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VCSY > SEC Filings for VCSY > Form 10-Q on 19-Nov-2012All Recent SEC Filings

Show all filings for VERTICAL COMPUTER SYSTEMS INC

Form 10-Q for VERTICAL COMPUTER SYSTEMS INC


19-Nov-2012

Quarterly Report


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 nine months ended September 30, 2012 and 2011, $240,030 and $228,154 of internal costs were capitalized, respectively.

Revenue Recognition

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

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

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

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

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

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

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

Cloud-based offering. 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 cloud-based 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 our 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 require measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares issued and the quoted price of our common stock.

Valuation of the Embedded 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.

Results of Operations

Three and Nine months ended September 30, 2012 Compared To Three and Nine months ended September 30, 2011

Total Revenues. We had total revenues of $1,285,614 and $1,441,464 for the three months ended September 30, 2012 and 2011, respectively. The decrease in total revenues was $155,850 for the three months ended September 30, 2012 representing a 10.8% decrease compared to the total revenues for the three months ended September 30, 2011. Substantially all of the revenues for the three months ended September 30, 2012 and 2011 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $17,572 or 1.4% of total revenues for the three months ended September 30, 2012 and $32,578 or 2.3% of total revenues for the three months ended September 30, 2011.

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. There were no new licensing sales of our emPath® product during the third quarter of 2012 or 2011. Software maintenance in the three months ended September 30, 2012 increased by $14,336 or 1.3% from the same period in the prior year. The revenue increase in software maintenance is primarily due to contractual increases to existing customer maintenance agreements somewhat offset by the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the three months ended September 30, 2012 decreased by $104,161 from the same period in the prior year, which represents a 69.9% decrease. This decrease was due to a completed version upgrades during the third quarter of 2011 and the effects of unfavorable currency exchange rates. Cloud-based revenues were $95,702 for the three months ended September 30, 2012 compared to $148,631 for the same period in the prior year, representing a $52,929 decrease or 35.6%. The decrease is primarily related to the loss of a major Canadian customer due to the customer being acquired for NOW Solutions and renegotiated contracts for our SnAPPnet offering during the 3 months ended September 30, 2012. Other revenue in the three months ended September 30, 2012 decreased by $13,096 or 42.6% 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 $4,080,406 and $4,588,884 in the nine months ended September 30, 2012 and 2011, respectively. The decrease in total revenues was $508,478 for the nine months ended September 30, 2012 representing an 11.1% decrease compared to the total revenues for the nine months ended September 30, 2011. Substantially all of the revenues for the nine months ended September 30, 2012 and 2011 were related to the business operations of NOW Solutions, a wholly-owned subsidiary. Revenue from SnAPPnet, Inc. was $75,695 or 1.9% of total revenues for the nine months ended September 30, 2012 and $103,084 or 2.2% of total revenues for the nine months ended September 30, 2011.

The total revenues primarily consist of fees derived from software licenses, consulting services, software maintenance and Cloud-based offerings. The revenue from new software licenses decreased by $198,103 compared to that for the nine months ended September 30, 2011 as there were substantially no new licensing sales of our emPath® product during the nine months ended September 30, 2012. Software maintenance in the nine months ended September 30, 2012 increased by $42,339 or 1.3% from the same period in the prior year. The revenue increase in software maintenance is primarily due to contractual increases to existing customer maintenance agreements somewhat offset by the effects of unfavorable currency rate changes on our Canadian maintenance revenue. Consulting revenue, in the nine months ended September 30, 2012 decreased by $223,721 from the same period in the prior year, which represents a 47.3% decrease. This decrease was due to completed consulting projects compared to the same period in 2011 and the effects of unfavorable currency exchange rates. Cloud-based revenues were $352,469 for the nine months ended September 30, 2012 compared to $463,336 for the same period in the prior year, representing an $110,867 decrease or 23.9%. The decrease is primarily related to The decrease is primarily related to the loss of a major Canadian customer due to the customer being acquired for NOW Solutions and renegotiated contracts for our SnAPPnet offering during the nine months ended September 30, 2012. Other revenue in the nine months ended September 30, 2012 decreased by $18,126 or 23.0% from the same period in the prior year. Other revenue consists primarily of reimbursable travel expenses, currency gains and losses, and other miscellaneous revenues.

Cost of Revenues. We had direct costs associated with our revenues of $583,433 for the three months ended September 30, 2012, compared to $624,165 for the three months ended September 30, 2011. The decrease in cost of revenues of $40,732 represents a 6.5% decrease. The decrease in direct cost of revenues was primarily due to decreased costs for third-party hosting expenses, lower travel expenses for consultants and lower payroll and commissions. During the three months ended September 30, 2012 and 2011, $75,568 and $82,770 of internal costs were capitalized, respectively.

For the nine months ended September 30, 2012, direct costs of revenues were $1,970,223 compared to $2,037,806 for the same period in 2011 resulting in a decrease of $67,583 or 3.3%. The decrease in direct cost of revenues was primarily due to decreased costs for third-party hosting expenses, lower travel expenses for consultants and lower payroll and commissions. During the nine months ended September 30, 2012 and 2011, $240,029 and $228,154 of internal costs were capitalized, respectively.

Selling, General and Administrative Expenses. We had selling, general and administrative expenses of $844,697 and $917,906 in the three months ended September 30, 2012 and 2011, respectively. The decrease of $73,209 is 8.0% less than the same period in 2011. We had lower employee expenses due to lower salaries, lower travel expenses, and legal fees and decreased consulting services. Of the selling, general and administrative expenses for the three months ended September 30, 2012 and 2011, $119,000 and $102,000 respectively, represented business development expenses for various initiatives being undertaken through VHS, PTS and SnAPPnet, Inc.

For the nine months ended September 30, 2012 we had $2,294,221 compared to $2,338,963 for the nine months ended September 30, 2011. The $44,742 or 1.9% decrease is due to lower legal and professional fees, decreased consulting services and travel. Of the selling, general and administrative expenses for the nine months ended September 30, 2012 and 2011, $455,000 and $528,000, respectively, represented business development expenses for various initiatives being undertaken including Vertical Healthcare Solutions, Inc., Priority Time Systems, Inc., and SnAPPnet, Inc.

Bad Debt Expense. We had bad debt expense of $20,872 for the nine months ended September 30, 2012. The expense related to non-payment of a portion of one of NOW Solutions' customer invoices.

Gain (Loss) on Derivative Liability. The existing derivative liability is adjusted each quarter for changes in the market value of the Company's common stock. The loss on derivative liability was $11,790 for the three months ended September 30, 2012 compared to a gain of $5,895 for the same period in 2011. The loss on derivative liability was $655 for the nine months ended September 30, 2012 compared to a gain of $5,895 for the nine months ended September 30, 2011

Interest Expense. We had interest expense of $174,636 and $162,723 for the three months ended September 30, 2012 and 2011, respectively. Interest expense increased by $11,913 representing an increase of 7.3% compared to the same expense in the three months ended September 30, 2011. The increase was primarily due to $25,300 of debt discounts recorded in the second quarter of 2012 somewhat offset by decreased interest on declining debt balances.

For the nine months ended September 30, 2012, we had interest expense of $494,501 compared to $455,360 for the same period in 2011, representing a $39,141 or 8.6% increase for the period. The increase was primarily due to $50,300 of debt discounts recorded in 2012 somewhat offset by decreased interest on declining debt balances

Loss on extinguishment of debt. We had loss on debt extinguishment of $5,000 and $20,000 for the three and nine months ended September 30, 2012, respectively. The expense related to payments made to extend the maturity date of a note payable.

Net Income (loss). We had a net loss of $329,914 and $242,786 for the three months ended September 30, 2012 and 2011, respectively. The net loss for the three months ended September 30, 2012 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 $157,320. This loss was increase by interest expense and a loss on derivative liability. The net loss for the three months ended September 30, 2011 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 $117,223. The operating loss was increased by interest expense and slightly reduced by the gain on derivative liability.

We incurred net losses of $708,572 and $215,681 for the nine months ended September 30, 2012 and 2011, respectively. The changes were due to the reasons discussed above.

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 $147,000 for both the three months ended September 30, 2012 and 2011 and $441,000 for both the nine months ended September 30, 2012 and 2011.

Net Loss Available to Common Stockholders. We had a net loss attributed to common stockholders of $476,914 and $389,786 for the three months ended September 30, 2012 and 2011, respectively. Net loss attributed to common stockholders was due to the factors discussed above.

We had a net loss attributed to common stockholders of $1,149,572 and $656,681 for the nine months ended September 30, 2012 and 2011, 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 nine months ended September 30, 2012 and 2011, respectively.

Liquidity and Capital Resources

At September 30, 2012, we had non-restricted cash-on-hand of $10,647 compared to $132,452 at December 31, 2011.

Net cash used in operating activities for the nine months ended September 30, 2012 was $333,268 compared to net cash provided by operating activities of $54,636 for the nine months ended September 30, 2011. For the nine months ended September 30, 2012, we collected cash from our customers of $3,507,852. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $2,504,358, attorney fees of $40,453, professional fees and consulting fees of $214,559, interest payments of $246,263, taxes (including sales tax and VAT) of $356,203, and other regular trade payables of $484,284. For the nine months ended September 30, 2011, we collected cash from our customers of $4,699,370 and other miscellaneous receipts of $74,441. We used the cash to pay for salaries, benefits, payroll taxes and payroll fees of $2,985,401, attorney fees of $62,542, professional fees and consulting fees of $419,225, interest expense of $166,896, taxes (including sales tax and VAT) of $317,309, and other regular trade payables of $767,802.

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 $521,062 or 20.4% from the balance at December 31, 2011. The decrease was due to a higher number of customers on calendar year maintenance agreements which results in higher deferred revenue in December.

Our accounts receivable trade decreased from $412,293 at December 31, 2011 to $173,463 (net of allowance for bad debts) at September 30, 2012. The decrease is a result of seasonal fluctuations in the timing of billing for software maintenance which typically yields higher receivables in December compared to September.

The accounts payable and accrued liabilities went from $6,566,970 at December 31, 2011 to $7,138,678 at September 30, 2012. As described above, we utilized some of the cash we received from collections on customer accounts receivable to pay current expenses and to pay down some of the accounts payable. The resulting balance at September 30, 2012 is 41 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 and the development of software products for the nine months ended September 30, 2012 and September 30, 2011 of $248,510 and $255,571, 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 nine months ended September 30, 2012, we paid $190,500 of principal on notes payable and notes payable to related parties and had $778,405 of new debt funding in the same period. We also paid $20,000 to a lender in order to extend the maturity date of a loan. For the nine months ended September 30, 2011, we paid $27,901 of principal on notes payable and notes payable to related parties and had $58,000 of new debt funding in the same period.

The total change in cash for the nine months ended September 30, 2012 was a decrease of $121,805.

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.

                            Balance at
                           September 30,                            Due in Next Five Years
Contractual Obligations        2012              2012           2013          2014          2015          2016+
Notes payable             $     4,464,320     $ 3,671,383     $ 130,005     $ 140,046     $ 160,781     $ 362,105
Convertible debenture              30,000          30,000             -             -             -             -
Operating lease                   239,129          22,678        93,269        93,330        29,852             -
Total                     $     4,733,449     $ 3,724,061     $ 223,274     $ 233,376     $ 190,633     $ 362,105

Following is the status of notes payable:

                       September 30, 2012       December 31, 2011

In default            $          1,439,122     $         1,007,824
Not in default                   3,055,198               2,808,938

Total Notes Payable   $          4,494,320     $         3,816,762

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 available to common stockholders of $1,149,572 and $656,681 for the nine months ended September 30, 2012 and 2011, respectively and 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 . . .

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