents a 10.1% decrease. This decrease was due to reduced consulting services for version upgrades and enhancements to existing accounts during the third quarter of 2016. Cloud-based revenues were $75,099 for the three months ended September 30, 2016 compared to $86,417 for the same period in the prior year, representing a $11,318 decrease or 13.1%. The decrease is related to a reduction in Canadian cloud-based revenue and SnAPPnet revenue. Other revenue in the three months ended September 30, 2016 decreased by $9,004 or 81.7% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

We had total revenues of $2,875,863 and $3,236,011 for the nine months ended September 30, 2016 and 2015, respectively. The decrease in total revenues was $360,148 for the nine months ended September 30, 2016 representing a 11.1% decrease compared to the total revenues for the nine months ended September 30, 2015. Substantially all the revenues for the nine months ended September 30, 2016 and 2015 were related to the business operations of NOW Solutions. Revenue from SnAPPnet, Inc. was $48,286 or 1.68% of total revenues for the nine months ended September 30, 2016 and $61,966 or 1.9% of total revenues for the nine months ended September 30, 2015.

Revenues for the nine months ended September 30, 2016 and 2015 primarily consist of fees derived from software licenses, consulting services, software maintenance and cloud-based offerings. The revenue from newlicenses and software licenses decreased by $3,210 or 14.3%$12,000 compared to that for the ninethree months ended September 30, 2015.March 31, 2016 due to the sale of our employee self-service module to an existing customer for 2016. Software maintenance in the ninethree months ended September 30, 2016March 31, 2017 decreased by $292,977 or 10.7%$283 from the same period in the prior year. The revenue decrease in software maintenance is relatedprimarily due to the loss or reduction of US and Canadacustomer maintenance revenue and the effects of unfavorableagreements offset by favorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the ninethree months ended September 30, 2016, increasedMarch 31, 2017, decreased by $11,179$9,283 from the same period in the prior year, which represents a 6.0% increase.an 11.3% decrease. This increasedecrease was primarily due to increasedless billable consulting services for version upgrades and enhancementsthe first quarter of 2017 compared to existing accounts in Canada during the nine months ended September 30, 2016. Cloud-based revenues were $199,565$59,703 for the ninethree months ended September 30, 2016March 31, 2017 compared to $248,444$43,283 for the same period in the prior year, representing a $48,879 decrease$16,420 increase or 19.7%37.9%. The decreaseincrease is primarily related a reduction in USto the conversion of one customer from maintenance to cloud-based revenue and SnAPPnet revenue. services.Other revenue in the ninethree months ended September 30, 2016March 31, 2017 decreased by $26,261$5,054 or 71.3%64.7% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses,sales discounts, and other miscellaneous revenues.

Cost of Revenues.We had direct costs associated with our revenues of $392,058$373,552 for the three months ended September 30, 2016,March 31, 2017, compared to $465,614$388,156 for the three months ended September 30, 2015.March 31, 2016. The decrease in cost of revenues of $73,556$14,604 represents a 15.8%3.8% decrease. The decrease in direct cost of revenues was primarily due to decreases in consulting fees, commissionslower payroll and renegotiated hosting fees.

Forbenefit costs. During the ninethree months ended September 30,March 31, 2017 and 2016, direct$0 and $143,927 of internal costs of revenues were $1,156,522 compared to $1,377,496 for the same period in 2015, resulting in a decrease of $220,974 or 16.0%. The decrease in direct cost of revenues was primarily due to decreases in consulting fees, commissions, travel expenses and renegotiated hosting fees.capitalized, respectively.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $1,126,309$1,082,185 and $563,406$667,816 in the three months ended September 30,March 31, 2017 and 2016, and 2015, respectively. The increase of $562,903$414,369 is 99.9%62.0% more than for the same period in 2015. We had2016. The increase is primarily due to increased salaries,salary and benefits as no internal software development costs were capitalized, increased stock compensation expense due to the issuance and penalties.

For the nine months ended September 30, 2016 we had selling, generalamortization of restricted stock and administrative expenses of $2,602,957 compared to $2,124,196 for the nine months ended September 30, 2015. The increase of $478,761 was 22.5% higher than the same period in 2015. We had increased salaries, stock compensation and consulting fees somewhat offset by decreased legal fees and shareholder communications.penalties on overdue payroll taxes.

Depreciation and amortizationAmortization. For the three months ended September 30, 2016, weWe had depreciation and amortization expense of $325 compared to $0and $108 for the three months ended September 30, 2015. ForMarch 31, 2017 and 2016, respectively. The increase of $217 or 200.9% relates to depreciation on purchases of computers in the ninefirst quarter of 2017. Amortization expenses relates to the amortization of intangible assets such as acquired software, customer lists and websites.

Bad Debt Recovery (Expense). We had bad debt recovery of $51,022 and bad debt expense of $6,138 for the three months ended September 30,March 31, 2017 and 2016, and 2015, $758 and $38,412, respectivelyrespectively. Bad debt recovery relates to the collection of depreciation and amortization was recorded.

customer accounts greater than 90 days past due previously expensed. Bad debt expense. During is related to the three and nine months ended September 30, 2016, $29,276 and $41,203, respectively was recorded forallowance of customer accounts receivables that was greater than ninety days past due. During the three and nine months ended September 30, 2015, $8,927 and $59,808, respectively was recorded for accounts receivables that was greater than ninety90 days past due.

ImpairmentOperating Loss. We had a net loss from operations of software costs. During$462,297 and $109,275 for the three months ended September 30,March 31, 2017 and 2016, $1,421,155 of Ploinks™ software development costsrespectively. The increased loss was expensed as impaired as management was unable to support the net realizable value required by GAAPprimarily due to the uniqueness of Ploinks™increased selling, general and lack of third-party information related to user growth rates for mobile devices’ apps. Although the Company has written these costs to expense, management will go to market with Ploinks™ once the application is complete.

administrative expenses.

Gain/Loss on Derivative Liability. Derivative liabilities are adjusted each quarter for changes in the market value of the Company’s common stock, common stock warrants, and convertible debentures. Market value for common stock warrants and convertible debentures is determined using the Black-Scholes Model.option pricing model. The gain on derivative liabilitiesliability was $160,326$339,467 for the three months ended September 30, 2016 compared to $0 for the comparable period in 2015. The gain on derivative liabilities was $49,291 for the nine months ended September 30, 2016March 31, 2017 compared to a lossgain of $78,680$28,712 for the nine months ended September 30, 2015.same period in 2016.

Forbearance Fees.. Forbearance fees relate to fees charged by our lenders on loans in default. Forbearance fees for the three months ended September 30,March 31, 2017 and 2016 were $2,500 compared to $699,900 for the three months ended September 30, 2015. The fees for the three months ended September 30, 2016 are related to a lender of VCSY. The fees for the three months ended September 30, 2015 are related to the fair market value of 10 million shares of VCSY common stock with the rule 144 restrictive legend issued to a VCSY lender$3,000 and 22 million shares of VCSY common stock with the rule 144 restrictive legend issued to the senior secured lenders of NOW Solutions.$11,100, respectively.

Forbearance fees for the nine months ended September 30, 2016 were $19,600 compared to $948,900 for the nine months ended September 30, 2015. The fees for the nine months ended September 30, 2016 are related to a VCSY lender. The fees for the nine months ended September 30, 2015 are related to the fair market value of 10 million shares of VCSY common stock with the rule 144 restrictive legend issued to a VCSY lender and 22 million shares of VCSY common stock with the rule 144 restrictive legend issued to the senior secured lenders of NOW Solutions.

Loss on Debt Extinguishment. We had a $35,969 gain on debt extinguishment for the nine months ended September 30, 2016. The gain relates to the fair market value of the issuance of 5 million shares with the rule 144 restrictive legend of VCSY common stock to a NOW Solutions lender to settle a portion of debt principal.

We had a $173,193 and $323,193 loss on debt extinguishment for the three and nine months ended September 30, 2015. The loss relates to the fair market value of the issuance of 28,556,522 shares with the rule 144 restrictive legend of VCSY common stock to VCSY, NOW Solutions and Priority Time lenders to settle debt and accrued interest payments.

Interest Expense. We had interest expense of $550,189$558,011 and $64,819$376,967 for the three months ended September 30,March 31, 2017 and 2016, and 2015, respectively. Interest expense in 2017 increased by $485,370$181,044, representing an increase of 748.8%48.0% compared to the same expense in the three months ended September 30, 2015.March 31, 2016. The increase wasis primarily due to interest andincreased debt discounts related todiscount amortization for the issuance of convertible debentures in 2016 and an adjustment credit in 2015 on interest recorded in a prior year on the settlement of Canadian income taxes.

For the ninethree months ended September 30, 2016, we hadMarch 31, 2017 and additional interest expense of $1,453,234 compared to $588,583 for the same period in 2015, representing an increase of $864,651 or 146.9% for the period. The increase wason borrowings and amounts due to interest and debt discounts related to the issuance of convertible debentures in 2016 and an adjustment credit in 2015 on interest recorded in a prior year on the settlement of Canadian income taxes.vendors.

Net loss before income taxes.tax provision. We had a net loss before income taxes of $2,408,202$683,826 and $950,664$468,620 for the three months ended September 30,March 31, 2017 and 2016, and 2015, respectively. The net loss before income taxes for the three months ended September 30, 2016 was due to the factors discussed above for revenues, cost of revenues, bad debt expense, impairment of software development costs and selling, general and administrative expenses, which essentially gave us an operating loss of $2,015,862. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities. The net loss before income taxes for the three months ended September 30, 2015March 31, 2017 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $12,753. This$462,297. The operating loss was increaseddecreased by forbearance fees, lossthe gain on debt extinguishmentderivative liability and interest expense.

We had a net loss before income taxes of $3,734,265 and $2,303,250 for the nine months ended September 20, 2016 and 2015, respectively. The net loss before income taxes for the nine months ended September 30, 2016 was due to the factors discussed above for revenues, cost of revenues, bad debt expense, impairment of software development costs and selling, general and administrative expenses, which essentially gave us an operating loss of $2,346,732. This loss was increased by forbearance fees and interest expense and reduced by gain on derivative liabilities and gain on debt extinguishments.resulting in a net loss of $683,826 for the three months ended March 31, 2017. The net loss before income taxes for the ninethree months ended September 30, 2015March 31, 2016 was due to the factors discussed above for revenues, cost of revenues and selling, general and administrative expenses, which essentially gave us an operating loss of $363,901. This$109,275. The operating loss was increaseddecreased by the gain on derivative liability and decreased by forbearance fees loss on derivative liability, loss on debt extinguishment and interest expense.expense resulting in a net loss of $468,620 for the three months ended March 31, 2016.

Income tax benefitTax Provision. We had an income tax expenseprovision of $1,154 and $103,910$35,910 for the three and nine months ended September 30, 2016, respectively. IncomeMarch 31, 2017 compared to $75,560 for the three months ended March 31, 2016. The income tax expenseprovision is related to NOW Solutions, a 75% owned subsidiary of the Company.

We had an income tax benefit of $675,895 and $562,373 for the three and nine months ended September 30, 2015, respectively. The income tax benefitprovision is primarily related to an adjustment for the settlement of Canadianforeign and US income taxes recorded in a previous year.tax.

Dividends Applicable to Preferred Stock. We have outstanding Series A 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a semi-annual basis. The Company also has outstanding Series C 4% convertible cumulative preferred stock that accrues dividends at a rate of 4% on a quarterly basis. The total dividends applicable to Series A and Series C preferred stock were $151,472 and $147,000 for both the three months ended September 30,March 31, 2017 and 2016, and 2015 and $441,000 for both the nine months ended September 30, 2016 and 2015.respectively.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $2,407,242$879,879 and $458,357$700,328 for the three months ended September 30,March 31, 2017 and 2016, and 2015, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

We had a net loss attributed to common stockholders of $4,159,401 and $2,246,080 for the nine months ended September 30, 2016 and 2015, respectively. Net loss available to common stockholders was due to the factors discussed above.

Net Loss Per Share. We had a net loss per share of $0.00 and $0.00 for the ninethree months ended September 30,March 31, 2017 and 2016, and 2015, respectively.

Liquidity and Capital Resources

At September 30, 2016,March 31, 2017, we had non-restricted cash-on-hand of $18,513$81,261 compared to $37,141at$190,448 at December 31, 2015.2016.

Net cash used in operating activities for the ninethree months ended September 30, 2016March 31, 2017 was $344,205$135,008 compared to net cash used inprovided by operating activities of $148,564$236,326 for the ninethree months ended September 30, 2015. DuringMarch 31, 2016. For the ninethree months ended September 30,March 31, 2017, we collected cash from our customers and other licensees of $982,400. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $743,221, attorney fees and professional fees of $85,269, interest payments of $22,747, sales taxes of $93,099, and other regular trade payables of $173,072. For the three months ended March 31, 2016, we received $2,501,986 ofcollected cash from our customers and other licensees of $1,145,434. We used $2,082,806the cash to pay for salaries, benefits, payroll benefitstaxes and payroll taxes, $172,618 forfees of $595,718, attorney fees and professional fees of $72,000, interest payments $208,101 for professional fees, $37,647 for insurance payments, $87,603 for tax paymentsof $107,200, sales taxes of $17,554, and other than payroll and $257,416 for accounts payable to vendors.

Net cash used in operating activities for the nine months ended September 30, 2015 was $148,564 compared to net cash used in operating activitiesregular trade payables of $24,702 for the nine months ended September 30, 2014. During the nine months ended September 30, 2015 we received $3,485,041 of cash from customers, used $1,925,341 for payroll, benefits and payroll taxes, $98,857 for interest payments, $378,691 for professional fees, $96,006 for insurance payments, $215,063 for tax payments other than payroll, $79,186 for audit fees and $840,460 for accounts payable to vendors.$116,636.

A large portion of our cash (and revenue) comes from software maintenance. When we bill and collect for software maintenance, we record a liability in deferred revenue and recognize income ratably over the maintenance period. Deferred revenue decreased $357,574increased $79,093 or 21.6%4.4% from the balance at December 31, 2015.2016. The decreaseincrease was due toprimarily a higher numberresult of the loss of US and Canadian customers on a calendar year renewal basis, who purchased limited maintenance agreements which results in higher deferred revenue in December.for less than one year.

Our accounts receivable trade decreasedincreased from $382,463$367,278 at December 31, 20152016 to $91,048$432,435 (net of allowance for bad debts) at September 30, 2016.March 31, 2017. The decreaseincrease is primarily the reduction in the allowance for doubtful accounts as a result of seasonal fluctuationsbad debt recoveries of $51,022 in the timingfirst quarter of billing for software maintenance which typically yields higher receivables in December compared to September.2017.

The accounts payable and accrued liabilities went from $10,645,353at$12,075,298 at December 31, 20152016 to $11,740,523$12,663,211 at September 30, 2016. The change is primarily related to increased accounts payable, executive payroll, payroll taxes and accrued interest, partially offset by decreased accounts payable.March 31, 2017. The resulting balance at SeptemberMarch 31, 2017 is 30 2016 is 127 times more than the balance in accounts receivable. This is one of the reasons why we do not have sufficient funds available to fund our operations and repay our debt obligations under their existing terms, as described below.

We used cash to invest in equipment andfor the development of new software products for the ninethree months ended September 30,March 31, 2017 and March 31, 2016 of $0 and September 30, 2015 of $246,184 and $489,148,$143,927 respectively. Most of the equipment was computer equipment and peripherals for upgraded network servers to increase the productivity of our software developers, and new personal computers for developers, consultants and sales personnel. Software development relates to the development of new products.

For the ninethree months ended September 30,March 31, 2017, we repaid $4,716 to third party lenders. For the three months ended March 31, 2016, we had $776,900repaid $62,190 to third party lenders.

For the three months ended March 31, 2017, one of new debt funding, $150,000 of equity financing, repaid $241,337 to lenders and paid $222,500our subsidiaries accrued $32,500 of dividends to noncontrolling shareholders of NOW Solutions. For the nine months ended September 30, 2015, we paid $53,228 of principal on notes payable and related party notes payable, paid dividends of $92,500 to NOW Solutions noncontrolling interest owners and had $885,333 of new debt funding in the same period.non-controlling interests.

The total change in cash for the ninethree months ended September 30, 2016March 31, 2017 was a decrease of $18,628.$109,187.

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.

As of March 31, 2017, the following contractual obligations and commercial commitments were outstanding:

Of the above notes payable, the default status is as follows:

The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. We had a net loss before noncontrolling interest of $3,838,175 and $1,740,877$728,407 for the ninethree months ended September 30,March 31, 2017 and a net loss of $553,328 for the three months ended March 31, 2016, and 2015, respectively andwe have historically incurred losses. Since December 31, 2009, we have used substantial funds in further developing our product line and in conducting present and new operations, and we need to raise additional funds and/or generate additional revenue through our existing businesses, including the licensing of our intellectual property, to accomplish our objectives. Additionally, at September 30, 2016,March 31, 2017, we had negative working capital of approximately $19.6$21.2 million (although this figure includes deferred revenue of approximately $1.3$1.9 million) and have defaulted on severalsubstantially all of our debt obligations. These conditions raise substantial doubt about our ability to continue as a going concern.

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures

Our management, principally our chief executive officer (who is also currently serving as our Principal Accounting Officer), evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our management concluded that our disclosure controls and procedures as of the end of the period covered by this report were not effective such that the information required to be disclosed by us in reports filed under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding disclosure.

Management’s annual report on internal control over financial reporting associated with our business is set forth on Form 10-K for the year ended December 31, 2015,2016, as filed on April 14, 2016.24, 2017.

There have been no material changes in our internal control over financial reporting since our reporting on Form 10-K for the year ended December 31, 2015.

2016.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in the following ongoing legal matters:

On December 31, 2011, the Company and InfiniTek corporation (“InfiniTek”) entered into a settlement agreement to dismiss an action filed by the Company against InfiniTek in the Texas State District Court in Fort Worth, Texas, for breach of contract and other claims, a counter claim filed by InfiniTek against the Company for non-payment of amounts claimed the Company owed to InfiniTek, and an action filed by InfiniTek against the Company in California Superior Court in Riverside, California seeking damages for breach of contract and lost profit. Pursuant to the terms of the settlement agreement, Vertical agreed to pay InfiniTek $82,500 in three equal installments with the last payment due by or before August 5, 2012. Upon full payment, InfiniTek shall transfer and assign ownership of the NAVPath software developed by InfiniTek for use with NOW Solutions emPath® software application and Microsoft Dynamics NAV (formerly Navision) business solution platform. The amounts in dispute were included in our accounts payable and accrued liabilities and have been adjusted to the settlement amount of $82,500 at December 31, 2011. The Company has made $37,500 in payments due under the settlement agreement as of the date of this Report and each party is alleging the other party is in breach of the settlement agreement. We intend to resolve all disputes with InfiniTek.

On February 13, 2017, the Company was served with a complaint filed by Parker Mills in the Superior Court of the State of California, County of Los Angeles, Central District, for failure to make payment on the outstanding balance due under a $100,000 convertible debenture issued by the Company to Parker Mills. The Company has $112,985 of principal and interest accrued as of March 31, 2017. The plaintiff seeks payment of the principal balance due under the convertible debenture of $100,000, interest at the rate of 12% per annum, attorney’s fees and court costs.  We intend to resolve this matter with Parker Mills. This case is styled Parker Mills, LLP v. Vertical Computer Systems, Inc., No.BC649122. William Mills is a partner of Parker Mills and the Secretary and a Director of the Company.

On April 12, 2017, NOW Solutions, Inc. was served with a Notice of Motion for Summary Judgment in Lieu of Complaint,  which was filed by Derek Wolman in the Supreme Court of the State of New York in County of New York for failure to make outstanding payments on the outstanding balance due under one promissory note in the principal amount of $150,000 (issued on November 17, 2009) and one promissory note in the principal amount of $50,000 (issued on August 28, 2014), both of which were issued by NOW Solutions to Mr. Wolman. The Company has $260,286 of principal and interest accrued as of March 31, 2017. The plaintiff seeks a judgment totaling $282,299 (which includes principal and accrued interest), plus additional accrued interest from the date the complaint was filed, attorney’s fees and expenses.  We intend to resolve this matter with Mr. Wolman. This case is styled Derek Wolman v. Now Solutions, Inc., No. 65/502/17.

Item 1A. Risk Factors

A description of the risks associated with our business, financial condition, and results of operations is set forth on Form 10-K for the year ended December 31, 2015,2016, as filed on April 14, 2016.24, 2017.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In January 2016,During the three months ended March 31, 2017, the Company granted 2,000,000 unregistered3,000,000 VCSY common shares of its common stock with the Rule 144 restrictive legend and 200,000 shares of Ploinks common stockpursuant to a consultantstock award to an employee of the Company and its subsidiaries pursuant to(at a consulting agreement with the Company. The aggregate fair market value of the 2,000,000 share award was determined to be $44,000. In addition, the Company agreed to issue up to 15,000,000 common shares of the Company and 1,500,000 shares of Ploinks common stock pursuant to restricted performance stock agreements with the consultant. These shares may vest over a term of 3 years and are based upon the Consultant achieving certain performance criteria.$72,000).

In March 2016, the Company cancelled 1,000,000 unregistered shares of its common stock issued during 2015 to a third party lender under an agreement to amend certain promissory notes issued by the Company and NOW Solutions in the aggregate principal amount of $715,000. Under the amendment, the Company agreed to make $22,000 monthly payments and an additional $10,000 penalty if such monthly payment is not timely made. The cancellation resulted in the reversal of forbearance fees expense of $28,900 duringDuring the three months ended March 31, 2016.2017, $10,109 of principal and interest under a convertible note issued in the principal amount of $80,000 was converted into 723,089 common shares.

InDuring the three months ended March 2016,31, 2017, 550,000 VCSY common shares issued under restricted stock agreements to employees and a consultant of the Company vested.

During the three months ended March 31, 2017, 200,001 shares of the common stock of Ploinks, Inc. issued 10,000,000under restricted stock agreements to consultants and employees of the Company vested

During the period from April 1 to May 22, 2017, the Company amended a convertible note originally issued to a third party lender in the principal amount of $80,000 to $90,000, cancelled a $10,000 note payable issued to the third party lender, and converted the $12,312 in outstanding principal and interest of the amended convertible note into 965,673 shares of the Company’s common stock.

During the period from April 1 to May 22, 2017, the Company entered into a restricted stock agreement for 120,000 shares of the Company’s common stock with the Rule 144 restrictive legend to its consolidated subsidiary Ploinks. These shares are held in treasury.  In exchange, Ploinks issued 5,000,000with an employee of its common shares to the Company.

In April 2016, the Company and a third party noteholder entered into an agreement under which the Company issued 5,000,000 shares of the Company’s common stock with the Rule 144 restrictive legend in exchange for the cancellation of $130,000 in principal owed under a note payable issued by NOW Solutions with a principal amount of $213,139. The fair market value of the shares was $92,500. A gain on debt extinguishment of $37,500 was recorded for the period ended September 30, 2016.