Edgar Filing: PAYMENT DATA SYSTEMS INC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-KSB

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No. 0-30152

PAYMENT DATA SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

NEVADA 98-0190072
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

12500 SAN PEDRO, SUITE 120, SAN ANTONIO, TEXAS 78216
(Address of principal executive offices, including Zip Code)

(210) 249-4100
(Issuer's telephone number)

Securities registered pursuant to section 12(b) of the Act: None

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

Common Stock, par value $.001 per share

Check whether the issuer (1) filed all reports required to be filed by section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Check if there is no disclosure of delinquent filers in response to item 405 of
Regulation S-B is not contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]

The issuer's revenues for the fiscal year ended December 31, 2004 were $357,566.

The aggregate market value of common stock held by non-affiliates of the issuer
as of March 9, 2005, was $6,739,536. As of March 9, 2005, 24,732,241 shares of
the issuer's common stock were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Definitive Proxy Statement for the issuer's 2005 Annual Meeting
of Stockholders to be filed within 120 days after the end of the fiscal year
covered by this report are incorporated by reference in Part III of this report.

Transitional Small Business Disclosure Format (Check one): Yes; No X
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PAYMENT DATA SYSTEMS, INC.

FORM 10-KSB
FOR THE YEAR ENDED DECEMBER 31, 2004

INDEX

Page
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PART I

Item 1. Description of Business 3
Item 2. Description of Property 6
Item 3. Legal Proceedings 7
Item 4. Submission of Matters to a Vote of Security Holders 7

PART II

Item 5. Market for Common Equity and Related Stockholder Matters 8
Item 6. Management's Discussion and Analysis or Plan of Operation 9
Item 7. Financial Statements 18
Item 8. Changes In and Disagreements With Accountants on
Accounting and Financial Disclosure 34
Item 8A. Controls and Procedures 34
Item 8B. Other Information 34

PART III

Item 9. Directors, Executive Officers, Promoters and Control
Persons; Compliance With Section 16 (a) of the
Exchange Act 35
Item 10. Executive Compensation 35
Item 11. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters 35
Item 12. Certain Relationships and Related Transactions 35
Item 13. Exhibits 35
Item 14. Principal Accountant Fees and Services 36

FACTORS THAT MAY AFFECT FUTURE RESULTS

This Annual Report on Form 10-KSB and the documents incorporated herein by
reference contain certain forward-looking statements within the meaning of the
Federal Securities Laws. Specifically, all statements other than statements of
historical facts included in this Annual Report on Form 10-KSB regarding our
financial performance, business strategy and plans and objectives of management
for future operations are forward-looking statements and based on our beliefs
and assumptions. If used in this report, the words "anticipate," "believe,"
"estimate", "expect," "intend," and words or phrases of similar import are
intended to identify forward-looking statements. Such statements reflect our
current view with respect to future events and are subject to certain risks,
uncertainties, and assumptions, including, but without limitation, those risks
and uncertainties contained in the Risk Factors section of Item 6, Management's
Discussion and Analysis, of this Annual Report on Form 10-KSB. Although we
believe that our expectations are reasonable, we can give no assurance that such
expectations will prove to be correct. Based upon changing conditions, any one
or more of these events described herein as anticipated, believed, estimated,
expected or intended may not occur. All prior and subsequent written and oral
forward-looking statements attributable to the Company or persons acting on its
behalf are expressly qualified in their entirety by this cautionary statement.

PART I

ITEM 1. DESCRIPTION OF BUSINESS.

Introduction

Payment Data Systems, Inc. was founded in July 1998 and is incorporated in the
State of Nevada. On July 25, 2003, we sold substantially all of our assets to
Harbor Payments, Inc., formerly known as CyberStarts, Inc. The aggregate selling
price for the asset group sold was $4,100,000, plus the assumption of certain
liabilities by Harbor Payments. The assets sold represented our proprietary
technology infrastructure, certain third party software and hardware platforms
and certain furniture and fixtures that supported our Electronic Bill
Presentment and Payment service offerings. 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.

Continuing Operations

General

We provide integrated electronic payment processing services to merchants and
businesses, including all types of Automated Clearinghouse processing and credit
and debit card-based processing services. The Automated Clearinghouse 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 Automated Clearinghouse 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 Automated
Clearinghouse 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 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.

Industry Background

The use of non-paper based forms of payment by consumers in the United States,
such as credit and debit cards, has steadily increased over the past several
years. According to the 2004 Federal Reserve Payments Study, the number of
electronic payment transactions totaled 44.5 billion in 2003 while the number of
checks paid totaled 36.7 billion. This marked the first time that electronic
payment transactions in the U.S. exceeded check payments. If current growth
rates are sustained, payments made by credit cards and debit cards will each
exceed the number of paid checks by 2010. 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.

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 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 payment methods. According to the
U.S. Small Business Administration, small businesses generate more than 50% of
the nonfarm private gross domestic product in the United States. 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 2004 were $69.2 billion, an
increase of 24% from $56.0 billion in 2003. 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.

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 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
Automated Clearinghouse 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 Automated
Clearinghouse transaction processing, such as Re-presented Check , which is a
consumer non-sufficient funds check that is re-presented for payment
electronically rather than through the paper check collection system, and
Accounts Receivable Check Conversion, which is a consumer paper check payment
that is converted into an e-check. Our customers can initiate Automated
Clearinghouse transactions directly using an online terminal accessible through
a web site or we can initiate Automated Clearinghouse 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 Automated Clearinghouse 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 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 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 paying and managing bills via the Internet. We also
market this portal service to online financial services providers looking to
provide online bill payment 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 Automated Clearinghouse transactions, we must maintain a
relationship with an Originating Depository Financial Institution in the
Automated Clearinghouse Network because we are not a bank and therefore not
eligible to be an Originating Depository Financial Institution. The third party
provider that handles our Automated Clearinghouse processing maintains a
relationship with several Originating Depository Financial Institutions 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
agreements with Network 1 Financial, Inc. and TriSource Solutions, LLC through
which their member banks sponsor us for membership in the Visa and MasterCard
card associations and settle card transactions for our merchants. These
agreements may be terminated by the processors 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.

Under our processing agreements with Network 1 Financial and TriSource
Solutions, 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.

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. 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. 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.

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
our bills.com customers and us 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 2,020 in
2003 to 2,190 in 2004.

Our other customers are merchants and businesses that use our Automated
Clearinghouse 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. Most of our merchant customers have signed long-term
contracts, with generally three-year terms, that provide for volume-based
transaction fees. We provided services to 51 and 8 merchant customers at
December 31, 2004 and 2003, respectively. We first offered Automated
Clearinghouse processing services in the third quarter of 2003 and card-based
processing services in the fourth quarter of 2003. Services provided to Credit
Payment Services, Inc. accounted for approximately 13% of our total consolidated
revenues for the year ended December 31, 2004. Revenue generated by our merchant

customers represented approximately 55% of our total revenues in 2004 and 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 continue to comprise the majority of our business in the future.

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, automatic
teller machine, 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 us 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; and
- multi-channel payment capability.

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. We 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

Prior to the sale of substantially all of our assets in July 2003, we provided
Electronic Bill Presentment and Payment and related services to companies that
generate recurring paper-based bills. Electronic Bill Presentment and Payment is
the process of sending bills to consumers securely through the Internet and
processing Internet payment of bills utilizing an electronic transfer of funds.
During the year ended December 31, 2003, the discontinued operations of the
asset group sold provided revenue of $2,155,000.

Employees

As of December 31, 2004, we had 8 employees. We are not a party to any
collective bargaining agreements. We believe that our relations with our
employees are good.

ITEM 2. DESCRIPTION OF PROPERTY.

As of December 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. The Company believes its
existing facilities will be adequate to meet its anticipated needs for the
foreseeable future.

ITEM 3. 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: (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 are no longer employed by
us. The margin loans were obtained in March 1999 from institutional lenders and
were secured by shares of our common stock owned by these officers. The pledged
funds were held in our name in accounts with the lenders that held the margin
loans of the officers. 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 its continuing efforts to secure additional
financing. The highest total amount of funds pledged for the margin loans
guaranteed by us was approximately $2.0 million. At the time the funds were
pledged, we believed we would have access to them because (a) the 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, the 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, 2004. 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 have been under an extended employment contract with us or have not
been amenable to such an action. On July 25, 2004, our employment agreements
with Michael Long, Chief Executive Officer and Chief Financial Officer, and
Louis Hoch, President and Chief Operating Officer, expired. We intend to enter
into new employment agreements with both of these individuals and are currently
negotiating the terms of such agreements. 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 the date of this report, there have been no material developments in the suit
other than the case being set for trial in late 2005. 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.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

There were no matters submitted to a vote of our stockholders during the fourth
quarter of fiscal year 2004.

PART II

ITEM 5. 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 Over the Counter Bulletin Board effective at opening of
business on February 4, 2003. Our common stock began trading under a new ticker
symbol, PYDS, on the Over the Counter Bulletin Board on August 20, 2003.

The following table sets forth for the quarterly periods indicated the range of
high and low closing prices of our common stock as reported on the Over the
Counter Bulletin Board:

High Low
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2004
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First Quarter $0.46 $0.15
Second Quarter $0.43 $0.21
Third Quarter $0.26 $0.16
Fourth Quarter $0.34 $0.21

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

Holders

As of March 9, 2005, 24,732,241 shares of our common stock are issued and
outstanding. As of March 9, 2005, there were approximately 4,865 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, instead, we intend to
reinvest our earnings, if any.

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR 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 Form 10-KSB. This report 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 Form 10-KSB.

Overview

On July 25, 2003, we sold substantially all of our assets to Harbor Payments,
Inc., formerly known as CyberStarts, Inc. The aggregate selling price for the
asset group was $4,100,000, plus the assumption by Harbor Payments of certain
liabilities. The sale of the asset group was approved by our Board of Directors
and a majority of our stockholders 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 Electronic Bill
Presentment and Payment service offerings. Electronic Bill Presentment and
Payment is the process of sending bills to consumers securely through the
Internet and processing Internet payment of bills utilizing an electronic
transfer of funds. The carrying value of these non-current assets was
approximately $1,068,000 at July 25, 2003. Harbor Payments 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 Electronic Bill Presentment and Payment operations and
continued to operate our bills.com consumer bill payment portal and concentrated
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 the 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.

We provide integrated electronic payment services, including credit and debit
card-based processing services and transaction processing via the Automated
Clearinghouse Network, and continue to operate an Internet electronic payment
processing service for consumers under the domain name www.bills.com. Since
inception, we have incurred operating losses each quarter, and as of December
31, 2004, we have an accumulated deficit of $48.2 million. Our prospects to
continue as a going concern must be considered in light of the risks, expenses
and difficulties frequently encountered by companies in their early stages of
growth, particularly companies in new and rapidly evolving markets such as
electronic commerce. Such risks include, but are not limited to, an evolving and
unpredictable business model and our ability to continue as a going concern. To
address these risks, we must, among other things, grow and maintain our customer
base, implement a successful marketing strategy, continue to maintain and
upgrade our technology and transaction-processing systems, provide superior
customer service, respond to competitive developments, attract, retain and
motivate qualified personnel, and respond to unforeseen industry developments
and other factors. We cannot assure you that we will be successful in addressing
such risks, and the failure to do so could have a material adverse effect on our
business, prospects, financial condition and results of operations.

We believe that our success will depend in large part on our ability to (a)
manage our operating expenses, (b) add quality customers to our client base, (c)
meet evolving customer requirements and (d) adapt to technological changes in an
emerging market. Accordingly, we intend to focus on customer acquisition
activities and outsource some of our processing services to third parties to
allow us to maintain an efficient operating infrastructure and expand our
operations without significantly increasing our fixed operating expenses.

As a result of our limited operating history and the emerging nature of the
markets in which we compete, we are unable to precisely forecast our revenues.
Our current and future expense levels are based largely on our investment plans
and estimates of future revenues. Revenue and operating results will depend on
the volume of payment transactions processed and related services rendered. The
timing of such services and transactions and our ability to fulfill a customer's
demands are difficult to forecast. Although we systematically budget for planned
outlays and maintain tight controls on our expenditures, we may be unable to
adjust spending in a timely manner to compensate for any unexpected revenue
shortfall. Accordingly, any significant shortfall in revenues in relation to our
planned expenditures could have a material adverse effect on our business,
prospects, financial condition and results of operations. Further, we may make
certain pricing, service, marketing or acquisition decisions that could have a
material adverse effect on each or all of these areas.

Critical Accounting Policies

General

Management's discussion and analysis of its 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 we believe 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.

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. This
reserve amount is subject to risk that actual losses may be greater than our
estimates. At December 31, 2004, the balance of our card merchant processing
loss reserve was $4,341.

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 did
not record any bad debt expense or bad debt write-offs in 2004. We recorded bad
debt expense of $10,700 and recorded bad debt write-offs of $54,742 to our
allowance for doubtful accounts in 2003. At both December 31, 2004 and 2003, the
balance of the allowance for doubtful accounts was $3,155. 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.

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 we determine that the carrying value of
long-lived and intangible assets may not be recoverable, we measure impairment
as the excess of the assets' carrying value over the estimated fair value. No
impairment losses were recorded in 2004. Impairment losses of $217,000 were
recorded in 2003 and are included in discontinued operations in the statements
of operations except for $17,000 that is included in continuing operations.

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 us. It is our
judgment that we cannot predict with reasonable certainty that the deferred tax
assets as of December 31, 2004 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, 2004, we have available net operating loss
carryforwards of approximately $36.1 million, which expire beginning in the year
2020.

Results of Operations

Total revenues for 2004 increased 200% to $357,566 from $119,297 for 2003. The
increase from the prior year was primarily attributable to the addition of
revenues generated from card-based and Automated Clearinghouse processing
services that we began providing during 2003. 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. The prior year increase was also attributable to an increase in the
average number of consumers subscribing to the bills.com payment service and an
increase in the monthly fee paid by certain consumers subscribing to the
bills.com payment service because these consumers were converted from a per
payment pricing plan to a flat monthly fee pricing plan during the second
quarter of 2004. The monthly average number of consumers using our online
payment service increased to 2,190 in 2004 from 2,020 in 2003.

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. Revenue generated by our merchant customers represented
approximately 55% of our total revenues for the year ended December 31, 2004,
and we believe that this percentage will increase as we anticipate adding new
merchant customers and experiencing growth in transaction volumes. We believe
that our merchant business provides us with the best opportunity for revenue
growth and that revenues from card-based processing services will continue to
grow and will make up the majority of our revenues in future periods.

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 Automated Clearinghouse 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 services was $327,474 and $138,009 for 2004 and 2003,
respectively. The increase from the prior year is due to fees incurred in 2004
for Automated Clearinghouse and card-based processing services.

Selling, general and administrative expenses decreased to $1,374,779 in 2004
from $1,726,028 for 2003. The decrease from the prior year is principally due to
lower corporate insurance, legal and accounting expenses and lower salary and
benefit costs due to the reduction of personnel during 2003.

Depreciation and amortization was $95,190 and $130,671 for 2004 and 2003,
respectively. The decrease from the prior year was due to lower depreciation
expense related to certain assets that became fully depreciated during 2004. We
purchased $5,000 of computer equipment during 2004 and do not anticipate making
significant capital expenditures in 2005.

Net other expense was $74,654 in 2004 compared to net other income of $101,112
in 2003. The change from 2003 to 2004 is primarily attributable to $165,000 of
consulting fees recognized in other income in the third quarter of 2003 for
transitional Electronic Bill Presentment and Payment consulting services
provided to our former equal partner in an Electronic Bill Presentment and
Payment 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.

Loss from continuing operations improved to $1,514,531 in 2004 from $1,774,299
in 2003, primarily as a result of the decrease in selling, general and
administrative expenses.

Liquidity and Capital Resources

At December 31, 2004, we had $154,000 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
our cash position and a deficit in working capital. We sold substantially all of
our assets in July 2003 and reduced expenditures for operating requirements. We
believe that our current available cash and cash equivalents along with
anticipated revenues may be insufficient to meet our anticipated cash needs for
the foreseeable future. Consequently, our ability to continue as a going concern
may be contingent on us receiving additional funds in the form of equity or debt
financing. We are currently aggressively pursuing strategic alternatives.

In February 2004, we executed an agreement for an equity line of credit with
Dutchess Private Equities Fund, LP. Under the terms of the agreement, we may
elect to receive as much as $10 million from Dutchess in common stock purchases
over three years at our option. We agreed to file with the Securities and
Exchange Commission, and have declared effective before any funds could be
received under the agreement, a registration statement registering the resale of
the shares of our common stock to be issued to Dutchess. On August 13, 2004, the
Securities and Exchange Commission declared an amended registration statement we
filed on Form SB-2 to register the resale of the shares to be issued under the
equity line of credit with Dutchess to be effective. During the year ended
December 31, 2004, we sold 1,459,435 shares of our common stock pursuant to the
equity line of credit and received total proceeds, net of issuance costs, of
$321,486. Pursuant to the terms of a promissory note with Dutchess, we are
obligated to use a portion of the proceeds from the equity line to pay back the
promissory note.

On August 24, 2004, we entered into a promissory note with Dutchess. Pursuant to
terms of the promissory note, we received $260,000 and promised to pay Dutchess
$284,000 with a maturity date of December 24, 2004. We repaid this note in full
on the maturity date. We also issued 75,000 shares of restricted common stock to
Dutchess as an incentive for the investment and agreed to register the common
stock issued pursuant to the promissory note on the next registration statement
that we file.

On December 10, 2004, we entered into another promissory note with Dutchess.
Pursuant to terms of the promissory note, we received $260,000 and promised to
pay Dutchess $284,000 with a maturity date of April 10, 2005. We also issued
75,000 shares of restricted common stock to Dutchess as an incentive for the
investment and agreed to register the common stock issued pursuant to the
promissory note on the next registration statement that we file.

Payments on the promissory note are to be made from the equity line of credit
that we previously entered into with Dutchess. We will pay to Dutchess the
lesser of $71,000 or 50% of each put, until the face amount of the promissory
note is paid in full. The first payment is due at the closing of the first put
30 days after the issuance of the promissory note and all subsequent payments
are due at the closing of every put to Dutchess. We issued as collateral
twenty-five put notices to Dutchess for the full amount applicable under the
terms of the equity line of credit and agreed to do so at the maximum frequency
allowed under the equity line agreement, until such time as the note is paid in
full.

In the event that on the maturity date, there are any remaining amounts unpaid
on this note, Dutchess can exercise its right to increase the residual amount by
2.5% per month paid as liquated damages. In the event that we default, Dutchess
has the right, but not the obligation, to switch the residual amount to a
three-year, 10% interest bearing convertible debenture at a conversion rate at
the lesser of (i) 75% of the average of the lowest closing bid price during the
fifteen trading immediately preceding the convertible maturity date or (ii) 100%
of the average of the lowest bid price for the twenty trading days immediately
preceding the convertible maturity date. If Dutchess chooses to convert the
residual amount to a convertible debenture, we shall have twenty business days
after notice of the same to file a registration statement covering an amount of
shares equal to 300% of the residual amount. In the event we do not file such
registration statement within twenty business days of Dutchess' request, or such
registration statement is not declared by the Securities and Exchange Commission
to be effective within the time period described above, the residual amount
shall increase by $1,000 per day.

The satisfactory completion of an additional investment or growth of cash flow
from operations is essential or we have no other alternative that will provide
sufficient cash flows to meet current operating requirements. The sale of
additional equity or convertible debt securities would result in additional
dilution to our 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 us, if at all. If we cannot raise funds, on acceptable terms, or achieve
positive cash flow, we 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 our business, operating results and financial condition.

Net cash used in operating activities was $941,000 and $2.2 million for 2004 and
2003, respectively. Net cash used in 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 2005.

Net cash provided by investing activities was $2,000 in 2004 and reflected the
return of $7,000 of deposits that had been used to secure the lease for our
corporate office offset by capital expenditures of $5,000 for computer
equipment. Net cash provided by investing activities of $4.1 million in 2003
reflected proceeds of $4.2 million from the sale of substantially all of our
assets in July 2003 offset by capital expenditures of $66,000 for computer
equipment and software. We do not anticipate making significant capital
expenditures during 2005.

Net cash provided by financing activities of $565,000 for 2004 resulted
primarily from proceeds, net of issuance costs, of $329,000 from the issuance of
common stock as well as $236,000 of net borrowings under short-term agreements.
Net cash used in financing activities of $1.7 million for 2003 primarily
resulted from the payment of $1.8 million under our convertible debt agreement
in July 2003.

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.

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 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 our results of operations or financial position.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities", and in December 2003 issued a revised
interpretation, FIN 46R. FIN 46 and FIN 46R address the accounting for, and
disclosure of, investments in variable interest entities. We adopted FIN 46 and
FIN 46R, which did not have a material impact on our financial position or
results of operations.

In December 2004, the FASB issued Statement No. 123R, "Share-Based Payment,"
which requires all companies to measure compensation cost for all share-based
payments (including employee stock options) at fair value, effective for public
companies for interim or annual periods beginning after June 15, 2005. The
adoption of this statement is not expected to have a material impact on our
results of operations or financial position.

RISK FACTORS

There are many factors that affect our business and the results of its
operations, some of which are beyond our control. The following is a description
of some of the important factors that may cause the actual results of our
operations in future periods to differ materially from those currently expected
or desired.

RISKS RELATED TO OUR BUSINESS

Our independent accountants have issued a going concern opinion and if we cannot
obtain additional financing, 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. 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, 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, 2004, our accumulated deficit
was $48.2 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.

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 in
the Automated Clearinghouse Network. The Automated Clearinghouse Network is a
nationwide batch-oriented electronic funds transfer system that provides for the
interbank clearing of electronic payments for participating financial
institutions. An Originating Depository Financial Institution is a participating
financial institution that must abide by the provisions of the Automated
Clearinghouse 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 Automated Clearinghouse 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 Automated
Clearinghouse, our business could be materially adversely affected.

If our third party card processing providers or our bank sponsors 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 providers, Network 1 Financial, Inc.
and TriSource Solutions, LLC, or our bank sponsors, Harris Bank and DuTrac
Community Credit Union, 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 had employment agreements with Mr. Long and Mr. Hoch
that expired in July 2004 and prohibited them from competing with us for a
period of two years upon termination of their employment. We intend to enter
into similar new employment agreements with both of these individuals and are
currently negotiating the terms of such agreements. Our business may not be
successful if, for any reason, either of these officers ceased to be active in
our management.

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 Automated Clearinghouse 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.

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
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.

RISKS RELATED TO OUR COMMON STOCK

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 2004, our closing stock
price fluctuated between $0.15 and $0.46. 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 currently registered 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;

- 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.

Our Board of Directors is 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.

ITEM 7. FINANCIAL STATEMENTS.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm 19

Consolidated Balance Sheets as of December 31, 2004 and 2003 20

Consolidated Statements of Operations for the years ended
December 31, 2004 and 2003 21

Consolidated Statement of Changes in Stockholders' Equity (Deficit) for
the years ended December 31, 2004 and 2003 22

Consolidated Statements of Cash Flows for the years ended
December 31, 2004 and 2003 23

Notes to Consolidated Financial Statements 24

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
Payment Data Systems, Inc. and Subsidiaries
San Antonio, Texas

We have audited the accompanying consolidated balance sheets of Payment Data
Systems, Inc., formerly known as Billserv, Inc, and subsidiaries (collectively
referred to as "the Company") as of December 31, 2004 and 2003, and the related
consolidated statements of operations, changes in stockholders' equity and cash
flows for the years ended December 31, 2004 and 2003. 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 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 the Company at
December 31, 2004 and 2003, and the consolidated results of its operations and
cash flows for the years then ended, in conformity with U.S. generally accepted
accounting principles.

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.

/s/ Akin, Doherty, Klein & Feuge, P.C.
AKIN, DOHERTY, KLEIN & FEUGE, P.C.
San Antonio, Texas
February 18, 2005, except for Note 15,
to which the date is March 11, 2005

PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS

December 31, December 31,
2004 2003
Assets:
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . $ 153,966 $ 528,119
Accounts receivable, net . . . . . . . . . . . . . . . . . . . 57,788 43,693
Prepaid expenses and other . . . . . . . . . . . . . . . . . . 47,833 113,650
-------------- --------------
Total current assets . . . . . . . . . . . . . . . . . . . . . 259,587 685,462

Property and equipment, net. . . . . . . . . . . . . . . . . . 132,064 215,156
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . 23,589 37,782
-------------- --------------
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $ 415,240 $ 938,400
============== ==============

Liabilities and stockholders' equity (deficit):
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . $ 482,788 $ 501,488
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . 392,515 224,180
Short-term borrowings. . . . . . . . . . . . . . . . . . . . 264,165 -
-------------- --------------
Total current liabilities. . . . . . . . . . . . . . . . . . . 1,139,468 725,668

Stockholders' equity (deficit):
Common stock, $.001 par value, 200,000,000 shares authorized;
23,569,180 and 20,987,956 issued and outstanding . . . . . . 23,569 20,988
Additional paid-in capital . . . . . . . . . . . . . . . . . . 47,417,898 46,842,908
Accumulated deficit. . . . . . . . . . . . . . . . . . . . . . (48,165,695) (46,651,164)
-------------- --------------
Total stockholders' equity (deficit) . . . . . . . . . . . . . (724,228) 212,732
-------------- --------------
Total liabilities and stockholders' equity (deficit) . . . . . $ 415,240 $ 938,400
============== ==============

See notes to consolidated financial statements.

PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

Year ended Year ended
December 31, December 31,
2004 2003

Revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 357,566 $ 119,297

Operating expenses:
Cost of services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327,474 138,009
Selling, general and administrative . . . . . . . . . . . . . . . . . . . 1,374,779 1,726,028
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . 95,190 130,671
-------------- --------------
Total operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . 1,797,443 1,994,708
-------------- --------------

Operating loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,439,877) (1,875,411)

Other income (expense), net:
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712 5,122
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (46,111) (61,432)
Other income (expense). . . . . . . . . . . . . . . . . . . . . . . . . . (29,255) 157,422
-------------- --------------
Total other income (expense), net . . . . . . . . . . . . . . . . . . . . (74,654) 101,112
-------------- --------------

Loss from continuing operations before income taxes . . . . . . . . . . . (1,514,531) (1,774,299)
Income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - -
-------------- --------------
Loss from continuing operations . . . . . . . . . . . . . . . . . . . . . (1,514,531) (1,774,299)

Discontinued operations:
Loss from discontinued operations, net of no income taxes . . . . . . . . - (477,846)

Gain on disposition of discontinued operations, net of no income taxes. . - 2,737,041
-------------- --------------
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,514,531) $ 484,896
============== ==============

Loss from continuing operations per common share - basic and diluted. . . $ (0.07) $ (0.09)

Income from discontinued operations per common share - basic and diluted. - 0.11
-------------- --------------
Net income (loss) per common share - basic and diluted. . . . . . . . . . $ (0.07) $ 0.02
============== ==============
Weighted average common shares
outstanding - basic and diluted. . . . . . . . . . . . . . . . . . . . . 21,813,979 20,883,218

See notes to consolidated financial statements.

PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)

Common Stock Additional Total
------------------------- Paid - In Accumulated Shareholders'
Shares Amount Capital Deficit Equity (Deficit)
------------ ----------- ------------ --------------- -----------------
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
Net loss for the year . . . . . . . . . . . . . - - - 484,896 484,896
------------ ----------- ------------ --------------- -----------------

Balance at December 31, 2003. . . . . . . . . . 20,987,956 20,988 46,842,908 (46,651,164) 212,732

Issuance of common stock - equity line of
credit. . . . . . . . . . . . . . . . . . . . 1,459,435 1,459 320,026 - 321,485
Issuance of common stock - other. . . . . . . . 1,070,789 1,071 218,215 - 219,286
Exercise of stock options . . . . . . . . . . . 51,000 51 7,074 - 7,125
Issuance of common stock warrants . . . . . . . - - 29,675 - 29,675
Net loss for the year . . . . . . . . . . . . . - - - (1,514,531) (1,514,531)
------------ ----------- ------------ --------------- -----------------
Balance at December 31, 2004. . . . . . . . . . 23,569,180 $ 23,569 $ 47,417,898 $ (48,165,695) $ (724,228)
============ =========== ============ =============== =================
See notes to consolidated financial statements.

PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

2004 2003
------------- -------------
Operating activities:
Loss from continuing operations. . . . . . . . . . . . . $(1,514,531) $(1,774,299)
Adjustments to reconcile loss from continuing
operations to net cash used in operating activities:
Depreciation . . . . . . . . . . . . . . . . . . . . . . 87,690 115,671
Amortization . . . . . . . . . . . . . . . . . . . . . . 7,500 15,000
Impairment of assets . . . . . . . . . . . . . . . . . . - 17,000
Non-cash issuance of common stock. . . . . . . . . . . . 215,710 -
Non-cash issuance of common stock warrants . . . . . . . 29,675 -
Amortization of debt discount. . . . . . . . . . . . . . 28,165 -
Changes in current assets and current liabilities:
Accounts receivable. . . . . . . . . . . . . . . . . . (14,095) 615,381
Prepaid expenses and other . . . . . . . . . . . . . . 65,817 144,160
Accounts payable and accrued expenses. . . . . . . . . 153,210 (763,034)
Deferred revenue . . . . . . . . . . . . . . . . . . . - (400,960)
------------ ------------
Net cash used in continuing operations . . . . . . . . . (940,859) (2,031,081)
Net cash used in discontinued operations . . . . . . . . - (145,038)
------------ ------------
Net cash used in operating activities. . . . . . . . . . (940,859) (2,176,119)

Investing activities:
Purchases of property and equipment. . . . . . . . . . . (4,598) (66,395)
Proceeds from sale of assets . . . . . . . . . . . . . . - 4,224,108
Long-term deposits, net. . . . . . . . . . . . . . . . . 6,693 (30,282)
------------ ------------
Net cash provided by investing activities. . . . . . . . 2,095 4,127,431

Financing activities:
Proceeds from notes payable. . . . . . . . . . . . . . . 520,000 -
Principal payments for notes payable . . . . . . . . . . (284,000) (1,800,000)
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. . . . . 328,611 56,856
------------ ------------
Net cash provided by (used in) financing activities. . . 564,611 (1,709,298)
------------ ------------

Change in cash and cash equivalents. . . . . . . . . . . (374,153) 242,014
Cash and cash equivalents, beginning of year . . . . . . 528,119 286,105
------------ ------------
Cash and cash equivalents, end of year . . . . . . . . . $ 153,966 $ 528,119
============ ============

Supplemental information:
Cash paid for interest . . . . . . . . . . . . . . . . $ 24,000 $ 41,623
Cash paid for federal income taxes . . . . . . . . . . - -

See notes to consolidated financial statements.

PAYMENT DATA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004 AND 2003

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 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 2). 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 referred to as "the Company"), provide integrated
electronic payment services, including credit and debit card-based processing
services and transaction processing via the automated clearinghouse ("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 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.

Principles of Consolidation and Basis of Presentation

The accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany accounts
and transactions have been eliminated in consolidation.

The accompanying financial statements have been presented assuming the Company
will continue as a going concern.

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 are reported at outstanding principal net of an allowance
for doubtful accounts of $3,155 at December 31, 2004 and 2003, respectively. 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. No bad debt expense or bad debt write-offs were recorded in 2004.
The Company recorded bad debt expense of $10,700 for 2003 and recorded bad debt
write-offs of $54,742 to its allowance for doubtful accounts in 2003. For the
year ended December 31, 2004, 13% of total revenues were from sales to a single
customer. No single customer accounted for more than 5% of total continuing
operating revenues for the year ended December 31, 2003.

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 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.

Revenue Recognition

Revenue consists primarily 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). Revenue also includes any up-front fees for
the work involved in implementing the basic functionality required to provide
electronic payment processing services to a customer. Revenue from such
implementation fees is recognized over the term of the related service contract.

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.

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,
2004 or 2003.

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.

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.

2004 2003
------------ ----------

Net income (loss), as reported $(1,514,531) $ 484,896

Less: Total stock-based employee
compensation expense determined
under fair value based method for
all awards, net of related tax effects (141,751) (573,186)
------------ ----------

Pro forma net loss $(1,656,282) $ (88,290)
============ ==========

Net income (loss) per common share:
Basic and diluted, as reported $ (0.07) $ 0.02

Basic and diluted, pro forma $ (0.08) $ -

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. See Notes 10 and 11 for
disclosure of securities that could potentially dilute basic EPS in the future
that were not included in the computation of diluted EPS because to do so would
have been antidilutive for the periods presented.

Recent Accounting Pronouncements

On May 15, 2003, the Financial Accounting Standards Board ("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.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"), and in December 2003 issued a revised
interpretation ("FIN 46R"). FIN 46 and FIN 46R address the accounting for, and
disclosure of, investments in variable interest entities. The Company adopted
FIN 46 and FIN 46R, which did not have a material impact on the Company's
financial position or results of operations.

NOTE 2. ISSUANCE OF COMMON STOCK

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. On August 11, 2004, the Company filed an amended registration statement
on Form SB-2 with the Securities and Exchange Commission to register the resale
of the shares to be issued under the equity line of credit with Dutchess Private
Equities Fund, LP. The Securities and Exchange Commission declared this amended
registration statement to be effective on August 13, 2004. During the year ended
December 31, 2004, the Company sold 1,459,435 shares of its common stock
pursuant to the equity line of credit and received total proceeds, net of
issuance costs, of $321,486. Pursuant to the terms of a promissory note with
Dutchess Private Equities Fund, II, LP., the Company is obligated to use a
portion of the proceeds from the equity line to pay back the promissory note
(see Note 7).

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 year ended December
31, 2004, the Company also issued a total of 943,564 shares of common stock
under the terms of its Comprehensive Employee Stock Plan to independent
contractors providing consulting services to the Company and recorded $202,960
of related expense.

During the year ended December 31, 2004, the Company issued 51,000 shares of
common stock and received cash proceeds of $7,125 related to the exercise of
stock options granted under the terms of its Comprehensive Employee Stock Plan.
There were no stock options exercised in 2003.

During the years ended December 31, 2004 and 2003, the Company issued 72,225 and
75,000 shares of common stock, respectively, 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 $11,375 and $16,250 of expense related to the issuance of this
stock in 2004 and 2003, respectively. The average closing price was used to
value the stock given as consideration because the related independent
contractor agreements called for the contractors to earn a certain number of
shares of common stock for each month (prorated for any partial month) spent
working on behalf of the Company with no specified term. In effect, the
contractors earned the same fixed number of shares for each day that they worked
for the Company so the performance commitment was met by the contractors on a
daily basis and valued as such in accordance with the measurement date guidance
provided by EITF 96-18.

NOTE 3. PROPERTY AND EQUIPMENT

The following is a summary of property and equipment at December 31:

2004 2003
---------- ----------

Furniture and fixtures. . . . . . . . . . . . . $ 175,856 $ 175,856
Equipment . . . . . . . . . . . . . . . . . . . 428,420 424,901
Software. . . . . . . . . . . . . . . . . . . . 175,819 174,740
Leasehold improvements. . . . . . . . . . . . . 8,434 8,434
---------- ----------
788,529 783,931
Less: accumulated depreciation and amortization (656,465) (568,775)
---------- ----------
Total property and equipment, net . . . . . . . $ 132,064 $ 215,156
========== ==========

NOTE 4. IMPAIRMENT OF ASSETS

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 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.

NOTE 5. ACCRUED EXPENSES

Accrued expenses consist of the following balances:

December 31, December 31,
2004 2003
-------------- ------------
Accrued salaries. . . . . $ 289,709 $ 11,325
Accrued sales taxes . . . 12,266 101,696
Accrued professional fees 32,875 100,515
Other accrued expenses. . 57,665 10,644
-------------- ------------
Total . . . . . . . . . . $ 392,515 $ 224,180
============== ============

NOTE 6. OPERATING LEASES

In August 2003, the Company signed a three-year lease for approximately 4,500
square feet that serves 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, 2004 and 2003, was $85,000 and $59,000, respectively. Future minimum lease
payments required under operating leases consist of the following at December
31, 2004:

Year ending December 31,

2005. . . . . . . . $ 83,199
2006. . . . . . . . 67,605
--------

Total minimum lease payments $150,804
========

NOTE 7. DEBT

On August 24, 2004, the Company entered into a zero-discount promissory note
with Dutchess Private Equities Fund, II, LP. Pursuant to terms of the promissory
note, the Company received $260,000 and promised to pay Dutchess $284,000 with a
maturity date of December 24, 2004, which represents an effective annual
interest rate of 28%. The Company repaid this note in full on the maturity date.
The Company also issued 75,000 shares of restricted common stock to Dutchess as
an incentive for the investment and agreed to register the common stock issued
pursuant to the promissory note on the next registration statement filed by the
Company.

On December 10, 2004, the Company entered into another zero-discount promissory
note with Dutchess Private Equities Fund, II, LP. Pursuant to terms of the
promissory note, the Company received $260,000 and promised to pay Dutchess
$284,000 with a maturity date of April 10, 2005, which represents an effective
annual interest rate of 28%. The Company also issued 75,000 shares of restricted
common stock to Dutchess as an incentive for the investment and agreed to
register the common stock issued pursuant to the promissory note on the next
registration statement filed by the Company.

Payments on the promissory note are to be made from the equity line of credit
that the Company previously entered into with Dutchess (see Note 2). The Company
will pay to Dutchess the lesser of $71,000 or 50% of each put, until the face
amount of the promissory note is paid in full. The first payment is due at the
closing of the first put 30 days after the issuance of the promissory note and
all subsequent payments are due at the closing of every put to Dutchess. The
Company issued as collateral twenty-five put notices to Dutchess for the full
amount applicable under the terms of the equity line of credit and agreed to do
so at the maximum frequency allowed under the equity line agreement, until such
time as the note is paid in full.

In the event that on the maturity date, the Company has any remaining amounts
unpaid on this note, Dutchess can exercise its right to increase the residual
amount by 2.5% per month paid as liquated damages. In the event that the Company
defaults, Dutchess has the right, but not the obligation, to switch the residual
amount to a three-year, 10% interest bearing convertible debenture at a
conversion rate at the lesser of (i) 75% of the average of the lowest closing
bid price during the fifteen trading immediately preceding the convertible
maturity date or (ii) 100% of the average of the lowest bid price for the twenty
trading days immediately preceding the convertible maturity date. If Dutchess
chooses to convert the residual amount to a convertible debenture, the Company
shall have twenty business days after notice of the same to file a registration
statement covering an amount of shares equal to 300% of the residual amount. In
the event the Company does not file such registration statement within twenty
business days of Dutchess' request, or such registration statement is not
declared by the Securities and Exchange Commission to be effective within the
time period described above, the residual amount shall increase by $1,000 per
day.

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 bearing
interest at 7% annually 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. 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

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 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. The pledged funds were held in the Company's name in
accounts with the lenders that held the margin loans of the officers. 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 highest total amount of funds pledged for the margin loans guaranteed by the
Company was approximately $2.0 million. 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 its balance sheet at
December 31, 2002 because it became probable at that point that it would be
unable to recover its 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, 2004. 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 our preliminary analysis. The Company
understands that these individuals may assert such claims based on the Company's
sale of substantially all of its assets to Harbor Payments, Inc. on July 25,
2003. The Company has not initiated any formal settlement negotiations with
these individuals because they have been under an extended employment contract
with us or have not been amenable to such an action. On July 25, 2004, the
Company's employment agreements with Michael Long, Chief Executive Officer and
Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer,
expired. The Company intends to enter into new employment agreements with both
of these individuals and is currently negotiating the terms of such agreements.
The Company has not pursued the outstanding repayment obligation of Mr. Jones
because the Company does not consider a recovery attempt to be cost beneficial.
In order to attempt a recovery from Mr. Jones, the Company estimates that it
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, the Company also
anticipates difficulty in retaining counsel on a contingency basis to pursue
collection of this obligation. The ultimate outcome of this matter cannot
presently be determined.

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:

2004 2003
============= =============
Deferred Tax Assets:
----------------------------------
Warrant expense. . . . . . . . . . $ 3,177,082 $ 3,166,992
Loss on related party guarantees . 434,567 434,567
Net operating loss carryforwards . 12,266,021 11,759,182
Other items. . . . . . . . . . . . 77,419 91,019
------------- -------------
15,955,089 15,451,760
Valuation allowance. . . . . . . . (15,914,425) (15,400,069)
------------- -------------
Total Deferred Tax Asset . . . . . 40,664 51,691

Deferred Tax Liabilities:
----------------------------------
Depreciation and other items . . . 40,664 51,691
------------- -------------
Net Deferred Tax Asset (Liability) $ - $ -
============= =============

For the period from inception (July 30, 1998) through December 31, 2004, the
Company has net operating loss carryforwards for tax purposes of approximately
$36.1 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:

2004 2003
---------- ----------
Tax (benefit) at statutory rate -- 34% $(514,941) $ 164,865
Change in valuation allowance. . . . . 514,356 (521,398)
Permanent and other differences. . . . 585 356,533
---------- ----------
Income tax expense . . . . . . . . . . $ - $ -
========== ==========

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
grants 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 10,000,000 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 1,500,000
shares of its common stock for issuance pursuant to the Director Plan.

Option activity under the Employee Plan and Director Plan is as follows:

Number of Shares Weighted Average Exercise Price
----------------- --------------------------------
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
Granted . . . . . . . . . . 30,000 0.20
Canceled. . . . . . . . . . (296,000) 0.86
Exercised . . . . . . . . . (51,000) 0.14
-----------------
Outstanding, December 31, 2004 4,234,770 $ 0.78
=================

There was an aggregate of 5,866,441 and 971,230 options to purchase the
Company's common stock available for future grants under the Employee and
Director Plans at December 31, 2004 and 2003, respectively. Exercisable stock
options amounted to 4,079,770 at a weighted average price of $0.81 and 3,171,770
at a weighted average price of $1.06 at December 31, 2004 and 2003,
respectively.

Summarized information about stock options outstanding at December 31, 2004 is
as follows:

Options Outstanding Options Exercisable
----------------------------------- ---------------------------
Weighted Average Weighted Weighted
Range of Exercise Options Remaining Average Exercise Number of Average Exercise
Prices Outstanding Contractual Life Price Options Price
------------------ ------------------- ------------------- ----------------- --------- -----------------
0.09 - $0.14 1,670,000 8.9 years $ 0.13 1,545,000 $ 0.13
0.18 - $0.26 1,104,100 6.5 years $ 0.19 1,074,100 $ 0.19
0.86 - $0.88 711,668 6.4 years $ 0.86 711,668 $ 0.86
1.88 - $2.07 334,001 6.0 years $ 2.06 334,001 $ 2.06
2.81 - $11.25 415,001 4.2 years $ 3.85 415,001 $ 3.85
------------------- ----------
4,234,770 7.2 years $ 0.78 4,079,770 $ 0.81
=================== ==========

The weighted average fair value of stock options at date of grant was $0.13 and
$0.10 per option for options granted during fiscal years 2004 and 2003,
respectively. The fair value of each option granted was estimated using the
Black-Scholes option-pricing model, utilizing the following assumptions:

2004 2003
----- -----

Dividend yield. . . . . None None
Expected volatility . . 143% 142%
Risk-free interest rate 2.50% 1.80%
Expected life . . . . . 2.00 2.45

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,
2004. A total of 43,857 shares were issued under the ESPP in 2003 at a price of
$0.15 per share. There were no shares issued under the ESPP in 2004.

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 2004 or 2003.

NOTE 11. STOCK WARRANTS

On September 30, 2004, the Company signed a performance-based warrant agreement
with Kubra Data Transfer, Ltd., a provider of enterprise information solutions
servicing EBPP customers, as consideration for entering into a customer referral
agreement with the Company for a three-year term. Under the terms of the
referral agreement, the Company will become Kubra's preferred provider of credit
and debit card payment processing. The incentive warrant agreement provides for
both an initial vested warrant for 250,000 shares of restricted common stock at
$0.24 per share and contingent warrants to be earned based on the achievement of
annual or quarterly goals for delivery of gross revenue to the Company through
the referral or transfer of profitable payment processing customers. The
contingent warrants will also be for restricted common stock and will be priced
at 120% of the market price for the common stock when earned.

At December 31, 2004, the outstanding vested warrants to purchase common stock
were as follows:

Shares of Aggregate
Common Exercise Exercise Expiration
Stock Price Price Date
----------- --------- ----------- ----------

2,179,121 $ 11.38 $24,798,397 06/02/2010
250,000 0.24 60,000 09/30/2009
2,000,000 1.80 3,600,000 11/27/2006
----------- -----------
4,429,121 $28,458,397
=========== ===========

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

NOTE 14. DISCONTINUED OPERATIONS

On July 25, 2003 (the "Closing") the Company sold substantially all of its
assets (the "Business") to Harbor Payments, Inc. (the "Purchaser"), formerly
known as CyberStarts, Inc. (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 stockholders of the Company 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. 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 year ended December 31, 2003, these
discontinued operations provided revenue of $2,155,000. 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 did
not earn any of the additional $700,000 subject to certain earnout provisions
based upon subsequent gross revenues of the Business. 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 $182,000 in the aggregate and
terminated their respective employee agreements.

NOTE 15. SUBSEQUENT EVENTS

In January 2005, the Company's Chief Executive Officer and Chief Financial
Officer; President and Chief Operating Officer, and all other employees owed
unpaid wages elected to receive common stock from the Company in lieu of a total
of $179,000 in accumulated unpaid salary. The Company's Board of Directors
granted a total of 859,743 shares of common stock in exchange for the unpaid
salaries. All shares are to be issued under the terms of the Company's Employee
Comprehensive Stock Plan.

Subsequent to December 31, 2004 and through March 11, 2005, the Company sold
455,125 shares of unregistered common stock to Dutchess Private Equities Fund
pursuant to the equity line of credit (see Note 2) and received total proceeds,
net of issuance costs, of $265,666.

Subsequent to December 31, 2004 and through March 11, 2005, the Company also
issued a total of 169,367 shares of common stock under the terms of its
Comprehensive Employee Stock Plan to independent contractors providing
consulting services to the Company for which it recorded $50,140 of related
expense.

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

None.

ITEM 8A. CONTROLS AND PROCEDURES.

As of the end of the period covered by this Annual Report on Form 10-KSB, an
evaluation was performed under the supervision and with the participation of our
management, including the Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rules 13a-14 and 15d-14 of the Securities Exchange Act
of 1934). Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures were
effective in ensuring that material information relating to us with respect to
the period covered by this report was made known to them. Since the date of
their evaluation, there have been no significant changes in our internal
controls or in other factors that could significantly affect these controls,
including any corrective actions with regard to significant deficiencies and
material weaknesses.

ITEM 8B. OTHER INFORMATION.

None.

PART III

We omitted certain information required by Part III from this Report because we
will file our definitive Proxy Statement for our 2005 Annual Meeting of
Stockholders pursuant to Regulation 14A of the Securities and Exchange Act of
1934 not later than 120 days after the end of the fiscal year covered by this
Report. Certain information included in the Proxy Statement is incorporated
herein by reference.

ITEM 9. DIRECTORS , EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.

There is incorporated in this Item 9, by reference, that portion of our
definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, which
appears therein under the captions "Election of Director," "Committees of the
Board of Directors and Meetings" and "Section 16(a) Beneficial Ownership
Reporting Compliance."

ITEM 10. EXECUTIVE COMPENSATION.

There is incorporated in this Item 10, by reference, that portion of our
definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, which
appears under the caption "Executive Compensation."

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.

There is incorporated in this Item 11, by reference, that portion of our
definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, which
appears under the caption "Security Ownership of Certain Beneficial Owners and
Management."

Equity Compensation Plan Information

Weighted-average Number of securities
Number of securities to be exercise price remaining available for
issued upon exercise of of outstanding future issuance under
outstanding options options compensation plan
-------------------------- -------------------- -----------------------
Employee Comprehensive Stock
Plan approved by stockholders. . . . 3,701,767 $ 0.63 4,899,444

Non-Employee Director
Plan approved by stockholders. . . . 533,003 $ 1.88 966,997

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

There are no reportable relationships or transactions.

ITEM 13. EXHIBITS.

The exhibits listed below are filed as part of or incorporated by reference in
this Report.

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)

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 26, 2005)

10.5 1999 Non-Employee Director Plan, as amended (incorporated by reference to
such exhibit in the Registrant's Registration Statement on Form S-8, filed
January 26, 2005)

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 between the Company and Executive Officers of
the Company, dated May 31, 2001 (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 6, 2004 (incorporated by reference to such exhibit in
the Registrant's Registration Statement on Form SB-2, filed June 18, 2004)

10.9 Registration Rights Agreement between the Company and Dutchess Private
Equities Fund, LP dated June 6, 2004 (incorporated by reference to such
exhibit in the Registrant's Registration Statement on Form SB-2, filed June
18, 2004)

10.10 Placement Agent Agreement between the Company, Clayton Dunning and Co,
Inc. and Dutchess Private Equities Fund, LP, dated June 4, 2004
(incorporated by reference to such exhibit in the Registrant's Registration
Statement on Form SB-2, filed July 23, 2004)

10.11 Affiliate Office Agreement between the Company and Network 1 Financial,
Inc., dated October 7, 2003 (incorporated by reference to such exhibit in
the Registrant's Registration Statement on Form SB-2, filed April 28, 2004)

10.12 Promissory Note between the Company and Dutchess Private Equities Fund,
II, LP, dated August 24, 2004 (incorporated by reference to such exhibit in
the Registrant's Report on Form 8-K, filed September 2, 2004)

10.13 Warrant Agreement between the Company and Kubra Data Transfer LTD, dated
as of September 30, 2004 (incorporated by reference to such exhibit in the
Registrant's Report on Form 8-K, filed October 6, 2004)

10.14 Promissory Note between the Company and Dutchess Private Equities Fund,
II, LP, dated December 10, 2004 (incorporated by reference to such exhibit
in the Registrant's Report on Form 8-K, filed December 16, 2004)

16.1 Letter from Ernst and Young LLP to the Securities and Exchange Commission
dated February 10, 2004 (incorporated by reference to such exhibit in the
Registrant's Current Report on Form 8-K, filed February 11, 2004)

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)

31.1 Certification pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)

32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.

There is incorporated in this Item 14, by reference, that portion of our
definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, which
appears under the caption "Fees Paid to the Independent Accountant."

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

PAYMENT DATA SYSTEMS, INC.

By: /s/ Michael R. Long
------------------------
Michael R. Long
Chairman of the Board, Chief Executive Officer, and
Chief Financial Officer
Date: March 30, 2005

In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities indicated on
March 30, 2005.

By: /s/ Michael R. Long
----------------------
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/ Louis A. Hoch
--------------------
Louis A. Hoch
President, Chief Operating Officer, and
Director

By: /s/ Peter G. Kirby
---------------------
Peter G. Kirby
Director