As filed with the Securities and Exchange Commission on July 23, 2004
File No. 333-116654
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
AMENDMENT NO. 1 TO THE
FORM SB-2
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
PAYMENT DATA SYSTEMS, INC.
(Name of small business issuer in its charter)
Nevada 6099 98-0190072
------- ---------- ----------
(State or jurisdiction (Primary Standard Industrial I.R.S. Employer
of incorporation or Classification Code Number) Identification
Organization No.
12500 SAN PEDRO, SUITE 120, SAN ANTONIO, TEXAS 78216
TELEPHONE: (210)249-4100
(Address and telephone number of principal executive offices)
12500 SAN PEDRO, SUITE 120, SAN ANTONIO, TEXAS 78216
TELEPHONE: (210)249-4100
(Address of principal place of business or intended principal place of
business)
MICHAEL R. LONG
CHIEF EXECUTIVE OFFICER
12500 SAN PEDRO
SUITE 120
SAN ANTONIO, TEXAS 78216
(210) 249-4100
(Name, address and telephone number of agent for service)
Copies of communications to:
AMY M. TROMBLY, ESQ.
TROMBLY BUSINESS LAW
1163 WALNUT STREET, SUITE 7
NEWTON, MA 02461
(617) 243-0060
Approximate date of proposed sale to the public: As soon as practicable after
this Registration Statement becomes effective.
If this Form is filed to register additional securities for an offering pursuant
to Rule 462(b) under the Securities Act, please check the following box and list
the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434, check
the following box. [ ]
If any of the securities being registered on this Form are to be offered on a
delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933 check the following box. [X]
The registrant hereby amends this registration statement on such date or dates
as may be necessary to delay its effective date until the registrant shall file
a further amendment which specifically states that this registration statement
shall thereafter become effective in accordance with Section 8(a) of the
Securities Act of 1933 or until the registration statement shall become
effective on such date as the Commission, acting pursuant to said Section 8(a),
may determine.
The information in this prospectus is not complete and may be changed. We may
not sell these securities until the registration statement filed with the
Securities and Exchange Commission is declared effective. This prospectus is not
an offer to sell these securities, and we are not soliciting offers to buy these
securities, in any state where the offer or sale is not permitted.
PROSPECTUS
PAYMENT DATA SYSTEMS, INC.
OFFERING UP TO 40,000,000 COMMON SHARES
This prospectus relates to the sale of up to 40,000,000 shares of our common
stock by a stockholder. We are not selling any securities in this offering and
therefore will not receive any proceeds from this offering. We will, however,
receive proceeds from the sale of securities under an Investment Agreement, also
referred to as an Equity Line of Credit, that we have entered into with Dutchess
Private Equities Fund, L.P., which permits us to "put" up to $10 million in
shares of common stock to Dutchess Private Equities Fund. Dutchess will pay us
95% of the lowest closing bid price of the common stock during the five
consecutive trading day period immediately following the date of our notice to
them of our election to put shares pursuant to the Equity Line of Credit. All
costs associated with this registration will be borne by us.
The shares of common stock are being offered for sale by the selling stockholder
at prices established on the Over-the-Counter Bulletin Board or in negotiated
transactions during the term of this offering. Our common stock is quoted on the
Over-the-Counter Bulletin Board under the symbol PYDS.OB. On July 21, 2004, the
last reported sale price of our common stock was $0.23 per share.
Dutchess Private Equities Fund, LP and Clayton Dunning and Co., Inc. are
"underwriters" within the meaning of the Securities Act of 1933, as amended, in
connection with the resale of common stock under the Investment Agreement.
This investment involves a high degree of risk. You should purchase securities
only if you can afford a complete loss.
SEE "RISK FACTORS" BEGINNING ON PAGE 8.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if this
prospectus is truthful or complete. Any representation to the contrary is a
criminal offense.
Subject to Completion, the date of this Prospectus is July 23, 2004
TABLE OF CONTENTS
PROSPECTUS SUMMARY 4
RISK FACTORS 8
USE OF PROCEEDS 13
DETERMINATION OF OFFERING PRICE 14
DILUTION 14
SELLING SECURITY HOLDERS 15
PLAN OF DISTRIBUTION 16
LEGAL PROCEEDINGS 18
DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS 19
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 20
DESCRIPTION OF SECURITIES 21
INTEREST OF NAMED EXPERTS AND COUNSEL 21
DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR SECURITIES
ACT LIABILITIES 22
CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS 22
DESCRIPTION OF BUSINESS 22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF PLAN OF OPERATION 30
DESCRIPTION OF PROPERTY 43
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 43
MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 45
EXECUTIVE COMPENSATION 46
FINANCIAL STATEMENTS F-1
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE F-31
PROSPECTUS SUMMARY
The following information is a summary of the prospectus and it does not contain
all of the information you should consider before making an investment decision.
You should read the entire prospectus carefully, including the financial
statements and the notes relating to the financial statements.
OUR COMPANY
We provide integrated electronic payment processing services to merchants and
businesses, including all types of Automated Clearinghouse, or ACH, Network
processing and credit and debit card-based processing services. The ACH Network
is a nationwide batch-oriented electronic funds transfer system that is
regulated by the Federal Reserve and provides for the interbank clearing of
electronic payments for participating financial institutions. Our ACH processing
services enable merchants or businesses to both remit or collect funds
electronically using e-checks to transfer funds instead of traditional paper
checks. An e-check is an electronic debit to a bank checking account that is
initiated at the point-of-sale, on the Internet, over the telephone or via a
bill remittance sent through the mail and is processed using the ACH network.
Our card-based processing services enable merchants to process both traditional
card-present, or "swipe," transactions, as well as card-not-present
transactions. A traditional card-present transaction occurs whenever a
cardholder physically presents a credit or debit card to a merchant at the
point-of-sale. A card-not-present transaction occurs whenever the customer does
not physically present a payment card at the point-of-sale and may occur over
the Internet, mail, fax or telephone. Our electronic payment processing may take
place in a variety of forms and channels. For example, our capabilities allow
merchants to convert a paper check to an e-check or receive card authorization
at the point-of-sale, have their customer service representatives take e-check
or card payments from their consumers by telephone, and enable their consumers
to make e-check or card payments directly through the use of a Web site or by
calling an Interactive Voice Response, or IVR, telephone system. We also operate
an online payment processing service for consumers under the domain name
www.bills.com through which consumers can pay anyone. We generate revenues by
charging fees for the electronic processing of payment transactions and related
services. We charge certain merchants for these processing services at a bundled
rate based on a percentage of the dollar amount of each transaction and, in some
instances, additional fees are charged for each transaction. We charge other
merchant customers a flat fee per transaction, and may also charge miscellaneous
fees to our customers, including fees for chargebacks or returns, monthly
minimums, and other miscellaneous services. We operate solely in the United
States as a single operating segment, and do not currently have any foreign
operations.
4
In July 2003, we sold substantially all of our assets to Harbor Payments Corp.,
formerly Saro, Inc. We had used the assets sold to provide Electronic Bill
Presentment and Payment and related services to companies that generate
recurring bills to their consumers. Electronic Bill Presentment and Payment is
the process of sending bills in an electronic format to consumers securely
through the Internet and processing Internet payment of bills utilizing an
electronic transfer of funds. After we sold these assets, we no longer provided
Electronic Bill Presentment and Payment and related services, which are
presented in our financial statements as discontinued operations. We believe
that the property and equipment we retained after this sale are sufficient to
support our continuing operations. We also believe that our current available
cash plus anticipated future revenues from continuing operations are likely to
be insufficient for us to continue as a going concern.
Our auditors have issued a going concern opinion on our audited financial
statements for the year ended December 31, 2003. As of March 31, 2004, our
available cash balance was $268,000 and we anticipate cash needs of
approximately $1.5 million for the next twelve months. Our ability to continue
as a going concern is likely contingent on us receiving additional capital. If
sufficient capital is not available to us, we would likely be required to reduce
or discontinue our operations. We intend to use the proceeds from our equity
line with Dutchess to pay current liabilities and fund our current level of
operations in the future until we achieve positive cash flow from operations, if
ever.
HOW TO CONTACT US
Our executive offices are located at 12500 San Pedro, Suite 120, San Antonio,
Texas 78216. Our phone number is (210) 249-4100. Our Internet address is
www.paymentdata.com.
THE OFFERING
This prospectus relates to the resale of up to 40,000,000 shares of our common
stock by Dutchess Private Equities Fund, LP, who will become a stockholder
pursuant to our Investment Agreement.
Common stock offered 40,000,000 shares
Use of proceeds We will not receive any proceeds from the sale by
the selling stockholders of our common stock. We
will receive proceeds from our Investment
Agreement with Dutchess Private Equities Fund.
See "Use of Proceeds."
Symbol for our common stock Our common stock trades on the OTCBB Market
under the symbol "PYDS.OB"
OUR CAPITAL STRUCTURE AND SHARES ELIGIBLE FOR FUTURE SALE
Shares of common stock outstanding as of
April 16, 2004 21,495,181 (1)
Shares of common stock potentially issuable
upon exercise of the put right to Dutchess Private
Equities Fund 40,000,000 (2)
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Total 61,495,181
==========
(1) Assumes:
- No exercise of the following options to purchase common stock outstanding at
March 31, 2004:
4,003,767 shares of common stock pursuant to Amended and Restated 1999 Employee
Comprehensive Stock Plan
533,003 shares of common stock pursuant to 1999 Non-Employee Director Plan
- No exercise of the outstanding vested warrants to purchase common stock at
March 31, 2004 as follows:
5
Shares of
Common Exercise Expiration
Holder Stock Price Date
----------------- --------- --------- ----------
Private Placement 41,237 $ 6.06 08/05/2004
Placement Agent 250 3.25 10/14/2004
Placement Agent 280 8.00 12/15/2004
Placement Agent 8,890 7.41 12/20/2004
Placement Agent 3,500 7.31 12/22/2004
Private Placement 2,000,000 1.80 11/27/2006
CheckFree 2,179,121 11.38 06/02/2010
---------
4,233,278
=========
(2) For the purpose of determining the number of shares subject to registration
with the Securities and Exchange Commission, we have assumed that we will issue
no more than 40,000,000 shares pursuant to the exercise of our put right under
the Investment Agreement. However, the number of shares that we will actually
issue pursuant to that put right may be more than or less than 40,000,000,
depending on the trading price of our common stock at the time of each put and
how many times we issue a put. We currently have no intent to exercise the put
right in a manner that would result in our issuance of more than 40,000,000
shares, but if we were to exercise the put right in that manner, we would be
required to file a subsequent registration statement with the Securities and
Exchange Commission and for that registration statement to be deemed effective
prior to the issuance of any such additional shares.
THE INVESTMENT AGREEMENT
The Investment Agreement we have with Dutchess Private Equities Fund, L.P.
allows us to "put" to Dutchess Private Equities Fund either (A) four hundred
percent of the average daily volume of our common stock for the ten trading days
prior to the applicable put notice date, multiplied by the average of the three
daily closing best bid prices immediately preceding the put date, or (B)
$25,000; provided that in no event will the put amount be more than $1,000,000
with respect to any single put. We shall not be entitled to submit a put notice
until after the previous put has been completed. The purchase price for the
common stock identified in the put notice shall be equal to 95% of the lowest
closing bid price of the common stock during the five consecutive trading day
period immediately following the date of our notice to them of our election to
put shares. The discount at which we will issue our common stock to Dutchess
will be accounted for as a direct cost of equity financing and recorded as
interest expense on the day the common stock is issued. Assuming we draw down
the full amount of the equity line of $10 million, we would incur approximately
$500,000 of such interest expense. Existing stockholders may experience
significant dilution from the sale of securities pursuant to our Investment
Agreement. The lower our stock price is at the time we exercise our put option,
the more shares we will have to issue to Dutchess Private Equities Fund to draw
down the full amount under the equity line with Dutchess Private Equities Fund.
At a stock price of $0.26 or less, we would have to issue all 40,000,000 shares
registered under this offering in order to draw down on the full equity line.
6
Dutchess Private Equities Fund, L.P. will only purchase shares when we meet the
following conditions:
- a registration statement has been declared effective and remains effective for
the resale of the common stock subject to the Equity Line of Credit;
- our common stock has not been suspended from trading for a period of five
consecutive trading days and we have not have been notified of any pending or
threatened proceeding or other action to delist or suspend our common stock;
- we have complied with our obligations under the Investment Agreement and the
Registration Rights Agreement;
- no injunction has been issued and remain in force, or action commenced by a
governmental authority which has not been stayed or abandoned, prohibiting the
purchase or the issuance of our common stock;
- the issuance of the common stock will not violate any shareholder approval
requirements of any exchange or market where our securities are traded;
- the registration statement does not contain any untrue statement of a material
fact or omit to state any material fact required to be stated or necessary to
make the statements not misleading or which would require public disclosure or
an update supplement to the prospectus; and
- We have not filed a petition in bankruptcy, either voluntarily or
involuntarily, and there shall not have commenced any proceedings under any
bankruptcy or insolvency laws.
The Investment Agreement will terminate when any of the following events occur:
- Dutchess Private Equities Fund, L.P. has purchased an aggregate of $10,000,000
of our common stock;
- 36 months after the SEC declares this registration statement effective;
- we file or otherwise enter an order for relief in bankruptcy;
- trading of our common stock is suspended for a period of 5 consecutive trading
days; or
- we issue or sell any equity securities or securities convertible into, or
exchangeable for, equity securities or enter into any other equity financing
facility during the term of the Investment Agreement in certain circumstances,
without the prior written approval of Dutchess.
7
RISK FACTORS
An investment in our common stock involves a high degree of risk. You should
carefully consider the following factors that management considers to be the
material risks facing the company as of the date of this prospectus, other
information included in this prospectus and information in our periodic reports
filed with the SEC. If any of the following risks actually occur, our business,
financial condition or results of operations could be materially and adversely
affected, and you may lose some or all of your investment.
RISKS RELATED TO OUR BUSINESS
OUR INDEPENDENT ACCOUNTANTS HAVE ISSUED A GOING CONCERN OPINION AND IF WE CANNOT
OBTAIN ADDITIONAL FINANCING BY JULY 31, 2004, WE MAY HAVE TO CURTAIL OPERATIONS
AND MAY ULTIMATELY CEASE TO EXIST.
Our independent accountants have issued a going concern opinion. Due to
continuing operating losses, our current available cash and cash equivalents
along with anticipated revenues are likely to be insufficient to meet our
anticipated cash needs for the near future. Consequently, our ability to
continue as a going concern is likely contingent on us receiving additional
funds in the form of equity or debt financing. We currently plan to meet our
capital requirements primarily through the issuance of equity securities or new
borrowing arrangements. Accordingly, we are aggressively pursuing strategic
alternatives, including the Equity Line of Credit for which we are registering
shares in this registration statement. However, financing may not be available
in amounts or on terms acceptable to us, if at all. If we cannot raise funds on
acceptable terms, or achieve positive cash flow, by July 31, 2004, we may be
forced to curtail operations or may ultimately cease to exist.
WE HAVE GENERATED SIGNIFICANT LOSSES AND EXPECT TO GENERATE OPERATING LOSSES FOR
THE FORESEEABLE FUTURE, THEREFORE WE MAY NOT BECOME PROFITABLE.
We organized in 1998 and began operations as a public company in 1999 by
offering electronic billing services to other companies. After the sale of our
primary business in July 2003, we have concentrated on building our electronic
payments services operations. We have not been profitable since inception and we
may never become profitable. As of December 31, 2003, our accumulated deficit
was $46.7 million.
IF OUR SECURITY APPLICATIONS ARE NOT SUFFICIENT TO ADDRESS CHANGING MARKET
CONDITIONS AND CUSTOMER CONCERNS, WE MAY NOT BE ABLE TO SELL OUR SERVICES.
Our use of applications designed for premium data security and integrity to
process electronic transactions may not be sufficient to address changing market
conditions or the security and privacy concerns of existing and potential
customers. Adverse publicity raising concerns about the safety or privacy of
electronic transactions, or widely reported breaches of our or another
provider's security, have the potential to undermine consumer confidence in the
technology and could have a materially adverse effect on our business.
IF THE TREND OF AN INCREASING PERCENTAGE OF PAYMENTS CLEARED ELECTRONICALLY DOES
NOT CONTINUE, WE MAY NOT BE ABLE TO GROW OUR BUSINESS.
Our future financial performance will be materially affected by the percentage
of payments that can be cleared electronically. Based on reports by the Federal
Reserve, paper check use as a percentage of retail non-cash payments declined
from 77.1% in 1995 to 59.5% in 2000. Accordingly, a reversal of the current
trend toward a smaller proportion of paper-based payments would limit the
potential growth of our business.
8
IF WE DO NOT ADAPT TO RAPID TECHNOLOGICAL CHANGE, OUR BUSINESS MAY FAIL.
Our success depends on our ability to develop new and enhanced services, and
related products that meet changing customer needs. The market for our services,
however, is characterized by rapidly changing technology, evolving industry
standards, emerging competition and frequent new and enhanced software, service
and related product introductions. In addition, the software market is subject
to rapid and substantial technological change. To remain successful, we must
respond to new developments in hardware and semiconductor technology, operating
systems, programming technology and computer capabilities. In many instances,
new and enhanced services, products and technologies are in the emerging stages
of development and marketing, and are subject to the risks inherent in the
development and marketing of new software, services and products. We may not
successfully identify new service opportunities, and develop and bring new and
enhanced services and related products to market in a timely manner. Even if we
do bring such services, products or technologies to market, they may not become
commercially successful. Additionally, services, products or technologies
developed by others may render our services and related products noncompetitive
or obsolete. If we are unable, for technological or other reasons, to develop
and introduce new services and products in a timely manner in response to
changing market conditions or customer requirements, our business may fail.
WE RELY ON OUR RELATIONSHIP WITH THE AUTOMATED CLEARINGHOUSE NETWORK AND IF THE
FEDERAL RESERVE RULES WERE TO CHANGE, OUR BUSINESS COULD BE ADVERSELY AFFECTED.
We have a contractual relationship with a third party provider, which maintains
a relationship with multiple Originating Depository Financial Institutions, or
ODFI, in the Automated Clearinghouse, or ACH, Network. The ACH Network is a
nationwide batch-oriented electronic funds transfer system that provides for the
interbank clearing of electronic payments for participating financial
institutions. An ODFI is a participating financial institution that must abide
by the provisions of the ACH Operating Rules and Guidelines. Through our
relationship with this third party provider, we are able to process payment
transactions on behalf of our customers and their consumers by submitting
payment instructions in a prescribed ACH format. We pay volume-based fees to the
third party provider for debit and credit transactions processed each month, and
pay fees for other transactions such as returns and notices of change to bank
accounts. These fees are part of our cost structure. If the Federal Reserve
rules were to change to introduce restrictions or modify access to the ACH, our
business could be materially adversely affected.
IF OUR THIRD PARTY CARD PROCESSING PROVIDER OR OUR BANK SPONSOR FAIL TO COMPLY
WITH THE APPLICABLE REQUIREMENTS OF VISA AND MASTERCARD CREDIT CARD
ASSOCIATIONS, WE MAY HAVE TO FIND A NEW THIRD PARTY PROCESSING PROVIDER WHICH
COULD INCREASE OUR COSTS.
Substantially all of the card-based transactions we process involve Visa or
MasterCard. If our third party processing provider, Network 1 Financial, Inc.,
or our bank sponsor, Harris Bank, fail to comply with the applicable
requirements of the Visa and MasterCard credit card associations, Visa or
MasterCard could suspend or terminate their registration. Also, our contract
with these third parties is subject to cancellation upon limited notice by
either party. The cancellation of our contract, termination of their
registration or any changes in the Visa or MasterCard rules that would impair
their registration could require us to stop providing such payment processing
services if we are unable to obtain another provider or sponsor at similar
costs. Additionally, changing our bank sponsor could adversely affect our
relationship with our merchants if the new sponsor provides inferior service or
charges higher costs.
WE DEPEND ON MICHAEL R. LONG AND LOUIS A. HOCH AND IF THESE OFFICERS CEASED TO
BE ACTIVE IN OUR MANAGEMENT, OUR BUSINESS MAY NOT BE SUCCESSFUL.
Our success depends to a significant degree upon the continued contributions of
our key management, marketing, service and related product development and
operational personnel, including our Chairman, Chief Executive Officer and Chief
Financial Officer, Michael R. Long and our President and Chief Operating
Officer, Louis A. Hoch. We have employment agreements with Mr. Long and Mr. Hoch
that expire in July 2004 and prohibit them from competing with us for a period
of two years upon termination of their employment. Our business may not be
successful if, for any reason, either of these officers ceased to be active in
our management.
9
IF OUR SOFTWARE FAILS, AND WE NEED TO REPAIR OR REPLACE IT, OR WE BECOME SUBJECT
TO WARRANTY CLAIMS, OUR COSTS COULD INCREASE.
Our software products could contain errors or "bugs" that could adversely affect
the performance of services or damage a user's data. We attempt to limit our
potential liability for warranty claims through technical audits and
limitation-of-liability provisions in our customer agreements. However, these
measures may not be effective in limiting our exposure to warranty claims. We
have not experienced a significant increase in software errors or warranty
claims. Despite the existence of various security precautions, our computer
infrastructure may also be vulnerable to viruses or similar disruptive problems
caused by our customers or third parties gaining access to our processing
system. If our software fails, and we need to replace or repair it, or we become
subject to warranty claims, our costs could increase.
OUR BUSINESS STRATEGY INCLUDES IDENTIFYING NEW BUSINESSES TO ACQUIRE, AND IF WE
CANNOT INTEGRATE ACQUISITIONS INTO OUR COMPANY SUCCESSFULLY, WE MAY NOT BECOME
PROFITABLE.
Our success partially depends upon our ability to identify and acquire
undervalued businesses within our industry. Although we believe that there are
companies available for potential acquisition that are undervalued and might
offer attractive business opportunities, we may not be able to make any
acquisitions, and if we do make acquisitions, they may not be profitable. As a
result, our business may not grow and we may not achieve or sustain
profitability.
IF WE DO NOT MANAGE OUR GROWTH, WE MAY NOT ACHIEVE OR SUSTAIN PROFITABILITY.
We may experience a period of rapid growth that could place a significant strain
on our resources. In order to manage our growth successfully, we will have to
continue to improve our operational, management and financial systems and expand
our work force. A significant increase in our customer base may necessitate the
hiring of a significant number of additional personnel, qualified candidates for
which, at the time needed, may be in short supply. In addition, the expansion
and adaptation of our computer and administrative infrastructure will require
substantial operational, management and financial resources. Although we believe
that our current infrastructure is adequate to meet the needs of our customers
in the foreseeable future, we may not be able to expand and adapt our
infrastructure to meet additional demand on a timely basis, at a commercially
reasonable cost, or at all. If our management is unable to manage growth
effectively, hire needed personnel, expand and adapt our computer infrastructure
and improve our operational, management, and financial systems and controls, we
may not attain or sustain profitability.
IF WE DO NOT MANAGE OUR CREDIT RISKS RELATED TO OUR MERCHANT ACCOUNTS, WE MAY
INCUR SIGNIFICANT LOSSES.
We rely on the Federal Reserve's ACH system for electronic fund transfers and
the Visa and MasterCard associations for settlement of payments by credit or
debit card on behalf of our merchant customers. In our use of these established
payment clearance systems, we generally bear the credit risks arising from
returned transactions caused by insufficient funds, stop payment orders, closed
accounts, frozen accounts, unauthorized use, disputes, customer charge backs
theft or fraud. Consequently, we assume the credit risk of merchant disputes,
fraud, insolvency or bankruptcy in the event we attempt to recover funds related
to such transactions from our customers. We have not experienced a significant
increase in the rate of returned transactions or incurred any losses with
respect to such transactions. We utilize a number of systems and procedures to
manage and limit credit risks, but if these actions are not successful in
managing such risks, we may incur significant losses.
10
RISKS RELATED TO OUR INDUSTRY
THE ELECTRONIC COMMERCE MARKET IS RELATIVELY NEW AND IF IT DOES NOT GROW, WE MAY
NOT BE ABLE TO SELL SUFFICIENT SERVICES TO MAKE OUR BUSINESS VIABLE.
The electronic commerce market is a relatively new and growing service industry.
If the electronic commerce market fails to grow or grows slower than
anticipated, or if we, despite an investment of significant resources, are
unable to adapt to meet changing customer requirements or technological changes
in this emerging market, or if our services and related products do not maintain
a proportionate degree of acceptance in this growing market, our business may
not grow and could even fail. Additionally, the security and privacy concerns of
existing and potential customers may inhibit the growth of the electronic
commerce market in general, and our customer base and revenues, in particular.
Similar to the emergence of the credit card and automatic teller machine, or
ATM, industries, we and other organizations serving the electronic commerce
market must educate users that electronic transactions use encryption technology
and other electronic security measures that make electronic transactions more
secure than paper-based transactions.
CHANGES IN REGULATION OF ELECTRONIC COMMERCE AND RELATED FINANCIAL SERVICES
INDUSTRIES COULD INCREASE OUR COSTS AND LIMIT OUR BUSINESS OPPORTUNITIES.
We believe that we are not required to be licensed by the Office of the
Comptroller of the Currency, the Federal Reserve Board, or other federal or
state agencies that regulate or monitor banks or other types of providers of
electronic commerce services. It is possible that a federal or state agency will
attempt to regulate providers of electronic commerce services, which could
impede our ability to do business in the regulator's jurisdiction. We are
subject to various laws and regulations relating to commercial transactions,
such as the Uniform Commercial Code, and may be subject to the electronic funds
transfer rules embodied in Regulation E, promulgated by the Federal Reserve
Board. Given the expansion of the electronic commerce market, the Federal
Reserve Board might revise Regulation E or adopt new rules for electronic funds
transfer affecting users other than consumers. Because of growth in the
electronic commerce market, Congress has held hearings on whether to regulate
providers of services and transactions in the electronic commerce market. It is
possible that Congress or individual states could enact laws regulating the
electronic commerce market. If enacted, such laws, rules and regulations could
be imposed on our business and industry and could increase our costs or limit
our business opportunities.
IF WE CANNOT COMPETE SUCCESSFULLY IN OUR INDUSTRY, WE COULD LOSE MARKET SHARE
AND OUR COSTS COULD INCREASE.
Portions of the electronic commerce market are becoming increasingly
competitive. We expect to face growing competition in all areas of the
electronic payment processing market. New companies could emerge and compete for
merchants of all sizes. We expect competition to increase from both established
and emerging companies and that such increased competition could lower our
market share and increase our costs. Moreover, our current and potential
competitors, many of whom have greater financial, technical, marketing and other
resources than us, may respond more quickly than us to new or emerging
technologies or could expand to compete directly against us in any or all of our
target markets. Accordingly, it is possible that current or potential
competitors could rapidly acquire market share. We may not be able to compete
against current or future competitors successfully. Additionally, competitive
pressures may increase our costs, which could lower our earnings, if any.
11
RISKS RELATED TO OUR COMMON STOCK AND THIS OFFERING
OUR STOCK PRICE IS VOLATILE AND YOU MAY NOT BE ABLE TO SELL YOUR SHARES AT A
PRICE HIGHER THAN WHAT YOU PAID.
The market for our common stock is highly volatile. In 2002, our stock price
fluctuated between $0.17 and $1.70. The trading price of our common stock could
be subject to wide fluctuations in response to, among other things, quarterly
variations in operating and financial results, announcements of technological
innovations or new products by our competitors or us, changes in prices of our
products and services or our competitors' products and services, changes in
product mix, or changes in our revenue and revenue growth rates.
EXISTING STOCKHOLDERS MAY EXPERIENCE SIGNIFICANT DILUTION FROM THE SALE OF
SECURITIES PURSUANT TO OUR INVESTMENT AGREEMENT WITH DUTCHESS PRIVATE EQUITIES
FUND.
The sale of shares pursuant to our Investment Agreement with Dutchess Private
Equities Fund may have a dilutive impact on our stockholders. As a result, our
net income per share could decrease in future periods and the market price of
our common stock could decline. In addition, the lower our stock price is at the
time we exercise our put option, the more shares we will have to issue to
Dutchess Private Equities Fund to draw down on the full equity line with
Dutchess Private Equities Fund. If our stock price decreases, then our existing
stockholders would experience greater dilution. At a stock price of $0.26 or
less, we would have to issue all 40,000,000 shares registered under this
offering in order to draw down on the full equity line.
DUTCHESS PRIVATE EQUITIES FUND WILL PAY LESS THAN THE THEN-PREVAILING MARKET
PRICE OF OUR COMMON STOCK WHICH COULD CAUSE THE PRICE OF OUR COMMON STOCK TO
DECLINE.
Our common stock to be issued under our agreement with Dutchess Private Equities
Fund will be purchased at a 5% discount to the lowest closing best bid price
during the five days immediately following our notice to Dutchess Private
Equities Fund of our election to exercise our put right. Dutchess Private
Equities Fund has a financial incentive to sell our common stock immediately
upon receiving the shares to realize the profit between the discounted price and
the market price. If Dutchess Private Equities Fund sells our shares, the price
of our stock could decrease. If our stock price decreases, Dutchess Private
Equities Fund may have a further incentive to sell the shares of our common
stock that it holds. The discounted sales under our agreement with Dutchess
Private Equities Fund could cause the price of our common stock to decline.
WE MUST COMPLY WITH PENNY STOCK REGULATIONS THAT COULD EFFECT THE LIQUIDITY AND
PRICE OF OUR STOCK.
The SEC has adopted rules that regulate broker-dealer practices in connection
with transactions in "penny stocks." Penny stocks generally are equity
securities with a price of less than $5.00, other than securities registered on
certain national securities exchanges or quoted on NASDAQ, provided that current
price and volume information with respect to transactions in such securities is
provided by the exchange or system. Prior to a transaction in a penny stock, a
broker-dealer is required to:
- deliver a standardized risk disclosure document prepared by the SEC;
- provide the customer with current bid and offer quotations for the penny
stock;
- explain the compensation of the broker-dealer and its salesperson in the
transaction;
12
- provide monthly account statements showing the market value of each penny
stock held in the customer's account;
- make a special written determination that the penny stock is a suitable
investment for the purchaser and receive the purchaser's executed
acknowledgement of the same; and
- provide a written agreement to the transaction.
These requirements may have the effect of reducing the level of trading activity
in the secondary market for our stock. Because our shares are subject to the
penny stock rules, you may find it more difficult to sell your shares.
WE HAVE ADOPTED CERTAIN MEASURES THAT MAY MAKE IT MORE DIFFICULT FOR A THIRD
PARTY TO ACQUIRE CONTROL OF OUR COMPANY AND COULD LOWER THE PRICE OF OUR STOCK.
On October 4, 2000, we approved a stockholder rights plan to protect
stockholders in the event of an unsolicited attempt to acquire our company in a
manner that would not be in the best interests of our stockholders. This
stockholder rights plan could have the effect of making it more difficult for a
third party to acquire, or of discouraging a third party from attempting to
acquire, control of our company. Our Board of Directors is also classified into
three classes of directors serving staggered three-year terms. Such
classification of the Board of Directors expands the time required to change the
composition of a majority of directors and may tend to discourage a proxy
contest or other takeover bid for our company. The issuance of common stock
under a stockholder rights plan could decrease the amount of earnings and assets
available for distribution to the holders of our common stock or could adversely
affect the rights and powers, including voting rights, of the holders of our
common stock. In certain circumstances, such issuance could have the effect of
decreasing the market price of our common stock.
USE OF PROCEEDS
The 40,000,000 shares of common stock covered by this prospectus will be sold by
Dutchess Private Equities Fund, LP who will receive all of the proceeds from
such sales. We will not receive any proceeds from the sale of the 40,000,000
shares. However, we will receive proceeds from the sale of our common shares
pursuant to our Investment Agreement with Dutchess Private Equities Fund.
For illustrative purposes, we have set forth below our intended use of proceeds
for the range of net proceeds indicated below to be received under the
Investment Agreement. The Gross Proceeds represent the total dollar amount that
Dutchess Private Equities Fund, L.P. is obligated to purchase. The table assumes
estimated offering expenses of $25,000.
Proceeds Proceeds Proceeds Proceeds
If 100% Sold If 50% Sold If 25% Sold If 10% Sold
------------- ------------ ----------- -----------
Gross Proceeds $10,000,000 $5,000,000 $2,500,000 $1,000,000
Estimated Expenses of the Offering $ 25,000 $ 25,000 $ 25,000 $ 25,000
------------- ----------- ----------- -----------
Net Proceeds $ 9,975,000 $4,975,000 $2,475,000 $ 975,000
============= =========== =========== ===========
Priority Priority Priority Priority
------------- ------------ ------------- ------------
Working capital and general corporate expenses 1st $2,000,000 $2,000,000 $2,000,000 $ 975,000
Expansion of internal operations 2nd $1,500,000 $1,500,000 $ 475,000 $ -
Potential acquisition costs (1) 3rd $6,475,000 $1,475,000 $ - $ -
------------ ----------- ------------ -----------
$9,975,000 $4,975,000 $2,475,000 $ 975,000
============ =========== ============ ===========
13
Proceeds of the offering which are not immediately required for the purposes
described above will be invested in United States government securities,
short-term certificates of deposit, money market funds and other high-grade,
short-term interest-bearing investments.
(1) From time to time we evaluate opportunities to make acquisitions of assets
or businesses that we believe would help us achieve our goal of profitability,
but we are not currently planning any material acquisitions.
DETERMINATION OF OFFERING PRICE
The selling stockholders may sell shares in any manner at the current market
price or through negotiated transactions with any person at any price.
DILUTION
Our net tangible book value as of December 31, 2003 was $205,232, or $0.01 per
share of common stock. Net tangible book value per share is determined by
dividing our tangible book value (total tangible assets less total liabilities)
by the number of outstanding shares of our common stock. Net tangible book value
as of December 31, 2003 is calculated by subtracting our net intangible asset of
$7,500 that is included in other assets from net total book value (total assets
less total liabilities) of $212,732. Since this offering is being made solely by
the selling stockholders and none of the proceeds will be paid to us, our net
tangible book value will be unaffected by this offering. Our net tangible book
value, however, will be impacted by the common stock to be issued to Dutchess
Private Equities Fund, L.P. The amount of dilution will depend on the offering
price and number of shares to be issued. The following example shows the
dilution to new investors at an assumed offering price of $0.24 per share which
is based on the closing price of our common stock on June 10, 2004 of $0.25
adjusted for the 5% discount at which we will issue shares under our agreement
with Dutchess Private Equities Fund. The discount is defined as 95% of the
lowest closing bid price of our common stock during the five consecutive trading
day period immediately following our notice to Dutchess Private Equities Fund of
our election to exercise our put rights.
If we assume that we were to issue 100%, 50%, 25% and 10% of the 40,000,000
shares of common stock to Dutchess Private Equities Fund, L.P. at an assumed
offering price of $0.24 per share, less $25,000 of offering expenses, our net
tangible book value as of December 31, 2003 would have been as follows:
Assumed percentage of shares issued 100% 50% 25% 10%
Number of shares issued (in millions) 40 20 10 4
Assumed public offering price per share $0.24 $0.24 $0.24 $0.24
Net tangible book value per share before this offering $0.01 $0.01 $0.01 $0.01
Net tangible book value after this offering $9,780,232 $4,980,232 $2,580,232 $1,140,232
Net tangible book value per share after this offering $0.16 $0.12 $0.08 $0.05
Dilution of net tangible book value per share to new investors $0.08 $0.12 $0.16 $0.19
Increase in net tangible book value per share to existing
shareholders $0.15 $0.11 $0.07 $0.04
14
You should be aware that there is an inverse relationship between our stock
price and the number of shares to be issued under the Investment Agreement to
Dutchess Private Equities Fund, L.P. That is, as our stock price declines, we
would be required to issue a greater number of shares under the Investment
Agreement for a given advance. This inverse relationship is demonstrated by the
table below, which shows the number of shares to be issued under the Investment
Agreement at a price of $0.24 per share and 75%, 50% and 25% discounts to that
price.
Offering price: $0.24 75% 50% 25% -
PURCHASE PRICE:(1) $0.06 $0.12 $0.18 $0.24
NO. OF SHARES:(2) 40,000,000 20,000,000 13,333,334 10,000,000
TOTAL OUTSTANDING:(3) . 60,987,956 40,987,956 34,321,289 30,987,956
PERCENT OUTSTANDING:(4) 65.6% 48.8% 38.8% 32.3%
(1) Represents market price.
(2) Represents the number of shares of common stock to be issued at the prices
set forth in the table to generate $2.4 million in gross proceeds.
(3) Represents the total number of shares of common stock outstanding after the
issuance of the shares, assuming no issuance of any other shares of common
stock.
(4) Represents the shares of common stock to be issued as a percentage of the
total number shares of common stock outstanding (assuming no exercise or
conversion of any options, warrants or other convertible securities).
CAPITALIZATION
The following table shows our capitalization at March 31, 2004:
Preferred stock, $0.01 par value, 10,000,000 shares
authorized, none issued and outstanding 0
Common stock, $0.001 par value, 200,000,000 shares
authorized, 21,445,181 issued and
outstanding 21,445
Additional paid-in capital 46,921,821
Accumulated deficit (47,051,880)
Total shareholders' equity (deficit) $ (108,614)
SELLING SECURITY HOLDERS
Based upon information available to us as of April 9, 2004, the following table
sets forth the name of the selling stockholder, the number of shares owned, the
number of shares registered by this prospectus and the number and percent of
outstanding shares that the selling stockholder will own after the sale of the
registered shares, assuming all of the shares are sold. The information provided
in the table and discussions below has been obtained from the selling
stockholder. The selling stockholder may have sold, transferred or otherwise
disposed of, or may sell, transfer or otherwise dispose of, at any time or from
time to time since the date on which they provided the information regarding the
shares beneficially owned, all or a portion of the shares of common stock
beneficially owned in transactions exempt from the registration requirements of
the Securities Act of 1933. As used in this prospectus, "selling stockholder"
includes donees, pledgees, transferees or other successors-in-interest selling
shares received from the named selling stockholder as a gift, pledge,
distribution or other non-sale related transfer. However, this registration
statement does not cover sales by donees, pledges, transferees or other
successors-in-interest of Dutchess Private Equities Fund, L.P.
15
Beneficial ownership is determined in accordance with Rule 13d-3(d) promulgated
by the Commission under the Securities Exchange Act of 1934. Unless otherwise
noted, each person or group identified possesses sole voting and investment
power with respect to the shares, subject to community property laws where
applicable.
Ownership Before Offering Shares Being Offered Ownership After Offering(1)
------------------------- -------------------- ------------------------
Dutchess Private Equities
Fund, LP(2) -0- 40,000,000 -0-
(1) The numbers assume that the selling stockholder has sold all of the
shares offered hereby prior to completion of this Offering.
(2) Dutchess is a private limited partnership whose business operations are
conducted through its general partner, Dutchess Capital Management, LLC.
Michael Novielli and Douglas H. Leighton are Managing Members of Dutchess
Capital Management, LLC, and have voting and dispositive power with respect
to securities held by Dutchess Private Equities Fund, LP.
PLAN OF DISTRIBUTION
The selling stockholder will act independently of us in making decisions with
respect to the timing, manner and size of each sale. The selling stockholder may
sell the shares from time to time:
- in transactions on the Over-the-Counter Bulletin Board or on any national
securities exchange or U.S. inter-dealer system of a registered national
securities association on which our common stock may be listed or quoted at the
time of sale;
-in private transactions and transactions otherwise than on these exchanges or
systems or in the over-the-counter market;
- at prices related to such prevailing market prices;
- in negotiated transactions;
- in a combination of such methods of sale; or
- any other method permitted by law.
The selling stockholder may effect such transactions by offering and selling the
shares directly to or through securities broker-dealers, and such broker-dealers
may receive compensation in the form of discounts, concessions or commissions
from the selling stockholder and/or the purchasers of the shares for whom such
broker-dealers may act as agent or to whom the selling stockholder may sell as
principal, or both, which compensation as to a particular broker-dealer might be
in excess of customary commissions.
16
Dutchess Private Equities Fund, L.P., Clayton Dunning and Co., Inc. and any
other broker-dealers who act in connection with the sale of its shares will be
deemed to be "underwriters" within the meaning of the Securities Act, and any
discounts, concessions or commissions received by them and profit on any resale
of the shares as principal will be deemed to be underwriting discounts,
concessions and commissions under the Securities Act.
On or prior to the effectiveness of the registration statement to which this
prospectus is a part, we will advise the selling stockholder that it and any
securities broker-dealers or others who may be deemed to be statutory
underwriters will be governed by the prospectus delivery requirements under the
Securities Act. Under applicable rules and regulations under the Securities
Exchange Act, any person engaged in a distribution of any of the shares may not
simultaneously engage in market activities with respect to the common stock for
the applicable period under Regulation M prior to the commencement of such
distribution. In addition and without limiting the foregoing, the selling
stockholder will be governed by the applicable provisions of the Securities
Exchange Act, and the rules and regulations thereunder, including without
limitation Rules 10b-5 and Regulation M, which provisions may limit the timing
of purchases and sales of any of the shares by the selling stockholder. All of
the foregoing may affect the marketability of our securities.
On or prior to the effectiveness of the registration statement of which this
prospectus is a part, we will advise the selling stockholder that the
anti-manipulation rules under the Securities Exchange Act may apply to sales of
shares in the market and to the activities of the selling stockholder and any of
its affiliates.
We have informed the selling stockholder that it may not:
- engage in any stabilization activity in connection with any of the shares;
- bid for or purchase any of the shares or any rights to acquire the shares;
- attempt to induce any person to purchase any of the shares or rights to
acquire the shares other than as permitted under the Securities Exchange Act; or
- effect any sale or distribution of the shares until after the prospectus shall
have been appropriately amended or supplemented, if required, to describe the
terms of the sale or distribution.
We have informed the selling stockholder that it must effect all sales of shares
in broker's transactions, through broker-dealers acting as agents, in
transactions directly with market makers, or in privately negotiated
transactions where no broker or other third party, other than the purchaser, is
involved.
The selling stockholder may indemnify any broker-dealer that participates in
transactions involving the sale of the shares against certain liabilities,
including liabilities arising under the Securities Act. Any commissions paid or
any discounts or concessions allowed to any broker-dealers, and any profits
received on the resale of shares, may be deemed to be underwriting discounts and
commissions under the Securities Act if the broker-dealers purchase shares as
principal.
In the absence of the registration statement to which this prospectus is a part,
the selling stockholder may be able to sell its shares only pursuant to the
limitations of Rule 144 promulgated under the Securities Act.
We expect to incur approximately $25,000 in expenses related to this
registration statement. Our expenses consist mainly of accounting and legal
fees. Our estimate of $25,000 in expenses does not include amounts we may pay to
Clayton Dunning and Co., Inc. as Placement Agent.
17
We engaged Clayton Dunning and Co., Inc. as our placement agent with respect to
the securities to be issued under the Equity Line of Credit. To our knowledge,
Clayton Dunning has no affiliation or business relationship with Dutchess
Private Equities Fund, L.P. Clayton Dunning will be our exclusive placement
agent in connection with the Investment Agreement. We agreed to pay Clayton
Dunning 1% of the gross proceeds from each put with an aggregate maximum of
$10,000 over the term of our agreement. The Placement Agent agreement terminates
when our Investment Agreement with Dutchess Private Equities Fund terminates
pursuant to the terms of that Investment Agreement.
LEGAL PROCEEDINGS
Beginning in December 2000, we pledged as loan guarantees certain funds held as
money market funds and certificates of deposit to collateralize margin loans for
the following executive officers of the Company: (1) Michael R. Long, then
Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A.
Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then
Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones,
then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees
of the Company. Our purpose in collateralizing the margin loans was to prevent
the sale of our common stock owned by these officers while we were pursuing
efforts to raise additional capital through private equity placements. The sale
of that common stock could have hindered our ability to raise capital in such a
manner and compromised our continuing efforts to secure additional financing. We
were also trying to accommodate the requests of the named executive officers,
who were seeking to preserve their financial liquidity. We believe this action
served our purpose of assuring stable management and leadership for our future.
The margin loans were obtained in March 1999 from institutional lenders and were
secured by shares of our common stock owned by these officers. Each of the
officers used the proceeds of their respective margin loans for investment
purposes and usual and customary living expenses.
None of the margin loans were recourse with respect to the officers and none of
the loan guarantees were recourse with respect to us because at the times the
margin loans were made and the funds pledged, the value of the common stock
collateralizing the margin loans exceeded the loan amounts. Under the original
terms of the arrangement, we charged each of the officers, pro rata, the
difference between the rate of return earned by us before the collateralization
of the margin loans on the funds that were to be the pledged funds and the rate
of return earned on the pledged funds after the collateralization of the margin
loans. We offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard
against their respective salaries from the date the funds were pledged until
November of 2002, when we underwent significant downsizing and Mr. Long, Mr.
Hoch, and Mr. Millard began deferring their salaries. We offset such amounts due
from Mr. Jones against his salary from the date the funds were pledged until the
date of his departure from the Company in August 2001.
The highest total amount of funds pledged for the margin loans guaranteed by us
was approximately $2.0 million. The total balance of the margin loans guaranteed
by us was approximately $1.3 million at December 31, 2002. At the time the funds
were pledged, we believed we would have access to them because (a) our stock
price was substantial and the stock pledged by the officers, if liquidated,
would produce funds in excess of the loans payable, and (b) with respect to one
of the institutional lenders (who was also assisting us as a financial advisor
at the time), even if the stock price fell, we had received assurances from that
institutional lender that the pledged funds would be made available as needed.
During the fourth quarter of 2002, we requested partial release of the funds for
operating purposes, which request was denied by an institutional lender. At that
time, our stock price had fallen as well, and it became clear that both
institutional lenders would not release the pledged funds.
In light of these circumstances, we recognized a loss on the guarantees of
$1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable
under related party guarantees on our balance sheet at December 31, 2002 because
it became probable at that point that we would be unable to recover our pledged
funds. During the quarter ended March 31, 2003, the lenders applied the pledged
funds to satisfy the outstanding balances of the loans. The total balance of the
margin loans guaranteed by us was zero at December 31, 2003.
18
The pledged funds were classified as cash and cash equivalents on our balance
sheet and disclosed in the accompanying footnotes in our Annual Report on Form
10-K for each of the years ended December 31, 2000 and 2001, respectively. The
pledged funds were classified as cash and cash equivalents on our balance sheet
and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q
for the quarters ended March 31, 2002 and June 30, 2002, respectively. Under the
terms of the related guaranty agreements, we could, at any time, terminate our
obligations and the lenders' rights under the guaranty agreements, but we would
remain liable for any losses incurred by the lenders in liquidating the
guaranteed accounts by selling the common stock held as collateral in the margin
loan accounts in order to pay off the margin loan balances in full during a
reasonable time subsequent to the receipt of our termination notice. Because we
had the right to withdraw our pledged funds at any time and would not incur any
losses as long as the value of the common stock held in the margin loan accounts
exceeded the total balance of the margin loans, the funds we had pledged were
properly reported as unrestricted as long as there was sufficient collateral
other than our pledged funds available to cover the loans. Based on the number
of shares of our common stock held by these officers in their margin accounts
collateralizing the loans and the price of our common stock at the time these
respective reports were filed, management determined that there was sufficient
coverage available for the lenders to liquidate the stock to pay off the margin
loans in full and return the full amount of our pledged funds to us if we had
withdrawn our guarantee. After the price of our common stock was too low to
provide the lenders with sufficient coverage of the margin loan balances and our
request for partial release of the funds was denied by an institutional lender,
the pledged funds were classified as cash pledged as collateral for related
party obligations on our balance sheet and disclosed in the accompanying
footnotes in our Quarterly Report on Form 10-Q for the quarter ended September
30, 2002. On June 30, 2003, we filed an amended Annual Report on Form 10-K for
the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for
the quarters ended March 31, 2002 and June 30, 2002 as a result of comments
received from the Securities and Exchange Commission in connection with their
review of our registration statement on Form S-3 that we originally filed on
August 9, 2002. These amended reports included restated balance sheets that
classified the pledged funds as cash pledged as collateral for related party
obligations because by the time the amended reports were filed, there was no
longer sufficient collateral other than our pledged funds available to cover the
loans and it was clear that the funds would not be released as we had been
assured.
We may institute litigation or arbitration in collection of the outstanding
repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which
currently total $1,278,138. Presently, we have refrained from initiating action
to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may
have offsetting claims that total $1,445,500 collectively by virtue of the
change of control clause in their respective employment agreements based on our
preliminary analysis. We understand that these individuals may assert such
claims based on our sale of substantially all of our assets to Harbor Payments,
Inc. on July 25, 2003. We have not initiated any formal settlement negotiations
with these individuals because they are presently under an extended employment
contract with us or have not been amenable to such an action. We have not
pursued the outstanding repayment obligation of Mr. Jones because we do not
consider a recovery attempt to be cost beneficial. In order to attempt a
recovery from Mr. Jones, we estimate that we would incur a minimum of $20,000 in
estimated legal costs with no reasonable assurance of success in recovering his
outstanding obligation of approximately $38,000. Because of the limited amount
of the obligation, we also anticipate difficulty in retaining counsel on a
contingency basis to pursue collection of this obligation. The ultimate outcome
of this matter cannot presently be determined.
On July 25, 2003, certain of our stockholders (those stockholders being Mike
Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and
James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana
Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert
Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry
Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick,
Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal
action against us, Ernst & Young, LLP, and certain of our current and former
directors (including the executive officers named above) in the District Court
of the 45th Judicial District, Bexar County, Texas. With respect to us and the
current and former directors named in the suit, the plaintiffs allege that we,
acting through such directors, misstated in our 2000 and 2001 Form 10-Ks our
ability to use for operational purposes the funds pledged as security for margin
loans of certain of our executive officers, as discussed above. The plaintiffs
allege and seek resulting economic and exemplary damages, rescission, interest,
attorneys' fees and costs of court. We believe this suit is without merit and
intend to vigorously defend the company and the directors named in the suit. As
of June 4, 2004, there have been no material developments in the suit. The
results of legal proceedings cannot be predicted with certainty. If we fail to
prevail in this legal matter, our financial position, results of operations, and
cash flows could be materially adversely affected.
DIRECTORS AND EXECUTIVE OFFICERS
The names and ages of all of our directors and executive officers, along with
their respective positions, term of office and period such position(s) was held,
is set forth in the following table. Members of the board are elected and serve
for one year terms or until their successors are elected and qualify. All of the
officers serve at the pleasure of the Board of Directors of the Company.
19
Name Age Position Held
----- --- --------------
Michael R. Long 59 Chief Executive Officer, Chief Financial Officer,
Chairman of the Board and Director
Louis A. Hoch 38 President, Chief Operating Officer, and Director
Peter G. Kirby 64 Director
BIOGRAPHIES OF OFFICERS AND DIRECTORS
Set forth below is a brief description of the background of our officers and
directors based on information provided by them to us.
MICHAEL R. LONG has been our Chief Executive Officer, Chairman of the Board and
Director since July 1998. In addition, Mr. Long has been our Chief Financial
Officer since September 2003. Mr. Long has more than thirty years of senior
executive management and systems development experience in six publicly traded
companies, as well as operating a systems consulting business. Before assuming
the top position at Payment Data Systems, Mr. Long was Vice President of
Information Technology at Billing Concepts, Inc., the largest third party
billing clearinghouse for the telecommunications industry. Mr. Long's career
experience also includes financial services industry business development for
Anderson Consulting and several executive positions in publicly traded
telecommunications and financial services companies.
LOUIS A. HOCH has been our President, Chief Operating Officer, and Director
since July 1998. Mr. Hoch has more than fourteen years of management experience
in large systems development; earning him national recognition as an expert in
call centers, voice-systems and computer telephony integration. Mr. Hoch has
held various key management positions with U.S. Long Distance, Billing Concepts,
Inc. and Anderson Consulting. Mr. Hoch holds a BBA in Computer Information
Systems and an MBA in International Business Management, both from Our Lady of
the Lake University Business School. In 2000 and 2001, he served as a board
member of Office e-procure, which provides branded office supply eCommerce sites
for businesses.
PETER G. KIRBY, Ph.D. SPHR CM, has been our Director since June 2001. Mr. Kirby
distinguished himself in professional and community activities in a career that
spans thirty-five years. He is an accomplished public speaker and has provided
consultative services to Fortune 100 firms. Mr. Kirby has published numerous
works in the fields of management, decision-making and human resources. He has
been a director on many university advisory councils and boards and has served
on many charitable committees and foundations. Mr. Kirby is currently a tenured
professor of Management at Our Lady of the Lake University in San Antonio,
Texas, where he has taught for the past fourteen years.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, to our knowledge, certain information concerning
the beneficial ownership of our common stock as of June 10, 2004 by each
stockholder known by us to be (i) the beneficial owner of more than 5% of the
outstanding shares of common stock, (ii) each current director, (iii) each of
the executive officers named in the Summary Compensation Table who were serving
as executive officers at the end of the 2003 fiscal year and (iv) all of our
directors and current executive officers as a group:
20
NAME AMOUNT AND NATURE OF PERCENT OF CLASS (1)
BENEFICIAL OWNERSHIP
5% STOCKHOLDERS
CheckFree Investment Corporation 3,168,242 (2) 14.7%
2920 Green Valley Road
Building 3, Suite 321-19
Henderson, NV 89014
NAMED EXECUTIVE OFFICERS AND DIRECTORS
Michael R. Long 1,840,001 (3) 8.6%
Louis A. Hoch 1,818,034 (4) 8.5%
Peter G. Kirby 293,600 (5) 1.4%
All executive officers and directors as a group (3 people) 3,951,635 (6) 18.4%
(1) Based on a total of 21,495,181 shares of common stock issued and outstanding on June 10, 2004.
(2) Based on a Schedule 13(g)/A filed on February 2, 2003, the most recent date for which information is available.
(3) Includes 1,248,334 shares that Mr. Long has the right to acquire upon the exercise of stock options.
(4) Includes 1,115,000 shares that Mr. Hoch has the right to acquire upon the exercise of stock options.
(5) Includes 293,000 shares that Mr. Kirby has the right to acquire upon the exercise of stock options.
(6) The address of all individual directors and executive officers is c/o Payment Data Systems, Inc., 12500 San Pedro,
Suite 120, San Antonio, Texas 78216.
DESCRIPTION OF SECURITIES
COMMON STOCK
Our Articles of Incorporation authorize us to issue 200,000,000 shares of common
stock, par value $.001 per share.
VOTING RIGHTS. Each share of our common stock entitles the holder thereof to one
vote, either in person or by proxy, at meetings of stockholders. Stockholders
are not permitted to vote their shares cumulatively. Accordingly, the holders of
more than 50% of the voting power can elect all of our directors.
DIVIDEND POLICY. All shares of common stock are entitled to participate ratably
in dividends when, as and if declared by our Board of Directors out of the funds
legally available therefore. Any such dividends may be paid in cash, property or
additional shares of common stock. We have not paid any dividends since
inception and presently anticipate that all earnings, if any, will be retained
for development of our business. We expect that no dividends on the shares of
common stock will be declared in the foreseeable future. Any future dividends
will be subject to the discretion of our Board of Directors and will depend
upon, among other things, our future earnings, operating and financial
condition, capital requirements, general business conditions and other pertinent
facts. We may never pay dividends on our common stock.
21
MISCELLANEOUS RIGHTS AND PROVISIONS. Holders of common stock have no preemptive
or other subscriptions rights, conversions rights, redemption or sinking fund
provisions. In the event of the liquidation or dissolution, whether voluntary or
involuntary, of the company, each share of common stock is entitled to share
ratably in any assets available for distribution to holders of the equity of the
company after satisfaction of all liabilities.
STOCKHOLDER RIGHTS PLAN. On October 4, 2000, we declared a dividend of one Right
for each outstanding share of our common stock. Each Right entitles the
registered holder to purchase one one-thousandth of a share of common stock at a
purchase price of $14 on the earlier of (i) the tenth day following the public
announcement that a person or group of affiliated or associated persons other
than us, our subsidiaries or our employee benefit plans has acquired, or
obtained the right to acquire, beneficial ownership of 20% or more of our
outstanding common stock or (ii) the tenth business day following the
commencement by any person other than us, our subsidiaries or our employee
benefit plans, or the announcement of the intention to commence, a tender or
exchange offer that would result in the ownership of 20% or more of our
outstanding common stock. The Rights automatically trade with the common stock.
INTEREST OF NAMED EXPERTS AND COUNSEL
No expert or counsel within the meaning of those terms under Item 504 of
Regulation S-B will receive a direct or indirect interest in our company or was
our promoter, underwriter, voting trustee, director, officer, or employee. Nor
does any such expert have any contingent based agreement with us or any other
interest in or connection to us.
DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR SECURITIES ACT
LIABILITIES
Nevada law generally sets forth the powers of corporations to indemnify
officers, directors, employees, and agents. Our Articles of Incorporation
provide as follows:
No director or officer shall have any personal liability to the corporation or
its stockholders for the damages for breach of fiduciary duty as a director or
officer, except that this Article shall not eliminate or limit the liability of
a director or officer for (i) acts or omissions that involve intentional
misconduct, fraud or a knowing violation of the law, or (ii) the payment of
dividends in violation of the Nevada Revised Statutes.
Insofar as indemnification for liabilities arising under the Securities Act of
1933 may be permitted to directors, officers or persons controlling us under the
foregoing provisions, we have been advised that in the opinion of the SEC such
indemnification is against public policy as expressed in the Securities Act, and
is unenforceable for that reason.
CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS
This prospectus contains forward-looking statements that involve risks and
uncertainties. We generally use words such as "believe," "may," "could," "will,"
"intend," "expect," "anticipate," "plan," and similar expressions to identify
forward-looking statements. You should not place undue reliance on these
forward-looking statements. Our actual results could differ materially from
those anticipated in the forward-looking statements for many reasons, including
the risks described in our "Risk Factor" section and elsewhere in this
prospectus. Although we believe the expectations reflected in the
forward-looking statements are reasonable, they relate only to events as of the
date on which the statements are made, and our future results, levels of
activity, performance or achievements may not meet these expectations. We do not
intend to update any of the forward-looking statements after the date of this
document to conform these statements to actual results or to changes in our
expectations, except as required by law.
DESCRIPTION OF BUSINESS
INTRODUCTION
We incorporated in the State of Nevada in July 1998. On July 25, 2003, we sold
substantially all of our assets to Saro, Inc., a Delaware corporation, which is
a wholly owned subsidiary of CyberStarts, Inc., a Delaware corporation.
CyberStarts, Inc. subsequently changed its name to Harbor Payments, Inc. The
aggregate selling price was $4,800,000, including $700,000 subject to certain
earnout provisions, plus Saro's assumption of certain of our liabilities. We
will receive $100,000 of the $700,000 contingent selling price if the gross
revenues associated with the asset group that we sold equal or exceed $5,000,000
for the one year period beginning immediately after the sale. We will receive
the remaining $600,000 of the $700,000 earnout if the gross revenues associated
with the asset group that we sold equal or exceed $1,500,000 for each of the
four consecutive quarterly periods beginning immediately after the sale. We do
not anticipate receiving any of the contingent selling price based on the gross
revenues for the eleven months ended June 30, 2004 associated with the asset
group that we sold as reported to us by Harbor Payments, Inc. The assets sold
represented our proprietary technology infrastructure along with certain third
party software and hardware platforms and certain furniture and fixtures that
supported our Electronic Bill Presentment and Payment, or EBPP, service
offerings, including our eServ and eConsulting products. The following details
the net book value of the assets sold at July 25, 2003:
22
Computer hardware 2,809,294
Software (third party) 1,462,983
Furniture and fixtures 596,140
Proprietary technology -
Total cost 4,868,417
Less:accumulated
depreciation
and amortization (3,800,198)
Total net book value
of assets sold 1,068,219
We expensed the costs to develop our proprietary technology infrastructure as
they were incurred so these assets had no recorded value at the date of sale.
The assets sold represented virtually all of our assets which we used to produce
substantially all of our revenue through the date we sold these assets.
Therefore, we discontinued our primary operations and began to concentrate on
building our electronic payments business using the assets that we retained
after this sale. Before the sale of these assets, our primary operations
consisted of hosting the electronic presentment of bills on the Internet for
other companies and managing the related electronic payments from their
consumers through third party payment processors. After the sale of these
assets, our primary operations consist of functioning as a processor of
electronic payments for other companies. We also continued to operate our
bills.com consumer bill payment Web site through which we process online
payments by consumers. We believe that the property and equipment we retained
after this sale are sufficient to support our continuing operations as described
below.
CONTINUING OPERATIONS
GENERAL
We currently provide integrated electronic payment processing services to
merchants and businesses, including all types of Automated Clearinghouse, or
ACH, Network processing and credit and debit card-based processing services. The
ACH Network is a nationwide electronic funds transfer system that is regulated
by the Federal Reserve and provides for the clearing of electronic payments
between participating financial institutions. Our ACH processing services enable
merchants or businesses to both disburse or collect funds electronically using
e-checks to transfer funds instead of traditional paper checks. An e-check is an
electronic debit to a bank checking account that is initiated at the
point-of-sale, on the Internet, over the telephone or via a bill payment sent
through the mail and is processed using the ACH network. Our card-based
processing services enable merchants to process both traditional card-present,
or "swipe," transactions, as well as card-not-present transactions. A
traditional card-present transaction occurs whenever a cardholder physically
presents a credit or debit card to a merchant at the point-of-sale. A
card-not-present transaction occurs whenever the customer does not physically
present a payment card at the point-of-sale and may occur over the Internet,
mail, fax or telephone. Our electronic payment processing may take place in a
variety of forms and situations. For example, our capabilities allow merchants
to convert a paper check to an e-check or receive card authorization at the
point-of-sale, have their customer service representatives take e-check or card
payments from their consumers by telephone, and enable their consumers to make
e-check or card payments directly through the use of a Web site or by calling an
Interactive Voice Response, or IVR, telephone system. We also operate an online
payment processing service for consumers under the domain name www.bills.com
through which consumers can pay anyone. We generate revenues by charging fees
for the electronic processing of payment transactions and related services. We
charge certain merchants for these processing services at a bundled rate based
on a percentage of the dollar amount of each transaction and, in some instances,
additional fees are charged for each transaction. We charge other merchant
customers a flat fee per transaction, and may also charge miscellaneous fees to
our customers, including fees for returns, monthly minimums, and other
miscellaneous services. We charge consumers that use our bills.com online
payment service a flat monthly fee that allows them to make a certain number of
payments in a month. We also charge these consumers an additional fee for each
payment that exceeds the allowed number of payments in a given month. We operate
solely in the United States as a single operating segment, and do not currently
have any foreign operations even though one of our subsidiaries is named
billserv.com - Canada, Inc.
23
INDUSTRY BACKGROUND
The use of non-paper based forms of payment by consumers in the United States,
such as credit and debit cards, ACH transfers and other electronic payments, has
increased significantly over the past several years. According to the Federal
Reserve, paper check use as a percentage of retail non-cash payments declined
from 77.1% in 1995 to 59.5% in 2000. The growth of electronic commerce has made
the acceptance of card-based and other electronic forms of payment a necessity
for businesses, both large and small, in order to remain competitive. NACHA -
The Electronic Payments Association reported that more than 1.3 billion e-check
payments were made in 2003, which was a 154% increase over 2002.
We believe that the electronic payment processing industry will continue to
benefit from the following trends:
Favorable Demographics
As consumers age, we expect that they will continue to use the payment
technology to which they have grown accustomed. More consumers are beginning to
use card-based and other electronic payment methods for purchases at an earlier
age. According to the Federal Reserve Survey of Consumer Finances, the
percentage of households with consumers under the age of 30 years using debit
cards increased from 24.5% in 1995 to 60.6% in 2001. As these consumers who have
witnessed the wide adoption of card products, technology and the Internet
comprise a greater percentage of the population and increasingly enter the work
force, we expect that purchases using electronic payment methods will comprise
an increasing percentage of total consumer spending. Because of the Internet's
increasing adoption rate, businesses have a growing opportunity to conduct
commerce with their consumers and business partners over the Internet.
Increased Electronic Payment Acceptance by Small Businesses
Small businesses are a vital component of the U.S. economy and are expected to
contribute to the increased use of electronic payments methods. According to the
U.S. Small Business Administration, small businesses generate more than 50% of
the nonfarm private gross domestic product in the U.S. The lower costs
associated with electronic payment methods are making these services more
affordable to a larger segment of the small business market. In addition, we
believe these businesses are experiencing increased pressure to accept
electronic payment methods in order to remain competitive and to meet consumer
expectations. As a result, many of these small businesses are seeking, and we
expect many new small businesses will seek, to provide customers with the
ability to pay for merchandise and services using electronic payment methods,
including those in industries that have historically accepted cash and checks as
the only forms of payment for their merchandise and services.
Growth In Online Transactions
Market researchers expect dramatic growth in card-not-present transactions due
to the rapid growth of the Internet and electronic commerce. According to the
U.S. Census Bureau, retail e-commerce sales for 2003 were $54.9 billion, an
increase of 26% from $43.5 billion in 2002. The prevalence of the Internet makes
having an online presence a basic consideration for those operating a business
today. To remain competitive, many companies are seeking to leverage the
Internet to provide operational efficiencies, create new revenue opportunities
and maximize the longevity and profitability of their customer relationships.
24
PRODUCTS AND SERVICES
Our service offerings are supported by our systems infrastructure that
integrates certain proprietary components with processing systems outsourced to
third party providers to offer our customers a flexible and secure payment
process. We utilize SSL, or a secure sockets layer, so that connections and
information are secure from outside inspection and 128-bit encryption to make
information unreadable as it passes over the Internet for all electronic
transactions that we process. Our systems infrastructure allows us to work with
our customers to build a customized electronic payment service offering tailored
to their specific needs. We have designed and implemented our integrated payment
systems to function as gateways between our customers and our third party
processing providers. Our systems provide for interfaces with our customers
through which payment data is captured electronically and transferred through
the connections we have with our processing providers. Our systems also provide
a data warehousing capability so that all of a customer's payment data can be
stored in one place to facilitate efficient data retrieval and analysis. We
outsource our ACH transaction processing and card-based transaction processing
to third party providers. Our card-based processing system is capable of
connecting with all of the major card-based processors in the United States. We
also outsource the processing of the payments initiated by consumers online at
our bills.com Web site.
The components of our service offering include all forms of ACH payment
transaction processing, such as Re-presented Check (RCK), which is a consumer
non-sufficient funds, or NSF, check that is re-presented for payment
electronically rather than through the paper check collection system, and
Accounts Receivable Check Conversion (ARC), which is a consumer paper check
payment that is converted into an e-check. Our customers can initiate ACH
transactions directly using an online terminal accessible through a Web site or
we can initiate ACH transactions on their behalf. Our service offering also
includes merchant account services for the processing of card-based transactions
through the VISA and MasterCard networks, including online terminal services
accessed through a Web site or retail services accessed via a physical terminal.
We offer a proprietary Web-based customer service application that combines both
ACH and card processing capabilities and allows companies to process one-time
and recurring payments via e-checks or credit cards at the request of their
consumers. In addition, we offer an Interactive Voice Response (IVR) telephone
system to companies that accepts payments directly from consumers over the
telephone using e-checks or credit cards.
We also operate a consumer Web site focused on providing online bill payment
services under the domain name www.bills.com. Consumers subscribe to the payment
service and are allowed to make a limited number of payments each month for a
flat monthly fee. The bills.com strategy is to provide the consumer with an
efficient and secure interface for viewing, paying and managing bills via the
Internet. We also market this portal service to online financial services
providers looking to provide EBPP capabilities as part of their service offering
to consumers.
RELATIONSHIPS WITH SPONSORS AND PROCESSORS
We have agreements with several processors to provide to us, on a non-exclusive
basis, transaction processing and transmittal, transaction authorization and
data capture, and access to various reporting tools. In order to provide payment
processing services for ACH transactions, we must maintain a relationship with
an Originating Depository Financial Institution, or ODFI, in the ACH Network ,
because we are not a bank and therefore not eligible to be an ODFI. The third
party provider that handles our ACH processing maintains a relationship with
several ODFIs on our behalf. Similarly, in order to provide payment processing
services for Visa and MasterCard transactions, we must be sponsored by a
financial institution that is a principal member of the Visa and MasterCard card
associations. We have an agreement with Network 1 Financial, Inc. through which
its member bank , Harris Bank, sponsors us for membership in the Visa and
MasterCard card associations and settles card transactions for our merchants.
This agreement may be terminated by the processor if we materially breach the
agreement and we do not cure the breach within 30 days, or if we enter
bankruptcy or file for bankruptcy.
25
Under our processing agreement with Network 1 Financial, we are financially
liable for all fees, chargebacks and losses related to our card processing
merchant customers. If, due to insolvency or bankruptcy of our merchant
customers, or for another reason, we are not able to collect from them amounts
that have been refunded to the cardholders because the cardholders properly
initiated a chargeback transaction to reverse the credit card charges, we must
bear the credit risk for the full amount of the cardholder transaction. We
utilize a number of systems and procedures to evaluate and manage merchant risk,
such as obtaining approval of prospective merchants from our processor and
sponsor bank, setting transaction limits and monitoring account activity. We may
also require cash deposits and other types of collateral from certain merchants
to mitigate any such risk. We maintain a reserve for losses resulting from card
processing and related chargebacks. We estimate our potential loss for
chargebacks by performing a historical analysis of our chargeback loss
experience with similar merchants and considering other factors that could
affect that experience in the future, such as the types of card transactions
processed and nature of the merchant relationship with their consumers.
We also maintain a separate allowance for doubtful accounts for estimated losses
resulting from the inability or failure of our merchant customers to make
required payments for fees charged by us. Amounts due from customers may be
deemed uncollectible because of merchant disputes, fraud, insolvency or
bankruptcy. We determine the allowance for doubtful accounts based on an
account-by-account review, taking into consideration such factors as the age of
the outstanding receivable, historical pattern of collections and financial
condition of the customer. We closely monitor extensions of credit and if the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make contractual payments, additional allowances
may be required.
CUSTOMERS
We do not depend on any one or a few major customers. Nearly all of our
customers are consumers geographically dispersed throughout the United States
utilizing our bills.com Internet bill payment service on a recurring monthly
basis to pay household bills. The service relationship between us and our
bills.com customers is not contractual and the fee we charge for the service is
not negotiable. We seek to retain customers by providing high service levels.
Customers are also more likely than not to continue using the service once
activated due to their investment of time in setting up the service with their
personal banking and payment information. The monthly average number of
bills.com customers using our online payment service increased from 1,037 in
2001 to 1,408 in 2002 and 2,020 in 2003. The number of bills.com customers
served by us for the three years ended December 31, 2003, including additions
and attrition, was as follows:
Number at beginning of period Additions Attrition Number at end of period
----------------------------- --------- --------- -----------------------
Year ended December 31, 2001 978 235 115 1,098
Year ended December 31, 2002 1,098 860 167 1,791
Year ended December 31, 2003 1,791 957 501 2,247
26
Our other customers are merchants and businesses that use our ACH and/or
card-based processing services in order to provide their consumers with the
ability to pay for goods and services without having to use cash or a paper
check. These merchant customers operate in a variety of retail industries and
are under contract with us to exclusively use the services that we provide to
them. As of December 31, 2003 we had 8 merchant customers that were each
generating an average of less than 100 transactions monthly. We first offered
ACH processing services in the third quarter of 2003 and card-based processing
services in the fourth quarter of 2003. Revenue generated by our merchant
customers represented approximately 2% of our total revenues in 2003, but we
believe that this percentage will increase as we anticipate adding new merchant
customers and experiencing growth in transaction volumes as a result. We believe
that our merchant business provides us with the best opportunity for revenue
growth and will comprise the majority of our business in the future.
SALES AND MARKETING
We market and sell our products and services through direct contact by our sales
personnel, as well as through non-exclusive resellers that act as an external
sales force, with minimal direct investment in sales infrastructure and
management. Our direct sales effort is coordinated by a sales executive and
supported by other employees who function in sales capacities. We will continue
to analyze our sales and marketing efforts in order to control costs, increase
the effectiveness of our sales force, and broaden our reach through reseller
initiatives and advantageous alliances.
Our primary market focus is on companies generating high volumes of electronic
payment transactions. We tailor our sales efforts to reach this market by using
resellers that have access to or existing relationships with such companies and
by pre-qualifying prospective sales leads through direct contact or market
research. Our sales personnel typically initiate contact with prospective
customers that we identify as meeting our target profile. Most of our merchant
customers have signed long-term contracts, with generally three-year terms, that
provide for volume-based transaction fees. We processed our first ACH
transactions during the third quarter of 2003 and processed our first card-based
transactions during the fourth quarter of 2003.
COMPETITION
The payment processing industry is highly competitive. Many small and large
companies compete with us in providing payment processing services and related
services to a wide range of merchants. There are a number of large transaction
processors, including First Data Merchant Services Corporation, Concord EFS,
Inc., National Processing, Inc., and Global Payments, Inc., that serve a broad
market spectrum from large to small merchants and provide banking, ATM and other
payment-related services and systems in addition to card-based payment
processing. There are also a large number of smaller transaction processors that
provide various services to small and medium-sized merchants. Many of our
competitors have substantially greater capital resources than we have and
operate as subsidiaries of financial or bank holding companies, which may allow
them on a consolidated basis to own and conduct depository and other banking
activities that we do not have the regulatory authority to own or conduct. We
believe that the principal competitive factors in our market include:
- quality of service
- reliability of service
- ability to evaluate, undertake and manage risk - speed in implementing payment
processes - price and other financial terms
- multi-channel payment capability
27
We believe that our specific focus on providing integrated payment processing
solutions to merchants, in addition to our understanding of the needs and risks
associated with providing payment processing services electronically, gives us a
competitive advantage over other competitors, which have a narrower market
perspective, and over competitors of a similar or smaller size that may lack our
experience in the electronic payments industry. Furthermore, we believe we
present a competitive distinction through the use of our internal technology to
provide a single integrated payment storage or warehouse that consolidates,
processes, tracks and reports all payments regardless of payment source or
channel.
TRADEMARKS
We own federally registered trademarks on the marks Bills.com, and Bills.com and
design, and have applied for trademarks on Payment Data Systems, Inc., and
Payment Data Systems, Inc. and design with the United States Patent and
Trademark Office. We have also secured domain name registrations for bills.com,
paymentdatasystems.com, paymentdata.org and paymentdata.com. We rely on a
combination of copyright, trademark and trade secret laws, employee and third
party nondisclosure agreements and other intellectual property protection
methods to protect our services and related products.
DISCONTINUED OPERATIONS
GENERAL
Prior to July 25, 2003, we provided EBPP and related services to companies that
generate recurring bills to their consumers. On July 25, 2003, we sold
substantially all of the assets that we used in providing these EBPP services.
After we sold these assets, we no longer provided EBPP services, which are
presented in our financial statements as discontinued operations. We believe
that the property and equipment we retained after this sale are sufficient to
support our continuing operations as described above. During the years ended
December 31, 2003, 2002 and 2001, our discontinued operations provided revenue
of $2,155,000, $4,129,000 and $2,925,000, respectively. EBPP is the process of
sending bills in an electronic format to consumers securely through the Internet
and processing Internet payment of bills utilizing an electronic transfer of
funds. This service offering allowed companies to outsource their electronic
billing process, providing them a single point of contact for designing,
developing, implementing and managing their EBPP process. We offered services to
consolidate billing information and then securely deliver an electronic bill to
the biller's payment Web site, the consumer's e-mail inbox and numerous Internet
bill consolidation Web sites, such as those sponsored by financial institutions.
Our EBPP services allowed billers to establish an interactive, online
relationship with their consumers by integrating Internet customer care and
direct marketing with the electronic bill. We also provided professional
services to assist with the implementation and maintenance of an electronic bill
offering. In addition, we offered consumer marketing support to assist billers
in encouraging their consumers to switch from paper to electronic billing.
We generated EBPP revenue by charging volume-based fees fixed under long-term
contracts for transactions processed through our system, such as loading,
delivering, viewing and paying bills, customer care interactions, handling
payment returns and consolidating remittances. In certain instances, we received
a fixed amount per e-bill delivered and made available to a consumer regardless
of whether that consumer paid the e-bill using our services. We also typically
received an up-front fee from a customer to cover the initial basic
implementation of the contracted services. We charged customers that contracted
for professional consulting services on a time and materials basis and charged
license fees for the use of our proprietary gateway services technology and the
CheckFree iSolutions software that was resold by us as an authorized reseller of
CheckFree iSolutions software in Australia only.
DISCONTINUED PRODUCTS AND SERVICES
The components of our EBPP service offering, all of which were available to
customers and generated revenue, included:
28
eServ
eServ was our flagship product and the foundation for our comprehensive EBPP
services. eServ provided our customers with a single offering for developing and
managing their entire EBPP capabilities. Our eServ product provided outsourced
creation and management of presentment and payment processes for a biller-direct
site and all aggregator sites, as well as payment processing and full reporting
and reconciliation capabilities. Our offering also supported the EBPP process
with Internet-enabled customer care services, available as either a Web-based
tool for our clients to deliver customer support in-house or on an outsourced
basis using our employees to perform customer service.
eConsulting
eConsulting was the our professional services group that offered electronic
billing, customer care, project management, and IT consulting services to both
existing billing customers and the EBPP industry in general. Our eConsulting
group offered services ranging from project monitoring to complete turnkey
project development and implementation.
eServ Gateway
Our eServ Gateway offered billers who were already participating in EBPP a
single distribution point to virtually all bill presentment and payment
locations across the World Wide Web. The Gateway was designed to improve a
biller's existing EBPP system, whether an in-house offering, biller direct site
or limited distribution channel, by expanding the range of distribution
partners. The Company's unique Gateway specifications could also be embedded as
an OEM (Original Equipment Manufacturer) component within other companies'
software or service offerings, affording such companies a cost-effective, proven
method to give their clients and consumers the ability to make online payments,
and view and pay bills through bank and internet payment portals.
PRODUCT DEVELOPMENT
Our total research and development expenses were $82,055, $461,065, and $760,082
for 2003, 2002, and 2001, respectively. We created a proprietary technology
infrastructure to support all of the components of our service offering. Our
systems consisted primarily of proprietary software applications that we
integrated with third party hardware and software platforms. Substantially all
of the assets related to our research and development expenditures were sold in
July 2003.
SALES AND MARKETING
We sold our EBPP services through direct sales efforts that included marketing
to existing customers led by our Account Management team. We also sold our
services through organizations that had exclusive reseller agreements with us to
sell our EBPP services. Our marketing efforts were primarily EBPP
adoption-focused. Our professional staff of Account Managers actively assisted
our customers in creating programs to encourage their consumers to utilize EBPP.
CUSTOMERS
Our primary market focus was on top-tier and middle-market companies generating
high volumes of recurring (usually monthly) paper-based bills. We serviced
billers in select vertical markets, such as utilities, telecom, cable, media and
financial services industries, as well as the higher education market. All of
our billing customers signed long-term contracts, with generally three to
five-year terms, that provided for set-up fees, in certain cases, and
volume-based transaction fees. The number of EBPP customers served by us for the
three years ended December 31, 2003, including additions and attrition, was as
follows:
29
Number at beginning of period Additions Attrition Number at end of period
----------------------------- --------- --------- -----------------------
Year ended December 31, 2001 49 53 1 101
Year ended December 31, 2002 101 34 16 119
Year ended December 31, 2003 119 0 119 0
The attrition in 2003 was due primarily to the assignment of the customer
contracts to Saro in conjunction with the sale of substantially all of our
assets in July 2003. The attrition in 2002 is primarily attributable to the loss
of certain customers serviced via resellers as a normal part of the resellers'
account turnover and the migration of certain customers to in-house EBPP
offerings after their billing agreements expired. EBPP services provided to
CenterPoint Energy, Inc., formerly Reliant Energy, accounted for approximately
12%, 16% and 23% of total revenues for the years ended December 31, 2003, 2002
and 2001, respectively.
EMPLOYEES
As of June 10, 2004, we had 7 employees. We are not a party to any collective
bargaining agreements. We believe that our relations with our employees are
good.
ADDITIONAL INFORMATION
Our common stock is registered with the SEC under section 12(g) of the
Securities Exchange Act of 1934. We file with the SEC periodic reports on Forms
10-K, 10-Q and 8-K, and proxy statements, and our officers and directors file
reports of stock ownership on Forms 3, 4 and 5. We intend to send annual reports
containing audited financial statements to our shareholders. Additionally, we
filed with the Securities and Exchange Commission a registration statement on
Form SB-2 under the Securities Act of 1933 for the shares of common stock in the
offering, of which this prospectus is a part. This prospectus does not contain
all of the information in the registration statement and the exhibits and
schedules that were filed with the registration statement. For further
information we refer you to the registration statement and the exhibits and
schedules that were filed with the registration statement.
Statements contained in this prospectus about the contents of any contract or
any other document that is filed as an exhibit to the registration statement are
not necessarily complete, and we refer you to the full text of the contract or
other document filed as an exhibit to the registration statement. A copy of the
registration statement and the exhibits and schedules that were filed with the
registration statement may be inspected without charge at the Public Reference
Room maintained by the Securities and Exchange Commission at 450 Fifth Street,
N.W., Washington, D.C. 20549, and copies of all or any part of the registration
statement may be obtained from the Securities and Exchange Commission upon
payment of the prescribed fee. Information regarding the operation of the Public
Reference Room may be obtained by calling the Securities and Exchange Commission
at 1-800-SEC-0330.
The Securities and Exchange Commission maintains a web site that contains
reports, proxy and information statements, and other information regarding
registrants that file electronically with the SEC. The address of the site is
www.sec.gov.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF PLAN OF OPERATION
The following discussion and analysis should be read in conjunction with the
Consolidated Financial Statements and Notes thereto, and other financial
information included elsewhere in this prospectus. This prospectus contains
forward-looking statements that involve risks and uncertainties. Actual results
in future periods may differ materially from those expressed or implied in such
forward-looking statements as a result of a number of factors, including, but
not limited to, the risks discussed under the heading "Risk Factors" and
elsewhere in this prospectus.
30
OVERVIEW
On July 25, 2003 we sold substantially all of our assets to Saro, Inc., a
Delaware corporation , which is a wholly owned subsidiary of CyberStarts, Inc.,
a Delaware corporation. The aggregate selling price was $4,800,000, including
$700,000 subject to certain earnout provisions, plus Saro's assumption of
certain or our liabilities. The selling price was determined through extensive
negotiations between Saro and us. Our Board of Directors, in its reasonable
business judgment, approved the transaction based upon the following factors:
1) the extensive search for a purchaser;
2) the number of offers made by potential purchasers;
3) our ability to raise capital to operate our business; and
4) future trends in the industry.
The transaction was approved by a majority of our shareholders at a Special
Meeting of Shareholders held on July 14, 2003. The assets sold represented our
proprietary technology infrastructure along with certain third party software
and hardware platforms and certain furniture and fixtures that supported our
EBPP service offerings, including our eServ and eConsulting products. The
carrying value of these non-current assets was approximately $1,068,000 at July
25, 2003. Saro also assumed certain of our current and non-current liabilities
with carrying values of $83,000 and $30,000, respectively, at July 25, 2003. The
assets sold represented virtually all of our assets, which we used to produce
nearly all of our revenue; therefore, we ceased our primary EBPP operations and
will continue to operate our bills.com consumer bill payment portal and
concentrate on building our electronic payments business. The results of
operations for the asset group disposed of have been reported as discontinued
operations in the accompanying statements of operations. We retained our
accounts receivable and related deferred revenue associated with the customers
of the discontinued operations, as well as certain accounts payable and accrued
liabilities related to the discontinued operations. At December 31, 2003, our
balance sheet included approximately $38,000 of net accounts receivable and
approximately $277,000 of current liabilities that related to the discontinued
operations.
Prior to the transaction, we provided EBPP and related services to companies
that generate recurring bills, primarily in the United States. EBPP is the
process of sending bills to consumers securely through the Internet and
processing Internet payment of bills utilizing an electronic transfer of funds.
Our service offering allowed companies to outsource their electronic billing
process, providing them a single point of contact for developing, implementing
and managing their EBPP process. We offered services to consolidate customer
billing information and then securely deliver an electronic bill to the biller's
own payment Web site hosted by us, the consumer's e-mail inbox and numerous
Internet bill consolidation Web sites, such as those sponsored by financial
institutions. Our EBPP services allowed billers to establish an interactive,
online relationship with their consumers by integrating Internet customer care
and direct marketing with the electronic bill. We also provided Internet-based
customer care interaction services and professional services to assist with the
implementation and maintenance of an electronic bill offering.
As a condition of the sale to Saro, Inc., we and certain of our principal
officers agreed, for a period of two years, not to compete in the business of
providing electronic bill presentment services in conjunction with bill payment
solutions. Under such non-compete provisions, we and the applicable officers are
prohibited from competing in the business of providing electronic bill
presentment services in conjunction with bill payment solutions
31
1) for our former customers; or
2) in geographic areas in which we provided electronic bill presentment services
in conjunction with bill payment solutions prior to the transaction.
We believe that these non-compete provisions will not have a significant impact
on our strategic plan to provide electronic payment processing and related
services.
We continue to operate an Internet electronic payment processing service for
consumers under the domain name www.bills.com and provide integrated electronic
payment services, including credit and debit card-based processing services and
transaction processing via the ACH network. Since inception, we have incurred
operating losses each quarter, and as of December 31, 2003, we have an
accumulated deficit of $46.7 million.
CRITICAL ACCOUNTING POLICIES
GENERAL
Management's discussion and analysis of our financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with U.S. generally accepted accounting principles. The
preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenue and
expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate our estimates, including those related to the
reported amounts of revenues and expenses, bad debt, investments, intangible
assets, income taxes, and contingencies and litigation. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results could differ from these
estimates under different assumptions or conditions. We consider the following
accounting policies to be critical because the nature of the estimates or
assumptions is material due to the levels of subjectivity and judgment necessary
to account for highly uncertain matters or the susceptibility of such matters to
change or because the impact of the estimates and assumptions on financial
condition or operating performance is material.
RESERVE FOR LOSSES ON CARD PROCESSING
If, due to insolvency or bankruptcy of the merchant, or for another reason, we
are not able to collect amounts from our card processing merchant customers that
have been properly "charged back" by the cardholders, we must bear the credit
risk for the full amount of the cardholder transaction. We may require cash
deposits and other types of collateral from certain merchants to minimize any
such risk. In addition, we utilize a number of systems and procedures to manage
merchant risk. Card merchant processing loss reserves are primarily determined
by performing a historical analysis of our chargeback loss experience and
considering other factors that could affect that experience in the future, such
as the types of card transactions processed and nature of the merchant
relationship with their consumers. This reserve amount is subject to risk that
actual losses may be greater than our estimates. At December 31, 2003, we did
not have a significant card merchant processing loss reserve due to the limited
volume of transactions that we processed since the inception of our card
processing services during the fourth quarter of 2003. We have not incurred any
chargeback losses to date. Our estimate for chargeback losses is likely to
increase in the future as our volume of card-based transactions processed
increases.
32
BAD DEBT
We maintain an allowance for doubtful accounts for estimated losses resulting
from the inability or failure of our customers to make required payments. We
determine the allowance for doubtful accounts based on an account-by-account
review, taking into consideration such factors as the age of the outstanding
balance, historical pattern of collections and financial condition of the
customer. Past losses incurred by us due to bad debt have been within our
expectations. We recorded bad debt expense of $10,700, $30,000 and $21,000 for
2003, 2002 and 2001, respectively, and recorded bad debt write-offs of $54,742,
$1,734 and $12,069 to our allowance for doubtful accounts in 2003, 2002 and
2001, respectively. At December 31, 2003 and 2002, the balance of the allowance
for doubtful accounts was $3,155 and $47,197, respectively. If the financial
condition of our customers were to deteriorate, resulting in an impairment of
their ability to make contractual payments, additional allowances may be
required. Our estimate for bad debt losses is likely to increase in the future
as our volume of transactions processed increases.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS
We assess the impairment of long-lived and intangible assets at least annually,
and whenever events or changes in circumstances indicate that the carrying value
may not be recoverable. Factors considered important, which could trigger an
impairment review, include the following: significant underperformance relative
to historical or projected future cash flows; significant changes in the manner
of use of the assets or the strategy of the overall business; and significant
negative industry trends. When management determines that the carrying value of
long-lived and intangible assets may not be recoverable, impairment is measured
as the excess of the assets' carrying value over the estimated fair value.
During the second quarter of 2003, we performed an impairment review because we
expected to sell the asset group used to provide electronic bill payment and
presentment services. We determined that the asset group to be sold was impaired
and recorded a non-cash charge of $200,000, which is included as a component of
discontinued operations in the accompanying consolidated statement of
operations. Fair value was based on the expected selling price of the asset
group. During the fourth quarter of 2003, we performed an impairment review
because we expected to sell certain furniture not currently being utilized. We
determined that the furniture expected to be sold was impaired and recorded a
non-cash charge of $17,000, which is included as a component of selling, general
and administrative expense in the accompanying consolidated statement of
operations. Fair value was based on the selling price of similar assets.
During the fourth quarter of 2002, we performed an impairment review because of
the uncertainty of our ability to continue as a going concern due to decreased
liquidity, which indicated that the carrying value of certain long-lived assets
may not be recoverable. We determined that customer relationship management
software and document archival and retrieval software with a total carrying
amount of $855,000 were no longer recoverable and recorded a non-cash charge of
$855,000, which is included as a component of discontinued operations in the
accompanying consolidated statement of operations. Fair value was based on the
expected future cash flows to be generated by these assets, which was determined
to be zero because of our inability to deploy and utilize the assets to provide
revenue-generating services.
No impairment losses were recorded in 2001.
33
INCOME TAXES
Deferred tax assets and liabilities are recorded based on the difference between
the tax bases of assets and liabilities and their carrying amount for financial
reporting purposes, as measured by the enacted tax rates and laws that will be
in effect when the differences are expected to reverse. Deferred tax assets are
computed with the presumption that they will be realizable in future periods
when pre-taxable income is generated. Predicting the ability to realize these
assets in future periods requires a great deal of judgment by management. It is
our judgment that we cannot predict with reasonable certainty that the deferred
tax assets as of December 31, 2003 will be fully realized in future periods.
Accordingly, a valuation allowance has been provided to reduce the net deferred
tax assets to $0. At December 31, 2003, we had available net operating loss
carryforwards of approximately $34.6 million, which expire beginning in the year
2020.
RESULTS OF CONTINUING OPERATIONS
Subsequent to the sale of substantially all of our assets to Saro, Inc., our
only continuing revenues were derived from the operation of an Internet
electronic payment processing service for consumers under the domain name
www.bills.com. We also provide integrated electronic payment services to
merchants and businesses, including credit and debit card-based processing
services and transaction processing via the ACH network. Revenues for the
quarter ended March 31, 2004 increased 129% to $55,197 from $24,156 for the
quarter ended March 31, 2003. The increase from the prior year quarter was
primarily attributable to the addition of revenues generated from card-based and
ACH processing services that the Company began providing during 2003. The
increase in revenue from the prior year quarter was also due to an increase in
the number of consumers subscribing to the bills.com payment service. We
processed our first ACH transactions during the third quarter of 2003 and
processed our first card-based transactions during the fourth quarter of 2003,
but the related transaction volumes for 2003 were not significant so the only
component of our service offering that generated significant revenue for 2003
was the bills.com payment service. Total revenues for 2003 increased 55% to
$119,297 from $77,070 for 2002. Total revenues for 2002 increased 76% from
$43,835 for 2001. The increases from the prior years were primarily attributable
to an increase in the number of consumers subscribing to the bills.com payment
service. The monthly average number of consumers using our online payment
service for the years ended December 31 was as follows:
2003 2002 2001
Average number of bills.com customers per month 2,020 1,408 1,037
The number of transactions generated by bills.com customers is not indicative of
revenue growth because the majority of these customers pay a flat monthly fee to
process up to a certain number of payments each month and do not exceed the
maximum number of payments allowed. We expect our revenues to increase as we
anticipate continued growth in the number of bills.com customers and additional
merchant customers.
Cost of services includes the cost of personnel dedicated to the creation and
maintenance of connections to third party payment processors and fees paid to
such third party providers for electronic payment processing services. Through
our contractual relationships with our payment processors, we are able to
process ACH and debit or credit card transactions on behalf of our customers and
their consumers. We pay volume-based fees for debit and credit transactions
initiated through these processors, and pay fees for other transactions such as
returns, notices of change to bank accounts and file transmission. Cost of
revenues was $63,640 and $17,530 for the quarters ended March 31, 2004 and 2003,
respectively. The increase from the prior year is due to fees incurred in 2004
for ACH and card-based processing services and the higher subscriber volume of
the bills.com payment service. Cost of revenues was $138,009, $58,739 and
$38,004 for 2003, 2002 and 2001, respectively. The increases from the prior
years are due to the higher subscriber volume of the bills.com payment service
and implementation fees charged in the last six months of 2003 by third party
payment processors to initiate electronic payment processing services. We expect
the cost of services to increase ratably as revenues increase.
34
Selling, general and administrative expenses decreased to $359,819 for the
quarter ended March 31, 2004, from $388,593 for the first quarter of 2003. The
decrease in such expenses from the prior year quarter is principally due to
lower corporate insurance expenses and lower salary and benefit costs due to the
reduction of personnel during 2003. Selling, general and administrative expenses
decreased to $1,726,028 in 2003 from $2,431,566 for 2002 and $3,077,783 in 2001.
The decrease in such expenses from 2002 to 2003 was primarily due to lower
salary and benefit costs resulting from the personnel reductions made during
2002 and then again with the sale of substantially all of our assets in July
2003. The number of employees decreased from 35 immediately preceding this sale
to 7 at December 31, 2003. The decrease from 2001 to 2002 is attributable to
cost reductions resulting from the restructuring and realignment of our
organization during the latter half of 2001 to better position us for current
economic and market conditions. During the third quarter of 2001, we downsized
and realigned our organization to make more efficient use of our resources and
better match our infrastructure to market conditions and the current business
environment since the overall growth of the economy and rate of technology
spending by businesses had slowed. This realignment included the layoff of
certain employees and reassignment of other employees to different functions to
reduce our cash outflows and allow us to utilize our limited resources more
prudently by eliminating functions that did not directly contribute to our goal
of profitability. We expect selling, general and administrative expenses to
decrease in 2004 as we realize the cost savings of downsizing to 7 employees for
the full year.
Depreciation and amortization decreased to $27,682 for the quarter ended March
31, 2004, as compared to $36,073 for the first quarter of 2003. This decrease
was due to lower depreciation related to certain assets that became fully
depreciated during 2003. We purchased $1,000 of computer software during the
quarter ended March 31, 2004 and do not anticipate making any significant
capital expenditures over the remaining nine months of 2004. Depreciation and
amortization was $130,671, $183,594 and $199,384 for 2003, 2002 and 2001,
respectively. The decreases from year to year were due to lower depreciation
related to certain assets that became fully depreciated during 2002 and 2001,
respectively. We purchased $66,000 of computer equipment and software during
2003 and do not anticipate making significant capital expenditures in 2004. We
expect depreciation and amortization to continue decreasing as existing assets
become fully depreciated and significant additions are not anticipated.
Net other expense was $4,772 for the quarter ended March 31, 2004, compared to
$46,265 for the first quarter of 2003. This decrease is primarily attributable
to lower interest expense in 2004 due to the repayment of the Company's
convertible debt in July 2003 and lower interest income earned in 2004 as a
result of lower invested balances. Net other income was $101,112 in 2003
compared to net other expense of $2,665,631 in 2002 and net other income of
$352,124 in 2001. The improvement from 2002 to 2003 is primarily attributable to
$1.1 million of interest expense related to the convertible debt issued in 2002,
a $300,000 penalty for default under this convertible debt, and a $1.3 million
loss on related party loan guarantees in 2002. The $1.1 million of interest
expense recognized in 2002 included $238,000 of financing costs, a $259,00 debt
discount for the detachable warrants issued with the convertible debt, and
$539,000 in additional debt discount for the beneficial conversion feature of
the debt. These items were to be amortized over the term of the debt, but were
all fully recognized as interest expense in 2002 as a result of our default. The
default occurred because we did not make the required principal payments in
cash. We were unable to make the required payments in stock because the
registration statement we filed with the Securities and Exchange Commission to
register the resale of the common stock issuable to pay the note was not
declared effective. The improvement is also due to $165,000 of consulting fees
recognized in other income in the third quarter of 2003 for transitional EBPP
consulting services provided to our former equal partner in an EBPP joint
venture in Australia. The joint venture was dissolved as a result of the sale of
substantially all of our assets during the third quarter of 2003. The consulting
fees of $165,000 are included in continuing operations because such services
were not prohibited as a condition of the sale of substantially all of our
assets in July 2003 and were performed after the sale of the asset group. In
addition to the expenses related to the convertible debt and related party
guarantees in 2002, the decrease in net other income from 2001 to 2002 is
attributable to lower interest income earned in 2002 as a result of lower
invested balances and market interest rates.
35
Net loss from continuing operations improved to $400,716 for the quarter ended
March 31, 2004, from $464,305 for the first quarter of 2003 primarily as a
result of the decrease in interest expense and increase in revenues from the
prior year quarter. Loss from continuing operations improved to $1,774,299 in
2003 from $5,262,460 in 2002, primarily as a result of decreases in net other
expenses and selling, general and administrative expenses. The increase in loss
from continuing operations from $2,919,212 in 2001 to $5,262,460 in 2002 was
primarily due to the increase in net other expenses. We expect that loss from
continuing operations will improve in 2004 given our expectations for increased
revenues, lower selling, general and administrative expenses and lower
depreciation and amortization.
RESULTS OF DISCONTINUED OPERATIONS
The following table presents the operating results for our discontinued
operations for the years ended December 31, 2003, 2002 and 2001, which are
reflected as discontinued operations in the Consolidated Statements of
Operations. Results of operations for 2003 are not comparable to results for
prior years because 2003 only includes operating revenues and expenses for the
period from January 1, 2003 through July 25, 2003, which was the date of the
sale of substantially all of our assets to Saro, Inc.
2003 2002 2001
----------------- ------------------ ------------------
Service revenues:
Implementation revenues $ 256,564 $ 311,712 $ 502,753
Transaction revenues 1,273,931 1,875,561 1,119,379
Consulting revenues 624,787 1,704,211 1,302,711
----------------- ------------------ ------------------
Total service revenues 2,155,282 3,891,484 2,924,843
Software license revenues - 238,000 -
----------------- ------------------ ------------------
Total revenues 2,155,282 4,129,484 2,924,843
Cost of service revenues 1,436,449 4,403,605 4,957,157
Cost of software license revenues - 228,000 -
----------------- ------------------ ------------------
Total cost of revenues 1,436,449 4,631,605 4,957,157
Gross margin 718,833 (502,121) (2,032,314)
General and administrative 308,998 1,517,118 1,403,097
Selling and marketing 120,833 873,775 1,942,435
Research and development 82,555 461,065 760,082
Provision for impairment of assets 200,000 855,117 -
Depreciation and amortization 579,227 1,475,292 1,356,242
Other income (expense) 94,934 (7,729) 7,676
----------------- ------------------ ------------------
Loss from discontinued operations before
gain on disposal (477,846) (5,692,217) (7,486,494)
Gain on disposal of discontinued
operations 2,737,041 - -
----------------- ------------------ ------------------
Income (loss) from discontinued
operations 2,259,195 (5,692,217) (7,486,494)
================= ================== ==================
36
Prior to the sale of substantially all of our assets, our revenues were
principally derived from fees for implementing EBPP capabilities, processing
EBPP transactions and providing related customer care, and consulting services.
We also became a licensed reseller of CheckFree's e-billing software in
Australia during 2002. The components of our service offering that generated
revenue through July 25, 2003, include:
- Internet billing services for EBPP through a hosted payment Web site, direct
delivery to the consumer's email inbox, or distribution via bill aggregators.
- Internet-enabled, interactive customer care services on an in-house or
outsourced basis.
- Professional consulting services for EBPP billers or software vendors needing
value-added resources to deliver customized EBPP services, including payment
gateway services that provided billers who were already participating in EBPP
using in-house software a single distribution point to virtually any bill
presentment and payment location across the World Wide Web in addition to their
existing distribution points or biller direct site.
- Licensing of CheckFree e-billing software as an authorized reseller in
Australia only.
Total revenues decreased 48% to $2,155,282 in 2003 from $4,129,484 in 2002 due
to the sale of substantially all of our assets in July 2003. Implementation fee
revenue for 2003 included the recognition of the remaining balance of deferred
revenue upon this sale. Total revenues increased 41% to $4,129,484 in 2002 from
$2,924,843 in 2001. Of the total increase from the prior year, 63% was
attributable to the growth in transaction fee revenue, while growth in
consulting revenues, which includes revenue from the licensing of our gateway
technology, accounted for 33% of the increase. These increases were due to an
increase in the number of implemented billers and volume of transactions. As of
December 31, 2002, we had 119 billers under contract who were in various stages
of development, including 106 billers that were in full production or pilot
stages, as compared to 84 billers in full production or pilot stages at December
31, 2001. Our first sale of a software license as a reseller of CheckFree's
e-billing software in Australia in 2002 also contributed $238,000 to the
increase in revenue from the prior year. The sale was made to an Australian
billing service provider that was also an equal partner with us in a joint
venture formed to provide EBPP services to the Australian market. One billing
customer accounted for approximately 12%, 16% and 23% of total revenues for the
years ended December 31, 2003, 2002 and 2001, respectively.
During 2002, we entered into two separate nonmonetary transactions whereby we
licensed the use of our gateway technology to certain third party software
vendors to be used as an original equipment manufacturer, or OEM, component of
their product offering in exchange for software products from those vendors. We
accounted for these transactions in accordance with APB Opinion No. 29,
"Accounting for Nonmonetary Transactions." These exchanges were determined to
culminate the earning process because the technology exchanged by us was held
for sale in the ordinary course of business and the products received by us were
expected to be deployed and utilized as productive assets. We recognized revenue
related to these transactions at the fair value of the software received, which
was determined by reference to vendor-specific objective evidence, because it
was more clearly evident than the value of the assets transferred. The value of
the software received was estimated by comparison to third party evidence
including vendor-specific established pricing lists and historical sales
information and was more readily determinable because we did not have a history
of comparable cash sales of our payment gateway technology. We recognized
$300,000 in a transaction where our technology was exchanged for customer
relationship management software and concurrent seat licenses to use in
providing customer care services via the Internet or telephone. We also
recognized $300,000 in a transaction where our technology was exchanged for
document archival and retrieval software to use in the storage of electronic
billing statements. The carrying value of the gateway technology exchanged in
both transactions was zero. We capitalized the software received at the time of
acquisition and subsequently recognized a loss on impairment of these assets
which took the carrying amount of these assets to zero.
37
Cost of revenues includes the cost of personnel dedicated to the design of
electronic bill templates, creation of connections to third party aggregators
and payment processors, testing and quality assurance processes related to
implementation and presentment, as well as professional staff dedicated to
providing contracted services to EBPP customers under consulting arrangements.
Cost of revenues also includes fees paid for presentation of consumer bills on
Web sites powered by aggregators and processing of payments for EBPP
transactions by third party providers. Cost of revenues decreased 69% to
$1,436,449 in 2003 from $4,631,605 for 2002. The decrease from 2002 was
partially attributable to the sale of substantially all of our assets in July
2003 as well as lower salary and benefit costs due to the personnel reductions
during 2002. Cost of revenues decreased 7% to $4,631,605 in 2002 from $4,957,157
for 2001. The decrease from 2001 to 2002 is primarily due to cost reductions
that were implemented in the second half of 2001, which included a decrease in
the number of personnel employed to provide revenue-producing services from an
average of 79 such employees for 2001 to 63 in 2002. The cost savings from the
prior year period were partially offset by the cost of the CheckFree software
license that was resold in 2002, which was $228,000.
General and administrative expenses directly related to the discontinued
operations consisted of rent and costs of personnel providing direct support
services for EBPP operations. These expenses decreased to $308,998 in 2003 from
$1,517,118 in 2002 and were $1,403,097 in 2001. The decrease from 2002 was
partially attributable to the sale of substantially all of our assets in July
2003 as well as lower salary and benefit costs due to the personnel reductions
during 2002, and lower rental expenses under our amended lease agreement. In May
2002, we renegotiated the lease terms for our corporate headquarters to provide
for a reduction in future rent expense of approximately $1.6 million over the
remaining term of the lease. The lease amendment required us to expense a
portion of our prepaid rent, which resulted in a one-time charge of $312,000 for
the second quarter of 2002. This charge offset the rent savings from the amended
lease agreement in 2002, which contributed to an overall increase in general and
administrative expenses from 2001.
Selling and marketing expenses directly related to the discontinued operations
decreased to $120,833 in 2003 from $873,775 for 2002 and $1,942,435 for 2001.
The decrease from 2002 was partially attributable to the sale of substantially
all of our assets in July 2003 and was also due to reductions in our direct
sales staff. The decrease in 2002 from 2001 was primarily the result of
reductions in our direct sales staff, which contributed 74% to the decrease from
the prior year, as well as lower related travel expenses and trade show
participation, which contributed 23% to the decrease from the prior year. As we
increased our focus throughout 2002 on using strategic reseller partners to
provide sales opportunities related to the deployment and use of our EBPP
services, we experienced a decrease in the amount of expenses related to our
direct sales force.
Research and development expenses directly related to the discontinued
operations consisted primarily of the cost of personnel devoted to the design of
new processes that would improve our electronic presentment and payment
abilities and capacities, new customer care and direct marketing services,
additional business-to-consumer applications, and integration of third party
applications. These expenses decreased to $82,555 in 2003 from $461,065 in 2002
and $760,082 in 2001. The decrease from 2002 was partially attributable to the
sale of substantially all of our assets in July 2003. The decreases from year to
year were also due to a progressive focus on our core competencies in order to
implement and service existing products. During our earlier stages, we applied
additional resources to design and develop our base technology infrastructure
and operating systems. All research and development costs were expensed as
incurred.
Depreciation and amortization was $579,227, $1,475,292 and $1,356,242 for 2003,
2002 and 2001, respectively. The decrease from 2002 was partially attributable
to the sale of substantially all of our assets in July 2003 and was also due to
lower depreciation related to certain assets that became fully depreciated
during 2002. The increase from 2001 was the result of writing off $207,000 of
leasehold improvements in 2002 related to our corporate office facility due to
the cancellation of the related lease in March 2003.
38
During the fourth quarter of 2002, we performed an impairment review because the
uncertainty of our ability to continue as a going concern due to decreased
liquidity indicated that the carrying value of certain long-lived assets may not
be recoverable. We determined that customer relationship management software and
document archival and retrieval software with a carrying amount of $855,117 were
no longer recoverable and recorded a non-cash charge of $855,117, which is
included as a component of discontinued operations in the accompanying
consolidated statement of operations. Fair value was based on the expected
future cash flows to be generated by these assets, which was determined to be
zero because of our inability to deploy and utilize the assets to provide
revenue-generating services, due to our limited resources and lack of liquidity.
During the second quarter of 2003, we performed an impairment review because we
expected to sell the asset group comprising the discontinued operations. We
determined that the asset group to be sold was impaired and recorded a non-cash
charge of $200,000, which is included as a component of discontinued operations
in the accompanying consolidated statement of operations. Fair value was based
on the expected selling price of the asset group.
Other income was $94,934 in 2003 and represented the gain on the settlement of a
vendor payable directly related to the discontinued operations. Other income
(expense) for 2002 and 2001 represented our equity in the loss and earnings,
respectively, of our unconsolidated EBPP joint venture in Australia. The joint
venture was dissolved as a result of our sale of substantially all of our assets
during the third quarter of 2003.
Income from discontinued operations improved to $2,259,195 in 2003 and included
a gain on the disposal of the discontinued operations of $2,737,041. Loss from
discontinued operations of $5,692,217 in 2002 decreased from $7,486,494 in 2001
primarily as a result of the overall increase in gross profit from the prior
year.
LIQUIDITY AND CAPITAL RESOURCES
Our financial statements were prepared on the assumption that we will continue
as a going concern, and our independent auditors have expressed doubt as to that
assumption by issuing a going concern opinion on our financial statements for
the year ended December 31, 2003. At March 31, 2004, our principal source of
liquidity consisted of $268,000 of cash and cash equivalents, compared to
$528,000 of cash and cash equivalents at December 31, 2003. We have incurred
substantial losses since inception, which has led to a significant decrease in
its cash position and a deficit in working capital. We sold substantially all of
our assets in July 2003 and reduced expenditures for operating requirements.
Despite these actions, we believe that our current available cash and cash
equivalents along with anticipated revenues are likely insufficient to meet our
anticipated cash needs for the foreseeable future. Consequently, our ability to
continue as a going concern is likely contingent on our receiving additional
funds in the form of equity or debt financing. We are currently aggressively
pursuing strategic alternatives, including investment via an equity line of
credit. In February 2004, we executed an agreement for an equity line of credit
with Dutchess Private Equities Fund, LP ("Dutchess"). Under the terms of the
agreement, we may elect to receive as much as $10 million from Dutchess in
common stock purchases over the next three years at our option . We agreed to
file a registration statement registering the resale of the shares of our common
stock to be issued to Dutchess with the Securities and Exchange Commission, and
have it declared effective before any funds may be received under the agreement.
Any funds received will be used, as needed, to support on-going operations and
enhance potential merger and acquisition activity. From time to time we evaluate
opportunities to make acquisitions of assets or businesses that we believe would
help us achieve our goal of profitability, but we are not currently planning any
material acquisitions. We anticipate that the equity line of credit will provide
sufficient cash flows to meet current operating requirements after the
registration statement is declared effective. We also anticipate that the
registration statement will become effective and we will be able to receive
funds under the equity line of credit before our currently available sources of
liquidity are extinguished. Our management estimates that our projected cash
flow from operations, plus our cash reserves, will be sufficient to permit us to
continue our current level of operations until July 31, 2004. If we are unable
to receive funds from the equity line of credit because the registration
statement becomes effective later than we currently anticipate or for any other
reason, we may have to curtail or cease operations.
39
Net cash used in continuing operating activities was $2.0 million, $2.2 million
and $2.8 million for 2003, 2002 and 2001, respectively. Net cash used in
continuing operating activities was primarily attributable to operating net
losses generated by early growth stage activities and overhead costs. We plan to
focus on expending our resources prudently given our current state of liquidity
and do not expect to achieve positive cash flow from operations for 2004.
Net cash provided by investing activities was $4.1 million in 2003 and reflected
proceeds of approximately $4.2 million from the sale of assets offset by capital
expenditures of approximately $66,000 for computer equipment and software. Net
cash provided by investing activities was $240,000 in 2002 and primarily
reflected the return of $256,000 of deposits that had been used to secure
leases. Net cash provided by investing activities for 2001 was $2.1 million and
reflected sales and maturities of marketable securities of $2.0 million and the
return of $219,000 of deposits that had been used to secure leases. We do not
anticipate making significant capital expenditures during 2004.
Net cash used in financing activities of $1.7 million for 2003 primarily
resulted from the payment of $1.8 million under our Laurus convertible debt
agreement in July 2003. Net cash provided by financing activities of $1.9
million for 2002 resulted primarily from $1.5 million of borrowings under the
convertible debt agreement and the return of $707,000 that had been pledged as
collateral for the margin loans of certain executive officers. Net cash provided
by financing activities of $6.5 million for 2001 resulted from proceeds, net of
issuance costs, of $9.2 million from the issuance of common stock private
placement offerings in March and November 2001. The $1.5 million repayment of
the outstanding line of credit in January 2001 and additional pledge of $1.0
million as collateral for margin loans of certain executive officers reduced the
amount of net cash provided by financing activities in 2001.
Off-balance Sheet Arrangements
We currently have no off-balance sheet arrangements that have or are reasonably
likely to have a current or future material effect on our financial condition,
changes in financial condition, revenues or expenses, results of operations,
liquidity, capital expenditures or capital resources.
PLEDGED FUNDS
Beginning in December 2000, we pledged as loan guarantees certain funds held as
money market funds and certificates of deposit to collateralize margin loans for
the following executive officers of the Company: (1) Michael R. Long, then
Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A.
Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then
Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones,
then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees
of the Company. Our purpose in collateralizing the margin loans was to prevent
the sale of our common stock owned by these officers while we were pursuing
efforts to raise additional capital through private equity placements. The sale
of that common stock could have hindered our ability to raise capital in such a
manner and compromised our continuing efforts to secure additional financing. We
were also trying to accommodate the requests of the named executive officers,
who were seeking to preserve their financial liquidity. We believe this action
served our purpose of assuring stable management and leadership for our future.
The margin loans were obtained in March 1999 from institutional lenders and were
secured by shares of our common stock owned by these officers. Each of the
officers used the proceeds of their respective margin loans for investment
purposes and usual and customary living expenses.
40
None of the margin loans were recourse with respect to the officers and none of
the loan guarantees were recourse with respect to us because at the times the
margin loans were made and the funds pledged, the value of the common stock
collateralizing the margin loans exceeded the loan amounts. Under the original
terms of the arrangement, we charged each of the officers, pro rata, the
difference between the rate of return earned by us before the collateralization
of the margin loans on the funds that were to be the pledged funds and the rate
of return earned on the pledged funds after the collateralization of the margin
loans. We offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard
against their respective salaries from the date the funds were pledged until
November of 2002, when we underwent significant downsizing and Mr. Long, Mr.
Hoch, and Mr. Millard began deferring their salaries. We offset such amounts due
from Mr. Jones against his salary from the date the funds were pledged until the
date of his departure from the Company in August 2001.
The highest total amount of funds pledged for the margin loans guaranteed by us
was approximately $2.0 million. The total balance of the margin loans guaranteed
by us was approximately $1.3 million at December 31, 2002. At the time the funds
were pledged, we believed we would have access to them because (a) our stock
price was substantial and the stock pledged by the officers, if liquidated,
would produce funds in excess of the loans payable, and (b) with respect to one
of the institutional lenders (who was also assisting us as a financial advisor
at the time), even if the stock price fell, we had received assurances from that
institutional lender that the pledged funds would be made available as needed.
During the fourth quarter of 2002, we requested partial release of the funds for
operating purposes, which request was denied by an institutional lender. At that
time, our stock price had fallen as well, and it became clear that both
institutional lenders would not release the pledged funds.
In light of these circumstances, we recognized a loss on the guarantees of
$1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable
under related party guarantees on our balance sheet at December 31, 2002 because
it became probable at that point that we would be unable to recover our pledged
funds. During the quarter ended March 31, 2003, the lenders applied the pledged
funds to satisfy the outstanding balances of the loans. The total balance of the
margin loans guaranteed by us was zero at December 31, 2003.
The pledged funds were classified as cash and cash equivalents on our balance
sheet and disclosed in the accompanying footnotes in our Annual Report on Form
10-K for each of the years ended December 31, 2000 and 2001, respectively. The
pledged funds were classified as cash and cash equivalents on our balance sheet
and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q
for the quarters ended March 31, 2002 and June 30, 2002, respectively. Under the
terms of the related guaranty agreements, we could, at any time, terminate our
obligations and the lenders' rights under the guaranty agreements, but we would
remain liable for any losses incurred by the lenders in liquidating the
guaranteed accounts by selling the common stock held as collateral in the margin
loan accounts in order to pay off the margin loan balances in full during a
reasonable time subsequent to the receipt of our termination notice. Because we
had the right to withdraw our pledged funds at any time and would not incur any
losses as long as the value of the common stock held in the margin loan accounts
exceeded the total balance of the margin loans, the funds we had pledged were
properly reported as unrestricted as long as there was sufficient collateral
other than our pledged funds available to cover the loans. Based on the number
of shares of our common stock held by these officers in their margin accounts
collateralizing the loans and the price of our common stock at the time these
respective reports were filed, management determined that there was sufficient
coverage available for the lenders to liquidate the stock to pay off the margin
loans in full and return the full amount of our pledged funds to us if we had
withdrawn our guarantee. After the price of our common stock was too low to
provide the lenders with sufficient coverage of the margin loan balances and our
request for partial release of the funds was denied by an institutional lender,
the pledged funds were classified as cash pledged as collateral for related
party obligations on our balance sheet and disclosed in the accompanying
footnotes in our Quarterly Report on Form 10-Q for the quarter ended September
30, 2002. On June 30, 2003, we filed an amended Annual Report on Form 10-K for
the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for
the quarters ended March 31, 2002 and June 30, 2002 as a result of comments
received from the Securities and Exchange Commission in connection with their
review of our registration statement on Form S-3 that we originally filed on
August 9, 2002. These amended reports included restated balance sheets that
classified the pledged funds as cash pledged as collateral for related party
obligations because by the time the amended reports were filed, there was no
longer sufficient collateral other than our pledged funds available to cover the
loans and it was clear that the funds would not be released as we had been
assured.
41
We may institute litigation or arbitration in collection of the outstanding
repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which
currently total $1,278,138. Presently, we have refrained from initiating action
to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may
have offsetting claims that total $1,445,500 collectively by virtue of the
change of control clause in their respective employment agreements based on our
preliminary analysis. We understand that these individuals may assert such
claims based on our sale of substantially all of our assets to Harbor Payments,
Inc. on July 25, 2003. We have not initiated any formal settlement negotiations
with these individuals because they are presently under an extended employment
contract with us or have not been amenable to such an action. We have not
pursued the outstanding repayment obligation of Mr. Jones because we do not
consider a recovery attempt to be cost beneficial. In order to attempt a
recovery from Mr. Jones, we estimate that we would incur a minimum of $20,000 in
estimated legal costs with no reasonable assurance of success in recovering his
outstanding obligation of approximately $38,000. Because of the limited amount
of the obligation, we also anticipate difficulty in retaining counsel on a
contingency basis to pursue collection of this obligation. The ultimate outcome
of this matter cannot presently be determined.
On July 25, 2003, certain of our stockholders (those stockholders being Mike
Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and
James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana
Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert
Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry
Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick,
Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal
action against us, Ernst & Young, LLP, and certain of our current and former
directors (including the executive officers named above) in the District Court
of the 45th Judicial District, Bexar County, Texas. With respect to us and the
current and former directors named in the suit, the plaintiffs allege that we,
acting through such directors, misstated in our 2000 and 2001 Form 10-Ks our
ability to use for operational purposes the funds pledged as security for margin
loans of certain of our executive officers, as discussed above. The plaintiffs
allege and seek resulting economic and exemplary damages, rescission, interest,
attorneys' fees and costs of court. We believe this suit is without merit and
intend to vigorously defend the company and the directors named in the suit. As
of June 4, 2004, there have been no material developments in the suit. The
results of legal proceedings cannot be predicted with certainty. If we fail to
prevail in this legal matter, our financial position, results of operations, and
cash flows could be materially adversely affected.
WORKING CAPITAL LINE OF CREDIT
We currently have no working capital line of credit agreement and no funds are
available to us under any working capital line of credit.
In June 2000, we executed a working capital line of credit agreement with a bank
in the amount of $1,500,000. We borrowed $1,500,000 on this line of credit for
the security deposit and leasehold improvements of our corporate headquarters
and repaid the entire outstanding balance plus accrued interest in January 2001.
The line of credit expired in July 2001 and was not renewed.
In March 2002, we executed a working capital line of credit agreement with a
bank in the amount of $700,000. We borrowed $645,000 under this line of credit
during the first six months of 2002. In September 2002, we repaid the
outstanding balance in full, including accrued interest, and terminated the line
of credit.
42
CONVERTIBLE NOTE
On July 24, 2002, we executed a financing agreement with Laurus Master Fund,
Ltd. in exchange for a $1.5 million convertible note and a four-year warrant to
purchase 300,000 shares of our common stock at exercise prices of $0.936 for the
first 150,000 shares, $0.975 for the next 50,000 shares, and $1.17 for the
remaining 100,000 shares. Laurus could convert the convertible note, which
accrued interest at 7% annually, at any time into shares of our common stock at
a fixed conversion price of $0.78, subject to certain restrictions in the
purchase agreement. We could pay the principal and interest on the convertible
note, which had a one-year term, in cash, shares of our common stock or a
combination of cash and stock. If common stock was used to pay the note, the
conversion price was the lesser of (i) $0.78 or (ii) 88% of the average of the 7
lowest closing prices during the 22 trading days prior to the date we gave
notice of payment. Accrued interest and one-ninth of the principal was due on
the first business day of each calendar month beginning on November 1, 2002 and
continuing until the maturity date of July 1, 2003. If the required principal
payment was made in cash, the principal amount paid was 105% of the amount due.
We granted Laurus a security interest in all of our assets. We defaulted under
the note during the fourth quarter of 2002 and a penalty of 120% of the
outstanding principal amount, or $300,000, was assessed to us for the default,
and was included in the balance of short-term borrowings on our balance sheet at
December 31, 2002.
We recorded a debt discount as a result of the issuance of the warrant to Laurus
of approximately $259,000, which was being charged to interest expense over the
term of the convertible note using the effective yield method. Upon our default
under the note, the remaining balance of the discount was charged to interest
expense. Furthermore, we recorded an additional debt discount as a result of the
beneficial conversion feature of approximately $283,000, which was charged to
interest expense at the date of issuance. The amount related to the beneficial
conversion feature was determined by dividing the note proceeds allocated to the
convertible security of approximately $1,241,000 by the number of shares into
which the note was convertible, or 1,923,077 shares based on the fixed
conversion price of $0.78 per common share. The resulting effective conversion
price of $0.65 per common share was then compared to the fair value of our
stock, which was $0.93 per common share on the issuance date. The difference of
$0.28 per common share between the fair value of the stock and the effective
conversion price was then multiplied by 1,009,586, which was the number of
shares the note was convertible into at the date of issuance, taking into
account the limitation on the number of shares that Laurus could convert at that
time. The agreement stipulated that Laurus could not convert that amount of the
note that would result in beneficial ownership of more than 4.9% of our
outstanding common shares on the date of conversion. The conversion limitation
was to become null and void upon an event of default under the note and could
have been raised if we chose to redeem the outstanding principal amount of the
note in cash and Laurus elected to convert the note instead. The limitation
could also have been raised if we had issued additional common shares for any
reason, thus increasing the number of outstanding shares. Due to our default
under the note during the fourth quarter of 2002, the 4.9% limitation became
null and void and additional interest expense of approximately $256,000 was
recognized at a rate of $0.28 per common share for the 913,491 additional shares
that the note became convertible into upon default. During 2002, we capitalized
$238,000 in financing costs related to the issuance of the Laurus debt that were
being charged to interest expense over the term of the convertible note using
the effective yield method. Upon default under the note in the fourth quarter of
2002, the remaining unamortized balance was charged to interest expense.
In connection with the sale of substantially all of our assets to Saro, Inc., we
paid $1.8 million in cash to Laurus during July 2003, in full settlement of the
outstanding balance of the convertible note, including accrued penalties and
interest, and all claims by Laurus. In addition, the four-year warrant to
purchase 300,000 shares of our common stock initially granted to Laurus was
canceled as part of the settlement.
42
EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS
On May 15, 2003, the FASB issued Statement No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity" ("FAS
150"). FAS 150 establishes standards for classifying and measuring as
liabilities certain freestanding financial instruments that embody obligations
of the issuer and have characteristics of both liabilities and equity. The
statement defines an obligation as "a conditional or unconditional duty or
responsibility on the part of the issuer to transfer assets or to issue its
equity shares." FAS 150 is effective for all financial instruments created or
modified after May 31, 2003, and otherwise effective at the beginning of the
first interim period beginning after June 15, 2003. The adoption of this
statement did not have a significant impact on the Company's results of
operations or financial position.
DESCRIPTION OF PROPERTY
As of March 31, 2004, our headquarters and operations were housed in
approximately 4,500 square feet of leased office space in San Antonio, Texas.
The office lease has a three-year term that expires in October 2006 and has a
renewal option for an additional three-year term. We believe our existing
facilities will be adequate to meet our anticipated needs for the foreseeable
future.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Mr. David Jones, a former Executive Vice President and Director of our company,
borrowed approximately $35,000 accruing interest at a rate of 8% during 2000, of
which $25,000 was outstanding at December 31, 2000. During 2001, we loaned an
additional $94,000 at a rate of 8% to Mr. Jones prior to his resignation from
us. Mr. Jones used the proceeds of these loans for usual and customary living
expenses and to pay down a margin loan to an institutional lender. At December
31, 2001, we had an aggregate of $115,000 in notes receivable accruing interest
at 8%, which was the largest amount owed to us by Mr. Jones during 2001. In
March 2002, Mr. Jones repaid the balance of these loans to us in full, including
accrued interest.
Beginning in December 2000, we pledged as loan guarantees certain funds held as
money market funds and certificates of deposit to collateralize margin loans for
the following executive officers of the Company: (1) Michael R. Long, then
Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A.
Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then
Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones,
then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees
of the Company. Our purpose in collateralizing the margin loans was to prevent
the sale of our common stock owned by these officers while we were pursuing
efforts to raise additional capital through private equity placements. The sale
of that common stock could have hindered our ability to raise capital in such a
manner and compromised our continuing efforts to secure additional financing. We
were also trying to accommodate the requests of the named executive officers,
who were seeking to preserve their financial liquidity. We believe this action
served our purpose of assuring stable management and leadership for our future.
The margin loans were obtained in March 1999 from institutional lenders and were
secured by shares of our common stock owned by these officers. Each of the
officers used the proceeds of their respective margin loans for investment
purposes and usual and customary living expenses.
43
None of the margin loans were recourse with respect to the officers and none of
the loan guarantees were recourse with respect to us because at the times the
margin loans were made and the funds pledged, the value of the common stock
collateralizing the margin loans exceeded the loan amounts. Under the original
terms of the arrangement, we charged each of the officers, pro rata, the
difference between the rate of return earned by us before the collateralization
of the margin loans on the funds that were to be the pledged funds and the rate
of return earned on the pledged funds after the collateralization of the margin
loans. We offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard
against their respective salaries from the date the funds were pledged until
November of 2002, when we underwent significant downsizing and Mr. Long, Mr.
Hoch, and Mr. Millard began deferring their salaries. We offset such amounts due
from Mr. Jones against his salary from the date the funds were pledged until the
date of his departure from the Company in August 2001.
The highest total amount of funds pledged for the margin loans guaranteed by us
was approximately $2.0 million. The total balance of the margin loans guaranteed
by us was approximately $1.3 million at December 31, 2002. At the time the funds
were pledged, we believed we would have access to them because (a) our stock
price was substantial and the stock pledged by the officers, if liquidated,
would produce funds in excess of the loans payable, and (b) with respect to one
of the institutional lenders (who was also assisting us as a financial advisor
at the time), even if the stock price fell, we had received assurances from that
institutional lender that the pledged funds would be made available as needed.
During the fourth quarter of 2002, we requested partial release of the funds for
operating purposes, which request was denied by an institutional lender. At that
time, our stock price had fallen as well, and it became clear that both
institutional lenders would not release the pledged funds.
In light of these circumstances, we recognized a loss on the guarantees of
$1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable
under related party guarantees on our balance sheet at December 31, 2002 because
it became probable at that point that we would be unable to recover our pledged
funds. During the quarter ended March 31, 2003, the lenders applied the pledged
funds to satisfy the outstanding balances of the loans. The total balance of the
margin loans guaranteed by us was zero at December 31, 2003.
The pledged funds were classified as cash and cash equivalents on our balance
sheet and disclosed in the accompanying footnotes in our Annual Report on Form
10-K for each of the years ended December 31, 2000 and 2001, respectively. The
pledged funds were classified as cash and cash equivalents on our balance sheet
and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q
for the quarters ended March 31, 2002 and June 30, 2002, respectively. Under the
terms of the related guaranty agreements, we could, at any time, terminate our
obligations and the lenders' rights under the guaranty agreements, but we would
remain liable for any losses incurred by the lenders in liquidating the
guaranteed accounts by selling the common stock held as collateral in the margin
loan accounts in order to pay off the margin loan balances in full during a
reasonable time subsequent to the receipt of our termination notice. Because we
had the right to withdraw our pledged funds at any time and would not incur any
losses as long as the value of the common stock held in the margin loan accounts
exceeded the total balance of the margin loans, the funds we had pledged were
properly reported as unrestricted as long as there was sufficient collateral
other than our pledged funds available to cover the loans. Based on the number
of shares of our common stock held by these officers in their margin accounts
collateralizing the loans and the price of our common stock at the time these
respective reports were filed, management determined that there was sufficient
coverage available for the lenders to liquidate the stock to pay off the margin
loans in full and return the full amount of our pledged funds to us if we had
withdrawn our guarantee. After the price of our common stock was too low to
provide the lenders with sufficient coverage of the margin loan balances and our
request for partial release of the funds was denied by an institutional lender,
the pledged funds were classified as cash pledged as collateral for related
party obligations on our balance sheet and disclosed in the accompanying
footnotes in our Quarterly Report on Form 10-Q for the quarter ended September
30, 2002. On June 30, 2003, we filed an amended Annual Report on Form 10-K for
the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for
the quarters ended March 31, 2002 and June 30, 2002 as a result of comments
received from the Securities and Exchange Commission in connection with their
review of our registration statement on Form S-3 that we originally filed on
August 9, 2002. These amended reports included restated balance sheets that
classified the pledged funds as cash pledged as collateral for related party
obligations because by the time the amended reports were filed, there was no
longer sufficient collateral other than our pledged funds available to cover the
loans and it was clear that the funds would not be released as we had been
assured.
We may institute litigation or arbitration in collection of the outstanding
repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which
currently total $1,278,138. Presently, we have refrained from initiating action
to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may
have offsetting claims that total $1,445,500 collectively by virtue of the
change of control clause in their respective employment agreements based on our
preliminary analysis. We understand that these individuals may assert such
claims based on our sale of substantially all of our assets to Harbor Payments,
Inc. on July 25, 2003. We have not initiated any formal settlement negotiations
with these individuals because they are presently under an extended employment
contract with us or have not been amenable to such an action. We have not
pursued the outstanding repayment obligation of Mr. Jones because we do not
consider a recovery attempt to be cost beneficial. In order to attempt a
recovery from Mr. Jones, we estimate that we would incur a minimum of $20,000 in
estimated legal costs with no reasonable assurance of success in recovering his
outstanding obligation of approximately $38,000. Because of the limited amount
of the obligation, we also anticipate difficulty in retaining counsel on a
contingency basis to pursue collection of this obligation. The ultimate outcome
of this matter cannot presently be determined.
44
On July 25, 2003, certain of our stockholders (those stockholders being Mike
Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and
James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana
Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert
Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry
Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick,
Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal
action against us, Ernst & Young, LLP, and certain of our current and former
directors (including the executive officers named above) in the District Court
of the 45th Judicial District, Bexar County, Texas. With respect to us and the
current and former directors named in the suit, the plaintiffs allege that we,
acting through such directors, misstated in our 2000 and 2001 Form 10-Ks our
ability to use for operational purposes the funds pledged as security for margin
loans of certain of our executive officers, as discussed above. The plaintiffs
allege and seek resulting economic and exemplary damages, rescission, interest,
attorneys' fees and costs of court. We believe this suit is without merit and
intend to vigorously defend the company and the directors named in the suit. As
of June 4, 2004, there have been no material developments in the suit. The
results of legal proceedings cannot be predicted with certainty. If we fail to
prevail in this legal matter, our financial position, results of operations, and
cash flows could be materially adversely affected.
MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Our common stock was traded on the National Association of Securities Dealers
Over the Counter Bulletin Board through March 13, 2000 at which time our common
stock was approved for trading on the NASDAQ Small Cap Market. Subsequently, our
stock was approved for trading on the NASDAQ National Market on July 31, 2000
under the symbol "BLLS." On February 4, 2003, the NASDAQ National Market
delisted our common stock because we did not meet the requirements for continued
listing on the NASDAQ National Market. Our common shares were immediately
eligible for quotation on the OTCBB effective at opening of business on February
4, 2003. We began trading under a new ticker symbol, PYDS, on the OTC BB on
August 20, 2003.
The following table sets forth for the quarterly periods indicated the range of
high and low closing prices of the common stock as reported on the OTCBB:
45
High Low
---------- ----------
2004
--------------------
First Quarter $ 0.46 $ 0.15
2003
--------------------
First Quarter $ 0.23 $ 0.07
Second Quarter $ 0.14 $ 0.08
Third Quarter $ 0.35 $ 0.09
Fourth Quarter $ 0.32 $ 0.14
2002
--------------------
First Quarter $ 1.25 $ 0.90
Second Quarter $ 1.70 $ 1.02
Third Quarter $ 1.25 $ 0.52
Fourth Quarter $ 0.70 $ 0.17
HOLDERS
As of April 23, 2004, there were approximately 4,833 stockholders of record of
our common stock.
DIVIDEND POLICY
We have never declared or paid cash or stock dividends and have no present plan
to pay any such dividends in the foreseeable future, intending instead to
reinvest our earnings, if any.
EXECUTIVE COMPENSATION
The following table sets forth the compensation earned during each of the years
ended December 31, 2003, 2002 and 2001 to our Chief Executive Officer and each
other executive officer that earned over $100,000 during the year ended December
31, 2003.
ANNUAL
COMPENSATION (1) LONG TERM COMPENSATION
----------------- -------------------------------------------
ALL OTHER
AWARDS COMPENSATION (2)
----------------------- ------------------
SECURITIES UNDERLYING
NAME AND PRINCIPAL POSITION(S) YEAR SALARY OPTIONS (#)
-------------------------------------- ---- ----------------- -----------------------
Michael R. Long 2003 $ 190,000 400,000 $ 11,529
Chairman, Chief Executive Officer 2002 $ 190,000 340,000 $ 11,130
And Chief Financial Officer. . . . . . 2001 $ 190,000 325,000 $ 11,074
Louis A. Hoch 2003 $ 175,000 425,000 $ 900
President and Chief Operating Officer. 2002 $ 175,000 340,000 $ 1,950
2001 $ 175,000 250,000 $ 1,596
Terri A. Hunter 2003 $ 152,499 - $ 540
Executive Vice President and Chief 2002 $ 145,000 350,000 $ 1,560
Financial Officer. . . . . . . . . . . 2001 $ 145,000 150,000 $ 1,368
(1) Each of the named executives except for Ms. Hunter has entered into
employment agreements expiring on July 25, 2004, which provide for annual salary
and bonuses at the discretion of the Board of Directors. Ms. Hunter resigned her
position as Executive Vice President and Chief Financial Officer effective
August 31, 2003. In 2004, each of the named officers is to receive salary
compensation as follows: Mr. Long, $190,000; and Mr. Hoch, $175,000.
(2) Reflects premiums paid for term life insurance coverage.
46
OPTION GRANTS
The following table provides information regarding the grant of stock options
during fiscal year 2003 to the named executive officers pursuant to our Employee
Comprehensive Stock Plan.
Number of Securities % of Total Options
Underlying Options Granted to Employees Exercise Price
Name Granted in Fiscal 2003 ($/Share) Expiration Date
------------------- -------------------- --------------- ----------------
Michael R. Long . . 400,000 22.8% $ 0.14 12/30/13
Louis A. Hoch . . . 425,000 24.2% $ 0.14 12/30/13
Terri A. Hunter (1) - - - -
(1) We did not grant any stock options to Ms. Hunter during fiscal year 2003.
OPTION EXERCISES AND YEAR-END VALUES
The following table provides certain information related to the exercise of
options during the year ended December 31, 2003 by the named executive officers
and the number and value of options held by the named executive officers at
December 31, 2003.
Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option
Values
SHARES NUMBER OF SECURITIES VALUE OF UNEXERCISED
ACQUIRED VALUE UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT
ON EXERCISE REALIZED OPTIONS AT FISCAL YEAR-END (#) FISCAL YEAR-END ($) (1)
NAME (#) ($ ) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
--------------- ----------- -------- ------------------------------ ------------------------ ------------ --------------
Michael R. Long - $ 0 898,334 400,000 $ 0 $ 8,000
Louis A. Hoch . - $ 0 765,000 425,000 $ 0 $ 8,500
(1) Calculated using the year-end per share price of $0.16.
DIRECTORS COMPENSATION
In 2003, we did not pay any cash compensation to our independent directors for
their services on our Board of Directors. However, on December 30, 2003, we
granted options to purchase 175,000 shares of our common stock at an exercise
price of $0.14 per share to our independent director, Peter G. Kirby, as
compensation for his service as a Director.
EMPLOYMENT CONTRACTS
We have employment agreements with our executive officers. The employment
agreements provide for an annual salary, bonuses at the discretion of the Board
of Directors and health benefits. In 2004, each of the named officers are to
receive salary compensation as follows: Mr. Long, $190,000 and Mr. Hoch,
$175,000.
Our agreements with our executive officers provide for change in control
protection for each executive. We may terminate any such agreement not later
than thirty days after a change of control. In such event, the executive would
be entitled to deferred compensation. Deferred compensation is calculated as the
greater of (A) the base salary payments the executive would have received had
his or her employment continued for the remaining term of the agreement
(including yearly increases calculated at the maximum increase for the prior two
years); or (B) an amount equal to 2.95 times the highest annual compensation
earned by the executive in the past two years.
In addition, the executive would be entitled to all of the benefits otherwise
provided in the agreement during a certain period of time defined in the
agreement as the greater of the remaining term of the agreement or one year. The
executive may also be entitled to an amount equal to the pro rata portion of the
bonus compensation for the year in which the executive's employment is
terminated determined on the basis of the number of days elapsed in such year
prior to such termination. Upon termination of employment, each employee is
prohibited from competing with us for a period of two years. The employment
agreements were supposed to terminate upon the change of control that occurred
on July 25, 2003, but were extended at our option for a period of one year. Upon
the expiration of the extended agreements on July 25, 2004, the executive
officers shall be entitled to the deferred compensation as provided above.
47
FINANCIAL STATEMENTS
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Reports of Independent Auditors F-1
Consolidated Balance Sheets as of December 31, 2003 and 2002 F-2
Consolidated Statements of Operations for the years ended
December 31, 2003, 2002 and 2001 F-3
Consolidated Statement of Changes in Shareholders' Equity
(Deficit) for the years ended December 31, 2003, 2002 and 2001 F-4
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001 F-5
Notes to Consolidated Financial Statements F-6 - F-24
Consolidated Balance Sheets as of March 31, 2003 and 2002 F-25
Consolidated Statements of Operations for the quarters ended
March 31, 2003, 2002 F-26
Consolidated Statements of Cash Flows for the quarters ended
March 31, 2003, 2002 F-27
Notes to Consolidated Financial Statements F-28 - F-30
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To The Board of Directors and Shareholders of Payment Data Systems, Inc. San
Antonio, Texas
We have audited the accompanying consolidated balance sheet of Payment Data
Systems, Inc., formerly known as Billserv, Inc, and subsidiaries as of December
31, 2003, and the related consolidated statements of operations, changes in
shareholders' equity, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with the auditing standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Payment Data
Systems, Inc. and subsidiaries at December 31, 2003, and the consolidated
results of their operations and their cash flows for the year then ended, in
conformity with U.S. generally accepted auditing standards.
The accompanying financial statements of Payment Data Systems, Inc. and
subsidiaries have been prepared assuming that the Company will continue as a
going concern. As more fully described in Note 1, the Company has incurred
substantial losses since inception, which has led to a significant decrease in
its cash position and a deficit in working capital. In addition, in July 2003,
substantially all operations were sold. These conditions raise substantial doubt
about the Company's ability to continue as a going concern. The financial
statements of Payment Data Systems, Inc. and subsidiaries do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from the outcome of this uncertainty.
Akin, Doherty, Klein & Feuge, P.C.
San Antonio, Texas
March 2, 2004, except for Note 15, to which the date is March 15, 2004
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To The Board of Directors and Shareholders of Payment Data Systems, Inc. San
Antonio, Texas
We have audited the accompanying consolidated balance sheet of Payment Data
Systems, Inc., formerly known as Billserv, Inc., and subsidiaries as of December
31, 2002, and the related consolidated statements of operations, changes in
shareholders' equity, and cash flows for the years ended December 31, 2002 and
2001. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the auditing standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Payment Data
Systems, Inc. and subsidiaries at December 31, 2002, and the consolidated
results of their operations and their cash flows for the years ended December
31, 2002 and 2001, in conformity with accounting principles generally accepted
in the United States.
The accompanying financial statements of Payment Data Systems, Inc. and
subsidiaries have been prepared assuming that the Company will continue as a
going concern. As more fully described in Note 1, the Company has incurred
substantial losses since inception and has experienced a material shortfall in
anticipated revenues, which has led to a significant decrease in its cash
position and a deficit in working capital. These conditions raise substantial
doubt about the Company's ability to continue as a going concern. The financial
statements of Payment Data Systems, Inc. and subsidiaries do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from the outcome of this uncertainty.
ERNST & YOUNG LLP
San Antonio, Texas
April 1, 2003
F-1
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
December 31, December 31,
2003 2002
---------------- ----------------
Assets:
Cash and cash equivalents $ 528,119 $ 286,105
Cash pledged as collateral for related party obligations - 1,311,984
Accounts receivable, net 43,693 659,074
Prepaid expenses and other 113,650 257,810
---------------- ----------------
Total current assets 685,462 2,514,973
Property and equipment, net 215,156 281,432
Other assets 37,782 22,500
Net property and equipment of discontinued operations - 1,890,358
---------------- ----------------
Total assets $ 938,400 $ 4,709,263
================ ================
Liabilities and shareholders' equity (deficit):
Current liabilities:
Accounts payable $ 501,488 $ 949,392
Accrued expenses 224,180 555,560
Payable under related party guarantees - 1,278,138
Short-term borrowings - 1,800,000
Deferred revenue - 400,960
Obligations under capital leases of discontinued operations - 70,483
---------------- ----------------
Total current liabilities 725,668 5,054,533
Shareholders' equity (deficit):
Common stock, $.001 par value, 200,000,000 shares authorized;
20,987,956 and 20,603,799 issued and outstanding 20,988 20,604
Additional paid-in capital 46,842,908 46,770,186
Accumulated deficit (46,651,164) (47,136,060)
---------------- ----------------
Total shareholders' equity (deficit) 212,732 (345,270)
---------------- ----------------
Total liabilities and shareholders' equity (deficit) $ 938,400 $ 4,709,263
================ ================
See notes to consolidated financial statements.
F-2
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year ended Year ended Year ended
December 31, December 31, December 31,
2003 2002 2001
------------------ ------------------ ------------------
Revenues $ 119,297 $ 77,070 $ 43,835
Operating expenses:
Cost of services 138,009 58,739 38,004
Selling, general and administrative 1,726,028 2,431,566 3,077,783
Depreciation and amortization 130,671 183,594 199,384
------------------ ------------------ ------------------
Total operating expenses 1,994,708 2,673,899 3,315,171
------------------ ------------------ ------------------
Operating loss (1,875,411) (2,596,829) (3,271,336)
Other income (expense), net:
Interest income 5,122 81,799 355,262
Interest expense (61,432) (1,114,798) (40,079)
Loss on guarantees - (1,278,138) -
Other income (expense) 157,422 (354,494) 36,941
------------------ ------------------ ------------------
Total other income (expense), net 101,112 (2,665,631) 352,124
------------------ ------------------ ------------------
Loss from continuing operations before income
taxes (1,774,299) (5,262,460) (2,919,212)
Income taxes - - -
------------------ ------------------ ------------------
Loss from continuing operations (1,774,299) (5,262,460) (2,919,212)
Discontinued operations (Note 14):
Loss from discontinued operations, net of no
income taxes (477,846) (5,692,217) (7,486,494)
Gain on disposition of discontinued
operations, net of no income taxes 2,737,041 - -
------------------ ------------------ ------------------
Net income (loss) $ 484,896 $ (10,954,677) $ (10,405,706)
================== ================== ==================
Loss from continuing operations per common
share - basic and diluted $ (0.09) $ (0.25) $ (0.16)
Income (loss) from discontinued operations
per common share - basic and diluted 0.11 (0.28) (0.42)
------------------ ------------------ ------------------
Net income (loss) per common share - basic
and diluted $ 0.02 $ (0.53) $ (0.58)
================== ================== ==================
Weighted average common shares
outstanding - basic and diluted 20,883,218 20,591,304 18,017,051
See notes to consolidated financial statements.
F-3
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
Common Stock Additional Other Total
----------------------- Paid - In Accumulated Comprehensive Shareholders'
Shares Amount Capital Deficit Income Equity (Deficit)
------------- --------- --------------- --------------- --------------- -----------------
Balance at December 31, 2000 15,527,870 $ 15,528 $ 36,758,450 $ (25,775,677) $ 13,109 $ 11,011,410
Exercise of stock options 8,000 8 34,992 - - 35,000
Issuance of common stock, net of
issuance costs 5,002,656 5,003 9,115,968 - - 9,120,971
Comprehensive loss:
Unrealized gain on investments - - - - (13,109) (13,109)
Net loss for the year ended
December 31, 2001 - - - (10,405,706) - (10,405,706)
-----------------
Comprehensive loss (10,418,815)
------------- --------- --------------- --------------- --------------- -----------------
Balance at December 31, 2001 20,538,526 20,539 45,909,410 (36,181,383) - 9,748,566
Issuance of common stock 65,273 65 63,170 - - 63,235
Value of beneficial conversion feature
granted in connection with issuance
of debt - - 538,461 - - 538,461
Value of common stock warrants granted
in connection with issuance of debt - - 259,145 - - 259,145
Comprehensive loss:
Net loss for the year ended
December 31, 2002 - - - (10,954,677) - (10,954,677)
------------- --------- --------------- --------------- --------------- -----------------
Balance at December 31, 2002 20,603,799 20,604 46,770,186 (47,136,060) - (345,270)
Issuance of common stock 118,857 119 22,841 - - 22,960
Exercise of stock options 265,300 265 49,881 - - 50,146
Comprehensive income:
Net income for the year ended
December 31, 2003 - - - 484,896 - 484,896
------------- --------- --------------- --------------- --------------- -----------------
Balance at December 31, 2003 20,987,956 $ 20,988 $ 46,842,908 $ (46,651,164) $ - $ 212,732
============= ========= =============== =============== =============== =================
See notes to consolidated financial statements.
F-4
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
2003 2002 2001
------------------- -------------------- -------------------
Operating activities:
Loss from continuing operations $ (1,774,299) $ (5,262,460) $ (2,919,212)
Adjustments to reconcile loss from continuing
operations to net cash used in operating
activities:
Depreciation and amortization 130,671 183,594 199,384
Impairment of assets 17,000 - -
Loss on related party guarantees - 1,278,138 -
Issuance of common stock warrants and convertible
debt - 1,035,255 -
Gain on disposition - - (36,070)
Changes in current assets and current liabilities:
Accounts receivable 615,381 (221,397) 344,860
Related party notes receivable - 162,154 121,584
Prepaid expenses and other 144,160 7,702 377,551
Accounts payable and accrued expenses (763,034) 893,818 (757,863)
Deferred revenue (400,960) (251,669) (173,371)
------------------- -------------------- -------------------
Net cash used in continuing operations (2,031,081) (2,174,865) (2,843,137)
Net cash used in discontinued operations (145,038) (3,836,809) (6,740,000)
------------------- -------------------- -------------------
Net cash used in operating activities (2,176,119) (6,011,674) (9,583,137)
Investing activities:
Purchases of property and equipment (66,395) (9,522) (120,676)
Proceeds from sale of assets 4,224,108 - -
Proceeds from sales and maturities of investments - - 2,028,680
Long-term deposits, net (30,282) 255,503 218,641
Other investing activities - (6,126) 2,577
------------------- -------------------- -------------------
Net cash provided by investing activities 4,127,431 239,855 2,129,222
Financing activities:
Proceeds from notes payable - 2,145,000 -
Principal payments for notes payable (1,800,000) (645,000) (1,500,000)
Financing costs, net - (237,649) -
Principal payments for capital lease obligations - (148,228) (181,328)
Cash pledged as collateral for related party
obligations 1,311,984 706,967 (1,018,951)
Payments for related party obligations (1,278,138) - -
Issuance of common stock, net of issuance costs 56,856 63,235 9,155,971
------------------- -------------------- -------------------
Net cash provided by (used in) financing activities (1,709,298) 1,884,325 6,455,692
------------------- -------------------- -------------------
Change in cash and cash equivalents 242,014 (3,887,494) (998,223)
Cash and cash equivalents, beginning of period 286,105 4,173,599 5,171,822
------------------- -------------------- -------------------
Cash and cash equivalents, end of period $ 528,119 $ 286,105 $ 4,173,599
=================== ==================== ===================
Supplemental information:
Cash paid for interest $ 41,623 $ 39,264 $ 52,027
Cash paid for federal income taxes - - -
See notes to consolidated financial statements.
F-5
PAYMENT DATA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003, 2002 AND 2001
NOTE 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GOING CONCERN
The Company has incurred substantial losses since inception, which has led to a
significant decrease in its cash position and a deficit in working capital. The
Company defaulted under its convertible debt agreement during the fourth quarter
of 2002 (see Note 7) and was unsuccessful in its attempt to access its funds
held as collateral to guarantee certain executive margin loans (see Note 8)
after attempting to retrieve such funds during the fourth quarter of 2002.
Consequently, the Company sold substantially all of its assets in July 2003 (see
Note 14) and reduced expenditures for operating requirements. Despite these
actions, the Company believes that its current available cash along with
anticipated revenues may be insufficient to meet its anticipated cash needs for
the foreseeable future. Accordingly, the Company is currently aggressively
pursuing strategic alternatives, including investment in the Company via an
equity line of credit (See Note 15). The satisfactory completion of an
additional investment in the Company or growth of cash flow from operations is
essential or the Company has no other alternative that will provide sufficient
funds to meet current operating requirements. The sale of additional equity or
convertible debt securities would result in additional dilution to the Company's
stockholders, and debt financing, if available, may involve restrictive
covenants which could restrict operations or finances. There can be no assurance
that financing will be available in amounts or on terms acceptable to the
Company, if at all. If the Company cannot raise funds, on acceptable terms, or
achieve positive cash flow, it may not be able to continue to exist, conduct
operations, grow market share, take advantage of future opportunities or respond
to competitive pressures or unanticipated requirements, any of which would
negatively impact its business, operating results and financial condition.
DESCRIPTION OF BUSINESS
Payment Data Systems, Inc., formerly known as Billserv, Inc., and its
subsidiaries (collectively, "PDS" or "the Company"), provides integrated
electronic payment services, including credit and debit card-based processing
services and transaction processing via the ACH network to billers and
retailers. In addition, the Company operates an Internet electronic payment
processing service for consumers under the domain name www.bills.com. Prior to
selling substantially all of its assets (the "Business") in July 2003, the
Company provided electronic bill presentment and payment ("EBPP") services to
companies generating recurring bills, primarily in the United States. The
Company also provided related EBPP consulting and Internet-based customer care
interaction services. In accordance with Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets" ("FAS 144"), the results of operations for the asset group disposed of
have been classified as discontinued operations. All financial information
presented for the years ended December 31, 2003, 2002 and 2001 has been restated
to reflect the operating results of this asset group as discontinued operations
(see Note 14).
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries, bills.com, Inc. and
billserv.com-canada, Inc. All significant intercompany accounts and transactions
have been eliminated.
F-6
The accompanying financial statements have been presented assuming the Company
will continue as a going concern.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation. These reclassifications had no impact on operating loss as
previously reported.
USE OF ESTIMATES
The preparation of financial statements in conformity with U.S. generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.
ACCOUNTS RECEIVABLE
Accounts receivable represent net amounts due for fees charged for the
electronic processing of payment transactions and related services provided by
the Company. Accounts receivable are reported at outstanding principal net of an
allowance for doubtful accounts of $3,155 at December 31, 2003 and $47,197 at
December 31, 2002. The Company normally does not charge interest on accounts
receivable. The allowance for doubtful accounts is generally determined based on
an account-by-account review. Accounts are charged off when collection efforts
have failed and the account is deemed uncollectible.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially expose the Company to credit risk consist
of cash and cash equivalents, investments and accounts receivable. The Company
is exposed to credit risk on its cash, cash equivalents and investments in the
event of default by the financial institutions or the issuers of these
investments to the extent of the amounts recorded on the balance sheet in excess
of amounts that are insured by the FDIC. Trade receivables potentially subject
the Company to concentrations of credit risk. The Company's customer base
operates in a variety of industries and is geographically dispersed, however,
the relatively small number of customers increases the risk. The Company closely
monitors extensions of credit and credit losses have been provided for in the
consolidated financial statements and have been within management's
expectations. The activity in the Company's allowance for doubtful accounts was
as follows:
Beginning Ending
Balance Additions Write-offs Balance
Year ended December 31, 2001 $10,000 $21,000 $12,069 $18,931
Year ended December 31, 2002 18,931 30,000 1,734 47,197
Year ended December 31, 2003 $47,197 $10,700 $54,742 $ 3,155
No single customer accounted for more than 5% of total continuing operating
revenues for the years ended December 31, 2003, 2002 or 2001.
F-7
FAIR VALUE OF FINANCIAL INSTRUMENTS
Cash and cash equivalents, accounts receivable, accounts payable, accrued
liabilities and short-term borrowings are reflected in the accompanying
consolidated financial statements at cost, which approximates fair value because
of the short-term maturity of these instruments.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation and amortization are
computed on a straight-line method over the estimated useful lives of the
related assets, ranging from three to seven years. Leasehold improvements are
amortized over the lesser of the estimated useful lives or remaining lease
period. Expenditures for maintenance and repairs are charged to expense as
incurred.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company periodically reviews, on at least an annual basis, the carrying
value of its long-lived assets, including intangible assets and property, plant
and equipment, whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. To the extent fair value of a long-lived
asset, determined based upon the estimated future cash inflows attributable to
the asset, less estimated future cash outflows, are less than the carrying
amount, an impairment loss is recognized.
INTANGIBLE ASSET
The cost of the domain name registration for www.bills.com is being amortized on
a straight-line basis over a five-year period and is included in other assets on
the accompanying consolidated balance sheets. The unamortized cost of this
intangible asset was $7,500 and $22,500 at December 31, 2003 and 2002,
respectively. The costs of trademarks registered to the Company have not been
material and have been expensed as incurred.
REVENUE RECOGNITION
Revenue consists of fees generated through the electronic processing of payment
transactions and related services, and are recognized as revenue in the period
the transactions are processed or when the related services are performed.
Merchants may be charged for these processing services at a bundled rate based
on a percentage of the dollar amount of each transaction and, in some instances,
additional fees are charged for each transaction. Certain merchant customers are
charged a flat fee per transaction, while others may also be charged
miscellaneous fees, including fees for chargebacks or returns, monthly minimums,
and other miscellaneous services. Revenues derived from electronic processing of
credit and debit card transactions that are authorized and captured through
third party networks are reported gross of amounts paid to sponsor banks as well
as interchange and assessments paid to credit card associations (MasterCard and
Visa).
RESERVE FOR LOSSES ON MERCHANT ACCOUNTS
Disputes between a cardholder and a merchant periodically arise as a result of,
among other things, cardholder dissatisfaction with merchandise quality or
merchant services. Such disputes may not be resolved in the merchant's favor. In
these cases, the transaction is "charged back" to the merchant and the purchase
price is refunded to the customer through the merchant's acquiring bank, and
charged to the merchant. If the merchant has inadequate funds, the Company must
bear the credit risk for the full amount of the transaction. The Company
evaluates its risk for such transactions and estimates its potential loss for
chargebacks based primarily on historical experience and other relevant factors.
The Company did not record a significant amount of chargeback expense to cost of
services in 2003 and did not have a significant reserve for losses at December
31, 2003. The Company did not incur any chargeback losses in 2003 and did not
maintain a reserve for losses on merchant accounts prior to offering card-based
processing services beginning in the fourth quarter of 2003.
F-8
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are expensed as incurred.
ADVERTISING COSTS
The cost of advertising is expensed as incurred. The Company's continuing
operations did not incur any advertising costs for the years ended December 31,
2003, 2002 or 2001.
FOREIGN OPERATIONS
The Company is currently not operating in any foreign countries. The Company
previously operated in Australia and Canada; however, the impact financially of
expanding internationally was not material to the Company's financial position
or results of operations in any year.
INCOME TAXES
Deferred tax assets and liabilities are recorded based on differences between
financial reporting and tax bases of assets and liabilities and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse.
COMPREHENSIVE LOSS
The Company's comprehensive loss in 2001 is comprised of net loss and unrealized
gains and losses on investments classified as available-for-sale.
STOCK-BASED COMPENSATION
The Company applies the intrinsic value method under the recognition and
measurement provisions of APB No. 25, "Accounting for Stock Issued to
Employees", in accounting for its stock option and stock purchase plans.
Accordingly, no stock-based employee compensation expense has been recognized
for options granted with an exercise price equal to the market value of the
underlying common stock on the date of grant or in connection with the employee
stock purchase plan. The following table illustrates the effect on net income
and earnings per share if the Company had applied the fair value recognition
provisions of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" ("FAS 123"), to stock-based employee compensation.
F-9
2002 2001 2000
---- ---- ----
Net income (loss), as reported $ 484,896 $(10,954,677) $(10,405,706)
Less: Total stock-based employee
compensation expense determined
under fair value based method for
all awards, net of related tax effects (573,186) (1,584,364) (2,782,995)
----------- ------------ ------------
Pro forma net income (loss) $ (88,290) $(12,539,041) $(13,188,701)
=========== ============ ============
Net income (loss) per common share
- basic and diluted, as reported $ 0.02 $ (0.53) $ (0.58)
Net income (loss) per common share
- basic and diluted, pro forma $ - $ (0.61) $ (0.73)
The Company recognizes expense for common stock issued in transactions with
other than employees. The shares issued are valued at the closing price of the
Company's common stock as reported on the NASD OTCBB on the day that the
non-employee agrees to accept the Company's common stock instead of cash as
compensation.
NET LOSS PER SHARE
Basic and diluted losses per common share are calculated by dividing net loss by
the weighted average number of common shares outstanding during the period.
Common stock equivalents, which consist of stock options and warrants and the
convertible debt, were excluded from the computation of the weighted average
number of common shares outstanding for purposes of calculating diluted loss per
common share because their effect was antidilutive.
A reconciliation of the weighted average common shares outstanding included in
basic and diluted EPS is as follows:
For the Year Ended December 31,
2003 2002 2001
Numerator:
Loss from continuing operations
available to common stockholders $(1,774,299) $(5,262,460) $(2,919,212)
Denominator:
Denominator for basic loss
per share, weighted average
shares outstanding . . . . . . . . 20,883,218 20,591,304 18,017,051
Effects of dilutive securities:
Stock options and warrants . . . - - -
Convertible debt . . . . . . . . - - -
Denominator for diluted loss
per share. . . . . . . . . . . . . 20,883,218 20,591,304 18,017,051
Basic loss per share . . . . . . . $ (0.09) $ (0.25) $ (0.16)
Diluted loss per share . . . . . . $ (0.09) $ (0.25) $ (0.16)
F-10
During a loss period, the assumed exercises of in-the-money stock options and
warrants and conversion of convertible securities have an antidilutive effect,
and are excluded from the computation of diluted EPS. The computation of diluted
net loss per share for the year ended December 31, 2003 excludes the impact of
options and warrants to purchase 8,785,048 shares of common stock, as such
impact would be antidilutive for this period. The computation of diluted net
loss per share for the year ended December 31, 2002 excludes the impact of
options and warrants to purchase 10,294,927 shares of common stock and the
conversion of the convertible debt, which was convertible into a minimum of
1,923,077 shares of common stock at December 31, 2002, as such impact would be
antidilutive for this period. The computation of diluted net loss per share for
the fiscal year ended December 31, 2001 excludes the impact of options and
warrants to purchase 8,601,014 shares of common stock, as such impact would be
antidilutive for this period. These options and warrants could be dilutive in
the future. See Notes 10 and 11 for information regarding the exercise prices of
our outstanding, unexercised options and warrants, respectively.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness to Others" ("FIN 45").
FIN 45 requires additional disclosures by a guarantor in its interim and annual
financial statements about its obligations under certain guarantees that it
issued. It also clarifies that a guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the guarantee. The
initial recognition and measurement provisions of this Interpretation are
applicable on a prospective basis to guarantees issued or modified after
December 21, 2002. The required disclosures are effective for financial
statements for interim or annual periods ending after December 15, 2002. The
adoption of FIN 45 did not have a significant impact on our financial position
and results of operations.
On December 31, 2002, the FASB issued Statement No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" ("FAS 148") which amends
Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"). FAS
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation and
amends the disclosure requirements of FAS 123 to require disclosures in both the
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The transition guidance and disclosure provisions of FAS 148 were
effective for the Company's financial statements issued for the first quarter of
2003. The adoption of FAS 148 did not have a significant impact on our results
of operations or financial position.
In November 2002, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"). FIN 46 requires that a variable interest
entity be consolidated by a company if that company is subject to a majority of
the risk of loss from the variable interest entity's activities or entitled to
receive a majority of the entity's residual returns or both. The consolidation
provisions of FIN 46 were originally effective for financial periods ending
after July 15, 2003. In October 2003, the FASB issued Staff Position FIN 46-6,
"Effective Date of FIN 46," which delayed the implementation date for certain
variable interest entities to financial periods ending after December 31, 2003.
In December 2003, the FASB published a revision to FIN 46 ("FIN 46R") to clarify
some of the provision of FIN 46, and to exempt certain entities from its
requirements. The Company does not expect the adoption of these standards to
have a significant impact on our financial position and results of operations.
F-11
On May 15, 2003, the FASB issued Statement No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity" ("FAS
150"). FAS 150 establishes standards for classifying and measuring as
liabilities certain freestanding financial instruments that embody obligations
of the issuer and have characteristics of both liabilities and equity. The
statement defines an obligation as "a conditional or unconditional duty or
responsibility on the part of the issuer to transfer assets or to issue its
equity shares." FAS 150 is effective for all financial instruments created or
modified after May 31, 2003, and otherwise effective at the beginning of the
first interim period beginning after June 15, 2003. The adoption of this
statement did not have a significant impact on the Company's results of
operations or financial position.
NOTE 2. ISSUANCE OF CAPITAL STOCK
On June 2, 2000, the Company entered into an extended biller service provider
agreement with CheckFree Investment Corporation, CheckFree Services Corporation
and CheckFree Holdings Corporation (collectively, "CheckFree"). As part of this
agreement, CheckFree purchased 879,121 shares of the Company's common stock at
$11.375 per share totaling $10.0 million. Offering proceeds to the Company, net
of issuance costs, were approximately $9.5 million. In connection with this
transaction, the Company also issued warrants to purchase 2,179,121 shares of
common stock, and warrants to purchase up to an additional 2,801,903 shares if
certain criteria were met (see Note 11).
In March 2001, the Company issued 2,885,462 shares of common stock under a
private placement offering. The shares were issued at an undiscounted price of
$2.50 per share. Net proceeds totaled approximately $6.6 million, net of
offering costs of approximately $565,000, which included approximately $540,000,
or 7.5% of the Offering, paid to the placement agent. The Company subsequently
filed a registration statement with the SEC to register the shares issued in
this offering.
In November 2001, the Company issued 2,000,000 shares of common stock under a
private placement offering (the "2001 Offering"). The shares were issued at an
undiscounted price of $1.25 per share. Net proceeds totaled approximately $2.3
million, net of offering costs of approximately $211,000, which included
approximately $200,000, or 8% of the Offering, paid to the placement agent. The
Company subsequently filed a registration statement with the SEC to register the
shares issued in this offering. In connection with this transaction, the Company
also issued warrants to purchase 2,000,000 shares of common stock (see Note 11).
During the year ended December 31, 2003, the Company issued 75,000 shares of
common stock to certain independent contractors performing services for the
Company. Such shares were issued pursuant to Section 506 of Regulation D of the
Securities and Exchange Act of 1933, as amended. The Company recorded $16,250 of
expense related to the issuance of this stock.
NOTE 3. PROPERTY AND EQUIPMENT
The following is a summary of property and equipment at December 31:
2003 2002
----------------- -----------------
Furniture and fixtures $ 175,856 $ 192,870
Equipment 424,901 392,499
Software 174,740 149,724
Leasehold improvements 8,434 -
----------------- -----------------
783,931 735,093
Less: accumulated depreciation and
amortization (568,775) (453,661)
----------------- -----------------
Total property and equipment, net $ 215,156 $ 281,432
================= =================
F-12
NOTE 4. IMPAIRMENT OF ASSETS
During the fourth quarter of 2002, the Company performed an impairment review
because of the uncertainty of the Company's ability to continue as a going
concern due to decreased liquidity, which indicated that the carrying value of
certain long-lived assets may not be recoverable. The Company determined that
customer relationship management software and document archival and retrieval
software with a total carrying amount of $855,000 were no longer recoverable and
recorded a non-cash charge of $855,000, which is included as a component of
discontinued operations in the accompanying consolidated statement of
operations. Fair value was based on the expected future cash flows to be
generated by these assets, which was determined to be zero because of the
Company's inability to deploy and utilize the assets to provide
revenue-generating services.
During the second quarter of 2003, the Company performed an impairment review
because the Company expected to sell the asset group comprising the Business.
The Company determined that the asset group to be sold was impaired and recorded
a non-cash charge of $200,000, which is included as a component of discontinued
operations in the accompanying consolidated statement of operations. Fair value
was based on the expected selling price of the asset group. During the fourth
quarter of 2003, the Company performed an impairment review because the Company
expected to sell certain assets not currently being utilized. The Company
determined that the assets expected to be sold within one year were impaired and
recorded a non-cash charge of $17,000, which is included as a component of
selling, general and administrative expense in the accompanying consolidated
statement of operations. Fair value was based on the selling price of similar
assets. The assets consist of furniture that has a net book value of $15,714 at
December 31, 2003 and are included as a component of property and equipment in
the accompanying consolidated balance sheets. These assets are not classified as
held for sale because management has not yet initiated an active program to
locate a buyer for the assets.
NOTE 5. ACCRUED EXPENSES
Accrued expenses consist of the following balances:
December 31, December 31,
2003 2002
---------------- ----------------
Accrued salaries $ 11,325 $ 185,178
Accrued vacation - 80,517
Accrued property taxes - 84,018
Accrued sales taxes 101,696 4,489
Accrued professional
fees 100,515 30,810
Other accrued expenses 10,644 170,548
---------------- ----------------
Total $ 224,180 $ 555,560
================ ================
F-13
NOTE 6. OPERATING LEASES
In August 2003, the Company signed a three-year lease for approximately 4,500
square feet that will serve as the Company's headquarters. Additionally, the
Company leases office equipment under non-cancelable operating leases. Rental
expense under operating leases for continuing operations for the years ended
December 31, 2003, 2002 and 2001, was $59,000, $97,000 and $87,000,
respectively. Future minimum lease payments required under operating leases, by
year and in the aggregate, consist of the following at December 31, 2003:
Year ending December 31,
2004 $ 84,599
2005 83,199
2006 67,605
----------
Total minimum
lease payments $ 235,403
==========
NOTE 7. DEBT
On July 24, 2002, the Company executed a financing agreement with Laurus Master
Fund, Ltd. ("Laurus") in exchange for a $1.5 million convertible note and a
four-year warrant to purchase 300,000 shares of the Company's common stock at
exercise prices of $0.936 for the first 150,000 shares, $0.975 for the next
50,000 shares, and $1.17 for the remaining 100,000 shares. Laurus could convert
the convertible note, which bore interest at 7% annually, at any time into
shares of the Company's common stock at a fixed conversion price of $0.78,
subject to certain restrictions in the purchase agreement. The Company could pay
the principal and interest on the convertible note, which had a one-year term,
in cash, shares of its common stock or a combination of cash and stock. If
common stock was used to pay the note, the conversion price was the lesser of
(i) $0.78 or (ii) 88% of the average of the 7 lowest closing prices during the
22 trading days prior to the date the Company gave notice of payment. Accrued
interest and one-ninth of the principal was due on the first business day of
each calendar month beginning on November 1, 2002 and continuing until the
maturity date of July 1, 2003. If the required principal payment was made in
cash, the principal amount paid was 105% of the amount due. The Company granted
Laurus a security interest in all of its assets. The Company defaulted under the
note during the fourth quarter of 2002 and a penalty of 120% of the outstanding
principal amount, or $300,000, was assessed to the Company for the default, and
was included in the balance of short-term borrowings on the Company's balance
sheet at December 31, 2002. The default occurred because the Company did not
make the required principal payments in cash. The Company was unable to make the
required payments in stock because the registration statement filed by the
Company with the Securities and Exchange Commission to register the resale of
the common stock issuable to pay the note was not declared effective.
F-14
The Company recorded a debt discount as a result of the issuance of the warrant
to Laurus of approximately $259,000, which was being charged to interest expense
over the term of the convertible note using the effective yield method. Upon the
Company's default under the note, the remaining balance of the discount was
charged to interest expense. Furthermore, the Company recorded an additional
debt discount as a result of the beneficial conversion feature of approximately
$283,000, which was charged to interest expense at the date of issuance. The
amount related to the beneficial conversion feature was determined by dividing
the note proceeds allocated to the convertible security of approximately
$1,241,000 by the number of shares into which the note was convertible, or
1,923,077 shares based on the fixed conversion price of $0.78 per common share.
The resulting effective conversion price of $0.65 per common share was then
compared to the fair value of the Company's stock, which was $0.93 per common
share on the issuance date. The difference of $0.28 per common share between the
fair value of the stock and the effective conversion price was then multiplied
by 1,009,586, which was the number of shares the note was convertible into at
the date of issuance, taking into account the limitation on the number of shares
that Laurus could convert at that time. The agreement stipulated that Laurus
could not convert that amount of the note that would result in beneficial
ownership of more than 4.9% of the outstanding common shares of the Company on
the date of conversion. The conversion limitation was to become null and void
upon an event of default under the note and could have been raised if the
Company chose to redeem the outstanding principal amount of the note in cash and
Laurus elected to convert the note instead. The limitation could also be raised
if the Company were to issue additional common shares for any reason, thus
increasing the number of outstanding shares. Due to the Company's default under
the note during the fourth quarter of 2002, the 4.9% limitation became null and
void and additional interest expense of approximately $256,000 was recognized at
a rate of $0.28 per common share for the 913,491 additional shares that the note
became convertible into upon default. During 2002, the Company capitalized
$238,000 in financing costs related to the issuance of the Laurus debt that were
being charged to interest expense over the term of the convertible note using
the effective yield method. Upon default under the note in the fourth quarter of
2002, the remaining unamortized balance was charged to interest expense.
In connection with the sale of substantially all of its assets (see Note 14),
the Company paid the outstanding balance of the convertible note in cash,
including accrued penalties and interest, in full settlement of all claims by
Laurus during July 2003. In addition, the four-year warrant to purchase 300,000
shares of the Company's common stock initially granted to Laurus was canceled as
part of the settlement.
NOTE 8. RELATED PARTY TRANSACTIONS AND GUARANTEES
From time to time, the Company has made loans to certain officers of the
Company. The highest aggregate amount outstanding of loans due from officers
(including an ex-officer of the Company) was $162,000 during 2002 and $230,000
during 2001. There were no loans due from officers during 2003.
In December 2000, an officer of the Company borrowed approximately $20,000 that
accrued interest at a rate of 8% annually. The loan was repaid in full during
2001.
On August 16, 2000, an officer of the Company borrowed approximately $60,000
that accrued interest at a rate of 8% annually. At December 31, 2001, $46,000
was outstanding under this loan. In May 2002, this officer repaid the balance of
this loan in full, including accrued interest. On December 21, 2000, the Company
entered into a 30-day promissory note with the same officer for $125,000. The
promissory note was repaid in full in January 2001, including interest at a rate
of 8% annually.
During 2000, an officer of the Company borrowed approximately $35,000, of which
$25,000 was outstanding at December 31, 2000. During 2001, the Company loaned an
additional $94,000 to this officer prior to his resignation from the Company. At
December 31, 2001, the Company had an aggregate of $115,000 in notes receivable
bearing interest at 8% annually from this ex-officer. In March 2002, this
ex-officer repaid the balance of these loans in full, including accrued
interest.
F-15
Beginning in December 2000, the Company pledged as loan guarantees certain funds
held as money market funds and certificates of deposit to collateralize certain
margin loans of four officers of the Company (only two of which are currently
employed by the Company). See Note 13 for a further discussion of these
guarantees and pledged funds.
NOTE 9. INCOME TAXES
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of December 31 are as
follows:
2003 2002
-------------------- -------------------
Deferred Tax Assets:
--------------------
Warrant expense $ 3,166,992 $ 3,166,992
Loss on related party guarantees 434,567 434,567
Net operating loss carryforwards 11,759,182 11,818,879
Other items 91,019 624,016
-------------------- -------------------
15,451,760 16,044,454
Valuation allowance (15,400,069) (15,921,467)
-------------------- -------------------
Total Deferred Tax Asset 51,691 122,987
Deferred Tax Liabilities:
-------------------------
Depreciation and other items 51,691 122,987
-------------------- -------------------
Net Deferred Tax Asset
(Liability) $ - $ -
==================== ===================
For the period from inception (July 30, 1998) through December 31, 2003, the
Company has net operating loss carryforwards for tax purposes of approximately
$34.6 million that begin to expire in the year 2020. In October 1999, the
Company issued common stock pursuant to a private placement offering. As a
result, an ownership change occurred under Section 382 that limits the
utilization of pre-change net operating loss carryforwards. Approximately $3.5
million of the total net operating loss is subject to the Section 382
limitations.
The reconciliation of income tax computed at the U.S. federal statutory tax
rates to income tax expense is as follows:
2003 2002 2001
-------------------- ------------------- -------------------
Tax at US statutory rate -- 34% $ 164,865 $ (3,724,590) $ (3,537,940)
Change in valuation allowance (521,398) 3,700,366 3,421,050
Permanent and other differences 356,533 24,224 116,890
-------------------- ------------------- -------------------
Income tax expense $ - $ - $ -
==================== =================== ===================
F-16
NOTE 10. EMPLOYMENT BENEFIT PLANS
STOCK OPTION PLANS
The Board of Directors and stockholders approved the 1999 Employee Comprehensive
Stock Plan ("Employee Plan") to provide qualified incentive stock options
("ISOs") and non-qualified stock options ("NQSOs") as well as restricted stock
to key employees. Under the terms of the Employee Plan, the exercise price of
ISOs must be equal to 100% of the fair market value on the date of grant (or
110% of fair market value in the case of an ISO granted to a 10%
stockholder/grantee). There is no price requirement for NQSOs, other than that
the option price must exceed the par value of the common stock. The Company has
reserved 5,000,000 shares of its common stock for issuance pursuant to the
Employee Plan. On December 29, 2003, the Employee Plan was amended and restated
by the Board of Directors to add provisions 1) allowing for stock awards to be
made to consultants as provided in Rule 405 promulgated under the Securities Act
of 1933, as amended from time to time, and other applicable law, 2) increasing
the amount of shares of common stock of the Company exercisable per fiscal year
from stock options, whether ISOs or NQSOs, from 350,000 to 500,000, and 3)
removing minimum holding periods on "Restricted Stock" as such term is defined
in the Employee Plan.
The 1999 Non-Employee Director Plan ("Director Plan") was approved by the Board
of Directors and stockholders in 1999. Under the Director Plan, non-employee
directors may be granted options to purchase shares of common stock at 100% of
fair market value on the date of grant. The Company has reserved 800,000 shares
of its common stock for issuance pursuant to the Director Plan.
In May 2002, the Company tendered an offer to employees and non-employee
directors to cancel certain outstanding stock options under a stock option
exchange program. In return for voluntarily canceling certain stock options,
employees and non-employee directors were granted an equal number of stock
options promptly after six months and one day from the cancellation date. The
exercise price of the new options granted was equal to the fair market value of
the Company's common stock on the grant date. The program is not expected to
result in any additional compensation expense or variable plan accounting. In
connection with this offer, 754,925 options were canceled on June 11, 2002 and
513,150 options were granted on December 13, 2002 at an exercise price of $0.26
per share.
Activity under the Employee Plan and Director Plan is as follows:
Weighted Average
Number of Shares Exercise Price
------------------- ------------------
Outstanding, December 31, 2000 2,899,175 $ 4.95
Granted 2,045,162 0.97
Canceled (646,032) 4.67
Exercised (8,000) 4.38
-------------------
Outstanding, December 31, 2001 4,290,305 3.10
Granted 3,104,250 0.23
Canceled (1,632,906) 5.09
Exercised - -
-------------------
Outstanding, December 31, 2002 5,761,649 0.99
Granted 1,755,000 0.13
Canceled (2,699,579) 0.87
Exercised (265,300) 0.19
-------------------
Outstanding, December 31, 2003 4,551,770 $ 0.78
===================
F-17
There was an aggregate of 971,230 and 26,651 options to purchase the Company's
common stock available for future grants under the Employee and Director Plans
at December 31, 2003 and 2002, respectively. Exercisable stock options amounted
to 3,171,770 at a weighted average price of $1.06 and 1,604,492 at a weighted
average price of $2.33 at December 31, 2003 and 2002, respectively.
Summarized information about stock options outstanding at December 31, 2003 is
as follows:
Options Outstanding Options Exercisable
------------------------------------- ------------------------------------
Weighted Average Weighted
Range of Exercise Options Remaining Average Number of Weighted Average
Prices Outstanding Contractual Life Exercise Price Options Exercise Price
----------------------- ----------------- ------------------- ----------------- ----------------- ------------------
$0.09 - $0.14 1,730,000 9.90 $0.13 350,000 $0.09
$0.18 - $0.26 1,271,100 8.99 $0.19 1,271,100 $0.19
$0.86 - $0.88 741,668 7.83 $0.86 741,668 $0.86
$1.88 - $2.07 354,001 7.03 $2.06 354,001 $2.06
$2.81 - $11.25 455,001 5.14 $3.76 455,001 $3.76
----------------- -----------------
4,551,770 8.61 $0.78 3,171,770 $1.06
================= =================
The weighted average fair value of stock options at date of grant was $0.10,
$0.17 and $0.73 per option for options granted during fiscal years 2003, 2002,
and 2001, respectively. The fair value of each option granted was estimated
using the Black-Scholes option-pricing model, utilizing the following
assumptions:
2003 2002 2001
---- ---- ----
Dividend yield None None None
Expected volatility 142% 128% 119%
Risk-free interest rate 1.80% 1.80% 3.40%
Expected life 2.45 3.74 3.95
EMPLOYEE STOCK PURCHASE PLAN
The Company established the 1999 Employee Stock Purchase Plan ("ESPP") under the
requirements of Section 423 of the Internal Revenue Code (the "Code") to allow
eligible employees to purchase the Company's common stock at regular intervals.
Participating employees may purchase common stock through voluntary payroll
deductions at the end of each participation period at a purchase price equal to
85% of the lower of the fair market value of the common stock at the beginning
or the end of the participation period. Common stock reserved for future
employee purchases under the plan aggregated 755,828 shares at December 31,
2003. A total of 43,857, 65,273 and 117,194 shares were issued under the ESPP in
2003, 2002 and 2001, respectively, at prices ranging from $0.15 per share to
$2.18 per share.
F-18
401(K) PLAN
In May 1999, the Company adopted a defined contribution plan (the "401(k) Plan")
pursuant to Section 401(k) of the Code. All eligible full and part-time
employees of the Company who meet certain age requirements may participate in
the 401(k) Plan. Participants may contribute between 1% and 15% of their pre-tax
compensation, but not in excess of the maximum allowable under the Code. The
401(k) Plan allows for discretionary and matching contributions by the Company.
The Company made no contributions during fiscal 2003, 2002 or 2001.
NOTE 11. STOCK WARRANTS
In connection with the CheckFree investment (see Note 2), the Company issued
CheckFree warrants to purchase 2,179,121 shares at $11.375 per share for
entering into the extended biller service provider agreement and investing $10.0
million. Under this agreement, CheckFree provided the Company with electronic
bill presentment services for volume-based fees. The Company recorded $7,488,000
of expense and a corresponding credit to additional paid-in capital related to
the estimated fair value of 1.3 million of these warrants, which were issued as
consideration for entering into the extended biller service provider agreement.
The related warrant expense was recognized immediately instead of being deferred
and recognized over the life of the agreement because the warrants were fully
vested at the date of grant and CheckFree did not have to perform under the
agreement to earn the warrants. Also, CheckFree had the ability to earn
incentive warrants on up to 2,801,903 additional shares, of which 1,000,000 were
exercisable at $11.375 per share and 1,801,903 were exercisable at $14.219 per
share. The incentive warrants were to vest upon the achievement of certain
target levels of referred billers to the Company by CheckFree and all such
warrants that were not vested within five years would expire. None of these
incentive warrants vested and all were effectively canceled with the assignment
of the related service agreement to the purchaser of substantially all of the
assets of the Company in July 2003 (see Note 14).
In connection with the 2001 Offering (see Note 2), the Company issued warrants
to the eighteen investors to purchase 2,000,000 shares of common stock at $1.80
per share, or one warrant for each share issued. The warrants are exercisable
for five years from the date of issuance, or until November 27, 2006. The
Company has the right to call the exercise of the warrants at any time after six
months after the date of the issuance and after the closing price of the common
stock exceeds $5.40 for a period of twenty consecutive trading days. Upon such
call notice, the holders of the warrants must exercise the warrants within
thirty days, after which time they may be redeemed for $.05 per warrant.
In connection with the July 2002 convertible debt issuance (see Note 7), the
Company issued a warrant to purchase 300,000 shares of the Company's common
stock at exercise prices of $0.936 for the first 150,000 shares, $0.975 for the
next 50,000 shares, and $1.17 for the remaining 100,000 shares. Using the fair
value-based method of accounting, the Company recorded $259,000 of expense and a
corresponding credit to paid-in-capital during 2002 related to the issuance of
this warrant. These warrants were subsequently canceled in July 2003 in
conjunction with the settlement and repayment of the related debt.
At December 31, 2003, the outstanding vested warrants to purchase common stock
are as follows:
Shares of Common Exercise Aggregate Expiration
Stock Price Exercise Date
Price
----------------------------------------------------------------
41,237 $ 6.06 $ 250,000 08/05/2004
250 3.25 813 10/14/2004
280 8.00 2,240 12/15/2004
8,890 7.41 65,875 12/20/2004
3,500 7.31 25,585 12/22/2004
2,179,121 11.38 24,798,397 06/02/2010
2,000,000 1.80 3,600,000 11/27/2006
--------- ------------
4,233,278 $ 28,742,910
========= ============
F-19
NOTE 12. COMMON STOCK LISTING
The Company's common stock began trading on the Over the Counter Bulletin Board
("OTCBB") operated by the National Association of Securities Dealers ("NASD") on
December 3, 1998. The NASD adopted eligibility rules in 1999, which required
clearance of comments by the SEC on all SEC filings. The Company filed its
initial filing on Form 10 with the SEC on June 10, 1999 but, as of October 7,
1999, the SEC had not cleared its comment period. In accordance with the OTCBB's
phase-in schedule for the new eligibility rules, the listing on the OTCBB was
terminated. The Company's common stock was quoted in the National Quotation
Board's Electronic Pink Sheets until December 7, 1999, when the SEC cleared the
comment period and the stock was relisted and traded on the OTCBB through March
13, 2000 at which time the stock was approved for trading on the NASDAQ Small
Cap Market. Subsequently the stock was approved for trading on the NASDAQ
National Market ("NNM") on July 31, 2000, under the symbol "BLLS." On February
4, 2003, the NNM delisted the Company's common stock because the Company did not
meet the requirements for continued listing on the NNM. The Company's common
shares were immediately eligible for quotation on the OTCBB effective at opening
of business on February 4, 2003. On July 29, 2003, the Company amended its
Articles of Incorporation to change its name to Payment Data Systems, Inc. and
began trading on the OTCBB under a new symbol, PYDS, on August 20, 2003.
NOTE 13. LEGAL PROCEEDINGS
Beginning in December 2000, the Company pledged as loan guarantees certain funds
held as money market funds and certificates of deposit to collateralize margin
loans for the following executive officers of the Company: (1) Michael R. Long,
then Chairman of the Board of Directors and Chief Executive Officer; (2) Louis
A. Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard,
then Secretary, Senior Vice President, and General Counsel; and (4) David S.
Jones, then Executive Vice President. Mr. Millard and Mr. Jones no longer are
employees of the Company. The Company's purpose in collateralizing the margin
loans was to prevent the sale of its common stock owned by these officers while
it was pursuing efforts to raise additional capital through private equity
placements. The sale of that common stock could have hindered the Company's
ability to raise capital in such a manner and compromised its continuing efforts
to secure additional financing. The Company was also trying to accommodate the
requests of the named executive officers, who were seeking to preserve their
financial liquidity. The Company believed this action served its purpose of
assuring stable management and leadership for their future. The margin loans
were obtained in March 1999 from institutional lenders and were secured by
shares of the Company's common stock owned by these officers. Each of the
officers used the proceeds of their respective margin loans for investment
purposes and usual and customary living expenses.
None of the margin loans were recourse with respect to the officers and none of
the loan guarantees were recourse with respect to the Company because at the
times the margin loans were made and the funds pledged, the value of the common
stock collateralizing the margin loans exceeded the loan amounts. Under the
original terms of the arrangement, the Company charged each of the officers, pro
rata, the difference between the rate of return earned by them before the
collateralization of the margin loans on the funds that were to be the pledged
funds and the rate of return earned on the pledged funds after the
collateralization of the margin loans. The Company offset such amounts due from
Mr. Long, Mr. Hoch, and Mr. Millard against their respective salaries from the
date the funds were pledged until November of 2002, when the Company underwent
significant downsizing and Mr. Long, Mr. Hoch, and Mr. Millard began deferring
their salaries. The Company offset such amounts due from Mr. Jones against his
salary from the date the funds were pledged until the date of his departure from
the Company in August 2001.
F-20
The highest total amount of funds pledged for the margin loans guaranteed by us
was approximately $2.0 million. The total balance of the margin loans guaranteed
by the Company was approximately $1.3 million at December 31, 2002. At the time
the funds were pledged, the Company believed they would have access to them
because (a) their stock price was substantial and the stock pledged by the
officers, if liquidated, would produce funds in excess of the loans payable, and
(b) with respect to one of the institutional lenders (who was also assisting the
Company as a financial advisor at the time), even if the stock price fell, they
had received assurances from that institutional lender that the pledged funds
would be made available as needed. During the fourth quarter of 2002, the
Company requested partial release of the funds for operating purposes, which
request was denied by an institutional lender. At that time, their stock price
had fallen as well, and it became clear that both institutional lenders would
not release the pledged funds.
In light of these circumstances, the Company recognized a loss on the guarantees
of $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable
under related party guarantees on their balance sheet at December 31, 2002
because it became probable at that point that they would be unable to recover
their pledged funds. During the quarter ended March 31, 2003, the lenders
applied the pledged funds to satisfy the outstanding balances of the loans. The
total balance of the margin loans guaranteed by the Company was zero at December
31, 2003.
The pledged funds were classified as cash and cash equivalents on the Company's
balance sheet and disclosed in the accompanying footnotes in the Company's
Annual Report on Form 10-K for each of the years ended December 31, 2000 and
2001, respectively. The pledged funds were classified as cash and cash
equivalents on the Company's balance sheet and disclosed in the accompanying
footnotes in the Company's Quarterly Report on Form 10-Q for the quarters ended
March 31, 2002 and June 30, 2002, respectively. Under the terms of the related
guaranty agreements, we could, at any time, terminate our obligations and the
lenders' rights under the guaranty agreements, but we would remain liable for
any losses incurred by the lenders in liquidating the guaranteed accounts by
selling the common stock held as collateral in the margin loan accounts in order
to pay off the margin loan balances in full during a reasonable time subsequent
to the receipt of our termination notice. Because we had the right to withdraw
our pledged funds at any time and would not incur any losses as long as the
value of the common stock held in the margin loan accounts exceeded the total
balance of the margin loans, the funds we had pledged were properly reported as
unrestricted as long as there was sufficient collateral other than our pledged
funds available to cover the loans. Based on the number of shares of our common
stock held by these officers in their margin accounts collateralizing the loans
and the price of our common stock at the time these respective reports were
filed, management determined that there was sufficient coverage available for
the lenders to liquidate the stock to pay off the margin loans in full and
return the full amount of our pledged funds to us if we had withdrawn our
guarantee. After the price of our common stock was too low to provide the
lenders with sufficient coverage of the margin loan balances and the Company's
request for partial release of the funds was denied by an institutional lender,
the pledged funds were classified as cash pledged as collateral for related
party obligations on the Company's balance sheet and disclosed in the
accompanying footnotes in the Company's Quarterly Report on Form 10-Q for the
quarter ended September 30, 2002. On June 30, 2003, the Company filed an amended
Annual Report on Form 10-K for the year ended December 31, 2001 and amended
Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002 and June
30, 2002 as a result of comments received from the Securities and Exchange
Commission in connection with their review of the Company's registration
statement on Form S-3 that was originally filed on August 9, 2002. These amended
reports included restated balance sheets that classified the pledged funds as
cash pledged as collateral for related party obligations because by the time the
amended reports were filed, there was no longer sufficient collateral other than
our pledged funds available to cover the loans and it was clear that the funds
would not be released as the Company had been assured.
F-21
The Company may institute litigation or arbitration in collection of the
outstanding repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr.
Jones, which currently total $1,278,138. Presently, the Company has refrained
from initiating action to recover these funds from Mr. Long, Mr. Hoch, and Mr.
Millard because they may have offsetting claims that total $1,445,500
collectively by virtue of the change of control clause in their respective
employment agreements based on the Company's preliminary analysis. We understand
that these individuals may assert such claims based on our sale of substantially
all of our assets to Harbor Payments, Inc. on July 25, 2003. We have not
initiated any formal settlement negotiations with these individuals because they
are presently under an extended employment contract with us or have not been
amenable to such an action. The Company has not pursued the outstanding
repayment obligation of Mr. Jones because they do not consider a recovery
attempt to be cost beneficial. In order to attempt a recovery from Mr. Jones, we
estimate that we would incur a minimum of $20,000 in estimated legal costs with
no reasonable assurance of success in recovering his outstanding obligation of
approximately $38,000. Because of the limited amount of the obligation, we also
anticipate difficulty in retaining counsel on a contingency basis to pursue
collection of this obligation. The ultimate outcome of this matter cannot
presently be determined.
On July 25, 2003, certain stockholders (those stockholders being Mike Procacci,
Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and James
Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana
Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert
Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry
Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick,
Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal
action against the Company, Ernst & Young, LLP and certain of the Company's
current and former directors (including the executive officers named above) in
the District Court of the 45th Judicial District, Bexar County, Texas (the
"Suit"). With respect to the Company and the current and former directors named
in the suit, the plaintiffs allege that the Company, acting through such
directors, misstated in the Company's 2000 and 2001 Form 10-Ks the Company's
ability to use for operational purposes the funds pledged as security for margin
loans of certain of the Company's executive officers, as discussed above. The
Plaintiffs allege and seek economic and exemplary damages, rescission, interest,
attorneys' fees and costs of court. The Company believes this suit is without
merit and intends to vigorously defend the company and the directors named in
the suit. The results of legal proceedings cannot be predicted with certainty.
If the Company fails to prevail in this legal matter, the Company's financial
position, results of operations, and cash flows could be materially adversely
affected.
NOTE 14. DISCONTINUED OPERATIONS
On July 25, 2003 (the "Closing") the Company sold substantially all of its
assets (the "Business") to Saro, Inc., a Delaware corporation (the "Purchaser"),
which is a wholly owned subsidiary of CyberStarts, Inc., a Delaware corporation
(the "Sale"). The aggregate selling price for the Business was $4,800,000 (the
"Purchase Price"), including $700,000 subject to certain earnout provisions,
plus the Purchaser's assumption of certain liabilities of the Company. The
Purchase Price was determined through extensive negotiations between the
Purchaser and the Company. The Board of Directors of the Company, in its
reasonable business judgment, approved the Purchase Price based upon the
following factors: 1) the extensive search for a purchaser of the Business; 2)
the number of offers made by potential purchasers for the Business; 3) the
Company's ability to raise other sources of capital to operate the Business; and
4) the future trends in the industry of the Business. The sale of the Business
was approved by a majority of the shareholders of PDS at a Special Meeting of
Shareholders held on July 14, 2003. The assets sold represented the Company's
proprietary technology infrastructure along with certain third party software
and hardware platforms and certain furniture and fixtures that supported its
service offerings, including its eServ and eConsulting products. The carrying
value of these non-current assets was approximately $1,068,000 at July 25, 2003
and $1,890,000 at December 31, 2002 as detailed below:
F-22
July 25, 2003 December 31, 2002
Computer hardware 2,809,294 2,808,985
Software (third party) 1,462,983 1,462,983
Furniture and fixtures 596,140 876,817
Proprietary technology - -
Total cost 4,868,417 5,184,236
Less:accumulated depreciation
and amortization (3,800,198) (3,293,878)
Total net book value of
assets sold 1,068,219 1,890,358
The Company expensed the costs to develop our proprietary technology
infrastructure as they were incurred so these assets had no recorded value at
the date of sale. The Purchaser also assumed certain current and non-current
liabilities with carrying values of $83,000 and $30,000, respectively, at July
25, 2003. The assets sold represented virtually all of the Company's assets,
which it used to produce nearly all of its revenue; therefore, the Company has
ceased its primary operations and will continue to operate its bills.com
consumer bill payment portal and concentrate on building its electronic payments
business. The results of operations for the asset group disposed of have been
reported as discontinued operations in the accompanying statements of
operations. During the years ended December 31, 2003, 2002 and 2001, these
discontinued operations provided revenue of $2,155,000, $4,129,000 and
$2,925,000, respectively. The Company retained its accounts receivable and
related deferred revenue associated with the customers of the Business, as well
as certain accounts payable and accrued liabilities related to the Business. At
December 31, 2003, the Company's balance sheet included approximately $38,000 of
net accounts receivable and approximately $277,000 of current liabilities that
related to the operations of the Business.
At Closing, the Purchaser paid the Company $4,100,000 in cash. The Company may
earn an additional $700,000 based upon two earnouts calculated upon gross
revenues of the Business for the four consecutive quarters following the
Closing, the first quarter of which begins the first day of the first full month
after the Closing. The Sale of the Business qualifies as a change of control
under the employee agreements of certain officers of the Company, which may
result in the assertion of claims by these officers under their employee
agreements. The ultimate outcome of this matter cannot presently be determined.
Subsequent to the Sale, the Company settled claims made under employee
agreements by the Chief Financial Officer and Chief Marketing Officer for cash
consideration of $200,000 in the aggregate, including approximately $30,000 that
is contingent on the Company meeting the earnout provisions of the Sale, and
terminated their respective employee agreements.
NOTE 15. SUBSEQUENT EVENTS
In February 2004, the Company executed an agreement for an equity line of credit
with Dutchess Private Equities Fund, LP ("Dutchess"). Under the terms of the
agreement, PDS may elect to receive as much as $10 million from Dutchess in
common stock purchases over the next three years at the option of the Company.
The Company agreed to file with the Securities and Exchange Commission, and have
declared effective before any funds may be received under the agreement, a
registration statement registering the resale of the shares of the Company's
common stock to be issued to Dutchess. Any funds received will be used, as
needed, to support on-going operations and enhance potential merger and
acquisition activity.
F-23
In February 2004, the Company issued 55,000 shares of common stock under the
terms of its Amended 1999 Comprehensive Employee Stock Plan ("Employee Plan") to
a former employee for services provided while employed by the Company in 2003.
During the quarter ended March 31, 2004, the Company issued a total of 300,000
shares of common stock under the terms of its Employee Plan to an independent
contractor providing financial consulting services to the Company.
Through March 15, 2004, the Company issued a total of 72,225 shares of common
stock to certain independent contractors performing services for the Company.
Such shares were issued pursuant to Section 506 of Regulation D of the
Securities and Exchange Act of 1933, as amended.
NOTE 16. QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data for 2003 and 2002 is presented below.
2003
-----------------------------------------------------
First Second Third Fourth
-----------------------------------------------------
Revenue $ 24,156 $ 28,915 $ 29,342 $ 36,884
Loss from continuing
operations (464,305) (489,516) (336,161) (484,317)
Income (loss) from
discontinued operations (337,653) (423,446) 2,956,579 63,715
Net income (loss) (801,958) (912,962) 2,620,418 (420,602)
Basic and diluted income
(loss) per common share (a):
Loss from continuing operations (0.02) (0.02) (0.01) (0.02)
Income (loss) from
discontinued operations (0.02) (0.02) 0.14 -
Net income (loss) (0.04) (0.04) 0.13 (0.02)
Weighted average common
shares outstanding 20,686,189 20,722,656 20,722,656 21,395,343
2002
-----------------------------------------------------
First Second Third Fourth
-----------------------------------------------------
Revenue $ 15,071 $ 18,422 $ 20,774 $ 22,803
Loss from continuing
operations (647,869) (718,701) (1,139,610) (2,756,280)
Income (loss) from
discontinued operations (1,244,761) (1,430,481) (1,136,095) (1,880,880)
Net loss (1,892,630) (2,149,182) (2,275,705) (4,637,160)
Basic and diluted income
(loss) per common share (a):
Loss from continuing operations (0.03) (0.03) (0.06) (0.14)
Income (loss) from
discontinued operations (0.06) (0.07) (0.05) (0.09)
Net income (loss) (0.09) (0.10) (0.11) (0.23)
Weighted average common shares
outstanding 20,577,813 20,581,126 20,602,074 20,603,799
(a) Earnings per common share are computed independently for each of the
quarters presented. Therefore, the sum of the quarterly per common share
information may not equal the annual income or loss per common share.
F-24
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
March 31, 2004 December 31, 2003
---------------- -------------------
(Unaudited)
----------------
Assets:
Current assets:
Cash and cash equivalents . . . . . . . . . . . . . . $ 268,230 $ 528,119
Accounts receivable, net. . . . . . . . . . . . . . . 28,227 43,693
Prepaid expenses and other. . . . . . . . . . . . . . 66,388 113,650
---------------- -------------------
Total current assets . . . . . . . . . . . . . . . . . . 362,845 685,462
Property and equipment, net. . . . . . . . . . . . . . . 192,303 215,156
Other assets . . . . . . . . . . . . . . . . . . . . . . 34,032 37,782
---------------- -------------------
Total assets . . . . . . . . . . . . . . . . . . . . . . $ 589,180 $ 938,400
---------------- -------------------
Liabilities and stockholders' equity (deficit):
Current liabilities:
Accounts payable. . . . . . . . . . . . . . . . . . . $ 511,376 $ 501,488
Accrued expenses. . . . . . . . . . . . . . . . . . . 186,418 224,180
---------------- -------------------
Total current liabilities. . . . . . . . . . . . . . . . 697,794 725,668
Stockholders' equity:
Common stock, $0.001 par value, 200,000,000 shares
authorized; 21,495,181 and 20,987,956 issued and
outstanding . . . . . . . . . . . . . . . . . . . . . . 21,445 20,988
Additional paid-in capital . . . . . . . . . . . . . . . 46,921,821 46,842,908
Accumulated deficit. . . . . . . . . . . . . . . . . . . (47,051,880) (46,651,164)
---------------- -------------------
Total stockholders' equity (deficit) . . . . . . . . . . (108,614) 212,732
---------------- -------------------
Total liabilities and stockholders' equity (deficit) . . $ 589,180 $ 938,400
---------------- -------------------
See notes to interim consolidated financial statements.
F-25
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended March 31,
2004 2003
--------------- -------------
Revenues . . . . . . . . . . . . . . . . . . . . . . . . $ 55,197 $ 24,156
Operating expenses:
Cost of services . . . . . . . . . . . . . . . . . . . . 63,640 17,530
Selling, general and administrative. . . . . . . . . . . 359,819 388,593
Depreciation and amortization. . . . . . . . . . . . . . 27,682 36,073
---------------- ------------
Total operating expenses . . . . . . . . . . . . . . . . 451,141 442,196
---------------- ------------
Operating loss . . . . . . . . . . . . . . . . . . . . . (395,944) (418,040)
Other income (expense), net:
Interest income. . . . . . . . . . . . . . . . . . . . . 398 4,168
Interest expense . . . . . . . . . . . . . . . . . . . . - (44,393)
Other income (expense) . . . . . . . . . . . . . . . . . (5,170) (6,040)
---------------- ------------
Total other income (expense), net. . . . . . . . . . . . (4,772) (46,265)
---------------- ------------
Loss from continuing operations before
income taxes. . . . . . . . . . . . . . . . . . . . . . (400,716) (464,305)
Income taxes . . . . . . . . . . . . . . . . . . . . . . - -
---------------- ------------
Loss from continuing operations. . . . . . . . . . . . . (400,716) (464,305)
Discontinued operations:
Loss from discontinued operations, net of
no income taxes . . . . . . . . . . . . . . . . . . . . - (337,653)
---------------- ------------
Net loss . . . . . . . . . . . . . . . . . . . . . . . . $ (400,716) $ (801,958)
---------------- ------------
Basic and diluted loss per common share:
Loss from continuing operations. . . . . . . . . . . . . $ (0.02) $ (0.02)
Loss from discontinued operations. . . . . . . . . . . . - (0.02)
---------------- ------------
Net loss . . . . . . . . . . . . . . . . . . . . . . . . $ (0.02) $ (0.04)
---------------- ------------
Weighted average common shares
outstanding . . . . . . . . . . . . . . . . . . . . . . 21,189,477 20,686,189
See notes to interim consolidated financial statements.
F-26
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
===========
Three Months Ended March 31,
---------------------------
2004 2003
---------- --------------
Operating activities:
Loss from continuing operations . . . . . . . . . . . . $(400,716) $ (464,305)
Adjustments to reconcile loss from continuing
operations to net cash used in operating activities:
Depreciation and amortization. . . . . . . . . . . . . 27,682 36,073
Non-cash issuance of common stock. . . . . . . . . . . 59,700 16,250
Changes in current assets and current liabilities:
Accounts receivable. . . . . . . . . . . . . . . . . . 15,466 (68,593)
Prepaid expenses and other . . . . . . . . . . . . . . 47,262 95,522
Accounts payable and accrued expenses. . . . . . . . . (11,549) 284,346
Deferred revenue . . . . . . . . . . . . . . . . . . . - (7,985)
---------- ------------
Net cash used in continuing operations. . . . . . . . . (262,155) (108,692)
Net cash used in discontinued operations. . . . . . . . - (51,220)
---------- ------------
Net cash used in operating activities . . . . . . . . . (262,155) (159,912)
Investing activities:
Purchases of property and equipment . . . . . . . . . . (1,079) -
---------- ------------
Net cash used in investing activities . . . . . . . . . (1,079) -
Financing activities:
Cash pledged as collateral for related party
obligations . . . . . . . . . . . . . . . . . . . . . . - 1,311,984
Payments for related party obligations. . . . . . . . . - (1,278,138)
Issuance of common stock, net of issuance costs . . . . 3,345 6,710
---------- ------------
Net cash provided by financing activities . . . . . . . 3,345 40,556
---------- ------------
Change in cash and cash equivalents . . . . . . . . . . (259,889) (119,356)
Cash and cash equivalents, beginning of period. . . . . 528,119 286,105
---------- ------------
Cash and cash equivalents, end of period. . . . . . . . $ 268,230 $ 166,749
---------- ------------
See notes to interim consolidated financial statements.
F-27
PAYMENT DATA SYSTEMS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note 1. Basis of Presentation
Payment Data Systems, Inc. and subsidiaries (the "Company"), has incurred
substantial losses since inception, which has led to a significant decrease in
its cash position and a deficit in working capital. The Company sold
substantially all of its assets in July 2003 (see Note 3) and reduced
expenditures for operating requirements. Despite these actions, the Company
believes that its current available cash along with anticipated revenues may be
insufficient to meet its anticipated cash needs for the foreseeable future.
Consequently, the Company's ability to continue as a going concern may be
contingent on the Company receiving additional funds in the form of equity or
debt financing. Accordingly, the Company is currently aggressively pursuing
strategic alternatives, including investment in the Company via an equity line
of credit (see Note 5). The sale of additional equity or convertible debt
securities would result in additional dilution to the Company's stockholders,
and debt financing, if available, may involve restrictive covenants which could
restrict operations or finances. There can be no assurance that financing will
be available in amounts or on terms acceptable to the Company, if at all. If the
Company cannot raise funds, on acceptable terms, or achieve positive cash flow,
it may not be able to continue to exist, conduct operations, grow market share,
take advantage of future opportunities or respond to competitive pressures or
unanticipated requirements, any of which would negatively impact its business,
operating results and financial condition. The accompanying unaudited
consolidated financial statements of the Company do not include any adjustments
to reflect the possible future effects on the recoverability and classification
of assets or the amounts and classification of liabilities that may result from
the outcome of this uncertainty.
The accompanying unaudited consolidated financial statements of the Company have
been prepared without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles have been condensed or omitted pursuant
to such rules and regulations. In the opinion of management, the accompanying
consolidated financial statements reflect all adjustments of a normal recurring
nature considered necessary to present fairly the Company's financial position,
results of operations and cash flows for such periods. The accompanying interim
consolidated financial statements should be read in conjunction with the
consolidated financial statements and the notes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003.
Results of operations for interim periods are not necessarily indicative of
results that may be expected for any other interim periods or the full fiscal
year. Certain prior period amounts have been reclassified to conform to the
current year presentation.
The preparation of financial statements in conformity with U.S. generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Note 2. Stock-Based Compensation
The Company applies the intrinsic value method under the recognition and
measurement provisions of APB No. 25, "Accounting for Stock Issued to
Employees," in accounting for its stock option and stock purchase plans.
Accordingly, no stock-based employee compensation expense has been recognized
for options granted with an exercise price equal to the market value of the
underlying common stock on the date of grant or in connection with the employee
stock purchase plan. The following table illustrates the effect on net income
and earnings per share if the Company had applied the fair value recognition
provisions of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation," to stock-based employee compensation.
F-28
Three Months Ended March 31,
2004 2003
---------- ----------
Net loss, as reported $(400,716) $(801,958)
Less: Total stock-based employee compensation expense determined
under fair value based method for all awards, net of related tax effects (67,755) (190,974)
---------- ----------
Pro forma net loss (468,471) (992,932)
========== ==========
Net loss per common share - basic and diluted, as reported $ (0.02) $ (0.04)
Net loss per common share - basic and diluted, pro forma $ (0.02) $ (0.05)
Note 3. Discontinued Operations
Prior to selling substantially all of its assets in July 2003, the Company
provided electronic bill presentment and payment ("EBPP") services to companies
generating recurring bills and also provided related EBPP consulting and
Internet-based customer care interaction services. In accordance with Statement
of Financial Accounting Standards No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," the results of operations for the asset group
disposed of have been classified as discontinued operations. All financial
information presented for the three months ended March 31, 2003 has been
restated to reflect the operating results of this asset group as discontinued
operations.
Note 4. Related Party Transactions
Beginning in December 2000, the Company pledged certain funds held as money
market funds and certificates of deposit to collateralize certain margin loans
of four executive officers of the Company (only two of which are currently
employed by the Company). The margin loans were from institutional lenders and
were secured by shares of the Company's common stock held by these officers. The
Company's purpose in collateralizing the margin loans was to prevent the sale of
the Company's common stock held by these officers while the Company was pursuing
efforts to raise additional capital through private equity placements. The sale
of the Company's common stock could have hindered the Company's ability to raise
capital in such a manner and compromised the Company's continuing efforts to
secure additional financing. The total balance of the margin loans guaranteed by
the Company was approximately $1.3 million at December 31, 2002. The Company
believed it had the unrestricted legal right to use the pledged funds for its
operations, if necessary, based on (i) its interpretation of the loan guarantee
agreements, (ii) the market price of the Company's stock at the time of the
pledge, and (iii) assurances the Company received from one of the institutional
lenders that funds would be made available if needed. During the fourth quarter
of 2002, the Company sought partial release of the funds for operating purposes,
which was denied by the institutional lender, based upon their interpretation of
the loan guarantee agreements. In light of this action, the Company recognized a
loss on the guarantees of $1,278,138 in the fourth quarter of 2002 and recorded
a corresponding payable under related party guarantees on the Company's balance
sheet at December 31, 2002. During the quarter ended March 31, 2003, the lenders
applied the pledged funds being held to satisfy the outstanding balances of the
loans. The total balance of the margin loans guaranteed by the Company was zero
at March 31, 2004. The Company may institute litigation or arbitration
concerning these matters, which may result in the assertion of claims by these
officers under their employee agreements. The ultimate outcome of this matter
cannot presently be determined.
F-29
Note 5. Equity Line of Credit
In February 2004, the Company executed an agreement for an equity line of credit
with Dutchess Private Equities Fund, LP ("Dutchess"). Under the terms of the
agreement, the Company may elect to receive as much as $10 million from Dutchess
in common stock purchases over the next three years at the option of the
Company. The Company agreed to file with the Securities and Exchange Commission,
and have declared effective before any funds may be received under the
agreement, a registration statement registering the resale of the shares of the
Company's common stock to be issued to Dutchess. The Company filed a
registration statement on Form SB-2 with the Securities and Exchange Commission
on April 28, 2004 to register the resale of these shares. As of the date of this
report, the Securities and Exchange Commission had not declared this
registration statement effective.
Note 6. Issuance of Capital Stock
In February 2004, the Company issued 55,000 shares of common stock under the
terms of its Comprehensive Employee Stock Plan to a former employee for services
provided while employed by the Company in 2003. During the quarter ended March
31, 2004, the Company also issued a total of 315,000 shares of common stock
under the terms of its Comprehensive Employee Stock Plan to independent
contractors providing consulting services to the Company and recorded
approximately $60,000 of related expense. The shares issued were valued at the
closing price of our common stock as reported on the NASD OTCBB on the day that
the respective recipient of the shares agreed to accept our common stock instead
of cash for their services.
In March 2004, the Company issued 15,000 shares of common stock and received
cash proceeds of approximately $3,000 related to the exercise of stock options
granted under the terms of its Comprehensive Employee Stock Plan.
During the quarter ended March 31, 2004, the Company issued a total of 72,225
shares of common stock to certain independent contractors performing services
for the Company. Such shares were issued pursuant to Section 506 of Regulation D
of the Securities and Exchange Act of 1933, as amended. The Company recorded
approximately $11,000 of equity related to the issuance of this stock. The
shares issued were valued at the average closing price of our common stock as
reported on the NASD OTCBB during the period that the respective recipient of
the shares provided services to us.
Note 7. Subsequent Events
In April 2004, the Company issued 50,000 shares of common stock under the terms
of its Comprehensive Employee Stock Plan to an independent contractor providing
consulting services to the Company. The Company recorded $9,500 of expense
related to the issuance of this stock.
F-30
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
On February 10, 2004, our Board of Directors of, upon recommendation of its
Audit Committee, dismissed Ernst & Young LLP as our independent accountants and
appointed the firm of Akin, Doherty, Klein & Feuge, P.C., a professional
corporation, to serve as our independent public accountants for the fiscal year
ending December 31, 2003.
Ernst & Young's report on our consolidated financial statements for the fiscal
year ended December 31, 2002 contained a qualified opinion as to the uncertainty
of our ability to continue as a going concern.
During the years ended December 31, 2002 and 2001 and through the date hereof,
there were no disagreements with Ernst & Young on any matter of accounting
principle or practice, financial statement disclosure, or auditing scope or
procedure which, if not resolved to Ernst & Young's satisfaction, would have
caused them to make reference to the subject matter of such disagreements in
connection with their report on our consolidated financial statements for such
years; and there were no reportable events as defined in Item 304(a)(1)(iv) of
Regulation S-K.
During the years ended December 31, 2002 and 2001 and through February 10, 2004,
we did not consult with Akin Doherty with respect to the application of
accounting principles to a specified transaction, either completed or proposed,
or the type of audit opinion that might be rendered on our consolidated
financial statements, or any other matters or reportable events as set forth in
Items 304(a)(2)(i) and (ii) of Regulation S-K.
PAYMENT DATA SYSTEMS, INC.
40,000,000 Shares of
Common Stock
No dealer, salesman or any other person has been authorized to give any
information or to make any representations other than those contained in this
Prospectus, and, if given or made, such information or representations must not
be relied on as having been authorized by Payment Data Systems, Inc. This
Prospectus does not constitute an offer to sell or a solicitation of an offer to
buy, by any person in any jurisdiction in which it is unlawful for such person
to make such offer or solicitation. Neither the delivery of this Prospectus nor
any offer, solicitation or sale made hereunder, shall under any circumstances
create an implication that the information herein is correct as of any time
subsequent to the date of the Prospectus.
F-31
PROSPECTUS
----------
Until [90 days from the date of effectiveness], all dealers effecting
transactions in the registered securities, whether or not participating in the
distribution thereof, may be required to deliver a Prospectus. This is in
addition to the obligation of dealers to deliver a Prospectus when acting as
Underwriters and with respect to their unsold allotment or subscriptions.
July 23, 2004
-------------
PART II. INFORMATION NOT REQUIRED IN PROSPECTUS
INDEMNIFICATION OF DIRECTORS AND OFFICERS
Please refer to "DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR
SECURITIES ACT LIABILITIES."
OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
The following table sets forth our expenses in connection with this registration
statement. All of these expenses are estimates, other than the filing fees
payable to the Securities and Exchange Commission.
Filing Fee--Securities and Exchange Commission $ 1,432
Legal Expenses $17,000
Accounting Expenses $ 2,500
Blue Sky Fees and Expenses $ 1,000
Printing Expenses $ 1,500
Miscellaneous expenses $ 1,568
---------
Total: $25,000
RECENT SALES OF UNREGISTERED SECURITIES
We sold an aggregate of 112,500 shares of our unregistered common stock, par
value $0.001, to Bil Manes, Marc Orcutt and Mike Jisha, three separate
independent contractors, in consideration for services completed on December 15,
2002, January 15, 2003, February 15, 2003, March 15, 2003, April 15, 2003, and
May 15, 2003. Mr. Manes and Mr. Orcutt provided sales and marketing consulting
services to us and Mr. Jisha provided telecommunications consulting services to
us. The total value of the services received from these contractors was $22,625.
The shares were valued at the average closing price of our common stock over the
period that the services were performed since the individual contractor service
agreements called for a specified number of shares to be issued for each month
that the contractor provided services.The offers and sales the subject hereof
satisfied the terms and conditions of Section 506 of Regulation D as no general
solicitation was undertaken.
In December 2003, we agreed to issue 34,725 shares of our unregistered common
stock, par value $0.001, to Comp-Utility Corporation, an independent contractor
in consideration for equipment installation services provided to us with a total
value of $5,000. The shares were valued at a 4% discount to the closing price of
our common stock of $0.15 on December 22, 2003, which was the date that the
contractor agreed to accept our common stock instead of cash as payment for
invoiced amounts of $5,000. The offer and sale the subject hereof satisfied the
terms and conditions of Section 506 of Regulation D as no general solicitation
was undertaken.
Exhibit Description
------- -----------
3.1 Articles of Incorporation, as amended (incorporated by reference to
such exhibit in the Registrant's Quarterly Report on Form 10-Q, filed
November 14, 2003)
3.2 By-laws, as amended (incorporated by reference to such exhibit in the
Registrant's Registration Statement on Form SB-2, filed December 29,
1999)
4.1 Rights Agreement, dated October 4, 2000 (incorporated by reference to
such exhibit in the Registrant's Registration Statement on Form 8-A,
filed October 11, 2000)
5.1 Opinion of counsel
10.1 Asset Purchase Agreement between the Company and Saro, Inc. dated May
15, 2003 (incorporated by reference to Appendix A in the Registrant's
Definitive Proxy Statement, filed June 19, 2003)
10.2 First Amendment to Asset Purchase Agreement dated July 25, 2003
(incorporated by reference to such exhibit in the Registrant's
Quarterly Report on Form 10-Q, filed November 14, 2003)
10.3 Standard Office Lease between the Company and Frost National Bank,
Trustee for a Designated Trust, dated August 22, 2003 (incorporated by
reference to such exhibit in the Registrant's Quarterly Report on Form
10-Q, filed November 14, 2003)
10.4 1999 Employee Comprehensive Stock Plan, as amended (incorporated by
reference to such exhibit in the Registrant's Registration Statement on
Form S-8, filed January 14, 2004)
10.5 1999 Non-Employee Director Plan (incorporated by reference to such
exhibit in the Registrant's Registration Statement on Form S-8, filed
February 23, 2000)
10.6 1999 Employee Stock Purchase Plan (incorporated by reference to such
exhibit in the Registrant's Registration Statement on Form S-8, filed
February 23, 2000)
10.7 Form of Employment Agreement dated May 31, 2001, between the Company
and Executive Officers of the Company (incorporated by reference to
such exhibit in the Registrant's Annual Report on Form 10-K, filed
April 1, 2002)
10.8** Investment Agreement between the Company and Dutchess Private
Equities Fund, LP dated June 4, 2004.
10.9** Registration Rights Agreement between the Company and Dutchess
Private Equities Fund, LP dated June 4, 2004.
10.10 Placement Agent Agreement between the Company, Clayton Dunning and Co,
Inc. and Dutchess Private Equities Fund, LP dated June 4, 2004.
10.11 Affiliate Office Agreement between the Company and Network 1 Financial,
Inc. dated October 7, 2003 (filed as Exhibit 10.11 to the Registrant's
Registration Statement on Form SB-2 on April 28, 2004 and incorporated
herein by reference).
21.1 Subsidiaries of the Registrant (incorporated by reference to such
exhibit in the Registrant's Annual Report on Form 10-K, filed April 1,
2002)
23.1 Consent of Akin Doherty Klein & Feuge, P.C., Independent Auditors
(filed herewith)
23.2 Consent of Ernst & Young LLP, Independent Auditors
(filed herewith)
23.3 Consent of counsel (filed as part of Exhibit 5.1)
------------
** Previously filed
UNDERTAKINGS
The Registrant hereby undertakes that it will:
(1) File, during any period in which it offers or sells securities, a
post-effective amendment to this registration statement to:
(i) Include any prospectus required by Section 10(a)(3) of the Securities Act;
(ii) Reflect in the prospectus any facts or events which, individually or
together, represent a fundamental change in the information in the registration
statement. Notwithstanding the foregoing, any increase or decrease in volume of
securities offered (if the total dollar value of securities offered would not
exceed that which was registered) and any deviation from the low or high end of
the estimated maximum offering range may be reflected in the form of prospectus
filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the
changes in volume and price represent no more than a 20% change in the maximum
offering price set forth in the "Calculation of Registration Fee" table in the
effective registration statement; and
(iii) Include any additional or changed material information on the plan of
distribution.
(2) For determining any liability under the Securities Act, treat each
post-effective amendment as a new registration statement of the securities
offered, and the offering of the securities at that time to be the initial bona
fide offering.
(3) File a post-effective amendment to remove from registration any of the
securities that remain unsold at the end of the offering.
Insofar as indemnification for liabilities arising under the Securities Act of
1933 (the "Act") may be permitted to directors, officers, and controlling
persons of the small business issuer pursuant to the foregoing provisions, or
otherwise, the small business issuer has been advised that in the opinion of the
Securities and Exchange Commission such indemnification is against public policy
as expressed in the Act and is, therefore, unenforceable.
In the event that a claim for indemnification against such liabilities (other
than the payment by the small business issuer of expenses incurred or paid by a
director, officer or controlling person of the small business issuer in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, the small business issuer will, unless in the opinion of its counsel
the matter has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act and will be governed by
the final adjudication of such issue.
(1) For determining any liability under the Securities Act, treat the
information omitted from the form of prospectus filed as part of this
registration statement in reliance upon Rule 430A and contained in a form of
prospectus filed by the Registrant under Rule 424(b)(1), or (4) or 497(h) under
the Securities Act as part of this registration statement as of the time the
Commission declared it effective.
(2) For determining any liability under the Securities Act, treat each
post-effective amendment that contains a form of prospectus as a new
registration statement for the securities offered in the registration statement,
and that offering of the securities at that time as the initial bona fide
offering of those securities.
SIGNATURES
In accordance with the requirements of the Securities Act of 1933, the
Registrant certifies that it has reasonable grounds to believe that it meets all
of the requirements of filing on Form SB-2 and authorized this Registration
Statement to be signed on its behalf by the undersigned, in the city of San
Antonio, Texas, on July 23, 2004.
PAYMENT DATA SYSTEMS, INC.
By: /s/ Michael Long
-------------------------------------
Michael R. Long
Chairman of the Board, Chief Executive
Officer and Chief Financial Officer
SIGNATURE DATE
By: /s/ Michael Long
--------------------------------- July 23, 2004
Michael R. Long
Chairman of the Board, Chief Executive
Officer and Chief Financial Officer
(principal executive officer and
principal financial and accounting officer)
By: /s/ * July 23, 2004
---------------------------------
Louis A. Hoch
President, Chief Operating Officer
and Director
By: /s/ * July 23, 2004
---------------------------------
Peter G. Kirby
Director
* By Power of Attorney