UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from___ to___

Commission file number 000-50280

iPayment Inc.

Registrant’s telephone number, including area code: (615) 665-1858

Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

Aggregate market value of registrant’s common stock held by non-affiliates of the registrant as of June 30, 2004, was $486,955,729.

Number of shares of the registrant’s common stock outstanding as of February 28, 2005, was 16,833,317.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement relating to the Annual Meeting of Stockholders to be held on June 6, 2005, are incorporated by reference in Part III.

TABLE OF CONTENTS

     Caution Regarding Forward-Looking Statements

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Caution Regarding Forward-Looking Statements

     This Form 10-K contains forward-looking statements about iPayment, Inc. within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. For example, statements in the future tense, words such as “anticipates,” “estimates,” “expects,” “intends,” “plans,” “believes,” and words and terms of similar substance used in connection with any discussion of future results, performance or achievements identify such forward-looking statements. Those forward-looking statements involve risks and uncertainties and are not guarantees of future results, performance or achievements, and actual results, performance or achievements could differ materially from the Company’s current expectations as a result of numerous factors, including those discussed in the “Risk Factors” section in Item 1 of this Form 10-K and elsewhere in this Form 10-K and the documents incorporated by reference in this Form 10-K.

     If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially including but not limited to the following: acquisitions; liability for merchant chargebacks; restrictive covenants governing the Company’s indebtedness; actions taken by its bank sponsors; migration of merchant portfolios to new bank sponsors; the Company’s reliance on card payment processors and on independent sales groups; changes in interchange fees; risks associated with the unauthorized disclosure of data; imposition of taxes on Internet transactions; actions by the Company’s competitors; and risks related to the integration of companies and merchant portfolios the Company has acquired or may acquire. Any forward-looking statements contained in this annual report or in the documents incorporated herein by reference reflect our current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We have no intention, and disclaim any obligation, to update or revise any forward-looking statements, whether as a result of new information, future results or otherwise. Readers should not place undue reliance on forward-looking statements, which reflect our view only as of the date of this Form 10-K. We undertake no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances.

PART I

ITEM 1 Business

Overview

     We are one of the fastest growing providers of credit and debit card-based payment processing services to small merchants. As of January 1, 2005, including the acquisition of the First Data Merchant Services merchant portfolio from First Data Corporation, which did not contribute to our results of operations until January 2005, we provided our services to over 125,000 active small merchants located across the United States (U.S.). We define a merchant as “active” if the merchant processes at least one Visa or MasterCard transaction in a given month. The small merchants we serve typically generate less than $500,000 of charge volume per year and typically have an average transaction value of approximately $65. These merchants have traditionally been underserved by larger payment processors due to the difficulty in identifying, servicing and managing the risks associated with them. 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 traditional card-present transaction occurs whenever a cardholder physically presents a credit or debit card to a merchant at the point-of-sale. A card-not-present transaction occurs whenever the customer does not physically present a payment card at the point-of-sale and may occur over the Internet, mail, fax or telephone.

     We believe our experience and knowledge in providing payment processing services to small merchants gives us the ability to effectively evaluate and manage the payment processing needs and risks that are unique to small businesses. In order to identify small merchants, we market and sell our services primarily through over 750 independent sales groups, which gives us a non-employee, external sales force representing more than 2,600 sales professionals. Our relationships with the independent sales groups allows us to access a large and experienced sales force with a local presence providing access to small merchants over a broad geographic area without incurring the additional overhead costs associated with an internal sales force. Independent sales groups and sales agents may market and sell our services to merchants under their own brand name and directly approach merchants and enroll them for our services. We enable merchants to accept credit and debit cards as payment for their merchandise and services by providing processing, risk management, fraud detection, merchant assistance and support and chargeback services in connection with disputes with cardholders. In addition, we rely on third party processors to provide card authorization and data capture, and banks to sponsor us for membership in the Visa and MasterCard associations and to settle transactions with merchants. We believe that this structure allows us to maintain an efficient operating structure, and enables us to easily expand our operations without significantly increasing our fixed costs.

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     The Nilson Report, a publication specializing in consumer payment systems worldwide, listed us in its 2003 ranking of the top bank card acquirers, or owners of merchant card processing contracts, as one of the fastest growing providers of card-based payment processing services in the United States. In 2004, we continued to grow as our merchant processing volume, which represents the total value of transactions processed by us, increased by 98.4% to $12,850 million in 2004 from $6,478 million in 2003. During the same period, our revenues increased by 61.1% to $364.2 million in 2004 from $226.1 million in 2003. These increases were primarily attributable to our acquisitions since August 2003 of the agent bank portfolio from First Data Merchant Services, two businesses and several smaller portfolios of merchant accounts, which resulted in an aggregate increase in revenues of $98.4 million in 2004, representing 71.3% of our total growth in revenues over 2003. As we have grown, our net income increased to $24.7 million in 2004 from $15.6 million in 2003. We believe our ability to recruit and retain independent sales groups and sales agents, combined with our experience in identifying, completing and integrating acquisitions, provides us with significant opportunities for future growth.

Industry Overview

     The use of card-based forms of payment, such as credit and debit cards, by consumers in the U.S. has steadily increased over the past ten years. According to The Nilson Report, total purchases by U.S. consumers using Visa and MasterCard card-based systems grew from $1.741 trillion in 2003 to $1.961 trillion in 2004. Such expenditures are expected to grow to $2.788 trillion by 2008. The proliferation of credit and debit cards has made the acceptance of card-based payment a necessity for businesses, both large and small, in order to remain competitive.

     We believe that the card-based payment processing industry will continue to benefit from the following trends:

	•	Favorable Demographics. As consumers age, we expect that they will continue to use the payment technology to which they have grown accustomed. Consumers are beginning to use card-based and other electronic payment methods for purchases at an earlier age. According to Nellie Mae, the number of college students who have credit cards grew from 67% in 1998 to 82% in 2002. As these consumers who have witnessed the wide adoption of card products, technology and the Internet comprise a greater percentage of the population and increasingly enter the work force, we expect that purchases using card-based payment methods will comprise an increasing percentage of total consumer spending.
	•	Increased Card Acceptance by Small Businesses. Small businesses are a vital component of the U.S. economy and are expected to contribute to the increased use of card-based payment methods. In 1997, the U.S. Census Bureau estimated that approximately 20 million businesses which average less than $1.0 million in annual sales in the United States or which had no payroll, generated an aggregate of $1.7 trillion in annual sales. We believe that the lower costs associated with card-based payment methods are making these services more affordable to a larger segment of the small business market. In addition, we believe these businesses are experiencing increased pressure to accept card-based payment methods in order to remain competitive and to meet consumer expectations. As a result, many of these small businesses are seeking, and we expect many new small businesses to seek, to provide customers with the ability to pay for merchandise and services using credit or debit cards, including those in industries that have historically accepted cash and checks as the only forms of payment for their merchandise and services.

Competitive Position

     We believe our competitive strengths include the following:

	•	Strong Position and Substantial Experience in Our Target Market. As of January 1, 2005, we were providing card-based payment processing to over 125,000 active small merchants located across the United States. We believe our understanding of the unique payment processing needs and risks of small merchants provides us with a competitive advantage over larger service providers that have a broader market perspective. We also believe that we have a competitive advantage over service providers of a similar or smaller size that may lack our extensive experience and resources.
	•	Large, Experienced, Efficient Sales Force. We market our services primarily through our contractual relationships with over 750 independent sales groups throughout the United States. Although it is not customary in our industry to obligate independent sales groups to refer their merchant applications to any one processing provider, many currently refer a majority of their new merchant applications to us as a result of our strong relationships with them. Our sales approach provides us with an experienced sales force representing more than 2,600 sales professionals who market our services, with minimal direct investment in sales infrastructure and management. We continually strive to strengthen these relationships by delivering superior service and support to our independent sales groups and sales agents.
	•	Scalable, Efficient Operating Structure. Our scalable, efficient operating structure allows us to expand our operations easily and without significantly increasing our fixed costs. We conduct our customer service and risk management operations in-house, where we believe we can add the most value due to our management’s experience and expertise in these areas. We

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		consider customer service and risk management highly important to our operations and overall success. Although total headcount increased to 310 at December 31, 2004, from 256 at December 31, 2003, due to internal growth and acquisitions made during the year, revenue per employee also increased 49.1% to $1.3 million in 2004 from $0.9 million in 2003. We outsource our remaining processing services to third parties, including the evaluation and acceptance of card numbers and receipt and settlement of funds. By outsourcing these non-core services, we believe we are able to maintain a highly efficient operating structure. Larger economies of scale lead to lower costs for processing, which we outsource. Processing costs declined to $0.18 per transaction in 2004 from $0.21 per transaction in 2003. Processing costs include bank sponsorship costs along with front and back-end processing costs. We believe there is sufficient capacity among third parties to meet our current and future outstanding needs. Many of our contracts include pricing terms that are more favorable to us as the transaction volume generated by our merchant base increases.
	•	Proven Acquisition and Integration Strategy. We have significant experience acquiring providers of payment processing services as well as portfolios of merchant accounts, having acquired nine providers of payment processing services and two significant portfolios and several smaller portfolios of merchant accounts since January 2001. We have enhanced revenues and improved operating efficiencies of our acquired entities by improving the services, support and benefits we offer to the independent sales groups that serve the entities and merchant accounts we acquire. In addition, we have increased operating efficiencies of many of the businesses we have acquired by conducting profitability analyses of acquired merchant accounts and reducing processing fees and overhead.
	•	Comprehensive Underwriting and Risk Management System. Through our experience in assessing risks associated with providing payment processing services to small merchants, we have developed business procedures and systems that provide effective risk management and fraud prevention solutions. Through our underwriting processes, we evaluate merchant applicants and balance the risks of accepting a merchant against the benefit of the charge volume we anticipate such merchant will generate. We believe our systems and procedures enable us to identify potentially fraudulent activity and other questionable business practices quickly, thereby minimizing our losses and those of our merchants.

Strategy

     Our goal is to build upon our market position as a provider of card-based payment processing services to small businesses. Key elements of our strategy include:

	•	Expand in Existing Small Merchant Market. We believe we have an opportunity to grow our business by further penetrating the small merchant market through our relationships with our independent sales groups and agent banks. We intend to focus our efforts on merchants that are newly-established or whose businesses involve card-not-present transactions. We also intend to target industries that have not historically accepted electronic payment methods.
	•	Enhance Relationships with Existing Sales Groups and Establish Relationships with New Independent Sales Groups. Through our superior customer service and our support of the marketing efforts of the more than 750 independent sales groups and various agent banks with which we have an existing relationship, we seek to increase the volume of merchant referrals from our independent sales groups, including groups affiliated with the providers of payment processing services that we acquire. We believe that our experience in this industry, coupled with our ability to evaluate and manage the risks related to providing payment processing services, allow us to accept a high rate of merchant applications and position us well to continue to increase the number of independent sales group relationships we maintain and the number of new applications our existing independent sales groups refer to us.
	•	Maintain a Stable and Recurring Revenue Base. By providing our merchants with a consistently high level of service and support, we strive to build merchant loyalty and limit merchant attrition. Through merchant retention and the benefit of increased card use, we strive to maintain our stable and recurring revenue base. In addition, we believe the low transaction volume of our individual merchants makes them less likely to change providers due to the inconvenience associated with transferring to another provider. By limiting merchant attrition, we believe that the increasing use of card-based payment systems will allow us to maintain a stable and recurring revenue base.
	•	Continue to Pursue Strategic Acquisitions. We intend to continue to expand our merchant base by acquiring other providers of payment processing services as well as portfolios of merchant accounts. The small merchant segment of the payment processing market is serviced by many independent providers of payment processing services that lack the resources to generate sufficient scale in this underserved market. We believe opportunities will exist for us to purchase these businesses when their resources begin to limit their ability to continue to grow independently. Other sources of portfolio acquisitions include commercial banks, which, in an effort to focus on their core competencies often sell or outsource their card-based payment processing operations, creating the opportunity for buyers to acquire their existing merchant portfolios.

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Services

     We provide a comprehensive solution for merchants accepting credit cards, including the various services described below:

	•	Application Evaluation Underwriting. We recognize that there are varying degrees of risk associated with different merchants based on the nature of their businesses, processing volume and average transaction amounts. We apply varying levels of scrutiny in our application evaluation and underwriting of prospective merchants accounts, ranging from basic due diligence for merchants with a low risk profile to a more thorough and detailed review for higher risk merchants. The results of this review serve as the basis for our decision whether to accept or reject a merchant account and also provide the criteria for establishing reserve requirements, processing limits, average transaction amounts and pricing, which assist us in monitoring merchant transactions for those accounts that exceed pre-determined criteria.
	•	Merchant Set-up and Training. After we establish a contract with a merchant, we create the software configuration that is downloaded to the merchant’s credit card terminal or computer. This configuration includes the merchant identification number, which allows the merchant to accept Visa and MasterCard as well as any other payment cards such as American Express, Discover and Diners Club provided for in the contract. The configuration might also accommodate check verification and gift and loyalty programs. If a merchant requires a pin-pad to accept debit cards, the configuration allows for the terminal or computer to communicate with the peripheral device. After the download has been completed, we conduct a training session on use of the products.
	•	Transaction Processing. A transaction begins with authorization of the customer’s credit or debit card. The transaction data is captured by the processor and electronically transmitted to the issuer of the card, which then determines availability of credit or debit funds. The issuer then communicates an approval decision back to the merchant through the processor. This process typically takes less than five seconds. After the transaction is completed, the processor transmits the final transaction data to the card issuer for settlement of funds. Generally, we outsource these services to third party processors.
	•	Risk Management/Detection of Fraudulent Transactions. Our risk management staff relies on the criteria set by the underwriting department to assist merchants in identifying and avoiding fraudulent transactions by monitoring exceptions and providing access to other resources for fraud detection. By employing these and other risk management procedures, we enable our merchants to balance the risk of fraud against the loss of a valid transaction.
	•	Merchant Service and Support. We provide merchants with ongoing service and support. Customer service and support includes answering billing questions, responding to requests for supplies, resolving failed payment transactions, troubleshooting and repair of equipment, educating merchants on Visa and MasterCard compliance, and assisting merchants with pricing changes and purchases of additional products and services. We maintain a toll-free help-line, which is staffed by our customer service representatives. The information access and retrieval capabilities of our proprietary decision support systems provide our customer service representatives prompt access to merchant account information and customer call history. This data allows them to quickly respond to inquiries relating to fees, charges and funding of accounts as well as technical issues.
	•	Chargeback Service. In the event of a billing dispute between a cardholder and a merchant, we assist the merchant in investigating and resolving the dispute as quickly and as accurately as possible. Before instructing the cardholder’s bank to debit the merchant’s account for the chargeback, we provide the merchant with the opportunity to demonstrate that the transaction was valid. If the merchant is unable to demonstrate that the transaction was valid and the dispute is resolved in favor of the cardholder, the transaction is charged back to the merchant, and that amount is credited to the cardholder. For the year ended December 31, 2004, chargebacks as a percentage of our total charge volume was 0.20%.
	•	Merchant Reporting. We organize our merchants’ transaction data into various files for merchant accounting purposes. We use this data to provide merchants with information, such as charge volume, discounts, fees and funds held for reserves to help them track their account activity. Merchants may access this archived information through our customer service representatives or online through our Internet-based customer service system.

The transactions for which we provide processing services involve the following third parties:

	•	Merchants. Merchants are the businesses that accept payment cards, including Visa and MasterCard, as payment for their merchandise and services.
	•	Sponsoring Banks. Sponsoring banks are financial institutions that are Visa and MasterCard association members and provide the funds on behalf of the card user, enabling merchants to accept payment cards.

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•

Processors. Processors, which may include banks, gather sales information from merchants, obtain authorization for merchants’ transactions from card issuers, facilitate the collection of funds from sponsoring banks for payment to merchants and provide merchant accounting and settlement services on our behalf.

     The following diagram illustrates the relationship between a merchant, a processor, a sponsoring bank and us:

     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. The percentage we charge varies upon several factors, including the transaction amount, as well as whether the transaction process is a swipe transaction or a non-swipe transaction. On average, the gross revenue we generate from processing transactions equals approximately $2.50 for every $100 transaction we process, excluding costs and expenses. The following diagram illustrates the percentage of a typical transaction amount paid to the processing bank, the Visa and MasterCard card associations and us:

An Example of A Typical $100 Transaction

Distribution of $2.50 Revenue

     Visa and MasterCard credit card transactions represent substantially all of the total card transaction volume generated by all of our merchant accounts.

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Marketing and Sales

     We market and sell our services to merchants primarily through our network of independent sales groups throughout the United States. As of January 1, 2005, we marketed and sold our services through over 750 independent sales groups, a non-employee, external sales force representing more than 2,600 sales professionals with which we have contractual relationships. These relationships are mutually non-exclusive, permitting us to establish relationships with multiple independent sales groups and permitting our groups to enter into relationships with other providers of payment processing services. We believe that this sales approach provides us with access to an experienced sales force to market our services with limited investment in sales infrastructure and management time. We believe our focus on the unique needs of small merchants allows us to develop compelling offerings for our independent sales groups to bring to prospective merchants and provides us with a competitive advantage in our target market. Among the services and capabilities we provide are rapid application response time, merchant application acceptance by fax or on-line submission, superior customer service and merchant reporting. Our industry expertise and daily monitoring activities enable us to accept higher risk merchants with relatively low losses. We keep an open dialogue with our independent sales groups to address their concerns as quickly as possible and to work with them in investigating chargebacks or potentially suspicious activity with the aim of ensuring their merchants do not unduly suffer downtime or the unnecessary withholding of funds.

     As compensation for their referral of merchant accounts, we pay our independent sales groups an agreed-upon residual, or percentage of the revenues we derive from the transactions we process from the merchants they refer to us. The amount of the residuals we pay to our independent sales groups varies on a case-by-case basis and depends on several factors, including the number of merchants each group refers to us. We provide additional incentives to our independent sales groups, including, from time to time, loans that are secured by and repayable from future compensation that may be earned by the groups in respect of the merchants they have referred to us. As of December 31, 2004, we had outstanding loans to independent sales groups in the aggregate amount of $2.2 million, and we may decide to loan additional amounts in the future. We have set a limit of $15 million on the amount of loans we may make to independent sales groups in accordance with the terms of our credit facility. The notes representing these loans bear interest in amounts ranging from 6% to 8.75% and are due through 2008. We secure the loans by the independent sales groups’ assets, including the rights they have to receive residuals and the fees generated by the merchants they refer to us and any other accounts receivable and typically by obtaining personal guarantees from the individuals who operate the independent sales groups. As of December 31, 2004, we had issued options to purchase 210,714 shares of our common stock to our independent sales groups, of which, 86,045 (or 0.5% of our common stock on a fully diluted basis), were still outstanding. In addition, we offer the independent sales groups more rapid and consistent review and acceptance of merchant applications than may be available from other service providers.

Relationships with Sponsors and Processors

     In order to provide payment processing services for Visa and MasterCard transactions, we must be sponsored by a financial institution that is a principal member of the Visa and MasterCard card associations. Additionally, we must be registered with Visa as an independent sales group and with MasterCard as a member service provider.

     Sponsoring Banks. We have agreements with several banks that sponsor us for membership in the Visa and MasterCard card associations and settle card transactions for our merchants. Our sponsoring banks include JPMorgan Chase Bank, HSBC Bank USA, Bank of America and Provident Bank. These sponsoring banks may terminate their agreements with us if we materially breach the agreements and do not cure the breach within an established cure period, if our membership with Visa or MasterCard terminates, if we enter bankruptcy or file for bankruptcy, or if applicable laws or regulations, including Visa and MasterCard regulations, change to prevent either the applicable bank or us from performing its services under the agreement. From time to time, we may enter into agreements with additional banks.

     Our agreement with JPMorgan Chase, which is our principal sponsor bank, grants Chase the right to approve our solicitation, application and qualification procedures for merchants, the terms of our agreements with merchants (including the processing fees that we charge), our customer service levels and our use of any independent sales groups. In addition, we have agreed with Chase not to solicit any merchants that currently process through Chase or any merchants that belong to industries that are considered unacceptable due, in part, to image concerns, card association rules, legitimacy and level of risk. In the event that we request to transfer any of our interest in the merchant portfolio that we have migrated to Chase, we are required to pay to Chase $1.5 million if the transfer occurs during 2005 and $750,000 if it occurs during 2006.

     Processors. We have agreements with several processors to provide to us on a non-exclusive basis transaction processing and transmittal, transaction authorization and data capture, and access to various reporting tools. Our primary processor is FDMS through which we have undertaken to process 75% of our annual transactions. For a summary of the key terms of our agreement with FDMS, see “Significant Developments” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” We also use the services of Vital Processing Services, LLC, Global Payments Direct, Inc. and CardSystems Solutions, Inc., and certain of our agreements with these processors include minimum commitments for transaction processing. If we submit a number of transactions that is lower than the minimum, we are required to pay to the processor the fees that

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it would have received if we had submitted the required minimum number of transactions. The First Data Merchant Services Corporation, Vital Processing Services and Global Payments Direct agreements may be terminated by the processors if we materially breach certain sections of the agreements and we do not cure the breach within 30 days, if our membership with Visa or MasterCard terminates, if we enter bankruptcy or file for bankruptcy, or if applicable laws or regulations, including Visa and MasterCard regulations, change to prevent either the applicable processor or us from performing its services under this agreement. In addition, Global Payments Direct may terminate upon 60 days notice prior to the end of the current term.

Our Merchant Base

     We serve a diverse portfolio of small merchants. As of January 1, 2005, we provided processing services to over 125,000 active small merchants located across the United States and engaged in a wide variety of businesses. We define a merchant as “active” if the merchant processes at least one Visa or MasterCard transaction in a given month. We also have agreements with approximately 46,000 non-active merchants who pay us monthly access fees, but do not generate sufficient transaction volume to be considered active.

Primary Merchant Categories Based on Our Charge Volume

     No single merchant accounted for more than 2% of our aggregate transaction volume for 2004. We believe that this merchant diversification makes us less sensitive to shifting economic conditions in the industries or regions in which our merchants operate. We believe that the loss of any single merchant would not have a material adverse effect on our financial condition or results of operations.

     Generally, our agreements with merchants are for one or two years and automatically renew for additional one year periods unless otherwise terminated. Our sponsoring banks are also a party to these agreements. The merchants are obligated to pay for all chargebacks, fines, assessments, and fees associated with their merchant account, and in some cases, annual fees and early termination fees. Generally, the sponsoring bank may terminate the agreement for any reason on 30 days notice, and the merchant may terminate the agreement on 30 days notice, subject to the payment of any applicable early termination fees. Typically, the agreement may also be terminated by the sponsoring bank immediately upon a breach by the merchant of any of its terms. Generally, the agreement may not be assigned by the merchant without the prior written consent of the sponsoring bank.

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     Merchant attrition is expected in the payment processing industry in the ordinary course of business; however, we believe the low average transaction volume of the merchants whose accounts we service make them less likely to change providers because of the inconveniences associated with a transfer. During 2004, we experienced an average monthly attrition of approximately 1.0% to 1.5% of our total charge volume, taking into consideration each of the acquisitions during this period. Much of our attrition is related to newly formed small businesses that ultimately fail. Because the transaction volumes of these unsuccessful businesses typically never reach meaningful levels, they do not significantly contribute to the profitability of our business. Accordingly, our merchant attrition related to failed businesses does not significantly reduce our revenues.

     We believe that we have extensive experience and resources in assessing the risks associated with providing payment processing services to small merchants. These risks include the limited operating history that many of the small merchants we serve have and the risk that these merchants could be subject to a higher rate of insolvency which could adversely affect us financially. In addition, because a larger portion of their sales are card-not-present transactions in relation to transactions of larger merchants, small merchants are more vulnerable to customer fraud.

Risk Management

     As a result of our exposure to potential liability for merchant fraud, chargebacks, and other losses created by our merchant services business, we view our risk management and fraud avoidance practices as integral to our operations and overall success.

     We currently have a staff of approximately 38 employees dedicated to risk management operations, which encompasses underwriting new accounts, monitoring and investigating merchant account activity for suspicious transactions or trends and avoiding or recovering losses. Effective risk management helps us minimize merchant losses for the mutual benefit of our merchant customers and ourselves. Our risk management procedures also help protect us from fraud perpetrated by our merchants. We believe our knowledge and experience in dealing with attempted fraud, established as a result of our management’s extensive experience with higher risk market segments, has resulted in our development and implementation of highly effective risk management and fraud prevention systems and procedures.

     We employ the following systems and procedures to minimize our exposure to merchant fraud and card-not-present transaction fraud:

	•	Underwriting. Our sales agents send new applications to our underwriting department for their review and screening. All of our underwriters have previous industry underwriting experience and have the authority to render judgment on new applications or to take additional actions such as adjusting processing limits, average charge per transaction or reserve requirements for new and existing merchants. We obtain a personal guaranty from most of the owners of new merchants we enroll.
	•	Proprietary Management Information Systems. Our proprietary systems automatically generate credit reports on new applicants, categorize risk based on all of the information provided and place the applications in a queue to be processed by our underwriting staff. The underwriting staff can access all of the collected information on a merchant online in order to render a decision on whether to approve or reject an application or whether to seek additional information.
	•	Merchant Monitoring. We provide several levels of merchant account monitoring to help us identify suspicious transactions and trends. Daily merchant activity is downloaded to our Bankcard Application Manager system from our third-party processors such as First Data Merchant Services Corporation and is sorted into a number of customized reports by our proprietary systems. Our risk management team also receives daily reports from Card Commerce International, a risk management services company, that highlight all exceptions to the established daily merchant parameters such as average ticket size, total processing volume or expected merchandise returns.
	•	Risk Review Department. We have established an in-house risk review department that monitors the sales activities of all of the merchants that we service. Our risk review department focuses particular attention on fewer than 2,000 merchants in our portfolio, measured by volume, average ticket and other criteria, which accounted for approximately 2% of our total charge volume for December 31, 2004. The risk review department conducts background checks on these merchants, interviews merchants, anonymously purchases products and services, reviews sales records and follows developments in risk management procedures and technology. The risk review department reports to the risk committee, consisting of our President, Chief Executive Officer and Chief Financial Officer.

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	•	Investigation and Loss Prevention. If a merchant exceeds any approved parameter as established by our underwriting and/or risk management staff or violates regulations established by the applicable card association or the terms of our agreement with the merchant, an investigator will identify the incident and take appropriate action to reduce our exposure to loss, as well as the exposure of our merchants. This action may include requesting additional transaction information, instructing the merchant acquirer/processor to retrieve, withhold or divert funds, verifying delivery of merchandise or even deactivating the merchant account.
	•	Reserves. We require some of our merchants to post reserves (cash deposits) that we use to offset against chargebacks we incur. Our sponsoring banks hold reserves related to our merchant accounts as long as we are exposed to loss resulting from a merchant’s processing activity. In the event that a small company finds it difficult to post a cash reserve upon opening an account with us, we may build the reserve by retaining a percentage of each transaction the merchant performs. This solution permits the merchant to fund our reserve requirements gradually as its business develops. As of December 31, 2004, these reserves (which are not included in our accompanying consolidated balance sheet) totaled approximately $35.3 million.

Technology

     In the course of our operations, we solicit, compile and maintain a large database of information relating to our merchants and their transactions in our proprietary BAM database. We place significant emphasis on providing a high level of security in order to protect the information of our merchants and their customers. We have engaged a network service provider to help us meet our security goals by providing us with equipment and support services for our critical network components. These components include T1 data communication lines, firewalls and a virtual private network. Our network service provider also provides sophisticated security analysis and monitoring 24 hours a day. We also continually update our proprietary BAM database.

     Our internal network configuration provides multiple layers of security to isolate our databases from unauthorized access and implements detailed security rules to limit access to all critical systems. We cannot assure you that these security measures will be sufficient to prevent unauthorized access to our internal network. Application components communicate using sophisticated security protocols and are directly accessible by a limited number of employees on a need-only basis. Our operation and customer support systems are located at our facilities in Calabasas and Santa Barbara, California; Westchester, Illinois and Bridgeville, Pennsylvania.

     We also rely on connections to the systems of our third party processing providers. In all cases, we install communications circuits with backup connectivity to withstand telecommunications problems.

Competition

     The payment processing industry is highly competitive. We compete with other providers of payment processing services on the basis of the following factors:

	•	quality of service;
	•	reliability of service;
	•	ability to evaluate, undertake and manage risk;
	•	speed in approving merchant applications; and
	•	price.

     Many small and large companies compete with us in providing payment processing services and related services for card-not-present and card-present transactions to a wide range of merchants. There are a number of large transaction processors, including First Data Merchant Services Corporation, National Processing, Inc. (a subsidiary of Bank of America), Global Payments, Inc. and NOVA Information Systems, Inc. (a subsidiary of U.S. Bancorp), that serve a broad market spectrum from large to small merchants and provide banking, ATM and other payment-related services and systems in addition to card-based payment processing. There are also a large number of smaller transaction processors that provide various services to small and medium sized merchants. Many of our competitors have substantially greater capital resources than we have and operate as subsidiaries of financial institutions or bank holding companies, which may allow them on a consolidated basis to own and conduct depository and other banking activities that we do not have the regulatory authority to own or conduct. We believe that our specific focus on smaller merchants, in addition to our understanding of the needs and risks associated with providing payment processing services to small merchants and smaller independent sales groups, gives us a competitive advantage over larger competitors, which have a broader market perspective and over competitors of a similar or smaller size that may lack our extensive experience and resources.

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Segment Information and Geographical Information

     We consider our business activities to be in a single reporting segment as we derive greater than 90% of our revenue and results of operations from one business segment representing processing revenues and other fees from card-based payments. During 2004, 2003 and 2002, we had no single merchant that represented 2.0% or more of revenues. All revenues are generated and all of our long-lived assets are located in the United States. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of the impact of seasonality on our business.

Significant Developments

     In December 2004, we entered into an Asset Purchase Agreement with First Data Merchant Services Corporation (“FDMS”), a subsidiary of First Data Corporation pursuant to which we acquired a portfolio of merchant contracts (the “FDMS Merchant Portfolio”) from FDMS for a price of $130.0 million in cash. We expanded our credit facility from $80.0 million to $180.0 million to finance the purchase. The portfolio has over 25,000 small merchant accounts representing approximately $9 to $10 billion in annual bankcard volume. The transaction also strengthens our existing strategic relationship with First Data’s merchant services unit. During February 2005, we expanded our revolving credit facility to $205.0 million and is further expandable to $280.0 million.

     In December 2003, we entered into an Asset Purchase Agreement with FDMS, pursuant to which we acquired a portfolio of merchant accounts and agent bank agreements (the “FDMS Agent Bank Portfolio”) from First Data for a price of $55.0 million in cash. We expanded our credit facility from $30.0 million to $65.0 million to finance the purchase. The portfolio has approximately 18,000 small merchant accounts representing approximately $4 billion in annual bankcard volume.

     Pursuant to these asset purchase agreements, we also entered into service agreements (the “Service Agreements”) with FDMS pursuant to which FDMS agreed to perform certain data processing and related services with respect to the merchant contracts acquired through 2011. In consideration for entering into the Service Agreements, we are required to pay FDMS an annual processing fee related to the acquired merchant contracts of at least $13.7 million in 2005, and for subsequent years at least 70% of the amount of the actual processing fees paid during the immediately preceding year. We are also required to pay FDMS certain additional amounts in accordance with the terms of the Service Agreement, including certain special fees for amounts paid to third-party providers. We also have agreed to utilize FDMS to process at least 75% of our consolidated transaction sales volume in any calendar year for the term of the Service Agreement and we are required to pay to FDMS an amount representing the fees that it would have received if we had submitted the required minimum number of transactions. We do not currently expect that we will be required to pay such a fee based on our present business plan.

Our History

     iPayment Technologies, Inc., was formed in 1992 as a California corporation. In July 2000, iPayment Technologies purchased assets from two former affiliates in exchange for the assumption of debt, cash, a note and the issuance of shares of common stock of iPayment Technologies. In December 2000, iPayment Technologies implemented a restructuring plan, which resulted in a reduction in overhead costs and personnel. In February 2001, Greg Daily joined iPayment Technologies as its CEO and Chairman of the Board.

     In February 2001, we were formed by the majority stockholders of iPayment Technologies, as a Tennessee corporation, under the name iPayment Holdings, Inc. as a holding company for iPayment Technologies and other card processing businesses. We then appointed Gregory S. Daily as our Chief Executive Officer and Chairman of the Board. In April 2001, we acquired a 94.63% interest in iPayment Technologies, and in July 2002, we acquired the remaining outstanding shares of iPayment Technologies, which then became our wholly owned subsidiary, in each case by issuing our shares to iPayment Technologies stockholders in exchange for iPayment Technologies shares.

     In August 2002, we were reincorporated in Delaware under the name iPayment, Inc. and in May 2003 we completed an initial public offering of 5,625,000 shares of common stock raising net proceeds of approximately $75.6 million. We are listed on the Nasdaq National Market.

     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 $75.6 million (after underwriters’ discount of $6.3 million and related offering expenses of $8.1 million). As described in Note 8 of the consolidated financial statements, 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 noncash 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 audited consolidated financial statements of iPayment, Inc. have been adjusted to

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reflect this reverse split.

Employees

     As of December 31, 2004, we employed 310 full-time personnel, including 15 information systems and technology employees, 38 risk management employees, 183 in operations and 74 in sales and administration. Many of our employees are highly skilled, and we believe our future success will depend in large part on our ability to attract and retain such employees. We have employment agreements with our President, our Chief Executive Officer and our Chief Financial Officer. None of our employees are represented by a labor union, and we have experienced no work stoppages. We consider our employee relations to be good.

Available Information

     Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are available free of charge on our website at www.ipaymentinc.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

Risks Relating to our Business

The full impact of our recent acquisitions on our operating results is not fully reflected in our historical financial results, which as a result, are not necessarily indicative of our future results of operations.

     Since January 2003, we have expanded our card-based payment processing services through the acquisition of two businesses, two significant portfolios and several smaller portfolios of merchant accounts. These acquisitions have contributed to a substantial portion of our total revenues. The full impact of these acquisitions on our operating results are not fully reflected in our historical results of operations due to the recent nature of these acquisitions and their varying stages of integration. As a result of these acquisitions, our historical results may not be indicative of results to be expected in future periods.

We have faced, and may in the future face, significant chargeback liability if our merchants refuse or cannot reimburse chargebacks resolved in favor of their customers, and we face potential liability for merchant or customer fraud; we may not accurately anticipate these liabilities.

     We have potential liability for chargebacks associated with the transactions we process. If a billing dispute between a merchant and a cardholder is not ultimately resolved in favor of the merchant, the disputed transaction is ''charged back’’ to the merchant’s bank and credited to the account of the cardholder. If we or our processing banks are unable to collect the chargeback from the merchant’s account, or if the merchant refuses or is financially unable, due to bankruptcy or other reasons, to reimburse the merchant’s bank for the chargeback, we bear the loss for the amount of the refund paid to the cardholder’s bank. For example, our largest chargeback loss resulted from the substantial non-compliance by a merchant with the Visa and MasterCard card association rules. We were obligated to pay the resulting chargebacks and losses that the merchant was unable to fund, which totaled $4.7 million. Please see ''Risk Factors — Risks Relating to Acquisitions’’ for more information.

     We also have potential liability for losses caused by fraudulent credit card transactions. Card fraud occurs when a merchant’s customer uses a stolen card (or a stolen card number in a card-not-present transaction) to purchase merchandise or services. In a traditional card-present transaction, if the merchant swipes the card, receives authorization for the transaction from the card issuing bank and verifies the signature on the back of the card against the paper receipt signed by the customer, the card issuing bank remains liable for any loss. In a fraudulent card-not-present transaction, even if the merchant receives authorization for the transaction, the merchant is liable for any loss arising from the transaction. Many of the small merchants that we serve are small businesses that transact a substantial percentage of their sales over the Internet or in response to telephone or mail orders. Because their sales are card-not-present transactions, these merchants are more vulnerable to customer fraud than larger merchants. Because we target these merchants, we experience chargebacks arising from cardholder fraud more frequently than providers of payment processing services that service larger merchants.

     Merchant fraud occurs when a merchant, rather than a customer, knowingly uses a stolen or counterfeit card or card number to record a false sales transaction, or intentionally fails to deliver the merchandise or services sold in an otherwise valid transaction. Anytime a merchant is unable to satisfy a chargeback, we are responsible for that chargeback. We have established systems and procedures to detect and reduce the impact of merchant fraud, but we cannot assure you that these measures are or will be effective. It is possible that incidents of fraud could increase in the future. Failure to effectively manage risk and prevent fraud could increase our chargeback liability. Please see ''Business — Risk Management’’ for a discussion of our procedures for detecting merchant fraud.

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     Charges incurred by us relating to chargebacks were $3.9 million, or 1.1% of revenues in 2004, $3.7 million (which excludes the $1.3 million reduction in an earlier estimate for merchant losses from a single merchant to reflect lower actual losses), or 1.6% of revenues in 2003, and $6.5 million, or 5.6% of revenues in 2002.

We have incurred substantial debt, which can impair our financial and operating flexibility.

     We have incurred debt in connection with the financing of our operations and acquisitions. As of December 31, 2004, we had total debt of $168.4 million, and net working capital of approximately $10.9 million. We may incur additional debt in the future in order to pursue our acquisition strategy or for other purposes. Substantial indebtedness could impair our ability to obtain additional financing for working capital, capital expenditures or further acquisitions. Covenants governing any indebtedness we incur would likely restrict our ability to take specific actions, including our ability to pay dividends or distributions on, or redeem or repurchase, our capital stock, issue, sell or allow distributions on capital stock of our subsidiaries, enter into transactions with affiliates, merge, consolidate or sell our assets or make capital expenditure investments. In addition, the use of a substantial portion of the cash generated by our operations to cover debt service obligations and any security interests we grant on our assets could limit our financial and business flexibility.

We rely on bank sponsors, which have substantial discretion with respect to certain elements of our business practices, in order to process bankcard transactions; if these sponsorships are terminated and we are not able to secure or successfully migrate merchant portfolios to new bank sponsors, we will not be able to conduct our business.

     Because we are not a bank, we are unable to belong to and directly access the Visa and MasterCard bankcard associations. Visa and MasterCard operating regulations require us to be sponsored by a bank in order to process bankcard transactions. We are currently registered with Visa and MasterCard through the sponsorship of banks that are members of the card associations. If these sponsorships are terminated and we are unable to secure a bank sponsor, we will not be able to process bankcard transactions. Furthermore, our agreements with our sponsoring banks give the sponsoring banks substantial discretion in approving certain elements of our business practices, including our solicitation, application and qualification procedures for merchants, the terms of our agreements with merchants, the processing fees that we charge, our customer service levels and our use of independent sales groups. We cannot guarantee that our sponsoring banks’ actions under these agreements will not be detrimental to us, nor can we guarantee that any of our sponsor banks will not terminate their sponsorship of us in the future.

If we or our bank sponsors fail to adhere to the standards of the Visa and MasterCard credit card associations, our registrations with these associations could be terminated and we could be required to stop providing payment processing services for Visa and MasterCard.

     Substantially all of the transactions we process involve Visa or MasterCard. If we or our bank sponsors fail to comply with the applicable requirements of the Visa and MasterCard credit card associations, Visa or MasterCard could suspend or terminate our registration. The termination of our registration or any changes in the Visa or MasterCard rules that would impair our registration could require us to stop providing payment processing services.

We rely on card payment processors and service providers; if they fail or no longer agree to provide their services, our merchant relationships could be adversely affected and we could lose business.

     We rely on agreements with several large payment processing organizations to enable us to provide card authorization, data capture, settlement and merchant accounting services and access to various reporting tools for the merchants we serve. In particular, we rely on FDMS through which we have undertaken to process 75% of our annual transactions. We have also undertaken to pay FDMS an annual processing fee of at least $13.7 million in 2005 and at least 70% of the processing fee paid during the immediately proceeding year for each subsequent year through 2011. Our gross margins would be adversely affected if we were required to pay these minimum fees as a result of insufficient transactions processed by FDMS.

     We also rely on third parties to whom we outsource specific services, such as reorganizing and accumulating daily transaction data on a merchant-by-merchant and card issuer-by-card issuer basis and forwarding the accumulated data to the relevant bankcard associations. Many of these organizations and service providers are our competitors and we do not have long-term contracts with most of them. Typically, our contracts with these third parties are for one-year terms and are subject to cancellation upon limited notice by either party. The termination by our service providers of their arrangements with us or their failure to perform their services efficiently and effectively may adversely affect our relationships with the merchants whose accounts we serve and may cause those merchants to terminate their processing agreements with us.

To acquire and retain merchant accounts, we depend on independent sales groups that do not serve us exclusively.

     We rely primarily on the efforts of independent sales groups to market our services to merchants seeking to establish an account with a payment processor. Independent sales groups are companies that seek to introduce both newly-established and existing small

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merchants, including retailers, restaurants and service providers, such as physicians, to providers of transaction payment processing services like us. Generally, our agreements with independent sales groups that refer merchants to us are not exclusive to us and they have the right to refer merchants to other service providers. Our failure to maintain our relationships with our existing independent sales groups and those serving other service providers that we may acquire, and to recruit and establish new relationships with other groups, could adversely affect our revenues and internal growth and increase our merchant attrition. Please see ''Business — Marketing and Sales’’ for a description of our independent sales group relationships.

On occasion, we experience increases in interchange costs; if we cannot pass these increases along to our merchants, our profit margins will be reduced.

     We pay interchange fees or assessments to card associations for each transaction we process using their credit and debit cards. From time to time, the card associations increase the interchange fees that they charge processors and the sponsoring banks. At their sole discretion, our sponsoring banks have the right to pass any increases in interchange fees on to us. In addition, our sponsoring banks may seek to increase their Visa and MasterCard sponsorship fees to us, all of which are based upon the dollar amount of the payment transactions we process. If we are not able to pass these fee increases along to merchants through corresponding increases in our processing fees, our profit margins will be reduced.

The loss of key personnel or damage to their reputations could adversely affect our relationships with independent sales groups, card associations, bank sponsors and our other service providers, which would adversely affect our business.

     Our success depends upon the continued services of our senior management and other key employees, in particular Gregory S. Daily, our Chairman and Chief Executive Officer, all of whom have substantial experience in the payment processing industry and the small merchant markets in which we offer our services. In addition, our success depends in large part upon the reputation and influence within the industry of Mr. Daily, who has, along with our other senior managers, over their years in the industry, developed long standing and highly favorable relationships with independent sales groups, card associations, bank sponsors and other payment processing and service providers. We would expect that the loss of the services of one or more of our key employees, particularly Mr. Daily, would have an adverse effect on our operations. We would also expect that any damage to the reputation of our senior managers, including Mr. Daily, would adversely affect our business. We do not maintain any ''key person’’ life insurance on any of our employees other than Mr. Daily.

The payment processing industry is highly competitive and such competition is likely to increase, which may further adversely influence our prices to merchants, and as a result, our profit margins.

     The market for card processing services is highly competitive. The level of competition has increased in recent years, and other providers of processing services have established a sizable market share in the small merchant processing sector. Some of our competitors are financial institutions, subsidiaries of financial institutions or well-established payment processing companies that have substantially greater capital and technological, management and marketing resources than we have. There are also a large number of small providers of processing services that provide various ranges of services to small and medium sized merchants. This competition may influence the prices we can charge and requires us to control costs aggressively in order to maintain acceptable profit margins. In addition, our competitors continue to consolidate as large banks merge and combine their networks. This consolidation may also require that we increase the consideration we pay for future acquisitions and could adversely affect the number of attractive acquisition opportunities presented to us.

Increased attrition in merchant charge volume due to an increase in closed merchant accounts that we cannot anticipate or offset with new accounts may reduce our revenues.

     We experience attrition in merchant charge volume in the ordinary course of business resulting from several factors, including business closures, transfers of merchants’ accounts to our competitors and account ''closures’’ that we initiate due to heightened credit risks relating to, and contract breaches by, a merchant. During 2004, we experienced average volume attrition of 1% to 1.5% per month. In addition, substantially all of our processing contracts with merchants may be terminated by either party on relatively short notice, allowing merchants to move their processing accounts to other providers with minimal financial liability and cost. Increased attrition in merchant charge volume may have a material adverse effect on our financial condition and results of operations. We cannot predict the level of attrition in the future, particularly in connection with our acquisitions of portfolios of merchant accounts. If we are unable to increase our transaction volume and establish accounts with new merchants in order to counter the effect of this attrition, or, if we experience a higher level of attrition in merchant charge volume than we anticipate, our revenues will decrease.

Our operating results are subject to seasonality, and if our revenues are below our seasonal norms during our historically stronger third and fourth quarters, our net income could be lower than expected.

     We have experienced in the past, and expect to continue to experience, seasonal fluctuations in our revenues as a result of consumer spending patterns. Historically, revenues have been weaker during the first quarter of the calendar year and stronger during

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the second, third and fourth quarters. If, for any reason, our revenues are below seasonal norms during the second, third or fourth quarter, our net income could be lower than expected.

Our systems may fail due to factors beyond our control, which could interrupt our business or cause us to lose business and would likely increase our costs.

     We depend on the efficient and uninterrupted operations of our computer network systems, software and data centers. We do not presently have fully redundant systems. Our systems and operations could be exposed to damage or interruption from fire, natural disaster, power loss, telecommunications failure, unauthorized entry and computer viruses. Our property and business interruption insurance may not be adequate to compensate us for all losses or failures that may occur. Defects in our systems, errors or delays in the processing of payment transactions or other difficulties could result in:

	•	additional development costs;
	•	diversion of technical and other resources;
	•	loss of merchants;
	•	loss of merchant and cardholder data;
	•	negative publicity;
	•	harm to our business or reputation; or
	•	exposure to fraud losses or other liabilities.

We face uncertainty about additional financing for our future capital needs, which may prevent us from growing our business.

     If we are unable to increase our revenues, we will need to raise additional funds to finance our future capital needs. We may need additional financing earlier than we anticipate if we:

	•	decide to expand faster than planned;
	•	need to respond to competitive pressures; or
	•	need to acquire complementary products, businesses or technologies.

     If we raise additional funds through the sale of equity or convertible debt securities, these transactions may dilute the value of our outstanding common stock. We may also decide to issue securities, including debt securities, that have rights, preferences and privileges senior to our common stock. We cannot assure you that we will be able to raise additional funds on terms favorable to us or at all. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs. This may prevent us from increasing our market share, capitalizing on new business opportunities or remaining competitive in our industry.

We currently rely solely on common law to protect certain of our intellectual property; should we seek additional protection in the future, we may fail to successfully register certain trademarks, causing us to potentially lose our rights to use such trademarks.

     Currently, we rely on common law rights to protect certain of our marks and logos. We do not rely heavily on the recognition of our marks to obtain and maintain business. We have recently been granted trademarks for certain of our marks, but these trademarks may be successfully challenged by others or invalidated.

If our merchants experience adverse business conditions, they may generate fewer transactions for us to process or become insolvent, increasing our exposure to chargeback liabilities.

     General economic conditions have caused some of the merchants we serve to experience difficulty in supporting their current operations and implementing their business plans. If these merchants make fewer sales of their products and services, we will have fewer transactions to process, resulting in lower revenues. In addition, in a recessionary environment, the merchants we serve could be subject to a higher rate of insolvency which could adversely affect us financially. We bear credit risk for chargebacks related to billing disputes between credit card holders and bankrupt merchants. If a merchant seeks relief under bankruptcy laws or is otherwise unable or unwilling to pay, we may be liable for the full transaction amount of a chargeback.

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New and potential governmental regulations designed to protect or limit access to consumer information could adversely affect our ability to provide the services we provide our merchants.

     Due to the increasing public concern over consumer privacy rights, governmental bodies in the United States and abroad have adopted, and are considering adopting additional laws and regulations restricting the purchase, sale and sharing of personal information about customers. For example, the Gramm-Leach-Bliley Act requires non-affiliated third party service providers to financial institutions to take certain steps to ensure the privacy and security of consumer financial information. We believe our present activities fall under exceptions to the consumer notice and opt-out requirements contained in this law for third party service providers to financial institutions. The law, however, is new and there have been very few rulings on its interpretation. We believe that current legislation permits us to access and use this information as we do now. The laws governing privacy generally remain unsettled, however, even in areas where there has been some legislative action, such as the Gramm-Leach-Bliley Act and other consumer statutes, it is difficult to determine whether and how existing and proposed privacy laws will apply to our business. Limitations on our ability to access and use customer information could adversely affect our ability to provide the services we offer to our merchants or could impair the value of these services.

     Several states have proposed legislation that would limit the uses of personal information gathered using the Internet. Some proposals would require proprietary online service providers and website owners to establish privacy policies. Congress has also considered privacy legislation that could further regulate use of consumer information obtained over the Internet or in other ways. The Federal Trade Commission has also recently settled a proceeding with one on-line service regarding the manner in which personal information is collected from users and provided to third parties. Our compliance with these privacy laws and related regulations could materially affect our operations.

		Changes to existing laws or the passage of new laws could, among other things:
	•	create uncertainty in the marketplace that could reduce demand for our services;
	•	limit our ability to collect and to use merchant and cardholder data;
	•	increase the cost of doing business as a result of litigation costs or increased operating costs; or
	•	in some other manner have a material adverse effect on our business, results of operations and financial condition.

We do not intend to pay cash dividends on our common stock in the foreseeable future.

     We currently anticipate that we will retain all future earnings, if any, to finance the growth and development of our business and do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our board of directors. Further, under the terms of a loan agreement, we are restricted from paying cash dividends and making other distributions to our stockholders.

Risks Relating to Acquisitions

     We have previously acquired, and expect to continue to acquire, other providers of payment processing services and portfolios of merchant processing accounts. These acquisitions entail risks in addition to those incidental to the normal conduct of our business.

Revenues generated by acquired businesses or account portfolios may be less than anticipated, resulting in losses or a decline in profits, as well as potential impairment charges.

     In evaluating and determining the purchase price for a prospective acquisition, we estimate the future revenues from that acquisition based on the historical transaction volume of the acquired provider of payment processing services or portfolio of merchant accounts. Following an acquisition, it is customary to experience some attrition in the number of merchants serviced by an acquired provider of payment processing services or included in an acquired portfolio of merchant accounts. Should the rate of post-acquisition merchant attrition exceed the rate we have forecasted, the revenues generated by the acquired providers of payment processing services or portfolio of accounts may be less than we estimated, which could result in losses or a decline in profits, as well as potential impairment charges.

We may fail to uncover all liabilities of acquisition targets through the due diligence process prior to an acquisition, exposing us to potentially large, unanticipated costs.

     Prior to the consummation of any acquisition, we perform a due diligence review of the provider of payment processing services or portfolio of merchant accounts that we propose to acquire. Our due diligence review, however, may not adequately uncover all of

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the contingent or undisclosed liabilities we may incur as a consequence of the proposed acquisition. For example, after we acquired the merchant processing portfolio of First Bank of Beverly Hills in June 2001, we discovered that one of the merchants for which it was providing processing services was in substantial violation of the Visa and MasterCard card association rules. This merchant was unable to fund the resulting credits and chargebacks. As a result, we were obligated to fund these credits and chargebacks, which resulted in a loss to us of approximately $4.7 million.

We may encounter delays and operational difficulties in completing the necessary transfer of data processing functions and connecting systems links required by an acquisition, resulting in increased costs for, and a delay in the realization of revenues from, that acquisition.

     The acquisition of a provider of payment processing services, as well as a portfolio of merchant processing accounts, requires the transfer of various data processing functions and connecting links to our systems and those of our own third party service providers. If the transfer of these functions and links does not occur rapidly and smoothly, payment processing delays and errors may occur, resulting in a loss of revenues, increased merchant attrition and increased expenditures to correct the transitional problems, which could preclude our attainment of, or reduce, our profits.

Special non-recurring and integration costs associated with acquisitions could adversely affect our operating results in the periods following these acquisitions.

     In connection with some acquisitions, we may incur non-recurring severance expenses, restructuring charges and change of control payments. These expenses, charges and payments, as well as the initial costs of integrating the personnel and facilities of an acquired business with those of our existing operations, may adversely affect our operating results during the initial financial periods following an acquisition. In addition, the integration of newly acquired companies may lead to diversion of management attention from other ongoing business concerns.

Our facilities, personnel and financial and management systems may not be adequate to effectively manage the future expansion we believe necessary to increase our revenues and remain competitive.

     We anticipate that future expansion will be necessary in order to increase our revenues. In order to effectively manage our expansion, we may need to attract and hire additional sales, administrative, operations and management personnel. We cannot assure you that our facilities, personnel and financial and management systems and controls will be adequate to support the expansion of our operations, and provide adequate levels of service to our merchants and independent sales groups. If we fail to effectively manage our growth, our business could be harmed.

We have significant intangible assets and goodwill, the carrying value of which we may have to reduce if our revenues relating to these assets decline.

     We have acquired numerous intangible assets related to purchased portfolios of merchant accounts and business operations. The intangible assets represent a substantial portion of our total assets. Statement of Financial Accounting Standards Nos. 141 and 142 require us to periodically re-examine the value of our purchased assets. A material decline in the revenues generated from any of our purchased portfolios of merchant accounts or business operations could reduce the fair value of the portfolio or operations. In that case, we may be required to reduce the carrying value of the related intangible asset. Please see ''Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies’’ for a discussion of how we test impairment of the assets. Additionally, changes in accounting policies or rules that affect the way in which we reflect these intangible assets in our financial statements, or the way in which we treat the assets for tax purposes, could have a material adverse effect on our financial condition.

ITEM 2. Properties

     Our principal executive offices are located in approximately 7,000 square feet of leased office space in Nashville, Tennessee. We also lease approximately 27,000 square feet in Calabasas, California, approximately 14,000 square feet in Westchester, Illinois, approximately 6,000 square feet in Santa Barbara, California and approximately 2,500 square feet in Bridgeville, Pennsylvania. We believe that these facilities are adequate for our current operations and, if necessary, can be replaced with little disruption to our company.

ITEM 3. Legal Proceedings

     See Note 7 — Commitments and Contingencies of the Notes to Financial Statements (Item 8) for information regarding legal proceedings.

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ITEM 4. Submission of Matters to a Vote of Security Holders

     No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2004.

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PART II

ITEM 5. Market for Registrant’s Common Equity and Related Stockholder Matters

Stock Market Information

     iPayment common stock is traded on the Nasdaq National Market under the symbol IPMT. On February 25, 2005, there were 106 holders of record of our common stock. The following table lists the high and low daily closing sales prices for each period indicated:

     We have never declared nor paid cash dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the further development and expansion of our business and have no intention of paying cash dividends on our common stock. In addition, the terms of our credit facility restrict us from paying cash dividends and making other distributions to our stockholders. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements, restrictions contained in current or future financing instruments and other factors that our board of directors deems relevant.

Securities Authorized for Issuance Under Equity Compensation Plans

     iPayment has equity incentive programs for its employees and directors that were approved by its stockholders pursuant to which options, rights or warrants may be granted. See Item 11 for further information on the material terms of these plans. iPayment has no other equity compensation plans pursuant to which options, rights or warrants could be granted.

     The following is a summary of the shares reserved for issuance as of December 31, 2004, pursuant to outstanding options, rights or warrants granted under iPayment’s equity compensation plans:

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ITEM 6. Selected Financial Data

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Notes to Consolidated Financial Statements” for information regarding accounting changes, asset acquisitions and dispositions, litigation matters, and other costs and other items affecting comparability.

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ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Item 6 — Selected Financial Data” and our consolidated financial statements and related notes included elsewhere in this report. References in this section to “iPayment, Inc.,” the “Company,” “we,” “us,” and “our” refer to iPayment, Inc. and our direct and indirect subsidiaries on a consolidated basis unless the context indicates otherwise.

Executive Overview

     We are one of the fastest growing providers of credit and debit card-based payment processing services to small merchants. As of January 1, 2005, we provided our services to over 125,000 small merchants located across the United States, up from over 90,000 as of January 1, 2004. Our payment processing services enable our merchants to process both traditional card-present, or swipe transactions, as well as card-not-present transactions over the Internet or by mail, fax or telephone. We market and sell our services primarily through over 750 independent sales groups, which gives us a non-employee, external sales force representing more than 2,600 sales professionals. We outsource certain processing functions such as card authorization, data capture and merchant accounting to third party processors such as FDMS and Vital Processing Services, and we rely on banks such as JP Morgan Chase to sponsor us for membership in the Visa and MasterCard associations and to settle transactions with merchants. We perform several core functions such as sales support, merchant services, underwriting, risk management and chargeback services, in our main operating centers in Calabasas, California and Westchester, Illinois.

     Our strategy is to grow profitably by increasing our penetration of the expanding small merchant marketplace for payment services. The industry for card-based payments, such as credit and debit cards, by consumers in the U.S. has steadily increased over the past ten years. According to The Nilson Report, total purchases by U.S. consumers using Visa and MasterCard card-based systems grew from $1.741 trillion in 2003 to $1.961 trillion in 2004. Such expenditures are expected to grow to $2.788 trillion by 2008. The proliferation of credit and debit cards has made the acceptance of card-based payment a necessity for businesses, both large and small, in order to remain competitive. Card-based payments are gradually replacing paper-based payments (check and cash) due to favorable demographics, with younger generations of consumers more accustomed to credit and debit cards. The Nilson Report estimates card-based payments will represent 51% of all U.S. payments by 2008. We find merchants through our independent sales groups and make occasional acquisitions on an opportunistic basis in the fragmented small merchant segment of the industry.

     Our operating results point to successful execution of this strategy during 2004. Charge volume increased to $12,850 million in 2004 from $6,478 million in 2003, and revenues increased 61% to $364.2 million in 2004 from $226.1 million in 2003. These increases were primarily the result of acquisitions, principally the FDMS Agent Bank Portfolio purchased in December of 2003 and two businesses purchased since August 2003. The FDMS Merchant Portfolio purchased in December of 2004 did not contribute to revenues until January of 2005. Income from operations increased to $39.9 million in 2004 from $27.2 million in 2003. We continued to improve operational efficiency in 2004. Our processing costs per transaction declined to $0.18 in 2004 from $0.21 in 2003 and revenues per employee (average) increased to $1,287,000 in 2004 from $863,000 in 2003, principally as a result of our acquisition of the FDMS Agent Bank Portfolio.

     Interest expense declined to $2.7 million in 2004 from $9.9 million in 2003, reflecting the repayment of $55.7 million of debt with a weighted average interest rate of approximately 10% in the second quarter of 2003 using proceeds from the initial public offering. This repayment resulted in a $4.4 million charge in the second quarter of 2003 due to the early extinguishment of certain debt. The decline in interest expense was more than offset by an increase in our effective income tax rate to approximately 34% in 2004 from approximately 8% in 2003, due to the utilization of net operating loss carryforwards. Net income increased 58% to $24.7 million in 2004 from $15.6 million in 2003.

Development of our Business

     iPayment Technologies, Inc., was formed in 1992 as a California corporation. In July 2000, iPayment Technologies purchased assets from two former affiliates in exchange for the assumption of debt, $400,000 in cash, a $2.0 million note and the issuance of 2,314 shares of iPayment Technologies’ common stock. We refer to this as the Caymas acquisition. In connection with the Caymas acquisition, Caymas, LLC purchased a majority interest in iPayment Technologies. We accounted for the Caymas acquisition as a purchase allocating its investment to the fair value of assets acquired and liabilities assumed and the excess basis allocated to goodwill. The Caymas acquisition was completed in order to transfer ownership of certain assets owned by former affiliates of iPayment Technologies, and to separate iPayment Technologies from its former affiliates.

     In December 2000, iPayment Technologies implemented a restructuring plan, which resulted in a reduction in overhead costs and personnel. Expenses related to the restructuring included severance and future lease costs, write downs of fixed assets and leasehold improvements.

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     In February 2001, we were formed by the majority stockholders of iPayment Technologies under the name iPayment Holdings, Inc. as a holding company for iPayment Technologies and other card processing businesses. We then appointed Gregory Daily as our Chief Executive Officer and Chairman of the Board. In April 2001, we acquired a 94.63% interest in iPayment Technologies, and in July 2002, we acquired the remaining outstanding shares of iPayment Technologies, which then became our wholly owned subsidiary, in each case by issuing our shares to iPayment Technologies stockholders in exchange for iPayment Technologies shares.

     In August 2002, we were reincorporated in Delaware under the name iPayment, Inc. and in May 2003 we completed an initial public offering of our common stock and listing on the Nasdaq National Market.

Acquisitions

     Since January 2001, we have expanded our card-based payment processing services through the acquisition of nine businesses, two significant portfolios and several smaller portfolios of merchant accounts, as set forth below. These acquisitions have significantly impacted our revenues, results of operations, and financial condition. Primarily due to these acquisitions, our merchant portfolio base increased from approximately 7,000 active small merchants on January 1, 2001, to over 125,000 on January 1, 2005 (including our acquisition of the FDMS Merchant Portfolio, which did not contribute to our results of operations until January 1, 2005). In addition, primarily due to these acquisitions, our revenues increased to $364.2 million for the year ended December 31, 2004, from $226.1 million for the year ended December 31, 2003. Income from operations improved to $39.9 million for 2004, from $27.2 million for 2003. Net income increased to $24.7 million for 2004 from $15.6 million for 2003. Net cash provided by operating activities increased to $38.5 million for 2004 from $20.1 million for 2003. The full impact of the acquisitions discussed below on our results of operations for fiscal 2004 is not fully reflected in our historical results of operations due to the recent nature of these acquisitions and their varying stages of integration.

     We expect our revenues, results of operations, and net cash provided by operating activities to continue to improve in 2005, as the full impact of these acquisitions are realized. If we engage in fewer acquisitions in the future, the revenues attributable to new acquisitions may decline as a percentage of our total revenues.

     The following table lists each of the acquisitions that we have made since January 1, 2003.

     On August 5, 2003, we entered into an agreement to purchase substantially all the assets and to assume certain liabilities of CardPayment Solutions, Inc. for $12.0 million in cash and 118,409 shares of our common stock valued at $25.34 per share for an aggregate of $3.0 million, plus a contingent payment based upon performance, which was subsequently paid in August 2004. CardPayment Solutions is a provider of credit card transaction processing services. The acquisition was recorded under the purchase method with the total consideration allocated to the fair value of assets acquired and liabilities assumed, including goodwill of $14.6 million and a merchant-processing portfolio of $3.7 million. The operating results of CardPayment Solutions from August 1, 2003, are included in our consolidated statements of operations included elsewhere in this report.

     On December 19, 2003, we entered into an Asset Purchase Agreement with FDMS pursuant to which we acquired the FDMS Agent Bank Portfolio for a price of $55.0 million in cash. Pursuant to the terms of the Asset Purchase Agreement, we commenced receiving revenue from these accounts on January 1, 2004. In order to finance the acquisition, we increased our borrowing capacity under our revolving credit facility from $30.0 million to $65.0 million. We borrowed $45.0 million under our credit facility and used available cash for the balance of the purchase price. We are currently a customer of First Data for merchant processing services.

     On September 15, 2004, we entered into an agreement to purchase substantially all the assets of TS Black and Gold, LP (“Transaction Solutions”). Transaction Solutions is a provider of credit card transaction processing services. Consideration included cash at closing and a contingent payment based upon future performance over two years which we anticipate to be partially supported by a letter of credit. The acquisition was recorded under the purchase method with the total consideration allocated to the fair value of assets acquired and liabilities assumed. The operating results of Transaction Solutions from September 1, 2004, are included in our consolidated statements of operations included elsewhere in this report.

     On December 28, 2004, we entered into an Asset Purchase Agreement with FDMS, pursuant to which we acquired the FDMS Merchant Portfolio for a price of $130.0 million in cash. Pursuant to the terms of the Asset Purchase Agreement, the acquisition

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became effective on December 31, 2004, and we will commence receiving revenue from the merchant accounts on January 1, 2005. We expanded our credit facility from $80.0 million to $180.0 million to finance the purchase. The transaction also strengthens our existing strategic relationship with First Data’s merchant services unit. We will continue to utilize processing services from First Data for the acquired portfolio. During February 2005, our revolving credit facility was expanded to $205.0 million and is further expandable to $280.0 million.

     For the year ended December 31, 2004, revenues attributable to acquisitions were $98.4 million or 71.3% of our total growth in revenues over 2003. For the year ended December 31, 2003, revenues attributable to acquisitions were $85.8 million or 77.8% of our total revenue growth from 2002. If we engage in fewer acquisitions in the future, the revenues attributable to new acquisitions may decline as a percentage of our total revenues.

     We accounted for all of the acquisitions described above under the purchase method. For acquisitions of a business, we allocate the purchase price based in part on valuations of the assets acquired and liabilities assumed. For acquisitions of merchant portfolios, we allocate the purchase price to intangible assets. For companies with modest growth prospects, our purchase prices primarily reflect the value of merchant portfolios, which are classified as amortizable intangible assets. Acquisition targets we identified as having entrepreneurial management teams, efficient operating platforms, proven distribution capabilities, all of which contribute to higher growth prospects, commanded purchase prices in excess of their merchant portfolio values. Consequently, purchase price allocations for these targets reflect a greater proportion of goodwill.

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 2 to our consolidated financial statements included in Item 8. 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.

     Accounting for goodwill and intangible assets. 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. If facts and circumstances indicate goodwill may be impaired, we perform a recoverability evaluation. Prior to the adoption of SFAS No. 142 on January 1, 2002, our policy was to compare undiscounted estimated future cash flows to the carrying amount of our net assets, including goodwill, to determine if the carrying amount was not recoverable and a write-down to fair value was required. Effective January 1, 2002, in accordance with SFAS No. 142, we began performing the recoverability analysis based on fair value rather than undiscounted cash flows. 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.

     We completed the testing for impairment of goodwill as of July 31, 2004, using the present value of future cash flows and determined that the fair value of the reporting unit exceeded the carrying amount of the net assets, including goodwill of the reporting unit. We determined that no impairment charge to goodwill was required.

     We periodically evaluate the carrying value of long-lived assets, in relation to the respective projected future undiscounted cash flows, to assess recoverability. An impairment loss is recognized if the sum of the expected net cash flows is less than the carrying amount of the long-lived assets being evaluated. The difference between the carrying amount of the long-lived assets being evaluated and the fair value, calculated as the sum of the expected cash flows discounted at a market rate, represents the impairment loss. We evaluated the carrying value of our intangible assets as of December 31, 2004 and 2003, and determined that no impairment charge was required.

     Accounting for Stock-Based Compensation. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment (“SFAS No. 123R”). This standard requires expensing of stock options and other share-based payments and supersedes SFAS No. 123, which had allowed companies to choose between expensing stock options or showing proforma disclosure only. This standard is effective as of July 2005 and will apply to all awards granted, modified, cancelled or repurchased after that date as well as the unvested portion of prior awards. SFAS No. 123R permits public companies to adopt its requirements using one of three methods: the “modified prospective” method, the “modified retrospective” method to January 1, 2005, or the “modified retrospective” method to all prior years for which SFAS No. 123 was effective. We have not yet determined which adoption method to utilize. Further, we have not yet decided whether we will adopt the provisions of this standard on July 1, 2005 as required, or earlier, as allowed.

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     As permitted by SFAS No. 123, we currently follow APB Opinion No. 25 which accounts for share-based payments to employees using the intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123R fair value method will have a significant impact on our consolidated results of operations, although it will have no impact on our cash flows. The exact impact of the adoption of SFAS No. 123R cannot be determined at this time because it will depend on the number of options issued during fiscal 2005 as well as the assumptions and valuation method used to measure compensation cost under the fair value method of accounting. The historical pro forma income statement impact is not be indicative of future results due to the uncertainty of the number of new option grants as well as the assumptions and valuation method used.

     Reserve for 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, the acquiring bank and us, must bear the credit risk for the full amount of the transaction. We evaluate the merchant’s risk for such transactions and estimate its potential loss for chargebacks based primarily on historical experience and other relevant factors. During the fourth quarter of 2003, we benefited from a favorable nonrecurring $1.3 million reduction in an earlier estimate for merchant losses from a single merchant to reflect lower actual losses. At December 31, 2004, our reserve for losses on merchant accounts totaled $1.1 million.

     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. At December 31, 2004, we had approximately $5.8 million of federal net operating loss carryforwards that will be available to offset regular taxable income through 2022, subject to annual limitations of up to $2.5 million. We also have approximately $2.9 million of state net operating loss carryforwards, again subject to annual limitations, that will expire in various states between 2011 and 2022. We have placed a valuation allowance on a portion of our net deferred tax asset, which is primarily comprised of operating loss carryforwards as a result of limitations placed on the ability to utilize the net operating loss carryforwards due to ownership changes, which occurred prior to our initial public offering.

Components of Revenues and Expenses

     Substantially 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 ourselves 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. Related interchange and assessment costs are also recognized at that time.

     We follow the requirements of EITF 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining our revenue reporting. Generally, where we have merchant portability, credit risk and ultimate responsibility for the merchant, revenues are reported at the time of sale on a gross basis equal to the full amount of the discount charged to the merchant. This amount includes interchange paid to card issuing banks and assessments paid to credit card associations pursuant to which such parties receive payments based primarily on processing volume for particular groups of merchants. Revenues generated from certain agent bank portfolios acquired as part of the FDMS acquisition are reported net of interchange, as required by EITF 99-19, where we may not have credit risk, portability or the ultimate reponsibility for the merchant accounts.

     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.

     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 include 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.

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     Other costs of services also include 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 a portion of the purchase price to the existing merchant processing portfolio.

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

     Seasonality Trend. Our revenues and earnings are impacted by the volume of consumer usage of credit and debit cards at the point of sale. For example, we experience increased point of sale activity during the traditional holiday shopping period in the fourth quarter. Revenues during the first quarter tend to decrease in comparison to the remaining three quarters of our fiscal year on a same store basis.

     Off-Balance Sheet Arrangements

     We do not have transactions, arrangements and other relationships with unconsolidated entities that are reasonably likely to effect our liquidity or capital resources. We have no special purpose or limited purpose entities that provided off-balance sheet financing, liquidity or market or credit risk support, engage in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financials.

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Results of Operations

Years ended December 31, 2004 and 2003 (in thousands, except percentages)

N/M — Not meaningful

     Revenues. Revenues increased 61.1% to $364.2 million in 2004 from $226.1 million in 2003. This increase was primarily due to the impact of our acquisitions since August 2003 of the FDMS Agent Bank Portfolio, two businesses and several smaller portfolios of merchant contracts, which resulted in an aggregate increase in revenues of $98.4 million, representing 71.3% of our total growth in revenues over the prior period.

     Interchange. Interchange expense increased 54.5% to $176.6 million in 2004 from $114.3 million in 2003. This increase was primarily the result of increased charge volume due to the acquisitions of businesses and portfolios of merchant contracts as previously noted. Interchange expense as a percentage of revenues decreased to 48.5% in 2004 from 50.5% in 2003, as we present revenue net of interchange for certain customers included in our acquisition of the FDMS Agent Bank Portfolio.

     Other Costs of Services. Other costs of services increased 76.7% to $135.3 million in 2004 from $76.6 million in 2003. This increase was primarily due to increased costs associated with increased charge volume related to our acquisitions. Other costs of services represented 37.2% of revenues in 2004 as compared to 33.9% of revenues in 2003. Other costs of services as a percentage of revenues increased primarily due to an increase in residuals expense and depreciation and amortization as a result of the acquisitions, mainly from the FDMS Agent Bank Portfolio.

     Selling, General and Administrative. Selling, general and administrative expenses increased 55.2% to $12.4 million in 2004 from $8.0 million in 2003. The increase was primarily due to an increase in personnel costs resulting from our acquisitions. Selling, general and administrative expenses as a percentage of revenues were relatively consistent at 3.4% in 2004 compared to 3.5% in 2003, as lower personnel-related costs as a percentage of revenues were partially offset by higher professional fees.

     Other Expense. Other expense decreased to $2.4 million in 2004 from $10.2 million in 2003, primarily due to a reduction in interest expense resulting from the repayment of $55.7 million of debt with a weighted average interest rate of 10% in the second quarter of 2003 using proceeds from the initial public offering. This repayment resulted in a $4.4 million charge in the second quarter of 2003 due to the early extinguishment of certain debt.

     Income Tax. The income tax provision increased to $12.7 million in 2004 from $1.4 million in 2003. The increase was attributable to an increase in taxable income in 2004. Our effective income tax rate for 2004 was 33.9% due to the utilization of net operating loss carryforwards and other deferred tax assets in 2004 that were previously unrecognized.

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Years ended December 31, 2003 and 2002 (in thousands, except percentages)

N/M — Not meaningful

     Revenues. Revenues increased 95.2% to $226.1 million in 2003 from $115.8 million in 2002. This increase was primarily due to our acquisitions since March 2002 of five businesses and several smaller portfolios of merchant contracts, which resulted in an aggregate increase in revenues of $85.8 million, representing 77.8% of our total growth in revenues over the prior period.

     Interchange. Interchange expense increased 120.4% to $114.3 million in 2003 from $51.8 million in 2002. This increase was primarily the result of increased charge volume due to the acquisitions of businesses and portfolios of merchant contracts as previously noted. Interchange expense as a percentage of revenues increased to 50.5% in 2003 from 44.8% in 2002, as the acquired businesses and portfolios had higher average costs as a percentage of revenues than our existing mix of business.

     Other Costs of Services. Other costs of services increased 60.2% to $76.6 million in 2003 from $47.8 million in 2002. This increase was primarily due to increased costs associated with increased charge volume related to our acquisitions. Other costs of services represented 33.9% of revenues in 2003 as compared to 41.3% of revenues in 2002. Other costs of services as a percentage of revenues decreased as the increase in revenues did not require a corresponding increase in other costs of services, such as merchant losses and personnel related costs. Merchant losses were 1.1% of revenues in 2003, compared to 5.6% in 2002. Merchant losses recognized in 2003 included a $1.3 million benefit attributable to a reduction in estimated chargebacks relating to one merchant. Approximately $3.3 million of estimated chargebacks for this merchant were expensed in the first half of 2002. The portion of personnel costs classified as other costs of services was approximately 5.9% of revenues in 2003 compared to 8.9% of revenues in 2002. The reduction was primarily due to improved efficiencies resulting from consolidation of our acquired entities.

     Selling, General and Administrative. Selling, general and administrative expenses increased 22.5% to $8.0 million in 2003 from $6.5 million in 2002. The increase was primarily due to an increase in personnel cost resulting from our acquisitions. Selling, general and administrative expenses as a percentage of revenues declined to 3.5% in 2003 from 5.6% in 2002, primarily due to the consolidation of the operations of acquired entities, which improved operational efficiencies and resulted in a reduction in personnel related costs as a percentage of revenues.

     Interest Expense. Interest expense increased 44.0% to $9.9 million in 2003 from $6.9 million in 2002. Cash paid for interest in 2003 actually decreased due to the repayment of approximately $55.7 million of debt (with a carrying value of $52.1 million) in the second quarter of 2003 using proceeds from our initial public offering. However, the repayment and the conversion of debt resulted in recognition of a noncash pre-tax charge of approximately $4.4 million of interest expense 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.

     Other Expense. Other expense decreased to $0.3 million in 2003 from $3.2 million in 2002. The decrease was primarily due to

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expenses in 2002 of $1.5 million from the settlement of litigation and $1.0 million related to the amendment of certain terms of the existing processing agreements and the termination of an acquisition agreement, which did not recur in 2003.

     Income Tax. The income tax provision increased to $1.4 million in 2003 from $10,000 in 2002. The increase was attributable to an increase in taxable income in 2003 from a pre-tax loss in 2002. Our effective income tax rate for 2003 was 8.2% due to the utilization of net operating loss carryforwards and other deferred tax assets in 2003 that were previously unrecognized.

Liquidity and Capital Resources

     Prior to our initial public offering, we funded our principal operations through private placements of debt and equity securities to executive officers, directors, principal stockholders, third parties and a credit facility from Bank of America. In May 2003, we raised net proceeds of $75.6 million through an initial public offering of our common stock. As of December 31, 2004, we had cash and cash equivalents totaling $0.9 million, compared to $0.7 million as of December 31, 2003. We had net working capital of $10.9 million as of December 31, 2004, compared to a net working capital deficit (current liabilities in excess of current assets) of $1.0 million at December 31, 2003. We believe that funds from future operations and proceeds from borrowings under our credit facility will be sufficient to settle our current obligations.

Operating activities

     Net cash provided by operating activities was $38.4 million in 2004, consisting of net income of $24.7 million, depreciation and amortization of $20.1 million and noncash interest expense of $0.7 million, partially offset by a net unfavorable change in operating assets and liabilities of $7.1 million. The net unfavorable change in operating assets and liabilities was primarily caused by an increase in accounts receivable due to our increased revenues in 2004 and approximately $2.4 million of capitalized debt issuance costs related to the amendment of the credit facility.

     Net cash provided by operating activities was $20.1 million in 2003, consisting of net income of $15.6 million, depreciation and amortization of $8.0 million and noncash interest expense of $6.4 million, partially offset by a net unfavorable change in operating assets and liabilities of $10.0 million. The noncash interest expense included a $4.4 million charge related to the acceleration of the unamortized discount on notes payable that were repaid or converted to common stock following our initial public offering in the second quarter of 2003. The net unfavorable change in operating assets and liabilities was primarily caused by the payment of approximately $4.0 million of offering costs, related to our initial public offering, that were included in accounts payable at December 31, 2002, and an increase in accounts receivable due to our increased revenues in 2003.

     Net cash used in operating activities was $9.0 million in 2002, consisting of a net loss of $0.5 million and net unfavorable changes in operating assets and liabilities of $16.0 million, partially offset by depreciation and amortization of $5.5 million and noncash interest expense of $2.1 million. The net unfavorable changes in operating assets and liabilities primarily included a $7.5 million increase in other assets mainly caused by capitalized costs related to our initial public offering, and a $7.3 million decrease in accounts payable, accrued liabilities and reserve for merchant losses.

Investing activities

     Net cash used in investing activities was $143.6 million in 2004. Cash paid for acquisitions of a business, portfolios and other intangibles was $148.6 million. These payments were partially offset by a net decrease in restricted cash of $7.9 million due to funds held on deposit by a former sponsor bank that were returned to us. Total capital expenditures for 2004 were $0.9 million. These expenditures were primarily related to leasehold improvements, computers and other equipment. We currently have no significant capital spending or purchase commitments, but expect to continue to engage in capital spending in the ordinary course of business.

     Net cash used in investing activities was $86.2 million in 2003. Cash paid for acquisitions of a business, portfolios and other intangibles was $77.8 million. Restricted cash increased by $7.9 million in 2003 as we escrowed a deposit of $5.5 million to a former sponsor bank until completion of the conversion to our new sponsor. Total capital expenditures for 2003 were $0.6 million. These expenditures were primarily related to the purchase of computers and other equipment.

     Net cash used in investing activities was $10.0 million for 2002, which primarily included $8.8 million paid for the acquisitions of four businesses in 2002. Total capital expenditures for 2002 were $0.4 million. These expenditures were primarily related to the purchase of computers and other equipment.

Financing activities

     Net cash provided by financing activities was $105.3 million in 2004, primarily consisting of $107.5 million of net borrowings on our credit facility.

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     Net cash provided by financing activities was $65.1 million in 2003, primarily consisting of $76.4 million from issuance of common stock (including net proceeds of $75.6 million from our initial public offering) and additional net borrowings on our credit facility of $44.0 million, partially offset by repayment of long-term debt and capital leases of $55.3 million.

     Net cash provided by financing activities was $20.5 million in 2002, consisting entirely of a net increase in total debt.

     As of December 31, 2004, we had notes, capital lease obligations and a credit facility arrangement outstanding in an aggregate principal amount of $168.4 million, consisting of $152.5 million outstanding under our senior credit facility and $15.9 million that is convertible into 662,079 shares of our common stock. The $15.9 million consists of convertible subordinated promissory notes (including $1.0 million of accrued interest) with an interest rate of 4.5%, which may be converted into shares of our common stock at the discretion of the holders at a price per share of $23.16 per share.

     In December 2004 we amended our credit facility with Bank of America and JP Morgan Chase as the lead banks. The amendment expanded the credit facility from $80.0 million to $180.0 million which was subsequently expanded to $205.0 million in February 2005 and is further expandable to $280.0 million. The credit facility includes a $5.0 million letter of credit sublimit. Interest on outstanding borrowings is payable at a rate of LIBOR plus a margin of 1.50% to 2.25% (currently LIBOR plus 2.00%) depending on our ratio of consolidated debt to EBITDA, as defined in the agreement. We have the option to choose 1-month, 2-month, 3-month or 6-month LIBOR rates each time we make a draw on the credit facility. In addition, the credit facility requires us to pay unused commitment fees of up to 0.45% (currently 0.40%) on any undrawn amounts. The credit facility contains customary affirmative and negative covenants including financial covenants requiring the maintenance of a debt-to-EBITDA ratio (as defined therein) of less than 2.5 to 1.0, as well as specified limitations on capitalization and restrictions on incurring liens and transactions with affiliates. We were in compliance with all debt covenants as of December 31, 2004. At December 31, 2004, $152.5 million was outstanding under the credit facility at the Base Rate of 5.5%. This rate was converted to LIBOR on January 6, 2005, at 4.4%. The amended credit facility expires on December 28, 2008, and all outstanding borrowings are due at that time.

     The following table of our material contractual obligations as of December 31, 2004, summarizes the aggregate effect that these obligations are expected to have on our cash flows in the periods indicated: (in thousands)

     We expect to be able to fund our operations, capital expenditures and contractual obligations above using our cash from operations. We intend to use our credit facility primarily to fund additional acquisition opportunities as they arise. To the extent we are unable to fund our operations, capital expenditures and contractual obligations above using cash from operations, we intend to use borrowings under our credit facility or future debt or equity financings. In addition, we may seek to sell additional equity or arrange debt financing to give us financial flexibility to pursue opportunities that may arise in the future if an opportunity that we consider attractive arises to raise additional funding. If we raise additional funds through the sale of equity or convertible debt securities, these transactions may dilute the value of our outstanding common stock. We may also decide to issue securities, including debt securities, which have rights, preferences and privileges senior to our common stock. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs, which may prevent us from increasing our market share, capitalizing on new business opportunities or remaining competitive in our industry.

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Effects of Inflation

     Our monetary assets, consisting primarily of cash and receivables, are not significantly affected by inflation. Our non-monetary assets, consisting primarily of intangible assets and goodwill, are not affected by inflation. We believe that replacement costs of equipment, furniture and leasehold improvements will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and telecommunications, which may not be readily recoverable in the price of services offered by us.

New Accounting Standards

     In December 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 Revised, Consolidation of Variable Interest Entities — an Interpretation of ARB No. 51 (“FIN 46R”), which provided, among other things, immediate deferral of the application of FIN 46 for entities that did not originally qualify as special purpose entities, and provided additional scope exceptions for joint ventures with business operations and franchises. Our adoption of FIN 46R did not have an impact on its consolidated financial statements.

     In October 2004, the FASB ratified Emerging Issues Task Force Issue No. 04-01, Accounting for Preexisting Relationships between the Parties to a Business Combination Abstract (“EITF 04-01”). EITF 04-01 requires that the consummation of a business combination between parties with a preexisting relationship should be evaluated to determine if a settlement of a preexisting relationship exists. EITF 04-01 should be applied to business combinations consummated and goodwill impairment tests performed in reporting periods beginning after October 13, 2004. Amounts previously recognized as goodwill should not be reclassified as an identifiable intangible asset, however, previously recognized goodwill should be tested for impairment. Any effect on a goodwill impairment charge should be reported in operating income. To date, we have not consummated a business combination that would fall within the scope of EITF 04-01 and as such, we do not expect the adoption of this standard to have a material impact on our financial position or results of operations.

     In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment (“SFAS No. 123R”). This standard requires expensing of stock options and other share-based payments and supersedes SFAS No. 123, which had allowed companies to choose between expensing stock options or showing proforma disclosure only. This standard is effective as of July 2005 and will apply to all awards granted, modified, cancelled or repurchased after that date as well as the unvested portion of prior awards. SFAS No. 123R permits public companies to adopt its requirements using one of three methods: the “modified prospective” method, the “modified retrospective” method to January 1, 2005, or the “modified retrospective” method to all prior years for which SFAS No. 123 was effective. We have not yet determined which adoption method to utilize. Further, we have not yet decided whether we will adopt the provisions of this standard on July 1, 2005, as required, or earlier, as allowed.

     As permitted by SFAS No. 123, we currently follow APB Opinion No. 25 which accounts for share-based payments to employees using the intrinsic value method and, as such, we generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123R fair value method will have a significant impact on our consolidated results of operations although it will have no impact on our cash flows. The exact impact of the adoption of SFAS No. 123R cannot be determined at this time because it will depend on the number of options issued during fiscal 2005 as well as the assumptions and valuation method used to measure compensation cost under the fair value method of accounting. The historical pro forma income statement impact is not indicative of future results due to the uncertainty of the number of new option grants as well as the assumptions and valuation method used.

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

     We transact business with merchants exclusively in the United States and receive payment for our services exclusively in United States dollars. As a result, our financial results are unlikely to be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.

     Our interest expense is sensitive to changes in the general level of interest rates in the United States, because a majority of our indebtedness is at variable rates. At December 31, 2004, $152.5 million of our outstanding indebtedness was at variable interest rates based on LIBOR. A rise in LIBOR rates of one percentage point would result in additional interest expense of $1.5 million.

     We do not hold derivative financial or commodity instruments, nor engage in any foreign currency denominated transactions, and all of our cash and cash equivalents are held in money market and checking funds.

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ITEM 8. Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of
iPayment, Inc.:

     We have audited the accompanying consolidated balance sheets of iPayment, Inc. (a Delaware corporation) as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in mandatorily redeemable convertible preferred stock and stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the index at Item 14(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

     We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of iPayment, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with United States generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

     We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of iPayment, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2005, expressed an unqualified opinion thereon.

	/s/ ERNST & YOUNG LLP

Los Angeles, California

March 11, 2005

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

See accompanying notes to consolidated financial statements.

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

See accompanying notes to consolidated financial statements.

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iPAYMENT, INC.
CONSOLIDATED STATEMENTS of CHANGES IN MANDATORILY REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)
(In thousands, except share data)

See accompanying notes to consolidated financial statements.

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

See accompanying notes to consolidated financial statements.

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