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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended September 30, 2003

Commission file number 000-50280

iPayment, Inc.
(Exact Name of Registrant as Specified in Its Charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO x

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date.

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INDEX

iPAYMENT, INC. and SUBSIDIARIES

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Part 1.

Item 1. Financial Statements

iPAYMENT, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

						September 30,				December 31,
						2003				2002
						(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents					$	11,691			$	1,831
	Accounts receivable, net of allowance for doubtful accounts of $53 and $93 at September 30, 2003 and December 31, 2002, respectively						10,400				6,687
	Prepaid expenses and other current assets						2,028				1,287
		Total current assets					24,119				9,805
Restricted cash							9,579				3,070
Property and equipment, net							1,654				1,610
Intangible assets, net							32,313				31,758
Goodwill, net							74,069				60,790
Other assets							6,918				9,948
		Total assets				$	148,652			$	116,981
			LIABILITIES, MANDATORILY REDEEMABLE CONVERTIBLE
				PREFERRED STOCK and STOCKHOLDERS’ EQUITY
Current liabilities:
	Reserve for merchant losses					$	3,144			$	4,411
	Accounts payable and accrued liabilities						10,810				12,192
	Current portion of long-term debt to a related party						5,044				7,383
		Total current liabilities					18,998				23,986
Long term liabilities:
	Long-term debt						15,538				70,688
	Other long-term liabilities						666				2,118
		Total liabilities					35,202				96,792
Commitments and contingencies
Series A mandatorily redeemable convertible preferred stock, no par value; 2,577,200 shares authorized and issued at September 30, 2003 and December 31, 2002; no shares outstanding at September 30, 2003 and 2,577,200 shares outstanding at December 31, 2002							—				6,670
Stockholders’ equity:
	Preferred stock, $0.01 par value; 17,422,800 shares authorized, no shares issued and outstanding at September 30, 2003 and December 31, 2002						—				—
	Common stock, $0.01 par value; 180,000,000 shares authorized, 16,363,027 shares issued and outstanding at September 30, 2003; 130,000,000 shares authorized, 6,736,075 shares issued and outstanding at December 31, 2002						124,902				29,736
	Accumulated deficit						(11,452	)			(16,217	)
		Total stockholders’ equity					113,450				13,519
Total liabilities and stockholders’ equity						$	148,652			$	116,981

See accompanying notes to consolidated financial statements.

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iPAYMENT, INC.
CONSOLIDATED STATEMENTS of OPERATIONS
(In thousands, except per share data)
(Unaudited)

See accompanying notes to consolidated financial statements.

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iPAYMENT, INC.
CONSOLIDATED STATEMENTS of CASH FLOWS
(In thousands)
(Unaudited)

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iPAYMENT, INC.
CONSOLIDATED STATEMENTS of CASH FLOWS — (Continued)
(In thousands)
(Unaudited)

See accompanying notes to consolidated financial statements.

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED

(1) Organization and Business and Basis of Presentation

Stock split

     Immediately prior to our initial public offering (see Note 9) we effected a reverse split of our outstanding common stock of 0.4627 shares for each share outstanding. All shares and per share calculations included in the accompanying unaudited consolidated financial statements of iPayment, Inc. have been adjusted to reflect this reverse split.

Organization and Business

     iPayment, Inc. (subsequently referred to as “iPayment” or the “Company”) was originally incorporated as iPayment Holdings, Inc. in Tennessee and was reincorporated in Delaware under the name iPayment, Inc. iPayment is a provider of card-based payment processing services to small business merchants located across the United States. We enable merchants to accept credit and debit cards as payment for their products and services by providing card authorization, data capture, settlement, risk management, fraud detection and chargeback services. Our services also include data organization and retrieval, ongoing merchant assistance and resolution support in connection with disputes with cardholders. We market and sell our services primarily through independent sales organizations (“ISOs”).

Basis of Presentation

     The accompanying unaudited consolidated financial statements of iPayment have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, the unaudited consolidated financial statements reflect all adjustments considered necessary for a fair presentation, consisting only of normal and recurring adjustments. All significant intercompany transactions have been eliminated in consolidation. Operating results for the three and nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2003. For further information, refer to the consolidated financial statements and notes thereto for the year ended December 31, 2002 (included in our Registration Statement on Form S-1).

     Certain prior year amounts have been reclassified to conform to the current year presentation, including separate presentation of interchange fees and classification of all depreciation and amortization expense as other cost of services in the consolidated statement of operations. Interchange fees had previously been included in cost of services and were $6.7 million, $7.6 million, $13.3 million and $24.2 million for the three months ended March 31, June 30, September 30, and December 31, 2002, respectively. Other costs of services include costs directly attributable to our provision of payment processing and related services to our merchants such as residual payments to ISOs, which are commissions we pay to our ISOs based upon a percentage of the net revenues we generate from their merchant referrals, and assessment fees payable to card associations, which are a percentage of the processing volume we generate from Visa and MasterCard. In addition, other costs of services includes telecommunications costs, personnel costs, occupancy costs, losses due to merchant defaults, other miscellaneous merchant supplies and services expenses, sponsorship costs and other third-party processing costs.

Stock-Based Compensation

     We have adopted the disclosure-only provision of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure — an amendment of FASB Statement No. 123. SFAS No. 148 requires prominent disclosures in annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We measure compensation expense for our stock option awards under the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (“APB 25”) and related interpretations. APB 25 requires compensation expense to be recognized based on the excess, if any, of the quoted market price of the stock at the date of the grant over the amount an employee must pay to acquire the stock. The following table presents the effect on net income (loss) and basic and diluted net income (loss) per common share had the Company adopted the fair value method of accounting for stock-based compensation under SFAS No. 123 (in thousands, except per share data):

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS (continued)
UNAUDITED

     The weighted-average fair value of each stock option included in the preceding pro forma amounts was estimated using the Black-Scholes option-pricing model and is amortized over the vesting period of the underlying options. Because additional options are expected to be granted each year, the above pro forma disclosures may not be representative of pro forma effects on reported results for future periods. The following assumptions were applied: (i) no expected dividend yield for all periods, (ii) expected volatility of 50% and 100% for 2003 and 2002, respectively (iii) expected lives of 3 years for all periods, (iv) and risk-free interest rates ranging from 2% to 4% for all periods.

(2) Acquisitions

     The effective date of each of the acquisitions discussed in this Note are the dates the acquisitions were recognized in our financial statements, unless otherwise noted.

CardPayment Solutions, Inc.

     On August 5, 2003, we entered into an Asset Purchase Agreement (the “CardPayment Agreement”) with CardPayment Solutions, Inc. (“CardPayment”), whereby we acquired substantially all of the assets and assumed debt of approximately $1.0 million, which was repaid in the third quarter of 2003, for $12.0 million cash and 118,409 shares of our common stock valued $25.34. CardPayment is an integrated provider of credit card transaction processing services. The acquisition was recorded under the purchase method. The operating results of CardPayment from August 1, 2003 are included in our consolidated statements of operations of the Company.

CardSync Processing, Inc.

     On September 5, 2002, we entered into an Agreement and Plan of Merger (the “CardSync Agreement”) with CardSync Processing, Inc. (“CardSync”), whereby CardSync merged with a wholly owned subsidiary of the Company. CardSync is an integrated provider of credit card transaction processing services. Under the terms of the CardSync Agreement, we purchased CardSync for $1.1 million cash and 670,915 shares of our common stock. The acquisition was accounted for as a purchase. Debt assumed in the acquisition is pursuant to a settlement of litigation between CardSync and NOVA Corporation (“NOVA”) under which CardSync was required to pay NOVA $8.0 million. The debt was repaid in the second quarter of 2003 using proceeds from our initial public offering (see Note 9).

First Merchants Bancard Services, Inc

     On August 28, 2002, we entered into an Agreement and Plan of Merger (the “FMBS Agreement”) with First Merchants Bancard Services, Inc. (“FMBS”), whereby FMBS merged into a wholly owned subsidiary of the Company. FMBS is an integrated provider of credit card transaction processing services. Under the terms of the FMBS Agreement,

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS (continued)
UNAUDITED

we purchased FMBS for $3.4 million cash and 740,320 shares of our common stock. The acquisition was accounted for as a purchase. Debt assumed in the acquisition included a note payable for $1.9 million (which also contained a one-time $250,000 loan fee due upon the repayment of the note). The note was repaid in the second quarter of 2003 using proceeds from our initial public offering (see Note 9).

Online Data Corporation

     On August 22, 2002, we entered into an Agreement and Plan of Merger (the “Online Agreement”) with Online Data Corporation (“Online”), whereby Online merged with a wholly owned subsidiary of the Company. Online is an integrated provider of credit card transaction processing services. Under the terms of the Online Agreement, we purchased Online for $2.0 million cash, a note for $5.0 million (the “Online Note”) and 844,428 shares of our common stock, as well as a deferred cash payment of $2.1 million which was paid in February 2003. The acquisition was accounted for as a purchase. Debt assumed in the acquisition included a note payable to Blueline Data Corporation (the “Blueline Note”) for $1.3 million. The Online Note and the Blueline Note were repaid in the second quarter of 2003 using proceeds from our initial public offering (see Note 9).

E-Commerce Exchange

     On March 19, 2002, we entered into an Agreement and Plan of Merger (the “ECX Agreement”) with ECX, a card-payment processor, whereby ECX merged into a wholly owned subsidiary of the Company. ECX is a provider of an end-to-end solution which enables merchants to accept credit card payments via the Internet. Under the terms of the ECX Agreement, we issued a series of convertible notes (the “ECX Notes”) to the prior Series A Preferred Stockholders of ECX (“ECX Preferred Stockholders”) in the aggregate amount of $15.0 million in exchange for all of the outstanding common shares of ECX. Subject to certain restrictions, such ECX Notes are convertible into 663,184 shares of our common stock, and the notes bear interest at 4.5 percent and are due March 2007. The acquisition was accounted for as a purchase.

Other Acquisitions of Portfolios and Residual Cash Flow Streams

     We made various other purchases of residual cash flow streams totaling $3.8 million during the nine months ended September 30, 2003. These purchases are accounted for as other assets in the accompanying consolidated balance sheets and are amortized over their expected useful lives of seven years.

(3) Intangible Assets

     As of September 30, 2003, we had the following amortizable intangible assets (in thousands):

     As of December 31, 2002, we had the following amortizable intangible assets (in thousands):

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS (continued)
UNAUDITED

     For the three months ended September 30, 2003 and 2002, respectively, amortization expense related to the merchant processing portfolios was $1,415,000 and $899,000, amortization expense related to acquired software was $127,000 and $187,000, and amortization expense related to bank contract costs and other was $70,000 and $72,000. For the nine months ended September 30, 2003 and 2002, respectively, amortization expense related to the merchant processing portfolios was $4,042,000 and $2,387,000, amortization expense related to acquired software was $620,000 and $669,000, and amortization expense related to bank contract costs and other was $183,000 and $345,000.

(4) Long-Term Debt

     In August, 2003 we obtained a $20.0 million revolving credit from Bank of America which was subsequently expanded to $30.0 million in October 2003. The revolving credit includes a $3.0 million letter of credit sublimit. Interest is payable at an adjusted LIBOR rate (LIBOR Rate plus 2.25%, each as in effect at such time). The revolving credit contains certain financial and nonfinancial covenants (as defined therein) and replaces the previous line of credit we had with Bank of America. The revolving credit expires on August 1, 2006. We were in compliance with all debt covenants as of September 30, 2003 and we currently have no borrowings.

     In May 2003, we completed an initial public offering (see Note 9) and used $55.7 million of the proceeds to repay outstanding debt with a carrying value of $52.1 million. Additionally, in conjunction with the offering we converted $9.0 million of debt with a carrying value of $8.2 million into 562,500 shares of common stock. These repayments and conversions resulted in a noncash pre-tax charge of approximately $4.4 million which was recognized as interest expense in the second quarter of 2003.

(5) Mandatorily redeemable convertible preferred stock

     As part of the initial public offering completed in May 2003 (see Note 9), all of our Mandatorily Redeemable Convertible Preferred Stock was converted into 1,192,470 shares of our common stock.

(6) Stockholders’ Equity

Earnings Per Share

     We report net income or loss per share in accordance with SFAS No. 128, Earnings per Share. Under SFAS No. 128, basic earnings per share (“EPS”), which excludes dilution, is computed by dividing net income or loss available to common stockholders by the weighted average number of common shares outstanding for the period. Net income or loss available to common stockholders represents reported net income or loss less accretion of mandatorily redeemable convertible preferred stock.

     Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted EPS includes in-the-money stock options and warrants using the treasury stock method and also includes the assumed conversion of preferred stock and convertible debt using the if-converted method. During a loss period, the assumed exercise of in-the-money stock options, warrants and conversion of convertible securities has an anti-dilutive effect, and therefore are excluded from the computation of diluted EPS. The following weighted average common stock equivalents were excluded from the computation of diluted EPS because their inclusion would have been anti-dilutive (in thousands):

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS (continued)
UNAUDITED

A reconciliation of basic to diluted weighted average common shares outstanding is as follows (in thousands):

(7) Revenue Recognition

     Revenues are reported gross of amounts paid to association banks as well as interchange and assessments paid by us to credit card associations pursuant to which such parties receive payments based primarily on processing volume for particular groups of merchants. Related interchange costs are also recognized at that time, as are bank sponsorship fees and assessments, which are included in other costs of services.

(8) 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, an

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS (continued)
UNAUDITED

interpretation of SFAS Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34 (“FIN 45”). Effective January 1, 2003, the Company adopted FIN 45, which requires the recognition of a liability for the amount of the fair value of a guarantee. A liability is required to be maintained until the settlement or expiration of the guarantee for transactions occurring after December 31, 2002. The Company recognizes a reserve for its merchant credit risk, which is partially mitigated by the collateral the Company obtains from those merchants considered at risk. Based on historical experience, ongoing credit risk assessments, and the collateral held, the fair value of the guarantee approximates the credit loss reserves. We adopted this statement and its adoption did not have a material impact on our financial position, results of operations or cash flows.

     In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123. This statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirement of SFAS No. 123 to require prominent disclosure in both 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. We adopted this statement and its adoption did not have any impact on our financial position, results of operations or cashflows (see Note 1).

     In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (“FIN 46”). FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. FIN 46 requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that we will consolidate or disclose information about variable interest entities when the interpretation becomes effective. We do not have ownership interests in variable interest entities, accordingly, the adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

     In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity, including mandatorily redeemable equity instruments. The Statement is effective for all interim periods beginning after June 15, 2003. We have classified our mandatorily redeemable convertible equity instruments in the mezzanine level between liabilities and stockholders’ equity on its balance sheet. However, all of our mandatorily redeemable convertible equity instruments were converted to common stock in conjunction with the initial public offering in May 2003 (see Note 9) and therefore, the adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

(9) Initial Public Offering

     In May 2003, we completed an initial public offering whereby we sold 5,625,000 shares of common stock (which included underwriters’ overallotment) and received net proceeds of $75.7 million (after underwriters’ discount of $6.3 million and related offering expenses of $8.0 million). As described in Note 4, during the second quarter of fiscal 2003 we used $55.7 million of the proceeds to repay debt that had a carrying value of $52.1 million and converted an additional $9.0 million of debt with a carrying value of $8.2 million into 562,500 shares of common stock. The repayment and conversion of debt resulted in recognition of a non-cash pre-tax charge of approximately $4.4 million in the second quarter of 2003 due to the acceleration of interest expense equal to the unamortized discount balance at the date of repayment or conversion. Immediately prior to the offering we effected a reverse split of our outstanding common stock of 0.4627 shares for each share outstanding. All shares and per share calculations included in the accompanying unaudited consolidated financial statements of iPayment, Inc. have been adjusted to reflect this reverse split.

(10) Income Taxes

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iPAYMENT, INC.
NOTES to CONSOLIDATED FINANCIAL STATEMENTS (continued)
UNAUDITED

     During the third quarter, we completed a study of our available federal and state net operating loss carryforwards. At December 31, 2002, we had approximately $18.1 million of federal net operating loss carryforwards that will be available to offset regular taxable income through 2022, subject to annual limitations of approximately $9.8 million in 2003 and up to $6.5 million per year thereafter. We also have approximately $15.6 million of state net operating loss carryforwards, again subject to similar annual limitations, that will expire in various states between 2013 and 2022. As a result of the study, we have adjusted our tax provision to reflect the anticipated effective rate for the year.

(11) Subsequent Events

     In October 2003, we acquired a merchant portfolio from NPMG, Inc. of Phoenix, Arizona. The merchant portfolio, currently located at JP Morgan Chase Bank, consists of approximately 1,500 merchants.

     In October 2003, we repaid $0.5 million of principal on an existing note payable owed to an officer of the Company. The remaining principal balance of $4.5 million is due in January 2004.

     On October 1, 2003, we amended our Credit Agreement with Bank of America, dated August 1, 2003 to increase our revolving credit in the amount of $10.0 million, from $20.0 million to $30.0 million in October 2003, under the terms and conditions of this Revolving Credit Facility. All of the terms, conditions and covenants of the Credit Agreement are expressly made a part of this Revolving Credit Facility and reference is made to the Credit Agreement for provisions relating to the interest rate, maturity, payment, prepayment, acceleration and other terms affecting this Revolving Credit Facility.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements May Prove Inaccurate

     This report includes various forward-looking statements regarding the Company that are subject to risks and uncertainties, including, without limitation, the factors set forth below and under the caption “Risk Factors” in the prospectus filed with the Securities and Exchange Commission (the “Commission”) on May 13, 2003, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, in connection with the Company’s Registration Statement on Form S-1 (File No. 333-101705). Forward-looking statements include, but are not limited to, discussions regarding our operating strategy, growth strategy, acquisition strategy, cost savings initiatives, industry, economic conditions, financial condition, liquidity and capital resources and results of operations. Such statements include, but are not limited to, statements preceded by, followed by or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “estimates” or similar expressions. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

     Certain important factors, which are discussed elsewhere in this document and in our prospectus filed May 13, 2003, could affect our future financial results and could cause actual results to differ materially from those expressed in forward-looking statements contained or incorporated by reference in this document.

Overview

     We are one of the fastest growing providers of credit and debit card-based payment processing services to small merchants. We currently provide our services to over 70,000 active small merchants located across the United States, and our merchant processing volume was $1,729 million and $4,624 million for the three and nine months ended September 30, 2003, respectively (compared to $736 million and $1,506 million for the three and nine months ended September 30, 2002, respectively). The small merchants we serve typically generate less than $250,000 of charge volume per year and have an average transaction value of approximately $75. These merchants have traditionally been underserved by larger payment processors due to the difficulty in identifying, servicing and managing the risks associated with these merchants. As a result, these merchants have historically paid higher transaction fees than larger merchants.

     Our payment processing services enable merchants to process both traditional card-present, or “swipe,” transactions, as well as card-not-present transactions. A card-not-present transaction occurs whenever a customer does not physically present a payment card at the point-of-sale and may occur over the Internet or by mail, fax or telephone. Our processing services include evaluation and acceptance of card numbers, detection of fraudulent transactions, receipt and settlement of funds and service and support. By outsourcing some of these services to third parties, including the evaluation and acceptance of card numbers and receipt and settlement of funds, we maintain an efficient operating structure, which allows us to easily expand our operations without significantly increasing our fixed costs. We derive the majority of our revenues from fee income related to transaction processing, which is primarily comprised of a percentage of the dollar amount of each transaction we process, as well as a flat fee per transaction. In the event we have outsourced any of the services provided in the transaction, we remit a portion of the fee income to the third parties that have provided these services.

     We believe our experience and knowledge in providing payment processing services to small merchants gives us the ability to effectively identify, evaluate and manage the payment processing needs and risks that are unique to small businesses.

     We market and sell our services primarily through our relationships with over 500 independent sales organizations, or ISOs, which we define as any party that sells card-based payment processing services to merchants. ISOs act as a non-employee, external sales force in communities throughout the United States. By providing the same high level of service and support to our ISOs as we do to our merchant customers, we maintain our access to an experienced sales force of approximately 2,000 sales professionals who will market our services, with minimal direct investment in sales infrastructure and management. After an ISO refers a merchant to us and we execute a processing agreement with that merchant, we pay the referring ISO a percentage of the revenues generated by that merchant. Although our relationships with ISOs are mutually non-exclusive, we believe that our understanding of the unique payment processing needs of small merchants enables us to develop compelling incentives for ISOs to continue to refer newly identified merchants to us. We also maintain an open dialogue with our ISOs, allowing us to quickly address their concerns and any problems facing the merchants they refer to us.

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Critical Accounting Policies

     The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, which require that management make numerous estimates and assumptions. Actual results could differ from those estimates and assumptions, impacting our reported results of operations and financial position. Our significant accounting policies are more fully described in Note 3 of our financial statements included in our prospectus filed with the Commission on May 13, 2003. The critical accounting policies described here are those that are most important to the depiction of our financial condition and results of operations and their application requires management’s most subjective judgment in making estimates about the effect of matters that are inherently uncertain.

     Restricted Cash

     Restricted cash represents funds held-on-deposit with processing banks pursuant to agreements to cover potential merchant losses, and funds held by lending institutions pursuant to loan agreements to provide additional collateral.

     Goodwill

     We adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, in the first quarter of 2002 (certain provisions of SFAS No. 142 were adopted in the third quarter of 2001). SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets, and requires that goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill is subject to at least an annual assessment for impairment utilizing the fair value approach. If facts and circumstances indicate goodwill may be impaired, we perform a recoverability evaluation. The calculation of fair value includes a number of estimates and assumptions, including projections of future income and cash flows, the identification of appropriate market multiples and the choice of an appropriate discount rate.

     Merchant losses

     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, which means 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, we or, under limited circumstances, together with the acquiring bank, must bear the credit risk for the full amount of the transaction. We evaluate the merchant’s risk for such transaction and estimate its potential loss for chargebacks based primarily on historical experience and other relevant factors. At September 30, 2003, our reserve for losses on merchant accounts totaled $3.1 million, of which approximately $1.3 million related to reserves from one merchant.

     Income taxes

     We account for income taxes pursuant to the provisions of SFAS No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are recorded to reflect the future tax consequences attributable to the effects of differences between the carrying amounts of existing assets and liabilities for financial reporting and for income tax purposes. We have placed a valuation allowance on our net deferred tax asset as a result of certain limitations.

Components of Revenues and Expenses

     All of our revenues are generated from fees charged to merchants for card-based payment processing services. We typically charge these merchants a bundled rate, primarily based upon the merchant’s monthly charge volume and risk profile. Our fees principally consist of discount fees, which are a percentage of the dollar amount of each credit or debit transaction. We charge all merchants higher discount rates for card-not-present transactions than for card-present transactions in order to compensate us for the higher risk of underwriting these transactions. We derive the balance of our revenues from a variety of fixed transaction or service fees, including fees for monthly minimum charge volume requirements, statement fees, annual fees and fees for other miscellaneous services, such as handling chargebacks. We recognize discounts and other fees related to payment transactions at the time the merchants’ transactions are processed. We recognize revenues derived from service fees at the time the service is performed. We report revenues gross of amounts paid to sponsoring banks, as well as interchange and assessments paid by us to credit card associations pursuant to which these associations receive payments based primarily on processing volume for particular groups of merchants. Related interchange and assessment costs and bank processing fees are also recognized at that time.

     The most significant component of operating expenses is interchange fees, which are amounts we pay to the card issuing banks. Interchange fees are based on transaction processing volume and are recognized at the time transactions are processed.

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     Other costs of services include costs directly attributable to our provision of payment processing and related services to our merchants such as residual payments to ISOs, which are commissions we pay to our ISOs based upon a percentage of the net revenues we generate from their merchant referrals, and assessment fees payable to card associations, which is a percentage of the processing volume we generate from Visa and MasterCard. In addition, other costs of services includes telecommunications costs, personnel costs, occupancy costs, losses due to merchant defaults, other miscellaneous merchant supplies and services expenses, bank sponsorship costs and other third-party processing costs.

     Other costs of services also includes depreciation and amortization expenses, which are recognized on a straight-line basis over the estimated useful life of the asset. Amortization of intangible assets resulted from our acquisitions of portfolios of merchant accounts or acquisitions of a business where we allocated purchase price to the existing merchant processing portfolio.

     Selling, general and administrative expenses consist primarily of salaries and wages and other general administrative expenses.

     From time to time, we enter into transactions with our ISOs. Sometimes, we acquire from an ISO the right, title and interest to a merchant portfolio, including the residual cash flow stream for merchants the ISOs have brought to us. The accounting for those acquisitions is dependent on the ISO’s relationship with us. If the ISO is considered an agent, then we record prepaid commission and amortize the asset through cost of sales. Otherwise, if we have no ongoing agent relationship with the ISO, we will record an intangible asset for that residual cash flow stream. Also, from time to time, we lend money to ISOs, usually to assist the ISOs in establishing and growing their businesses. This directly impacts the number, quality and type of merchants these ISOs are able to bring to us.

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, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34 (“FIN 45”). Effective January 1, 2003, the Company adopted FIN 45, which requires the recognition of a liability for the amount of the fair value of a guarantee. A liability is required to be maintained until the settlement or expiration of the guarantee for transactions occurring after December 31, 2002. The Company recognizes a reserve for its merchant credit risk, which is partially mitigated by the collateral the Company obtains from those merchants considered at risk. Based on historical experience, ongoing credit risk assessments, and the collateral held, the fair value of the guarantee approximates the credit loss reserves. We adopted this statement and its adoption did not have a material impact on our financial position, results of operations or cash flows.

     In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123. This statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirement of SFAS No. 123 to require prominent disclosure in both 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. We adopted this statement and its adoption did not have a material impact on our financial position, results of operations or cash flows (see Note 1).

     In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (“FIN 46”). FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. FIN 46 requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that we will consolidate or disclose information about variable interest entities when the interpretation becomes effective. We do not have variable interests in variable interest entities.

     In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of

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both Liabilities and Equity. This statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity, including mandatorily redeemable equity instruments. The Statement is effective for all interim periods beginning after June 15, 2003. We have classified our mandatorily redeemable equity instruments in the mezzanine level between liabilities and stockholders’ equity on its balance sheet. However, all of our mandatorily redeemable equity instruments were converted to common stock in conjunction with the initial public offering in May 2003 (see Note 9) and we, therefore, do not anticipate this Statement will have a material effect on our consolidated financial statements.

Results of Operations

     The following table sets forth certain financial data as a percentage of revenues for the periods indicated: