UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
OR
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE EXCHANGE ACT
For the transition period from ____ to ____
Commission file number 000-30152
Payment Data Systems, Inc.
(Exact name of small business issuer as specified in its charter)
Nevada 98-0190072
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
12500 San Pedro, Suite 120
San Antonio, TX 78216
(Address of principal executive offices)
(210) 249-4100
(Issuer's telephone number)
Check whether the issuer (1) filed all reports required to be filed by section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirement for the past 90 days. Yes X No ___
--
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes ___ No X
--- --
As of November 8, 2005, 32,644,561 shares of the issuer's common stock, $0.001
par value, were outstanding.
Transitional Small Business Disclosure Format (Check one): Yes ___ No X
1
PAYMENT DATA SYSTEMS, INC.
INDEX
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets as of September 30, 2005
and December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . 3
Consolidated Statements of Operations for the three and nine months
ended September 30, 2005 and 2004 . . . . . . . . . . . . . . . . . 4
Consolidated Statements of Cash Flows for the nine months
ended September 30, 2005 and 2004 . . . . . . . . . . . . . . . . . 5
Notes to Consolidated Financial Statements. . . . . . . . . . . . . 6
Item 2 Management's Discussion and Analysis or Plan of Operation . . . . . 11
Item 3 Controls and Procedures
PART II - OTHER INFORMATION
Item 1 Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . 18
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds . . . . 19
Item 3 Defaults Upon Senior Securities . . . . . . . . . . . . . . . . . . 20
Item 4 Submission of Matters to a Vote of Security Holders . . . . . . . . 20
Item 5 Other Information
Item 6 Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . . . . . 20
2
PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
September 30, 2005 December 31, 2004
-------------------- -------------------
(Unaudited)
Assets:
Current assets:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 254,190 $ 153,966
Accounts receivable, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,994 57,788
Prepaid expenses and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,152 47,833
-------------------- -------------------
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459,336 259,587
Property and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . 173,143 132,064
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,868 23,589
-------------------- -------------------
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 654,347 $ 415,240
==================== ===================
Liabilities and stockholders' equity (deficit):
Current liabilities:
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 558,565 $ 482,788
Accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,331 392,515
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527,664 264,165
-------------------- -------------------
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,486,560 1,139,468
Stockholders' equity (deficit):
Common stock, $0.001 par value, 200,000,000 shares authorized;
32,313,667 and 23,569,180 issued and outstanding . . . . . . . . . . . . . . . . . 32,313 23,569
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,418,674 47,417,898
Deferred compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (492,828) -
Accumulated deficit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (49,790,372) (48,165,695)
-------------------- -------------------
Total stockholders' equity (deficit) . . . . . . . . . . . . . . . . . . . . . . . (832,213) (724,228)
-------------------- -------------------
Total liabilities and stockholders' equity (deficit) . . . . . . . . . . . . . . . $ 654,347 $ 415,240
==================== ===================
See notes to interim consolidated financial statements.
3
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- --------------------------------
2005 2004 2005 2004
---------------- -------------- ---------------- --------------
Revenues. . . . . . . . . . . . . . . . . . . . $ 318,206 $ 69,201 $ 876,094 $ 188,600
Operating expenses:
Cost of services. . . . . . . . . . . . . . . 275,242 61,974 771,082 191,333
Selling, general and administrative . . . . . 429,469 353,352 1,290,458 986,055
Depreciation and amortization . . . . . . . . 24,583 20,988 62,694 74,023
---------------- -------------- ---------------- --------------
Total operating expenses. . . . . . . . . . . 729,294 436,314 2,124,234 1,251,411
---------------- -------------- ---------------- --------------
Operating loss. . . . . . . . . . . . . . . . (411,088) (367,113) (1,248,140) (1,062,811)
Other income (expense), net:
Interest income . . . . . . . . . . . . . . . 441 57 707 700
Interest expense. . . . . . . . . . . . . . . (59,897) (9,261) (125,734) (9,261)
Other income (expense). . . . . . . . . . . . (201,622) (12,750) (251,510) (21,360)
---------------- -------------- ---------------- --------------
Total other income (expense), net . . . . . . (261,078) (21,954) (376,537) (29,921)
---------------- -------------- ---------------- --------------
Loss from operations before income taxes. . . (672,166) (389,067) (1,624,677) (1,092,732)
Income taxes. . . . . . . . . . . . . . . . . - - - -
---------------- -------------- ---------------- --------------
Net loss. . . . . . . . . . . . . . . . . . . $ (672,166) $ (389,067) $ (1,624,677) $ (1,092,732)
================ ============== ================ ==============
Basic and diluted net loss per common share:. $ (0.02) $ (0.02) $ (0.06) $ (0.05)
Weighted average common shares
outstanding. . . . . . . . . . . . . . . . . 31,264,161 21,695,525 28,120,758 21,459,825
See notes to interim consolidated financial statements.
4
PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended September 30,
----------------------------------
2005 2004
---------------- ----------------
Operating activities:
Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,624,677) $ (1,092,732)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . 62,694 74,023
Non-cash issuance of common stock. . . . . . . . . . . . . . . . . . . . . 426,547 120,910
Non-cash issuance of common stock warrants . . . . . . . . . . . . . . . . 151,309 29,675
Deferred compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . 98,562 -
Amortization of debt discount. . . . . . . . . . . . . . . . . . . . . . . 95,374 6,000
Changes in current assets and current liabilities:
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . (21,206) 951
Prepaid expenses and other . . . . . . . . . . . . . . . . . . . . . . . . 93,506 43,176
Accounts payable and accrued expenses. . . . . . . . . . . . . . . . . . . 89,437 200,444
---------------- ----------------
Net cash used in operating activities . . . . . . . . . . . . . . . . . . . (628,454) (617,553)
Investing activities:
Purchases of property and equipment . . . . . . . . . . . . . . . . . . . . (93,773) (4,598)
Long-term deposits, net . . . . . . . . . . . . . . . . . . . . . . . . . . 6,896 6,693
---------------- ----------------
Net cash provided by (used in) investing activities . . . . . . . . . . . . (86,877) 2,095
Financing activities:
Proceeds from notes payable . . . . . . . . . . . . . . . . . . . . . . . . 600,000 260,000
Principal payments for notes payable. . . . . . . . . . . . . . . . . . . . (431,875) (10,571)
Financing costs, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . (20,000) -
Issuance of common stock, net of issuance costs . . . . . . . . . . . . . . 667,430 32,787
---------------- ----------------
Net cash provided by financing activities . . . . . . . . . . . . . . . . . 815,555 282,216
---------------- ----------------
Change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . 100,224 (333,242)
Cash and cash equivalents, beginning of period. . . . . . . . . . . . . . . 153,966 528,119
---------------- ----------------
Cash and cash equivalents, end of period. . . . . . . . . . . . . . . . . . $ 254,190 $ 194,877
================ ================
See notes to interim consolidated financial statements.
5
PAYMENT DATA SYSTEMS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note 1. Basis of Presentation
Payment Data Systems, Inc. and subsidiaries (the "Company"), has incurred
substantial losses since inception, which has led to a significant decrease in
its cash position and a deficit in working capital. The Company 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 is likely contingent on the
Company receiving additional funds in the form of equity or debt financing. The
Company is currently aggressively pursuing strategic alternatives (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 covenants which could restrict operations or finances.
There can be no assurance that financing will be available in amounts or on
terms acceptable to the Company, if at all. If the Company cannot raise funds on
acceptable terms, or achieve positive cash flow, it may not be able to continue
to exist, conduct operations, grow market share, take advantage of future
opportunities or respond to competitive pressures or unanticipated requirements,
any of which would negatively impact its business, operating results and
financial condition. The accompanying unaudited consolidated financial
statements of the Company do not include any adjustments to reflect the possible
future effects on the recoverability and classification of assets or the amounts
and classification of liabilities that may result from the outcome of this
uncertainty.
The accompanying unaudited consolidated financial statements of the Company have
been prepared without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles have been condensed or omitted pursuant
to such rules and regulations. In the opinion of management, the accompanying
consolidated financial statements reflect all adjustments of a normal recurring
nature considered necessary to present fairly the Company's financial position,
results of operations and cash flows for such periods. The accompanying interim
consolidated financial statements should be read in conjunction with the
consolidated financial statements and the notes thereto included in the
Company's Annual Report on Form 10-KSB for the year ended December 31, 2004.
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.
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.
6
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- --------------------------------
2005 2004 2005 2004
---------------- -------------- ---------------- --------------
Net loss, as reported $ (672,166) $ (389,067) $ (1,624,677) $ (1,092,732)
Less: Total stock-based employee
compensation expense determined
under fair value based method for
all awards, net of related tax effects (275) (3,198) (1,865) (138,708)
---------------- -------------- ---------------- --------------
Pro forma net loss $ (672,441) $ (392,265) $ (1,626,542) $ (1,231,440)
================ ============== ================ ==============
Net loss per common share
- basic and diluted, as reported $ (0.02) $ (0.02) $ (0.06) $ (0.05)
Net loss per common share
- basic and diluted, pro forma $ (0.02) $ (0.02) $ (0.06) $ (0.06)
Note 3. Related Party Transactions
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 are no longer
employees of the Company. The margin loans were obtained in March 1999 from
institutional lenders and were secured by shares of the Company's common stock
owned by these officers. The pledged funds were held in the Company's name in
accounts with the lenders that held the margin loans of the officers. The
Company's purpose in collateralizing the margin loans was to prevent the sale of
its common stock owned by these officers while it was pursuing efforts to raise
additional capital through private equity placements. The sale of that common
stock could have hindered the Company's ability to raise capital in such a
manner and compromised its continuing efforts to secure additional financing.
The highest total amount of funds pledged for the margin loans guaranteed by the
Company was approximately $2.0 million. 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 September 30, 2005. The Company may institute litigation or
arbitration in collection of the outstanding repayment obligations of Mr. Long,
Mr. Hoch, Mr. Millard, and Mr. Jones, which currently total $1,278,138.
Presently, the Company has refrained from initiating action to recover these
funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may have offsetting
claims that total $1,445,500 collectively by virtue of the change of control
clause in their respective employment agreements based on our preliminary
analysis. The Company understands that these individuals may assert such claims
based on the Company's sale of substantially all of its assets to Harbor
Payments, Inc. on July 25, 2003. While Mr. Long and Mr. Hoch agreed, in
connection with such sale, to forego any affirmative recovery of their
compensation by virtue of a change of control, they have maintained the right to
claim an offset of that amount in the event the Company seeks recovery of the
loan balances. The Company has not initiated any formal settlement negotiations
with these individuals because they have been under an extended employment
contract with us or have not been amenable to such an action. On July 25, 2004,
the Company's employment agreements with Michael Long, Chief Executive Officer
and Chief Financial Officer, and Louis Hoch, President and Chief Operating
Officer, expired. The Company intends to enter into new employment agreements
with both of these individuals and is currently negotiating the terms of such
agreements. The Company has not pursued the outstanding repayment obligation of
Mr. Jones because the Company does not consider a recovery attempt to be cost
beneficial. In order to attempt a recovery from Mr. Jones, the Company estimates
that it would incur a minimum of $20,000 in estimated legal costs with no
reasonable assurance of success in recovering his outstanding obligation of
approximately $38,000. Because of the limited amount of the obligation, the
Company also anticipates difficulty in retaining counsel on a contingency basis
to pursue collection of this obligation. The ultimate outcome of this matter
cannot presently be determined.
7
Note 4. Note Payable
On December 10, 2004, the Company entered into a zero-discount promissory note
with Dutchess Private Equities Fund, II, LP ("Dutchess"). Pursuant to terms of
the promissory note, the Company received $260,000 and promised to pay Dutchess
$284,000 with a maturity date of April 10, 2005, which represents an effective
annual interest rate of 28%. The Company also issued 75,000 shares of restricted
common stock to Dutchess as an incentive for the investment and agreed to
register the common stock issued pursuant to the promissory note on the next
registration statement filed by the Company. The Company defaulted on final
payment of this promissory note to Dutchess on its maturity date.
On May 12, 2005, the Company entered into a zero-discount promissory note with
Dutchess. Pursuant to terms of the promissory note, the Company received
$600,000 and promised to pay Dutchess $720,000 with a maturity date of December
22, 2005, which represents an effective annual interest rate of 33%. The Company
also issued 500,000 shares of restricted common stock to Dutchess as an
incentive for the investment and agreed to register the common stock issued
pursuant to the promissory note on the next registration statement filed by the
Company. The Company used a portion of the proceeds from this note to repay the
balance of the note due April 10, 2005 to Dutchess in full, including a penalty
of $5,116 for late payment.
Payments on the promissory note are to be made from the equity line of credit
that the Company previously entered into with Dutchess (see Note 5). The Company
will make payments to Dutchess in the amount of 50% of each put, until the face
amount of the promissory note is paid in full. The payments are due at the
closing of every put to Dutchess and the payment amount as a percentage of a put
escalates to 75% after the cumulative amount of financing we receive from any
source during the term of the note exceeds $250,000. The payment amount as a
percentage of a put increases to 80% after the cumulative amount of financing
exceeds $600,000 and reaches a maximum of 100% once the Company has raised over
$700,000 in financing. The Company issued as collateral twenty-five put notices
to Dutchess for the full amount applicable under the terms of the equity line of
credit and agreed to do so at the maximum frequency allowed under the equity
line agreement, until such time as the note is paid in full.
In the event that on the maturity date, there are any remaining amounts unpaid
on this note, Dutchess can exercise its right to increase the residual amount by
10% as an initial penalty and 2.5% per month paid as liquated damages. In the
event that the Company defaults, Dutchess has the right, but not the obligation,
to switch the residual amount to a five-year, 10% interest bearing convertible
debenture at a conversion rate at the lesser of (i) 75% of the average of the
lowest closing bid price during the fifteen trading immediately preceding the
convertible maturity date or (ii) 100% of the average of the lowest bid price
for the twenty trading days immediately preceding the convertible maturity date.
If Dutchess chooses to convert the residual amount to a convertible debenture,
the Company shall have twenty business days after notice of the same to file a
registration statement covering an amount of shares equal to 300% of the
residual amount. In the event the Company does not file such registration
statement within twenty business days of Dutchess' request, or such registration
statement is not declared by the Securities and Exchange Commission to be
effective within the time period described above, the residual amount shall
increase by $1,000 per day.
8
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. During the nine months ended September 30, 2005, the Company sold
3,019,884 shares of its common stock pursuant to the equity line of credit and
received total proceeds, net of issuance costs, of $575,795. Pursuant to the
terms of a promissory note with Dutchess Private Equities Fund, II, LP, the
Company is obligated to use a portion of the proceeds from the equity line to
pay back the promissory note (see Note 4).
Note 6. Issuance of Capital Stock
In January 2005, the Company's Chief Executive Officer and Chief Financial
Officer; President and Chief Operating Officer, and all other employees owed
unpaid wages elected to receive common stock from the Company in lieu of a total
of $179,000 in accumulated unpaid salary. The Company's Board of Directors
granted a total of 859,743 shares of common stock in exchange for the unpaid
salaries. All shares were issued under the terms of the Company's Employee
Comprehensive Stock Plan.
On March 28, 2005, the Company's Board of Directors granted a total of 2,956,950
shares of common stock to employees as a long-term incentive and recorded
$591,390 of deferred compensation. The common stock is restricted and vests
equally over three years on the anniversary date of the grant. The Company's
Board of Directors also granted a total of 50,000 shares of unrestricted common
stock under the terms of the Company's Employee Comprehensive Stock Plan to
certain employees and recorded $10,000 of compensation expense.
In April 2005, the Company issued 250,000 shares of common stock and received
cash proceeds of $60,000 related to the exercise of stock warrants granted under
the terms of a warrant agreement with Kubra Data Transfer, Ltd.
During the nine months ended September 30, 2005, the Company issued a total of
792,950 shares of common stock under the terms of its Comprehensive Employee
Stock Plan to independent contractors providing consulting services to the
Company and recorded $164,468 of related expense.
During the nine months ended September 30, 2005, the Company issued 15,000
shares of common stock and received cash proceeds of $1,275 related to the
exercise of stock options granted under the terms of its Comprehensive Employee
Stock Plan.
Note 7. Shareholder Rights Plan
On April 22, 2005, the Company's Board of Directors declared a dividend of one
right for each outstanding share of common stock. The rights were issued to
shareholders of record on April 29, 2005 and will expire on April 29, 2009.
Until the rights become exercisable, the rights will trade automatically with
the common stock and separate rights certificates will not be issued. The rights
will be exercisable only if a person or group acquires 15% or more of the
Company's common stock, whether through open market or private purchases or
consummation of a tender or exchange offer, or announces an offer the
consummation of which would result in such person or group owning 15% or more of
the Company's common stock. When the rights first become exercisable, each right
will entitle the holder to purchase one share of common stock for $0.23, subject
to adjustment. If the Company is involved in a merger or other business
combination after a person or group has acquired 15% or more of its common
stock, each right will entitle its holder to purchase, at the right's
then-current exercise price, a number of the acquiring company's shares having a
market value of twice the exercise price of each right. If a person or group
acquires 15% or more of the Company's common stock, each right will entitle its
holder to purchase a number of additional shares of common stock having a market
value of twice the exercise price of each right.
9
Note 8. Subsequent Events
Subsequent to September 30, 2005 and through the date of this report, the
Company sold 160,000 shares of its common stock pursuant to the equity line of
credit (see Note 5) and received total proceeds, net of issuance costs, of
$21,367.
Subsequent to September 30, 2005 and through the date of this report, the
Company issued a total of 170,894 shares of common stock under the terms of its
Comprehensive Employee Stock Plan to independent contractors providing
consulting services to the Company for which it recorded $24,480 of related
expense.
In October 2005, the Company signed a non-binding letter of intent to sell its
bills.com domain name and related trademark to Alivio Holdings, LLC and provide
related online payment processing services for total consideration of $964,500.
The Company plans to continue offering online payment processing services
directly to consumers under a new domain name, www.billx.com, as well as through
resellers, including Alivio. The Company's existing customer base currently
using bills.com for online payment services will be retained and transitioned to
the new billx.com domain name.
On November 9, 2005, the Company entered into a settlement agreement with all
the plaintiffs named in the stockholder suit filed on July 23, 2005. Under the
terms of the settlement, the plaintiffs will dismiss the pending litigation,
with prejudice, and release all claims against the Company, its current and
former officers and directors, and our former auditors, Ernst & Young, LLP.
Additionally, the Company will reset the exercise price of 1,912,400 warrants to
purchase our common stock held by the plaintiffs from $1.80 per share to a new
exercise price of $0.20 per share. The Company will also extend the expiration
date of the warrants from November 27, 2006 to November 27, 2007. The Company
recorded a non-cash expense of $151,309 in the quarter ended September 30, 2005
as a result of the modification of the warrant terms. The Company is not paying
any other economic consideration to fund this settlement.
10
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
FORWARD-LOOKING STATEMENTS DISCLAIMER
Except for the historical information contained herein, the matters discussed in
this Form 10-QSB include certain forward-looking statements that involve risks
and uncertainties, which are intended to be covered by safe harbors. Those
statements include, but are not limited to, all statements regarding our and
management's intent, belief and expectations, such as statements concerning our
future and our operating and growth strategy. 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 our ability to implement our business plan, our ability
to raise additional funds and manage our substantial debts, consumer acceptance
of our products, our ability to broaden our customer base, our ability to
maintain a satisfactory relationship with our suppliers and other risks
described in our reports filed with the Securities and Exchange Commission.
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. Investors are cautioned that all
forward-looking statements involve risks and uncertainties including, without
limitation, the factors set forth under the Risk Factors section of Item 6,
Management's Discussion and Analysis of Financial Condition and Results of
Operations, of the Annual Report on Form 10-KSB for the year ended December 31,
2004 and other factors detailed from time to time in our filings with the
Securities and Exchange Commission. In light of the significant uncertainties
inherent in the forward-looking statements included herein, the inclusion of
such information should not be regarded as a representation by us or any other
person that our objectives and plans will be achieved. All forward-looking
statements made in this Form 10-QSB are based on information presently available
to our management. 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.
This discussion and analysis should be read in conjunction with the unaudited
interim consolidated financial statements and the notes thereto included in this
report, and our Annual Report on Form 10-KSB for the year ended December 31,
2004.
Overview
We provide integrated electronic payment processing services to merchants and
businesses, including credit and debit card-based processing services and
transaction processing via the Automated Clearinghouse Network. We also operate
an online payment processing service for consumers under the domain name
www.bills.com through which consumers can pay anyone. Since inception, we have
incurred operating losses each quarter, and as of September 30, 2005, we have an
accumulated deficit of $49.8 million. Our prospects to continue as a going
concern must be considered in light of the risks, expenses and difficulties
frequently encountered by companies in their early stages of growth,
particularly companies in new and rapidly evolving markets such as electronic
commerce. Such risks include, but are not limited to, an evolving and
unpredictable business model and our ability to continue as a going concern. To
address these risks we must, among other things, grow and maintain our customer
base, implement a successful marketing strategy, continue to maintain and
upgrade our technology and transaction-processing systems, provide superior
customer service, respond to competitive developments, attract, retain and
motivate qualified personnel, and respond to unforeseen industry developments
and other factors. We cannot assure you that we will be successful in addressing
such risks, and the failure to do so could have a material adverse effect on our
business, prospects, financial condition and results of operations. We believe
that our success will depend in large part on our ability to (a) manage our
operating expenses, (b) add quality customers to our client base, (c) meet
evolving customer requirements and (d) adapt to technological changes in an
emerging market. Accordingly, we intend to focus on customer acquisition
activities and outsource some of our processing services to third parties to
allow us to maintain an efficient operating infrastructure and expand our
operations without significantly increasing our fixed operating expenses.
11
Critical Accounting Policies
General
Management's Discussion and Analysis or Plan of Operation 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 September 30, 2005, our card
merchant processing loss reserve was $22,091. 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.
Bad Debts
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 debts have been within our
expectations. We did not record any bad debt expense or bad debt write-offs in
2004. At September 30, 2005, the balance of the allowance for doubtful accounts
was $12,820. 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. No
impairment losses were recorded in 2004 or during the nine months ended
September 30, 2005.
12
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 September 30, 2005 will be realized in future periods.
Accordingly, a valuation allowance has been provided to reduce the net deferred
tax assets to $0. At December 31, 2004, we had available net operating loss
carryforwards of approximately $36.1 million, which expire beginning in the year
2020.
Results of Operations
Our revenues are principally derived from providing integrated electronic
payment services to merchants and businesses, including credit and debit
card-based processing services and transaction processing via the Automated
Clearinghouse Network. We also operate an online payment processing service for
consumers under the domain name www.bills.com. Revenues for the quarter ended
September 30, 2005 increased 360% to $318,206 from $69,201 for the quarter ended
September 30, 2004. Revenues for the nine months ended September 30, 2005
increased 365% to $876,094 from $188,600 for the nine months ended September 30,
2004. The increases from the prior year periods were primarily attributable to
the increase in revenues generated from card-based processing services due to
increased transaction volume.
The increase in revenue from the nine months ended September 30, 2004 was also
due to an increase in the average number of consumers subscribing to the
bills.com payment service. The monthly average number of consumers using our
online payment service increased to 2,598 in the first nine months of 2005 from
2,035 in the first nine months of 2004. 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.
Revenues generated by our bills.com payment service for the third quarter of
2005 decreased from the prior year quarter due to a decrease in the average
number of consumers subscribing to the bills.com payment service as we
transitioned to processing the online payments ourselves during the third
quarter of 2005. The monthly average number of consumers using our online
payment service decreased to 1,936 in the third quarter of 2005 from 2,026 in
the third quarter of 2004. We had previously been using a third party provider
to process the payments, but are now able to market the service as a
private-label application to prospective resellers.
In October 2005, we signed a non-binding letter of intent to sell our bills.com
domain name and trademark to Alivio Holdings, LLC and provide related online
payment processing services. We also anticipate signing additional agreements
with Alivio to provide merchant processing and other payment services. We expect
to continue offering online payment processing services directly to consumers
under a new domain name, www.billx.com, as well as through resellers, including
Alivio. We will retain our existing customer base currently using bills.com for
online payment services and expect to seamlessly transition this current
customer base to our new billx.com domain name.
We expect our total revenues to increase as we anticipate continued growth in
the volume of card transactions and additional merchant customers. Revenue
generated by our merchant customers represented approximately 89% of our total
revenues in the three months ended September 30, 2005, and we believe that this
percentage will increase as we anticipate adding new merchant customers and
experiencing growth in transaction volumes as a result. We believe that our
merchant business provides us with the best opportunity for revenue growth and
that revenues from card-based processing services will continue to grow in
future periods.
Cost of services includes the cost of personnel dedicated to the creation and
maintenance of connections to third party payment processors and fees paid to
such third party providers for electronic payment processing services. Through
our contractual relationships with our payment processors, we are able to
process Automated Clearinghouse and debit or credit card transactions on behalf
of our customers and their consumers. We pay volume-based fees for debit and
credit transactions initiated through these processors, and pay fees for other
transactions such as returns, notices of change to bank accounts and file
transmission. Cost of services was $275,242 and $61,974 for the quarters ended
September 30, 2005 and 2004, respectively, and $771,082 and $191,333 for the
nine months ended September 30, 2005 and 2004, respectively. The increases from
the prior year periods were due primarily to the increases in fees related to
processing the increased card-based transaction volume.
13
Selling, general and administrative expenses increased to $429,469 for the
quarter ended September 30, 2005, from $353,352 for the third quarter of 2004.
The increase from the prior year quarter was principally due to non-cash
amortization of deferred compensation of $46,731 related to employee incentive
stock grants and an increase in other personnel expenses and legal fees.
Selling, general and administrative expenses for the nine months ended September
30, 2005 increased to $1,290,458 from $986,055 for the nine months ended
September 30, 2004. The increase from the prior year period was primarily due to
non-cash deferred compensation expense of $93,462 recorded in the second and
third quarters of 2005 and an increase in consulting expenses related to debt
and equity financing efforts of approximately $69,000. In addition, higher sales
personnel costs and legal fees also contributed to the increase from the prior
year period.
Depreciation and amortization increased to $24,583 for the quarter ended
September 30, 2005, as compared to $20,988 for the third quarter of 2004. This
increase was due to depreciation related to certain asset additions that were
put into production during the third quarter of 2005. Depreciation and
amortization for the nine months ended September 30, 2005 decreased to $62,694
from $74,023 for the nine months ended September 30, 2004. This decrease was due
to lower depreciation related to certain assets that became fully depreciated
during 2004. We capitalized $93,773 of computer hardware and software purchased
during the nine months ended September 30, 2005 and anticipate making additional
capital expenditures of approximately $25,000 over the remaining three months of
2005.
Net other expense was $261,078 for the quarter ended September 30, 2005,
compared to $21,954 for the third quarter of 2004. Net other expense was
$376,537 for the nine months ended September 30, 2005, compared to $29,921 for
the nine months ended September 30, 2004. The increases from the prior year
periods were partially attributable to $110,210 and $225,935 of interest expense
and financing costs incurred in the quarter and nine months ended September 30,
2005, respectively, related to our notes payable to Dutchess. The increases were
also attributable to $151,309 of non-cash expense recorded during the third
quarter of 2005 related to the settlement of the shareholder suit. Under the
terms of the settlement, we modified the terms of the warrants held by the
plaintiffs and gave no other economic consideration.
Net loss increased to $672,166 for the quarter ended September 30, 2005 from
$389,067 for the prior year quarter and increased to $1,624,677 for the nine
months ended September 30, 2005 from $1,092,732 for the prior year comparable
period. Net loss increased from both the prior year quarter and period primarily
as a result of the increases in selling, general and administrative expenses and
net other expense as discussed.
Liquidity and Capital Resources
At September 30, 2005, we had $254,190 of cash and cash equivalents, compared to
$153,966 of cash and cash equivalents at December 31, 2004. We have incurred
substantial losses since inception, which has led to a significant decrease in
our cash position and a deficit in working capital. We believe that our current
available cash and cash equivalents along with anticipated revenues may be
insufficient to meet our anticipated cash needs for the foreseeable future.
Consequently, our ability to continue as a going concern may be contingent on us
receiving additional funds in the form of equity or debt financing. We are
currently aggressively pursuing strategic alternatives.
On May 12, 2005, we entered into a promissory note with Dutchess Private
Equities Fund, II, LP. Pursuant to terms of the promissory note, we received
$600,000 and promised to pay Dutchess $720,000 with a maturity date of December
22, 2005. We also issued 500,000 shares of restricted common stock to Dutchess
as an incentive for the investment and agreed to register the common stock
issued pursuant to the promissory note on the next registration statement that
we file. We used a portion of the proceeds from this note to repay the balance
of the note due April 10, 2005 to Dutchess in full, including a penalty of
$5,116 for late payment. We had previously defaulted on final payment of this
promissory note to Dutchess on its maturity date.
Payments on the promissory note are to be made from the equity line of credit
that we previously entered into with Dutchess. We will make payments to Dutchess
in the amount of 50% of each put, until the face amount of the promissory note
is paid in full. The payments are due at the closing of every put to Dutchess
and the payment amount as a percentage of a put escalates to 75% after the
cumulative amount of financing we receive from any source during the term of the
note exceeds $250,000. The payment amount as a percentage of a put increases to
80% after the cumulative amount of financing exceeds $600,000 and reaches a
maximum of 100% once we have raised over $700,000 in financing. We will issue as
collateral twenty-five put notices to Dutchess for the full amount applicable
under the terms of the equity line of credit and shall do so at the maximum
frequency allowed under the equity line agreement, until such time as the note
is paid in full. As of September 30, 2005, the balance of the note payable due
to Dutchess was $527,664.
14
In the event that on the maturity date, there are any remaining amounts unpaid
on this note, Dutchess can exercise its right to increase the residual amount by
10% as an initial penalty and 2.5% per month paid as liquated damages. In the
event that we default, Dutchess has the right, but not the obligation, to switch
the residual amount to a five-year, 10% interest bearing convertible debenture
at a conversion rate at the lesser of (i) 75% of the average of the lowest
closing bid price during the fifteen trading immediately preceding the
convertible maturity date or (ii) 100% of the average of the lowest bid price
for the twenty trading days immediately preceding the convertible maturity date.
If Dutchess chooses to convert the residual amount to a convertible debenture,
we shall have twenty business days after notice of the same to file a
registration statement covering an amount of shares equal to 300% of the
residual amount. In the event we do not file such registration statement within
twenty business days of Dutchess' request, or such registration statement is not
declared by the Securities and Exchange Commission to be effective within the
time period described above, the residual amount shall increase by $1,000 per
day.
In June 2004, we executed an agreement for an equity line of credit with
Dutchess Private Equities Fund, LP. Under the terms of the agreement, we may
elect to receive as much as $10 million from Dutchess in common stock purchases
over three years at our option. Through September 30, 2005, we have sold a total
of 4,479,279 shares of our common stock pursuant to the equity line of credit
and received total proceeds, net of issuance costs, of $897,281. Pursuant to the
terms of a promissory note with Dutchess, we are obligated to use a portion of
the proceeds from the equity line to pay back the promissory note.
In October 2005, we signed a non-binding letter of intent to sell our bills.com
domain name and related trademark to Alivio Holdings, LLC and provide related
services for total consideration of $964,500. We expect to use a portion of the
proceeds received from this sale to pay back the note payable to Dutchess by
December 22, 2005.
The satisfactory completion of an additional investment, adequate sales of stock
under our equity line of credit, or growth of cash flow from operations is
essential or we have no other alternative that will provide sufficient cash
flows to meet current operating requirements. The sale of additional equity or
convertible debt securities would result in additional dilution to our
stockholders, and debt financing, if available, may involve restrictive
covenants which could restrict operations or finances. There can be no assurance
that financing will be available in amounts or on terms acceptable to us, if at
all. If we cannot raise funds, on acceptable terms, or achieve positive cash
flow, we may not be able to continue to exist, conduct operations, grow market
share, take advantage of future opportunities or respond to competitive
pressures or unanticipated requirements, any of which would negatively impact
our business, operating results and financial condition.
Net cash used in operating activities was $628,454 and $617,553 for the nine
months ended September 30, 2005 and 2004, respectively. Net cash used in
operating activities was primarily attributable to operating net losses
generated by growth stage activities and overhead costs. We plan to focus on
expending our resources prudently given our current state of liquidity and do
not expect to achieve positive cash flow from operations for 2005.
Net cash used in investing activities was $86,877 for the nine months ended
September 30, 2005 and primarily reflected capital expenditures for computer
hardware and software. Net cash provided by investing activities was $2,095 for
the nine months ended September 30, 2004 and reflected the return of $6,693 of a
long-term lease deposit, which was partially offset by capital expenditures for
computer hardware and software. We anticipate making capital expenditures of
approximately $25,000 during the remaining three months of 2005.
Net cash provided by financing activities of $815,555 for the nine months ended
September 30, 2005 resulted from receiving $667,430 in net proceeds from the
issuance of common stock, primarily under our equity line of credit, and
receiving $168,125 in net proceeds under our notes payable. Net cash provided by
financing activities of $282,216 for the nine months ended September 30, 2004
resulted primarily from borrowing $260,000 under a note payable and receiving
$32,787 from the issuance of common stock.
15
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. The margin loans were obtained in March 1999 from institutional
lenders and were secured by shares of our common stock owned by these officers.
The pledged funds were held in our name in accounts with the lenders that held
the margin loans of the officers. Our purpose in collateralizing the margin
loans was to prevent the sale of our common stock owned by these officers while
we were pursuing efforts to raise additional capital through private equity
placements. The sale of that common stock could have hindered our ability to
raise capital in such a manner and compromised our continuing efforts to secure
additional financing. The highest total amount of funds pledged for the margin
loans guaranteed by us was approximately $2.0 million. 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 September 30, 2005. We may institute
litigation or arbitration in collection of the outstanding repayment obligations
of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which currently total
$1,278,138. Presently, we have refrained from initiating action to recover these
funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may have offsetting
claims that total $1,445,500 collectively by virtue of the change of control
clause in their respective employment agreements based on our preliminary
analysis. We understand that these individuals may assert such claims based on
our sale of substantially all of our assets to Harbor Payments, Inc. on July 25,
2003. While Mr. Long and Mr. Hoch agreed, in connection with such sale, to
forego any affirmative recovery of their compensation by virtue of a change of
control, they have maintained the right to claim an offset of that amount in the
event the Company seeks recovery of the loan balances. We have not initiated any
formal settlement negotiations with these individuals because they have been
under an extended employment contract with us or have not been amenable to such
an action. We have not pursued the outstanding repayment obligation of Mr. Jones
because we do not consider a recovery attempt to be cost beneficial. In order to
attempt a recovery from Mr. Jones, we estimate that we would incur a minimum of
$20,000 in estimated legal costs with no reasonable assurance of success in
recovering his outstanding obligation of approximately $38,000. Because of the
limited amount of the obligation, we also anticipate difficulty in retaining
counsel on a contingency basis to pursue collection of this obligation. The
ultimate outcome of this matter cannot presently be determined.
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.
16
Item 3. CONTROLS AND PROCEDURES
Our management evaluated, with the participation of our Chief Executive
Officer/Chief Financial Officer, the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this Quarterly Report on
Form 10-QSB. Based on this evaluation, our Chief Executive Officer/Chief
Financial Officer has concluded that our disclosure controls and procedures are
effective to ensure that information we are required to disclose in reports that
we file or submit under the Securities Exchange Act of 1934 (i) is recorded,
processed, summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms, and (ii) is accumulated and
communicated to our management, including our Chief Executive Officer/Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure. Our disclosure controls and procedures are designed to provide
reasonable assurance that such information is accumulated and communicated to
our management. Our disclosure controls and procedures include components of our
internal control over financial reporting. Management's assessment of the
effectiveness of our internal control over financial reporting is expressed at
the level of reasonable assurance that the control system, no matter how well
designed and operated, can provide only reasonable, but not absolute, assurance
that the control system's objectives will be met.
There was no change in our internal control over financial reporting that
occurred during our last fiscal quarter covered by this report that materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.
17
PART II - OTHER INFORMATION
Item 1. 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 are no longer our
employees. The pledged funds were held in our name in accounts with the lenders
that held the margin loans of the officers. Our purpose in collateralizing the
margin loans was to prevent the sale of our common stock owned by these officers
while we were pursuing efforts to raise additional capital through private
equity placements. The sale of that common stock could have hindered our ability
to raise capital in such a manner and compromised 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 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 September 30, 2005.
The pledged funds were classified as cash and cash equivalents on our balance
sheet and disclosed in the accompanying footnotes in our Annual Report on Form
10-K for each of the years ended December 31, 2000 and 2001, respectively. The
pledged funds were classified as cash and cash equivalents on our balance sheet
and disclosed in the accompanying footnotes in our Quarterly Report on Form 10-Q
for the quarters ended March 31, 2002 and June 30, 2002, respectively. Under the
terms of the related guaranty agreements, we could, at any time, terminate our
obligations and the lenders' rights under the guaranty agreements, but we would
remain liable for any losses incurred by the lenders in liquidating the
guaranteed accounts by selling the common stock held as collateral in the margin
loan accounts in order to pay off the margin loan balances in full during a
reasonable time subsequent to the receipt of our termination notice. 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. These amended reports included restated balance
sheets that classified the pledged funds as cash pledged as collateral for
related party obligations beginning at December 31, 2000 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.
18
We may institute litigation or arbitration in collection of the outstanding
repayment obligations of Mr. Long, Mr. Hoch, Mr. Millard, and Mr. Jones, which
currently total $1,278,138. Presently, we have refrained from initiating action
to recover these funds from Mr. Long, Mr. Hoch, and Mr. Millard because they may
have offsetting claims that total $1,445,500 collectively by virtue of the
change of control clause in their respective employment agreements based on our
preliminary analysis. We understand that these individuals may assert such
claims based on our sale of substantially all of our assets to Harbor Payments,
Inc. on July 25, 2003. While Mr. Long and Mr. Hoch agreed, in connection with
such sale, to forego any affirmative recovery of their compensation by virtue of
a change of control, they have maintained the right to claim an offset of that
amount in the event the Company seeks recovery of the loan balances. We have not
initiated any formal settlement negotiations with these individuals because they
were under an extended employment contract with us or have not been amenable to
such an action. We have not pursued the outstanding repayment obligation of Mr.
Jones because we do not consider a recovery attempt to be cost beneficial. In
order to attempt a recovery from Mr. Jones, we estimate that we would incur a
minimum of $20,000 in estimated legal costs with no reasonable assurance of
success in recovering his outstanding obligation of approximately $38,000.
Because of the limited amount of the obligation, we also anticipate difficulty
in retaining counsel on a contingency basis to pursue collection of this
obligation. The ultimate outcome of this matter cannot presently be determined.
On July 25, 2003, certain of our stockholders (those stockholders being Mike
Procacci, Jr., Mark and Stefanie McMahon, Anthony and Lois Tedeschi, Donna and
James Knoll, John E. Hamilton, III, William T. Hagan, Samuel A. Fruscione, Dana
Fruscione-Penzone, Gia Fruscione, Alicia Fruscione, Joseph Fruscione, Robert
Evans, John Arangio, Gary and JoAnne Gardner, Lee and Margaret Getson, G. Harry
Bonham, Jr., Gary Brewer, Bob Lastowski, Robert Filipe, Mitchell D. Hovendick,
Dr. John Diephold, Joseph Maressa, Jr., and Charles Brennan) commenced legal
action against us, Ernst & Young, LLP, and certain of our current and former
directors (including the executive officers named above) in the District Court
of the 45th Judicial District, Bexar County, Texas. With respect to us and the
current and former directors named in the suit, the plaintiffs alleged 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
alleged and sought resulting economic and exemplary damages, rescission,
interest, attorneys' fees and court costs.
On November 9, 2005, we entered into a settlement agreement with all the
plaintiffs named above. Under the terms of the settlement, the plaintiffs will
dismiss the pending litigation, with prejudice, and release all claims against
the Company, its current and former officers and directors, and our former
auditors, Ernst & Young, LLP. Additionally, we will reset the exercise price of
1,912,400 warrants to purchase our common stock held by the plaintiffs from
$1.80 per share to a new exercise price of $0.20 per share. We will also extend
the expiration date of the warrants from November 27, 2006, to November 27,
2007. We recorded a non-cash expense of $151,309 in the third quarter of 2005 as
a result of the modification of the warrant terms. We are not paying any other
economic consideration to fund this settlement. On balance, we believe the terms
of this settlement to be fair and equitable to the Company and its shareholders.
We will no longer incur significant expenses associated with defense of the
litigation and the uncertainly inherent in any litigation is now resolved at a
reasonable cost.
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the quarter ended September 30, 2005, we sold 1,284,486 shares of our
common stock to Dutchess Private Equities Fund pursuant to an equity line of
credit and received total proceeds, net of issuance costs, of $201,325.
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Item 3. DEFAULTS UPON SENIOR SECURITIES
On April 10, 2005, we defaulted on payment of a note payable to Dutchess Private
Equities Fund, II, LP in the amount of $194,900, including principal and accrued
interest. As of the date of this report, there was no amount in arrearage
because we repaid the full balance of the note plus accrued interest and
penalties using a portion of the proceeds from a promissory note we entered into
with Dutchess dated May 12, 2005.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
Item 5. OTHER INFORMATION
Not Applicable.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Exhibit
Number Description
------ -----------
3.1 Articles of Incorporation, as amended (included as exhibit 3.1 to the
Form 10-Q filed November 14, 2003, and incorporated herein by reference).
3.2 By-laws, as amended (included as exhibit 3.2 to the Form SB-2 filed
December 29, 1999, and incorporated herein by reference).
4.1 Amended and Restated 1999 Employee Comprehensive Stock Plan (included as
exhibit 4.1 to the Form S-8 filed January 26, 2005, and incorporated herein by
reference).
4.2 Amended and Restated 1999 Non-Employee Director Plan (included as
exhibit 4.2 to the Form S-8 filed January 26, 2005, and incorporated herein by
reference).
4.3 Employee Stock Purchase Plan (included as exhibit 4.3 to the Form S-8
filed February 23, 2000, and incorporated herein by reference).
4.4 Registration Rights Agreement between the Company and Dutchess Private
Equities Fund, LP, dated June 6, 2004 (included as exhibit 10.9 to the Form SB-2
filed June 18, 2004, and incorporated herein by reference).
4.5 Rights Agreement between the Company and American Stock Transfer & Trust
Company, dated May 2, 2005 (included as exhibit 4.1 to the Form 8-A filed May 5,
2005, and incorporated herein by reference).
10.1 Asset Purchase Agreement between the Company and Saro, Inc., dated May
19, 2003 (included as Appendix A to the Definitive Proxy Statement on Form DEF
14A filed June 19, 2003, and incorporated herein by reference).
10.2 First Amendment to Asset Purchase Agreement between the Company and
Saro, Inc., dated July 25, 2003 (included as exhibit 10.2 to the Form 10-Q filed
November 14, 2003, and incorporated herein by reference).
10.3 Lease Agreement between the Company and Frost National Bank, Trustee
for a Designated Trust, dated August 2003 (included as exhibit 10.3 to the Form
10-Q filed November 14, 2003, and incorporated herein by reference).
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10.4 Employment Agreement Form between the Company and Executive Officers,
dated May 31, 2001 (included as exhibit 10.4 to the Form 10-K filed April 1,
2002, and incorporated herein by reference).
10.5 Investment Agreement between the Company and Dutchess Private Equities
Fund, LP, dated June 4, 2004 (included as exhibit 10.8 to the Form SB-2 filed
June 18, 2004, and incorporated herein by reference).
10.6 Placement Agent Agreement between the Company, Charleston Capital
Corporation, and Dutchess Private Equities Fund, LP, dated June 4, 2004
(included as exhibit 10.10 to the Form SB-2 filed June 18, 2004, and
incorporated herein by reference).
10.7 Affiliate Office Agreement between the Company and Network 1 Financial,
Inc. (included as exhibit 10.11 to the Form SB-2 filed April 28, 2004, and
incorporated herein by reference).
10.8 Promissory Note between the Company and Dutchess Private Equities Fund,
II, LP, dated August 24, 2004 (included as exhibit 10.1 to the Form 8-K filed
September 2, 2004, and incorporated herein by reference).
10.9 Warrant Agreement between the Company and Kubra Data Transfer LTD,
dated as of September 30, 2004 (included as exhibit 10.1 to the Form 8-K filed
October 6, 2004, and incorporated herein by reference).
10.10 Promissory Note between the Company and Dutchess Private Equities
Fund, II, LP, dated December 10, 2004 (included as exhibit 10.1 to the Form 8-K
filed December 16, 2004, and incorporated herein by reference).
10.11 Promissory Note between the Company and Dutchess Private Equities
Fund, II, LP, dated May 12, 2005 (included as exhibit 10.11 to the Form 10-QSB
filed May 16, 2005, and incorporated herein by reference).
10.12 Corporate Consulting Agreement between the Company and Theodore Smith,
dated April 26, 2005 (included as exhibit 10.1 to the Form S-8 filed June 3,
2005, and incorporated herein by reference).
21.1 Subsidiaries of the Company (included as exhibit 21.1 to the Form 10-K
filed April 1, 2002, and incorporated herein by reference).
31.1 Certification of the Chief Executive Officer/Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Officers pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K:
The Company did not file any reports on Form 8-K during the three months ended
September 30, 2005.
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SIGNATURE
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
PAYMENT DATA SYSTEMS, INC.
Date: November 14, 2005 By: /s/ Michael R. Long
----------------------
Michael R. Long
Chairman of the Board,
Chief Executive Officer and
Chief Financial Officer
(principal executive officer and principal
financial and accounting officer)
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