-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, PS5xt8ISsFlZ0RI+FjiubFAWEIA1jw/xL/ZJOPRLbMKeFR2PD+LdSsNVZr/hc784 /FHNTh1TcEfHVglLizv90g== 0001231742-04-000422.txt : 20040618 0001231742-04-000422.hdr.sgml : 20040618 20040618165801 ACCESSION NUMBER: 0001231742-04-000422 CONFORMED SUBMISSION TYPE: SB-2 PUBLIC DOCUMENT COUNT: 6 FILED AS OF DATE: 20040618 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PAYMENT DATA SYSTEMS INC CENTRAL INDEX KEY: 0001088034 STANDARD INDUSTRIAL CLASSIFICATION: FUNCTIONS RELATED TO DEPOSITORY BANKING, NEC [6099] IRS NUMBER: 980190072 STATE OF INCORPORATION: NV FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: SB-2 SEC ACT: 1933 Act SEC FILE NUMBER: 333-116654 FILM NUMBER: 04871120 BUSINESS ADDRESS: STREET 1: 211 N LOOP 1604 EAST STREET 2: SUITE 200 CITY: SAN ANTONIO STATE: TX ZIP: 78232 BUSINESS PHONE: 2104025039 MAIL ADDRESS: STREET 1: 211 N LOOP 1604 EAST STREET 2: STE 200 CITY: SAN ANTONIO STATE: TX ZIP: 78232 FORMER COMPANY: FORMER CONFORMED NAME: BILLSERV INC DATE OF NAME CHANGE: 20011219 FORMER COMPANY: FORMER CONFORMED NAME: BILLSERV COM INC DATE OF NAME CHANGE: 19990607 SB-2 1 doc1.txt As filed with the Securities and Exchange Commission on June 18, 2004 File No. ___________________ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM SB-2 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 PAYMENT DATA SYSTEMS, INC. (Name of small business issuer in its charter) Nevada 6099 98-0190072 ------- ---------- ---------- (State or jurisdiction (Primary Standard Industrial I.R.S. Employer of incorporation or Classification Code Number) Identification Organization No. 12500 SAN PEDRO, SUITE 120, SAN ANTONIO, TEXAS 78216 TELEPHONE: (210)249-4100 (Address and telephone number of principal executive offices) 12500 SAN PEDRO, SUITE 120, SAN ANTONIO, TEXAS 78216 TELEPHONE: (210)249-4100 (Address of principal place of business or intended principal place of business) MICHAEL R. LONG CHIEF EXECUTIVE OFFICER 12500 SAN PEDRO SUITE 120 SAN ANTONIO, TEXAS 78216 (210) 249-4100 (Name, address and telephone number of agent for service) Copies of communications to: AMY M. TROMBLY, ESQ. TROMBLY BUSINESS LAW 1163 WALNUT STREET, SUITE 7 NEWTON, MA 02461 (617) 243-0060 Approximate date of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. [ ] If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box. [X] CALCULATION OF REGISTRATION FEE
Proposed Proposed maximum maximum Amount of Title of each class of Amount to be offering price per Aggregate registration fee securities to be registered registered(1) security(2) offering price - ---------------------------------------- ------------- -------------------- --------------- ----------------- Common stock, par value $0.001 per share 40,000,000 $ 0.22 $ 8,800,000 $ 1,115 - ---------------------------------------- ------------- -------------------- --------------- ----------------- (1) Pursuant to Rule 416(a) of the Securities Act of 1933, as amended, this registration statement shall be deemed to cover additional securities that may be offered or issued to prevent dilution resulting from stock splits, stock dividends or similar transactions. (2) Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457(c). For the purposes of this table, we have used the average of the closing bid and ask prices of the common stock as traded in the over the counter market and reported on the OTC Electronic Bulletin Board on June 16, 2004.
The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is declared effective. This prospectus is not an offer to sell these securities, and we are not soliciting offers to buy these securities, in any state where the offer or sale is not permitted. PROSPECTUS PAYMENT DATA SYSTEMS, INC. OFFERING UP TO 40,000,000 COMMON SHARES This prospectus relates to the sale of up to 40,000,000 shares of our common stock by a stockholder. We are not selling any securities in this offering and therefore will not receive any proceeds from this offering. We will, however, receive proceeds from the sale of securities under an Investment Agreement, also referred to as an Equity Line of Credit, that we have entered into with Dutchess Private Equities Fund, L.P., which permits us to "put" up to $10 million in shares of common stock to Dutchess Private Equities Fund. Dutchess will pay us 95% of the lowest closing bid price of the common stock during the five consecutive trading day period immediately following the date of our notice to them of our election to put shares pursuant to the Equity Line of Credit. All costs associated with this registration will be borne by us. The shares of common stock are being offered for sale by the selling stockholder at prices established on the Over-the-Counter Bulletin Board or in negotiated transactions during the term of this offering. Our common stock is quoted on the Over-the-Counter Bulletin Board under the symbol PYDS.OB. On June 10, 2004, the last reported sale price of our common stock was $0.25 per share. Dutchess Private Equities Fund, LP and Charleston Capital Corporation are "underwriters" within the meaning of the Securities Act of 1933, as amended, in connection with the resale of common stock under the Investment Agreement. This investment involves a high degree of risk. You should purchase securities only if you can afford a complete loss. SEE "RISK FACTORS" BEGINNING ON PAGE 8. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Subject to Completion, the date of this Prospectus is June 18, 2004 TABLE OF CONTENTS PROSPECTUS SUMMARY 4 RISK FACTORS 8 USE OF PROCEEDS 13 DETERMINATION OF OFFERING PRICE 14 DILUTION 14 SELLING SECURITY HOLDERS 15 PLAN OF DISTRIBUTION 16 LEGAL PROCEEDINGS 18 DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS 19 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 20 DESCRIPTION OF SECURITIES 21 INTEREST OF NAMED EXPERTS AND COUNSEL 21 DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR SECURITIES ACT LIABILITIES 22 CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS 22 DESCRIPTION OF BUSINESS 22 MANAGEMENT'S DISCUSSION AND ANALYSIS OF PLAN OF OPERATION 30 DESCRIPTION OF PROPERTY 44 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 44 MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 46 EXECUTIVE COMPENSATION 47 FINANCIAL STATEMENTS F-1 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE F-22 PROSPECTUS SUMMARY The following information is a summary of the prospectus and it does not contain all of the information you should consider before making an investment decision. You should read the entire prospectus carefully, including the financial statements and the notes relating to the financial statements. OUR COMPANY We provide integrated electronic payment processing services to merchants and businesses, including all types of Automated Clearinghouse, or ACH, Network processing and credit and debit card-based processing services. The ACH Network is a nationwide batch-oriented electronic funds transfer system that is regulated by the Federal Reserve and provides for the interbank clearing of electronic payments for participating financial institutions. Our ACH processing services enable merchants or businesses to both remit or collect funds electronically using e-checks to transfer funds instead of traditional paper checks. An e-check is an electronic debit to a bank checking account that is initiated at the point-of-sale, on the Internet, over the telephone or via a bill remittance sent through the mail and is processed using the ACH network. Our card-based processing services enable merchants to process both traditional card-present, or "swipe," transactions, as well as card-not-present transactions. A traditional card-present transaction occurs whenever a cardholder physically presents a credit or debit card to a merchant at the point-of-sale. A card-not-present transaction occurs whenever the customer does not physically present a payment card at the point-of-sale and may occur over the Internet, mail, fax or telephone. Our electronic payment processing may take place in a variety of forms and channels. For example, our capabilities allow merchants to convert a paper check to an e-check or receive card authorization at the point-of-sale, have their customer service representatives take e-check or card payments from their consumers by telephone, and enable their consumers to make e-check or card payments directly through the use of a Web site or by calling an Interactive Voice Response, or IVR, telephone system. We also operate an online payment processing service for consumers under the domain name www.bills.com through which consumers can pay anyone. We generate revenues by charging fees for the electronic processing of payment transactions and related services. We charge certain merchants for these processing services at a bundled rate based on a percentage of the dollar amount of each transaction and, in some instances, additional fees are charged for each transaction. We charge other merchant customers a flat fee per transaction, and may also charge miscellaneous fees to our customers, including fees for chargebacks or returns, monthly minimums, and other miscellaneous services. We operate solely in the United States as a single operating segment, and do not currently have any foreign operations. In July 2003, we sold substantially all of our assets to Harbor Payments Corp., formerly Saro, Inc. We had used the assets sold to provide Electronic Bill Presentment and Payment and related services to companies that generate recurring bills to their consumers. Electronic Bill Presentment and Payment is the process of sending bills in an electronic format to consumers securely through the Internet and processing Internet payment of bills utilizing an electronic transfer of funds. After we sold these assets, we no longer provided Electronic Bill Presentment and Payment and related services, which are presented in our financial statements as discontinued operations. We believe that the property and equipment we retained after this sale are sufficient to support our continuing operations. We also believe that our current available cash plus anticipated future revenues from continuing operations are likely to be insufficient for us to continue as a going concern. 4 Our auditors have issued a going concern opinion on our audited financial statements for the year ended December 31, 2003. As of March 31, 2004, our available cash balance was $268,000 and we anticipate cash needs of approximately $1.5 million for the next twelve months. Our ability to continue as a going concern is likely contingent on us receiving additional capital. If sufficient capital is not available to us, we would likely be required to reduce or discontinue our operations. We intend to use the proceeds from our equity line with Dutchess to pay current liabilities and fund our current level of operations in the future until we achieve positive cash flow from operations, if ever. HOW TO CONTACT US Our executive offices are located at 12500 San Pedro, Suite 120, San Antonio, Texas 78216. Our phone number is (210) 249-4100. Our Internet address is www.paymentdata.com. - -------------------- THE OFFERING This prospectus relates to the resale of up to 40,000,000 shares of our common stock by Dutchess Private Equities Fund, LP, who will become a stockholder pursuant to our Investment Agreement.
Common stock offered 40,000,000 shares Use of proceeds We will not receive any proceeds from the sale by the selling stockholders of our common stock. We will receive proceeds from our Investment Agreement with Dutchess Private Equities Fund. See "Use of Proceeds." Symbol for our common stock Our common stock trades on the OTCBB Market under the symbol "PYDS.OB"
OUR CAPITAL STRUCTURE AND SHARES ELIGIBLE FOR FUTURE SALE Shares of common stock outstanding as of April 16, 2004 21,495,181 (1) Shares of common stock potentially issuable upon exercise of the put right to Dutchess Private Equities Fund 40,000,000 (2) ---------- Total 61,495,181 ========== 5 (1) Assumes: - - No exercise of the following options to purchase common stock outstanding at March 31, 2004: 4,003,767 shares of common stock pursuant to Amended and Restated 1999 Employee Comprehensive Stock Plan 533,003 shares of common stock pursuant to 1999 Non-Employee Director Plan - - No exercise of the outstanding vested warrants to purchase common stock at March 31, 2004 as follows:
Shares of Common Exercise Expiration Holder Stock Price Date - ----------------- --------- --------- ---------- Private Placement 41,237 $ 6.06 08/05/2004 Placement Agent 250 3.25 10/14/2004 Placement Agent 280 8.00 12/15/2004 Placement Agent 8,890 7.41 12/20/2004 Placement Agent 3,500 7.31 12/22/2004 Private Placement 2,000,000 1.80 11/27/2006 CheckFree 2,179,121 11.38 06/02/2010 --------- 4,233,278 =========
(2) For the purpose of determining the number of shares subject to registration with the Securities and Exchange Commission, we have assumed that we will issue no more than 40,000,000 shares pursuant to the exercise of our put right under the Investment Agreement. However, the number of shares that we will actually issue pursuant to that put right may be more than or less than 40,000,000, depending on the trading price of our common stock at the time of each put and how many times we issue a put. We currently have no intent to exercise the put right in a manner that would result in our issuance of more than 40,000,000 shares, but if we were to exercise the put right in that manner, we would be required to file a subsequent registration statement with the Securities and Exchange Commission and for that registration statement to be deemed effective prior to the issuance of any such additional shares. 6 THE INVESTMENT AGREEMENT The Investment Agreement we have with Dutchess Private Equities Fund, L.P. allows us to "put" to Dutchess Private Equities Fund either (A) four hundred percent of the average daily volume of our common stock for the ten trading days prior to the applicable put notice date, multiplied by the average of the three daily closing best bid prices immediately preceding the put date, or (B) $25,000; provided that in no event will the put amount be more than $1,000,000 with respect to any single put. We shall not be entitled to submit a put notice until after the previous put has been completed. The purchase price for the common stock identified in the put notice shall be equal to 95% of the lowest closing bid price of the common stock during the five consecutive trading day period immediately following the date of our notice to them of our election to put shares. The discount at which we will issue our common stock to Dutchess will be accounted for as a direct cost of equity financing and netted against the proceeds from the sale of such stock that is recorded as equity. Dutchess Private Equities Fund, L.P. will only purchase shares when we meet the following conditions: - - a registration statement has been declared effective and remains effective for the resale of the common stock subject to the Equity Line of Credit; - - our common stock has not been suspended from trading for a period of five consecutive trading days and we have not have been notified of any pending or threatened proceeding or other action to delist or suspend our common stock; - - we have complied with our obligations under the Investment Agreement and the Registration Rights Agreement; - - no injunction has been issued and remain in force, or action commenced by a governmental authority which has not been stayed or abandoned, prohibiting the purchase or the issuance of our common stock; - - the issuance of the common stock will not violate any shareholder approval requirements of any exchange or market where our securities are traded; - - the registration statement does not contain any untrue statement of a material fact or omit to state any material fact required to be stated or necessary to make the statements not misleading or which would require public disclosure or an update supplement to the prospectus; and - - We have not filed a petition in bankruptcy, either voluntarily or involuntarily, and there shall not have commenced any proceedings under any bankruptcy or insolvency laws. The Investment Agreement will terminate when any of the following events occur: - - Dutchess Private Equities Fund, L.P. has purchased an aggregate of $10,000,000 of our common stock; - - 36 months after the SEC declares this registration statement effective; - - we file or otherwise enter an order for relief in bankruptcy; - - trading of our common stock is suspended for a period of 5 consecutive trading days; or - - we issue or sell any equity securities or securities convertible into, or exchangeable for, equity securities or enter into any other equity financing facility during the term of the Investment Agreement in certain circumstances, without the prior written approval of Dutchess. 7 RISK FACTORS An investment in our common stock involves a high degree of risk. You should carefully consider the following factors that management considers to be the material risks facing the company as of the date of this prospectus, other information included in this prospectus and information in our periodic reports filed with the SEC. If any of the following risks actually occur, our business, financial condition or results of operations could be materially and adversely affected, and you may lose some or all of your investment. RISKS RELATED TO OUR BUSINESS OUR INDEPENDENT ACCOUNTANTS HAVE ISSUED A GOING CONCERN OPINION AND IF WE CANNOT OBTAIN ADDITIONAL FINANCING BY JULY 31, 2004, WE MAY HAVE TO CURTAIL OPERATIONS AND MAY ULTIMATELY CEASE TO EXIST. Our independent accountants have issued a going concern opinion. Due to continuing operating losses, our current available cash and cash equivalents along with anticipated revenues are likely to be insufficient to meet our anticipated cash needs for the near future. Consequently, our ability to continue as a going concern is likely contingent on us receiving additional funds in the form of equity or debt financing. We currently plan to meet our capital requirements primarily through the issuance of equity securities or new borrowing arrangements. Accordingly, we are aggressively pursuing strategic alternatives, including the Equity Line of Credit for which we are registering shares in this registration statement. However, financing may not be available in amounts or on terms acceptable to us, if at all. If we cannot raise funds on acceptable terms, or achieve positive cash flow, by July 31, 2004, we may be forced to curtail operations or may ultimately cease to exist. WE HAVE GENERATED SIGNIFICANT LOSSES AND EXPECT TO GENERATE OPERATING LOSSES FOR THE FORESEEABLE FUTURE, THEREFORE WE MAY NOT BECOME PROFITABLE. We organized in 1998 and began operations as a public company in 1999 by offering electronic billing services to other companies. After the sale of our primary business in July 2003, we have concentrated on building our electronic payments services operations. We have not been profitable since inception and we may never become profitable. As of December 31, 2003, our accumulated deficit was $46.7 million. IF OUR SECURITY APPLICATIONS ARE NOT SUFFICIENT TO ADDRESS CHANGING MARKET CONDITIONS AND CUSTOMER CONCERNS, WE MAY NOT BE ABLE TO SELL OUR SERVICES. Our use of applications designed for premium data security and integrity to process electronic transactions may not be sufficient to address changing market conditions or the security and privacy concerns of existing and potential customers. Adverse publicity raising concerns about the safety or privacy of electronic transactions, or widely reported breaches of our or another provider's security, have the potential to undermine consumer confidence in the technology and could have a materially adverse effect on our business. IF THE TREND OF AN INCREASING PERCENTAGE OF PAYMENTS CLEARED ELECTRONICALLY DOES NOT CONTINUE, WE MAY NOT BE ABLE TO GROW OUR BUSINESS. 8 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, or ODFI, in the Automated Clearinghouse, or ACH, Network. The ACH Network is a nationwide batch-oriented electronic funds transfer system that provides for the interbank clearing of electronic payments for participating financial institutions. An ODFI is a participating financial institution that must abide by the provisions of the ACH Operating Rules and Guidelines. Through our relationship with this third party provider, we are able to process payment transactions on behalf of our customers and their consumers by submitting payment instructions in a prescribed ACH format. We pay volume-based fees to the third party provider for debit and credit transactions processed each month, and pay fees for other transactions such as returns and notices of change to bank accounts. These fees are part of our cost structure. If the Federal Reserve rules were to change to introduce restrictions or modify access to the ACH, our business could be materially adversely affected. IF OUR THIRD PARTY CARD PROCESSING PROVIDER OR OUR BANK SPONSOR FAIL TO COMPLY WITH THE APPLICABLE REQUIRMENTS OF VISA AND MASTERCARD CREDIT CARD ASSOCIATIONS, WE MAY HAVE TO FIND A NEW THIRD PARTY PROCESSING PROVIDER WHICH COULD INCREASE OUR COSTS. 9 Substantially all of the card-based transactions we process involve Visa or MasterCard. If our third party processing provider, Network 1 Financial, Inc., or our bank sponsor, Harris Bank, fail to comply with the applicable requirements of the Visa and MasterCard credit card associations, Visa or MasterCard could suspend or terminate their registration. Also, our contract with these third parties is subject to cancellation upon limited notice by either party. The cancellation of our contract, termination of their registration or any changes in the Visa or MasterCard rules that would impair their registration could require us to stop providing such payment processing services if we are unable to obtain another provider or sponsor at similar costs. Additionally, changing our bank sponsor could adversely affect our relationship with our merchants if the new sponsor provides inferior service or charges higher costs. WE DEPEND ON MICHAEL R. LONG AND LOUIS A. HOCH AND IF THESE OFFICERS CEASED TO BE ACTIVE IN OUR MANAGEMENT, OUR BUSINESS MAY NOT BE SUCESSFUL. Our success depends to a significant degree upon the continued contributions of our key management, marketing, service and related product development and operational personnel, including our Chairman, Chief Executive Officer and Chief Financial Officer, Michael R. Long and our President and Chief Operating Officer, Louis A. Hoch. We have employment agreements with Mr long and Mr. Hoch that expire in July 2004 and prohibit them from competing with us for a period of two years upon termination of their employment. Our business may not be successful if, for any reason, either of these officers ceased to be active in our management. 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. 10 IF WE DO NOT MANAGE OUR GROWTH, WE MAY NOT ACHIEVE OR SUSTAIN PROFITABILITY. We may experience a period of rapid growth that could place a significant strain on our resources. In order to manage our growth successfully, we will have to continue to improve our operational, management and financial systems and expand our work force. A significant increase in our customer base may necessitate the hiring of a significant number of additional personnel, qualified candidates for which, at the time needed, may be in short supply. In addition, the expansion and adaptation of our computer and administrative infrastructure will require substantial operational, management and financial resources. Although we believe that our current infrastructure is adequate to meet the needs of our customers in the foreseeable future, we may not be able to expand and adapt our infrastructure to meet additional demand on a timely basis, at a commercially reasonable cost, or at all. If our management is unable to manage growth effectively, hire needed personnel, expand and adapt our computer infrastructure and improve our operational, management, and financial systems and controls, we may not attain or sustain profitability. IF WE DO NOT MANAGE OUR CREDIT RISKS RELATED TO OUR MERCHANT ACCOUNTS, WE MAY INCUR SIGNIFICANT LOSSES. We rely on the Federal Reserve's ACH system for electronic fund transfers and the Visa and MasterCard associations for settlement of payments by credit or debit card on behalf of our merchant customers. In our use of these established payment clearance systems, we generally bear the credit risks arising from returned transactions caused by insufficient funds, stop payment orders, closed accounts, frozen accounts, unauthorized use, disputes, customer charge backs theft or fraud. Consequently, we assume the credit risk of merchant disputes, fraud, insolvency or bankruptcy in the event we attempt to recover funds related to such transactions from our customers. We have not experienced a significant increase in the rate of returned transactions or incurred any losses with respect to such transactions. We utilize a number of systems and procedures to manage and limit credit risks, but if these actions are not successful in managing such risks, we may incur significant losses. RISKS RELATED TO OUR INDUSTRY THE ELECTRONIC COMMERCE MARKET IS RELATIVELY NEW AND IF IT DOES NOT GROW, WE MAY NOT BE ABLE TO SELL SUFFICIENT SERVICES TO MAKE OUR BUSINESS VIABLE. The electronic commerce market is a relatively new and growing service industry. If the electronic commerce market fails to grow or grows slower than anticipated, or if we, despite an investment of significant resources, are unable to adapt to meet changing customer requirements or technological changes in this emerging market, or if our services and related products do not maintain a proportionate degree of acceptance in this growing market, our business may not grow and could even fail. Additionally, the security and privacy concerns of existing and potential customers may inhibit the growth of the electronic commerce market in general, and our customer base and revenues, in particular. Similar to the emergence of the credit card and automatic teller machine, or ATM, industries, we and other organizations serving the electronic commerce market must educate users that electronic transactions use encryption technology and other electronic security measures that make electronic transactions more secure than paper-based transactions. 11 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 AND THIS OFFERING OUR STOCK PRICE IS VOLATILE AND YOU MAY NOT BE ABLE TO SELL YOUR SHARES AT A PRICE HIGHER THAN WHAT YOU PAID. The market for our common stock is highly volatile. In 2002, our stock price fluctuated between $0.17 and $1.70. The trading price of our common stock could be subject to wide fluctuations in response to, among other things, quarterly variations in operating and financial results, announcements of technological innovations or new products by our competitors or us, changes in prices of our products and services or our competitors' products and services, changes in product mix, or changes in our revenue and revenue growth rates. 12 EXISTING STOCKHOLDERS MAY EXPERIENCE SIGNIFICANT DILUTION FROM THE SALE OF SECURITIES PURSUANT TO OUR INVESTMENT AGREEMENT WITH DUTCHESS PRIVATE EQUITIES FUND. The sale of shares pursuant to our Investment Agreement with Dutchess Private Equities Fund may have a dilutive impact on our stockholders. As a result, our net income per share could decrease in future periods and the market price of our common stock could decline. In addition, the lower our stock price is at the time we exercise our put option, the more shares we will have to issue to Dutchess Private Equities Fund to draw down on the full equity line with Dutchess Private Equities Fund. If our stock price decreases, then our existing stockholders would experience greater dilution. At a stock price of $0.26 or less, we would have to issue all 40,000,000 shares registered under this offering in order to draw down on the full equity line. DUTCHESS PRIVATE EQUITIES FUND WILL PAY LESS THAN THE THEN-PREVAILING MARKET PRICE OF OUR COMMON STOCK WHICH COULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE. Our common stock to be issued under our agreement with Dutchess Private Equities Fund will be purchased at a 5% discount to the lowest closing best bid price during the five days immediately following our notice to Dutchess Private Equities Fund of our election to exercise our put right. Dutchess Private Equities Fund has a financial incentive to sell our common stock immediately upon receiving the shares to realize the profit between the discounted price and the market price. If Dutchess Private Equities Fund sells our shares, the price of our stock could decrease. If our stock price decreases, Dutchess Private Equities Fund may have a further incentive to sell the shares of our common stock that it holds. The discounted sales under our agreement with Dutchess Private Equities Fund could cause the price of our common stock to decline. WE MUST COMPLY WITH PENNY STOCK REGULATIONS THAT COULD EFFECT THE LIQUIDITY AND PRICE OF OUR STOCK. The SEC has adopted rules that regulate broker-dealer practices in connection with transactions in "penny stocks." Penny stocks generally are equity securities with a price of less than $5.00, other than securities registered on certain national securities exchanges or quoted on NASDAQ, provided that current price and volume information with respect to transactions in such securities is provided by the exchange or system. Prior to a transaction in a penny stock, a broker-dealer is required to: - - deliver a standardized risk disclosure document prepared by the SEC; - - provide the customer with current bid and offer quotations for the penny stock; - - explain the compensation of the broker-dealer and its salesperson in the transaction; - - provide monthly account statements showing the market value of each penny stock held in the customer's account; - - make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser's executed acknowledgement of the same; and - - provide a written agreement to the transaction. These requirements may have the effect of reducing the level of trading activity in the secondary market for our stock. Because our shares are subject to the penny stock rules, you may find it more difficult to sell your shares. WE HAVE ADOPTED CERTAIN MEASURES THAT MAY MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE CONTROL OF OUR COMPANY AND COULD LOWER THE PRICE OF OUR STOCK. On October 4, 2000, we approved a stockholder rights plan to protect stockholders in the event of an unsolicited attempt to acquire our company in a manner that would not be in the best interests of our stockholders. This stockholder rights plan could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of our company. Our Board of Directors is also classified into three classes of directors serving staggered three-year terms. Such classification of the Board of Directors expands the time required to change the composition of a majority of directors and may tend to discourage a proxy contest or other takeover bid for our company. The issuance of common stock under a stockholder rights plan could decrease the amount of earnings and assets available for distribution to the holders of our common stock or could adversely affect the rights and powers, including voting rights, of the holders of our common stock. In certain circumstances, such issuance could have the effect of decreasing the market price of our common stock. USE OF PROCEEDS The 40,000,000 shares of common stock covered by this prospectus will be sold by Dutchess Private Equities Fund, LP who will receive all of the proceeds from such sales. We will not receive any proceeds from the sale of the 40,000,000 shares. However, we will receive proceeds from the sale of our common shares pursuant to our Investment Agreement with Dutchess Private Equities Fund. 13 For illustrative purposes, we have set forth below our intended use of proceeds for the range of net proceeds indicated below to be received under the Investment Agreement. The Gross Proceeds represent the total dollar amount that Dutchess Private Equities Fund, L.P. is obligated to purchase. The table assumes estimated offering expenses of $25,000.
Proceeds Proceeds Proceeds Proceeds If 100% Sold If 50% Sold If 25% Sold If 10% Sold ------------- ------------ ----------- ----------- Gross Proceeds $10,000,000 $5,000,000 $2,500,000 $1,000,000 Estimated Expenses of the Offering $ 25,000 $ 25,000 $ 25,000 $ 25,000 ------------- ----------- ----------- ----------- Net Proceeds $ 9,975,000 $4,975,000 $2,475,000 $ 975,000 ============= =========== =========== =========== Priority Priority Priority Priority ------------- ------------ ------------- ------------ Working capital and general corporate expenses 1st $2,000,000 $2,000,000 $2,000,000 $ 975,000 Expansion of internal operations 2nd $1,500,000 $1,500,000 $ 475,000 $ - Potential acquisition costs (1) 3rd $6,475,000 $1,475,000 $ - $ - ------------ ----------- ------------ ----------- $9,975,000 $4,975,000 $2,475,000 $ 975,000 ============ =========== ============ ===========
Proceeds of the offering which are not immediately required for the purposes described above will be invested in United States government securities, short-term certificates of deposit, money market funds and other high-grade, short-term interest-bearing investments. (1) From time to time we evaluate opportunities to make acquisitions of assets or businesses that we believe would help us achieve our goal of profitability, but we are not currently planning any material acquisitions. DETERMINATION OF OFFERING PRICE The selling stockholders may sell shares in any manner at the current market price or through negotiated transactions with any person at any price. DILUTION Our net tangible book value as of December 31, 2003 was $205,232, or $0.01 per share of common stock. Net tangible book value per share is determined by dividing our tangible book value (total tangible assets less total liabilities) by the number of outstanding shares of our common stock. Net tangible book value as of December 31, 2003 is calculated by subtracting our net intangible asset of $7,500 that is included in other assets from net total book value (total assets less total liabilities) of $212,732. Since this offering is being made solely by the selling stockholders and none of the proceeds will be paid to us, our net tangible book value will be unaffected by this offering. Our net tangible book value, however, will be impacted by the common stock to be issued to Dutchess Private Equities Fund, L.P. The amount of dilution will depend on the offering price and number of shares to be issued. The following example shows the dilution to new investors at an assumed offering price of $0.24 per share which is based on the closing price of our common stock on June 10, 2004 of $0.25 adjusted for the 5% discount at which we will issue shares under our agreement with Dutchess Private Equities Fund. The discount is defined as 95% of the lowest closing bid price of our common stock during the five consecutive trading day period immediately following our notice to Dutchess Private Equities Fund of our election to exercise our put rights. 14 If we assume that we were to issue 100%, 50%, 25% and 10% of the 40,000,000 shares of common stock to Dutchess Private Equities Fund, L.P. at an assumed offering price of $0.24 per share, less $25,000 of offering expenses, our net tangible book value as of December 31, 2003 would have been as follows:
Assumed percentage of shares issued 100% 50% 25% 10% Number of shares issued (in millions) 40 20 10 4 Assumed public offering price per share $0.24 $0.24 $0.24 $0.24 Net tangible book value per share before this offering $0.01 $0.01 $0.01 $0.01 Net tangible book value after this offering $9,780,232 $4,980,232 $2,580,232 $1,140,232 Net tangible book value per share after this offering $0.16 $0.12 $0.08 $0.05 Dilution of net tangible book value per share to new investors $0.08 $0.12 $0.16 $0.19 Increase in net tangible book value per share to existing shareholders $0.15 $0.11 $0.07 $0.04
You should be aware that there is an inverse relationship between our stock price and the number of shares to be issued under the Investment Agreement to Dutchess Private Equities Fund, L.P. That is, as our stock price declines, we would be required to issue a greater number of shares under the Investment Agreement for a given advance. This inverse relationship is demonstrated by the table below, which shows the number of shares to be issued under the Investment Agreement at a price of $0.24 per share and 75%, 50% and 25% discounts to that price.
Offering price: $0.24 75% 50% 25% - PURCHASE PRICE:(1) $0.06 $0.12 $0.18 $0.24 NO. OF SHARES:(2) 40,000,000 20,000,000 13,333,334 10,000,000 TOTAL OUTSTANDING:(3) . 60,987,956 40,987,956 34,321,289 30,987,956 PERCENT OUTSTANDING:(4) 65.6% 48.8% 38.8% 32.3% (1) Represents market price. (2) Represents the number of shares of common stock to be issued at the prices set forth in the table to generate $2.4 million in gross proceeds. (3) Represents the total number of shares of common stock outstanding after the issuance of the shares, assuming no issuance of any other shares of common stock. (4) Represents the shares of common stock to be issued as a percentage of the total number shares of common stock outstanding (assuming no exercise or conversion of any options, warrants or other convertible securities).
CAPITALIZATION The following table shows our capitalization at March 31, 2004:
Preferred stock, $0.01 par value, 10,000,000 shares authorized, none issued and outstanding 0 Common stock, $0.001 par value, 200,000,000 shares authorized, 21,445,181 issued and outstanding 21,445 Additional paid-in capital 46,921,821 Accumulated deficit (47,051,880) Total shareholders' equity (deficit) $ (108,614)
SELLING SECURITY HOLDERS Based upon information available to us as of April 9, 2004, the following table sets forth the name of the selling stockholder, the number of shares owned, the number of shares registered by this prospectus and the number and percent of outstanding shares that the selling stockholder will own after the sale of the registered shares, assuming all of the shares are sold. The information provided in the table and discussions below has been obtained from the selling stockholder. The selling stockholder may have sold, transferred or otherwise disposed of, or may sell, transfer or otherwise dispose of, at any time or from time to time since the date on which they provided the information regarding the shares beneficially owned, all or a portion of the shares of common stock beneficially owned in transactions exempt from the registration requirements of the Securities Act of 1933. As used in this prospectus, "selling stockholder" includes donees, pledgees, transferees or other successors-in-interest selling shares received from the named selling stockholder as a gift, pledge, distribution or other non-sale related transfer. However, this registration statement does not cover sales by donees, pledges, transferees or other successors-in-interest of Dutchess Private Equities Fund, L.P. 15 Beneficial ownership is determined in accordance with Rule 13d-3(d) promulgated by the Commission under the Securities Exchange Act of 1934. Unless otherwise noted, each person or group identified possesses sole voting and investment power with respect to the shares, subject to community property laws where applicable.
Ownership Before Offering Shares Being Offered Ownership After Offering(1) ------------------------- -------------------- ------------------------ Dutchess Private Equities Fund, LP(2) -0- 40,000,000 -0- (1) The numbers assume that the selling stockholder has sold all of the shares offered hereby prior to completion of this Offering. (2) Dutchess is a private limited partnership whose business operations are conducted through its general partner, Dutchess Capital Management, LLC. Michael Novielli and Douglas H. Leighton are Managing Members of Dutchess Capital Management, LLC, and have voting and dispositive power with respect to securities held by Dutchess Private Equities Fund, LP.
PLAN OF DISTRIBUTION The selling stockholder will act independently of us in making decisions with respect to the timing, manner and size of each sale. The selling stockholder may sell the shares from time to time: - - in transactions on the Over-the-Counter Bulletin Board or on any national securities exchange or U.S. inter-dealer system of a registered national securities association on which our common stock may be listed or quoted at the time of sale; - - in private transactions and transactions otherwise than on these exchanges or systems or in the over-the-counter market; - - at prices related to such prevailing market prices; - - in negotiated transactions; - - in a combination of such methods of sale; or - - any other method permitted by law. The selling stockholder may effect such transactions by offering and selling the shares directly to or through securities broker-dealers, and such broker-dealers may receive compensation in the form of discounts, concessions or commissions from the selling stockholder and/or the purchasers of the shares for whom such broker-dealers may act as agent or to whom the selling stockholder may sell as principal, or both, which compensation as to a particular broker-dealer might be in excess of customary commissions. Dutchess Private Equities Fund, L.P., Charleston Capital Corporation and any other broker-dealers who act in connection with the sale of its shares will be deemed to be "underwriters" within the meaning of the Securities Act, and any discounts, concessions or commissions received by them and profit on any resale of the shares as principal will be deemed to be underwriting discounts, concessions and commissions under the Securities Act. 16 On or prior to the effectiveness of the registration statement to which this prospectus is a part, we will advise the selling stockholder that it and any securities broker-dealers or others who may be deemed to be statutory underwriters will be governed by the prospectus delivery requirements under the Securities Act. Under applicable rules and regulations under the Securities Exchange Act, any person engaged in a distribution of any of the shares may not simultaneously engage in market activities with respect to the common stock for the applicable period under Regulation M prior to the commencement of such distribution. In addition and without limiting the foregoing, the selling stockholder will be governed by the applicable provisions of the Securities Exchange Act, and the rules and regulations thereunder, including without limitation Rules 10b-5 and Regulation M, which provisions may limit the timing of purchases and sales of any of the shares by the selling stockholder. All of the foregoing may affect the marketability of our securities. On or prior to the effectiveness of the registration statement of which this prospectus is a part, we will advise the selling stockholder that the anti-manipulation rules under the Securities Exchange Act may apply to sales of shares in the market and to the activities of the selling stockholder and any of its affiliates. We have informed the selling stockholder that it may not: - - engage in any stabilization activity in connection with any of the shares; - - bid for or purchase any of the shares or any rights to acquire the shares; - - attempt to induce any person to purchase any of the shares or rights to acquire the shares other than as permitted under the Securities Exchange Act; or - - effect any sale or distribution of the shares until after the prospectus shall have been appropriately amended or supplemented, if required, to describe the terms of the sale or distribution. We have informed the selling stockholder that it must effect all sales of shares in broker's transactions, through broker-dealers acting as agents, in transactions directly with market makers, or in privately negotiated transactions where no broker or other third party, other than the purchaser, is involved. The selling stockholder may indemnify any broker-dealer that participates in transactions involving the sale of the shares against certain liabilities, including liabilities arising under the Securities Act. Any commissions paid or any discounts or concessions allowed to any broker-dealers, and any profits received on the resale of shares, may be deemed to be underwriting discounts and commissions under the Securities Act if the broker-dealers purchase shares as principal. In the absence of the registration statement to which this prospectus is a part, the selling stockholder may be able to sell its shares only pursuant to the limitations of Rule 144 promulgated under the Securities Act. We expect to incur approximately $25,000 in expenses related to this registration statement. Our expenses consist mainly of accounting and legal fees. Our estimate of $25,000 in expenses does not include amounts we may pay to Charleston Capital Corporation as Placement Agent. 17 We engaged Charleston Capital Corporation as our placement agent with respect to the securities to be issued under the Equity Line of Credit. To our knowledge, Charleston has no affiliation or business relationship with Dutchess Private Equities Fund, L.P. Charleston will be our exclusive placement agent in connection with the Investment Agreement. We agreed to pay Charleston 1% of the gross proceeds from each put with an aggregate maximum of $10,000 over the term of our agreement. The Placement Agent agreement terminates when our Investment Agreement with Dutchess Private Equities Fund terminates pursuant to the terms of that Investment Agreement. LEGAL PROCEEDINGS Beginning in December 2000, we pledged as loan guarantees certain funds held as money market funds and certificates of deposit to collateralize margin loans for the following executive officers of the Company: (1) Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A. Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones, then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees of the Company. Our purpose in collateralizing the margin loans was to prevent the sale of our common stock owned by these officers while we were pursuing efforts to raise additional capital through private equity placements. The sale of that common stock could have hindered our ability to raise capital in such a manner and compromised our continuing efforts to secure additional financing. We were also trying to accommodate the requests of the named executive officers, who were seeking to preserve their financial liquidity. We believe this action served our purpose of assuring stable management and leadership for our future. The margin loans were obtained in March 1999 from institutional lenders and were secured by shares of our common stock owned by these officers. Each of the officers used the proceeds of their respective margin loans for investment purposes and usual and customary living expenses. None of the margin loans were recourse with respect to the officers and none of the loan guarantees were recourse with respect to us because at the times the margin loans were made and the funds pledged, the value of the common stock collateralizing the margin loans exceeded the loan amounts. Under the original terms of the arrangement, we charged each of the officers, pro rata, the difference between the rate of return earned by us before the collateralization of the margin loans on the funds that were to be the pledged funds and the rate of return earned on the pledged funds after the collateralization of the margin loans. We offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard against their respective salaries from the date the funds were pledged until November of 2002, when we underwent significant downsizing and Mr. Long, Mr. Hoch, and Mr. Millard began deferring their salaries. We offset such amounts due from Mr. Jones against his salary from the date the funds were pledged until the date of his departure from the Company in August 2001. The highest total amount of funds pledged for the margin loans guaranteed by us was approximately $2.0 million. The total balance of the margin loans guaranteed by us was approximately $1.3 million at December 31, 2002. At the time the funds were pledged, we believed we would have access to them because (a) our stock price was substantial and the stock pledged by the officers, if liquidated, would produce funds in excess of the loans payable, and (b) with respect to one of the institutional lenders (who was also assisting us as a financial advisor at the time), even if the stock price fell, we had received assurances from that institutional lender that the pledged funds would be made available as needed. During the fourth quarter of 2002, we requested partial release of the funds for operating purposes, which request was denied by an institutional lender. At that time, our stock price had fallen as well, and it became clear that both institutional lenders would not release the pledged funds. In light of these circumstances, we recognized a loss on the guarantees of $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable under related party guarantees on our balance sheet at December 31, 2002 because it became probable at that point that we would be unable to recover our pledged funds. During the quarter ended March 31, 2003, the lenders applied the pledged funds to satisfy the outstanding balances of the loans. The total balance of the margin loans guaranteed by us was zero at December 31, 2003. The pledged funds were classified as cash and cash equivalents on our balance sheet and disclosed in the accompanying footnotes in our Annual Report on Form 10-K for each of the years ended December 31, 2000 and 2001, respectively. The pledged funds were classified as cash and cash equivalents on our balance sheet and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002, respectively. After our request for partial release of the funds was denied by an institutional lender, the pledged funds were classified as cash pledged as collateral for related party obligations on our balance sheet and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. On June 30, 2003, we filed an amended Annual Report on Form 10-K for the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002 as a result of comments received from the Securities and Exchange Commission in connection with their review of our registration statement on Form S-3 that we originally filed on August 9, 2002. These amended reports included restated balance sheets that classified the pledged funds as cash pledged as collateral for related party obligations because by the time the amended reports were filed, it was clear that the funds would not be released as we had been assured. We may institute litigation or arbitration in collection of the outstanding repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which currently total $1,278,138. Presently, we have refrained from initiating action to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may have offsetting claims that total $1,445,500 collectively by virtue of their respective employment agreements based on our preliminary analysis. We have not pursued the outstanding repayment obligation of Mr. Jones because we do not consider a recovery attempt to be cost beneficial. The ultimate outcome of this matter cannot presently be determined. 18 On July 25, 2003, certain of our stockholders (those stockholders being Mike Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick, Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal action against us, Ernst & Young, LLP, and certain of our current and former directors (including the executive officers named above) in the District Court of the 45th Judicial District, Bexar County, Texas. With respect to us and the current and former directors named in the suit, the plaintiffs allege that we, acting through such directors, misstated in our 2000 and 2001 Form 10-Ks our ability to use for operational purposes the funds pledged as security for margin loans of certain of our executive officers, as discussed above. The plaintiffs allege and seek resulting economic and exemplary damages, rescission, interest, attorneys' fees and costs of court. We believe this suit is without merit and intend to vigorously defend the company and the directors named in the suit. As of June 4, 2004, there have been no material developments in the suit. The results of legal proceedings cannot be predicted with certainty. If we fail to prevail in this legal matter, our financial position, results of operations, and cash flows could be materially adversely affected. DIRECTORS AND EXECUTIVE OFFICERS The names and ages of all of our directors and executive officers, along with their respective positions, term of office and period such position(s) was held, is set forth in the following table. Members of the board are elected and serve for one year terms or until their successors are elected and qualify. All of the officers serve at the pleasure of the Board of Directors of the Company. Name Age Position Held - ----- --- -------------- Michael R. Long 59 Chief Executive Officer, Chief Financial Officer, Chairman of the Board and Director Louis A. Hoch 38 President, Chief Operating Officer, and Director Peter G. Kirby 64 Director BIOGRAPHIES OF OFFICERS AND DIRECTORS Set forth below is a brief description of the background of our officers and directors based on information provided by them to us. MICHAEL R. LONG has been our Chief Executive Officer, Chairman of the Board and Director since July 1998. In addition, Mr. Long has been our Chief Financial Officer since September 2003. Mr. Long has more than thirty years of senior executive management and systems development experience in six publicly traded companies, as well as operating a systems consulting business. Before assuming the top position at Payment Data Systems, Mr. Long was Vice President of Information Technology at Billing Concepts, Inc., the largest third party billing clearinghouse for the telecommunications industry. Mr. Long's career experience also includes financial services industry business development for Anderson Consulting and several executive positions in publicly traded telecommunications and financial services companies. LOUIS A. HOCH has been our President, Chief Operating Officer, and Director since July 1998. Mr. Hoch has more than fourteen years of management experience in large systems development; earning him national recognition as an expert in call centers, voice-systems and computer telephony integration. Mr. Hoch has held various key management positions with U.S. Long Distance, Billing Concepts, Inc. and Anderson Consulting. Mr. Hoch holds a BBA in Computer Information Systems and an MBA in International Business Management, both from Our Lady of the Lake University Business School. In 2000 and 2001, he served as a board member of Office e-procure, which provides branded office supply eCommerce sites for businesses. PETER G. KIRBY, Ph.D. SPHR CM, has been our Director since June 2001. Mr. Kirby distinguished himself in professional and community activities in a career that spans thirty-five years. He is an accomplished public speaker and has provided consultative services to Fortune 100 firms. Mr. Kirby has published numerous works in the fields of management, decision-making and human resources. He has been a director on many university advisory councils and boards and has served on many charitable committees and foundations. Mr. Kirby is currently a tenured professor of Management at Our Lady of the Lake University in San Antonio, Texas, where he has taught for the past fourteen years. 19 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, to our knowledge, certain information concerning the beneficial ownership of our common stock as of June 10, 2004 by each stockholder known by us to be (i) the beneficial owner of more than 5% of the outstanding shares of common stock, (ii) each current director, (iii) each of the executive officers named in the Summary Compensation Table who were serving as executive officers at the end of the 2003 fiscal year and (iv) all of our directors and current executive officers as a group:
NAME AMOUNT AND NATURE OF PERCENT OF CLASS (1) BENEFICIAL OWNERSHIP 5% STOCKHOLDERS CheckFree Investment Corporation 3,168,242 (2) 14.7% 2920 Green Valley Road Building 3, Suite 321-19 Henderson, NV 89014 NAMED EXECUTIVE OFFICERS AND DIRECTORS Michael R. Long 1,840,001 (3) 8.6% Louis A. Hoch 1,818,034 (4) 8.5% Peter G. Kirby 293,600 (5) 1.4% All executive officers and directors as a group (3 people) 3,951,635 (6) 18.4% (1) Based on a total of 21,495,181 shares of common stock issued and outstanding on June 10, 2004. (2) Based on a Schedule 13(g)/A filed on February 2, 2003, the most recent date for which information is available. (3) Includes 1,248,334 shares that Mr. Long has the right to acquire upon the exercise of stock options. (4) Includes 1,115,000 shares that Mr. Hoch has the right to acquire upon the exercise of stock options. (5) Includes 293,000 shares that Mr. Kirby has the right to acquire upon the exercise of stock options. (6) The address of all individual directors and executive officers is c/o Payment Data Systems, Inc., 12500 San Pedro, Suite 120, San Antonio, Texas 78216.
20 DESCRIPTION OF SECURITIES COMMON STOCK Our Articles of Incorporation authorize us to issue 200,000,000 shares of common stock, par value $.001 per share. VOTING RIGHTS. Each share of our common stock entitles the holder thereof to one vote, either in person or by proxy, at meetings of stockholders. Stockholders are not permitted to vote their shares cumulatively. Accordingly, the holders of more than 50% of the voting power can elect all of our directors. DIVIDEND POLICY. All shares of common stock are entitled to participate ratably in dividends when, as and if declared by our Board of Directors out of the funds legally available therefore. Any such dividends may be paid in cash, property or additional shares of common stock. We have not paid any dividends since inception and presently anticipate that all earnings, if any, will be retained for development of our business. We expect that no dividends on the shares of common stock will be declared in the foreseeable future. Any future dividends will be subject to the discretion of our Board of Directors and will depend upon, among other things, our future earnings, operating and financial condition, capital requirements, general business conditions and other pertinent facts. We may never pay dividends on our common stock. MISCELLANEOUS RIGHTS AND PROVISIONS. Holders of common stock have no preemptive or other subscriptions rights, conversions rights, redemption or sinking fund provisions. In the event of the liquidation or dissolution, whether voluntary or involuntary, of the company, each share of common stock is entitled to share ratably in any assets available for distribution to holders of the equity of the company after satisfaction of all liabilities. STOCKHOLDER RIGHTS PLAN. On October 4, 2000, we declared a dividend of one Right for each outstanding share of our common stock. Each Right entitles the registered holder to purchase one one-thousandth of a share of common stock at a purchase price of $14 on the earlier of (i) the tenth day following the public announcement that a person or group of affiliated or associated persons other than us, our subsidiaries or our employee benefit plans has acquired, or obtained the right to acquire, beneficial ownership of 20% or more of our outstanding common stock or (ii) the tenth business day following the commencement by any person other than us, our subsidiaries or our employee benefit plans, or the announcement of the intention to commence, a tender or exchange offer that would result in the ownership of 20% or more of our outstanding common stock. The Rights automatically trade with the common stock. INTEREST OF NAMED EXPERTS AND COUNSEL No expert or counsel within the meaning of those terms under Item 504 of Regulation S-B will receive a direct or indirect interest in our company or was our promoter, underwriter, voting trustee, director, officer, or employee. Nor does any such expert have any contingent based agreement with us or any other interest in or connection to us. 21 DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR SECURITIES ACT LIABILITIES Nevada law generally sets forth the powers of corporations to indemnify officers, directors, employees, and agents. Our Articles of Incorporation provide as follows: No director or officer shall have any personal liability to the corporation or its stockholders for the damages for breach of fiduciary duty as a director or officer, except that this Article shall not eliminate or limit the liability of a director or officer for (i) acts or omissions that involve intentional misconduct, fraud or a knowing violation of the law, or (ii) the payment of dividends in violation of the Nevada Revised Statutes. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or persons controlling us under the foregoing provisions, we have been advised that in the opinion of the SEC such indemnification is against public policy as expressed in the Securities Act, and is unenforceable for that reason. CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS This prospectus contains forward-looking statements that involve risks and uncertainties. We generally use words such as "believe," "may," "could," "will," "intend," "expect," "anticipate," "plan," and similar expressions to identify forward-looking statements. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the risks described in our "Risk Factor" section and elsewhere in this prospectus. Although we believe the expectations reflected in the forward-looking statements are reasonable, they relate only to events as of the date on which the statements are made, and our future results, levels of activity, performance or achievements may not meet these expectations. We do not intend to update any of the forward-looking statements after the date of this document to conform these statements to actual results or to changes in our expectations, except as required by law. DESCRIPTION OF BUSINESS INTRODUCTION We incorporated in the State of Nevada in July 1998. On July 25, 2003, we sold substantially all of our assets to Saro, Inc., a Delaware corporation, which is a wholly owned subsidiary of CyberStarts, Inc., a Delaware corporation. CyberStarts, Inc. subsequently changed its name to Harbor Payments, Inc. The aggregate selling price was $4,800,000, including $700,000 subject to certain earnout provisions, plus Saro's assumption of certain of our liabilities. We will receive $100,000 of the $700,000 contingent selling price if the gross revenues associated with the asset group that we sold equal or exceed $5,000,000 for the one year period beginning immediately after the sale. We will receive the remaining $600,000 of the $700,000 earnout if the gross revenues associated with the asset group that we sold equal or exceed $1,500,000 for each of the four consecutive quarterly periods beginning immediately after the sale. The assets sold represented our proprietary technology infrastructure along with certain third party software and hardware platforms and certain furniture and fixtures that supported our Electronic Bill Presentment and Payment, or EBPP, service offerings, including our eServ and eConsulting products. The following details the net book value of the assets sold at July 25, 2003: 22 Computer hardware 2,809,294 Software (third party) 1,462,983 Furniture and fixtures 596,140 Proprietary technology - Total cost 4,868,417 Less:accumulated depreciation and amortization (3,800,198) Total net book value of assets sold 1,068,219 We expensed the costs to develop our proprietary technology infrastructure as they were incurred so these assets had no recorded value at the date of sale. The assets sold represented virtually all of our assets which we used to produce substantially all of our revenue through the date we sold these assets. Therefore, we discontinued our primary operations and began to concentrate on building our electronic payments business using the assets that we retained after this sale. Before the sale of these assets, our primary operations consisted of hosting the electronic presentment of bills on the Internet for other companies and managing the related electronic payments from their consumers through third party payment processors. After the sale of these assets, our primary operations consist of functioning as a processor of electronic payments for other companies. We also continued to operate our bills.com consumer bill payment Web site through which we process online payments by consumers. We believe that the property and equipment we retained after this sale are sufficient to support our continuing operations as described below. CONTINUING OPERATIONS GENERAL We currently provide integrated electronic payment processing services to merchants and businesses, including all types of Automated Clearinghouse, or ACH, Network processing and credit and debit card-based processing services. The ACH Network is a nationwide electronic funds transfer system that is regulated by the Federal Reserve and provides for the clearing of electronic payments between participating financial institutions. Our ACH processing services enable merchants or businesses to both disburse or collect funds electronically using e-checks to transfer funds instead of traditional paper checks. An e-check is an electronic debit to a bank checking account that is initiated at the point-of-sale, on the Internet, over the telephone or via a bill payment sent through the mail and is processed using the ACH network. Our card-based processing services enable merchants to process both traditional card-present, or "swipe," transactions, as well as card-not-present transactions. A traditional card-present transaction occurs whenever a cardholder physically presents a credit or debit card to a merchant at the point-of-sale. A card-not-present transaction occurs whenever the customer does not physically present a payment card at the point-of-sale and may occur over the Internet, mail, fax or telephone. Our electronic payment processing may take place in a variety of forms and situations. For example, our capabilities allow merchants to convert a paper check to an e-check or receive card authorization at the point-of-sale, have their customer service representatives take e-check or card payments from their consumers by telephone, and enable their consumers to make e-check or card payments directly through the use of a Web site or by calling an Interactive Voice Response, or IVR, telephone system. We also operate an online payment processing service for consumers under the domain name www.bills.com through which consumers can pay anyone. We generate revenues by ------ charging fees for the electronic processing of payment transactions and related services. We charge certain merchants for these processing services at a bundled rate based on a percentage of the dollar amount of each transaction and, in some instances, additional fees are charged for each transaction. We charge other merchant customers a flat fee per transaction, and may also charge miscellaneous fees to our customers, including fees for returns, monthly minimums, and other miscellaneous services. We charge consumers that use our bills.com online payment service a flat monthly fee that allows them to make a certain number of payments in a month. We also charge these consumers an additional fee for each payment that exceeds the allowed number of payments in a given month. We operate solely in the United States as a single operating segment, and do not currently have any foreign operations even though one of our subsidiaries is named billserv.com - Canada, Inc. 23 INDUSTRY BACKGROUND The use of non-paper based forms of payment by consumers in the United States, such as credit and debit cards, ACH transfers and other electronic payments, has increased significantly over the past several years. According to the Federal Reserve, paper check use as a percentage of retail non-cash payments declined from 77.1% in 1995 to 59.5% in 2000. The growth of electronic commerce has made the acceptance of card-based and other electronic forms of payment a necessity for businesses, both large and small, in order to remain competitive. NACHA - The Electronic Payments Association reported that more than 1.3 billion e-check payments were made in 2003, which was a 154% increase over 2002. We believe that the electronic payment processing industry will continue to benefit from the following trends: Favorable Demographics As consumers age, we expect that they will continue to use the payment technology to which they have grown accustomed. More consumers are beginning to use card-based and other electronic payment methods for purchases at an earlier age. According to the Federal Reserve Survey of Consumer Finances, the percentage of households with consumers under the age of 30 years using debit cards increased from 24.5% in 1995 to 60.6% in 2001. As these consumers who have witnessed the wide adoption of card products, technology and the Internet comprise a greater percentage of the population and increasingly enter the work force, we expect that purchases using electronic payment methods will comprise an increasing percentage of total consumer spending. Because of the Internet's increasing adoption rate, businesses have a growing opportunity to conduct commerce with their consumers and business partners over the Internet. Increased Electronic Payment Acceptance by Small Businesses Small businesses are a vital component of the U.S. economy and are expected to contribute to the increased use of electronic payments methods. According to the U.S. Small Business Administration, small businesses generate more than 50% of the nonfarm private gross domestic product in the U.S. The lower costs associated with electronic payment methods are making these services more affordable to a larger segment of the small business market. In addition, we believe these businesses are experiencing increased pressure to accept electronic payment methods in order to remain competitive and to meet consumer expectations. As a result, many of these small businesses are seeking, and we expect many new small businesses will seek, to provide customers with the ability to pay for merchandise and services using electronic payment methods, including those in industries that have historically accepted cash and checks as the only forms of payment for their merchandise and services. Growth In Online Transactions Market researchers expect dramatic growth in card-not-present transactions due to the rapid growth of the Internet and electronic commerce. According to the U.S. Census Bureau, retail e-commerce sales for 2003 were $54.9 billion, an increase of 26% from $43.5 billion in 2002. The prevalence of the Internet makes having an online presence a basic consideration for those operating a business today. To remain competitive, many companies are seeking to leverage the Internet to provide operational efficiencies, create new revenue opportunities and maximize the longevity and profitability of their customer relationships. 24 PRODUCTS AND SERVICES Our service offerings are supported by our systems infrastructure that integrates certain proprietary components with processing systems outsourced to third party providers to offer our customers a flexible and secure payment process. We utilize SSL, or a secure sockets layer, so that connections and information are secure from outside inspection and 128-bit encryption to make information unreadable as it passes over the Internet for all electronic transactions that we process. Our systems infrastructure allows us to work with our customers to build a customized electronic payment service offering tailored to their specific needs. We have designed and implemented our integrated payment systems to function as gateways between our customers and our third party processing providers. Our systems provide for interfaces with our customers through which payment data is captured electronically and transferred through the connections we have with our processing providers. Our systems also provide a data warehousing capability so that all of a customer's payment data can be stored in one place to facilitate efficient data retrieval and analysis. We outsource our ACH transaction processing and card-based transaction processing to third party providers. Our card-based processing system is capable of connecting with all of the major card-based processors in the United States. We also outsource the processing of the payments initiated by consumers online at our bills.com Web site. The components of our service offering include all forms of ACH payment transaction processing, such as Re-presented Check (RCK), which is a consumer non-sufficient funds, or NSF, check that is re-presented for payment electronically rather than through the paper check collection system, and Accounts Receivable Check Conversion (ARC), which is a consumer paper check payment that is converted into an e-check. Our customers can initiate ACH transactions directly using an online terminal accessible through a Web site or we can initiate ACH transactions on their behalf. Our service offering also includes merchant account services for the processing of card-based transactions through the VISA and MasterCard networks, including online terminal services accessed through a Web site or retail services accessed via a physical terminal. We offer a proprietary Web-based customer service application that combines both ACH and card processing capabilities and allows companies to process one-time and recurring payments via e-checks or credit cards at the request of their consumers. In addition, we offer an Interactive Voice Response (IVR) telephone system to companies that accepts payments directly from consumers over the telephone using e-checks or credit cards. We also operate a consumer Web site focused on providing online bill payment services under the domain name www.bills.com. Consumers subscribe to the payment service and are allowed to make a limited number of payments each month for a flat monthly fee. The bills.com strategy is to provide the consumer with an efficient and secure interface for viewing, paying and managing bills via the Internet. We also market this portal service to online financial services providers looking to provide EBPP capabilities as part of their service offering to consumers. RELATIONSHIPS WITH SPONSORS AND PROCESSORS We have agreements with several processors to provide to us, on a non-exclusive basis, transaction processing and transmittal, transaction authorization and data capture, and access to various reporting tools. In order to provide payment processing services for ACH transactions, we must maintain a relationship with an Originating Depository Financial Institution, or ODFI, in the ACH Network , because we are not a bank and therefore not eligible to be an ODFI. The third party provider that handles our ACH processing maintains a relationship with several ODFIs on our behalf. Similarly, in order to provide payment processing services for Visa and MasterCard transactions, we must be sponsored by a financial institution that is a principal member of the Visa and MasterCard card associations. We have an agreement with Network 1 Financial, Inc. through which its member bank , Harris Bank, sponsors us for membership in the Visa and MasterCard card associations and settles card transactions for our merchants. This agreement may be terminated by the processor if we materially breach the agreement and we do not cure the breach within 30 days, or if we enter bankruptcy or file for bankruptcy. 25 Under our processing agreement with Network 1 Financial, we are financially liable for all fees, chargebacks and losses related to our card processing merchant customers. If, due to insolvency or bankruptcy of our merchant customers, or for another reason, we are not able to collect from them amounts that have been refunded to the cardholders because the cardholders properly initiated a chargeback transaction to reverse the credit card charges, we must bear the credit risk for the full amount of the cardholder transaction. We utilize a number of systems and procedures to evaluate and manage merchant risk, such as obtaining approval of prospective merchants from our processor and sponsor bank, setting transaction limits and monitoring account activity. We may also require cash deposits and other types of collateral from certain merchants to mitigate any such risk. We maintain a reserve for losses resulting from card processing and related chargebacks. We estimate our potential loss for chargebacks by performing a historical analysis of our chargeback loss experience with similar merchants and considering other factors that could affect that experience in the future, such as the types of card transactions processed and nature of the merchant relationship with their consumers. We also maintain a separate allowance for doubtful accounts for estimated losses resulting from the inability or failure of our merchant customers to make required payments for fees charged by us. Amounts due from customers may be deemed uncollectible because of merchant disputes, fraud, insolvency or bankruptcy. We determine the allowance for doubtful accounts based on an account-by-account review, taking into consideration such factors as the age of the outstanding receivable, historical pattern of collections and financial condition of the customer. We closely monitor extensions of credit and if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make contractual payments, additional allowances may be required. CUSTOMERS We do not depend on any one or a few major customers. Nearly all of our customers are consumers geographically dispersed throughout the United States utilizing our bills.com Internet bill payment service on a recurring monthly basis to pay household bills. The monthly average number of bills.com customers using our online payment service increased from 1,037 in 2001 to 1,408 in 2002 and 2,020 in 2003. Our other customers are merchants and businesses that use our ACH and/or card-based processing services in order to provide their consumers with the ability to pay for goods and services without having to use cash or a paper check. These merchant customers operate in a variety of retail industries. As of December 31, 2003 we had 8 merchant customers that were each generating an average of less than 100 transactions monthly. We first offered ACH processing services in the third quarter of 2003 and card-based processing services in the fourth quarter of 2003. SALES AND MARKETING We market and sell our products and services through direct contact by our sales personnel, as well as through non-exclusive resellers that act as an external sales force, with minimal direct investment in sales infrastructure and management. Our direct sales effort is coordinated by a sales executive and supported by other employees who function in sales capacities. We will continue to analyze our sales and marketing efforts in order to control costs, increase the effectiveness of our sales force, and broaden our reach through reseller initiatives and advantageous alliances. 26 Our primary market focus is on companies generating high volumes of electronic payment transactions. We tailor our sales efforts to reach this market by using resellers that have access to or existing relationships with such companies and by pre-qualifying prospective sales leads through direct contact or market research. Our sales personnel typically initiate contact with prospective customers that we identify as meeting our target profile. Most of our merchant customers have signed long-term contracts, with generally three-year terms, that provide for volume-based transaction fees. We processed our first ACH transactions during the third quarter of 2003 and processed our first card-based transactions during the fourth quarter of 2003. COMPETITION The payment processing industry is highly competitive. Many small and large companies compete with us in providing payment processing services and related services to a wide range of merchants. There are a number of large transaction processors, including First Data Merchant Services Corporation, Concord EFS, Inc., National Processing, Inc., and Global Payments, Inc., that serve a broad market spectrum from large to small merchants and provide banking, ATM and other payment-related services and systems in addition to card-based payment processing. There are also a large number of smaller transaction processors that provide various services to small and medium-sized merchants. Many of our competitors have substantially greater capital resources than we have and operate as subsidiaries of financial or bank holding companies, which may allow them on a consolidated basis to own and conduct depository and other banking activities that we do not have the regulatory authority to own or conduct. We believe that the principal competitive factors in our market include: - - quality of service - - reliability of service - - ability to evaluate, undertake and manage risk - - speed in implementing payment processes - - price and other financial terms - - multi-channel payment capability We believe that our specific focus on providing integrated payment processing solutions to merchants, in addition to our understanding of the needs and risks associated with providing payment processing services electronically, gives us a competitive advantage over other competitors, which have a narrower market perspective, and over competitors of a similar or smaller size that may lack our experience in the electronic payments industry. Furthermore, we believe we present a competitive distinction through the use of our internal technology to provide a single integrated payment storage or warehouse that consolidates, processes, tracks and reports all payments regardless of payment source or channel. TRADEMARKS We own federally registered trademarks on the marks Bills.com, and Bills.com and design, and have applied for trademarks on Payment Data Systems, Inc., and Payment Data Systems, Inc. and design with the United States Patent and Trademark Office. We have also secured domain name registrations for bills.com, paymentdatasystems.com, paymentdata.org and paymentdata.com. We rely on a combination of copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and other intellectual property protection methods to protect our services and related products. DISCONTINUED OPERATIONS GENERAL 27 Prior to July 25, 2003, we provided EBPP and related services to companies that generate recurring bills to their consumers. On July 25, 2003, we sold substantially all of the assets that we used in providing these EBPP services. After we sold these assets, we no longer provided EBPP services, which are presented in our financial statements as discontinued operations. We believe that the property and equipment we retained after this sale are sufficient to support our continuing operations as described above. During the years ended December 31, 2003, 2002 and 2001, our discontinued operations provided revenue of $2,155,000, $4,129,000 and $2,925,000, respectively. EBPP is the process of sending bills in an electronic format to consumers securely through the Internet and processing Internet payment of bills utilizing an electronic transfer of funds. This service offering allowed companies to outsource their electronic billing process, providing them a single point of contact for designing, developing, implementing and managing their EBPP process. We offered services to consolidate billing information and then securely deliver an electronic bill to the biller's payment Web site, the consumer's e-mail inbox and numerous Internet bill consolidation Web sites, such as those sponsored by financial institutions. Our EBPP services allowed billers to establish an interactive, online relationship with their consumers by integrating Internet customer care and direct marketing with the electronic bill. We also provided professional services to assist with the implementation and maintenance of an electronic bill offering. In addition, we offered consumer marketing support to assist billers in encouraging their consumers to switch from paper to electronic billing. We generated EBPP revenue by charging volume-based fees fixed under long-term contracts for transactions processed through our system, such as loading, delivering, viewing and paying bills, customer care interactions, handling payment returns and consolidating remittances. In certain instances, we received a fixed amount per e-bill delivered and made available to a consumer regardless of whether that consumer paid the e-bill using our services. We also typically received an up-front fee from a customer to cover the initial basic implementation of the contracted services. We charged customers that contracted for professional consulting services on a time and materials basis and charged license fees for the use of our proprietary gateway services technology and the CheckFree iSolutions software that was resold by us as an authorized reseller of CheckFree iSolutions software in Australia only. DISCONTINUED PRODUCTS AND SERVICES The components of our EBPP service offering, all of which were available to customers and generated revenue, included: eServ eServ was our flagship product and the foundation for our comprehensive EBPP services. eServ provided our customers with a single offering for developing and managing their entire EBPP capabilities. Our eServ product provided outsourced creation and management of presentment and payment processes for a biller-direct site and all aggregator sites, as well as payment processing and full reporting and reconciliation capabilities. Our offering also supported the EBPP process with Internet-enabled customer care services, available as either a Web-based tool for our clients to deliver customer support in-house or on an outsourced basis using our employees to perform customer service. eConsulting eConsulting was the our professional services group that offered electronic billing, customer care, project management, and IT consulting services to both existing billing customers and the EBPP industry in general. Our eConsulting group offered services ranging from project monitoring to complete turnkey project development and implementation. eServ Gateway 28 Our eServ Gateway offered billers who were already participating in EBPP a single distribution point to virtually all bill presentment and payment locations across the World Wide Web. The Gateway was designed to improve a biller's existing EBPP system, whether an in-house offering, biller direct site or limited distribution channel, by expanding the range of distribution partners. The Company's unique Gateway specifications could also be embedded as an OEM (Original Equipment Manufacturer) component within other companies' software or service offerings, affording such companies a cost-effective, proven method to give their clients and consumers the ability to make online payments, and view and pay bills through bank and internet payment portals. PRODUCT DEVELOPMENT Our total research and development expenses were $82,055, $461,065, and $760,082 for 2003, 2002, and 2001, respectively. We created a proprietary technology infrastructure to support all of the components of our service offering. Our systems consisted primarily of proprietary software applications that we integrated with third party hardware and software platforms. Substantially all of the assets related to our research and development expenditures were sold in July 2003. SALES AND MARKETING We sold our EBPP services through direct sales efforts that included marketing to existing customers led by our Account Management team. We also sold our services through organizations that had exclusive reseller agreements with us to sell our EBPP services. Our marketing efforts were primarily EBPP adoption-focused. Our professional staff of Account Managers actively assisted our customers in creating programs to encourage their consumers to utilize EBPP. CUSTOMERS Our primary market focus was on top-tier and middle-market companies generating high volumes of recurring (usually monthly) paper-based bills. We serviced billers in select vertical markets, such as utilities, telecom, cable, media and financial services industries, as well as the higher education market. All of our billing customers signed long-term contracts, with generally three to five-year terms, that provided for set-up fees, in certain cases, and volume-based transaction fees. The number of EBPP customers served by us for the three years ended December 31, 2003, including additions and attrition, was as follows:
Number at beginning of period Additions Attrition Number at end of period ----------------------------- --------- --------- ----------------------- Year ended December 31, 2001 49 53 1 101 Year ended December 31, 2002 101 34 16 119 Year ended December 31, 2003 119 0 119 0
29 The attrition in 2003 was due primarily to the assignment of the customer contracts to Saro in conjunction with the sale of substantially all of our assets in July 2003. The attrition in 2002 is primarily attributable to the loss of certain customers serviced via resellers as a normal part of the resellers' account turnover and the migration of certain customers to in-house EBPP offerings after their billing agreements expired. EBPP services provided to CenterPoint Energy, Inc., formerly Reliant Energy, accounted for approximately 12%, 16% and 23% of total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. EMPLOYEES As of June 10, 2004, we had 7 employees. We are not a party to any collective bargaining agreements. We believe that our relations with our employees are good. ADDITIONAL INFORMATION Our common stock is registered with the SEC under section 12(g) of the Securities Exchange Act of 1934. We file with the SEC periodic reports on Forms 10-K, 10-Q and 8-K, and proxy statements, and our officers and directors file reports of stock ownership on Forms 3, 4 and 5. We intend to send annual reports containing audited financial statements to our shareholders. Additionally, we filed with the Securities and Exchange Commission a registration statement on Form SB-2 under the Securities Act of 1933 for the shares of common stock in the offering, of which this prospectus is a part. This prospectus does not contain all of the information in the registration statement and the exhibits and schedules that were filed with the registration statement. For further information we refer you to the registration statement and the exhibits and schedules that were filed with the registration statement. Statements contained in this prospectus about the contents of any contract or any other document that is filed as an exhibit to the registration statement are not necessarily complete, and we refer you to the full text of the contract or other document filed as an exhibit to the registration statement. A copy of the registration statement and the exhibits and schedules that were filed with the registration statement may be inspected without charge at the Public Reference Room maintained by the Securities and Exchange Commission at 450 Fifth Street, N.W., Washington, D.C. 20549, and copies of all or any part of the registration statement may be obtained from the Securities and Exchange Commission upon payment of the prescribed fee. Information regarding the operation of the Public Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a web site that contains reports, proxy and information statements, and other information regarding registrants that file electronically with the SEC. The address of the site is www.sec.gov. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PLAN OF OPERATION The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto, and other financial information included elsewhere in this prospectus. This prospectus contains forward-looking statements that involve risks and uncertainties. Actual results in future periods may differ materially from those expressed or implied in such forward-looking statements as a result of a number of factors, including, but not limited to, the risks discussed under the heading "Risk Factors" and elsewhere in this prospectus. 30 OVERVIEW On July 25, 2003 we sold substantially all of our assets to Saro, Inc., a Delaware corporation , which is a wholly owned subsidiary of CyberStarts, Inc., a Delaware corporation. The aggregate selling price was $4,800,000, including $700,000 subject to certain earnout provisions, plus Saro's assumption of certain or our liabilities. The selling price was determined through extensive negotiations between Saro and us. Our Board of Directors, in its reasonable business judgment, approved the transaction based upon the following factors: 1) the extensive search for a purchaser; 2) the number of offers made by potential purchasers; 3) our ability to raise capital to operate our business; and 4) future trends in the industry. The transaction was approved by a majority of our shareholders at a Special Meeting of Shareholders held on July 14, 2003. The assets sold represented our proprietary technology infrastructure along with certain third party software and hardware platforms and certain furniture and fixtures that supported our EBPP service offerings, including our eServ and eConsulting products. The carrying value of these non-current assets was approximately $1,068,000 at July 25, 2003. Saro also assumed certain of our current and non-current liabilities with carrying values of $83,000 and $30,000, respectively, at July 25, 2003. The assets sold represented virtually all of our assets, which we used to produce nearly all of our revenue; therefore, we ceased our primary EBPP operations and will continue to operate our bills.com consumer bill payment portal and concentrate on building our electronic payments business. The results of operations for the asset group disposed of have been reported as discontinued operations in the accompanying statements of operations. We retained our accounts receivable and related deferred revenue associated with the customers of the discontinued operations, as well as certain accounts payable and accrued liabilities related to the discontinued operations. At December 31, 2003, our balance sheet included approximately $38,000 of net accounts receivable and approximately $277,000 of current liabilities that related to the discontinued operations. Prior to the transaction, we provided EBPP and related services to companies that generate recurring bills, primarily in the United States. EBPP is the process of sending bills to consumers securely through the Internet and processing Internet payment of bills utilizing an electronic transfer of funds. Our service offering allowed companies to outsource their electronic billing process, providing them a single point of contact for developing, implementing and managing their EBPP process. We offered services to consolidate customer billing information and then securely deliver an electronic bill to the biller's own payment Web site hosted by us, the consumer's e-mail inbox and numerous Internet bill consolidation Web sites, such as those sponsored by financial institutions. Our EBPP services allowed billers to establish an interactive, online relationship with their consumers by integrating Internet customer care and direct marketing with the electronic bill. We also provided Internet-based customer care interaction services and professional services to assist with the implementation and maintenance of an electronic bill offering. As a condition of the sale to Saro, Inc., we and certain of our principal officers agreed, for a period of two years, not to compete in the business of providing electronic bill presentment services in conjunction with bill payment solutions. Under such non-compete provisions, we and the applicable officers are prohibited from competing in the business of providing electronic bill presentment services in conjunction with bill payment solutions 1) for our former customers; or 2) in geographic areas in which we provided electronic bill presentment services in conjunction with bill payment solutions prior to the transaction. 31 We believe that these non-compete provisions will not have a significant impact on our strategic plan to provide electronic payment processing and related services. We continue to operate an Internet electronic payment processing service for consumers under the domain name www.bills.com and provide integrated electronic payment services, including credit and debit card-based processing services and transaction processing via the ACH network. Since inception, we have incurred operating losses each quarter, and as of December 31, 2003, we have an accumulated deficit of $46.7 million. CRITICAL ACCOUNTING POLICIES GENERAL Management's discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to the reported amounts of revenues and expenses, bad debt, investments, intangible assets, income taxes, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates under different assumptions or conditions. We consider the following accounting policies to be critical because the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change or because the impact of the estimates and assumptions on financial condition or operating performance is material. RESERVE FOR LOSSES ON CARD PROCESSING If, due to insolvency or bankruptcy of the merchant, or for another reason, we are not able to collect amounts from our card processing merchant customers that have been properly "charged back" by the cardholders, we must bear the credit risk for the full amount of the cardholder transaction. We may require cash deposits and other types of collateral from certain merchants to minimize any such risk. In addition, we utilize a number of systems and procedures to manage merchant risk. Card merchant processing loss reserves are primarily determined by performing a historical analysis of our chargeback loss experience and considering other factors that could affect that experience in the future, such as the types of card transactions processed and nature of the merchant relationship with their consumers. This reserve amount is subject to risk that actual losses may be greater than our estimates. At December 31, 2003, we did not have a significant card merchant processing loss reserve due to the limited volume of transactions that we processed since the inception of our card processing services during the fourth quarter of 2003. We have not incurred any chargeback losses to date. Our estimate for chargeback losses is likely to increase in the future as our volume of card-based transactions processed increases. 32 BAD DEBT We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or failure of our customers to make required payments. We determine the allowance for doubtful accounts based on an account-by-account review, taking into consideration such factors as the age of the outstanding balance, historical pattern of collections and financial condition of the customer. Past losses incurred by us due to bad debt have been within our expectations. We recorded bad debt expense of $10,700, $30,000 and $21,000 for 2003, 2002 and 2001, respectively, and recorded bad debt write-offs of $54,742, $1,734 and $12,069 to our allowance for doubtful accounts in 2003, 2002 and 2001, respectively. At December 31, 2003 and 2002, the balance of the allowance for doubtful accounts was $3,155 and $47,197, respectively. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make contractual payments, additional allowances may be required. Our estimate for bad debt losses is likely to increase in the future as our volume of transactions processed increases. VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS We assess the impairment of long-lived and intangible assets at least annually, and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important, which could trigger an impairment review, include the following: significant underperformance relative to historical or projected future cash flows; significant changes in the manner of use of the assets or the strategy of the overall business; and significant negative industry trends. When management determines that the carrying value of long-lived and intangible assets may not be recoverable, impairment is measured as the excess of the assets' carrying value over the estimated fair value. During the second quarter of 2003, we performed an impairment review because we expected to sell the asset group used to provide electronic bill payment and presentment services. We determined that the asset group to be sold was impaired and recorded a non-cash charge of $200,000, which is included as a component of discontinued operations in the accompanying consolidated statement of operations. Fair value was based on the expected selling price of the asset group. During the fourth quarter of 2003, we performed an impairment review because we expected to sell certain furniture not currently being utilized. We determined that the furniture expected to be sold was impaired and recorded a non-cash charge of $17,000, which is included as a component of selling, general and administrative expense in the accompanying consolidated statement of operations. Fair value was based on the selling price of similar assets. During the fourth quarter of 2002, we performed an impairment review because of the uncertainty of our ability to continue as a going concern due to decreased liquidity, which indicated that the carrying value of certain long-lived assets may not be recoverable. We determined that customer relationship management software and document archival and retrieval software with a total carrying amount of $855,000 were no longer recoverable and recorded a non-cash charge of $855,000, which is included as a component of discontinued operations in the accompanying consolidated statement of operations. Fair value was based on the expected future cash flows to be generated by these assets, which was determined to be zero because of our inability to deploy and utilize the assets to provide revenue-generating services. No impairment losses were recorded in 2001. 33 INCOME TAXES Deferred tax assets and liabilities are recorded based on the difference between the tax bases of assets and liabilities and their carrying amount for financial reporting purposes, as measured by the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred tax assets are computed with the presumption that they will be realizable in future periods when pre-taxable income is generated. Predicting the ability to realize these assets in future periods requires a great deal of judgment by management. It is our judgment that we cannot predict with reasonable certainty that the deferred tax assets as of December 31, 2003 will be fully realized in future periods. Accordingly, a valuation allowance has been provided to reduce the net deferred tax assets to $0. At December 31, 2003, we had available net operating loss carryforwards of approximately $34.6 million, which expire beginning in the year 2020. RESULTS OF CONTINUING OPERATIONS Subsequent to the sale of substantially all of our assets to Saro, Inc., our only continuing revenues were derived from the operation of an Internet electronic payment processing service for consumers under the domain name www.bills.com. We also provide integrated electronic payment services to merchants and businesses, including credit and debit card-based processing services and transaction processing via the ACH network. We processed our first ACH transactions during the third quarter of 2003 and processed our first card-based transactions during the fourth quarter of 2003, but the related transaction volumes for 2003 were not significant so the only component of our service offering that generated significant revenue for 2003 was the bills.com payment service. Total revenues for 2003 increased 55% to $119,297 from $77,070 for 2002. Total revenues for 2002 increased 76% from $43,835 for 2001. The increases from the prior years were primarily attributable to an increase in the number of consumers subscribing to the bills.com payment service. The monthly average number of consumers using our online payment service for the years ended December 31 was as follows: 2003 2002 2001 ---- ---- ---- Average number of bills.com customers per month 2,020 1,408 1,037 The number of transactions generated by bills.com customers is not indicative of revenue growth because the majority of these customers pay a flat monthly fee to process up to a certain number of payments each month and do not exceed the maximum number of payments allowed. We expect our revenues to increase as we anticipate continued growth in the number of bills.com customers and additional merchant customers. Cost of services includes the cost of personnel dedicated to the creation and maintenance of connections to third party payment processors and fees paid to such third party providers for electronic payment processing services. Through our contractual relationships with our payment processors, we are able to process ACH and debit or credit card transactions on behalf of our customers and their consumers. We pay volume-based fees for debit and credit transactions initiated through these processors, and pay fees for other transactions such as returns, notices of change to bank accounts and file transmission. Cost of revenues was $138,009, $58,739 and $38,004 for 2003, 2002 and 2001, respectively. The increases from the prior years are due to the higher subscriber volume of the bills.com payment service and implementation fees charged in the last six months of 2003 by third party payment processors to initiate electronic payment processing services. We expect the cost of services to increase ratably as revenues increase. 34 Selling, general and administrative expenses decreased to $1,726,028 in 2003 from $2,431,566 for 2002 and $3,077,783 in 2001. The decrease in such expenses from 2002 to 2003 was primarily due to lower salary and benefit costs resulting from the personnel reductions made during 2002 and then again with the sale of substantially all of our assets in July 2003. The number of employees decreased from 35 immediately preceding this sale to 7 at December 31, 2003. The decrease from 2001 to 2002 is attributable to cost reductions resulting from the restructuring and realignment of our organization during the latter half of 2001 to better position us for current economic and market conditions. During the third quarter of 2001, we downsized and realigned our organization to make more efficient use of our resources and better match our infrastructure to market conditions and the current business environment since the overall growth of the economy and rate of technology spending by businesses had slowed. This realignment included the layoff of certain employees and reassignment of other employees to different functions to reduce our cash outflows and allow us to utilize our limited resources more prudently by eliminating functions that did not directly contribute to our goal of profitability. We expect selling, general and administrative expenses to decrease in 2004 as we realize the cost savings of downsizing to 7 employees for the full year. Depreciation and amortization was $130,671, $183,594 and $199,384 for 2003, 2002 and 2001, respectively. The decreases from year to year were due to lower depreciation related to certain assets that became fully depreciated during 2002 and 2001, respectively. We purchased $66,000 of computer equipment and software during 2003 and do not anticipate making significant capital expenditures in 2004. We expect depreciation and amortization to continue decreasing as existing assets become fully depreciated and significant additions are not anticipated. Net other income was $101,112 in 2003 compared to net other expense of $2,665,631 in 2002 and net other income of $352,124 in 2001. The improvement from 2002 to 2003 is primarily attributable to $1.1 million of interest expense related to the convertible debt issued in 2002, a $300,000 penalty for default under this convertible debt, and a $1.3 million loss on related party loan guarantees in 2002. The $1.1 million of interest expense recognized in 2002 included $238,000 of financing costs, a $259,00 debt discount for the detachable warrants issued with the convertible debt, and $539,000 in additional debt discount for the beneficial conversion feature of the debt. These items were to be amortized over the term of the debt, but were all fully recognized as interest expense in 2002 as a result of our default. The default occurred because we did not make the required principal payments in cash. We were unable to make the required payments in stock because the registration statement we filed with the Securities and Exchange Commission to register the resale of the common stock issuable to pay the note was not declared effective. The improvement is also due to $165,000 of consulting fees recognized in other income in the third quarter of 2003 for transitional EBPP consulting services provided to our former equal partner in an EBPP joint venture in Australia. The joint venture was dissolved as a result of the sale of substantially all of our assets during the third quarter of 2003. The consulting fees of $165,000 are included in continuing operations because such services were not prohibited as a condition of the sale of substantially all of our assets in July 2003 and were performed after the sale of the asset group. In addition to the expenses related to the convertible debt and related party guarantees in 2002, the decrease in net other income from 2001 to 2002 is attributable to lower interest income earned in 2002 as a result of lower invested balances and market interest rates. Loss from continuing operations improved to $1,774,299 in 2003 from $5,262,460 in 2002, primarily as a result of decreases in net other expenses and selling, general and administrative expenses. The increase in loss from continuing operations from $2,919,212 in 2001 to $5,262,460 in 2002 was primarily due to the increase in net other expenses. We expect that loss from continuing operations will improve in 2004 given our expectations for increased revenues, lower selling, general and administrative expenses and lower depreciation and amortization. 35 RESULTS OF DISCONTINUED OPERATIONS The following table presents the operating results for our discontinued operations for the years ended December 31, 2003, 2002 and 2001, which are reflected as discontinued operations in the Consolidated Statements of Operations. Results of operations for 2003 are not comparable to results for prior years because 2003 only includes operating revenues and expenses for the period from January 1, 2003 through July 25, 2003, which was the date of the sale of substantially all of our assets to Saro, Inc.
2003 2002 2001 ----------------- ------------------ ------------------ Service revenues: Implementation revenues $ 256,564 $ 311,712 $ 502,753 Transaction revenues 1,273,931 1,875,561 1,119,379 Consulting revenues 624,787 1,704,211 1,302,711 ----------------- ------------------ ------------------ Total service revenues 2,155,282 3,891,484 2,924,843 Software license revenues - 238,000 - ----------------- ------------------ ------------------ Total revenues 2,155,282 4,129,484 2,924,843 Cost of service revenues 1,436,449 4,403,605 4,957,157 Cost of software license revenues - 228,000 - ----------------- ------------------ ------------------ Total cost of revenues 1,436,449 4,631,605 4,957,157 Gross margin 718,833 (502,121) (2,032,314) General and administrative 308,998 1,517,118 1,403,097 Selling and marketing 120,833 873,775 1,942,435 Research and development 82,555 461,065 760,082 Provision for impairment of assets 200,000 855,117 - Depreciation and amortization 579,227 1,475,292 1,356,242 Other income (expense) 94,934 (7,729) 7,676 ----------------- ------------------ ------------------ Loss from discontinued operations before gain on disposal (477,846) (5,692,217) (7,486,494) Gain on disposal of discontinued operations 2,737,041 - - ----------------- ------------------ ------------------ Income (loss) from discontinued operations 2,259,195 (5,692,217) (7,486,494) ================= ================== ==================
Prior to the sale of substantially all of our assets, our revenues were principally derived from fees for implementing EBPP capabilities, processing EBPP transactions and providing related customer care, and consulting services. We also became a licensed reseller of CheckFree's e-billing software in Australia during 2002. The components of our service offering that generated revenue through July 25, 2003, include: - - Internet billing services for EBPP through a hosted payment Web site, direct delivery to the consumer's email inbox, or distribution via bill aggregators. - - Internet-enabled, interactive customer care services on an in-house or outsourced basis. 36 - - Professional consulting services for EBPP billers or software vendors needing value-added resources to deliver customized EBPP services, including payment gateway services that provided billers who were already participating in EBPP using in-house software a single distribution point to virtually any bill presentment and payment location across the World Wide Web in addition to their existing distribution points or biller direct site. - - Licensing of CheckFree e-billing software as an authorized reseller in Australia only. Total revenues decreased 48% to $2,155,282 in 2003 from $4,129,484 in 2002 due to the sale of substantially all of our assets in July 2003. Implementation fee revenue for 2003 included the recognition of the remaining balance of deferred revenue upon this sale. Total revenues increased 41% to $4,129,484 in 2002 from $2,924,843 in 2001. Of the total increase from the prior year, 63% was attributable to the growth in transaction fee revenue, while growth in consulting revenues, which includes revenue from the licensing of our gateway technology, accounted for 33% of the increase. These increases were due to an increase in the number of implemented billers and volume of transactions. As of December 31, 2002, we had 119 billers under contract who were in various stages of development, including 106 billers that were in full production or pilot stages, as compared to 84 billers in full production or pilot stages at December 31, 2001. Our first sale of a software license as a reseller of CheckFree's e-billing software in Australia in 2002 also contributed $238,000 to the increase in revenue from the prior year. The sale was made to an Australian billing service provider that was also an equal partner with us in a joint venture formed to provide EBPP services to the Australian market. One billing customer accounted for approximately 12%, 16% and 23% of total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. During 2002, we entered into two separate nonmonetary transactions whereby we licensed the use of our gateway technology to certain third party software vendors to be used as an original equipment manufacturer, or OEM, component of their product offering in exchange for software products from those vendors. We accounted for these transactions in accordance with APB Opinion No. 29, "Accounting for Nonmonetary Transactions." These exchanges were determined to culminate the earning process because the technology exchanged by us was held for sale in the ordinary course of business and the products received by us were expected to be deployed and utilized as productive assets. We recognized revenue related to these transactions at the fair value of the software received, which was determined by reference to vendor-specific objective evidence, because it was more clearly evident than the value of the assets transferred. The value of the software received was estimated by comparison to third party evidence including vendor-specific established pricing lists and historical sales information and was more readily determinable because we did not have a history of comparable cash sales of our payment gateway technology. We recognized $300,000 in a transaction where our technology was exchanged for customer relationship management software and concurrent seat licenses to use in providing customer care services via the Internet or telephone. We also recognized $300,000 in a transaction where our technology was exchanged for document archival and retrieval software to use in the storage of electronic billing statements. The carrying value of the gateway technology exchanged in both transactions was zero. We capitalized the software received at the time of acquisition and subsequently recognized a loss on impairment of these assets which took the carrying amount of these assets to zero. 37 Cost of revenues includes the cost of personnel dedicated to the design of electronic bill templates, creation of connections to third party aggregators and payment processors, testing and quality assurance processes related to implementation and presentment, as well as professional staff dedicated to providing contracted services to EBPP customers under consulting arrangements. Cost of revenues also includes fees paid for presentation of consumer bills on Web sites powered by aggregators and processing of payments for EBPP transactions by third party providers. Cost of revenues decreased 69% to $1,436,449 in 2003 from $4,631,605 for 2002. The decrease from 2002 was partially attributable to the sale of substantially all of our assets in July 2003 as well as lower salary and benefit costs due to the personnel reductions during 2002. Cost of revenues decreased 7% to $4,631,605 in 2002 from $4,957,157 for 2001. The decrease from 2001 to 2002 is primarily due to cost reductions that were implemented in the second half of 2001, which included a decrease in the number of personnel employed to provide revenue-producing services from an average of 79 such employees for 2001 to 63 in 2002. The cost savings from the prior year period were partially offset by the cost of the CheckFree software license that was resold in 2002, which was $228,000. General and administrative expenses directly related to the discontinued operations consisted of rent and costs of personnel providing direct support services for EBPP operations. These expenses decreased to $308,998 in 2003 from $1,517,118 in 2002 and were $1,403,097 in 2001. The decrease from 2002 was partially attributable to the sale of substantially all of our assets in July 2003 as well as lower salary and benefit costs due to the personnel reductions during 2002, and lower rental expenses under our amended lease agreement. In May 2002, we renegotiated the lease terms for our corporate headquarters to provide for a reduction in future rent expense of approximately $1.6 million over the remaining term of the lease. The lease amendment required us to expense a portion of our prepaid rent, which resulted in a one-time charge of $312,000 for the second quarter of 2002. This charge offset the rent savings from the amended lease agreement in 2002, which contributed to an overall increase in general and administrative expenses from 2001. Selling and marketing expenses directly related to the discontinued operations decreased to $120,833 in 2003 from $873,775 for 2002 and $1,942,435 for 2001. The decrease from 2002 was partially attributable to the sale of substantially all of our assets in July 2003 and was also due to reductions in our direct sales staff. The decrease in 2002 from 2001 was primarily the result of reductions in our direct sales staff, which contributed 74% to the decrease from the prior year, as well as lower related travel expenses and trade show participation, which contributed 23% to the decrease from the prior year. As we increased our focus throughout 2002 on using strategic reseller partners to provide sales opportunities related to the deployment and use of our EBPP services, we experienced a decrease in the amount of expenses related to our direct sales force. Research and development expenses directly related to the discontinued operations consisted primarily of the cost of personnel devoted to the design of new processes that would improve our electronic presentment and payment abilities and capacities, new customer care and direct marketing services, additional business-to-consumer applications, and integration of third party applications. These expenses decreased to $82,555 in 2003 from $461,065 in 2002 and $760,082 in 2001. The decrease from 2002 was partially attributable to the sale of substantially all of our assets in July 2003. The decreases from year to year were also due to a progressive focus on our core competencies in order to implement and service existing products. During our earlier stages, we applied additional resources to design and develop our base technology infrastructure and operating systems. All research and development costs were expensed as incurred. 38 Depreciation and amortization was $579,227, $1,475,292 and $1,356,242 for 2003, 2002 and 2001, respectively. The decrease from 2002 was partially attributable to the sale of substantially all of our assets in July 2003 and was also due to lower depreciation related to certain assets that became fully depreciated during 2002. The increase from 2001 was the result of writing off $207,000 of leasehold improvements in 2002 related to our corporate office facility due to the cancellation of the related lease in March 2003. During the fourth quarter of 2002, we performed an impairment review because the uncertainty of our ability to continue as a going concern due to decreased liquidity indicated that the carrying value of certain long-lived assets may not be recoverable. We determined that customer relationship management software and document archival and retrieval software with a carrying amount of $855,117 were no longer recoverable and recorded a non-cash charge of $855,117, which is included as a component of discontinued operations in the accompanying consolidated statement of operations. Fair value was based on the expected future cash flows to be generated by these assets, which was determined to be zero because of our inability to deploy and utilize the assets to provide revenue-generating services, due to our limited resources and lack of liquidity. During the second quarter of 2003, we performed an impairment review because we expected to sell the asset group comprising the discontinued operations. We determined that the asset group to be sold was impaired and recorded a non-cash charge of $200,000, which is included as a component of discontinued operations in the accompanying consolidated statement of operations. Fair value was based on the expected selling price of the asset group. Other income was $94,934 in 2003 and represented the gain on the settlement of a vendor payable directly related to the discontinued operations. Other income (expense) for 2002 and 2001 represented our equity in the loss and earnings, respectively, of our unconsolidated EBPP joint venture in Australia. The joint venture was dissolved as a result of our sale of substantially all of our assets during the third quarter of 2003. Income from discontinued operations improved to $2,259,195 in 2003 and included a gain on the disposal of the discontinued operations of $2,737,041. Loss from discontinued operations of $5,692,217 in 2002 decreased from $7,486,494 in 2001 primarily as a result of the overall increase in gross profit from the prior year. LIQUIDITY AND CAPITAL RESOURCES Our financial statements were prepared on the assumption that we will continue as a going concern, and our independent auditors have expressed doubt as to that assumption by issuing a going concern opinion on our financial statements for the year ended December 31, 2003. At March 31, 2004, our principal source of liquidity consisted of $268,000 of cash and cash equivalents, compared to $528,000 of cash and cash equivalents at December 31, 2003. We have incurred substantial losses since inception, which has led to a significant decrease in its cash position and a deficit in working capital. We sold substantially all of our assets in July 2003 and reduced expenditures for operating requirements. Despite these actions, we believe that our current available cash and cash equivalents along with anticipated revenues are likely insufficient to meet our anticipated cash needs for the foreseeable future. Consequently, our ability to continue as a going concern is likely contingent on our receiving additional funds in the form of equity or debt financing. We are currently aggressively pursuing strategic alternatives, including investment via an equity line of credit. In February 2004, we executed an agreement for an equity line of credit with Dutchess Private Equities Fund, LP ("Dutchess"). Under the terms of the agreement, we may elect to receive as much as $10 million from Dutchess in common stock purchases over the next three years at our option . We agreed to file a registration statement registering the resale of the shares of our common stock to be issued to Dutchess with the Securities and Exchange Commission, and have it declared effective before any funds may be received under the agreement. Any funds received will be used, as needed, to support on-going operations and enhance potential merger and acquisition activity. From time to time we evaluate opportunities to make acquisitions of assets or businesses that we believe would help us achieve our goal of profitability, but we are not currently planning any material acquisitions. We anticipate that the equity line of credit will provide sufficient cash flows to meet current operating requirements after the registration statement is declared effective. We also anticipate that the registration statement will become effective and we will be able to receive funds under the equity line of credit before our currently available sources of liquidity are extinguished. Our management estimates that our projected cash flow from operations, plus our cash reserves, will be sufficient to permit us to continue our current level of operations until July 31, 2004. If we are unable to receive funds from the equity line of credit because the registration statement becomes effective later than we currently anticipate or for any other reason, we may have to curtail or cease operations. 39 Net cash used in continuing operating activities was $2.0 million, $2.2 million and $2.8 million for 2003, 2002 and 2001, respectively. Net cash used in continuing operating activities was primarily attributable to operating net losses generated by early growth stage activities and overhead costs. We plan to focus on expending our resources prudently given our current state of liquidity and do not expect to achieve positive cash flow from operations for 2004. Net cash provided by investing activities was $4.1 million in 2003 and reflected proceeds of approximately $4.2 million from the sale of assets offset by capital expenditures of approximately $66,000 for computer equipment and software. Net cash provided by investing activities was $240,000 in 2002 and primarily reflected the return of $256,000 of deposits that had been used to secure leases. Net cash provided by investing activities for 2001 was $2.1 million and reflected sales and maturities of marketable securities of $2.0 million and the return of $219,000 of deposits that had been used to secure leases. We do not anticipate making significant capital expenditures during 2004. Net cash used in financing activities of $1.7 million for 2003 primarily resulted from the payment of $1.8 million under our Laurus convertible debt agreement in July 2003. Net cash provided by financing activities of $1.9 million for 2002 resulted primarily from $1.5 million of borrowings under the convertible debt agreement and the return of $707,000 that had been pledged as collateral for the margin loans of certain executive officers. Net cash provided by financing activities of $6.5 million for 2001 resulted from proceeds, net of issuance costs, of $9.2 million from the issuance of common stock private placement offerings in March and November 2001. The $1.5 million repayment of the outstanding line of credit in January 2001 and additional pledge of $1.0 million as collateral for margin loans of certain executive officers reduced the amount of net cash provided by financing activities in 2001. Off-balance Sheet Arrangements We currently have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. PLEDGED FUNDS Beginning in December 2000, we pledged as loan guarantees certain funds held as money market funds and certificates of deposit to collateralize margin loans for the following executive officers of the Company: (1) Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A. Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones, then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees of the Company. Our purpose in collateralizing the margin loans was to prevent the sale of our common stock owned by these officers while we were pursuing efforts to raise additional capital through private equity placements. The sale of that common stock could have hindered our ability to raise capital in such a manner and compromised our continuing efforts to secure additional financing. We were also trying to accommodate the requests of the named executive officers, who were seeking to preserve their financial liquidity. We believe this action served our purpose of assuring stable management and leadership for our future. The margin loans were obtained in March 1999 from institutional lenders and were secured by shares of our common stock owned by these officers. Each of the officers used the proceeds of their respective margin loans for investment purposes and usual and customary living expenses. 40 None of the margin loans were recourse with respect to the officers and none of the loan guarantees were recourse with respect to us because at the times the margin loans were made and the funds pledged, the value of the common stock collateralizing the margin loans exceeded the loan amounts. Under the original terms of the arrangement, we charged each of the officers, pro rata, the difference between the rate of return earned by us before the collateralization of the margin loans on the funds that were to be the pledged funds and the rate of return earned on the pledged funds after the collateralization of the margin loans. We offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard against their respective salaries from the date the funds were pledged until November of 2002, when we underwent significant downsizing and Mr. Long, Mr. Hoch, and Mr. Millard began deferring their salaries. We offset such amounts due from Mr. Jones against his salary from the date the funds were pledged until the date of his departure from the Company in August 2001. The highest total amount of funds pledged for the margin loans guaranteed by us was approximately $2.0 million. The total balance of the margin loans guaranteed by us was approximately $1.3 million at December 31, 2002. At the time the funds were pledged, we believed we would have access to them because (a) our stock price was substantial and the stock pledged by the officers, if liquidated, would produce funds in excess of the loans payable, and (b) with respect to one of the institutional lenders (who was also assisting us as a financial advisor at the time), even if the stock price fell, we had received assurances from that institutional lender that the pledged funds would be made available as needed. During the fourth quarter of 2002, we requested partial release of the funds for operating purposes, which request was denied by an institutional lender. At that time, our stock price had fallen as well, and it became clear that both institutional lenders would not release the pledged funds. In light of these circumstances, we recognized a loss on the guarantees of $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable under related party guarantees on our balance sheet at December 31, 2002 because it became probable at that point that we would be unable to recover our pledged funds. During the quarter ended March 31, 2003, the lenders applied the pledged funds to satisfy the outstanding balances of the loans. The total balance of the margin loans guaranteed by us was zero at December 31, 2003. The pledged funds were classified as cash and cash equivalents on our balance sheet and disclosed in the accompanying footnotes in our Annual Report on Form 10-K for each of the years ended December 31, 2000 and 2001, respectively. The pledged funds were classified as cash and cash equivalents on our balance sheet and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002, respectively. After our request for partial release of the funds was denied by an institutional lender, the pledged funds were classified as cash pledged as collateral for related party obligations on our balance sheet and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. On June 30, 2003, we filed an amended Annual Report on Form 10-K for the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002 as a result of comments received from the Securities and Exchange Commission in connection with their review of our registration statement on Form S-3 that we originally filed on August 9, 2002. These amended reports included restated balance sheets that classified the pledged funds as cash pledged as collateral for related party obligations because by the time the amended reports were filed, it was clear that the funds would not be released as we had been assured. 41 We may institute litigation or arbitration in collection of the outstanding repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which currently total $1,278,138. Presently, we have refrained from initiating action to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may have offsetting claims that total $1,445,500 collectively by virtue of their respective employment agreements based on our preliminary analysis. We have not pursued the outstanding repayment obligation of Mr. Jones because we do not consider a recovery attempt to be cost beneficial. The ultimate outcome of this matter cannot presently be determined. On July 25, 2003, certain of our stockholders (those stockholders being Mike Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick, Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal action against us, Ernst & Young, LLP, and certain of our current and former directors (including the executive officers named above) in the District Court of the 45th Judicial District, Bexar County, Texas. With respect to us and the current and former directors named in the suit, the plaintiffs allege that we, acting through such directors, misstated in our 2000 and 2001 Form 10-Ks our ability to use for operational purposes the funds pledged as security for margin loans of certain of our executive officers, as discussed above. The plaintiffs allege and seek resulting economic and exemplary damages, rescission, interest, attorneys' fees and costs of court. We believe this suit is without merit and intend to vigorously defend the company and the directors named in the suit. As of June 4, 2004, there have been no material developments in the suit. The results of legal proceedings cannot be predicted with certainty. If we fail to prevail in this legal matter, our financial position, results of operations, and cash flows could be materially adversely affected. WORKING CAPITAL LINE OF CREDIT We currently have no working capital line of credit agreement and no funds are available to us under any working capital line of credit. In June 2000, we executed a working capital line of credit agreement with a bank in the amount of $1,500,000. We borrowed $1,500,000 on this line of credit for the security deposit and leasehold improvements of our corporate headquarters and repaid the entire outstanding balance plus accrued interest in January 2001. The line of credit expired in July 2001 and was not renewed. In March 2002, we executed a working capital line of credit agreement with a bank in the amount of $700,000. We borrowed $645,000 under this line of credit during the first six months of 2002. In September 2002, we repaid the outstanding balance in full, including accrued interest, and terminated the line of credit. 42 CONVERTIBLE NOTE On July 24, 2002, we executed a financing agreement with Laurus Master Fund, Ltd. in exchange for a $1.5 million convertible note and a four-year warrant to purchase 300,000 shares of our common stock at exercise prices of $0.936 for the first 150,000 shares, $0.975 for the next 50,000 shares, and $1.17 for the remaining 100,000 shares. Laurus could convert the convertible note, which accrued interest at 7% annually, at any time into shares of our common stock at a fixed conversion price of $0.78, subject to certain restrictions in the purchase agreement. We could pay the principal and interest on the convertible note, which had a one-year term, in cash, shares of our common stock or a combination of cash and stock. If common stock was used to pay the note, the conversion price was the lesser of (i) $0.78 or (ii) 88% of the average of the 7 lowest closing prices during the 22 trading days prior to the date we gave notice of payment. Accrued interest and one-ninth of the principal was due on the first business day of each calendar month beginning on November 1, 2002 and continuing until the maturity date of July 1, 2003. If the required principal payment was made in cash, the principal amount paid was 105% of the amount due. We granted Laurus a security interest in all of our assets. We defaulted under the note during the fourth quarter of 2002 and a penalty of 120% of the outstanding principal amount, or $300,000, was assessed to us for the default, and was included in the balance of short-term borrowings on our balance sheet at December 31, 2002. We recorded a debt discount as a result of the issuance of the warrant to Laurus of approximately $259,000, which was being charged to interest expense over the term of the convertible note using the effective yield method. Upon our default under the note, the remaining balance of the discount was charged to interest expense. Furthermore, we recorded an additional debt discount as a result of the beneficial conversion feature of approximately $283,000, which was charged to interest expense at the date of issuance. The amount related to the beneficial conversion feature was determined by dividing the note proceeds allocated to the convertible security of approximately $1,241,000 by the number of shares into which the note was convertible, or 1,923,077 shares based on the fixed conversion price of $0.78 per common share. The resulting effective conversion price of $0.65 per common share was then compared to the fair value of our stock, which was $0.93 per common share on the issuance date. The difference of $0.28 per common share between the fair value of the stock and the effective conversion price was then multiplied by 1,009,586, which was the number of shares the note was convertible into at the date of issuance, taking into account the limitation on the number of shares that Laurus could convert at that time. The agreement stipulated that Laurus could not convert that amount of the note that would result in beneficial ownership of more than 4.9% of our outstanding common shares on the date of conversion. The conversion limitation was to become null and void upon an event of default under the note and could have been raised if we chose to redeem the outstanding principal amount of the note in cash and Laurus elected to convert the note instead. The limitation could also have been raised if we had issued additional common shares for any reason, thus increasing the number of outstanding shares. Due to our default under the note during the fourth quarter of 2002, the 4.9% limitation became null and void and additional interest expense of approximately $256,000 was recognized at a rate of $0.28 per common share for the 913,491 additional shares that the note became convertible into upon default. During 2002, we capitalized $238,000 in financing costs related to the issuance of the Laurus debt that were being charged to interest expense over the term of the convertible note using the effective yield method. Upon default under the note in the fourth quarter of 2002, the remaining unamortized balance was charged to interest expense. In connection with the sale of substantially all of our assets to Saro, Inc., we paid $1.8 million in cash to Laurus during July 2003, in full settlement of the outstanding balance of the convertible note, including accrued penalties and interest, and all claims by Laurus. In addition, the four-year warrant to purchase 300,000 shares of our common stock initially granted to Laurus was canceled as part of the settlement. 43 EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS On May 15, 2003, the FASB issued Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("FAS 150"). FAS 150 establishes standards for classifying and measuring as liabilities certain freestanding financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The statement defines an obligation as "a conditional or unconditional duty or responsibility on the part of the issuer to transfer assets or to issue its equity shares." FAS 150 is effective for all financial instruments created or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a significant impact on the Company's results of operations or financial position. DESCRIPTION OF PROPERTY As of March 31, 2004, our headquarters and operations were housed in approximately 4,500 square feet of leased office space in San Antonio, Texas. The office lease has a three-year term that expires in October 2006 and has a renewal option for an additional three-year term. We believe our existing facilities will be adequate to meet our anticipated needs for the foreseeable future. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Mr. David Jones, a former Executive Vice President and Director of our company, borrowed approximately $35,000 accruing interest at a rate of 8% during 2000, of which $25,000 was outstanding at December 31, 2000. During 2001, we loaned an additional $94,000 at a rate of 8% to Mr. Jones prior to his resignation from us. Mr. Jones used the proceeds of these loans for usual and customary living expenses and to pay down a margin loan to an institutional lender. At December 31, 2001, we had an aggregate of $115,000 in notes receivable accruing interest at 8%, which was the largest amount owed to us by Mr. Jones during 2001. In March 2002, Mr. Jones repaid the balance of these loans to us in full, including accrued interest. Beginning in December 2000, we pledged as loan guarantees certain funds held as money market funds and certificates of deposit to collateralize margin loans for the following executive officers of the Company: (1) Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A. Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones, then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees of the Company. Our purpose in collateralizing the margin loans was to prevent the sale of our common stock owned by these officers while we were pursuing efforts to raise additional capital through private equity placements. The sale of that common stock could have hindered our ability to raise capital in such a manner and compromised our continuing efforts to secure additional financing. We were also trying to accommodate the requests of the named executive officers, who were seeking to preserve their financial liquidity. We believe this action served our purpose of assuring stable management and leadership for our future. The margin loans were obtained in March 1999 from institutional lenders and were secured by shares of our common stock owned by these officers. Each of the officers used the proceeds of their respective margin loans for investment purposes and usual and customary living expenses. None of the margin loans were recourse with respect to the officers and none of the loan guarantees were recourse with respect to us because at the times the margin loans were made and the funds pledged, the value of the common stock collateralizing the margin loans exceeded the loan amounts. Under the original terms of the arrangement, we charged each of the officers, pro rata, the difference between the rate of return earned by us before the collateralization of the margin loans on the funds that were to be the pledged funds and the rate of return earned on the pledged funds after the collateralization of the margin loans. We offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard against their respective salaries from the date the funds were pledged until November of 2002, when we underwent significant downsizing and Mr. Long, Mr. Hoch, and Mr. Millard began deferring their salaries. We offset such amounts due from Mr. Jones against his salary from the date the funds were pledged until the date of his departure from the Company in August 2001. 44 The highest total amount of funds pledged for the margin loans guaranteed by us was approximately $2.0 million. The total balance of the margin loans guaranteed by us was approximately $1.3 million at December 31, 2002. At the time the funds were pledged, we believed we would have access to them because (a) our stock price was substantial and the stock pledged by the officers, if liquidated, would produce funds in excess of the loans payable, and (b) with respect to one of the institutional lenders (who was also assisting us as a financial advisor at the time), even if the stock price fell, we had received assurances from that institutional lender that the pledged funds would be made available as needed. During the fourth quarter of 2002, we requested partial release of the funds for operating purposes, which request was denied by an institutional lender. At that time, our stock price had fallen as well, and it became clear that both institutional lenders would not release the pledged funds. In light of these circumstances, we recognized a loss on the guarantees of $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable under related party guarantees on our balance sheet at December 31, 2002 because it became probable at that point that we would be unable to recover our pledged funds. During the quarter ended March 31, 2003, the lenders applied the pledged funds to satisfy the outstanding balances of the loans. The total balance of the margin loans guaranteed by us was zero at December 31, 2003. The pledged funds were classified as cash and cash equivalents on our balance sheet and disclosed in the accompanying footnotes in our Annual Report on Form 10-K for each of the years ended December 31, 2000 and 2001, respectively. The pledged funds were classified as cash and cash equivalents on our balance sheet and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002, respectively. After our request for partial release of the funds was denied by an institutional lender, the pledged funds were classified as cash pledged as collateral for related party obligations on our balance sheet and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. On June 30, 2003, we filed an amended Annual Report on Form 10-K for the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002 as a result of comments received from the Securities and Exchange Commission in connection with their review of our registration statement on Form S-3 that we originally filed on August 9, 2002. These amended reports included restated balance sheets that classified the pledged funds as cash pledged as collateral for related party obligations because by the time the amended reports were filed, it was clear that the funds would not be released as we had been assured. We may institute litigation or arbitration in collection of the outstanding repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which currently total $1,278,138. Presently, we have refrained from initiating action to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may have offsetting claims that total $1,445,500 collectively by virtue of their respective employment agreements based on our preliminary analysis. We have not pursued the outstanding repayment obligation of Mr. Jones because we do not consider a recovery attempt to be cost beneficial. The ultimate outcome of this matter cannot presently be determined. On July 25, 2003, certain of our stockholders (those stockholders being Mike Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick, Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal action against us, Ernst & Young, LLP, and certain of our current and former directors (including the executive officers named above) in the District Court of the 45th Judicial District, Bexar County, Texas. With respect to us and the current and former directors named in the suit, the plaintiffs allege that we, acting through such directors, misstated in our 2000 and 2001 Form 10-Ks our ability to use for operational purposes the funds pledged as security for margin loans of certain of our executive officers, as discussed above. The plaintiffs allege and seek resulting economic and exemplary damages, rescission, interest, attorneys' fees and costs of court. We believe this suit is without merit and intend to vigorously defend the company and the directors named in the suit. As of June 4, 2004, there have been no material developments in the suit. The results of legal proceedings cannot be predicted with certainty. If we fail to prevail in this legal matter, our financial position, results of operations, and cash flows could be materially adversely affected. 45 MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION Our common stock was traded on the National Association of Securities Dealers Over the Counter Bulletin Board through March 13, 2000 at which time our common stock was approved for trading on the NASDAQ Small Cap Market. Subsequently, our stock was approved for trading on the NASDAQ National Market on July 31, 2000 under the symbol "BLLS." On February 4, 2003, the NASDAQ National Market delisted our common stock because we did not meet the requirements for continued listing on the NASDAQ National Market. Our common shares were immediately eligible for quotation on the OTCBB effective at opening of business on February 4, 2003. We began trading under a new ticker symbol, PYDS, on the OTC BB on August 20, 2003. The following table sets forth for the quarterly periods indicated the range of high and low closing prices of the common stock as reported on the OTCBB: High Low ---------- ---------- 2004 - -------------------- First Quarter $ 0.46 $ 0.15 2003 - -------------------- First Quarter $ 0.23 $ 0.07 Second Quarter $ 0.14 $ 0.08 Third Quarter $ 0.35 $ 0.09 Fourth Quarter $ 0.32 $ 0.14 2002 - -------------------- First Quarter $ 1.25 $ 0.90 Second Quarter $ 1.70 $ 1.02 Third Quarter $ 1.25 $ 0.52 Fourth Quarter $ 0.70 $ 0.17 HOLDERS As of April 23, 2004, there were approximately 4,833 stockholders of record of our common stock. DIVIDEND POLICY We have never declared or paid cash or stock dividends and have no present plan to pay any such dividends in the foreseeable future, intending instead to reinvest our earnings, if any. 46 EXECUTIVE COMPENSATION The following table sets forth the compensation earned during each of the years ended December 31, 2003, 2002 and 2001 to our Chief Executive Officer and each other executive officer that earned over $100,000 during the year ended December 31, 2003.
ANNUAL COMPENSATION (1) LONG TERM COMPENSATION ----------------- ------------------------------------------- ALL OTHER AWARDS COMPENSATION (2) ----------------------- ------------------ SECURITIES UNDERLYING NAME AND PRINCIPAL POSITION(S) YEAR SALARY OPTIONS (#) - -------------------------------------- ---- ----------------- ----------------------- Michael R. Long 2003 $ 190,000 400,000 $ 11,529 Chairman, Chief Executive Officer 2002 $ 190,000 340,000 $ 11,130 And Chief Financial Officer. . . . . . 2001 $ 190,000 325,000 $ 11,074 Louis A. Hoch 2003 $ 175,000 425,000 $ 900 President and Chief Operating Officer. 2002 $ 175,000 340,000 $ 1,950 2001 $ 175,000 250,000 $ 1,596 Terri A. Hunter 2003 $ 152,499 - $ 540 Executive Vice President and Chief 2002 $ 145,000 350,000 $ 1,560 Financial Officer. . . . . . . . . . . 2001 $ 145,000 150,000 $ 1,368 (1) Each of the named executives except for Ms. Hunter has entered into employment agreements expiring on July 25, 2004, which provide for annual salary and bonuses at the discretion of the Board of Directors. Ms. Hunter resigned her position as Executive Vice President and Chief Financial Officer effective August 31, 2003. In 2004, each of the named officers is to receive salary compensation as follows: Mr. Long, $190,000; and Mr. Hoch, $175,000. (2) Reflects premiums paid for term life insurance coverage.
OPTION GRANTS The following table provides information regarding the grant of stock options during fiscal year 2003 to the named executive officers pursuant to our Employee Comprehensive Stock Plan. 47
Number of Securities % of Total Options Underlying Options Granted to Employees Exercise Price Name Granted in Fiscal 2003 ($/Share) Expiration Date ------------------- -------------------- --------------- ---------------- Michael R. Long . . 400,000 22.8% $ 0.14 12/30/13 Louis A. Hoch . . . 425,000 24.2% $ 0.14 12/30/13 Terri A. Hunter (1) - - - - (1) We did not grant any stock options to Ms. Hunter during fiscal year 2003.
OPTION EXERCISES AND YEAR-END VALUES The following table provides certain information related to the exercise of options during the year ended December 31, 2003 by the named executive officers and the number and value of options held by the named executive officers at December 31, 2003.
Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values SHARES NUMBER OF SECURITIES VALUE OF UNEXERCISED ACQUIRED VALUE UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT ON EXERCISE REALIZED OPTIONS AT FISCAL YEAR-END (#) FISCAL YEAR-END ($) (1) NAME (#) ($ ) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - --------------- ----------- -------- ------------------------------ ------------------------ ------------ -------------- Michael R. Long - $ 0 898,334 400,000 $ 0 $ 8,000 Louis A. Hoch . - $ 0 765,000 425,000 $ 0 $ 8,500 (1) Calculated using the year-end per share price of $0.16.
DIRECTORS COMPENSATION In 2003, we did not pay any cash compensation to our independent directors for their services on our Board of Directors. However, on December 30, 2003, we granted options to purchase 175,000 shares of our common stock at an exercise price of $0.14 per share to our independent director, Peter G. Kirby, as compensation for his service as a Director. EMPLOYMENT CONTRACTS We have employment agreements with our executive officers. The employment agreements provide for an annual salary, bonuses at the discretion of the Board of Directors and health benefits. In 2004, each of the named officers are to receive salary compensation as follows: Mr. Long, $190,000 and Mr. Hoch, $175,000. Our agreements with our executive officers provide for change in control protection for each executive. We may terminate any such agreement not later than thirty days after a change of control. In such event, the executive would be entitled to deferred compensation. Deferred compensation is calculated as the greater of (A) the base salary payments the executive would have received had his or her employment continued for the remaining term of the agreement (including yearly increases calculated at the maximum increase for the prior two years); or (B) an amount equal to 2.95 times the highest annual compensation earned by the executive in the past two years. In addition, the executive would be entitled to all of the benefits otherwise provided in the agreement during a certain period of time defined in the agreement as the greater of the remaining term of the agreement or one year. The executive may also be entitled to an amount equal to the pro rata portion of the bonus compensation for the year in which the executive's employment is terminated determined on the basis of the number of days elapsed in such year prior to such termination. Upon termination of employment, each employee is prohibited from competing with us for a period of two years. The employment agreements were supposed to terminate upon the change of control that occurred on July 25, 2003, but were extended at our option for a period of one year. Upon the expiration of the extended agreements on July 25, 2004, the executive officers shall be entitled to the deferred compensation as provided above. FINANCIAL STATEMENTS FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Reports of Independent Auditors F-1 Consolidated Balance Sheets as of December 31, 2003 and 2002 F-2 Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001 F-3 Consolidated Statement of Changes in Shareholders' Equity (Deficit) for the years ended December 31, 2003, 2002 and 2001 F-4 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001 F-5 Notes to Consolidated Financial Statements F-6 - F-22 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To The Board of Directors and Shareholders of Payment Data Systems, Inc. San Antonio, Texas We have audited the accompanying consolidated balance sheet of Payment Data Systems, Inc., formerly known as Billserv, Inc, and subsidiaries as of December 31, 2003, and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Payment Data Systems, Inc. and subsidiaries at December 31, 2003, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted auditing standards. The accompanying financial statements of Payment Data Systems, Inc. and subsidiaries have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has incurred substantial losses since inception, which has led to a significant decrease in its cash position and a deficit in working capital. In addition, in July 2003, substantially all operations were sold. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The financial statements of Payment Data Systems, Inc. and subsidiaries do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Akin, Doherty, Klein & Feuge, P.C. San Antonio, Texas March 2, 2004, except for Note 15, to which the date is March 15, 2004 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To The Board of Directors and Shareholders of Payment Data Systems, Inc. San Antonio, Texas We have audited the accompanying consolidated balance sheet of Payment Data Systems, Inc., formerly known as Billserv, Inc., and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for the years ended December 31, 2002 and 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Payment Data Systems, Inc. and subsidiaries at December 31, 2002, and the consolidated results of their operations and their cash flows for the years ended December 31, 2002 and 2001, in conformity with accounting principles generally accepted in the United States. The accompanying financial statements of Payment Data Systems, Inc. and subsidiaries have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has incurred substantial losses since inception and has experienced a material shortfall in anticipated revenues, which has led to a significant decrease in its cash position and a deficit in working capital. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The financial statements of Payment Data Systems, Inc. and subsidiaries do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. ERNST & YOUNG LLP San Antonio, Texas April 1, 2003
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS December 31, December 31, 2003 2002 ---------------- ---------------- Assets: Cash and cash equivalents $ 528,119 $ 286,105 Cash pledged as collateral for related party obligations - 1,311,984 Accounts receivable, net 43,693 659,074 Prepaid expenses and other 113,650 257,810 ---------------- ---------------- Total current assets 685,462 2,514,973 Property and equipment, net 215,156 281,432 Other assets 37,782 22,500 Net property and equipment of discontinued operations - 1,890,358 ---------------- ---------------- Total assets $ 938,400 $ 4,709,263 ================ ================ Liabilities and shareholders' equity (deficit): Current liabilities: Accounts payable $ 501,488 $ 949,392 Accrued expenses 224,180 555,560 Payable under related party guarantees - 1,278,138 Short-term borrowings - 1,800,000 Deferred revenue - 400,960 Obligations under capital leases of discontinued operations - 70,483 ---------------- ---------------- Total current liabilities 725,668 5,054,533 Shareholders' equity (deficit): Common stock, $.001 par value, 200,000,000 shares authorized; 20,987,956 and 20,603,799 issued and outstanding 20,988 20,604 Additional paid-in capital 46,842,908 46,770,186 Accumulated deficit (46,651,164) (47,136,060) ---------------- ---------------- Total shareholders' equity (deficit) 212,732 (345,270) ---------------- ---------------- Total liabilities and shareholders' equity (deficit) $ 938,400 $ 4,709,263 ================ ================ See notes to consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS Year ended Year ended Year ended December 31, December 31, December 31, 2003 2002 2001 ------------------ ------------------ ------------------ Revenues $ 119,297 $ 77,070 $ 43,835 Operating expenses: Cost of services 138,009 58,739 38,004 Selling, general and administrative 1,726,028 2,431,566 3,077,783 Depreciation and amortization 130,671 183,594 199,384 ------------------ ------------------ ------------------ Total operating expenses 1,994,708 2,673,899 3,315,171 ------------------ ------------------ ------------------ Operating loss (1,875,411) (2,596,829) (3,271,336) Other income (expense), net: Interest income 5,122 81,799 355,262 Interest expense (61,432) (1,114,798) (40,079) Loss on guarantees - (1,278,138) - Other income (expense) 157,422 (354,494) 36,941 ------------------ ------------------ ------------------ Total other income (expense), net 101,112 (2,665,631) 352,124 ------------------ ------------------ ------------------ Loss from continuing operations before income taxes (1,774,299) (5,262,460) (2,919,212) Income taxes - - - ------------------ ------------------ ------------------ Loss from continuing operations (1,774,299) (5,262,460) (2,919,212) Discontinued operations (Note 14): Loss from discontinued operations, net of no income taxes (477,846) (5,692,217) (7,486,494) Gain on disposition of discontinued operations, net of no income taxes 2,737,041 - - ------------------ ------------------ ------------------ Net income (loss) $ 484,896 $ (10,954,677) $ (10,405,706) ================== ================== ================== Loss from continuing operations per common share - basic and diluted $ (0.09) $ (0.25) $ (0.16) Income (loss) from discontinued operations per common share - basic and diluted 0.11 (0.28) (0.42) ------------------ ------------------ ------------------ Net income (loss) per common share - basic and diluted $ 0.02 $ (0.53) $ (0.58) ================== ================== ================== Weighted average common shares outstanding - basic and diluted 20,883,218 20,591,304 18,017,051 See notes to consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT) Common Stock Additional Other Total ----------------------- Paid - In Accumulated Comprehensive Shareholders' Shares Amount Capital Deficit Income Equity (Deficit) ------------- --------- --------------- --------------- --------------- ----------------- Balance at December 31, 2000 15,527,870 $ 15,528 $ 36,758,450 $ (25,775,677) $ 13,109 $ 11,011,410 Exercise of stock options 8,000 8 34,992 - - 35,000 Issuance of common stock, net of issuance costs 5,002,656 5,003 9,115,968 - - 9,120,971 Comprehensive loss: Unrealized gain on investments - - - - (13,109) (13,109) Net loss for the year ended December 31, 2001 - - - (10,405,706) - (10,405,706) ----------------- Comprehensive loss (10,418,815) ------------- --------- --------------- --------------- --------------- ----------------- Balance at December 31, 2001 20,538,526 20,539 45,909,410 (36,181,383) - 9,748,566 Issuance of common stock 65,273 65 63,170 - - 63,235 Value of beneficial conversion feature granted in connection with issuance of debt - - 538,461 - - 538,461 Value of common stock warrants granted in connection with issuance of debt - - 259,145 - - 259,145 Comprehensive loss: Net loss for the year ended December 31, 2002 - - - (10,954,677) - (10,954,677) ------------- --------- --------------- --------------- --------------- ----------------- Balance at December 31, 2002 20,603,799 20,604 46,770,186 (47,136,060) - (345,270) Issuance of common stock 118,857 119 22,841 - - 22,960 Exercise of stock options 265,300 265 49,881 - - 50,146 Comprehensive income: Net income for the year ended December 31, 2003 - - - 484,896 - 484,896 ------------- --------- --------------- --------------- --------------- ----------------- Balance at December 31, 2003 20,987,956 $ 20,988 $ 46,842,908 $ (46,651,164) $ - $ 212,732 ============= ========= =============== =============== =============== ================= See notes to consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS 2003 2002 2001 ------------------- -------------------- ------------------- Operating activities: Loss from continuing operations $ (1,774,299) $ (5,262,460) $ (2,919,212) Adjustments to reconcile loss from continuing operations to net cash used in operating activities: Depreciation and amortization 130,671 183,594 199,384 Impairment of assets 17,000 - - Loss on related party guarantees - 1,278,138 - Issuance of common stock warrants and convertible debt - 1,035,255 - Gain on disposition - - (36,070) Changes in current assets and current liabilities: Accounts receivable 615,381 (221,397) 344,860 Related party notes receivable - 162,154 121,584 Prepaid expenses and other 144,160 7,702 377,551 Accounts payable and accrued expenses (763,034) 893,818 (757,863) Deferred revenue (400,960) (251,669) (173,371) ------------------- -------------------- ------------------- Net cash used in continuing operations (2,031,081) (2,174,865) (2,843,137) Net cash used in discontinued operations (145,038) (3,836,809) (6,740,000) ------------------- -------------------- ------------------- Net cash used in operating activities (2,176,119) (6,011,674) (9,583,137) Investing activities: Purchases of property and equipment (66,395) (9,522) (120,676) Proceeds from sale of assets 4,224,108 - - Proceeds from sales and maturities of investments - - 2,028,680 Long-term deposits, net (30,282) 255,503 218,641 Other investing activities - (6,126) 2,577 ------------------- -------------------- ------------------- Net cash provided by investing activities 4,127,431 239,855 2,129,222 Financing activities: Proceeds from notes payable - 2,145,000 - Principal payments for notes payable (1,800,000) (645,000) (1,500,000) Financing costs, net - (237,649) - Principal payments for capital lease obligations - (148,228) (181,328) Cash pledged as collateral for related party obligations 1,311,984 706,967 (1,018,951) Payments for related party obligations (1,278,138) - - Issuance of common stock, net of issuance costs 56,856 63,235 9,155,971 ------------------- -------------------- ------------------- Net cash provided by (used in) financing activities (1,709,298) 1,884,325 6,455,692 ------------------- -------------------- ------------------- Change in cash and cash equivalents 242,014 (3,887,494) (998,223) Cash and cash equivalents, beginning of period 286,105 4,173,599 5,171,822 ------------------- -------------------- ------------------- Cash and cash equivalents, end of period $ 528,119 $ 286,105 $ 4,173,599 =================== ==================== =================== Supplemental information: Cash paid for interest $ 41,623 $ 39,264 $ 52,027 Cash paid for federal income taxes - - - See notes to consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003, 2002 AND 2001 NOTE 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GOING CONCERN The Company has incurred substantial losses since inception, which has led to a significant decrease in its cash position and a deficit in working capital. The Company defaulted under its convertible debt agreement during the fourth quarter of 2002 (see Note 7) and was unsuccessful in its attempt to access its funds held as collateral to guarantee certain executive margin loans (see Note 8) after attempting to retrieve such funds during the fourth quarter of 2002. Consequently, the Company sold substantially all of its assets in July 2003 (see Note 14) and reduced expenditures for operating requirements. Despite these actions, the Company believes that its current available cash along with anticipated revenues may be insufficient to meet its anticipated cash needs for the foreseeable future. Accordingly, the Company is currently aggressively pursuing strategic alternatives, including investment in the Company via an equity line of credit (See Note 15). The satisfactory completion of an additional investment in the Company or growth of cash flow from operations is essential or the Company has no other alternative that will provide sufficient funds to meet current operating requirements. The sale of additional equity or convertible debt securities would result in additional dilution to the Company's stockholders, and debt financing, if available, may involve restrictive covenants which could restrict operations or finances. There can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all. If the Company cannot raise funds, on acceptable terms, or achieve positive cash flow, it may not be able to continue to exist, conduct operations, grow market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which would negatively impact its business, operating results and financial condition. DESCRIPTION OF BUSINESS Payment Data Systems, Inc., formerly known as Billserv, Inc., and its subsidiaries (collectively, "PDS" or "the Company"), provides integrated electronic payment services, including credit and debit card-based processing services and transaction processing via the ACH network to billers and retailers. In addition, the Company operates an Internet electronic payment processing service for consumers under the domain name www.bills.com. Prior to selling substantially all of its assets (the "Business") in July 2003, the Company provided electronic bill presentment and payment ("EBPP") services to companies generating recurring bills, primarily in the United States. The Company also provided related EBPP consulting and Internet-based customer care interaction services. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144"), the results of operations for the asset group disposed of have been classified as discontinued operations. All financial information presented for the years ended December 31, 2003, 2002 and 2001 has been restated to reflect the operating results of this asset group as discontinued operations (see Note 14). PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, bills.com, Inc. and billserv.com-canada, Inc. All significant intercompany accounts and transactions have been eliminated. The accompanying financial statements have been presented assuming the Company will continue as a going concern. RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications had no impact on operating loss as previously reported. USE OF ESTIMATES The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. ACCOUNTS RECEIVABLE Accounts receivable represent net amounts due for fees charged for the electronic processing of payment transactions and related services provided by the Company. Accounts receivable are reported at outstanding principal net of an allowance for doubtful accounts of $3,155 at December 31, 2003 and $47,197 at December 31, 2002. The Company normally does not charge interest on accounts receivable. The allowance for doubtful accounts is generally determined based on an account-by-account review. Accounts are charged off when collection efforts have failed and the account is deemed uncollectible. CONCENTRATION OF CREDIT RISK Financial instruments that potentially expose the Company to credit risk consist of cash and cash equivalents, investments and accounts receivable. The Company is exposed to credit risk on its cash, cash equivalents and investments in the event of default by the financial institutions or the issuers of these investments to the extent of the amounts recorded on the balance sheet in excess of amounts that are insured by the FDIC. Trade receivables potentially subject the Company to concentrations of credit risk. The Company's customer base operates in a variety of industries and is geographically dispersed, however, the relatively small number of customers increases the risk. The Company closely monitors extensions of credit and credit losses have been provided for in the consolidated financial statements and have been within management's expectations. The Company recorded bad debt expense of $10,700, $30,000 and $21,000 for 2003, 2002, and 2001, respectively, and recorded bad debt write-offs of $54,742, $1,734 and $12,069 to its allowance for doubtful accounts in 2003, 2002 and 2001, respectively. No single customer accounted for more than 5% of total continuing operating revenues for the years ended December 31, 2003, 2002 or 2001. FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and short-term borrowings are reflected in the accompanying consolidated financial statements at cost, which approximates fair value because of the short-term maturity of these instruments. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation and amortization are computed on a straight-line method over the estimated useful lives of the related assets, ranging from three to seven years. Leasehold improvements are amortized over the lesser of the estimated useful lives or remaining lease period. Expenditures for maintenance and repairs are charged to expense as incurred. IMPAIRMENT OF LONG-LIVED ASSETS The Company periodically reviews, on at least an annual basis, the carrying value of its long-lived assets, including intangible assets and property, plant and equipment, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. To the extent fair value of a long-lived asset, determined based upon the estimated future cash inflows attributable to the asset, less estimated future cash outflows, are less than the carrying amount, an impairment loss is recognized. INTANGIBLE ASSET The cost of the domain name registration for www.bills.com is being amortized on a straight-line basis over a five-year period and is included in other assets on the accompanying consolidated balance sheets. The unamortized cost of this intangible asset was $7,500 and $22,500 at December 31, 2003 and 2002, respectively. The costs of trademarks registered to the Company have not been material and have been expensed as incurred. REVENUE RECOGNITION Revenue consists of fees generated through the electronic processing of payment transactions and related services, and are recognized as revenue in the period the transactions are processed or when the related services are performed. Merchants may be charged for these processing services at a bundled rate based on a percentage of the dollar amount of each transaction and, in some instances, additional fees are charged for each transaction. Certain merchant customers are charged a flat fee per transaction, while others may also be charged miscellaneous fees, including fees for chargebacks or returns, monthly minimums, and other miscellaneous services. Revenues derived from electronic processing of credit and debit card transactions that are authorized and captured through third party networks are reported gross of amounts paid to sponsor banks as well as interchange and assessments paid to credit card associations (MasterCard and Visa). RESERVE FOR LOSSES ON MERCHANT ACCOUNTS Disputes between a cardholder and a merchant periodically arise as a result of, among other things, cardholder dissatisfaction with merchandise quality or merchant services. Such disputes may not be resolved in the merchant's favor. In these cases, the transaction is "charged back" to the merchant and the purchase price is refunded to the customer through the merchant's acquiring bank, and charged to the merchant. If the merchant has inadequate funds, the Company must bear the credit risk for the full amount of the transaction. The Company evaluates its risk for such transactions and estimates its potential loss for chargebacks based primarily on historical experience and other relevant factors. The Company did not record a significant amount of chargeback expense to cost of services in 2003 and did not have a significant reserve for losses at December 31, 2003. The Company did not incur any chargeback losses in 2003 and did not maintain a reserve for losses on merchant accounts prior to offering card-based processing services beginning in the fourth quarter of 2003. RESEARCH AND DEVELOPMENT COSTS Research and development costs are expensed as incurred. ADVERTISING COSTS The cost of advertising is expensed as incurred. The Company's continuing operations did not incur any advertising costs for the years ended December 31, 2003, 2002 or 2001. FOREIGN OPERATIONS The Company is currently not operating in any foreign countries. The Company previously operated in Australia and Canada; however, the impact financially of expanding internationally was not material to the Company's financial position or results of operations in any year. INCOME TAXES Deferred tax assets and liabilities are recorded based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. COMPREHENSIVE LOSS The Company's comprehensive loss in 2001 is comprised of net loss and unrealized gains and losses on investments classified as available-for-sale. STOCK-BASED COMPENSATION The Company applies the intrinsic value method under the recognition and measurement provisions of APB No. 25, "Accounting for Stock Issued to Employees", in accounting for its stock option and stock purchase plans. Accordingly, no stock-based employee compensation expense has been recognized for options granted with an exercise price equal to the market value of the underlying common stock on the date of grant or in connection with the employee stock purchase plan. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), to stock-based employee compensation.
2002 2001 2000 ---- ---- ---- Net income (loss), as reported $ 484,896 $(10,954,677) $(10,405,706) Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (573,186) (1,584,364) (2,782,995) ----------- ------------ ------------ Pro forma net income (loss) $ (88,290) $(12,539,041) $(13,188,701) =========== ============ ============ Net income (loss) per common share - - basic and diluted, as reported $ 0.02 $ (0.53) $ (0.58) Net income (loss) per common share - - basic and diluted, pro forma $ - $ (0.61) $ (0.73)
NET LOSS PER SHARE Basic and diluted losses per common share are calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Common stock equivalents, which consist of stock options and warrants and the convertible debt, were excluded from the computation of the weighted average number of common shares outstanding for purposes of calculating diluted loss per common share because their effect was antidilutive. A reconciliation of the weighted average common shares outstanding included in basic and diluted EPS is as follows:
For the Year Ended December 31, 2003 2002 2001 Numerator: Loss from continuing operations available to common stockholders $(1,774,299) $(5,262,460) $(2,919,212) Denominator: Denominator for basic loss per share, weighted average shares outstanding . . . . . . . . 20,883,218 20,591,304 18,017,051 Effects of dilutive securities: Stock options and warrants . . . - - - Convertible debt . . . . . . . . - - - Denominator for diluted loss per share. . . . . . . . . . . . . 20,883,218 20,591,304 18,017,051 Basic loss per share . . . . . . . $ (0.09) $ (0.25) $ (0.16) Diluted loss per share . . . . . . $ (0.09) $ (0.25) $ (0.16)
During a loss period, the assumed exercises of in-the-money stock options and warrants and conversion of convertible securities have an antidilutive effect, and are excluded from the computation of diluted EPS. The computation of diluted net loss per share for the year ended December 31, 2003 excludes the impact of options and warrants to purchase 8,785,048 shares of common stock, as such impact would be antidilutive for this period. The computation of diluted net loss per share for the year ended December 31, 2002 excludes the impact of options and warrants to purchase 10,294,927 shares of common stock and the conversion of the convertible debt, which was convertible into a minimum of 1,923,077 shares of common stock at December 31, 2002, as such impact would be antidilutive for this period. The computation of diluted net loss per share for the fiscal year ended December 31, 2001 excludes the impact of options and warrants to purchase 8,601,014 shares of common stock, as such impact would be antidilutive for this period. These options and warrants could be dilutive in the future. See Notes 10 and 11 for information regarding the exercise prices of our outstanding, unexercised options and warrants, respectively. RECENT ACCOUNTING PRONOUNCEMENTS In November 2002, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others" ("FIN 45"). FIN 45 requires additional disclosures by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the guarantee. The initial recognition and measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 21, 2002. The required disclosures are effective for financial statements for interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a significant impact on our financial position and results of operations. On December 31, 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("FAS 148") which amends Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"). FAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and amends the disclosure requirements of FAS 123 to require disclosures in both the annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and disclosure provisions of FAS 148 were effective for the Company's financial statements issued for the first quarter of 2003. The adoption of FAS 148 did not have a significant impact on our results of operations or financial position. In November 2002, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 requires that a variable interest entity be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation provisions of FIN 46 were originally effective for financial periods ending after July 15, 2003. In October 2003, the FASB issued Staff Position FIN 46-6, "Effective Date of FIN 46," which delayed the implementation date for certain variable interest entities to financial periods ending after December 31, 2003. In December 2003, the FASB published a revision to FIN 46 ("FIN 46R") to clarify some of the provision of FIN 46, and to exempt certain entities from its requirements. The Company does not expect the adoption of these standards to have a significant impact on our financial position and results of operations. On May 15, 2003, the FASB issued Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("FAS 150"). FAS 150 establishes standards for classifying and measuring as liabilities certain freestanding financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The statement defines an obligation as "a conditional or unconditional duty or responsibility on the part of the issuer to transfer assets or to issue its equity shares." FAS 150 is effective for all financial instruments created or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a significant impact on the Company's results of operations or financial position. NOTE 2. ISSUANCE OF CAPITAL STOCK On June 2, 2000, the Company entered into an extended biller service provider agreement with CheckFree Investment Corporation, CheckFree Services Corporation and CheckFree Holdings Corporation (collectively, "CheckFree"). As part of this agreement, CheckFree purchased 879,121 shares of the Company's common stock at $11.375 per share totaling $10.0 million. Offering proceeds to the Company, net of issuance costs, were approximately $9.5 million. In connection with this transaction, the Company also issued warrants to purchase 2,179,121 shares of common stock, and warrants to purchase up to an additional 2,801,903 shares if certain criteria were met (see Note 11). In March 2001, the Company issued 2,885,462 shares of common stock under a private placement offering. The shares were issued at an undiscounted price of $2.50 per share. Net proceeds totaled approximately $6.6 million, net of offering costs of approximately $565,000, which included approximately $540,000, or 7.5% of the Offering, paid to the placement agent. The Company subsequently filed a registration statement with the SEC to register the shares issued in this offering. In November 2001, the Company issued 2,000,000 shares of common stock under a private placement offering (the "2001 Offering"). The shares were issued at an undiscounted price of $1.25 per share. Net proceeds totaled approximately $2.3 million, net of offering costs of approximately $211,000, which included approximately $200,000, or 8% of the Offering, paid to the placement agent. The Company subsequently filed a registration statement with the SEC to register the shares issued in this offering. In connection with this transaction, the Company also issued warrants to purchase 2,000,000 shares of common stock (see Note 11). During the year ended December 31, 2003, the Company issued 75,000 shares of common stock to certain independent contractors performing services for the Company. Such shares were issued pursuant to Section 506 of Regulation D of the Securities and Exchange Act of 1933, as amended. The Company recorded $16,250 of expense related to the issuance of this stock. NOTE 3. PROPERTY AND EQUIPMENT The following is a summary of property and equipment at December 31:
2003 2002 ----------------- ----------------- Furniture and fixtures $ 175,856 $ 192,870 Equipment 424,901 392,499 Software 174,740 149,724 Leasehold improvements 8,434 - ----------------- ----------------- 783,931 735,093 Less: accumulated depreciation and amortization (568,775) (453,661) ----------------- ----------------- Total property and equipment, net $ 215,156 $ 281,432 ================= =================
NOTE 4. IMPAIRMENT OF ASSETS During the fourth quarter of 2002, the Company performed an impairment review because of the uncertainty of the Company's ability to continue as a going concern due to decreased liquidity, which indicated that the carrying value of certain long-lived assets may not be recoverable. The Company determined that customer relationship management software and document archival and retrieval software with a total carrying amount of $855,000 were no longer recoverable and recorded a non-cash charge of $855,000, which is included as a component of discontinued operations in the accompanying consolidated statement of operations. Fair value was based on the expected future cash flows to be generated by these assets, which was determined to be zero because of the Company's inability to deploy and utilize the assets to provide revenue-generating services. During the second quarter of 2003, the Company performed an impairment review because the Company expected to sell the asset group comprising the Business. The Company determined that the asset group to be sold was impaired and recorded a non-cash charge of $200,000, which is included as a component of discontinued operations in the accompanying consolidated statement of operations. Fair value was based on the expected selling price of the asset group. During the fourth quarter of 2003, the Company performed an impairment review because the Company expected to sell certain assets not currently being utilized. The Company determined that the assets expected to be sold within one year were impaired and recorded a non-cash charge of $17,000, which is included as a component of selling, general and administrative expense in the accompanying consolidated statement of operations. Fair value was based on the selling price of similar assets. The assets consist of furniture that has a net book value of $15,714 at December 31, 2003 and are included as a component of property and equipment in the accompanying consolidated balance sheets. These assets are not classified as held for sale because management has not yet initiated an active program to locate a buyer for the assets. NOTE 5. ACCRUED EXPENSES Accrued expenses consist of the following balances:
December 31, December 31, 2003 2002 ---------------- ---------------- Accrued salaries $ 11,325 $ 185,178 Accrued vacation - 80,517 Accrued property taxes - 84,018 Accrued sales taxes 101,696 4,489 Accrued professional fees 100,515 30,810 Other accrued expenses 10,644 170,548 ---------------- ---------------- Total $ 224,180 $ 555,560 ================ ================
NOTE 6. OPERATING LEASES In August 2003, the Company signed a three-year lease for approximately 4,500 square feet that will serve as the Company's headquarters. Additionally, the Company leases office equipment under non-cancelable operating leases. Rental expense under operating leases for continuing operations for the years ended December 31, 2003, 2002 and 2001, was $59,000, $97,000 and $87,000, respectively. Future minimum lease payments required under operating leases, by year and in the aggregate, consist of the following at December 31, 2003: Year ending December 31, 2004 $ 84,599 2005 83,199 2006 67,605 ---------- Total minimum lease payments $ 235,403 ========== NOTE 7. DEBT On July 24, 2002, the Company executed a financing agreement with Laurus Master Fund, Ltd. ("Laurus") in exchange for a $1.5 million convertible note and a four-year warrant to purchase 300,000 shares of the Company's common stock at exercise prices of $0.936 for the first 150,000 shares, $0.975 for the next 50,000 shares, and $1.17 for the remaining 100,000 shares. Laurus could convert the convertible note, which bore interest at 7% annually, at any time into shares of the Company's common stock at a fixed conversion price of $0.78, subject to certain restrictions in the purchase agreement. The Company could pay the principal and interest on the convertible note, which had a one-year term, in cash, shares of its common stock or a combination of cash and stock. If common stock was used to pay the note, the conversion price was the lesser of (i) $0.78 or (ii) 88% of the average of the 7 lowest closing prices during the 22 trading days prior to the date the Company gave notice of payment. Accrued interest and one-ninth of the principal was due on the first business day of each calendar month beginning on November 1, 2002 and continuing until the maturity date of July 1, 2003. If the required principal payment was made in cash, the principal amount paid was 105% of the amount due. The Company granted Laurus a security interest in all of its assets. The Company defaulted under the note during the fourth quarter of 2002 and a penalty of 120% of the outstanding principal amount, or $300,000, was assessed to the Company for the default, and was included in the balance of short-term borrowings on the Company's balance sheet at December 31, 2002. The default occurred because the Company did not make the required principal payments in cash. The Company was unable to make the required payments in stock because the registration statement filed by the Company with the Securities and Exchange Commission to register the resale of the common stock issuable to pay the note was not declared effective. The Company recorded a debt discount as a result of the issuance of the warrant to Laurus of approximately $259,000, which was being charged to interest expense over the term of the convertible note using the effective yield method. Upon the Company's default under the note, the remaining balance of the discount was charged to interest expense. Furthermore, the Company recorded an additional debt discount as a result of the beneficial conversion feature of approximately $283,000, which was charged to interest expense at the date of issuance. The amount related to the beneficial conversion feature was determined by dividing the note proceeds allocated to the convertible security of approximately $1,241,000 by the number of shares into which the note was convertible, or 1,923,077 shares based on the fixed conversion price of $0.78 per common share. The resulting effective conversion price of $0.65 per common share was then compared to the fair value of the Company's stock, which was $0.93 per common share on the issuance date. The difference of $0.28 per common share between the fair value of the stock and the effective conversion price was then multiplied by 1,009,586, which was the number of shares the note was convertible into at the date of issuance, taking into account the limitation on the number of shares that Laurus could convert at that time. The agreement stipulated that Laurus could not convert that amount of the note that would result in beneficial ownership of more than 4.9% of the outstanding common shares of the Company on the date of conversion. The conversion limitation was to become null and void upon an event of default under the note and could have been raised if the Company chose to redeem the outstanding principal amount of the note in cash and Laurus elected to convert the note instead. The limitation could also be raised if the Company were to issue additional common shares for any reason, thus increasing the number of outstanding shares. Due to the Company's default under the note during the fourth quarter of 2002, the 4.9% limitation became null and void and additional interest expense of approximately $256,000 was recognized at a rate of $0.28 per common share for the 913,491 additional shares that the note became convertible into upon default. During 2002, the Company capitalized $238,000 in financing costs related to the issuance of the Laurus debt that were being charged to interest expense over the term of the convertible note using the effective yield method. Upon default under the note in the fourth quarter of 2002, the remaining unamortized balance was charged to interest expense. In connection with the sale of substantially all of its assets (see Note 14), the Company paid the outstanding balance of the convertible note in cash, including accrued penalties and interest, in full settlement of all claims by Laurus during July 2003. In addition, the four-year warrant to purchase 300,000 shares of the Company's common stock initially granted to Laurus was canceled as part of the settlement. NOTE 8. RELATED PARTY TRANSACTIONS AND GUARANTEES From time to time, the Company has made loans to certain officers of the Company. The highest aggregate amount outstanding of loans due from officers (including an ex-officer of the Company) was $162,000 during 2002 and $230,000 during 2001. There were no loans due from officers during 2003. In December 2000, an officer of the Company borrowed approximately $20,000 that accrued interest at a rate of 8% annually. The loan was repaid in full during 2001. On August 16, 2000, an officer of the Company borrowed approximately $60,000 that accrued interest at a rate of 8% annually. At December 31, 2001, $46,000 was outstanding under this loan. In May 2002, this officer repaid the balance of this loan in full, including accrued interest. On December 21, 2000, the Company entered into a 30-day promissory note with the same officer for $125,000. The promissory note was repaid in full in January 2001, including interest at a rate of 8% annually. During 2000, an officer of the Company borrowed approximately $35,000, of which $25,000 was outstanding at December 31, 2000. During 2001, the Company loaned an additional $94,000 to this officer prior to his resignation from the Company. At December 31, 2001, the Company had an aggregate of $115,000 in notes receivable bearing interest at 8% annually from this ex-officer. In March 2002, this ex-officer repaid the balance of these loans in full, including accrued interest. Beginning in December 2000, the Company pledged as loan guarantees certain funds held as money market funds and certificates of deposit to collateralize certain margin loans of four officers of the Company (only two of which are currently employed by the Company). See Note 13 for a further discussion of these guarantees and pledged funds. NOTE 9. INCOME TAXES Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31 are as follows:
2003 2002 -------------------- ------------------- Deferred Tax Assets: - -------------------- Warrant expense $ 3,166,992 $ 3,166,992 Loss on related party guarantees 434,567 434,567 Net operating loss carryforwards 11,759,182 11,818,879 Other items 91,019 624,016 -------------------- ------------------- 15,451,760 16,044,454 Valuation allowance (15,400,069) (15,921,467) -------------------- ------------------- Total Deferred Tax Asset 51,691 122,987 Deferred Tax Liabilities: - ------------------------- Depreciation and other items 51,691 122,987 -------------------- ------------------- Net Deferred Tax Asset (Liability) $ - $ - ==================== ===================
For the period from inception (July 30, 1998) through December 31, 2003, the Company has net operating loss carryforwards for tax purposes of approximately $34.6 million that begin to expire in the year 2020. In October 1999, the Company issued common stock pursuant to a private placement offering. As a result, an ownership change occurred under Section 382 that limits the utilization of pre-change net operating loss carryforwards. Approximately $3.5 million of the total net operating loss is subject to the Section 382 limitations. The reconciliation of income tax computed at the U.S. federal statutory tax rates to income tax expense is as follows:
2003 2002 2001 -------------------- ------------------- ------------------- Tax at US statutory rate -- 34% $ 164,865 $ (3,724,590) $ (3,537,940) Change in valuation allowance (521,398) 3,700,366 3,421,050 Permanent and other differences 356,533 24,224 116,890 -------------------- ------------------- ------------------- Income tax expense $ - $ - $ - ==================== =================== ===================
NOTE 10. EMPLOYMENT BENEFIT PLANS STOCK OPTION PLANS The Board of Directors and stockholders approved the 1999 Employee Comprehensive Stock Plan ("Employee Plan") to provide qualified incentive stock options ("ISOs") and non-qualified stock options ("NQSOs") as well as restricted stock to key employees. Under the terms of the Employee Plan, the exercise price of ISOs must be equal to 100% of the fair market value on the date of grant (or 110% of fair market value in the case of an ISO granted to a 10% stockholder/grantee). There is no price requirement for NQSOs, other than that the option price must exceed the par value of the common stock. The Company has reserved 5,000,000 shares of its common stock for issuance pursuant to the Employee Plan. On December 29, 2003, the Employee Plan was amended and restated by the Board of Directors to add provisions 1) allowing for stock awards to be made to consultants as provided in Rule 405 promulgated under the Securities Act of 1933, as amended from time to time, and other applicable law, 2) increasing the amount of shares of common stock of the Company exercisable per fiscal year from stock options, whether ISOs or NQSOs, from 350,000 to 500,000, and 3) removing minimum holding periods on "Restricted Stock" as such term is defined in the Employee Plan. The 1999 Non-Employee Director Plan ("Director Plan") was approved by the Board of Directors and stockholders in 1999. Under the Director Plan, non-employee directors may be granted options to purchase shares of common stock at 100% of fair market value on the date of grant. The Company has reserved 800,000 shares of its common stock for issuance pursuant to the Director Plan. In May 2002, the Company tendered an offer to employees and non-employee directors to cancel certain outstanding stock options under a stock option exchange program. In return for voluntarily canceling certain stock options, employees and non-employee directors were granted an equal number of stock options promptly after six months and one day from the cancellation date. The exercise price of the new options granted was equal to the fair market value of the Company's common stock on the grant date. The program is not expected to result in any additional compensation expense or variable plan accounting. In connection with this offer, 754,925 options were canceled on June 11, 2002 and 513,150 options were granted on December 13, 2002 at an exercise price of $0.26 per share. Activity under the Employee Plan and Director Plan is as follows:
Weighted Average Number of Shares Exercise Price ------------------- ------------------ Outstanding, December 31, 2000 2,899,175 $ 4.95 Granted 2,045,162 0.97 Canceled (646,032) 4.67 Exercised (8,000) 4.38 ------------------- Outstanding, December 31, 2001 4,290,305 3.10 Granted 3,104,250 0.23 Canceled (1,632,906) 5.09 Exercised - - ------------------- Outstanding, December 31, 2002 5,761,649 0.99 Granted 1,755,000 0.13 Canceled (2,699,579) 0.87 Exercised (265,300) 0.19 ------------------- Outstanding, December 31, 2003 4,551,770 $ 0.78 ===================
There was an aggregate of 971,230 and 26,651 options to purchase the Company's common stock available for future grants under the Employee and Director Plans at December 31, 2003 and 2002, respectively. Exercisable stock options amounted to 3,171,770 at a weighted average price of $1.06 and 1,604,492 at a weighted average price of $2.33 at December 31, 2003 and 2002, respectively. Summarized information about stock options outstanding at December 31, 2003 is as follows:
Options Outstanding Options Exercisable ------------------------------------- ------------------------------------ Weighted Average Weighted Range of Exercise Options Remaining Average Number of Weighted Average Prices Outstanding Contractual Life Exercise Price Options Exercise Price - ----------------------- ----------------- ------------------- ----------------- ----------------- ------------------ $0.09 - $0.14 1,730,000 9.90 $0.13 350,000 $0.09 $0.18 - $0.26 1,271,100 8.99 $0.19 1,271,100 $0.19 $0.86 - $0.88 741,668 7.83 $0.86 741,668 $0.86 $1.88 - $2.07 354,001 7.03 $2.06 354,001 $2.06 $2.81 - $11.25 455,001 5.14 $3.76 455,001 $3.76 ----------------- ----------------- 4,551,770 8.61 $0.78 3,171,770 $1.06 ================= =================
The weighted average fair value of stock options at date of grant was $0.10, $0.17 and $0.73 per option for options granted during fiscal years 2003, 2002, and 2001, respectively. The fair value of each option granted was estimated using the Black-Scholes option-pricing model, utilizing the following assumptions:
2003 2002 2001 ---- ---- ---- Dividend yield None None None Expected volatility 142% 128% 119% Risk-free interest rate 1.80% 1.80% 3.40% Expected life 2.45 3.74 3.95
EMPLOYEE STOCK PURCHASE PLAN The Company established the 1999 Employee Stock Purchase Plan ("ESPP") under the requirements of Section 423 of the Internal Revenue Code (the "Code") to allow eligible employees to purchase the Company's common stock at regular intervals. Participating employees may purchase common stock through voluntary payroll deductions at the end of each participation period at a purchase price equal to 85% of the lower of the fair market value of the common stock at the beginning or the end of the participation period. Common stock reserved for future employee purchases under the plan aggregated 755,828 shares at December 31, 2003. A total of 43,857, 65,273 and 117,194 shares were issued under the ESPP in 2003, 2002 and 2001, respectively, at prices ranging from $0.15 per share to $2.18 per share. 401(K) PLAN In May 1999, the Company adopted a defined contribution plan (the "401(k) Plan") pursuant to Section 401(k) of the Code. All eligible full and part-time employees of the Company who meet certain age requirements may participate in the 401(k) Plan. Participants may contribute between 1% and 15% of their pre-tax compensation, but not in excess of the maximum allowable under the Code. The 401(k) Plan allows for discretionary and matching contributions by the Company. The Company made no contributions during fiscal 2003, 2002 or 2001. NOTE 11. STOCK WARRANTS In connection with the CheckFree investment (see Note 2), the Company issued CheckFree warrants to purchase 2,179,121 shares at $11.375 per share for entering into the extended biller service provider agreement and investing $10.0 million. Under this agreement, CheckFree provided the Company with electronic bill presentment services for volume-based fees. The Company recorded $7,488,000 of expense and a corresponding credit to additional paid-in capital related to the estimated fair value of 1.3 million of these warrants, which were issued as consideration for entering into the extended biller service provider agreement. The related warrant expense was recognized immediately instead of being deferred and recognized over the life of the agreement because the warrants were fully vested at the date of grant and CheckFree did not have to perform under the agreement to earn the warrants. Also, CheckFree had the ability to earn incentive warrants on up to 2,801,903 additional shares, of which 1,000,000 were exercisable at $11.375 per share and 1,801,903 were exercisable at $14.219 per share. The incentive warrants were to vest upon the achievement of certain target levels of referred billers to the Company by CheckFree and all such warrants that were not vested within five years would expire. None of these incentive warrants vested and all were effectively canceled with the assignment of the related service agreement to the purchaser of substantially all of the assets of the Company in July 2003 (see Note 14). In connection with the 2001 Offering (see Note 2), the Company issued warrants to the eighteen investors to purchase 2,000,000 shares of common stock at $1.80 per share, or one warrant for each share issued. The warrants are exercisable for five years from the date of issuance, or until November 27, 2006. The Company has the right to call the exercise of the warrants at any time after six months after the date of the issuance and after the closing price of the common stock exceeds $5.40 for a period of twenty consecutive trading days. Upon such call notice, the holders of the warrants must exercise the warrants within thirty days, after which time they may be redeemed for $.05 per warrant. In connection with the July 2002 convertible debt issuance (see Note 7), the Company issued a warrant to purchase 300,000 shares of the Company's common stock at exercise prices of $0.936 for the first 150,000 shares, $0.975 for the next 50,000 shares, and $1.17 for the remaining 100,000 shares. Using the fair value-based method of accounting, the Company recorded $259,000 of expense and a corresponding credit to paid-in-capital during 2002 related to the issuance of this warrant. These warrants were subsequently canceled in July 2003 in conjunction with the settlement and repayment of the related debt. At December 31, 2003, the outstanding vested warrants to purchase common stock are as follows:
Shares of Common Exercise Aggregate Expiration Stock Price Exercise Date Price - ---------------------------------------------------------------- 41,237 $ 6.06 $ 250,000 08/05/2004 250 3.25 813 10/14/2004 280 8.00 2,240 12/15/2004 8,890 7.41 65,875 12/20/2004 3,500 7.31 25,585 12/22/2004 2,179,121 11.38 24,798,397 06/02/2010 2,000,000 1.80 3,600,000 11/27/2006 --------- ------------ 4,233,278 $ 28,742,910 ========= ============
NOTE 12. COMMON STOCK LISTING The Company's common stock began trading on the Over the Counter Bulletin Board ("OTCBB") operated by the National Association of Securities Dealers ("NASD") on December 3, 1998. The NASD adopted eligibility rules in 1999, which required clearance of comments by the SEC on all SEC filings. The Company filed its initial filing on Form 10 with the SEC on June 10, 1999 but, as of October 7, 1999, the SEC had not cleared its comment period. In accordance with the OTCBB's phase-in schedule for the new eligibility rules, the listing on the OTCBB was terminated. The Company's common stock was quoted in the National Quotation Board's Electronic Pink Sheets until December 7, 1999, when the SEC cleared the comment period and the stock was relisted and traded on the OTCBB through March 13, 2000 at which time the stock was approved for trading on the NASDAQ Small Cap Market. Subsequently the stock was approved for trading on the NASDAQ National Market ("NNM") on July 31, 2000, under the symbol "BLLS." On February 4, 2003, the NNM delisted the Company's common stock because the Company did not meet the requirements for continued listing on the NNM. The Company's common shares were immediately eligible for quotation on the OTCBB effective at opening of business on February 4, 2003. On July 29, 2003, the Company amended its Articles of Incorporation to change its name to Payment Data Systems, Inc. and began trading on the OTCBB under a new symbol, PYDS, on August 20, 2003. NOTE 13. LEGAL PROCEEDINGS Beginning in December 2000, the Company pledged as loan guarantees certain funds held as money market funds and certificates of deposit to collateralize margin loans for the following executive officers of the Company: (1) Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A. Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard, then Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones, then Executive Vice President. Mr. Millard and Mr. Jones no longer are employees of the Company. The Company's purpose in collateralizing the margin loans was to prevent the sale of its common stock owned by these officers while it was pursuing efforts to raise additional capital through private equity placements. The sale of that common stock could have hindered the Company's ability to raise capital in such a manner and compromised its continuing efforts to secure additional financing. The Company was also trying to accommodate the requests of the named executive officers, who were seeking to preserve their financial liquidity. The Company believed this action served its purpose of assuring stable management and leadership for their future. The margin loans were obtained in March 1999 from institutional lenders and were secured by shares of the Company's common stock owned by these officers. Each of the officers used the proceeds of their respective margin loans for investment purposes and usual and customary living expenses. None of the margin loans were recourse with respect to the officers and none of the loan guarantees were recourse with respect to the Company because at the times the margin loans were made and the funds pledged, the value of the common stock collateralizing the margin loans exceeded the loan amounts. Under the original terms of the arrangement, the Company charged each of the officers, pro rata, the difference between the rate of return earned by them before the collateralization of the margin loans on the funds that were to be the pledged funds and the rate of return earned on the pledged funds after the collateralization of the margin loans. The Company offset such amounts due from Mr. Long, Mr. Hoch, and Mr. Millard against their respective salaries from the date the funds were pledged until November of 2002, when the Company underwent significant downsizing and Mr. Long, Mr. Hoch, and Mr. Millard began deferring their salaries. The Company offset such amounts due from Mr. Jones against his salary from the date the funds were pledged until the date of his departure from the Company in August 2001. The highest total amount of funds pledged for the margin loans guaranteed by us was approximately $2.0 million. The total balance of the margin loans guaranteed by the Company was approximately $1.3 million at December 31, 2002. At the time the funds were pledged, the Company believed they would have access to them because (a) their stock price was substantial and the stock pledged by the officers, if liquidated, would produce funds in excess of the loans payable, and (b) with respect to one of the institutional lenders (who was also assisting the Company as a financial advisor at the time), even if the stock price fell, they had received assurances from that institutional lender that the pledged funds would be made available as needed. During the fourth quarter of 2002, the Company requested partial release of the funds for operating purposes, which request was denied by an institutional lender. At that time, their stock price had fallen as well, and it became clear that both institutional lenders would not release the pledged funds. In light of these circumstances, the Company recognized a loss on the guarantees of $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable under related party guarantees on their balance sheet at December 31, 2002 because it became probable at that point that they would be unable to recover their pledged funds. During the quarter ended March 31, 2003, the lenders applied the pledged funds to satisfy the outstanding balances of the loans. The total balance of the margin loans guaranteed by the Company was zero at December 31, 2003. The pledged funds were classified as cash and cash equivalents on the Company's balance sheet and disclosed in the accompanying footnotes in the Company's Annual Report on Form 10-K for each of the years ended December 31, 2000 and 2001, respectively. The pledged funds were classified as cash and cash equivalents on the Company's balance sheet and disclosed in the accompanying footnotes in the Company's Quarterly Report on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002, respectively. After the Company's request for partial release of the funds was denied by an institutional lender, the pledged funds were classified as cash pledged as collateral for related party obligations on the Company's balance sheet and disclosed in the accompanying footnotes in the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. On June 30, 2003, the Company filed an amended Annual Report on Form 10-K for the year ended December 31, 2001 and amended Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002 as a result of comments received from the Securities and Exchange Commission in connection with their review of the Company's registration statement on Form S-3 that was originally filed on August 9, 2002. These amended reports included restated balance sheets that classified the pledged funds as cash pledged as collateral for related party obligations because by the time the amended reports were filed, it was clear that the funds would not be released as the Company had been assured. 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 their respective employment agreements based on the Company's preliminary analysis. The Company has not pursued the outstanding repayment obligation of Mr. Jones because they do not consider a recovery attempt to be cost beneficial. The ultimate outcome of this matter cannot presently be determined. On July 25, 2003, certain stockholders (those stockholders being Mike Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick, Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal action against the Company, Ernst & Young, LLP and certain of the Company's current and former directors (including the executive officers named above) in the District Court of the 45th Judicial District, Bexar County, Texas (the "Suit"). With respect to the Company and the current and former directors named in the suit, the plaintiffs allege that the Company, acting through such directors, misstated in the Company's 2000 and 2001 Form 10-Ks the Company's ability to use for operational purposes the funds pledged as security for margin loans of certain of the Company's executive officers, as discussed above. The Plaintiffs allege and seek economic and exemplary damages, rescission, interest, attorneys' fees and costs of court. The Company believes this suit is without merit and intends to vigorously defend the company and the directors named in the suit. The results of legal proceedings cannot be predicted with certainty. If the Company fails to prevail in this legal matter, the Company's financial position, results of operations, and cash flows could be materially adversely affected. NOTE 14. DISCONTINUED OPERATIONS On July 25, 2003 (the "Closing") the Company sold substantially all of its assets (the "Business") to Saro, Inc., a Delaware corporation (the "Purchaser"), which is a wholly owned subsidiary of CyberStarts, Inc., a Delaware corporation (the "Sale"). The aggregate selling price for the Business was $4,800,000 (the "Purchase Price"), including $700,000 subject to certain earnout provisions, plus the Purchaser's assumption of certain liabilities of the Company. The Purchase Price was determined through extensive negotiations between the Purchaser and the Company. The Board of Directors of the Company, in its reasonable business judgment, approved the Purchase Price based upon the following factors: 1) the extensive search for a purchaser of the Business; 2) the number of offers made by potential purchasers for the Business; 3) the Company's ability to raise other sources of capital to operate the Business; and 4) the future trends in the industry of the Business. The sale of the Business was approved by a majority of the shareholders of PDS at a Special Meeting of Shareholders held on July 14, 2003. The assets sold represented the Company's proprietary technology infrastructure along with certain third party software and hardware platforms and certain furniture and fixtures that supported its service offerings, including its eServ and eConsulting products. The carrying value of these non-current assets was approximately $1,068,000 at July 25, 2003 and $1,890,000 at December 31, 2002 as detailed below:
July 25, 2003 December 31, 2002 Computer hardware 2,809,294 2,808,985 Software (third party) 1,462,983 1,462,983 Furniture and fixtures 596,140 876,817 Proprietary technology - - Total cost 4,868,417 5,184,236 Less:accumulated depreciation and amortization (3,800,198) (3,293,878) Total net book value of assets sold 1,068,219 1,890,358
The Company expensed the costs to develop our proprietary technology infrastructure as they were incurred so these assets had no recorded value at the date of sale. The Purchaser also assumed certain current and non-current liabilities with carrying values of $83,000 and $30,000, respectively, at July 25, 2003. The assets sold represented virtually all of the Company's assets, which it used to produce nearly all of its revenue; therefore, the Company has ceased its primary operations and will continue to operate its bills.com consumer bill payment portal and concentrate on building its electronic payments business. The results of operations for the asset group disposed of have been reported as discontinued operations in the accompanying statements of operations. During the years ended December 31, 2003, 2002 and 2001, these discontinued operations provided revenue of $2,155,000, $4,129,000 and $2,925,000, respectively. The Company retained its accounts receivable and related deferred revenue associated with the customers of the Business, as well as certain accounts payable and accrued liabilities related to the Business. At December 31, 2003, the Company's balance sheet included approximately $38,000 of net accounts receivable and approximately $277,000 of current liabilities that related to the operations of the Business. At Closing, the Purchaser paid the Company $4,100,000 in cash. The Company may earn an additional $700,000 based upon two earnouts calculated upon gross revenues of the Business for the four consecutive quarters following the Closing, the first quarter of which begins the first day of the first full month after the Closing. The Sale of the Business qualifies as a change of control under the employee agreements of certain officers of the Company, which may result in the assertion of claims by these officers under their employee agreements. The ultimate outcome of this matter cannot presently be determined. Subsequent to the Sale, the Company settled claims made under employee agreements by the Chief Financial Officer and Chief Marketing Officer for cash consideration of $200,000 in the aggregate, including approximately $30,000 that is contingent on the Company meeting the earnout provisions of the Sale, and terminated their respective employee agreements. NOTE 15. SUBSEQUENT EVENTS In February 2004, the Company executed an agreement for an equity line of credit with Dutchess Private Equities Fund, LP ("Dutchess"). Under the terms of the agreement, PDS may elect to receive as much as $10 million from Dutchess in common stock purchases over the next three years at the option of the Company. The Company agreed to file with the Securities and Exchange Commission, and have declared effective before any funds may be received under the agreement, a registration statement registering the resale of the shares of the Company's common stock to be issued to Dutchess. Any funds received will be used, as needed, to support on-going operations and enhance potential merger and acquisition activity. In February 2004, the Company issued 55,000 shares of common stock under the terms of its Amended 1999 Comprehensive Employee Stock Plan ("Employee Plan") to a former employee for services provided while employed by the Company in 2003. During the quarter ended March 31, 2004, the Company issued a total of 300,000 shares of common stock under the terms of its Employee Plan to an independent contractor providing financial consulting services to the Company. Through March 15, 2004, the Company issued a total of 72,225 shares of common stock to certain independent contractors performing services for the Company. Such shares were issued pursuant to Section 506 of Regulation D of the Securities and Exchange Act of 1933, as amended. NOTE 16. QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for 2003 and 2002 is presented below.
2003 ----------------------------------------------------- First Second Third Fourth ----------------------------------------------------- Revenue $ 24,156 $ 28,915 $ 29,342 $ 36,884 Loss from continuing operations (464,305) (489,516) (336,161) (484,317) Income (loss) from discontinued operations (337,653) (423,446) 2,956,579 63,715 Net income (loss) (801,958) (912,962) 2,620,418 (420,602) Basic and diluted income (loss) per common share (a): Loss from continuing operations (0.02) (0.02) (0.01) (0.02) Income (loss) from discontinued operations (0.02) (0.02) 0.14 - Net income (loss) (0.04) (0.04) 0.13 (0.02) Weighted average common shares outstanding 20,686,189 20,722,656 20,722,656 21,395,343 2002 ----------------------------------------------------- First Second Third Fourth ----------------------------------------------------- Revenue $ 15,071 $ 18,422 $ 20,774 $ 22,803 Loss from continuing operations (647,869) (718,701) (1,139,610) (2,756,280) Income (loss) from discontinued operations (1,244,761) (1,430,481) (1,136,095) (1,880,880) Net loss (1,892,630) (2,149,182) (2,275,705) (4,637,160) Basic and diluted income (loss) per common share (a): Loss from continuing operations (0.03) (0.03) (0.06) (0.14) Income (loss) from discontinued operations (0.06) (0.07) (0.05) (0.09) Net income (loss) (0.09) (0.10) (0.11) (0.23) Weighted average common shares outstanding 20,577,813 20,581,126 20,602,074 20,603,799
(a) Earnings per common share are computed independently for each of the quarters presented. Therefore, the sum of the quarterly per common share information may not equal the annual income or loss per common share. PAYMENT DATA SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS March 31, 2004 December 31, 2003 ---------------- ------------------- (Unaudited) ---------------- Assets: Current assets: Cash and cash equivalents . . . . . . . . . . . . . . $ 268,230 $ 528,119 Accounts receivable, net. . . . . . . . . . . . . . . 28,227 43,693 Prepaid expenses and other. . . . . . . . . . . . . . 66,388 113,650 ---------------- ------------------- Total current assets . . . . . . . . . . . . . . . . . . 362,845 685,462 Property and equipment, net. . . . . . . . . . . . . . . 192,303 215,156 Other assets . . . . . . . . . . . . . . . . . . . . . . 34,032 37,782 ---------------- ------------------- Total assets . . . . . . . . . . . . . . . . . . . . . . $ 589,180 $ 938,400 ---------------- ------------------- Liabilities and stockholders' equity (deficit): Current liabilities: Accounts payable. . . . . . . . . . . . . . . . . . . $ 511,376 $ 501,488 Accrued expenses. . . . . . . . . . . . . . . . . . . 186,418 224,180 ---------------- ------------------- Total current liabilities. . . . . . . . . . . . . . . . 697,794 725,668 Stockholders' equity: Common stock, $0.001 par value, 200,000,000 shares authorized; 21,495,181 and 20,987,956 issued and outstanding . . . . . . . . . . . . . . . . . . . . . . 21,445 20,988 Additional paid-in capital . . . . . . . . . . . . . . . 46,921,821 46,842,908 Accumulated deficit. . . . . . . . . . . . . . . . . . . (47,051,880) (46,651,164) ---------------- ------------------- Total stockholders' equity (deficit) . . . . . . . . . . (108,614) 212,732 ---------------- ------------------- Total liabilities and stockholders' equity (deficit) . . $ 589,180 $ 938,400 ---------------- ------------------- See notes to interim consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) Three Months Ended March 31, 2004 2003 --------------- ------------- Revenues . . . . . . . . . . . . . . . . . . . . . . . . $ 55,197 $ 24,156 Operating expenses: Cost of services . . . . . . . . . . . . . . . . . . . . 63,640 17,530 Selling, general and administrative. . . . . . . . . . . 359,819 388,593 Depreciation and amortization. . . . . . . . . . . . . . 27,682 36,073 ---------------- ------------ Total operating expenses . . . . . . . . . . . . . . . . 451,141 442,196 ---------------- ------------ Operating loss . . . . . . . . . . . . . . . . . . . . . (395,944) (418,040) Other income (expense), net: Interest income. . . . . . . . . . . . . . . . . . . . . 398 4,168 Interest expense . . . . . . . . . . . . . . . . . . . . - (44,393) Other income (expense) . . . . . . . . . . . . . . . . . (5,170) (6,040) ---------------- ------------ Total other income (expense), net. . . . . . . . . . . . (4,772) (46,265) ---------------- ------------ Loss from continuing operations before income taxes. . . . . . . . . . . . . . . . . . . . . . (400,716) (464,305) Income taxes . . . . . . . . . . . . . . . . . . . . . . - - ---------------- ------------ Loss from continuing operations. . . . . . . . . . . . . (400,716) (464,305) Discontinued operations: Loss from discontinued operations, net of no income taxes . . . . . . . . . . . . . . . . . . . . - (337,653) ---------------- ------------ Net loss . . . . . . . . . . . . . . . . . . . . . . . . $ (400,716) $ (801,958) ---------------- ------------ Basic and diluted loss per common share: Loss from continuing operations. . . . . . . . . . . . . $ (0.02) $ (0.02) Loss from discontinued operations. . . . . . . . . . . . - (0.02) ---------------- ------------ Net loss . . . . . . . . . . . . . . . . . . . . . . . . $ (0.02) $ (0.04) ---------------- ------------ Weighted average common shares outstanding . . . . . . . . . . . . . . . . . . . . . . 21,189,477 20,686,189 See notes to interim consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) =========== Three Months Ended March 31, --------------------------- 2004 2003 ---------- Operating activities: Loss from continuing operations . . . . . . . . . . . . $(400,716) $ (464,305) Adjustments to reconcile loss from continuing operations to net cash used in operating activities: Depreciation and amortization. . . . . . . . . . . . . 27,682 36,073 Non-cash issuance of common stock. . . . . . . . . . . 59,700 16,250 Changes in current assets and current liabilities: Accounts receivable. . . . . . . . . . . . . . . . . . 15,466 (68,593) Prepaid expenses and other . . . . . . . . . . . . . . 47,262 95,522 Accounts payable and accrued expenses. . . . . . . . . (11,549) 284,346 Deferred revenue . . . . . . . . . . . . . . . . . . . - (7,985) ---------- ------------ Net cash used in continuing operations. . . . . . . . . (262,155) (108,692) Net cash used in discontinued operations. . . . . . . . - (51,220) ---------- ------------ Net cash used in operating activities . . . . . . . . . (262,155) (159,912) Investing activities: Purchases of property and equipment . . . . . . . . . . (1,079) - ---------- ------------ Net cash used in investing activities . . . . . . . . . (1,079) - Financing activities: Cash pledged as collateral for related party obligations . . . . . . . . . . . . . . . . . . . . . . - 1,311,984 Payments for related party obligations. . . . . . . . . - (1,278,138) Issuance of common stock, net of issuance costs . . . . 3,345 6,710 ---------- ------------ Net cash provided by financing activities . . . . . . . 3,345 40,556 ---------- ------------ Change in cash and cash equivalents . . . . . . . . . . (259,889) (119,356) Cash and cash equivalents, beginning of period. . . . . 528,119 286,105 ---------- ------------ Cash and cash equivalents, end of period. . . . . . . . $ 268,230 $ 166,749 ---------- ------------ See notes to interim consolidated financial statements.
PAYMENT DATA SYSTEMS, INC. NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Note 1. Basis of Presentation The accompanying unaudited consolidated financial statements of Payment Data Systems, Inc. and subsidiaries (the "Company"), have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to present fairly the Company's financial position, results of operations and cash flows for such periods. The accompanying interim consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Results of operations for interim periods are not necessarily indicative of results that may be expected for any other interim periods or the full fiscal year. Certain prior period amounts have been reclassified to conform to the current year presentation. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Note 2. Stock-Based Compensation The Company applies the intrinsic value method under the recognition and measurement provisions of APB No. 25, "Accounting for Stock Issued to Employees," in accounting for its stock option and stock purchase plans. Accordingly, no stock-based employee compensation expense has been recognized for options granted with an exercise price equal to the market value of the underlying common stock on the date of grant or in connection with the employee stock purchase plan. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation.
Three Months Ended March 31, 2004 2003 ---------- ---------- Net loss, as reported $(400,716) $(801,958) Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (67,755) (190,974) ---------- ---------- Pro forma net loss (468,471) (992,932) ========== ========== Net loss per common share - basic and diluted, as reported $ (0.02) $ (0.04) Net loss per common share - basic and diluted, pro forma $ (0.02) $ (0.05)
Note 3. Discontinued Operations Prior to selling substantially all of its assets in July 2003, the Company provided electronic bill presentment and payment ("EBPP") services to companies generating recurring bills and also provided related EBPP consulting and Internet-based customer care interaction services. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," the results of operations for the asset group disposed of have been classified as discontinued operations. All financial information presented for the three months ended March 31, 2003 has been restated to reflect the operating results of this asset group as discontinued operations. Note 4. Related Party Transactions Beginning in December 2000, the Company pledged certain funds held as money market funds and certificates of deposit to collateralize certain margin loans of four executive officers of the Company (only two of which are currently employed by the Company). The margin loans were from institutional lenders and were secured by shares of the Company's common stock held by these officers. The Company's purpose in collateralizing the margin loans was to prevent the sale of the Company's common stock held by these officers while the Company was pursuing efforts to raise additional capital through private equity placements. The sale of the Company's common stock could have hindered the Company's ability to raise capital in such a manner and compromised the Company's continuing efforts to secure additional financing. The total balance of the margin loans guaranteed by the Company was approximately $1.3 million at December 31, 2002. The Company believed it had the unrestricted legal right to use the pledged funds for its operations, if necessary, based on (i) its interpretation of the loan guarantee agreements, (ii) the market price of the Company's stock at the time of the pledge, and (iii) assurances the Company received from one of the institutional lenders that funds would be made available if needed. During the fourth quarter of 2002, the Company sought partial release of the funds for operating purposes, which was denied by the institutional lender, based upon their interpretation of the loan guarantee agreements. In light of this action, the Company recognized a loss on the guarantees of $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable under related party guarantees on the Company's balance sheet at December 31, 2002. During the quarter ended March 31, 2003, the lenders applied the pledged funds being held to satisfy the outstanding balances of the loans. The total balance of the margin loans guaranteed by the Company was zero at March 31, 2004. The Company may institute litigation or arbitration concerning these matters, which may result in the assertion of claims by these officers under their employee agreements. The ultimate outcome of this matter cannot presently be determined. Note 5. Equity Line of Credit In February 2004, the Company executed an agreement for an equity line of credit with Dutchess Private Equities Fund, LP ("Dutchess"). Under the terms of the agreement, the Company may elect to receive as much as $10 million from Dutchess in common stock purchases over the next three years at the option of the Company. The Company agreed to file with the Securities and Exchange Commission, and have declared effective before any funds may be received under the agreement, a registration statement registering the resale of the shares of the Company's common stock to be issued to Dutchess. The Company filed a registration statement on Form SB-2 with the Securities and Exchange Commission on April 28, 2004 to register the resale of these shares. As of the date of this report, the Securities and Exchange Commission had not declared this registration statement effective. Note 6. Issuance of Capital Stock In February 2004, the Company issued 55,000 shares of common stock under the terms of its Comprehensive Employee Stock Plan to a former employee for services provided while employed by the Company in 2003. During the quarter ended March 31, 2004, the Company also issued a total of 315,000 shares of common stock under the terms of its Comprehensive Employee Stock Plan to independent contractors providing consulting services to the Company and recorded approximately $60,000 of related expense. In March 2004, the Company issued 15,000 shares of common stock and received cash proceeds of approximately $3,000 related to the exercise of stock options granted under the terms of its Comprehensive Employee Stock Plan. During the quarter ended March 31, 2004, the Company issued a total of 72,225 shares of common stock to certain independent contractors performing services for the Company. Such shares were issued pursuant to Section 506 of Regulation D of the Securities and Exchange Act of 1933, as amended. The Company recorded approximately $11,000 of equity related to the issuance of this stock. Note 7. 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 3) and reduced expenditures for operating requirements. Despite these actions, the Company believes that its current available cash along with anticipated revenues may be insufficient to meet its anticipated cash needs for the foreseeable future. Consequently, the Company's ability to continue as a going concern may be contingent on the Company receiving additional funds in the form of equity or debt financing. Accordingly, the Company is currently aggressively pursuing strategic alternatives, including investment in the Company via an equity line of credit (see Note 5). The sale of additional equity or convertible debt securities would result in additional dilution to the Company's stockholders, and debt financing, if available, may involve restrictive covenants which could restrict operations or finances. There can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all. If the Company cannot raise funds, on acceptable terms, or achieve positive cash flow, it may not be able to continue to exist, conduct operations, grow market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which would negatively impact its business, operating results and financial condition. Note 8. Subsequent Events In April 2004, the Company issued 50,000 shares of common stock under the terms of its Comprehensive Employee Stock Plan to an independent contractor providing consulting services to the Company. The Company recorded $9,500 of expense related to the issuance of this stock. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On February 10, 2004, our Board of Directors of, upon recommendation of its Audit Committee, dismissed Ernst & Young LLP as our independent accountants and appointed the firm of Akin, Doherty, Klein & Feuge, P.C., a professional corporation, to serve as our independent public accountants for the fiscal year ending December 31, 2003. Ernst & Young's report on our consolidated financial statements for the fiscal year ended December 31, 2002 contained a qualified opinion as to the uncertainty of our ability to continue as a going concern. During the years ended December 31, 2002 and 2001 and through the date hereof, there were no disagreements with Ernst & Young on any matter of accounting principle or practice, financial statement disclosure, or auditing scope or procedure which, if not resolved to Ernst & Young's satisfaction, would have caused them to make reference to the subject matter of such disagreements in connection with their report on our consolidated financial statements for such years; and there were no reportable events as defined in Item 304(a)(1)(iv) of Regulation S-K. During the years ended December 31, 2002 and 2001 and through February 10, 2004, we did not consult with Akin Doherty with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on our consolidated financial statements, or any other matters or reportable events as set forth in Items 304(a)(2)(i) and (ii) of Regulation S-K. PAYMENT DATA SYSTEMS, INC. 40,000,000 Shares of Common Stock No dealer, salesman or any other person has been authorized to give any information or to make any representations other than those contained in this Prospectus, and, if given or made, such information or representations must not be relied on as having been authorized by Payment Data Systems, Inc. This Prospectus does not constitute an offer to sell or a solicitation of an offer to buy, by any person in any jurisdiction in which it is unlawful for such person to make such offer or solicitation. Neither the delivery of this Prospectus nor any offer, solicitation or sale made hereunder, shall under any circumstances create an implication that the information herein is correct as of any time subsequent to the date of the Prospectus. PROSPECTUS ---------- Until [90 days from the date of effectiveness], all dealers effecting transactions in the registered securities, whether or not participating in the distribution thereof, may be required to deliver a Prospectus. This is in addition to the obligation of dealers to deliver a Prospectus when acting as Underwriters and with respect to their unsold allotment or subscriptions. June 18, 2004 ------------- PART II. INFORMATION NOT REQUIRED IN PROSPECTUS INDEMNIFICATION OF DIRECTORS AND OFFICERS Please refer to "DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR SECURITIES ACT LIABILITIES." OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION The following table sets forth our expenses in connection with this registration statement. All of these expenses are estimates, other than the filing fees payable to the Securities and Exchange Commission. Filing Fee--Securities and Exchange Commission $ 1,432 Legal Expenses $17,000 Accounting Expenses $ 2,500 Blue Sky Fees and Expenses $ 1,000 Printing Expenses $ 1,500 Miscellaneous expenses $ 1,568 --------- Total: $25,000 RECENT SALES OF UNREGISTERED SECURITIES We sold an aggregate of 112,500 shares of our unregistered common stock, par value $0.001, to Bil Manes, Marc Orcutt and Mike Jisha, three separate independent contractors, in consideration for services completed on December 15, 2002, January 15, 2003, February 15, 2003, March 15, 2003, April 15, 2003, and May 15, 2003. Mr. Manes and Mr. Orcutt provided sales and marketing consulting services to us and Mr. Jisha provided telecommunications consulting services to us. The total value of the services received from these contractors was $22,625. The shares were valued at the average closing price of our common stock over the period that the services were performed since the individual contractor service agreements called for a specified number of shares to be issued for each month that the contractor provided services.The offers and sales the subject hereof satisfied the terms and conditions of Section 506 of Regulation D as no general solicitation was undertaken. In December 2003, we agreed to issue 34,725 shares of our unregistered common stock, par value $0.001, to Comp-Utility Corporation, an independent contractor in consideration for equipment installation services provided to us with a total value of $5,000. The shares were valued at a 4% discount to the closing price of our common stock of $0.15 on December 22, 2003, which was the date that the contractor agreed to accept our common stock instead of cash as payment for invoiced amounts of $5,000. The offer and sale the subject hereof satisfied the terms and conditions of Section 506 of Regulation D as no general solicitation was undertaken. EXHIBITS Exhibit Description - ------- ----------- 3.1 Articles of Incorporation, as amended (incorporated by reference to such exhibit in the Registrant's Quarterly Report on Form 10-Q, filed November 14, 2003) 3.2 By-laws, as amended (incorporated by reference to such exhibit in the Registrant's Registration Statement on Form SB-2, filed December 29, 1999) 4.1 Rights Agreement, dated October 4, 2000 (incorporated by reference to such exhibit in the Registrant's Registration Statement on Form 8-A, filed October 11, 2000) 5.1* Opinion of counsel 10.1 Asset Purchase Agreement between the Company and Saro, Inc. dated May 15, 2003 (incorporated by reference to Appendix A in the Registrant's Definitive Proxy Statement, filed June 19, 2003) 10.2 First Amendment to Asset Purchase Agreement dated July 25, 2003 (incorporated by reference to such exhibit in the Registrant's Quarterly Report on Form 10-Q, filed November 14, 2003) 10.3 Standard Office Lease between the Company and Frost National Bank, Trustee for a Designated Trust, dated August 22, 2003 (incorporated by reference to such exhibit in the Registrant's Quarterly Report on Form 10-Q, filed November 14, 2003) 10.4 1999 Employee Comprehensive Stock Plan, as amended (incorporated by reference to such exhibit in the Registrant's Registration Statement on Form S-8, filed January 14, 2004) 10.5 1999 Non-Employee Director Plan (incorporated by reference to such exhibit in the Registrant's Registration Statement on Form S-8, filed February 23, 2000) 10.6 1999 Employee Stock Purchase Plan (incorporated by reference to such exhibit in the Registrant's Registration Statement on Form S-8, filed February 23, 2000) 10.7 Form of Employment Agreement dated May 31, 2001, between the Company and Executive Officers of the Company (incorporated by reference to such exhibit in the Registrant's Annual Report on Form 10-K, filed April 1, 2002) 10.8 Investment Agreement between the Company and Dutchess Private Equities Fund, LP dated June 4, 2004. 10.9 Registration Rights Agreement between the Company and Dutchess Private Equities Fund, LP dated June 4, 2004. 10.10 Placement Agent Agreement between the Company, Charleston Capital Corporation and Dutchess Private Equities Fund, LP dated June 4, 2004. 10.11** Affiliate Office Agreement between the Company and Network 1 Financial, Inc. dated October 7, 2003 (filed as Exhibit 10.11 to the Registrant's Registration Statement on Form SB-2 on April 28, 2004 and incorporated herein by reference). 21.1 Subsidiaries of the Registrant (incorporated by reference to such exhibit in the Registrant's Annual Report on Form 10-K, filed April 1, 2002) 23.1 Consent of Akin Doherty Klein & Feuge, P.C., Independent Auditors (filed herewith) 23.2 Consent of Ernst & Young LLP, Independent Auditors (filed herewith) 23.3* Consent of counsel (filed as part of Exhibit 5.1) - ------------ * To be filed by amendment ** Previously filed UNDERTAKINGS The Registrant hereby undertakes that it will: (1) File, during any period in which it offers or sells securities, a post-effective amendment to this registration statement to: (i) Include any prospectus required by Section 10(a)(3) of the Securities Act; (ii) Reflect in the prospectus any facts or events which, individually or together, represent a fundamental change in the information in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than a 20% change in the maximum offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement; and (iii) Include any additional or changed material information on the plan of distribution. (2) For determining any liability under the Securities Act, treat each post-effective amendment as a new registration statement of the securities offered, and the offering of the securities at that time to be the initial bona fide offering. (3) File a post-effective amendment to remove from registration any of the securities that remain unsold at the end of the offering. Insofar as indemnification for liabilities arising under the Securities Act of 1933 (the "Act") may be permitted to directors, officers, and controlling persons of the small business issuer pursuant to the foregoing provisions, or otherwise, the small business issuer has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the small business issuer of expenses incurred or paid by a director, officer or controlling person of the small business issuer in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the small business issuer will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. (1) For determining any liability under the Securities Act, treat the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant under Rule 424(b)(1), or (4) or 497(h) under the Securities Act as part of this registration statement as of the time the Commission declared it effective. (2) For determining any liability under the Securities Act, treat each post-effective amendment that contains a form of prospectus as a new registration statement for the securities offered in the registration statement, and that offering of the securities at that time as the initial bona fide offering of those securities. SIGNATURES In accordance with the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets all of the requirements of filing on Form SB-2 and authorized this Registration Statement to be signed on its behalf by the undersigned, in the city of San Antonio, Texas, on June 18, 2004. PAYMENT DATA SYSTEMS, INC. By: /s/ Michael Long - ------------------------------------- Michael R. Long Chairman of the Board, Chief Executive Officer and Chief Financial Officer POWER OF ATTORNEY We, the undersigned officers and directors of Payment Data Systems, Inc., hereby severally constitute and appoint Michael R. Long, our true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution in him and in his name, place and stead, and in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Registration Statement (or any other Registration Statement for the same offering that is to be effective upon filing pursuant to Rule 462(b) under the Securities Act of 1933), and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and Agent, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as full to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities held on the dates indicated. SIGNATURE DATE By: /s/ Michael Long --------------------------------- June 18, 2004 Michael R. Long Chairman of the Board, Chief Executive Officer and Chief Financial Officer (principal executive officer and principal financial and accounting officer) By: /s/ Louis Hoch June 18, 2004 --------------------------------- Louis A. Hoch President, Chief Operating Officer and Director By: /s/ Peter Kirby June 18, 2004 --------------------------------- Peter G. Kirby Director EX-10.8 2 doc2.txt EXHIBIT 10.8 INVESTMENT AGREEMENT INVESTMENT AGREEMENT (this "AGREEMENT"), dated as of June 4, 2004 by and between Payment Data Systems, Inc., a Nevada corporation (the "Company"), and Dutchess Private Equities Fund, L.P., a Delaware limited partnership (the "Investor"). Whereas, the parties desire that, upon the terms and subject to the conditions contained herein, the Investor shall invest up to Ten Million Dollars ($10,000,000) to purchase the Company's Common Stock, .001 par value per share (the "Common Stock"); Whereas, such investments will be made in reliance upon the provisions of Section 4(2) under the Securities Act of 1933, as amended (the "1933 Act"), Rule 506 of Regulation D, and the rules and regulations promulgated thereunder, and/or upon such other exemption from the registration requirements of the 1933 Act as may be available with respect to any or all of the investments in Common Stock to be made hereunder; and Whereas, contemporaneously with the execution and delivery of this Agreement, the parties hereto are executing and delivering a Registration Rights Agreement substantially in the form attached hereto as Exhibit A (as amended from time to time, the "Registration Rights Agreement") pursuant to which the Company has agreed to provide certain registration rights under the 1933 Act, and the rules and regulations promulgated thereunder, and applicable state securities laws. NOW THEREFORE, in consideration of the foregoing recitals, which shall be considered an integral part of this Agreement, the covenants and agreements set forth hereafter, and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the Company and the Investor hereby agree as follows: Section 1. DEFINITIONS. As used in this Agreement, the following terms shall have the following meanings specified or indicated below, and such meanings shall be equally applicable to the singular and plural forms of such defined terms. "1933 Act" shall have the meaning set forth in the preamble, above. "1934 Act" shall mean the Securities Exchange Act of 1934, as it may be amended. "Affiliate" shall have the meaning specified in Section 5(h), below. "Agreement" shall mean this Investment Agreement. "Best Bid" shall mean the highest posted bid price of the Common Stock. "Buy In" shall have the meaning specified in Section 6, below. "Buy In Adjustment Amount" shall have the meaning specified in Section 6. "Closing" shall have the meaning specified in Section 2(h). "Closing Date" shall mean seven (7) Trading Days following the Put Notice Date. "Common Stock" shall have the meaning set forth in the preamble to this Agreement. "Control" or "Controls" shall have the meaning specified in Section 5(h). "Covering Shares" shall have the meaning specified in Section 6. "Effective Date" shall mean the date the SEC declares effective under the 1933 Act the Registration Statement covering the Securities. "Environmental Laws" shall have the meaning specified in Section 4(m), below. "Execution Date" shall mean the date indicated in the preamble to this Agreement. "Indemnitiees" shall have the meaning specified in Section 11, below. "Indemnified Liabilities" shall have the meaning specified in Section 11, below. "Ineffective Period" shall mean any period of time that the Registration Statement or any Supplemental Registration Statement (as defined in the Registration Rights Agreement) becomes ineffective or unavailable for use for the sale or resale, as applicable, of any or all of the Registrable Securities (as defined in the Registration Rights Agreement) for any reason (or in the event the prospectus under either of the above is not current and deliverable) during any time period required under the Registration Rights Agreement. "Investor" shall have the meaning indicated in the preamble of this Agreement. "Major Transaction" shall have the meaning specified in Section 2(g), above. "Material Adverse Effect" shall have the meaning specified in Section 4(a). "Maximum Common Stock Issuance" shall have the meaning specified in Section 2(i). "Minimum Acceptable Price" with respect to any Put Notice Date shall mean 75% of the lowest closing bid prices for the ten Trading Day period immediately preceding such Put Notice Date. "Open Period" shall mean the period beginning on and including the Trading Day immediately following the Effective Date and ending on the earlier to occur of (i) the date which is thirty six (36) months from the Effective Date; and (ii) termination of the Agreement in accordance with Section 9, below. "Pricing Period" shall mean the period beginning on the Put Notice Date and ending on and including the date that is five (5) Trading Days after such Put Notice Date. "Principal Market" shall mean the American Stock Exchange, Inc., the National Association of Securities Dealers, Inc. Over-the-Counter Bulletin Board, the Nasdaq National Market System or the Nasdaq SmallCap Market, whichever is the principal market on which the Common Stock is listed. "Prospectus" shall mean the prospectus, preliminary prospectus and supplemental prospectus used in connection with the Registration Statement. "Purchase Amount" shall mean the total amount being paid by the Investor on a particular Closing Date to purchase the Securities. "Purchase Price" shall mean ninety-five percent (95%) of the lowest closing Best Bid price of the Common Stock during the Pricing Period. "Put Amount" shall have the meaning set forth in Section 2(b) hereof. "Put Notice" shall mean a written notice sent to the Investor by the Company stating the Put Amount of Shares the Company intends to sell to the Investor pursuant to the terms of the Agreement and stating the current number of Shares issued and outstanding on such date. "Put Notice Date" shall mean the Trading Day immediately following the day on which the Investor receives a Put Notice, however a Put Notice shall be deemed delivered on (x) the Trading Day it is received by facsimile or otherwise by the Investor if such notice is received prior to 9:00 am Eastern Time, or (y) the immediately succeeding Trading Day if it is received by facsimile or otherwise after 9:00 am Eastern Time on a Trading Day. No Put Notice may be deemed delivered on a day that is not a Trading Day. "Put Restriction" shall mean the days between the end of the Pricing Period and the date on which the Investor deems the Put closed. During this time, the Company shall not be entitled to deliver another Put Notice. "Registration Period" shall have the meaning specified in Section 5(c), below. "Registration Rights Agreement" shall have the meaning set forth in the recitals, above. "Registration Statement" means the registration statement of the Company filed under the 1933 Act covering the Common Stock issuable hereunder. "Related Party" shall have the meaning specified in Section 5(h). "Resolution" shall have the meaning specified in Section 8(e). "SEC" shall mean the U.S. Securities & Exchange Commission. "SEC Documents" shall have the meaning specified in Section 4(f). "Securities" shall mean the shares of Common Stock issued pursuant to the terms of the Agreement. "Shares" shall mean the shares of the Company's Common Stock. "Sold Shares" shall have the meaning specified in Section 6. "Subsidiaries" shall have the meaning specified in Section 4(a). "Trading Day" shall mean any day on which the Principal Market for the Common Stock is open for trading, from the hours of 9:30 am until 4:00 pm. "Transaction Documents" shall mean this Agreement, the Registration Rights Agreement, and each of the other agreements entered into by the parties hereto in connection with this Agreement. "Valuation Event" shall have the meaning specified in Section 2(j). Section 2. PURCHASE AND SALE OF COMMON STOCK. (a) Purchase and Sale of Common Stock. Subject to the terms and conditions set forth herein, the Company shall issue and sell to the Investor, and the Investor shall purchase from the Company, up to that number of Shares having an aggregate Purchase Price of Ten Million Dollars ($10,000,000). (b) Delivery of Put Notices. (i) Subject to the terms and conditions of the Transaction Documents, and from time to time during the Open Period, the Company may, in its sole discretion, deliver a Put Notice to the Investor which states the Put Amount which the Company intends to sell to the Investor on a Closing Date. The Put Notice shall be in the form attached hereto as Exhibit B and incorporated herein by reference. The amount that the Company shall be entitled to Put to the Investor in any single Put Notice (the "Put Amount") shall be equal to, at the Company's election, either: (a) four hundred percent (400%) of the average daily volume (U.S. market only) of the Common Stock for the ten (10) Trading Days prior to the applicable Put Notice Date, multiplied by the average of the three (3) daily closing Best Bid prices immediately preceding the Put Date, or (b) twenty five thousand $25,000; provided that in no event will the Put Amount be more than One Million Dollars ($1,000,000) with respect to any single Put. During the Open Period, the Company shall not be entitled to submit a Put Notice until after the previous Closing has been completed. The Purchase Price for the Common Stock identified in the Put Notice shall be equal to 95% of the lowest closing bid price of the Common Stock during the Pricing Period. (ii) If any closing bid price during the applicable Pricing Period with respect to that Put Notice is less than 75% of the lowest closing Best Bid prices of the Common Stock for the Ten (10) Trading Days prior to the Put Notice Date (the "Minimum Acceptable Price"), the Put Notice will terminate at the Company's request sent in accordance with Section 9 of this Agreement. In the event that the closing bid price for the applicable Pricing Period is less than the Minimum Acceptable Price, the Company may elect, by sending written notice to the Investor to cancel the Put Notice. (iii) Within seven calendar days prior the commencement of each calendar quarter occurring subsequent to the commencement of the Open Period, the Company shall undertake to notify Investor as to its reasonable expectations as to the Put Amount it intends to raise during such calendar quarter, if any, through the issuance of Put Notices. Such notification shall constitute only the Company's good faith estimate with respect to such calendar quarter and shall in no way obligate the Company to raise such amount during such calendar quarter or otherwise limit its ability to deliver Put Notices during such calendar quarter. The failure by the Company to comply with this provision may be cured by notifying the Investor at any time as to the Company's reasonable expectations with respect to the current calendar quarter. (c) Interest. It is the intention of the parties that any interest that may be deemed to be payable under this Agreement shall not exceed the maximum amount permitted under applicable law. If any applicable law sets the maximum interest amount, and any payment required under this Agreement exceeds such limit, then: (i) any such interest shall be reduced by the amount necessary to reduce the interest to the legally permitted limit; and (ii) any sums already collected (if any) from a party which exceed the legally permitted limits will be refunded to such party. (d) Investor's Obligation to Purchase Shares. Subject to the conditions set forth in this Agreement, following the Investor's receipt of a validly delivered Put Notice, the Investor shall be required to purchase from the Company during the related Pricing Period that number of Shares having an aggregate Purchase Price equal to the lesser of (i) the Put Amount set forth in the Put Notice, and (ii) 20% of the aggregate trading volume of the Common Stock during the applicable Pricing Period times (x) 95% of the lowest closing bid prices of the Company's Common Stock during the specified Pricing Period, but only if said Shares bear no restrictive legend, are not subject to stop transfer instructions, pursuant to Section 2(h), prior to the applicable Closing Date. (e) Limitation on Investor's Obligation to Purchase Shares. In no event shall the Investor purchase Shares (whether from the Company or in public or private secondary transactions) other than pursuant to this Agreement until such date as this Agreement is terminated. (f) Conditions to Investor's Obligation to Purchase Shares. Notwithstanding anything to the contrary in this Agreement, the Company shall not be entitled to deliver a Put Notice and the Investor shall not be obligated to purchase any Shares at a Closing (as defined in Section 2(h)) unless each of the following conditions are satisfied: (i) a Registration Statement shall have been declared effective and shall remain effective and available for the resale of all the Registrable Securities (as defined in the Registration Rights Agreement) at all times until the Closing with respect to the subject Put Notice; (ii) at all times during the period beginning on the related Put Notice Date and ending on and including the related Closing Date, the Common Stock shall have been listed on the Principal Market and shall not have been suspended from trading thereon for a period of five consecutive Trading Days during the Open Period or one day during a Pricing Period, and the Company shall not have been notified of any pending or threatened proceeding or other action to de-list or suspend the Common Stock; (iii) the Company has complied with its obligations and is otherwise not in breach of a material provision of, or in default under, this Agreement, the Registration Rights Agreement or any other agreement executed in connection herewith which has not been corrected prior to delivery of the Put Notice Date; (iv) no injunction shall have been issued and remain in force, or action commenced by a governmental authority which has not been stayed or abandoned, prohibiting the purchase or the issuance of the Securities; and (v) the issuance of the Securities will not violate any shareholder approval requirements of the Principal Market. If any of the events described in clauses (i) through (v) above occurs during a Pricing Period, then the Investor shall have no obligation to purchase the Put Amount of Common Stock set forth in the applicable Put Notice. (g) Major Transaction. For purposes of this Agreement, a "Major Transaction" shall be deemed to have occurred upon the closing of any of the following events: (i) the consolidation, merger or other business combination of the Company with or into another person (other than pursuant to a migratory merger effected solely for the purposes of changing the jurisdiction of incorporation of the Company or other than a transaction in which the Company is the surviving corporation); (ii) the sale or transfer of all or substantially all of the Company's assets; or (iii) the consummation of a purchase, tender or exchange offer made to, and accepted by, the holders of more than 50% of the economic interest in, or the combined voting power of all classes of voting stock of, the Company. (h) Mechanics of Purchase of Shares by Investor. Subject to the satisfaction of the conditions set forth in Sections 2(f), 7 and 8, the closing of the purchase by the Investor of Shares (a "Closing") shall occur on the date which is no later than seven Trading Days following the applicable Put Notice Date (each a "Closing Date"). Prior to each Closing Date, (i) the Company shall deliver to the Investor pursuant to the this Agreement, certificates representing the Shares to be issued to the Investor on such date and registered in the name of the Investor; and (ii) the Investor shall deliver to the Company the Purchase Price to be paid for such Shares, determined as set forth in accordance with the terms of this Agreement. In lieu of delivering physical certificates representing the Securities and provided that the Company's transfer agent then is participating in The Depository Trust Company ("DTC") Fast Automated Securities Transfer ("FAST") program, upon request of the Investor, the Company shall use its commercially reasonable efforts to cause its transfer agent to electronically transmit the Securities by crediting the account of the Investor's prime broker (which shall be specified by the Investor a reasonably sufficient time in advance) with DTC through its Deposit Withdrawal Agent Commission ("DWAC") system. The Company understands that a delay in the issuance of Securities beyond the Closing Date could result in economic loss to the Investor. After the Effective Date, as compensation to the Investor for such loss, the Company agrees to pay late payments to the Investor for late issuance of Securities (delivery of Securities after the applicable Closing Date) in accordance with the following schedule (where "No. of Days Late" is defined as the number of days beyond the Closing Date): Late Payment For Each No. of Days Late $10,000 of Common Stock 1 $100 2 $200 3 $300 4 $400 5 $500 6 $600 7 $700 8 $800 9 $900 10 $1,000 Over 10 $1,000 + $200 for each Business Day late beyond 10 days The Company shall pay any payments incurred under this Section in immediately available funds upon demand. Nothing herein shall limit the Investor's right to pursue actual damages for the Company's failure to issue and deliver the Securities to the Investor, except to the extent that such late payments shall constitute payment for and offset any such actual damages alleged by the Investor, and any Buy In Adjustment Amount. (i) Overall Limit on Common Stock Issuable. Notwithstanding anything contained herein to the contrary, if during the Open Period the Company becomes listed on an exchange that limits the number of shares of Common Stock that may be issued without shareholder approval, then the number of Shares issuable by the Company and purchasable by the Investor, shall not exceed that number of the shares of Common Stock that may be issuable without shareholder approval, subject to appropriate adjustment for stock splits, stock dividends, combinations or other similar recapitalization affecting the Common Stock (the "Maximum Common Stock Issuance"), unless the issuance of Shares, in excess of the Maximum Common Stock Issuance shall first be approved by the Company's shareholders in accordance with applicable law and the By-laws and Amended and Restated Certificate of Incorporation of the Company, if such issuance of shares of Common Stock could cause a delisting on the Principal Market. The parties understand and agree that the Company's failure to seek or obtain such shareholder approval shall in no way adversely affect the validity and due authorization of the issuance and sale of Securities or the Investor's obligation in accordance with the terms and conditions hereof to purchase a number of Shares in the aggregate up to the Maximum Common Stock Issuance limitation, and that such approval pertains only to the applicability of the Maximum Common Stock Issuance limitation provided in this Section 2(i). (j) For the purpose of this Agreement, the term "Valuation Event" means the Company taking any of the following actions at any time during a Pricing Period: (i) the subdivision or combinations of the Company's Common Stock; (ii) the payment of a dividend or any other distribution with respect to shares of the Company's Common Stock; (iii) the issuance of any options or other rights to subscribe for or purchase Common Stock ("Options") or any securities convertible into or exchangeable for Common Stock ("Convertible Securities"), the price per share for which Common Stock is shall be less than the bid price in effect immediately prior to such issuance of such Options or Convertible Securities; (iv) the issuance of shares of Common Stock other than as provided in the foregoing subsections (i) through (iii), at a price per share less, or for other consideration lower, than the bid price in effect immediately prior to such issuance, or without consideration; or (v) the distribution of its assets or evidences of indebtedness to the holders of Common Stock as a dividend in liquidation or by way of return of capital or other than as a dividend payable out of earnings or surplus legally available for dividends under applicable law or any distribution to such holders made in respect of the sale of all or substantially all of the Company's assets (other than under the circumstances provided for in the foregoing subsections (i) through (iv)). (k) The Company agrees that it shall not take any action that would result in a Valuation Event occurring during a Pricing Period. (l) Governmental or Criminal Actions. During the Open Period, the Company or any of its management or board of directors ("Insiders") shall not be the cause for an investigation by any governmental agencies whether foreign or domestic. All Insiders shall also not be charged with any criminal activities whether it be foreign or domestic, securities related or non-securities related for the Open Period. Section 3. INVESTOR'S REPRESENTATIONS, WARRANTIES AND COVENANTS. The Investor represents and warrants to the Company, and covenants, that: (a) Sophisticated Investor. The Investor has, by reason of its business and financial experience, such knowledge, sophistication and experience in financial and business matters and in making investment decisions of this type that it is capable of (i) evaluating the merits and risks of an investment in the Securities and making an informed investment decision; (ii) protecting its own interest; and (iii) bearing the economic risk of such investment for an indefinite period of time. (b) Authorization; Enforcement. This Agreement has been duly and validly authorized, executed and delivered on behalf of the Investor and is a valid and binding agreement of the Investor enforceable against the Investor in accordance with its terms, subject as to enforceability to general principles of equity and to applicable bankruptcy, insolvency, reorganization, moratorium, liquidation and other similar laws relating to, or affecting generally, the enforcement of applicable creditors' rights and remedies. (c) Section 9 of the 1934 Act. During the term of this Agreement, the Investor will comply with the provisions of Section 9 of the 1934 Act, and the rules promulgated thereunder, with respect to transactions involving the Common Stock. The Investor agrees not to short, either directly or indirectly through its affiliates, principals or advisors, the Company's common stock during the term of this Agreement. (d) Accredited Investor. Investor is an "Accredited Investor" as that term is defined in Rule 501(a)(3) of Regulation D of the 1933 Act. (e) No Conflicts. The execution, delivery and performance of the Transaction Documents by the Investor and the consummation by the Investor of the transactions contemplated hereby and thereby will not result in a violation of Partnership Agreement or other organizational documents of the Investor. (f) Opportunity to Discuss. The Investor has had an opportunity to discuss the business, management and financial affairs of the Company with the Company's management to a level of satisfactory conditions for this type of investment. (g) Investment Purposes. The Investor is purchasing the Securities for its own account for investment purposes and not with a view towards distribution and agrees to resell or otherwise dispose of the Securities solely in accordance with the registration provisions of the 1933 Act (or pursuant to an exemption from such registration provisions). (h) No Registration as a Broker or Dealer. The Investor is not and will not be required to be registered as a "broker or "dealer" under the 1934 Act, either as a result of its execution and performance of its obligations under this Agreement or otherwise. (i) Good Standing. The Investor is a Limited Partnership, duly organized, validly existing and in good standing in the State of Delaware. (j) Tax Liabilities. The Investor understands that it is liable for its own tax liabilities. (k) Regulation M. The Investor will comply with Regulation M under the 1934 Act, if applicable Section 4. REPRESENTATIONS AND WARRANTIES OF THE COMPANY. Except as set forth in the Schedules attached hereto, or as disclosed on the Company's SEC Documents, the Company represents and warrants to the Investor that: (a) Organization and Qualification. The Company is a corporation duly organized and validly existing in good standing under the laws of the State of Nevada, and has the requisitecorporate power and authorization to own its properties and to carry on its business as now being conducted. Each of the Company and its Subsidiaries is duly qualified as a foreign corporation to do business and is in good standing in every jurisdiction in which its ownership of property or the nature of the business conducted by it makes such qualification necessary, except to the extent that the failure to be so qualified or be in good standing would not have a Material Adverse Effect. As used in this Agreement, "Material Adverse Effect" means any material adverse effect on the business, properties, assets, operations, results of operations, financial condition or prospects of the Company and its Subsidiaries, if any, taken as a whole, or on the transactions contemplated hereby or by the agreements and instruments to be entered into in connection herewith, or on the authority or ability of the Company to perform its obligations under the Transaction Documents (as defined in Section 1 and 4(b), below). (b) Authorization; Enforcement; Compliance with Other Instruments. (i) The Company has the requisite corporate power and authority to enter into and perform this Agreement, the Registration Rights Agreement, and each of the other agreements entered into by the parties hereto in connection with the transactions contemplated by this Agreement (collectively, the "Transaction Documents"), and to issue the Securities in accordance with the terms hereof and thereof. (ii) The execution and delivery of the Transaction Documents by the Company and the consummation by it of the transactions contemplated hereby and thereby, including without limitation the reservation for issuance and the issuance of the Securities pursuant to this Agreement, have been duly and validly authorized by the Company's Board of Directors and no further consent or authorization is required by the Company, its Board of Directors, or its shareholders. (iii) The Transaction Documents have been duly and validly executed and delivered by the Company. (iv) The Transaction Documents constitute the valid and binding obligations of the Company enforceable against the Company in accordance with their terms, except as such enforceability may be limited by general principles of equity or applicable bankruptcy, insolvency, reorganization, moratorium, liquidation or similar laws relating to, or affecting generally, the enforcement of creditors' rights and remedies. (c) Capitalization. As of the date hereof, the authorized capital stock of the Company consists of (i) 200,000,000 shares of Common Stock, .001 par value per share, of which as of the date hereof, 20,722,656 shares are issued and outstanding. All of such outstanding shares have been, or upon issuance will be, validly issued and are fully paid and nonassessable. Except as disclosed in the Company's publicly available filings with Periodic Filings, (i) no shares of the Company's capital stock are subject to preemptive rights or any other similar rights or any liens or encumbrances suffered or permitted by the Company; (ii) there are no outstanding debt securities; (iii) there are no outstanding shares of capital stock, options, warrants, scrip, rights to subscribe to, calls or commitments of any character whatsoever relating to, or securities or rights convertible into, any shares of capital stock of the Company or any of its Subsidiaries, or contracts, commitments, understandings or arrangements by which the Company or any of its Subsidiaries is or may become bound to issue additional shares of capital stock of the Company or any of its Subsidiaries or options, warrants, scrip, rights to subscribe to, calls or commitments of any character whatsoever relating to, or securities or rights convertible into, any shares of capital stock of the Company or any of its Subsidiaries; (iv) there are no agreements or arrangements under which the Company or any of its Subsidiaries is obligated to register the sale of any of their securities under the 1933 Act (except the Registration Rights Agreement); (v) there are no outstanding securities of the Company or any of its Subsidiaries which contain any redemption or similar provisions, and there are no contracts, commitments, understandings or arrangements by which the Company or any of its Subsidiaries is or may become bound to redeem a security of the Company or any of its Subsidiaries; (vi) there are no securities or instruments containing anti-dilution or similar provisions that will be triggered by the issuance of the Securities as described in this Agreement; (vii) the Company does not have any stock appreciation rights or "phantom stock" plans or agreements or any similar plan or agreement; and (viii) there is no dispute as to the classification of any shares of the Company's capital stock. The Company has furnished to the Investor, or the Investor has had access through EDGAR to, true and correct copies of the Company's Amended and Restated Certificate of Incorporation, as in effect on the date hereof (the "Certificate of Incorporation"), and the Company's By-laws, as in effect on the date hereof (the "By-laws"), and the terms of all securities convertible into or exercisable for Common Stock and the material rights of the holders thereof in respect thereto. (d) Issuance of Shares. The Company has reserved 40,000,000 Shares for issuance pursuant to this Agreement has been duly authorized and reserved for issuance (subject to adjustment pursuant to the Company's covenant set forth in Section 5(f) below) pursuant to this Agreement. Upon issuance in accordance with this Agreement, the Securities will be validly issued, fully paid and non-assessable and free from all taxes, liens and charges with respect to the issue thereof. In the event the Company cannot register a sufficient number of Shares for issuance pursuant to this Agreement, the Company will use its best efforts to authorize and reserve for issuance the number of Shares required for the Company to perform its obligations hereunder as soon as reasonably practicable. (e) No Conflicts. The execution, delivery and performance of the Transaction Documents by the Company and the consummation by the Company of the transactions contemplated hereby and thereby will not (i) result in a violation of the Certificate of Incorporation, any Certificate of Designations, Preferences and Rights of any outstanding series of preferred stock of the Company or the By-laws; or (ii) conflict with, or constitute a material default (or an event which with notice or lapse of time or both would become a material default) under, or give to others any rights of termination, amendment, acceleration or cancellation of, any material agreement, contract, indenture mortgage, indebtedness or instrument to which the Company or any of its Subsidiaries is a party, or result in a violation of any law, rule, regulation, order, judgment or decree (including United States federal and state securities laws and regulations and the rules and regulations of the Principal Market or principal securities exchange or trading market on which the Common Stock is traded or listed) applicable to the Company or any of its Subsidiaries or by which any property or asset of the Company or any of its Subsidiaries is bound or affected. Except as disclosed in Schedule 4(e), neither the Company nor its Subsidiaries is in violation of any term of, or in default under, the Certificate of Incorporation, any Certificate of Designations, Preferences and Rights of any outstanding series of preferred stock of the Company or the By-laws or their organizational charter or by-laws, respectively, or any contract, agreement, mortgage, indebtedness, indenture, instrument, judgment, decree or order or any statute, rule or regulation applicable to the Company or its Subsidiaries, except for possible conflicts, defaults, terminations, amendments, accelerations, cancellations and violations that would not individually or in the aggregate have a Material Adverse Effect. The business of the Company and its Subsidiaries is not being conducted, and shall not be conducted, in violation of any law, statute, ordinance, rule, order or regulation of any governmental authority or agency, regulatory or self-regulatory agency, or court, except for possible violations the sanctions for which either individually or in the aggregate would not have a Material Adverse Effect. Except as specifically contemplated by this Agreement and as required under the 1933 Act, the Company is not required to obtain any consent, authorization, permit or order of, or make any filing or registration (except the filing of a registration statement) with, any court, governmental authority or agency, regulatory or self-regulatory agency or other third party in order for it to execute, deliver or perform any of its obligations under, or contemplated by, the Transaction Documents in accordance with the terms hereof or thereof. All consents, authorizations, permits, orders, filings and registrations which the Company is required to obtain pursuant to the preceding sentence have been obtained or effected on or prior to the date hereof and are in full force and effect as of the date hereof. Except as disclosed in Schedule 4(e), the Company and its Subsidiaries are unaware of any facts or circumstances which might give rise to any of the foregoing. The Company is not, and will not be, in violation of the listing requirements of the Principal Market as in effect on the date hereof and on each of the Closing Dates and is not aware of any facts which would reasonably lead to delisting of the Common Stock by the Principal Market in the foreseeable future. (f) SEC Documents; Financial Statements. Since at least September 30th, 2003, the Company has filed all reports, schedules, forms, statements and other documents required to be filed by it with the SEC pursuant to the reporting requirements of the 1934 Act (all of the foregoing filed prior to the date hereof and all exhibits included therein and financial statements and schedules thereto and documents incorporated by reference therein being hereinafter referred to as the "SEC Documents"). The Company has delivered to the Investor or its representatives, or they have had access through EDGAR to, true and complete copies of the SEC Documents. As of their respective dates, the SEC Documents complied in all material respects with the requirements of the 1934 Act and the rules and regulations of the SEC promulgated thereunder applicable to the SEC Documents, and none of the SEC Documents, at the time they were filed with the SEC, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. As of their respective filing dates, the financial statements of the Company included in the SEC Documents complied as to form in all material respects with applicable accounting requirements and the published rules and regulations of the SEC with respect thereto. Such financial statements have been prepared in accordance with generally accepted accounting principles, consistently applied, during the periods involved (except (i) as may be otherwise indicated in such financial statements or the notes thereto, or (ii) in the case of unaudited interim statements, to the extent they may exclude footnotes or may be condensed or summary statements) and fairly present in all material respects the financial position of the Company as of the dates thereof and the results of its operations and cash flows for the periods then ended (subject, in the case of unaudited statements, to normal year-end audit adjustments). No other written information provided by or on behalf of the Company to the Investor which is not included in the SEC Documents, including, without limitation, information referred to in Section 4(d) of this Agreement, contains any untrue statement of a material fact or omits to state any material fact necessary to make the statements therein, in the light of the circumstance under which they are or were made, not misleading. Neither the Company nor any of its Subsidiaries or any of their officers, directors, employees or agents have provided the Investor with any material, nonpublic information which was not publicly disclosed prior to the date hereof and any material, nonpublic information provided to the Investor by the Company or its Subsidiaries or any of their officers, directors, employees or agents prior to any Closing Date shall be publicly disclosed by the Company prior to such Closing Date. (g) Absence of Certain Changes. Except as set forth in the SEC Documents, the Company does not intend to change the business operations of the Company. The Company has not taken any steps, and does not currently expect to take any steps, to seek protection pursuant to any bankruptcy law nor does the Company or its Subsidiaries have any knowledge or reason to believe that its creditors intend to initiate involuntary bankruptcy proceedings. (h) Absence of Litigation. Except as set forth in the SEC Documents, there is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of the executive officers of Company or any of its Subsidiaries, threatened against or affecting the Company, the Common Stock or any of the Company's Subsidiaries or any of the Company's or the Company's Subsidiaries' officers or directors in their capacities as such, in which an adverse decision could have a Material Adverse Effect. (i) Acknowledgment Regarding Investor's Purchase of Shares. The Company acknowledges and agrees that the Investor is acting solely in the capacity of arm's length purchaser with respect to the Transaction Documents and the transactions contemplated hereby and thereby. The Company further acknowledges that the Investor is not acting as a financial advisor or fiduciary of the Company (or in any similar capacity) with respect to the Transaction Documents and the transactions contemplated hereby and thereby and any advice given by the Investor or any of its respective representatives or agents in connection with the Transaction Documents and the transactions contemplated hereby and thereby is merely incidental to the Investor's purchase of the Securities. The Company further represents to the Investor that the Company's decision to enter into the Transaction Documents has been based solely on the independent evaluation by the Company and its representatives. (j) No Undisclosed Events, Liabilities, Developments or Circumstances. Except as set forth in the SEC Documents, since November 24, 2003, no event, liability, development or circumstance has occurred or exists, or to the Company's knowledge is contemplated to occur, with respect to the Company or its Subsidiaries or their respective business, properties, assets, prospects, operations or financial condition, that would be required to be disclosed by the Company under applicable securities laws on a registration statement filed with the SEC relating to an issuance and sale by the Company of its Common Stock and which has not been publicly announced. (k) Employee Relations. Neither the Company nor any of its Subsidiaries is involved in any union labor dispute nor, to the knowledge of the Company or any of its Subsidiaries, is any such dispute threatened. Neither the Company nor any of its Subsidiaries is a party to a collective bargaining agreement, and the Company and its Subsidiaries believe that relations with their employees are good. No executive officer (as defined in Rule 501(f) of the 1933 Act) has notified the Company that such officer intends to leave the Company's employ or otherwise terminate such officer's employment with the Company. (l) Intellectual Property Rights. The Company and its Subsidiaries own or possess adequate rights or licenses to use all trademarks, trade names, service marks, service mark registrations, service names, patents, patent rights, copyrights, inventions, licenses, approvals, governmental authorizations, trade secrets and rights necessary to conduct their respective businesses as now conducted. Except as set forth the SEC Documents, none of the Company's trademarks, trade names, service marks, service mark registrations, service names, patents, patent rights, copyrights, inventions, licenses, approvals, government authorizations, trade secrets or other intellectual property rights necessary to conduct its business as now or as proposed to be conducted have expired or terminated, or are expected to expire or terminate within two years from the date of this Agreement. The Company and its Subsidiaries do not have any knowledge of any infringement by the Company or its Subsidiaries of trademark, trade name rights, patents, patent rights, copyrights, inventions, licenses, service names, service marks, service mark registrations, trade secret or other similar rights of others, or of any such development of similar or identical trade secrets or technical information by others and, except as set forth on the SEC Documents, there is no claim, action or proceeding being made or brought against, or to the Company's knowledge, being threatened against, the Company or its Subsidiaries regarding trademark, trade name, patents, patent rights, invention, copyright, license, service names, service marks, service mark registrations, trade secret or other infringement; and the Company and its Subsidiaries are unaware of any facts or circumstances which might give rise to any of the foregoing. The Company and its Subsidiaries have taken commercially reasonable security measures to protect the secrecy, confidentiality and value of all of their intellectual properties. (m) Environmental Laws. The Company and its Subsidiaries (i) are, to the knowledge of management of the Company, in compliance with any and all applicable foreign, federal, state and local laws and regulations relating to the protection of human health and safety, the environment or hazardous or toxic substances or wastes, pollutants or contaminants ("Environmental Laws"); (ii) have, to the knowledge of management of the Company, received all permits, licenses or other approvals required of them under applicable Environmental Laws to conduct their respective businesses; and (iii) are in compliance, to the knowledge of the Company, with all terms and conditions of any such permit, license or approval where, in each of the three foregoing cases, the failure to so comply would have, individually or in the aggregate, a Material Adverse Effect. (n) Title. The Company and its Subsidiaries have good and marketable title in fee simple to all real property and good and marketable title to all personal property owned by them which is material to the business of the Company and its Subsidiaries, in each case free and clear of all liens, encumbrances and defects except such as are described in the SEC Documents or such as do not materially affect the value of such property and do not interfere with the use made and proposed to be made of such property by the Company or any of its Subsidiaries. Any real property and facilities held under lease by the Company or any of its Subsidiaries are held by them under valid, subsisting and enforceable leases with such exceptions as are not material and do not interfere with the use made and proposed to be made of such property and buildings by the Company and its Subsidiaries. (o) Insurance. The Company and each of its Subsidiaries are insured by insurers of recognized financial responsibility against such losses and risks and in such amounts as management of the Company reasonably believes to be prudent and customary in the businesses in which the Company and its Subsidiaries are engaged. Neither the Company nor any such Subsidiary has been refused any insurance coverage sought or applied for and neither the Company nor any such Subsidiary has any reason to believe that it will not be able to renew its existing insurance coverage as and when such coverage expires or to obtain similar coverage from similar insurers as may be necessary to continue its business at a cost that would not have a Material Adverse Effect. (p) Regulatory Permits. The Company and its Subsidiaries have in full force and effect all certificates, approvals, authorizations and permits from the appropriate federal, state, local or foreign regulatory authorities and comparable foreign regulatory agencies, necessary to own, lease or operate their respective properties and assets and conduct their respective businesses, and neither the Company nor any such Subsidiary has received any notice of proceedings relating to the revocation or modification of any such certificate, approval, authorization or permit, except for such certificates, approvals, authorizations or permits which if not obtained, or such revocations or modifications which, would not have a Material Adverse Effect. (q) Internal Accounting Controls. The Company and each of its Subsidiaries maintain a system of internal accounting controls sufficient to provide reasonable assurance that (i) transactions are executed in accordance with management's general or specific authorizations; (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain asset accountability; (iii) access to assets is permitted only in accordance with management's general or specific authorization; and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. (r) No Materially Adverse Contracts, Etc. Neither the Company nor any of its Subsidiaries is subject to any charter, corporate or other legal restriction, or any judgment, decree, order, rule or regulation which in the judgment of the Company's officers has or is expected in the future to have a Material Adverse Effect. Neither the Company nor any of its Subsidiaries is a party to any contract or agreement which in the judgment of the Company's officers has or is expected to have a Material Adverse Effect. (s) Tax Status. The Company and each of its Subsidiaries has made or filed all United States federal and state income and all other tax returns, reports and declarations required byany jurisdiction to which it is subject (unless and only to the extent that the Company and each of its Subsidiaries has set aside on its books provisions reasonably adequate for the payment of all unpaid and unreported taxes) and has paid all taxes and other governmental assessments and charges that are material in amount, shown or determined to be due on such returns, reports and declarations, except those being contested in good faith and has set aside on its books provision reasonably adequate for the payment of all taxes for periods subsequent to the periods to which such returns, reports or declarations apply. There are no unpaid taxes in any material amount claimed to be due by the taxing authority of any jurisdiction, and the officers of the Company know of no basis for any such claim. (t) Certain Transactions. Except as set forth in the SEC Documents filed at least ten days prior to the date hereof and except for arm's length transactions pursuant to which the Company makes payments in the ordinary course of business upon terms no less favorable than the Company could obtain from third parties and other than the grant of stock options disclosed in the SEC Documents, none of the officers, directors, or employees of the Company is presently a party to any transaction with the Company or any of its Subsidiaries (other than for services as employees, officers and directors), including any contract, agreement or other arrangement providing for the furnishing of services to or by, providing for rental of real or personal property to or from, or otherwise requiring payments to or from any officer, director or such employee or, to the knowledge of the Company, any corporation, partnership, trust or other entity in which any officer, director, or any such employee has a substantial interest or is an officer, director, trustee or partner. (u) Dilutive Effect. The Company understands and acknowledges that the number of Shares issuable upon purchases pursuant to this Agreement will increase in certain circumstances including, but not necessarily limited to, the circumstance wherein the trading price of the Common Stock declines during the period between the Effective Date and the end of the Open Period. The Company's executive officers and directors have studied and fully understand the nature of the transactions contemplated by this Agreement and recognize that they have a potential dilutive effect. The Board of Directors of the Company has concluded, in its good faith business judgment, that such issuance is in the best interests of the Company. The Company specifically acknowledges that, subject to such limitations as are expressly set forth in the Transaction Documents, its obligation to issue Shares of Common Stock upon purchases pursuant to this Agreement is absolute and unconditional regardless of the dilutive effect that such issuance may have on the ownership interests of other shareholders of the Company. (v) Right of First Refusal. The Company shall not, directly or indirectly, without the prior written consent of Investor offer, sell, grant any option to purchase, or otherwise dispose of (or announce any offer, sale, grant or any option to purchase or other disposition) any of its Common Stock or securities convertible into Common Stock at a price that is less than the market price of the Common Stock at the time of issuance of such security or investment (a "Subsequent Financing") for a period of one year after the Effective Date, except (i) the granting of options or warrants to employees, officers, directors and consultants, and the issuance of Shares upon exercise of options granted, under any stock option plan heretofore or hereafter duly adopted by the Company or for services rendered or to be rendered; (ii) Shares issued upon exercise of any currently outstanding warrants or options and upon conversion of any currently outstanding convertible debenture or convertible preferred stock, in each case disclosed pursuant to Section 4(c); (iii) securities issued in connection with the capitalization or creation of a joint venture with a strategic partner; (iv) Shares issued to pay part or all of the purchase price for the acquisition by the Company of another entity (which, for purposes of this clause (iv), shall not include an individual or group of individuals); and (v) Shares issued in a bona fide public offering by the Company of its securities, unless (A) the Company delivers to Investor a written notice (the "Subsequent Financing Notice") of its intention to effect such Subsequent Financing, which Subsequent Financing Notice shall describe in reasonable detail the proposed terms of such Subsequent Financing, the amount of proceeds intended to be raised thereunder, the person with whom such Subsequent Financing shall be effected, and attached to which shall be a term sheet or similar document relating thereto; and (B) Investor shall not have notified the Company by 5:00 p.m. (New York time) on the fifth Trading Day after its receipt of the Subsequent Financing Notice of its willingness to provide, subject to completion of mutually acceptable documentation, financing to the Company on substantially the terms set forth in the Subsequent Financing Notice. If Investor shall fail to notify the Company of its intention to enter into such negotiations within such time period, then the Company may effect the Subsequent Financing substantially upon the terms set forth in the Subsequent Financing Notice; provided that the Company shall provide Investor with a second Subsequent Financing Notice, and Investor shall again have the right of first refusal set forth above in this Section, if the Subsequent Financing subject to the initial Subsequent Financing Notice shall not have been consummated for any reason on the terms set forth in such Subsequent Financing Notice within thirty Trading Days after the date of the initial Subsequent Financing Notice. The rights granted to Investor in this Section are not subject to any prior right of first refusal given to any other person disclosed on Schedule 4(c). (w) Lock-up. The Company shall cause its officers, insiders, directors, affiliates or other related parties to refrain from selling Common Stock during each Pricing Period. (x) No General Solicitation. Neither the Company, nor any of its affiliates, nor any person acting on its behalf, has engaged in any form of general solicitation or general advertising (within the meaning of Regulation D) in connection with the offer or sale of the Common Stock offered hereby. (y) No brokers, finders or financial advisory fees or commissions will be payable by the Company with respect to the transaction contemplated by this Agreement other than described in Section 12 (m) of this Agreement. Section 5. COVENANTS OF THE COMPANY (a) Best Efforts. The Company shall use commercially reasonable efforts timely to satisfy each of the conditions to be satisfied by it as provided in Section 7 of this Agreement. (b) Blue Sky. The Company shall, at its sole cost and expense, on or before each of the Closing Dates, take such action as the Company shall reasonably determine is necessary to qualify the Securities for, or obtain exemption for the Securities for, sale to the Investor at each of the Closings pursuant to this Agreement under applicable securities or "Blue Sky" laws of such states of the United States, as reasonably specified by Investor, and shall provide evidence of any such action so taken to the Investor on or prior to the Closing Date. (c) Reporting Status. Until the earlier to occur of (i) the first date which is after the date this Agreement is terminated pursuant to Section 9 and on which the Holders (as that term is defined in the Registration Rights Agreement) may sell all of the Securities without restriction pursuant to Rule 144(k) promulgated under the 1933 Act (or successor thereto); and (ii) the date on which (A) the Holders shall have sold all the Securities; and (B) this Agreement has been terminated pursuant to Section 9 (the "Registration Period"), the Company shall file all reports required to be filed with the SEC pursuant to the 1934 Act, and the Company shall not terminate its status as a reporting company under the 1934 Act. (d) Use of Proceeds. The Company will use the proceeds from the sale of the Shares (excluding amounts paid by the Company for fees as set forth in the Transaction Documents) for general corporate and working capital purposes or for other purposes deemed fit by the Company's Board of Directors. (e) Financial Information. The Company agrees to make available to the Investor via EDGAR or other electronic means the following to the Investor during the Registration Period: (i) within five (5) Trading Days after the filing thereof with the SEC, a copy of its Annual Reports on Form 10-KSB, its Quarterly Reports on Form 10-QSB, any Current Reports on Form 8-K and any Registration Statements or amendments filed pursuant to the 1933 Act; (ii) on the same day as the release thereof, facsimile copies of all press releases issued by the Company or any of its Subsidiaries; (iii) copies of any notices and other information made available or given to the shareholders of the Company generally, contemporaneously with the making available or giving thereof to the shareholders; and (iv) within two (2) calendar days of filing or delivery thereof, copies of all documents filed with, and all correspondence sent to, the Principal Market, any securities exchange or market, or the National Association of Securities Dealers, Inc., unless such information is material nonpublic information. (f) Reservation of Shares. Subject to the following sentence, the Company shall take all action necessary to at all times have authorized, and reserved for the purpose of issuance, a sufficient number of Shares of Common Stock to provide for the issuance of the Securities hereunder. In the event that the Company determines that it does not have a sufficient number of authorized Shares to reserve and keep available for issuance as described in this Section 5(f), the Company shall use its best efforts to increase the number of authorized Shares by seeking shareholder approval for the authorization of such additional shares. (g) Listing. The Company shall promptly secure and maintain the listing of all of the Registrable Securities (as defined in the Registration Rights Agreement) upon the Principal Market and each other national securities exchange and automated quotation system, if any, upon which shares of Common Stock are then listed (subject to official notice of issuance) and shall maintain, such listing of all Registrable Securities from time to time issuable under the terms of the Transaction Documents. The Company shall maintain the Common Stock's authorization for quotation on the Principal Market. Neither the Company nor any of its Subsidiaries shall take any action which would be reasonably expected to result in the delisting or suspension of the Common Stock on the Principal Market (excluding suspensions of not more than one trading day resulting from business announcements by the Company). The Company shall promptly provide to the Investor copies of any notices it receives from the Principal Market regarding the continued eligibility of the Common Stock for listing on such automated quotation system or securities exchange. The Company shall pay all fees and expenses in connection with satisfying its obligations under this Section 5(g). (h) Transactions With Affiliates. The Company shall not, and shall cause each of its Subsidiaries not to, enter into, amend, modify or supplement, or permit any Subsidiary to enter into, amend, modify or supplement, any agreement, transaction, commitment or arrangement with any of its or any Subsidiary's officers, directors, persons who were officers or directors at any time during the previous two (2) years, shareholders who beneficially own five percent (5%) or more of the Common Stock, or affiliates or with any individual related by blood, marriage or adoption to any such individual or with any entity in which any such entity or individual owns a five percent (5%) or more beneficial interest (each a "Related Party"), except for (i) customary employment arrangements and benefit programs on reasonable terms, (ii) any agreement, transaction, commitment or arrangement on an arms-length basis on terms no less favorable than terms which would have been obtainable from a person other than such Related Party, or (iii) any agreement, transaction, commitment or arrangement which is approved by a majority of the disinterested directors of the Company. For purposes hereof, any director who is also an officer of the Company or any Subsidiary of the Company shall not be a disinterested director with respect to any such agreement, transaction, commitment or arrangement. "Affiliate" for purposes hereof means, with respect to any person or entity, another person or entity that, directly or indirectly, (i) has a five percent (5%) or more equity interest in that person or entity, (ii) has five percent (5%) or more common ownership with that person or entity, (iii) controls that person or entity, or (iv) is under common control with that person or entity. "Control" or "Controls" for purposes hereof means that a person or entity has the power, direct or indirect, to conduct or govern the policies of another person or entity. (i) Filing of Form 8-K. On or before the date which is three Trading Days after the Execution Date, the Company shall file a Current Report on Form 8-K with the SEC describing the terms of the transaction contemplated by the Transaction Documents in the form required by the 1934 Act, if such filing is required. (j) Corporate Existence. The Company shall use its best efforts to preserve and continue the corporate existence of the Company. (k) Notice of Certain Events Affecting Registration; Suspension of Right to Make a Put. The Company shall promptly notify Investor upon the occurrence of any of the following events in respect of a Registration Statement or related prospectus in respect of an offering of the Securities and shall not deliver any Put Notice during the continuation of any of the following events: (i) receipt of any request for additional information by the SEC or any other federal or state governmental authority during the period of effectiveness of the Registration Statement for amendments or supplements to the Registration Statement or related prospectus; (ii) the issuance by the SEC or any other federal or state governmental authority of any stop order suspending the effectiveness of any Registration Statement or the initiation of any proceedings for that purpose; (iii) receipt of any notification with respect to the suspension of the qualification or exemption from qualification of any of the Securities for sale in any jurisdiction or the initiation or threatening of any proceeding for such purpose; (iv) the happening of any event that makes any statement made in such Registration Statement or related prospectus or any document incorporated or deemed to be incorporated therein by reference untrue in any material respect or that requires the making of any changes in the Registration Statement, related prospectus or documents so that, in the case of a Registration Statement, it will not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein not misleading, and that in the case of the related prospectus, it will not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading; and (v) the Company's reasonable determination that a post-effective amendment to the Registration Statement would be appropriate, and the Company shall promptly make available to Investor any such supplement or amendment to the related prospectus. The Company shall not deliver to Investor any Put Notice during the continuation of any of the foregoing events. (l) Reimbursement. If (i) Investor becomes involved in any capacity in any action, proceeding or investigation brought by any shareholder of the Company, in connection with or as a result of the consummation of the transactions contemplated by the Transaction Documents, or if Investor is impleaded in any such action, proceeding or investigation by any person (other than as a result of a breach of the Investor's representations and warranties set forth in this Agreement); or (ii) Investor becomes involved in any capacity in any action, proceeding or investigation brought by the SEC against or involving the Company or in connection with or as a result of the consummation of the transactions contemplated by the Transaction Documents (other than as a result of a breach of the Investor's representations and warranties set forth in this Agreement), or if Investor is impleaded in any such action, proceeding or investigation by any person, then in any such case, the Company will reimburse Investor for its reasonable legal and other expenses (including the cost of any investigation and preparation) incurred in connection therewith, as such expenses are incurred. In addition, other than with respect to any matter in which Investor is a named party, the Company will pay to Investor the charges, as reasonably determined by Investor, for the time of any officers or employees of Investor devoted to appearing and preparing to appear as witnesses, assisting in preparation for hearings, trials or pretrial matters, or otherwise with respect to inquiries, hearing, trials, and other proceedings relating to the subject matter of this Agreement. The reimbursement obligations of the Company under this section shall be in addition to any liability which the Company may otherwise have, shall extend upon the same terms and conditions to any affiliates of Investor that are actually named in such action, proceeding or investigation, and partners, directors, agents, employees, attorneys, accountants, auditors and controlling persons (if any), as the case may be, of Investor and any such affiliate, and shall be binding upon and inure to the benefit of any successors of the Company, Investor and any such affiliate and any such person. Section 6. COVER. If the number of Shares represented by any Put Notices become restricted or are no longer freely trading for any reason, and after the applicable Closing Date, the Investor purchases, in an open market transaction or otherwise, the Company's Common Stock (the "Covering Shares") in order to make delivery in satisfaction of a sale of Common Stock by the Investor (the "Sold Shares"), which delivery such Investor anticipated to make using the Shares represented by the Put Notice (a "Buy-In"), the Company shall pay to the Investor the Buy-In Adjustment Amount (as defined below). The "Buy-In Adjustment Amount" is the amount equal to the excess, if any, of (a) the Investor's total purchase price (including brokerage commissions, if any) for the Covering Shares over (b) the net proceeds (after brokerage commissions, if any) received by the Investor from the sale of the Sold Shares. The Company shall pay the Buy-In Adjustment Amount to the Investor in immediately available funds immediately upon demand by the Investor. By way of illustration and not in limitation of the foregoing, if the Investor purchases Common Stock having a total purchase price (including brokerage commissions) of $11,000 to cover a Buy-In with respect to the Common Stock it sold for net proceeds of $10,000, the Buy-In Adjustment Amount which the Company will be required to pay to the Investor will be $1,000. Section 7. CONDITIONS OF THE COMPANY'S OBLIGATION TO SELL. The obligation hereunder of the Company to issue and sell the Securities to the Investor is further subject to the satisfaction, at or before each Closing Date, of each of the following conditions set forth below. These conditions are for the Company's sole benefit and may be waived by the Company at any time in its sole discretion. (a) The Investor shall have executed each of this Agreement and the Registration Rights Agreement and delivered the same to the Company. (b) The Investor shall have delivered to the Company the Purchase Price for the Securities being purchased by the Investor at the Closing (after receipt of confirmation of delivery of such Securities) by wire transfer of immediately available funds pursuant to the wire instructions provided by the Company. (c) The representations and warranties of the Investor shall be true and correct as of the date when made and as of the applicable Closing Date as though made at that time (except for representations and warranties that speak as of a specific date), and the Investor shall have performed, satisfied and complied with the covenants, agreements and conditions required by the Transaction Documents to be performed, satisfied or complied with by the Investor at or prior to such Closing Date. (d) No statute, rule, regulation, executive order, decree, ruling or injunction shall have been enacted, entered, promulgated or endorsed by any court or governmental authority of competent jurisdiction which prohibits the consummation of any of the transactions contemplated by this Agreement. (e) No Valuation Event shall have occurred since the applicable Put Notice Date. Section 8. FURTHER CONDITIONS OF THE INVESTOR'S OBLIGATION TO PURCHASE. The obligation of the Investor hereunder to purchase Securities is subject to the satisfaction, on or before each Closing Date, of each of the following conditions set forth below. (a) The Company shall have executed each of the Transaction Documents and delivered the same to the Investor. (b) The Common Stock shall be authorized for quotation on the Principal Market and trading in the Common Stock shall not have been suspended by the Principal Market or the SEC, at any time beginning on the date hereof and through and including the respective Closing Date (excluding suspensions of not more than one Trading Day resulting from business announcements by the Company, provided that such suspensions occur prior to the Company's delivery of the Put Notice related to such Closing). (c) The representations and warranties of the Company shall be true and correct as of the date when made and as of the applicable Closing Date as though made at that time (except for (i) representations and warranties that speak as of a specific date and (ii) with respect to the representations made in Sections 4(g), (h) and (j) and the third sentence of Section 4(k) hereof, events which occur on or after the date of this Agreement and are disclosed in SEC filings made by the Company at least ten Trading Days prior to the applicable Put Notice Date) and the Company shall have performed, satisfied and complied with the covenants, agreements and conditions required by the Transaction Documents to be performed, satisfied or complied with by the Company on or before such Closing Date. The Investor may request an update as of such Closing Date regarding the representation contained in Section 4(c) above. (d) The Company shall have executed and delivered to the Investor the certificates representing, or have executed electronic book-entry transfer of, the Securities (in such denominations as such Investor shall request) being purchased by the Investor at such Closing. (e) The Board of Directors of the Company shall have adopted resolutions consistent with Section 4(b)(ii) above (the "Resolutions") and such Resolutions shall not have been amended or rescinded prior to such Closing Date. (f) reserved. (g) No statute, rule, regulation, executive order, decree, ruling or injunction shall have been enacted, entered, promulgated or endorsed by any court or governmental authority of competent jurisdiction which prohibits the consummation of any of the transactions contemplated by this Agreement. (h) The Registration Statement shall be effective on each Closing Date and no stop order suspending the effectiveness of the Registration statement shall be in effect or shall be pending or threatened. Furthermore, on each Closing Date (i) neither the Company nor Investor shall have received notice that the SEC has issued or intends to issue a stop order with respect to such Registration Statement or that the SEC otherwise has suspended or withdrawn the effectiveness of such Registration Statement, either temporarily or permanently, or intends or has threatened to do so (unless the SEC's concerns have been addressed and Investor is reasonably satisfied that the SEC no longer is considering or intends to take such action), and (ii) no other suspension of the use or withdrawal of the effectiveness of such Registration Statement or related prospectus shall exist. (i) At the time of each Closing, the Registration Statement (including information or documents incorporated by reference therein) and any amendments or supplements thereto shall not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein not misleading or which would require public disclosure or an update supplement to the prospectus. (j) If applicable, the shareholders of the Company shall have approved the issuance of any Shares in excess of the Maximum Common Stock Issuance in accordance with Section 2(i). (k) The conditions to such Closing set forth in Section 2(f) shall have been satisfied on or before such Closing Date. (l) The Company shall have certified to the Investor the number of Shares of Common Stock outstanding when a Put Notice is given to the Investor. Section 9. TERMINATION. This Agreement shall terminate upon any of the following events: (i) when the Investor has purchased an aggregate of Ten Million Dollars ($10,000,000) in the Common Stock of the Company pursuant to this Agreement; provided that the Company's representations, warranties and covenants contained in this Agreement insofar as applicable to the transactions consummated hereunder prior to such termination, shall survive the termination of this Agreement for the period of any applicable statute of limitations; (ii) on the date which is thirty-six (36) months after the Effective Date; (iii) if the Company shall file or consent by answer or otherwise to the entry of an order for relief or approving a petition for relief, reorganization or arrangement or any other petition in bankruptcy for liquidation or to take advantage of any bankruptcy or insolvency law of any jurisdiction, or shall make an assignment for the benefit of its creditors, or shall consent to the appointment of a custodian, receiver, trustee or other officer with similar powers of itself or of any substantial part of its property, or shall be adjudicated a bankrupt or insolvent, or shall take corporate action for the purpose of any of the foregoing, or if a court or governmental authority of competent jurisdiction shall enter an order appointing a custodian, receiver, trustee or other officer with similar powers with respect to the Company or any substantial part of its property or an order for relief or approving a petition for relief or reorganization or any other petition in bankruptcy or for liquidation or to take advantage of any bankruptcy or insolvency law, or an order for the dissolution, winding up or liquidation of the Company, or if any such petition shall be filed against the Company; (iv) if the Company shall issue or sell any equity securities or securities convertible into, or exchangeable for, equity securities or enter into any other equity financing facility during the Open Period, other than in compliance with Section 4(v); Section 10. SUSPENSION. This Agreement shall be suspended upon any of the following events, and shall remain suspended until such event is rectified: (i) the trading of the Common Stock is suspended by the SEC, the Principal Market or the NASD for a period of five consecutive Trading Days during the Open Period; (ii) the Company shall not have filed with the SEC the initial Registration Statement with respect to the resale of the Registrable Securities in accordance with the terms of the initial Registration Rights Agreement within 60 calendar days of the date hereof or the Registration Statement has not been declared effective within 180 calendar days of the date hereof; or (iii) The Common Stock ceases to be registered under the 1934 Act or listed or traded on the Principal Market. Upon the occurrence of one of the above-described events, the Company shall send written notice of such event to the Investor. Section 11. INDEMNIFICATION. In consideration of the parties mutual obligations set forth in the Transaction Documents, each of the parties (in such capacity, an "Indemnitor") shall defend, protect, indemnify and hold harmless the the other and all of the other party's shareholders, officers, directors, employees, counsel, and direct or indirect investors and any of the foregoing person's agents or other representatives (including, without limitation, those retained in connection with the transactions contemplated by this Agreement) (collectively, the "Indemnitees") from and against any and all actions, causes of action, suits, claims, losses, costs, penalties, fees, liabilities and damages, and expenses in connection therewith (irrespective of whether any such Indemnitee is a party to the action for which indemnification hereunder is sought), and including reasonable attorneys' fees and disbursements (the "Indemnified Liabilities"), incurred by any Indemnitee as a result of, or arising out of, or relating to (i) any misrepresentation or breach of any representation or warranty made by the Indemnitor or any other certificate, instrument or document contemplated hereby or thereby; (ii) any breach of any covenant, agreement or obligation of the Indemnitor contained in the Transaction Documents or any other certificate, instrument or document contemplated hereby or thereby; or (iii) any cause of action, suit or claim brought or made against such Indemnitee by a third party and arising out of or resulting from the execution, delivery, performance or enforcement of the Transaction Documents or any other certificate, instrument or document contemplated hereby or thereby, except insofar as any such misrepresentation, breach or any untrue statement, alleged untrue statement, omission or alleged omission is made in reliance upon and in conformity with written information furnished to Indemnitor which is specifically intended for use in the preparation of any such Registration Statement, preliminary prospectus, prospectus or amendments to the prospectus. To the extent that the foregoing undertaking by the Indenitor may be unenforceable for any reason, the Indemnitor shall make the maximum contribution to the payment and satisfaction of each of the Indemnified Liabilities which is permissible under applicable law. The indemnity provisions contained herein shall be in addition to any cause of action or similar rights Indemnitor may have, and any liabilities the Indemnitor or the Indemnitees may be subject to. Section 12. GOVERNING LAW; MISCELLANEOUS. (a) Governing Law. This Agreement shall be governed by and interpreted in accordance with the laws of the Commonwealth of Massachusetts without regard to the principles of conflict of laws. Each party hereby irrevocably submits to the exclusive jurisdiction of the state and federal courts sitting in the City of Boston, County of Suffolk, for the adjudication of any dispute hereunder or in connection herewith or with any transaction contemplated hereby or discussed herein, and hereby irrevocably waives, and agrees not to assert in any suit, action or proceeding, any claim that it is not personally subject to the jurisdiction of any such court, that such suit, action or proceeding is brought in an inconvenient forum or that the venue of such suit, action or proceeding is improper. Each party hereby irrevocably waives personal service of process and consents to process being served in any such suit, action or proceeding by mailing a copy thereof to such party at the address for such notices to it under this Agreement and agrees that such service shall constitute good and sufficient service of process and notice thereof. Nothing contained herein shall be deemed to limit in any way any right to serve process in any manner permitted by law. If any provision of this Agreement shall be invalid or unenforceable in any jurisdiction, such invalidity or unenforceability shall not affect the validity or enforceability of the remainder of this Agreement in that jurisdiction or the validity or enforceability of any provision of this Agreement in any other jurisdiction. (b) Legal Fees; and Miscellaneous Fees. Except as otherwise set forth in the Transaction Documents, the Company shall pay the fees and expenses of its advisers, counsel, the accountants and other experts, if any, and all other expenses incurred by such party incident to the negotiation, preparation, execution, delivery and performance of this Agreement. Any attorneys' fees and expenses incurred by either the Company or by the Investor in connection with the preparation, negotiation, execution and delivery of any amendments to this Agreement or relating to the enforcement of the rights of any party, after the occurrence of any breach of the terms of this Agreement by another party or any default by another party in respect of the transactions contemplated hereunder, shall be paid on demand by the party which breached the Agreement and/or defaulted, as the case may be. The Company shall pay all stamp and other taxes and duties levied in connection with the issuance of any Securities. (c) Counterparts. This Agreement may be executed in two (2) or more identical counterparts, all of which shall be considered one and the same agreement and shall become effective when counterparts have been signed by each party and delivered to the other party; provided that a facsimile signature shall be considered due execution and shall be binding upon the signatory thereto with the same force and effect as if the signature were an original, not a facsimile signature. (d) Headings; Singular/Plural. The headings of this Agreement are for convenience of reference and shall not form part of, or affect the interpretation of, this Agreement. Whenever required by the context of this Agreement, the singular shall include the plural and masculine shall include the feminine. (e) Severability. If any provision of this Agreement shall be invalid or unenforceable in any jurisdiction, such invalidity or unenforceability shall not affect the validity or enforceability of the remainder of this Agreement in that jurisdiction or the validity or enforceability of any provision of this Agreement in any other jurisdiction. (f) Entire Agreement; Amendments. This Agreement supersedes all other prior oral or written agreements between the Investor, the Company, their affiliates and persons acting on their behalf with respect to the matters discussed herein, and this Agreement and the instruments referenced herein (including the other Transaction Documents) contain the entire understanding of the parties with respect to the matters covered herein and therein and, except as specifically set forth herein or therein, neither the Company nor the Investor makes any representation, warranty, covenant or undertaking with respect to such matters. No provision of this Agreement may be amended other than by an instrument in writing signed by the Company and the Investor, and no provision hereof may be waived other than by an instrument in writing signed by the party against whom enforcement is sought. (g) Notices. Any notices or other communications required or permitted to be given under the terms of this Agreement must be in writing and will be deemed to have been delivered (i) upon receipt, when delivered personally; (ii) upon receipt, when sent by facsimile (provided confirmation of transmission is mechanically or electronically generated and kept on file by the sending party); or (iii) one (1) day after deposit with a nationally recognized overnight delivery service, in each case properly addressed to the party to receive the same. The addresses and facsimile numbers for such communications shall be: If to the Company: Payment Data Systems, Inc. 12500 San Pedro Suite 120 San Antonio, TX 78232 Telephone: 210-249-4100 Facsimile: 210-249-4130 If to the Investor: Dutchess Private Equities fund, LP 312 Stuart Street Boston, MA 02116 Telephone: 617-960-3582 Facsimile: 617-960-3772 Each party shall provide five days' prior written notice to the other party of any change in address or facsimile number. (h) No Assignment. This Agreement may not be assigned. (i) No Third Party Beneficiaries. This Agreement is intended for the benefit of the parties hereto and is not for the benefit of, nor may any provision hereof be enforced by, any other person. (j) Survival. The representations and warranties of the Company and the Investor contained in Sections 2 and 3, the agreements and covenants set forth in Sections 4 and 5, and the indemnification provisions set forth in Section 11, shall survive each of the Closings and the termination of this Agreement. (k) Publicity. The Company and Investor shall consult with each other in issuing any press releases or otherwise making public statements with respect to the transactions contemplated hereby and no party shall issue any such press release or otherwise make any such public statement without the prior written consent of the other parties, which consent shall not be unreasonably withheld or delayed, except that no prior consent shall be required if such disclosure is required by law, in which such case the disclosing party shall provide the other parties with prior notice of such public statement. Notwithstanding the foregoing, the Company shall not publicly disclose the name of Investor without the prior written consent of such Investor, except to the extent required by law. Investor acknowledges that this Agreement and all or part of the Transaction Documents may be deemed to be "material contracts" as that term is defined by Item 601(b)(10) of Regulation S-B, and that the Company may therefore be required to file such documents as exhibits to reports or registration statements filed under the 1933 Act or the 1934 Act. Investor further agrees that the status of such documents and materials as material contracts shall be determined solely by the Company, in consultation with its counsel. (l) Further Assurances. Each party shall do and perform, or cause to be done and performed, all such further acts and things, and shall execute and deliver all such other agreements, certificates, instruments and documents, as the other party may reasonably request in order to carry out the intent and accomplish the purposes of this Agreement and the consummation of the transactions contemplated hereby. (m) Placement Agent. The Company agrees to pay Charleston Capital Corporation, ("Charleston") a registered broker dealer, $10,000. The $10,000 shall be payable from 1% (one percent) of the Put Amount on each draw toward the fee. Charleston Capital Corporation will also act as an unaffiliated broker dealer. The Investor shall have no obligation with respect to any fees or with respect to any claims made by or on behalf of other persons or entities for fees of a type contemplated in this Section that may be due in connection with the transactions contemplated by the Transaction Documents. The Company shall indemnify and hold harmless the Investor, their employees, officers, directors, agents, and partners, and their respective affiliates, from and against all claims, losses, damages, costs (including the costs of preparation and attorney's fees) and expenses incurred in respect of any such claimed or existing fees, as such fees and expenses are incurred. (n) No Strict Construction. The language used in this Agreement will be deemed to be the language chosen by the parties to express their mutual intent, and no rules of strict construction will be applied against any party. (o) Remedies. The Investor and each holder of the Shares shall have all rights and remedies set forth in this Agreement and the Registration Rights Agreement and all rights and remedies which such holders have been granted at any time under any other agreement or contract and all of the rights which such holders have under any law. Any person having any rights under any provision of this Agreement shall be entitled to enforce such rights specifically (without posting a bond or other security), to recover damages by reason of any default or breach of any provision of this Agreement, including the recovery of reasonable attorneys fees and costs, and to exercise all other rights granted by law. (p) Payment Set Aside. To the extent that the Company makes a payment or payments to the Investor hereunder or the Registration Rights Agreement or the Investor enforces or exercises its rights hereunder or thereunder, and such payment or payments or the proceeds of such enforcement or exercise or any part thereof are subsequently invalidated, declared to be fraudulent or preferential, set aside, recovered from, disgorged by or are required to be refunded, repaid or otherwise restored to the Company, a trustee, receiver or any other person under any law (including, without limitation, any bankruptcy law, state or federal law, common law or equitable cause of action), then to the extent of any such restoration the obligation or part thereof originally intended to be satisfied shall be revived and continued in full force and effect as if such payment had not been made or such enforcement or setoff had not occurred. (q) Pricing of Common Stock. For purposes of this Agreement, the bid price of the Common Stock in this Agreement shall be as reported on Bloomberg.com. - * * SIGNATURE PAGE OF INVESTMENT AGREEMENT The signature of the authorized representative of the on this Signature Page evidences the Company's agreement to be bound by the terms and conditions of the Investment Agreement and the Registration Rights Agreement as of the date first written above. The undersigned signatory hereby certifies that he has read and understands the Investment Agreement, and the representations made by the Company in this Investment Agreement are true and accurate, and on behalf of the Company, agrees to be bound by its terms. DUTCHESS PRIVATE EQUITIES FUND, L.P. BY ITS GENERAL PARTNER, DUTCHESS CAPITAL MANAGEMENT, LLC By:____________________________ Douglas H. Leighton, Managing Member PAYMENT DATA SYSTEMS, INC. By__________________________________ Michael Long, Chief Executive Officer LIST OF EXHIBITS ----------------- EXHIBIT A Registration Rights Agreement EXHIBIT B Opinion of Company's Counsel EXHIBIT C [reserved] EXHIBIT D Broker Representation Letter EXHIBIT E Board Resolution EXHIBIT F Put Notice EXHIBIT G Put Settlement Sheet LIST OF SCHEDULES ----------------- Schedule 4(a) Subsidiaries Schedule 4(c) Capitalization Schedule 4(e) Conflicts Schedule 4(g) Material Changes Schedule 4(h) Litigation Schedule 4(l) Intellectual Property Schedule 4(n) Liens Schedule 4(t) Certain Transactions EXHIBIT A EXHIBIT B EXHIBIT D [BROKER'S LETTERHEAD] Date Via Facsimile Attention: ______________________ ______________________ ______________________ Re: Payment Data Systems, Inc. Dear __________________: It is our understanding that the Form______ Registration Statement bearing SEC File Number ( ___-______) filed by Payment Data Systems, Inc.on Form _____ on __________, 2004 was declared effective on _________, 2004. This letter shall confirm that ______________ shares of the common stock of Payment Data Systems, Inc. are being sold on behalf of __________________ and that we shall comply with the prospectus delivery requirements set forth in that Registration Statement by filing the same with the purchaser. If you have any questions please do not hesitate to call. Sincerely, ______________________ cc: . EXHIBIT E EXHIBIT F Date: RE: Put Notice Number __ Dear Mr. Leighton, This is to inform you that as of today, Payment Data Systems, Inc., a Nevada corporation (the "Company"), hereby elects to exercise its right pursuant to the Investment Agreement to require Dutchess Private Equities Fund, LP. to purchase shares of its common stock. The Company hereby certifies that: The amount of this put is $__________. The Pricing Period runs from ________ until _______. The current number of shares issued and outstanding as of the Company are: ____________________ Regards, ________________________ Michael Long Payment Data Systems, Inc. EXHIBIT G PUT SETTLEMENT SHEET Date: Michael, Pursuant to the Put given by Payment Data Systems, Inc. to Dutchess Private Equities Fund, L.P. on _________________ 200x, we are now submitting the amount of common shares for you to issue to Dutchess. Please have a certificate baring no restrictive legend totaling __________ shares issued to Dutchess Private Equities Fund, LP immediately and send via DWAC to the following account: XXXXXX If not DWAC eligible, please send Fedex Priority Overnight to: XXXXXX Once these shares are received by us, we will break have the funds wired to the Company. Regards, Douglas H. Leighton Date Price Date of Day 1 Closing Bid of Day 1 Date of Day 2 Closing Bid of Day 2 Date of Day 3 Closing Bid of Day 3 Date of Day 4 Closing Bid of Day 4 Date of Day 5 Closing Bid of Day 5 Lowest 1 (one) Closing Bid in Pricing Period Put Amount Amount Wired to Company Purchase Price (95% (ninety-five percent)) Amount of Shares Due The undersigned has completed this Put as of this ___th day of _________, 20xx. Payment Data Systems, Inc. ________________________________ Michael Long, CEO SCHEDULE 4(c) CAPITALIZATION SCHEDULE 4(e) CONFLICTS SCHEDULE 4(g) MATERIAL CHANGES SCHEDULE 4(h) LITIGATION SCHEDULE 4(l) INTELLECTUAL PROPERTY SCHEDULE 4(n) LIENS SCHEDULE 4(t) CERTAIN TRANSACTIONS EX-10.9 3 doc3.txt EXHIBIT 10.9 REGISTRATION RIGHTS AGREEMENT Registration Rights Agreement (the "Agreement"), dated as of June 4, 2004, by and between Payment Data Systems, Inc., a corporation organized under the laws of State of Nevada, with its principal executive office at with its principal executive office at Primary Business Systems, 12500 San Pedro, Suite 120, San Antonio, TX 78216 (the "Company"), and Dutchess Private Equities Fund, L.P., a Delaware limited partnership with its principal office at 312 Stuart Street, Boston, MA 02116 (the "Investor"). Whereas, in connection with the Investment Agreement by and between the Company and the Investor of even date herewith (the "Investment Agreement"), the Company has agreed to issue and sell to the Investor an indeterminate number of shares of the Company's Common Stock, .001 par value per share (the "Common Stock"), to be purchased pursuant to the terms and subject to the conditions set forth in the Investment Agreement; and Whereas, to induce the Investor to execute and deliver the Investment Agreement, the Company has agreed to provide certain registration rights under the Securities Act of 1933, as amended, and the rules and regulations thereunder, or any similar successor statute (collectively, the "1933 Act"), and applicable state securities laws, with respect to the shares of Common Stock issuable pursuant to the Investment Agreement. Now therefore, in consideration of the foregoing premises and the mutual covenants contained hereinafter and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Company and the Investor hereby agree as follows: SECTION 1. DEFINITIONS. As used in this Agreement, the following terms shall have the following meanings: "Execution Date" means the date first written above. "Investor" means Dutchess Private Equities Fund, L.P., a Delaware limited partnership. "Person" means a corporation, a limited liability company, an association, a partnership, an organization, a business, an individual, a governmental or political subdivision thereof or a governmental agency. "Potential Material Event" means any of the following: (I) the possession by the Company of material information not ripe for disclosure in a Registration Statement, which shall be evidenced by determinations in good faith by the Board of Directors of the Company that disclosure of such information in the Registration Statement would be detrimental to the business and affairs of the Company, or (II) any material engagement or activity by the Company which would, in the good faith determination of the Board of Directors of the Company, be adversely affected by disclosure in a Registration Statement at such time, which determination shall be accompanied by a good faith determination by the Board of Directors of the Company that the Registration Statement would be materially misleading absent the inclusion of such information. "Principal Market" shall mean The American Stock Exchange, National Association of Securities Dealer's, Inc. Over-the-Counter electronic bulletin board, the Nasdaq National Market or The Nasdaq SmallCap Market whichever is the principal market on which the Common Stock is listed. "Register," "Registered," and "Registration" refer to a registration effected by preparing and filing one or more Registration Statements in compliance with the 1933 Act and pursuant to Rule 415 under the 1933 Act or any successor rule providing for offering securities on a continuous basis ("Rule 415"), and the declaration or ordering of effectiveness of such Registration Statement(s) by the United States Securities and Exchange Commission (the "SEC"). "Registrable Securities" means (I) the shares of Common Stock issued or issuable pursuant to the Investment Agreement, and (II) any shares of capital stock issued or issuable with respect to such shares of Common Stock, if any, as a result of any stock split, stock dividend, recapitalization, exchange or similar event or otherwise, which have not been (X) included in a Registration Statement that has been declared effective by the SEC or (Y) sold under circumstances meeting all of the applicable conditions of Rule 144 (or any similar provision then in force) under the 1933 Act. "Registration Statement" means a registration statement of the Company filed under the 1933 Act covering the Registrable Securities. All capitalized terms used in this Agreement and not otherwise defined herein shall have the same meaning ascribed to them as in the Investment Agreement. SECTION 2. REGISTRATION. (A) On or before the execution of this Agreement, the Company shall have provided a draft of the Registration Statement covering the Registrable Securities to the Investor. The Company shall, as soon as practicable, but not later than fifteen calendar days following the Execution Date, file with the SEC a Registration Statement or Registration Statements (as is necessary) on Form SB-2 (or, if such form is unavailable for such a registration, on such other form as is available for such a registration), covering the resale of all of the Registrable Securities, which Registration Statement(s) shall state that, in accordance with Rule 416 promulgated under the 1933 Act, such Registration Statement also covers such indeterminate number of additional shares of Common Stock as may become issuable upon stock splits, stock dividends or similar transactions. The Company shall initially register for resale 40,000,000 shares of Common Stock which would be issuable on the date preceding the filing of the Registration Statement based on the closing bid price of the Company's Common Stock on such date and the amount reasonably calculated that represents Common Stock issuable to other parties as set forth in the Investment Agreement except to the extent that the SEC requires the share amount to be reduced as a condition of effectiveness. (B) The Company shall use commercially reasonable efforts to have the Registration Statement(s) declared effective by the SEC within 90 calendar days after the Execution Date. (C) The Company agrees not to include any other securities in the Registration Statement covering the Registrable Securities without Investor's prior written consent which Investor may withhold in its sole discretion. Furthermore, the Company agrees that it will not file any other Registration Statement for other securities, until thirty calendar days after the Registration Statement for the Registrable Securities is declared effective by the SEC. SECTION 3. RELATED OBLIGATIONS. At such time as the Company is obligated to prepare and file a Registration Statement with the SEC pursuant to Section 2(a), the Company will effect the registration of the Registrable Securities in accordance with the intended method of disposition thereof and, with respect thereto, the Company shall have the following obligations: (A) The Company shall use commercially reasonable efforts to cause such Registration Statement relating to the Registrable Securities to become effective within 90 days after the Execution Date and shall keep such Registration Statement effective until the earlier to occur of (I) the date as of which the Investor may sell all of the Registrable Securities without restriction pursuant to Rule 144(k) promulgated under the 1933 Act (or successor thereto); or (II) the date on which (A) the Investor shall have sold all the Registrable Securities; and (B) the Investor has no right to acquire any additional shares of Common Stock under the Investment Agreement (the "Registration Period"). The Registration Statement (including any amendments or supplements thereto and prospectuses contained therein) shall not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein, or necessary to make the statements therein, in light of the circumstances in which they were made, not misleading. The Company shall use its best efforts to respond to all SEC comments within seven business days from receipt of such comments by the Company. The Company shall use its best efforts to cause the Registration Statement relating to the Registrable Securities to become effective no later than three business days after notice from the SEC that the Registration Statement may be declared effective. The Investor agrees to provide all information which it is required by law to provide to the Company, including the intended method of disposition of the Registrable Securities, and the Company's obligations set forth above shall be conditioned on the receipt of such information. (B) The Company shall prepare and file with the SEC such amendments (including post-effective amendments) and supplements to a Registration Statement and the prospectus used in connection with such Registration Statement, which prospectus is to be filed pursuant to Rule 424 promulgated under the 1933 Act, as may be necessary to keep such Registration Statement effective during the Registration Period, and, during such period, comply with the provisions of the 1933 Act with respect to the disposition of all Registrable Securities of the Company covered by such Registration Statement until such time as all of such Registrable Securities shall have been disposed of in accordance with the intended methods of disposition by the Investor thereof as set forth in such Registration Statement. In the event the number of shares of Common Stock covered by a Registration Statement filed pursuant to this Agreement is at any time insufficient to cover all of the Registrable Securities, the Company shall amend such Registration Statement, or file a new Registration Statement (on the short form available therefor, if applicable), or both, so as to cover all of the Registrable Securities, in each case, as soon as practicable, but in any event within 30 calendar days after the necessity therefor arises (based on the then Purchase Price of the Common Stock and other relevant factors on which the Company reasonably elects to rely), assuming the Company has sufficient authorized shares at that time, and if it does not, within 30 calendar days after such shares are authorized. The Company shall use commercially reasonable efforts to cause such amendment and/or new Registration Statement to become effective as soon as practicable following the filing thereof. (C) The Company shall make available to the Investor whose Registrable Securities are included in any Registration Statement and its legal counsel without charge (I) promptly after the same is prepared and filed with the SEC at least one copy of such Registration Statement and any amendment(s) thereto, including financial statements and schedules, all documents incorporated therein by reference and all exhibits, the prospectus included in such Registration Statement (including each preliminary prospectus) and, with regards to such Registration Statement(s), any correspondence by or on behalf of the Company to the SEC or the staff of the SEC and any correspondence from the SEC or the staff of the SEC to the Company or its representatives; (II) upon the effectiveness of any Registration Statement, the Company shall make available copies of the prospectus included in such Registration Statement and all amendments and supplements thereto; and (III) such other documents, including copies of any preliminary or final prospectus, as the Investor may reasonably request from time to time in order to facilitate the disposition of the Registrable Securities. (D) The Company shall use commercially reasonable efforts to (I) register and qualify the Registrable Securities covered by a Registration Statement under such other securities or "blue sky" laws of such states in the United States as any Investor reasonably requests; (II) prepare and file in those jurisdictions, such amendments (including post-effective amendments) and supplements to such registrations and qualifications as may be necessary to maintain the effectiveness thereof during the Registration Period; (III) take such other actions as may be necessary to maintain such registrations and qualifications in effect at all times during the Registration Period, and (IV) take all other actions reasonably necessary or advisable to qualify the Registrable Securities for sale in such jurisdictions; provided, however, that the Company shall not be required in connection therewith or as a condition thereto to (X) qualify to do business in any jurisdiction where it would not otherwise be required to qualify but for this Section 3(d), or (Y) subject itself to general taxation in any such jurisdiction. The Company shall promptly notify each Investor who holds Registrable Securities of the receipt by the Company of any notification with respect to the suspension of the registration or qualification of any of the Registrable Securities for sale under the securities or "blue sky" laws of any jurisdiction in the United States or its receipt of actual notice of the initiation or threatening of any proceeding for such purpose. (E) As promptly as practicable after becoming aware of such event, the Company shall notify each Investor in writing of the happening of any event as a result of which the prospectus included in a Registration Statement, as then in effect, includes an untrue statement of a material fact or omission to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading ("Registration Default") and use all diligent efforts to promptly prepare a supplement or amendment to such Registration Statement and take any other necessary steps to cure the Registration Default, (which, if such Registration Statement is on Form S-3, may consist of a document to be filed by the Company with the SEC pursuant to Section 13(a), 13(c), 14 or 15(d) of the 1934 Act (as defined below) and to be incorporated by reference in the prospectus) to correct such untrue statement or omission, and make available copies of such supplement or amendment to each Investor. The Company shall also promptly notify each Investor (I) when a prospectus or any prospectus supplement or post-effective amendment has been filed, and when a Registration Statement or any post-effective amendment has become effective (the Company will prepare notification of such effectiveness which shall be delivered to the Investor on the same day of such effectiveness and by overnight mail), additionally, the Company will promptly provide to the Investor a copy of the effectiveness order prepared by the SEC once it is received by the Company; (II) of any request by the SEC for amendments or supplements to a Registration Statement or related prospectus or related information, (III) of the Company's reasonable determination that a post-effective amendment to a Registration Statement would be appropriate, (IV) in the event the Registration Statement is no longer effective, or (V) if Registration Statement is stale as a result of the Company's failure to timely file its financials or otherwise. The Company acknowledges that its failure to cure the Registration Default within ten business days will cause the Investor to suffer damages in an amount that will be difficult to ascertain. Accordingly, the parties agree that it is appropriate to include a provision for liquidated damages, such provision being described as "late payments" under Section 2(h) of the Investment Agreement between the parties. The parties acknowledge and agree that the liquidated damages provision set forth in this section represents the parties' good faith effort to quantify such damages and, as such, agree that the form and amount of such liquidated damages are reasonable and will not constitute a penalty. It is the intention of the parties that interest payable under any of the terms of this Agreement shall not exceed the maximum amount permitted under any applicable law. If a law, which applies to this Agreement which sets the maximum interest amount, is finally interpreted so that the interest in connection with this Agreement exceeds the permitted limits, then: (1) any such interest shall be reduced by the amount necessary to reduce the interest to the permitted limit; and (2) any sums already collected (if any) from the Company which exceed the permitted limits will be refunded to the Company. The Investor may choose to make this refund by reducing the amount that the Company owes under this Agreement or by making a direct payment to the Company. If a refund reduces the amount that the Company owes the Investor, the reduction will be treated as a partial payment. In case any provision of this Agreement is held by a court of competent jurisdiction to be excessive in scope or otherwise invalid or unenforceable, such provision shall be adjusted rather than voided, if possible, so that it is enforceable to the maximum extent possible, and the validity and enforceability of the remaining provisions of this Agreement will not in any way be affected or impaired thereby. (F) The Company shall use commercially reasonable efforts to prevent the issuance of any stop order or other suspension of effectiveness of a Registration Statement, or the suspension of the qualification of any of the Registrable Securities for sale in any jurisdiction and, if such an order or suspension is issued, to obtain the withdrawal of such order or suspension at the earliest possible moment and to notify the Investor who holds Registrable Securities being sold of the issuance of such order and the resolution thereof or its receipt of actual notice of the initiation or threat of any proceeding for such purpose. (G) The Company shall permit the Investor and one legal counsel, designated by the Investor, to review and comment upon a Registration Statement and all amendments and supplements thereto at least three business days prior to their filing with the SEC, and not file any document in a form to which such counsel reasonably objects. The Company may request to shorten the Investor's review period and the Investor will, if possible, attempt to comply with the accelerated review period. The Company shall not submit to the SEC a request for acceleration of the effectiveness of a Registration Statement or file with the SEC a Registration Statement or any amendment or supplement thereto without the prior approval of such counsel, which approval shall not be unreasonably withheld. (H) Reserved (I) Reserved (J) The Company shall hold in confidence and not make any disclosure of information concerning a Investor provided to the Company unless (I) disclosure of such information is necessary to comply with federal or state securities laws, (II) the disclosure of such information is necessary to avoid or correct a misstatement or omission in any Registration Statement, (III) the release of such information is ordered pursuant to a subpoena or other final, non-appealable order from a court or governmental body of competent jurisdiction, or (IV) such information has been made generally available to the public other than by disclosure in violation of this Agreement or any other agreement. The Company agrees that it shall, upon learning that disclosure of such information concerning a Investor is sought in or by a court or governmental body of competent jurisdiction or through other means, give prompt written notice to such Investor and allow such Investor, at the Investor's expense, to undertake appropriate action to prevent disclosure of, or to obtain a protective order for, such information. (K) The Company shall use commercially reasonable efforts to maintain designation and quotation of all the Registrable Securities covered by any Registration Statement on the Principal Market. If, despite the Company's best efforts, the Company is unsuccessful in satisfying the preceding sentence, it shall use commercially reasonable efforts to cause all the Registrable Securities covered by any Registration Statement to be listed on each other national securities exchange and automated quotation system, if any, on which securities of the same class or series issued by the Company are then listed, if any, if the listing of such Registrable Securities is then permitted under the rules of such exchange or system. The Company shall pay all fees and expenses in connection with satisfying its obligation under this Section 3(k). (L) The Company shall cooperate with the Investor to facilitate the prompt preparation and delivery of certificates (not bearing any restrictive legend) representing the Registrable Securities to be offered pursuant to a Registration Statement and enable such certificates to be in such denominations or amounts, as the case may be, as the Investor may reasonably request. (M) The Company shall provide a transfer agent for all the Registrable Securities not later than the effective date of the first Registration Statement filed pursuant hereto. (N) If requested by the Investor, the Company shall (I) as soon as reasonably practical incorporate in a prospectus supplement or post-effective amendment such information as such Investor reasonably determine should be included therein relating to the sale and distribution of Registrable Securities, including, without limitation, information with respect to the offering of the Registrable Securities to be sold in such offering; (II) make all required filings of such prospectus supplement or post-effective amendment as soon as reasonably possible after being notified of the matters to be incorporated in such prospectus supplement or post-effective amendment; and (III) supplement or make amendments to any Registration Statement if reasonably requested by such Investor. (O) The Company shall use commercially reasonable efforts to cause the Registrable Securities covered by the applicable Registration Statement to be registered with or approved by such other governmental agencies or authorities as may be necessary to consummate the disposition of such Registrable Securities. (P) The Company shall otherwise use commercially reasonable efforts to comply with all applicable rules and regulations of the SEC in connection with any registration hereunder. (Q) Within one business day after the Registration Statement which includes Registrable Securities is declared effective by the SEC, the Company shall deliver to the transfer agent for such Registrable Securities, with copies to the Investor, confirmation that such Registration Statement has been declared effective by the SEC. (R) At or prior to the date of the first Put Notice (as that term is defined in the Investment Agreement) and at such other times as the Investor may reasonably request, the Company shall cause to be delivered a certification from the Chief Executive Officer of the Company setting forth that the Company's periodic filings, including any amendments thereto, with the Securities and Exchange Commission truthfully and accurately set forth the financial position of the Company when filed. (S) The Company shall take all other reasonable actions necessary to expedite and facilitate disposition by the Investor of Registrable Securities pursuant to a Registration Statement. SECTION 4. OBLIGATIONS OF THE INVESTOR. (A) At least five calendar days prior to the first anticipated filing date of a Registration Statement the Company shall notify the Investor in writing of the information the Company requires from each such Investor if such Investor elects to have any of such Investor's Registrable Securities included in such Registration Statement. It shall be a condition precedent to the obligations of the Company to complete the registration pursuant to this Agreement with respect to the Registrable Securities of a particular Investor that such Investor shall furnish in writing to the Company such information regarding itself, the Registrable Securities held by it and the intended method of disposition of the Registrable Securities held by it as shall reasonably be required to effect the registration of such Registrable Securities and shall execute such documents in connection with such registration as the Company may reasonably request. Each Investor covenants and agrees that, in connection with any sale of Registrable Securities by it pursuant to a Registration Statement, it shall comply with the "Plan of Distribution" section of the current prospectus relating to such Registration Statement. (B) The Investor, by such Investor's acceptance of the Registrable Securities, agrees to cooperate with the Company as reasonably requested by the Company in connection with the preparation and filing of any Registration Statement hereunder, unless such Investor has notified the Company in writing of such Investor's election to exclude all of such Investor's Registrable Securities from such Registration Statement. (C) The Investor agrees that, upon receipt of written notice from the Company of the happening of any event of the kind described in Section 3(f) or the first sentence of 3(e), such Investor will immediately discontinue disposition of Registrable Securities pursuant to any Registration Statement(s) covering such Registrable Securities until such Investor's receipt of the copies of the supplemented or amended prospectus contemplated by Section 3(f) or the first sentence of 3(e). SECTION 5. EXPENSES OF REGISTRATION. All expenses, other than underwriting discounts and commissions and other than as set forth in the Investment Agreement, incurred in connection with registrations including comments, filings or qualifications pursuant to Sections 2 and 3, including, without limitation, all registration, listing and qualifications fees, printing and accounting fees, and fees and disbursements of counsel for the Company or for the Investor shall be paid by the Company. SECTION 6. INDEMNIFICATION. In the event any Registrable Securities are included in a Registration Statement under this Agreement: (A) To the fullest extent permitted by law, the Company will, and hereby does, indemnify, hold harmless and defend each Investor who holds such Registrable Securities, the directors, officers, partners, employees, counsel, agents, representatives of, and each Person, if any, who controls, any Investor within the meaning of the 1933 Act or the Securities Exchange Act of 1934, as amended (the "1934 Act") (each, an "Indemnified Person"), against any losses, claims, damages, liabilities, judgments, fines, penalties, charges, costs, attorneys' fees, amounts paid in settlement or expenses, joint or several (collectively, "Claims"), incurred in investigating, preparing or defending any action, claim, suit, inquiry, proceeding, investigation or appeal taken from the foregoing by or before any court or governmental, administrative or other regulatory agency, body or the SEC, whether pending or threatened, whether or not an indemnified party is or may be a party thereto ("Indemnified Damages"), to which any of them may become subject insofar as such Claims (or actions or proceedings, whether commenced or threatened, in respect thereof) arise out of or are based upon: (I) any untrue statement or alleged untrue statement of a material fact in a Registration Statement or any post-effective amendment thereto or in any filing made in connection with the qualification of the offering under the securities or other "blue sky" laws of any jurisdiction in which the Investor has requested in writing that the Company register or qualify the Shares ("Blue Sky Filing"), or the omission or alleged omission to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which the statements therein were made, not misleading, (II) any untrue statement or alleged untrue statement of a material fact contained in the final prospectus (as amended or supplemented, if the Company files any amendment thereof or supplement thereto with the SEC) or the omission or alleged omission to state therein any material fact necessary to make the statements made therein, in light of the circumstances under which the statements therein were made, not misleading, or (III) any violation or alleged violation by the Company of the 1933 Act, the 1934 Act, any other law, including, without limitation, any state securities law, or any rule or regulation thereunder relating to the offer or sale of the Registrable Securities pursuant to a Registration Statement (the matters in the foregoing clauses (i) through (iii) being, collectively, "Violations"). Subject to the restrictions set forth in Section 6(c) with respect to the number of legal counsel, the Company shall reimburse the Investor and each such controlling person, promptly as such expenses are incurred and are due and payable, for any reasonable legal fees or other reasonable expenses incurred by them in connection with investigating or defending any such Claim. Notwithstanding anything to the contrary contained herein, the indemnification agreement contained in this Section 6(a): (I) shall not apply to a Claim arising out of or based upon a Violation which is due to the inclusion in the Registration Statement of the information furnished to the Company by any Indemnified Person expressly for use in connection with the preparation of the Registration Statement or any such amendment thereof or supplement thereto; (II) shall not be available to the extent such Claim is based on (A) a failure of the Investor to deliver or to cause to be delivered the prospectus made available by the Company or (B) the Indemnified Person's use of an incorrect prospectus despite being promptly advised in advance by the Company in writing not to use such incorrect prospectus; (III) any claims based on the manner of sale of the Registrable Securities by the Investor or of the Investor's failure to register as a dealer under applicable securities laws; (IV) any omission of the Investor to notify the Company of any material fact that should be stated in the Registration Statement or prospectus relating to the Investor or the manner of sale; and (V) any amounts paid in settlement of any Claim if such settlement is effected without the prior written consent of the Company, which consent shall not be unreasonably withheld. Such indemnity shall remain in full force and effect regardless of any investigation made by or on behalf of the Indemnified Person and shall survive the resale of the Registrable Securities by the Investor pursuant to the Registration Statement. (B) In connection with any Registration Statement in which a Investor is participating, each such Investor agrees to severally and jointly indemnify, hold harmless and defend, to the same extent and in the same manner as is set forth in Section 6(a), the Company, each of its directors, each of its officers who signs the Registration Statement, each Person, if any, who controls the Company within the meaning of the 1933 Act or the 1934 Act and the Company's agents (collectively and together with an Indemnified Person, an "Indemnified Party"), against any Claim or Indemnified Damages to which any of them may become subject, under the 1933 Act, the 1934 Act or otherwise, insofar as such Claim or Indemnified Damages arise out of or are based upon any Violation, in each case to the extent, and only to the extent, that such Violation is due to the inclusion in the Registration Statement of the written information furnished to the Company by such Investor expressly for use in connection with such Registration Statement; and, subject to Section 6(c), such Investor will reimburse any legal or other expenses reasonably incurred by them in connection with investigating or defending any such Claim; provided, however, that the indemnity agreement contained in this Section 6(b) and the agreement with respect to contribution contained in Section 7 shall not apply to amounts paid in settlement of any Claim if such settlement is effected without the prior written consent of such Investor, which consent shall not be unreasonably withheld; provided, further, however, that the Investor shall be liable under this Section 6(b) for only that amount of a Claim or Indemnified Damages as does not exceed the net proceeds to such Investor as a result of the sale of Registrable Securities pursuant to such Registration Statement. Such indemnity shall remain in full force and effect regardless of any investigation made by or on behalf of such Indemnified Party and shall survive the resale of the Registrable Securities by the Investor pursuant to the Registration Statement. Notwithstanding anything to the contrary contained herein, the indemnification agreement contained in this Section 6(b) with respect to any preliminary prospectus shall not inure to the benefit of any Indemnified Party if the untrue statement or omission of material fact contained in the preliminary prospectus were corrected on a timely basis in the prospectus, as then amended or supplemented. This indemnification provision shall apply separately to each Investor and liability hereunder shall not be joint and several. (C) Promptly after receipt by an Indemnified Person or Indemnified Party under this Section 6 of notice of the commencement of any action or proceeding (including any governmental action or proceeding) involving a Claim, such Indemnified Person or Indemnified Party shall, if a Claim in respect thereof is to be made against any indemnifying party under this Section 6, deliver to the indemnifying party a written notice of the commencement thereof, and the indemnifying party shall have the right to participate in, and, to the extent the indemnifying party so desires, jointly with any other indemnifying party similarly noticed, to assume control of the defense thereof with counsel mutually satisfactory to the indemnifying party and the Indemnified Person or the Indemnified Party, as the case may be; provided, however, that an Indemnified Person or Indemnified Party shall have the right to retain its own counsel with the fees and expenses to be paid by the indemnifying party, if, in the reasonable opinion of counsel retained by the Indemnified Person or Indemnified Party, the representation by counsel of the Indemnified Person or Indemnified Party and the indemnifying party would be inappropriate due to actual or potential differing interests between such Indemnified Person or Indemnified Party and any other party represented by such counsel in such proceeding. The indemnifying party shall pay for only one separate legal counsel for the Indemnified Persons or the Indemnified Parties, as applicable, and such counsel shall be selected by the Investor, if the Investor are entitled to indemnification hereunder, or the Company, if the Company is entitled to indemnification hereunder, as applicable. The Indemnified Party or Indemnified Person shall cooperate fully with the indemnifying party in connection with any negotiation or defense of any such action or Claim by the indemnifying party and shall furnish to the indemnifying party all information reasonably available to the Indemnified Party or Indemnified Person which relates to such action or Claim. The indemnifying party shall keep the Indemnified Party or Indemnified Person fully appraised at all times as to the status of the defense or any settlement negotiations with respect thereto. No indemnifying party shall be liable for any settlement of any action, claim or proceeding effected without its written consent, provided, however, that the indemnifying party shall not unreasonably withhold, delay or condition its consent. No indemnifying party shall, without the consent of the Indemnified Party or Indemnified Person, consent to entry of any judgment or enter into any settlement or other compromise which does not include as an unconditional term thereof the giving by the claimant or plaintiff to such Indemnified Party or Indemnified Person of a release from all liability in respect to such Claim. Following indemnification as provided for hereunder, the indemnifying party shall be surrogated to all rights of the Indemnified Party or Indemnified Person with respect to all third parties, firms or corporations relating to the matter for which indemnification has been made. The failure to deliver written notice to the indemnifying party within a reasonable time of the commencement of any such action shall not relieve such indemnifying party of any liability to the Indemnified Person or Indemnified Party under this Section 6, except to the extent that the indemnifying party is prejudiced in its ability to defend such action. (D) The indemnity agreements contained herein shall be in addition to (I) any cause of action or similar right of the Indemnified Party or Indemnified Person against the indemnifying party or others, and (II) any liabilities the indemnifying party may be subject to pursuant to the law. SECTION 7. CONTRIBUTION. To the extent any indemnification by an indemnifying party is prohibited or limited by law, the indemnifying party agrees to make the maximum contribution with respect to any amounts for which it would otherwise be liable under Section 6 to the fullest extent permitted by law; provided, however, that: (I) no contribution shall be made under circumstances where the maker would not have been liable for indemnification under the fault standards set forth in Section 6; (II) no seller of Registrable Securities guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the 1933 Act) shall be entitled to contribution from any seller of Registrable Securities who was not guilty of fraudulent misrepresentation; and (III) contribution by any seller of Registrable Securities shall be limited in amount to the net amount of proceeds received by such seller from the sale of such Registrable Securities. SECTION 8. REPORTS UNDER THE 1934 ACT. With a view to making available to the Investor the benefits of Rule 144 promulgated under the 1933 Act or any other similar rule or regulation of the SEC that may at any time permit the Investor to sell securities of the Company to the public without registration ("Rule 144"), the Company agrees to: (A) make and keep public information available, as those terms are understood and defined in Rule 144; (B) file with the SEC in a timely manner all reports and other documents required of the Company under the 1933 Act and the 1934 Act so long as the Company remains subject to such requirements (it being understood that nothing herein shall limit the Company's obligations under Section 5(c) of the Investment Agreement) and the filing of such reports and other documents is required for the applicable provisions of Rule 144; and (C) furnish to the Investor, promptly upon request, (I) a written statement by the Company that it has complied with the reporting requirements of Rule 144, the 1933 Act and the 1934 Act, (II) a copy of the most recent annual or quarterly report of the Company and such other reports and documents so filed by the Company, and (III) such other information as may be reasonably requested to permit the Investor to sell such securities pursuant to Rule 144 without registration. SECTION 9. NO ASSIGNMENT OF REGISTRATION RIGHTS. THE RIGHTS UNDER THIS AGREEMENT SHALL NOT BE ASSIGNABLE. SECTION 10. AMENDMENT OF REGISTRATION RIGHTS. Provisions of this Agreement may be amended only with the written consent of the Company and Investor. No such amendment shall be effective to the extent that it applies to less than all of the Investor of the Registrable Securities. SECTION 11. MISCELLANEOUS. (A) Any notices or other communications required or permitted to be given under the terms of this Agreement that must be in writing will be deemed to have been delivered (I) upon receipt, when delivered personally; (II) upon receipt, when sent by facsimile (provided a confirmation of transmission is mechanically or electronically generated and kept on file by the sending party); or (III) one day after deposit with a nationally recognized overnight delivery service, in each case properly addressed to the party to receive the same. The addresses and facsimile numbers for such communications shall be: If to the Company: Payment Data Systems, Inc. 12500 San Pedro, Suite 120 San Antonio, TX 78216 Telephone: 210-249-4100 Facsimile: 210-249-4130 If to the Investor: Dutchess Private Equities Fund, LP 312 Stuart St, Third Floor Boston, MA 02116 Telephone: 617-960-3570 Facsimile: 617-960-3772 Each party shall provide five business days prior notice to the other party of any change in address, phone number or facsimile number. (B) Failure of any party to exercise any right or remedy under this Agreement or otherwise, or delay by a party in exercising such right or remedy, shall not operate as a waiver thereof. (C) The laws of the Commonwealth of Massachusetts shall govern all issues arising from or related to this Agreement without regard to the principles of conflict of laws. Each party hereby irrevocably submits to the exclusive jurisdiction of the state and federal courts sitting in the City of Boston, County of Suffolk, for the adjudication of any dispute hereunder or in connection herewith or with any transaction contemplated hereby or discussed herein, and hereby irrevocably waives, and agrees not to assert in any suit, action or proceeding, any claim that it is not personally subject to the jurisdiction of any such court, that such suit, action or proceeding is brought in an inconvenient forum or that the venue of such suit, action or proceeding is improper. Each party hereby irrevocably waives personal service of process and consents to process being served in any such suit, action or proceeding by mailing a copy thereof to such party at the address for such notices to it under this Agreement and agrees that such service shall constitute good and sufficient service of process and notice thereof. Nothing contained herein shall be deemed to limit in any way any right to serve process in any manner permitted by law. If any provision of this Agreement shall be invalid or unenforceable in any jurisdiction, such invalidity or unenforceability shall not affect the validity or enforceability of the remainder of this Agreement in that jurisdiction or the validity or enforceability of any provision of this Agreement in any other jurisdiction. (D) This Agreement and the Transaction Documents constitute the entire agreement among the parties hereto with respect to the subject matter hereof and thereof. There are no restrictions, promises, warranties or undertakings, other than those set forth or referred to herein and therein. (E) This Agreement and the Transaction Documents supersede all prior agreements and understandings among the parties hereto with respect to the subject matter hereof and thereof. (F) The headings in this Agreement are for convenience of reference only and shall not limit or otherwise affect the meaning hereof. Whenever required by the context of this Agreement, the singular shall include the plural and masculine shall include the feminine. This Agreement shall not be construed as if it had been prepared by one of the parties, but rather as if all the parties had prepared the same. (G) This Agreement may be executed in two or more identical counterparts, each of which shall be deemed an original but all of which shall constitute one and the same agreement. This Agreement, once executed by a party, may be delivered to the other party hereto by facsimile transmission of a copy of this Agreement bearing the signature of the party so delivering this Agreement. (H) Each party shall do and perform, or cause to be done and performed, all such further acts and things, and shall execute and deliver all such other agreements, certificates, instruments and documents, as the other party may reasonably request in order to carry out the intent and accomplish the purposes of this Agreement and the consummation of the transactions contemplated hereby. * * * SIGNATURE PAGE OF REGISTRATION RIGHTS AGREEMENT Agreed as of the date first written above. DUTCHESS PRIVATE EQUITIES FUND, L.P. BY ITS GENERAL PARTNER, DUTCHESS CAPITAL MANAGEMENT, LLC /s/ Douglas Leighton By:____________________________ Douglas H. Leighton, Managing Member PAYMENT DATA SYSTEMS, INC. /s/ Michael Long By__________________________________ Michael Long, Chief Executive Officer EX-10.10 4 doc4.txt EXHIBIT 10.10 Payment Data Systems, Inc PLACEMENT AGENT AGREEMENT Dated as of: June 4, 2004. The undersigned, Payment Data Systems, Inc., a Nevada corporation (the "COMPANY"), hereby agrees with Charleston Capital Corporation (the "PLACEMENT AGENT") and Dutchess Private Equities Fund, L.P., a Delaware Limited Partnership (the "INVESTOR") as follows: 1. OFFERING. The Company hereby engages the Placement Agent to act as its exclusive placement agent in connection with the Investment Agreement dated June 4, 2004 (the "INVESTMENT AGREEMENT") pursuant to which the Company shall issue and sell to the Investor, from time to time, and the Investor shall purchase from the Company (the "OFFERING") up to Ten Million Dollars ($10,000,000) of the Company's Class A Voting Common Stock (the "COMMITMENT AMOUNT"), par value $0.001 per share (the "COMMON STOCK"), at price per share equal to the Purchase Price, as that term is defined in the Investment Agreement. Pursuant to the terms hereof, the Placement Agent shall render consulting services to the Company with respect to the Investment Agreement and shall be available for consultation in connection with the advances to be requested by the Company pursuant to the Investment Agreement. All capitalized terms used herein and not otherwise defined herein shall have the same meaning ascribed to them as in the Investment Agreement. The Investor will be granted certain registration rights with respect to the Common Stock as more fully set forth in a Registration Rights Agreement between the Company and the Investor dated June 4, 2004 (the "REGISTRATION RIGHTS AGREEMENT"). The documents to be executed and delivered in connection with the Offering, including, but not limited, to this Agreement, the Investment Agreement, and the Registration Rights Agreement, and any Prospectus or other disclosure document (including all amendments and supplements ) utilized in connection with the Offering are referred to sometimes hereinafter collectively as the "OFFERING MATERIALS." The Company's Common Stock is sometimes referred to hereinafter as the "SECURITIES." The Placement Agent shall not be obligated to sell any Securities and this Offering by the Placement Agent shall be solely on a "best efforts basis." 2. REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE PLACEMENT AGENT. A. The Placement Agent represents, warrants and covenants as follows: (i) The Placement Agent has the necessary power to enter into this Agreement and to consummate the transactions contemplated hereby. (ii) The execution and delivery by the Placement Agent of this Agreement and the consummation of the transactions contemplated herein will not result in any violation of, or be in conflict with, or constitute a default under, any agreement or instrument to which the Placement Agent is a party or by which the Placement Agent or its properties are bound, or any judgment, decree, order or, to the Placement Agent's knowledge, any statute, rule or regulation applicable to the Placement Agent. This Agreement when executed and delivered by the Placement Agent, will constitute the legal, valid and binding obligations of the Placement Agent, enforceable in accordance with their respective terms, except to the extent that (a) the enforceability hereof or thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws from time to time in effect and affecting the rights of creditors generally, (b) the enforceability hereof or thereof is subject to general principles of equity, or (c) the indemnification provisions hereof or thereof may be held to be in violation of public policy. (iii) Upon receipt and execution of this Agreement the Placement Agent will promptly forward copies of this Agreement to the Company or its counsel and the Investor or its counsel. (iv) The Placement Agent will not take any action that it reasonably believes would cause the Offering to violate the provisions of the Securities Act of 1933, as amended (the "1933 ACT"), the Securities Exchange Act of 1934 (the "1934 ACT"), the respective rules and regulations promulgated there under (the "RULES AND REGULATIONS") or applicable "Blue Sky" laws of any state or jurisdiction. (v) The Placement Agent will use all reasonable efforts to determine (a) whether the Investor is an Accredited Investor and (b) that any information furnished by the Investor is true and accurate. The Placement Agent shall have no obligation to insure that (x) any check, note, draft or other means of payment for the Common Stock will be honored, paid or enforceable against the Investor in accordance with its terms, or (y) subject to the performance of the Placement Agent's obligations and the accuracy of the Placement Agent's representations and warranties hereunder, (1) the Offering is exempt from the registration requirements of the 1933 Act or any applicable state "Blue Sky" law or (2) the Investor is an Accredited Investor. (vi) The Placement Agent is a member of the National Association of Securities Dealers, Inc., and is a broker-dealer registered as such under the 1934 Act and under the securities laws of the states in which the Securities will be offered or sold by the Placement Agent unless an exemption for such state registration is available to the Placement Agent. The Placement Agent is in compliance with all material rules and regulations applicable to the Placement Agent generally and applicable to the Placement Agent's participation in the Offering. 3. REPRESENTATIONS AND WARRANTIES OF THE COMPANY. A. The Company makes to the Placement Agent all the representations and warranties it makes to the Investor in the Investment Agreement and, in addition, represents and warrants as follows: (i) The execution, delivery and performance of each of this Agreement, the Investment Agreement and the Registration Rights Agreement has been or will be duly and validly authorized by the Company and is, and with respect to this Agreement, the Investment Agreement and the Registration Rights Agreement will each be, a valid and binding agreement of the Company, enforceable in accordance with its respective terms, except to the extent that (a) the enforceability hereof or thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws from time to time in effect and affecting the rights of creditors generally, (b) the enforceability hereof or thereof is subject to general principles of equity or (c) the indemnification provisions hereof or thereof may be held to be in violation of public policy. The Securities to be issued pursuant to the transactions contemplated by this Agreement and the Investment Agreement have been duly authorized and, when issued and paid for in accordance with (x) this Agreement, the Investment Agreement and the certificates/instruments representing such Securities, (y) will be valid and binding obligations of the Company, enforceable in accordance with their respective terms, except to the extent that (1) the enforceability thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws from time to time in effect and affecting the rights of creditors generally, and (2) the enforceability thereof is subject to general principles of equity. All corporate action required to be taken for the authorization, issuance and sale of the Securities has been duly and validly taken by the Company. (ii) The Company has a duly authorized, issued and outstanding capitalization as set forth herein and in the Investment Agreement. The Company is not a party to or bound by any instrument, agreement or other arrangement providing for it to issue any capital stock, rights, warrants, options or other securities, except for this Agreement, the agreements described herein and as described in the Investment Agreement, dated the date hereof and the agreements described therein. All issued and outstanding securities of the Company, have been duly authorized and validly issued and are fully paid and non-assessable; the holders thereof have no rights of rescission or preemptive rights with respect thereto and are not subject to personal liability solely by reason of being security holders; and none of such securities were issued in violation of the preemptive rights of any holders of any security of the Company. As of the date hereof, the authorized capital stock of the Company consists of (i) 200,000,000 shares of Common Stock, .001 par value per share, of which as of the date hereof, 20,722,656 shares are issued and outstanding. (iii) The Common Stock to be issued in accordance with this Agreement and the Investment Agreement has been duly authorized and when issued and paid for in accordance with this Agreement, the Investment Agreement and the certificates/instruments representing such Common Stock, will be validly issued, fully-paid and non-assessable; the holders thereof will not be subject to personal liability solely by reason of being such holders; such Securities are not and will not be subject to the preemptive rights of any holder of any security of the Company. 4. REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE INVESTOR. A. The Investor makes to the Placement Agent all the representations and warranties it makes to the Company in the Investment Agreement and, in addition represents, warrants and covenants as follows: (i) The Investor has the necessary power to enter into this Agreement and to consummate the transactions contemplated hereby. (ii) The execution and delivery by the Investor of this Agreement and the consummation of the transactions contemplated herein will not result in any violation of, or be in conflict with, or constitute a default under, any agreement or instrument to which the Investor is a party or by which the Investor or its properties are bound, or any judgment, decree, order or, to the Investor's knowledge, any statute, rule or regulation applicable to the Investor. This Agreement when executed and delivered by the Investor, will constitute the legal, valid and binding obligations of the Investor, enforceable in accordance with their respective terms, except to the extent that (a) the enforceability hereof or thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws from time to time in effect and affecting the rights of creditors generally, (b) the enforceability hereof or thereof is subject to general principles of equity, or (c) the indemnification provisions hereof or thereof may be held to be in violation of public policy. (iii) the Investor is not, and will not be, as a result of the transactions contemplated by the Offering Materials a "dealer" within the meaning of the Securities Exchange Act of 1934 and applicable federal and state securities laws and regulations. The Investor covenants that in this respect it is and will remain in compliance with the requirements of applicable "no action" rulings of the U.S. Securities Exchange Commission. (iv) The Investor will promptly forward copies of any and all due diligence questionnaires compiled by the Investor to the Placement Agent. 5. CERTAIN COVENANTS AND AGREEMENTS OF THE COMPANY. The Company covenants and agrees at its expense and without any expense to the Placement Agent as follows: A. To advise the Placement Agent of any material adverse change in the Company's financial condition, prospects or business or of any development materially affecting the Company or rendering untrue or misleading any material statement in the Offering Materials occurring at any time as soon as the Company is either informed or becomes aware thereof. B. To use its commercially reasonable efforts to cause the Common Stock issuable in connection with the Equity Line of Credit to be qualified or registered for sale on terms consistent with those stated in the Registration Rights Agreement and under the securities laws of such jurisdictions as the Placement Agent and the Investor shall reasonably request. Qualification, registration and exemption charges and fees shall be at the sole cost and expense of the Company. C. Upon written request, to provide and continue to provide the Placement Agent and the Investor copies of all quarterly financial statements and audited annual financial statements prepared by or on behalf of the Company, other reports prepared by or on behalf of the Company for public disclosure and all documents delivered to the Company's stockholders. D. To deliver, during the registration period of the Investment Agreement, to the Placement Agent upon the Placement Agent's request, (i) within forty five (45) days, a statement of its income for each such quarterly period, and its balance sheet and a statement of changes in stockholders' equity as of the end of such quarterly period, all in reasonable detail, certified by its principal financial or accounting officer; (ii) within ninety (90) days after the close of each fiscal year, its balance sheet as of the close of such fiscal year, together with a statement of income, a statement of changes in stockholders' equity and a statement of cash flow for such fiscal year, such balance sheet, statement of income, statement of changes in stockholders' equity and statement of cash flow to be in reasonable detail and accompanied by a copy of the certificate or report thereon of independent auditors if audited financial statements are prepared; and (iii) a copy of all documents, reports and information furnished to its stockholders at the time that such documents, reports and information are furnished to its stockholders. (iv) a copy of all documents, reports and information furnished to the Investor at the time that such documents, reports and information are furnished to the Investor. E. To comply with the terms of the Offering Materials. F. To ensure that any transactions between or among the Company, or any of its officers, directors and affiliates be on terms and conditions that are no less favorable to the Company, than the terms and conditions that would be available in an "arm's length" transaction with an independent third party. 6. INDEMNIFICATION. A. The Company hereby agrees that it will indemnify and hold the Placement Agent and each officer, director, shareholder, employee or representative of the Placement Agent and each person controlling, controlled by or under common control with the Placement Agent within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act or the SEC's Rules and Regulations promulgated there under (the "Rules and Regulations"), harmless from and against any and all loss, claim, damage, liability, cost or expense whatsoever (including, but not limited to, any and all reasonable legal fees and other expenses and disbursements incurred in connection with investigating, preparing to defend or defending any action, suit or proceeding, including any inquiry or investigation, commenced or threatened, or any claim whatsoever or in appearing or preparing for appearance as a witness in any action, suit or proceeding, including any inquiry, investigation or pretrial proceeding such as a deposition) to which the Placement Agent or such indemnified person of the Placement Agent may become subject under the 1933 Act, the 1934 Act, the Rules and Regulations, or any other federal or state law or regulation, common law or otherwise, arising out of or based upon (i) any untrue statement or alleged untrue statement of a material fact contained in (a) Section 4 of this Agreement, (b) the Offering Materials (except those written statements relating to the Placement Agent given by an indemnified person for inclusion therein), (c) any application or other document or written communication executed by the Company or based upon written information furnished by the Company filed in any jurisdiction in order to qualify the Common Stock under the securities laws thereof, or any state securities commission or agency; (ii) the omission or alleged omission from documents described in clauses (a), (b) or (c) above of a material fact required to be stated therein or necessary to make the statements therein not misleading; or (iii) the breach of any representation, warranty, covenant or agreement made by the Company in this Agreement. The Company further agrees that upon demand by an indemnified person, at any time or from time to time, it will promptly reimburse such indemnified person for any loss, claim, damage, liability, cost or expense actually and reasonably paid by the indemnified person as to which the Company has indemnified such person pursuant hereto. Notwithstanding the foregoing provisions of this Paragraph 6(A), any such payment or reimbursement by the Company of fees, expenses or disbursements incurred by an indemnified person in any proceeding in which a final judgment by a court of competent jurisdiction (after all appeals or the expiration of time to appeal) is entered against the Placement Agent or such indemnified person based upon specific finding of fact as to the Placement Agent or such indemnified person's gross negligence or willful misfeasance will be promptly repaid to the Company. B. The Placement Agent hereby agrees that it will indemnify and hold the Company and each officer, director, shareholder, employee or representative of the Company, and each person controlling, controlled by or under common control with the Company within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act or the Rules and Regulations, harmless from and against any and all loss, claim, damage, liability, cost or expense whatsoever (including, but not limited to, any and all reasonable legal fees and other expenses and disbursements incurred in connection with investigating, preparing to defend or defending any action, suit or proceeding, including any inquiry or investigation, commenced or threatened, or any claim whatsoever or in appearing or preparing for appearance as a witness in any action, suit or proceeding, including any inquiry, investigation or pretrial proceeding such as a deposition) to which the Company or such indemnified person of the Company may become subject under the 1933 Act, the 1934 Act, the Rules and Regulations, or any other federal or state law or regulation, common law or otherwise, arising out of or based upon (i) the conduct of the Placement Agent or its officers, employees or representatives in willful violation of any of such laws and regulations while acting as Placement Agent for the Offering or (ii) the material breach of any representation, warranty, covenant or agreement made by the Placement Agent in this Agreement (iii) any false or misleading information provided to the Company by one of the Placement Agent's indemnified persons. C. The Investor hereby agrees that it will indemnify and hold the Placement Agent and each officer, director, shareholder, employee or representative of the Placement Agent, and each person controlling, controlled by or under common control with the Placement Agent within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act or the Rules and Regulations, harmless from and against any and all loss, claim, damage, liability, cost or expense whatsoever (including, but not limited to, any and all reasonable legal fees and other expenses and disbursements incurred in connection with investigating, preparing to defend or defending any action, suit or proceeding, including any inquiry or investigation, commenced or threatened, or any claim whatsoever or in appearing or preparing for appearance as a witness in any action, suit or proceeding, including any inquiry, investigation or pretrial proceeding such as a deposition) to which the Placement Agent or such indemnified person of the Placement Agent may become subject under the 1933 Act, the 1934 Act, the Rules and Regulations, or any other federal or state law or regulation, common law or otherwise, arising out of or based upon (i) the conduct of the Investor or its officers, employees or representatives in its acting as the Investor for the Offering or (ii) the material breach of any representation, warranty, covenant or agreement made by the Investor in the Offering Materials (iii) any false or misleading information provided to the Placement Agent by the Investor or one of the Investor's indemnified persons. D. The Placement Agent hereby agrees that it will indemnify and hold the Investor and each officer, director, shareholder, employee or representative of the Investor, and each person controlling, controlled by or under common control with the Investor within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act or the Rules and Regulations, harmless from and against any and all loss, claim, damage, liability, cost or expense whatsoever (including, but not limited to, any and all reasonable legal fees and other expenses and disbursements incurred in connection with investigating, preparing to defend or defending any action, suit or proceeding, including any inquiry or investigation, commenced or threatened, or any claim whatsoever or in appearing or preparing for appearance as a witness in any action, suit or proceeding, including any inquiry, investigation or pretrial proceeding such as a deposition) to which the Investor or such indemnified person of the Investor may become subject under the 1933 Act, the 1934 Act, the Rules and Regulations, or any other federal or state law or regulation, common law or otherwise, arising out of or based upon (i) the conduct of the Placement Agent or its officers, employees or representatives in willful violation of any of such laws and regulations while acting as the Placement Agent for the Offering or (ii) the material breach of any representation, warranty, covenant or agreement made by the Placement Agent in this Agreement (iii) any false or misleading information provided to the Investor by one of the Placement Agent's indemnified persons. E. Promptly after receipt by an indemnified party of notice of commencement of any action covered by Section 6(A), (B), (C) or (D), the party to be indemnified shall, within five (5) business days, notify the indemnifying party of the commencement thereof; the omission by one (1) indemnified party to so notify the indemnifying party shall not relieve the indemnifying party of its obligation to indemnify any other indemnified party that has given such notice and shall not relieve the indemnifying party of any liability outside of this indemnification if not materially prejudiced thereby. In the event that any action is brought against the indemnified party, the indemnifying party will be entitled to participate therein and, to the extent it may desire, to assume and control the defense thereof with counsel chosen by it which is reasonably acceptable to the indemnified party. After notice from the indemnifying party to such indemnified party of its election to so assume the defense thereof, the indemnifying party will not be liable to such indemnified party under such Section 6(A), (B), (C), or (D) for any legal or other expenses subsequently incurred by such indemnified party in connection with the defense thereof, but the indemnified party may, at its own expense, participate in such defense by counsel chosen by it, without, however, impairing the indemnifying party's control of the defense. Subject to the proviso of this sentence and notwithstanding any other statement to the contrary contained herein, the indemnified party or parties shall have the right to choose its or their own counsel and control the defense of any action, all at the expense of the indemnifying party if, (i) the employment of such counsel shall have been authorized in writing by the indemnifying party in connection with the defense of such action at the expense of the indemnifying party, or (ii) the indemnifying party shall not have employed counsel reasonably satisfactory to such indemnified party to have charge of the defense of such action within a reasonable time after notice of commencement of the action, or (iii) such indemnified party or parties shall have reasonably concluded that there may be defenses available to it or them which are different from or additional to those available to one or all of the indemnifying parties (in which case the indemnifying parties shall not have the right to direct the defense of such action on behalf of the indemnified party or parties), in any of which events such fees and expenses of one additional counsel shall be borne by the indemnifying party; provided, however, that the indemnifying party shall not, in connection with any one action or separate but substantially similar or related actions in the same jurisdiction arising out of the same general allegations or circumstance, be liable for the reasonable fees and expenses of more than one separate firm of attorneys at any time for all such indemnified parties. No settlement of any action or proceeding against an indemnified party shall be made without the consent of the indemnifying party. F. In order to provide for just and equitable contribution in circumstances in which the indemnification provided for in Section 6 is due in accordance with its terms but is for any reason held by a court to be unavailable on grounds of policy or otherwise, the Company and the Placement Agent and the Investor shall contribute to the aggregate losses, claims, damages and liabilities (including legal or other expenses reasonably incurred in connection with the investigation or defense of same) which the other may incur in such proportion so that the Company, the Placement Agent and the Investor shall be responsible for such percent of the aggregate of such losses, claims, damages and liabilities as shall equal the percentage of the gross proceeds paid to each of them.; provided, however, that no person guilty of fraudulent misrepresentation within the meaning of Section 11(f) of the 1933 Act shall be entitled to contribution from any person who was not guilty of such fraudulent misrepresentation. For purposes of this Section 6(F), any person controlling, controlled by or under common control with the Placement Agent, or any partner, director, officer, employee, representative or any agent of any thereof, shall have the same rights to contribution as the Placement Agent and each person controlling, controlled by or under common control with the Company within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act and each officer of the Company and each director of the Company shall have the same rights to contribution as the Company and each person controlling, controlled by or under common control with the Investor within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act and each member of the general partner of the Investor shall have the same rights to contribution as the Company. Any party entitled to contribution will, promptly after receipt of notice of commencement of any action, suit or proceeding against such party in respect of which a claim for contribution may be made against the other party under this Section 6(F), notify such party from whom contribution may be sought, but the omission to so notify such party shall not relieve the party from whom contribution may be sought from any obligation they may have hereunder or otherwise if the party from whom contribution may be sought is not materially prejudiced thereby. The indemnity and contribution agreements contained in this Section 6 shall remain operative and in full force and effect regardless of any investigation made by or on behalf of any indemnified person or any termination of this Agreement. 7. FEES. The Company hereby agrees to pay the Placement Agent 1% for the gross proceeds from each Put with a maximum of ten thousand dollars ($10,000) upon the execution of this Agreement. 8. PAYMENT OF EXPENSES. The Company hereby agrees to bear all of the expenses in connection with the Offering, including, but not limited to the following: filing fees, printing and duplicating costs, advertisements, postage and mailing expenses with respect to the transmission of Offering Materials, registrar and transfer agent fees, and expenses, fees of the Company's counsel and accountants, issue and transfer taxes, which expenses, if any, will not exceed One Hundred and No/100 Dollars ($100.00) in aggregate. The Company agrees to bear all the reasonable expenses of the Placement Agent in performing its services under this Agreement including but not limited to the fees and expenses of counsel, which expenses, if any, will not exceed One Hundred and No/100 Dollars ($100.00) in aggregate. 9. CONDITIONS OF CLOSING. The Closing shall be held at the offices of the Investor or its counsel. The obligations of the Placement Agent hereunder shall be subject to the continuing accuracy of the representations and warranties of the Company herein as of the date hereof and as of the Date of Closing (the "Closing Date") with respect to the Company as if it had been made on and as of such Closing Date; the accuracy on and as of the Closing Date of the statements of the officers of the Company made pursuant to the provisions hereof; and the performance by the Company on and as of the Closing Date of its covenants and obligations hereunder and to the following further conditions: A. Upon the effectiveness of a registration statement in accordance with the Investment Agreement, the Placement Agent shall receive the opinions of Counsel to the Company and of the Investor, dated as of the date thereof, which opinion shall be in form and substance reasonably satisfactory to the Investor, the Company, their counsel and the Placement Agent. B. At or prior to the Closing, the Placement Agent shall have been furnished such documents, certificates and opinions as it may reasonably require for the purpose of enabling them to review or pass upon the matters referred to in this Agreement and the Offering Materials, or in order to evidence the accuracy, completeness or satisfaction of any of the representations, warranties or conditions herein contained. C. At and prior to the Closing, and except as otherwise disclosed in that certain Investment Agreement by and between the Company and Dutchess Private Equities Fund, L.P., (i) there shall have been no material adverse change nor development involving a prospective change in the condition or prospects or the business activities, financial or otherwise, of the Company from the latest dates as of which such condition is set forth in the Offering Materials; (ii) there shall have been no transaction, not in the ordinary course of business except the transactions pursuant to the Investment Agreement entered into by the Company which has not been disclosed in the Offering Materials or to the Placement Agent in writing; (iii) except as set forth in the Offering Materials, the Company shall not be in default under any provision of any instrument relating to any outstanding indebtedness for which a waiver or extension has not been otherwise received; (iv) except as set forth in the Offering Materials, the Company shall not have issued any securities (other than those to be issued as provided in the Offering Materials) or declared or paid any dividend or made any distribution of its capital stock of any class and there shall not have been any change in the indebtedness (long or short term) or liabilities or obligations of the Company (contingent or otherwise) and trade payable debt; (v) no material amount of the assets of the Company shall have been pledged or mortgaged, except as indicated in the Offering Materials; and (v) no action, suit or proceeding, at law or in equity, against the Company or affecting any of its properties or businesses shall be pending or threatened before or by any court or federal or state commission, board or other administrative agency, domestic or foreign, wherein an unfavorable decision, ruling or finding could materially adversely affect the businesses, prospects or financial condition or income of the Company, except as set forth in the Offering Materials. D. At Closing, the Placement Agent shall receive a certificate of the Company signed by an executive officer and chief financial officer, dated as of the applicable Closing, to the effect that the conditions set forth in subparagraph (C) above have been satisfied and that, as of the applicable closing, the representations and warranties of the Company set forth herein are true and correct. 10. TERMINATION. This Agreement shall be co-terminus with, and terminate upon the same terms and conditions as those set forth in, the Investment Agreement. The rights of the Investor and the obligations of the Company under the Registration Rights Agreement, and the rights of the Placement Agent and the obligations of the Company shall survive the termination of this Agreement unabridged for a period of twenty-four (24) months after the Closing Date. 11. MISCELLANEOUS. A. This Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original, but all which shall be deemed to be one and the same instrument. B. Any notice required or permitted to be given hereunder shall be given in writing and shall be deemed effective when deposited in the United States mail, postage prepaid, or when received if personally delivered or faxed (upon confirmation of receipt received by the sending party), addressed as follows: If to Placement Agent, to: Charleston Capital Corporation Attention: Ara Proudian, President 216 East 45th Street, Suite 903 New York, NY 10017 (212) 244-1555 (212) 244-6955, fax If to the Company, to: PAYMENT DATA SYSTEMS INC 12500 San Pedro Suite 120 San Antonio TX 78216 (210)249-4100 (210)249-4130 fax If to the Investor: Dutchess Private Equities fund, LP 312 Stuart St. Boston, MA 02116 Tel: (617) 960-3582 Fax: (617) 960-3772 or to such other address of which written notice is given to the others. C. This Agreement shall be governed by and construed in all respects under the laws of the State of Delaware, without reference to its conflict of laws rules or principles. Any suit, action, proceeding or litigation arising out of or relating to this Agreement shall be brought and prosecuted in such federal or state court or courts located within the Commonwealth of Massachusetts as provided by law. The parties hereby irrevocably and unconditionally consent to the jurisdiction of each such court or courts located within the Commonwealth of Massachusetts and to service of process by registered or certified mail, return receipt requested, or by any other manner provided by applicable law, and hereby irrevocably and unconditionally waive any right to claim that any suit, action, proceeding or litigation so commenced has been commenced in an inconvenient forum. D. This Agreement and the other agreements referenced herein contain the entire understanding between the parties hereto and may not be modified or amended except by a writing duly signed by the party against whom enforcement of the modification or amendment is sought. E. If any provision of this Agreement shall be held to be invalid or unenforceable, such invalidity or unenforceability shall not affect any other provision of this Agreement. [REMAINDER OF PAGE INTENTIONALLY LEFT BLANK] IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first written above. COMPANY: By: /s/ Michael Long Name: Michael Long Title: CEO PLACEMENT AGENT: By: /s/ Ara Proudian Name: Ara Proudian Title: President INVESTOR: DUTCHESS PRIVATE EQUITIES FUND, L.P. BY ITS GENERAL PARTNER DUTCHESS CAPITAL MANAGEMENT, LLC /s/ Douglas Leighton By:__________________________________ Name: Douglas H. Leighton Title: A Managing Member EX-23.1 5 doc5.txt EXHIBIT 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the inclusion in this Registration Statement on Form SB-2 and in the Prospectus constituting part of this Registration Statement of our report dated March 2, 2004, except for Note 15, to which the date is March 15, 2004, on the financial statements of Payment Data Systems, Inc. included in the Prospectus. Akin, Doherty, Klein & Feuge, P.C. San Antonio, Texas June 16, 2004 EX-23.2 6 doc6.txt EXHIBIT 23.2 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the use of our report dated April 1, 2003, in the Registration Statement (Form SB-2) and related Prospectus of Payment Data Systems, Inc. for the registration of 40,000,000 shares of its common stock. Ernst & Young LLP San Antonio, Texas June 16, 2004 -----END PRIVACY-ENHANCED MESSAGE-----