10-K 1 0001.txt SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------ FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000 COMMISSION FILE NUMBER 000-28187 ------------ OFFICIAL PAYMENTS CORPORATION (Exact name of Registrant as Specified in its Charter) DELAWARE 52-2190781 -------- ---------- (State or Other Jurisdiction of (IRS Employer Incorporation or Organization) Identification Number) THREE LANDMARK SQUARE STAMFORD, CONNECTICUT 06901-2501 -------------------------------- (Address of Principal Executive Offices including Zip Code) (203) 356-4200 -------------- (Registrant's Telephone Number, Including Area Code) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED ------------------- ----------------------------------------- NONE NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, PAR VALUE $0.01 PER SHARE --------------------------------------- (Title of Class) 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 requirement for the past 90 days. Yes [X] No [ ] 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 the 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. [ ] As of March 28, 2001, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $44,765,535 based upon the average of the high and low prices of the Common Stock as reported on The Nasdaq National Market on such date. All executive officers and directors of the registrant have been deemed, solely for the purpose of the foregoing calculation, to be "affiliates" of the registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of March 28, 2001, the Registrant had outstanding 21,978,115 shares of Common Stock. ------------ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's definitive proxy statement to be mailed to stockholders in connection with the Company's 2001 Annual Meeting of Stockholders to be held on May 8, 2001 are incorporated by reference into Part III hereof. OFFICIAL PAYMENTS CORPORATION FORM 10-K DECEMBER 31, 2000 TABLE OF CONTENTS ITEM PAGE NUMBER ---- ----------- PART I 1. Business...............................................................3 2. Properties............................................................21 3. Legal Proceedings.....................................................21 4. Submission of Matters to a Vote of Security Holders...................21 PART II 5. Market for Registrant's Common Equity and Related Stockholder Matters..............................................22 6. Selected Financial Data...............................................24 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................25 7A. Quantitative and Qualitative Disclosures About Market Risk............35 8. Financial Statements and Supplementary Data...........................36 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.........................................36 PART III 10. Directors and Executive Officers of the Registrant....................36 11. Executive Compensation................................................36 12. Security Ownership of Certain Beneficial Owners and Management.......................................................36 13. Certain Relationships and Related Transactions........................37 PART IV 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.......37 Signatures..................................................................38 Index to Exhibits PART I ITEM 1. BUSINESS Official Payments Corporation (the "Company" or "Official Payments") is a leading provider of electronic payment options to government entities. The Company's systems enable consumers to use their credit cards and "pin-less" debit cards to pay, through the Internet or by telephone, personal federal and state income taxes, sales and use taxes, property taxes, tuition payments, motor vehicles fees, fines for traffic violations and parking citations and other government-imposed taxes and fees. In 2000 the Company processed an aggregate of $927 million of such payments. The Company's Internet Web site (www.officialpayments.com) and interactive toll-free telephone number (1-800-2PAY-TAX(sm)) allow consumers to access payment information, make payments and receive certain customer service information. References in this document to the Company's provision of "credit card" payment services shall be deemed to include provision of payment services for pin-less debit cards bearing the American Express, VISA or MasterCard logos. Incorporated in Delaware in September 1999, the Company changed its name from U.S. Audiotex Corporation in October 1999. The Company's principal executive offices are located at Three Landmark Square, Stamford, Connecticut 06901. Comerica Incorporated, a financial holding company ("Comerica"), is the beneficial owner of approximately 55% of the outstanding common stock of the Company. SERVICES Government Clients In 1998, the Company signed a credit card payment contract with the Internal Revenue Service (the "IRS") to provide its services for the payment by telephone of personal federal "balance due" income taxes. For the 1999 tax year, the Company began processing estimated and extension tax payments, as well. In March 2000, the IRS awarded Official Payments a contract to accept, via the Internet and telephone balance-due and estimated tax payments for the 2000 tax year, as well as estimated payments for the 2001 tax year. This new contract has an initial one-year term, with the IRS having the option to renew the contract for one additional year. The IRS exercised this renewal option in March 2001. The Company is an industry partner of the IRS's Electronic Tax Administration division. For the 2000 tax year, the IRS has included Official Payments' telephone number and Web site address in the instruction booklets for Form 1040 and on Form 1040ES and Form 4868. As of December 31, 2000, Official Payments was processing, or had recently entered into contracts to process, payments for the District of Columbia and 15 state governments including Alabama, Arkansas, California, Connecticut, Illinois, Kansas, Maryland, Minnesota, New Jersey, New York, Ohio, Oklahoma, Virginia, Washington and West Virginia. In the first quarter of 2001, Official Payments announced that it has entered into similar agreements with the states of Wisconsin, Iowa and Mississippi, respectively. In addition, as of December 31, 2000, the Company had entered into agreements with over 723 counties and municipalities in 41 states. The highest concentrations of local government entities serviced by the Company are in California, Texas and Virginia. The table below lists, as of March 15, 2001, the Company's existing government clients and the types of payments it processes or has contracted to process for those clients: Government Client Type of Payment IRS Balance due, estimated and extension personal federal income taxes Alabama Balance due, estimated and delinquent personal income taxes Arkansas Balance due, estimated and extension personal income taxes; sales and use taxes; motor vehicle fees California Balance due, estimated, extension and past due personal income taxes; sales and use taxes; benefit overpayments Connecticut Balance due, estimated and extension personal income taxes District of Columbia Balance due and delinquent personal income taxes Illinois Balance due, estimated, extension and prior year personal income taxes; business license fees Iowa Delinquency taxes and fees Kansas Balance due and estimated personal income taxes; retail sales and use taxes Maryland Balance due personal income taxes; income tax established liabilities Minnesota Balance due and estimated personal income taxes; penalty payments Mississippi Delinquent taxes New Jersey Balance due, fiduciary, estimated, extension personal income taxes; sales and use taxes; gross withholding taxes; unemployment and disability contributions; deficiency payments New York Balance due, estimated and extension personal income taxes Ohio Balance due, estimated and extension personal income taxes; school district taxes Oklahoma Balance due and estimated personal income taxes; corporate balance due and estimated taxes; withholding and franchise taxes Virginia Balance due personal income taxes Washington Business sales and use taxes West Virginia Various tax and fee payments to be determined Wisconsin Various tax and fee payments to be determined 554 counties and Real estate and personal property taxes municipalities 618 counties and Fines for traffic violations, parking citations and/ municipalities or other services (e.g., utility bill payments) In addition, the Company designs, installs and implements individual systems for county and municipal government clients that may be purchased by such entities in order to accept certain types of payments. These installed products include property tax, citation processing, parking and automated fax filing systems, which incorporate the Company's electronic payment conduits, as well as provide connections between databases to transfer information simultaneously. The Company also builds and sells custom applications such as a polling place locator application, county social service inquiry system and additional government-related applications. These systems are typically sold to a government entity for a fixed fee. Electronic payments often provide significant benefits for government entities, including improved service, cost savings, reduced paperwork, fraud and error reduction and faster transaction processing. Government entities may prefer to outsource electronic payment options rather than provide these options themselves because they lack the expertise, technical personnel and economies of scale necessary to implement and maintain the required software and hardware systems. In addition, legislation prohibits some government entities from paying credit card payment processing fees associated with accepting credit cards. Most of the Company's agreements with government clients are non-exclusive, short-term contracts or memoranda of understanding and can be terminated without cause on short notice, generally 30 to 90 days. In addition, a government client may choose not to renew its contract with the Company or may not choose the Company's proposal in response to a request for proposals to perform additional services or the existing service in subsequent time periods. If one of the Company's larger existing government clients (such as the IRS) chooses to terminate its contract or memorandum of understanding with the Company, the business, operating results and financial condition of the Company could be materially and adversely affected. Credit Card Processing The Company currently processes payments made by individuals or small businesses using the American Express(R) Card, MasterCard, VISA card and the Discover(R) card. Imperial Bank (a wholly owned subsidiary of Comerica), American National Bank, Centura Bank, First Data Corporation's alliance partners, Fifth Third Bank, Michigan National Bank (expected to begin in Spring 2001), National City Bank, Norwest Bank, SunTrust Bank and Union Bank of California, in addition to other processing banks used by the Company, are all long-standing members of the VISA and MasterCard associations and process transactions utilizing those credit cards for the Company. Official Payments is a merchant agent for American Express, eliminating the need for government entities to enter into separate contracts with American Express. In addition, the Company is authorized by Discover Financial Services, Inc. to accept Discover Card transactions. All four credit card associations and organizations with whom the Company does business allow for convenience fees to be charged to cardholders as long as a cardholder receives added convenience from the service provided. All of these card associations, except for VISA, allow for a variable fee schedule according to which the amount of the fee changes depending on the amount charged. Because of VISA's rules against variable convenience fees, the Company does not accept VISA cards as a means of payment in federal and state payment programs. However, the Company does accept VISA as a means of payment in many county and municipal payment programs, such as parking citations processing. Consumer Payment Conduits and Fee Structure Depending upon the specific desires of the Company's government clients, consumers can make credit card payments to the Company's government clients by using the 1-800-2PAY-TAX(sm) telephone number and/or through the Company's Web site at www.officialpayments.com. Official Payments works with its government clients to develop the script for its fully automated telephone conduit. Payment and other information for the interactive voice response telephone system ("IVR") is received from consumers who respond to voice prompts by pressing touch-tone buttons on their telephones. Once the convenience fee and other necessary information is conveyed to and confirmed by the consumer, approval is sought from the relevant credit card issuing bank and the payment is processed. Upon completion of the payment, the consumer receives a transaction confirmation number. The Company's secure Web site currently allows consumers to make all federal, state and county payments. The Company is working with its municipal clients to provide this service for more payment programs later in 2001. Consumers enter payment-related information via the "payment center" section of the Company's Web site. Once this payment data is entered, the systems seek approval of the transaction from the credit card issuing bank and, if the approval is obtained, the payment is processed. As with the telephone conduit, upon completion of the payment, the consumer receives a transaction confirmation number. The Company recently introduced the first phase of several enhancements to its Web site, including the introduction of a convenience fee calculator, optional e-mail confirmation of transactions, a multiple password-protected payment verification capability, a user registration function and a comprehensive "frequently asked questions" section. The Company is continuing to develop the capability on its Web site for consumers to make multiple payments per transaction session and search for products by zip code, which functions it currently plans to introduce later in 2001. Consumers who use the Company's credit card payment services obtain the convenience of being able to make payments to government entities by credit card, eliminating the need to mail checks, obtain money orders or make payments in person. In addition, they gain the cash management flexibility to pay their credit card balances over time rather than when a government obligation is due and may be able to take advantage of frequent flyer, cash-back or other rewards programs offered by their credit card issuers for which they are enrolled and eligible. REVENUES AND OPERATIONS Operations The Company's technological solutions and operations are focused primarily on producing four integrated results for its government clients and consumers: reliability, security, audit capability and customer service/operational support. In designing its operations and technology around these core concepts, the Company believes it provides its government clients with a value-added payment solution resulting in improved efficiencies and potential cost-savings. Reliability. The Company's foremost service goal is reliability, which it seeks to accomplish through redundant hardware that provides disaster recovery and allows it to implement seamless real-time backup and 99.99% system availability. The Company's primary Internet payment servers are housed at Digex, Inc. facilities in San Jose, California. This Digex site is the Company's primary processing location, offering redundancy for power, telecommunications, servers and applications. The Company's San Ramon operations center serves as a backup site in the event the Digex facility is rendered inoperative, and upon the Company implementing a change in the location of the Company's Web site servers, this back-up facility would fully assume the traffic handled through the Digex site. The Company's interactive telephone systems have the same dual facility scheme as its Internet systems. The Company's primary interactive telephone authorization and processing facility is located at the Company's operations center in San Ramon, California, where its computers have interchangeable power supplies and hard drives so that if a system fails, the redundant systems will assume the workload. Official Payments also maintains a backup facility in Stockton, California, used for disaster recovery and transaction overflows. Transaction Security. The Company places a high priority on transaction security, fraud prevention and maintaining the confidentiality of all consumer credit card and related information. For its Internet conduit delivery vehicle, the Company employs secured socket layers for user security from the consumer's browser to the Company's Web site. Taxpayer identity validations for credit card payments are transmitted in an encrypted manner and are performed in accordance with existing industry procedures. The Company has several system functions that are designed to combat fraud. For example, credit card authorizations are performed on-line and in real time. The Company's system captures the cardholder's credit card account number, card expiration date, billing statement mailing address (Internet only) and zip code. Credit card information is transmitted exclusively to the credit card processor. No one outside of the Company's system and the credit card processor's system receives the credit card information, including the IRS and other government clients. The Company's systems were audited by independent auditors on behalf of the IRS in December 2000 and were determined to comply with the IRS's standards regarding systems penetration, security and privacy. Audit Capability. The Company's proprietary mirror balancing system (which is used for many of its government clients) and its reporting systems provide Official Payments and its government clients with electronic audit capability. These applications enable the Company to account for all transactions, ensure that data transmissions to government clients are complete and that files are updated accurately. Customer Service. Official Payments provides automated customer service systems, such as the transaction verification system, which allow consumers to confirm their transaction posting. In addition, the Company employs customer service representatives who are available to assist consumers and representatives of the Company's government clients with individual needs via telephone or e-mail. The Company also provides a "Frequently Asked Questions" feature on its Web site to answer common questions asked by consumers. Revenues The Company generally provides its services at no cost to the authorizing government entity. The Company generates revenues primarily from charging consumers a convenience fee for using its services. For many payments, such as personal federal and state income tax payments and local property tax payments, Official Payments charges a convenience fee based on the amount of the payment. For other payments, such as fines for traffic violations and parking citations, Official Payments charges a fixed convenience fee. The same convenience fee applies for payments made through the Internet or by telephone. In the majority of transactions, the financial institution processing the credit card transaction forwards the convenience fee to the Company and transmits the tax payment to the respective government entity. The Company uses most of the convenience fee paid by the consumer to pay its credit card processor's merchant discount fee. For the 2000 fiscal year, convenience fees from payments to the IRS accounted for approximately 69% of the Company's total revenues. The IRS has selected Official Payments to provide electronic payment services with respect to balance-due and extension tax payments for the 2000 tax year, as well as estimated payments for the 2001 tax year. The IRS had the option to renew the Company's services for an additional year, which it exercised in March 2001 (which extends the contract until March 2002). If the IRS does not continue to select the Company to perform this service in subsequent years, the Company's business, operating results and financial condition would be materially and adversely affected. SEASONALITY The Company's revenue generally reflects the seasonality of its business, which is due primarily to the fact that the majority of federal and state personal balance-due income tax payments are made in early to mid-April, federal and state estimated personal income tax payments are made quarterly and local property tax payments are made only once or twice per year in many jurisdictions. COMPETITION Alternative Payment Options In addition to using the Company's credit card payment services, consumer users have the following payment options when making payments to government entities: o Checks, money orders or cash. Payment by mailing checks, obtaining money orders and paying in person are the traditional and currently the most widely used methods for making payments to government entities. o Credit card checks. Many of the issuing banks for VISA and MasterCard distribute cash advance checks to their cardholders. In March and early April, issuing banks generally promote the use of these checks to pay taxes. Because these checks are treated as a cash advance, they may be a more expensive solution than the Company's services. The typical terms for a cash advance include a one-time fee, and the advance starts to accrue interest immediately at the issuing bank's applicable rate. In addition, many issuing banks apply the consumer's payments to other less expensive balances first. Moreover, cash advances typically do not qualify for frequent flyer mileage programs or any other perquisites. In contrast, payments made through the Company's systems require a convenience fee, but are treated as purchases subject to generally lower interest rates, may not immediately accrue interest, and may qualify for various award programs. o Direct debit. Consumer users can arrange through their bank or otherwise to have payments to government entities directly debited from their checking or savings account. If arranged through the bank in which a consumer user's checking or savings account is maintained, this service is often provided free of charge. Competing Providers of Credit Card Services for Payments to Government Entities In selecting a provider of outsourced electronic payment services, the Company believes government entities consider the following: o the Company's ability to offer these services at no cost to the government entity; o the Company's existing relationships and referrals from other government entities currently using the Company's services; o the Company's proven technology systems; o the Company's ability to offer integrated federal, state and local payment options; o established consumer usage of the Company's services; o the Company's experience in implementing its services for new government clients efficiently and expeditiously; o the greatest possible consumer reach through both Internet and telephone conduits; o the Company's relationships with financial institutions and credit card companies; o the Company's flexibility in adapting to unique government procedures; o quality and convenience of the Company's service; o marketing and brand name recognition; and o price of the Company's services to consumers. A number of competitors currently provide credit card payment services for making payments to government entities. The Company believes it has a larger government client base and greater name recognition than its competitors. There are a number of larger credit card payment and electronic commerce companies with similar technological capabilities who may become potential competitors of the Company, some of whom have greater resources than the Company. For personal federal income tax payments by credit card, the Company had 100% market share for American Express and MasterCard payments and 59% for Discover Card payments through December 31, 2000. The only competitor for 1999 and 2000 tax year federal payments was a joint development effort by Intuit (TurboTax) and Discover Financial Services, Inc., for which the Discover Card (which had approximately 8% of the IRS balance-due credit card market based on total payment volume in 2000) was the only credit card accepted. Beginning in January 2001, with respect to the federal 2000 tax year and 2001 tax year estimated payments, the IRS has authorized one other service provider (PhoneCharge, Inc.) to collect American Express, MasterCard and Discover Card payments through a telephone and Internet conduit. Beginning with balance-due payments in 2001, the IRS has announced that software developers and credit card processing companies who offer an integrated personal federal income tax filing and payment program are permitted to compete against the Company (and similar stand-alone payment processors) without the need to enter into a formal contract with the IRS, subject to their compliance with certain technical processing requirements. To the Company's knowledge, as of the date of this Report, the Company's alliances with Jackson Hewitt, Inc. and Orrtax Software Inc., and Discover's alliance with Intuit are the only such integrated personal federal income tax filing and payment programs. With respect to all of the states (except New York, where there is one other authorized service provider for state income taxes) and counties and municipalities for whom the Company provides its credit card payment services, the Company believes it is the only provider of such services for the tax and other government payment programs in which it is involved. INTELLECTUAL PROPERTY The Company protects its intellectual property rights through a combination of trademark, service mark, copyright and trade secrets laws. No assurance can be given that the steps taken to protect the Company's intellectual property rights, however, will be adequate to deter misappropriation of those rights. The Company may not be able to detect unauthorized use of and take appropriate steps to enforce its intellectual property rights. It may also be possible for unauthorized third parties to copy certain portions of the Company's proprietary information or reverse engineer the proprietary information used in the Company's services. In order to limit access to and disclosure of the Company's proprietary information, all of the Company's employees are subject to confidentiality and invention assignment arrangements, and the Company enters into nondisclosure agreements with third parties that are material to its business. The Company has been, and from time to time expects to be, subject to claims by third parties in the ordinary course of business, including claims of alleged infringement of service marks, trademarks, copyrights, patents and other intellectual property rights of third parties. Although there has not been any litigation relating to such claims to date, these claims and any resultant litigation would subject the Company to significant liability for damages and could result in the invalidation of its proprietary rights. In addition, even if the Company prevails, the litigation could be time-consuming and expensive to defend and could result in a diversion of time and attention from the business, any of which could materially and adversely affect its business, operating results and financial condition. Any claims or litigation from third parties may also result in limitations on the ability of the Company to use the service marks, trademarks and other intellectual property subject to these claims or litigation, unless the Company enters into agreements with the third parties. However, these agreements may be unavailable on commercially reasonable terms, or not available at all. The Company intends to continue to license technology from third parties, including its Web server and encryption technology. The Company cannot be certain that these third-party content licenses will be available to it on commercially reasonable terms or that it will be able to integrate the technology into the Company's products and services. The Company licenses its base interactive telephone hardware and software systems from Alliance Systems Incorporated, which manufactures the hardware and provides the operating system and other development tools that the Company uses. The license fee is included in the cost of each system. Licenses for the processor software that enables the Company to receive authorizations from credit card companies are obtained from third party vendors. An additional license has been acquired from Artisoft Inc. to allow the Company to develop its interactive telephone applications. The Company also licenses patented technology for its IVR system from A2D, L.P., and pays a royalty to this patent holder for each call to the IVR. Finally, the Company obtained separate licenses from CyberSource Corp. and CyberCash, Inc. for credit card processing software with respect to each government client that is supported on the Company's Internet payment platform and IVR payment platform, respectively. RESEARCH AND DEVELOPMENT The Company's current business operations began in June 1996. The Company continues to provide enhancements to the IVR payment platform on an ongoing basis. The Company introduced the Internet payment platform in August 1999. Total development costs were $3.0 million, $2.1 million and $608,000 for the fiscal years ended December 31, 2000, 1999 and 1998, respectively. As of December 31, 2000, the Company has capitalized approximately $2.7 million for costs related to the research and development of new software products and enhancements to existing software products where technical feasibility was established. The Company believes its software and Internet applications teams and core technologies do not represent a significant competitive advantage. However, the Company believes that is has developed a technically skilled and highly productive development organization and technological infrastructure that should benefit it competitively in introducing and implementing new products in the future. The Company must continue to attract and retain highly qualified employees to further the Company's development efforts. The Company's business could be seriously harmed if the Company is not able to hire and retain a sufficient number of these individuals. GROWTH STRATEGY The Company's goal is to continue to be the leading provider of, and further develop the market for, electronic payment services to pay government obligations. The following are key elements of this strategy. Leverage IRS Relationship to Obtain Additional State Government Clients The Company is leveraging its IRS relationship to provide services to additional state government entities. These efforts have been bolstered by the fact that the IRS has publicly endorsed the concept of joint federal and state payments either via telephone or the Internet or through electronic filing. The Company currently provides, or has recently signed contracts to provide, its electronic payment services to 18 state governments and the District of Columbia, which experience the Company seeks to promote in establishing relationships with other states. A key element of the Company's strategy for obtaining personal state income tax accounts is the integration of the federal and state personal income tax payment processes. The Company's integrated solution allows consumers to pay their federal and state personal income taxes in a single session, which the Company believes should enhance consumer convenience and usage. Competitors who do not currently provide services to the IRS will be unable to offer this integrated service. Once the Company begins providing services to a particular state, it seeks opportunities to provide additional services for that state. Leverage IRS and State Government Client Relationships to Obtain Additional Local Clients As of December 31, 2000, the Company provided services to approximately 723 county and municipal clients. Its relationships with the IRS and state government entities provide the Company an advantage in establishing relationships with additional local clients. The Company is targeting county and municipal clients through direct sales, participation in industry trade shows and conferences and targeted newsletters and other mailings. Internet Services In August 1999, the Company began providing credit card payment services through the Internet. In addition to the Company's IVR payment services, the Company now makes Internet payment services available as an option to all of its existing government clients. Introduce New Services and Service Enhancements The Company seeks to remain at the forefront of its industry by continuing to develop additional and complementary services. While the Company's primary business to date has involved the collection of personal income taxes, property taxes and parking/traffic citations and fees, the Company has begun processing other payments, such as business sales and taxes, professional license fees and university tuition. It is also exploring other types of government obligations for which it might provide its services and opportunities to provide direct debiting and other electronic fund transfer features to consumers in the future. Increase Brand Awareness and Consumer Use The Company has primarily relied on its government clients and credit card issuers, and will continue to work with them, to publicize the Company's services through government bills and publications, as well as credit card promotions and billing inserts. Use of these specific promotional devices is arranged by the government clients and credit card companies at no cost to the Company. In addition, in October 2000 and March 2001, the Company entered into cooperative advertising arrangements with MasterCard International and American Express pursuant to which it received $255,000 from each to use for advertising campaigns promoting the Company's income tax payment services. In order to increase the number of transactions processed, the Company intends to increase consumer awareness of its credit card payment services through its own newspaper, television and radio advertising and public relations campaigns. The Company's marketing is also focused on promoting additional payment opportunities to its existing consumers. The Company believes that once a consumer uses its system, he or she is more likely to use these services to make other types of payments to government entities. The Company's Web site and interactive telephone system promote different types of payments that can be made using the Company's services. The Company also runs a national trade advertising campaign throughout the year to drive increased brand awareness amongst potential government clients. Pursue Strategic Relationships and Acquisitions The Company has begun providing its payment services to customers of the Jackson Hewitt(R) Tax Service, OrrTax Software Inc., and Nationtax Online and is pursuing similar strategic relationships with other tax preparation services, tax preparation software providers and electronic income tax filing providers. In the ordinary course of its business, the Company investigates relationships with Internet portals and other Internet financial service providers in order potentially to reach additional Internet users. The Company has formed a strategic alliance with E*Trade Group, Inc., pursuant to which E*Trade and the Company have agreed to engage in cross-marketing and joint promotions targeting the two companies' customer bases. In addition, Official Payments may pursue opportunistic acquisitions that will enhance its product offering and technical capabilities, including companies that provide government client or consumer user products or services closely related to the Company's, although the Company currently has not allocated specific proceeds to fund such acquisition plans. The Company also has relationships with a number of its processing banks to provide its services for their government clients. For example, Discover Financial Services and First Data Merchant Services were awarded the contract to provide personal income tax payment services for the State of California and subcontracted the provision of taxpayer services through IVR and Internet platforms to the Company. The Company has similar arrangements with Fifth Third Bank (Ohio), National City Bank (Illinois), Norwest Bank (Minnesota) and Paymentech L.L.C. (Kansas). The Company's product implementation model and revenues as a subcontractor are identical to a directly contracted account. Official Payments will look for additional strategic opportunities to provide services to government entities in conjunction with these and other partners. REGULATORY MATTERS By virtue of Comerica's ownership interest in the Company, and owing to the nature of the Company's business, the Company may be subject to various regulatory requirements. Comerica is a financial holding company that is subject to supervision and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended. Subject to certain exceptions, under the Act, Comerica historically has been prohibited from engaging in activities other than those of banking or managing or controlling banks, or from acquiring or retaining direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company whose activities the FRB has not determined to be so closely related to banking as to be a proper incident thereto. However, under the Gramm-Leach-Bliley Act of 1999 (which became effective in March 2000), this provision does not prohibit Comerica's present ownership interest in the Company because the Company's activities are, in the FRB's determination, financial in nature, incidential to such financial activity or complementary to a financial activity and do not impose a substantial risk to the safety or soundness of depository institutions or the financial system generally. For as long as Comerica owns a voting equity interest in the Company which equals 25% or more, or may otherwise be deemed by the regulatory authorities to constitute "control", the Company will also be subject to certain state and federal statutes and regulations that apply to Comerica. For example, the Company will be required to limit any transactions it may have with "affiliates" of Comerica in the same manner as Comerica must limit its transactions with its affiliates. Among other things, all such dealings with affiliates must be at arms' length. There is no guarantee that the financial holding company laws will not be amended or construed differently, or that new laws or regulations will not be adopted, the effect of which could materially and adversely affect the Company's business, operating results and financial condition. The Company is also subject to the laws and regulations relating to commercial transactions generally, such as the Uniform Commercial Code, and to the electronic fund transfer rules embodied in Regulation E issued by the Federal Reserve. The Federal Reserve's Regulation E implements the Electronic Fund Transfer Act, which was enacted in 1978. Regulation E protects consumers engaging in electronic transfers, and sets forth basic rights, liabilities and responsibilities of consumers who use electronic money services and of financial institutions that offer these services. For the Company, Regulation E sets forth disclosure and investigative procedures. For consumers, Regulation E establishes procedures and time periods for reporting unauthorized use of electronic money transfer services and limitations on the consumers' liability if the notification procedures are followed within prescribed periods. These limitations on the consumers' liability may result in liability to the Company. Given the expansion of the Internet commerce market, it is possible that the Federal Reserve might revise Regulation E or adopt new rules for electronic funds transfer affecting users other than consumers. Because of growth in the Internet commerce market, Congress has held hearings on whether to regulate providers of services and transactions in the Internet commerce market. It is possible that Congress or individual states could enact laws regulating the Internet commerce market. The privacy provisions of the Gramm-Leach-Bliley Act prohibit financial institutions from disclosing to unaffiliated third parties nonpublic personal information regarding consumers, subject to certain exceptions, and require those institutions to develop and disclose consumer privacy policies. Federal agencies are developing regulations that implement this new privacy law. In addition, a number of state legislatures are considering their own consumer privacy laws, which may be more stringent than the federal provisions. If enacted, these laws, rules and regulations could be imposed on the Company's business and industry and could have a material adverse effect on the Company's business, operating results and financial condition. Federal, local and state laws and regulations may be adopted in the future to address issues such as user privacy, pricing, online content regulation, taxation and the characteristics and quality of online products and services. Any new law or regulation relating to the Internet could have a material and adverse effect on the Company's business, operating results and financial condition. FORWARD-LOOKING INFORMATION The information in this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based upon the current economic environment and current expectations that involve risks and uncertainties, and you are cautioned that these statements are not guarantees of future performance. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. For example, words such as "may," "will," "should," "estimates," "predicts," "potential," "continue," "strategy," "believes," "anticipates," "plans," "expects," "intends," and similar expressions are intended to identify forward-looking statements. The Company's actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statement. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those discussed below in the section entitled "Risk Related to the Company's Business" and in "ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS," as well as the risks discussed in the Company's other Securities and Exchange Commission ("SEC") filings. RECENT EVENTS In March 2001, Official Payments reached an agreement with the State of Mississippi pursuant to which the Company will begin collecting delinquent taxes by credit card through its IVR and Internet payment platforms. In March 2001, Official Payments entered into a cooperative advertising agreement with American Express for $255,000. The Company will utilize these funds for an advertising campaign related to its federal income tax payment program with the IRS, which will run in March and April 2001. In March 2001, Official Payments entered into an agreement with the State of Iowa under which the Company will provide a service enabling Iowa citizens to pay a variety of delinquent tax and fee payments by credit card through the Company's IVR and Internet payment platforms. In March 2001, the IRS exercised its option to extend its existing contract with Official Payments for an additional calendar year. This renewal covers the 2001 tax year for personal federal balance due and extension payments, as well as estimated personal federal taxes for the 2002 tax year. In February 2001, the State of Oklahoma renewed and expanded the Company's existing contract with the state. The Company's previous agreements gave Oklahoma taxpayers the ability to pay their individual return balance-due personal state income tax payments by credit card through the Company's Web site. The new award adds the IVR option and six new tax payment categories: Corporate Income Tax, Corporate Estimated Tax, Individual Estimated Tax, Income Withholding, Income Tax Franchise, and Sales and Use Tax. On January 30, 2001, Imperial Bancorp, the parent holding company of Imperial Bank (which then owned approximately 55% of the Company's outstanding common stock), was acquired by Comerica in a tax-free, stock-for-stock transaction. Consummation of the merger resulted in the acceleration of various employee stock options and restricted stock granted under such plans of the Company under the Company's 2000 Stock Incentive Plan and 1999 Stock Incentive Plan. In addition, under the respective employment agreements for Thomas R. Evans (Chairman and Chief Executive Officer), Michael P. Presto (Chief Operating Officer) and Michael Barrett (Chief Internet and Sales Officer), this change of control event enables each of them to terminate his employment with the Company for "good reason" after July 30, 2001 and in connection therewith to continue receiving payment of his base salary and benefits for one year following such date. The employment agreement for Edward J. DiMaria (Chief Financial Officer) contains a similar provision, but he is only eligible to terminate his employment for good reason due to this event between April 30, 2001 and May 30, 2001. In March 2001, Imperial Bank transferred ownership of its shares of Company common stock to its new parent holding company, Comerica. In January 2001, the State of Connecticut renewed and expanded the Company's existing contract with the state. The Company's previous agreements gave Connecticut taxpayers the ability to pay their individual return balance-due personal state income tax payments by credit card over the Company's interactive telephone system. The new award adds the Company's Internet payment option and two new payment categories: 2000 Extension Tax and 2001 Estimated Tax. In January 2001, Official Payments announced its new contract with the State of Wisconsin which authorizes the Company to work directly with any Wisconsin state agency to provide a service for the collection of various taxes, fees, fines, licenses, and tuition payments by credit card via the Company's Web site and IVR. Currently, the Company has arranged to collect personal balance due income taxes and is in the process of contacting a number of state agencies to offer its services under the general state authorization contract. EMPLOYEES As of December 31, 2000, the Company had a total of 93 employees. None of these employees is represented by a collective bargaining agreement, nor has the Company experienced any work stoppage. The Company considers its relations with employees to be good. OTHER FACTORS AFFECTING THE COMPANY'S BUSINESS In addition to other information in this Form 10-K, the following factors should be carefully considered in evaluating the Company and its business because such factors currently may have a significant impact on the Company's business, operating results and financial condition. As a result of the factors set forth below and elsewhere in this Form 10-K, and the risks discussed in the Company's other Securities and Exchange Commission filings, actual results could differ materially from those projected in any forward-looking statements. RISKS RELATED TO THE COMPANY'S BUSINESS The Company has a history of losses and expects to continue to incur losses. The Company has incurred net losses of approximately $41.4 million for the period from its inception on June 26, 1996 to December 31, 2000. The Company expects to incur losses from operations for the foreseeable future. The Company has expended significant resources on increasing its customer service, engineering, sales and marketing staffs and enhancing the capabilities of its IVR system and Web site. As a result of these expenditures and its normal course operating expenses, the Company will need to significantly increase its revenues to achieve and maintain profitability. If the Company's revenues do not increase sufficiently, the operating results and financial condition of the Company could be materially and adversely affected. Because the Company's business model is continuing to evolve, it is difficult to evaluate the Company's business. The use of credit cards to make payments to government agencies is still relatively new and evolving. To date, the Company's business has consisted primarily of providing credit card payment options for the payment of balance-due federal and state personal income taxes, property taxes and fines for traffic violations and parking citations. Because the Company has only a limited operating history, it is difficult to evaluate its business and prospects and the risks, expenses and difficulties that the Company may face in implementing its business model. The Company's success will depend on maintaining its relationship with the IRS and on maintaining existing, and developing additional, relationships with state and local government agencies, especially state taxing authorities, and their respective constituents. There are no assurances that the Company will be able to develop new relationships or maintain existing relationships, and the failure to do so could have a material and adverse effect on the business, operating results and financial condition of the Company. The Company's future growth depends on the acceptance of its payment systems as a method for making payments to government entities. The Company works with government entities to allow it to provide credit card payment services to the government entities' constituents. While many government entities have initiatives or legislative mandates in place to foster the growth of electronic payments, the business, operating results and financial condition of the Company would suffer if there were a reduction in these initiatives. Traditionally, individuals and small businesses have made substantially all payments to government entities by check or money order. The Company is providing its payment services through its interactive telephone conduit and has developed and will continue to expand the availability of its Internet conduit. However, there are no assurances that the Company will be successful in attracting enough additional consumers to use its Internet and interactive telephone conduits to make their payments to the Company's government clients. The lack of meaningful growth in the market for credit card payments to government entities could have a material adverse effect on the business, operating results and financial condition of the Company. If consumers are unwilling to pay convenience fees for the Company's services, the Company's current business model will fail. The Company's current business model is based on consumers' willingness to pay a convenience fee in addition to their required government payment for the use of the Company's credit card payment option. If consumers are not receptive to paying a convenience fee, demand for the Company's services will decline or fail to grow, which could jeopardize the implementation of the Company's business plan and would have a material and adverse effect on the business, operating results and financial condition of the Company. If credit card associations change their rules and do not allow the Company to charge convenience fees, operating results of the Company would be materially and adversely affected. Credit card association rules governing the use of VISA and MasterCard at merchant locations generally prohibit merchants from charging a convenience fee for cardholder purchases. The Company and Imperial Bank, a California chartered bank and wholly owned subsidiary of the Company's majority stockholder, have worked with these credit card associations to permit the Company to charge convenience fees for credit card payments for government services and taxes. To date, VISA permits a convenience fee, but only if it is a flat amount for a particular government service and will not allow fees that are variable in amount depending on the kind of service provided or the amount involved. If the Company's ability to charge convenience fees is limited or eliminated, the business, operating results and financial condition of the Company would be materially and adversely affected. The IRS currently accounts for a significant portion of the Company's revenues, and the loss of the IRS as a client would materially and adversely impact the Company's operating results. In the year ended December 31, 2000, convenience fees from payments to the IRS accounted for approximately 69% of the Company's total revenues. The IRS has selected the Company to provide electronic payment services with respect to balance-due and extension tax payments for the 2000 tax year, as well as estimated tax payments for the 2001 tax year (with the IRS, in March 2001, having exercised the option to renew the Company's services for an additional year). If the IRS does not continue to select the Company to perform this service in subsequent years, the business, operating results and financial condition of the Company would be materially and adversely affected. Most of the Company's contracts with government clients are not exclusive or long-term contracts and, as a result, large government clients may terminate their relationships with the Company on short notice. Most of the Company's agreements with government clients are non-exclusive, short-term contracts or memoranda of understanding and can be terminated without cause on short notice, generally 30 to 90 days. In addition, a government client may choose not to renew its contract with the Company or may not choose the Company's proposal in response to a government request for proposals. If one of the Company's larger existing government clients chooses to terminate its contract or memorandum of understanding with the Company, or does not choose the Company's proposal, the business, operating results and financial condition of the Company could be materially and adversely affected. Increased competition in the market for payment services to government entities could result in lower operating margins and decreased market share. The Company's credit card payment services face competitive pressures from various card- issuing banks for VISA and MasterCard, which send out checks that function as cash advances and can be used for payments to government entities. In addition, a number of data and bill processing companies have the technical capability and other resources to commence providing credit card payment services, and have indicated an intent to do so. Increased competition from other providers of payment options to government entities could have a material and adverse effect on the business, operating results and financial condition of the Company. Many of the Company's current and potential competitors have significantly greater financial, marketing, technical, sales, customer support and other resources than the Company. In addition, some of these competitors may be able to devote greater resources to the development, promotion and sale of their services, adopt more aggressive pricing strategies and devote substantially more resources to the development of technology and systems than the Company will be able to devote or adopt. Increased competition may result in lower operating margins and loss of market share. The Company may not be able to compete successfully against current and future competitors, and competitive pressures could have a material and adverse effect on the business, operating results and financial condition of the Company. If the Company's services do not function as designed, the Company may incur significant liability for the processing of fraudulent or erroneous transactions. The Company's electronic payment services are designed to provide payment management functions and to limit its government clients' risk of fraud or loss in effecting transactions with their constituents. As electronic services become more critical to the Company's government clients, there is the potential for significant liability claims for the processing of fraudulent or erroneous transactions. In addition, defects or programming errors in the software the Company uses could cause service interruptions. The Company's services depend on complex software that is both internally developed and licensed from third parties. Although the Company conducts extensive testing, complex software may contain defects or programming errors, or may not properly interface with third party systems, particularly when first introduced or when new versions are released. To the extent that defects or errors are undetected in the future and cannot be resolved satisfactorily or in a timely manner, the Company's business could suffer. If a liability claim or claims were brought against the Company, even if not successful, their defense would likely be time consuming and costly and could damage the Company's reputation. Any such liability or claim could have a material and adverse effect on the business, operating results and financial condition of the Company. If the Company's system security is breached, it may be liable to government clients and consumer users for damages resulting from the breach. The Company's failure to prevent system security breaches could have a material and adverse effect on the business, operating results and financial condition of the Company. A fundamental requirement for electronic payment services is the secure transmission of confidential information over public communication networks. Third parties may attempt to breach the Company's system security or that of the Company's government clients or consumer users. If they are successful, the Company may be liable to its government clients or consumer users for any damages resulting from a breach in the Company's system security, and any breach could harm the Company's reputation. The Company may be required to expend significant capital and other resources to license additional encryption and other technologies to protect against system security breaches or to alleviate problems caused by any such breaches. If the Company's systems fail, it may not be able to provide adequate service, and the Company's operations could be damaged. The Company's success depends on the efficient and uninterrupted operation of its computer and communications systems. The majority of the Company's computer and communications systems are located in San Ramon, San Jose and Stockton, California. Although the Company has developed contingency plans and redundancies for its systems, the Company's systems and operations are vulnerable to damage or interruption from: o telecommunication failures; o power loss; o earthquakes, fires or floods; o computer viruses; o physical and electronic break-ins; and o acts of sabotage, vandalism and similar events. Any failure of the Company's systems could impede the timely processing of consumer user payments and other data and the day-to-day management of the business. Despite any precautions the Company takes, a natural disaster or other unanticipated problem that leads to the corruption or loss of data at the Company's facilities could result in an interruption of services. Service interruptions could have a material and adverse effect on the reputation, business, operating results and financial condition of the Company and would have a significant adverse effect if they occurred in early April. A constraint in the Company's capacity to process transactions could impair the quality and availability of the Company's service. Capacity constraints may cause unanticipated system disruptions, impair quality and lower the level of the Company's service, all of which could have a material and adverse effect on the business, operating results and financial condition of the Company. Although the Company believes that it has sufficiently expanded its system capacity to accommodate expected additional personal federal income tax payments and other anticipated growth for the foreseeable future, there are no assurances that the Company will not suffer capacity constraints caused by a sharp increase in the use of its services. Due to the large number of tax payments made in March and early April, there is an increased risk that the Company will suffer a capacity constraint during that period, which would have an adverse effect on the business, operating results and financial condition of the Company. If the Company fails to respond to rapid technological change, its systems and services could be rendered obsolete. The electronic payment industry is characterized by rapid technological change. If the Company cannot adapt or respond in a cost-effective and timely manner to technological changes, the business, operating results and financial condition of the Company will be materially and adversely affected, and the Company's technology and systems, and thus its services, could be rendered obsolete. The development of the Company's technologies and necessary service enhancements entails significant technical and business risks and requires substantial lead-time and expenditures. The Company may not be able to keep pace with the latest technological developments, successfully identify and meet the demands of its government clients and consumer users, use new technologies effectively, or adapt its services to emerging industry standards or to its government clients' or consumer users' requirements. The Company's operating results may fluctuate significantly from quarter to quarter, which may negatively impact the Company's stock price. The Company believes its quarterly operating results will continue to fluctuate significantly in the future as a result of a variety of factors, many of which are outside of the Company's control. These factors include: o the seasonality of the Company's business, which is due primarily to the fact that the majority of federal and state personal income tax payments is being made in early April and to the fact that property tax payments are made only once or twice per year in most jurisdictions; o the amount and timing of costs related to the Company's sales and marketing efforts and other initiatives; and o the Company's ability to upgrade, enhance and maintain its systems and infrastructure in a timely and cost-effective manner. Because of these factors, the Company believes that comparisons of its quarterly operating results are not necessarily meaningful. In addition, it is possible that in some future quarters the Company's operating results will be below the expectations of research analysts and investors, in which case the price of the Company common stock is likely to decline. If government clients and credit card issuers cease to publicize the Company's services, consumer use of its services may slow, and the Company would suffer a large increase in advertising costs. Currently, the Company's government clients and credit card issuers provide most of the publicity for its services, without any cost to the Company. If these entities cease to publicize the Company's services, or charge the Company for this publicity, advertising costs will increase substantially, which could have a material and adverse effect on the business, operating results and financial condition of the Company. The Company's government clients and credit card issuers have no obligation to continue to provide this publicity, and there are no assurances that they will continue to do so. In addition, the government clients may publicize other services, including those of its competitors. If the Company does not effectively manage its internal growth, the Company may not be able to expand its business. The Company is currently experiencing a period of rapid expansion. There are no assurances that the Company's current and planned personnel levels, systems, procedures and controls will be adequate to support its future operations. If inadequate, the Company may not be able to exploit existing and potential strategic relationships and market opportunities. Any delays or difficulties the Company encounters could impair its ability to attract new, and enhance its relationships with existing, government clients and consumer users. If the Company is unsuccessful in hiring, integrating and retaining new personnel, or unable to effectively manage its internal growth, the business, operating results and financial condition of the Company could be materially and adversely affected. The Company depends on a relatively few number of key employees. The Company currently does not maintain key man life insurance policies on any of its employees. The loss of the services of any key employees or the inability to hire and retain additional key employees would have a material and adverse effect on the business, operating results and financial condition of the Company. The Company may not be able to protect its intellectual property rights, which may result in damages to the Company, or the Company may infringe on the rights of others, which may subject it to liability for damages caused to third parties. The Company protects its intellectual property rights through a combination of trademark, service mark, copyright and trade secrets laws. There are no assurances, however, that the steps the Company has taken to protect its intellectual property rights will be adequate to deter misappropriation of those rights. The Company does not have any proprietary technology or patent protections. In addition, the Company cannot be certain that its services do not infringe on valid patents, copyrights and intellectual property rights held by third parties. The Company may be subject to legal proceedings and claims from time to time in the ordinary course of its business, including claims of alleged infringement of the intellectual property rights of third parties. Intellectual property litigation is expensive and time- consuming and could divert management's attention away from running the business. The Company may not be able to license technologies, including Web server and encryption technologies, from third parties on favorable terms, and the Company may not be able to utilize these technologies successfully. The Company intends to continue to license technology from third parties, including its Web server, IVR and encryption technology. The Company's business is evolving, and it may need to license additional technologies to remain competitive or adequately protect the security of its systems. The Company may not be able to license these technologies on commercially reasonable terms or at all. In addition, the Company may fail to successfully integrate any licensed technology into its services. These third party licenses may fail to generate revenues sufficient to offset associated acquisition and maintenance costs, or may divert the Company's resources from the development of its own proprietary technology. The Company's inability to obtain any of these licenses could delay product and service development until equivalent technology can be identified, licensed and integrated. Any such delays in services could cause the business and operating results of the Company to suffer. The Company substantially depends on the sponsorship of its processing banks to maintain its status as a credit card member service provider; and the Company's status in each credit card association could be suspended or terminated if it cannot comply with standards or if the associations change their membership rules. Termination of the Company's member service provider registrations or any changes in the rules of the credit card associations that limit the Company's ability to provide processing and marketing services, could have a material adverse effect on the business, operating results and financial condition of the Company. As a nonbank processor, in order to process credit card transactions, the Company must be authorized by American Express and Discover Financial Services and be sponsored by a financial institution that is a principal member of VISA and MasterCard. Through its processing banks, the Company is registered with VISA and MasterCard as a member service provider. The Company is a merchant agent for American Express and is authorized to accept Discover Card transactions. The Company's status in each association and with American Express and Discover Financial Services depends on its compliance with their standards, which may change and may vary from association to association, and could be suspended or terminated if the Company is unable to comply. There are no assurances that the credit card associations will maintain the Company's registrations or authorizations or keep their current rules in effect. Additionally, some of the member financial institutions that set the rules for each credit card association are the Company's or its processing banks' competitors, and may help effect rules that are less favorable to the Company. The Company's failure to successfully integrate any future acquisitions could strain its managerial, operational and financial resources. As part of the Company's business strategy, it intends to pursue opportunistic acquisitions that would provide additional technologies, products, services or experienced personnel. Acquisitions present a number of potential risks that could have a material and adverse effect on the business, operating results and financial condition of the Company, including: o difficulty in assimilating the acquired company's personnel, operations and technologies; o entrance into markets in which the Company has limited or no prior experience; o the potential loss of key employees of the acquired company; o the distraction of its management's attention from other business concerns; and o the potentially dilutive issuance of the Company's common stock, the use of significant amounts of cash or the incurrence of substantial amounts of debt. RISKS RELATED TO THE COMPANY'S INDUSTRY If the growth in the use and capacity of the Internet does not continue, or the Internet is not secure, the growth of the Company's business will be negatively impacted. The growth of the Company's business would be materially and adversely affected if Internet usage does not continue to grow rapidly. Internet usage may be inhibited for a number of reasons, including: o concerns about the security of confidential information; o lack of reliability and ease of access; o lack of cost-effective, high-speed service; o inconsistent quality and interruption of service; o inadequate network infrastructure; and o adoption of onerous laws or governmental regulations. The Internet infrastructure may not be able to support the demands placed on it by increased usage and its performance and reliability may decline. Internet Web sites have experienced interruptions and delays in their service as a result of outages occurring throughout the Internet network infrastructure. If these outages or delays occur frequently in the future, Internet usage, as well as the use of the Company's Internet payment service, could grow more slowly than projected or decline. In addition, because a number of the Company's services involve the transfer of confidential information, the business, operating results and financial condition of the Company could be materially and adversely affected if Internet users significantly reduce their use of the Internet due to security concerns. The Company may become subject to Federal Reserve Board licensing laws, expanded electronic fund transfer rules or more extensive credit card acceptance laws, which could increase the Company's operating costs, decrease its margins and/or restrict its business activities. The Company's management believes that it is not required to be licensed by the Federal Reserve Board, or other federal or state agencies that regulate or monitor banks or other types of providers of electronic commerce services. There are no assurances that a federal or state agency will not attempt, either now or in the future, to require that providers of services like the Company's be licensed. This would impede the Company's ability to do business in the areas within the regulator's jurisdiction. In conducting several aspects of the Company's business, the Company is subject to various laws and regulations relating to commercial transactions generally, such as the Uniform Commercial Code. The Company is also subject to the electronic fund transfer rules embodied in Regulation E issued by the Federal Reserve Board. Given the expansion of the electronic commerce market, it is possible that the Federal Reserve Board might revise Regulation E or adopt new rules for electronic fund transfers affecting users other than consumers. It is possible that Congress or individual states could enact laws regulating the electronic commerce market, enabling government entities in the affected jurisdictions to accept credit cards directly where they are currently prohibited from doing so or limiting the convenience fees that service providers can charge to accept and process credit card payments for government obligations. If enacted, these laws, rules and regulations could be imposed on the Company's business and industry and could have a material and adverse effect on the business, operating results and financial condition of the Company. If there are changes in tax laws which decrease the amount, the methods or the frequency of consumer tax payments, the Company's revenues could decrease. Congress, as well as individual states and municipalities, regularly consider a wide array of tax proposals. These tax proposals may result in a reduction of federal, state or local tax rates, collection of a greater percentage of taxes through withholding or other changes that could result in a decrease in the number and amount of payments that consumer users have to make directly to a government entity. In addition, some of these proposals may result in taxation of credit card perquisites, such as frequent flyer miles. If any of these proposals were to be passed, it may reduce the number and amount of tax payments effected through the Company's services and the dollar amount of the Company's revenue derived from the convenience fees charged to consumer users. If enacted, these laws could have a material and adverse effect on the business, operating results and financial condition of the Company. If there is a general economic downturn, the amount of income tax paid could decrease and/or consumers may be less willing to incur convenience fees in connection with the Company's services, which, in both cases, would reduce the Company's operating results. Income taxes are dependent on the amount of income earned by tax paying citizens. A significant economic downturn could reduce the per capita income of citizens, and thus reduce the amount of income tax payments consumer users have to make to a government entity, which may reduce the Company's revenues from convenience fees. In addition, an economic downturn may result in a reduction in consumer spending, particularly for non-essential goods and services, which may result in a reduction in consumers' use of the Company's services. If the United States experiences an economic downturn, it could have a material and adverse effect on the business, operating results and financial condition of the Company. ITEM 2. PROPERTIES The Company's corporate headquarters (including its marketing and finance operations) are located in Stamford, Connecticut in approximately 13,800 square feet of office space. The lease for this space expires in 2005. In addition, many of the Company's technical and customer service personnel are located in approximately 14,300 square feet of office space in San Ramon, California. The lease for this space expires in 2005. ITEM 3. LEGAL PROCEEDINGS The Company currently is not involved in any material legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K, there were no matters submitted to a vote of security holders through a solicitation of proxies or otherwise. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on The Nasdaq National Market under the symbol "OPAY." The Company's initial public offering of stock commenced on November 23, 1999 at $15.00 per share. The price range per share reflected in the table below, is the highest and lowest sale price for the Company's stock as reported by The Nasdaq National Market for the fiscal quarters indicated. The Company has never declared or paid cash dividends on its common stock. The Company presently intends to retain all future earnings, if any, to finance future growth and, therefore, does not anticipate paying any cash dividends in the foreseeable future. High Low ----------------- ---------------- 1999 Fourth Quarter $57.37 $17.25 2000 First Quarter $55.00 $32.00 Second Quarter $42.50 $4.00 Third Quarter $10.72 $3.81 Fourth Quarter $10.00 $4.00 As of March 15, 2001, there were approximately 22 stockholders of record of the Company's common stock, although the Company believes that there is a significantly larger number of beneficial owners of its common stock. The Company commenced its initial public offering on November 23, 1999 and completed it on November 29, 1999, after selling all of the 5,750,000 shares of common stock registered under the corresponding Registration Statement on Form S-1(No. 333-87325), including 750,000 shares sold in connection with the exercise of the underwriters' over-allotment option. The initial public offering price was $15.00 per share, resulting in gross proceeds from the initial public offering of $86.2 million. The Company paid a total of $6.0 million in underwriting discounts and commissions and incurred approximately $1.5 million for costs and expenses related to the offering. None of the costs and expenses related to the offering were paid directly or indirectly to any director or officer of the Company or their associates, persons owning 10 percent or more of any class of equity securities of the Company or an affiliate of the Company. After deducting the underwriting discounts and commissions and the offering expenses the estimated net proceeds to the Company from the offering were approximately $78.7 million. The net offering proceeds have been used, in addition to general corporate purposes, to make the following payments: approximately $2.0 million for the purchase and installation of computer equipment to expand transaction processing capabilities; approximately $2.8 million to add functionality to its Web site; approximately $1.5 million for the build-out of the Company's headquarters in Stamford, Connecticut and expansion of its leased office space in San Ramon, California; and approximately $5.2 million for direct marketing and promotional activities. Except for $135,000 and $151,000 of fees incurred by the Company in 2000 and 1999, respectively, for the provision of certain general administrative services by Imperial Bank (See "ITEM 13-CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS"), none of these costs or expenses were paid directly or indirectly to any director or officer of the Company or their associates, persons owning 10% or more of any class of equity securities of the Company or an affiliate of the Company. In the future, the Company may use a portion of its net proceeds to acquire or invest in businesses, technologies, products or services (which amount has not been specifically allocated as of the date hereof). Unused proceeds are invested in short-term investments. SALES OF THE COMPANY'S COMMON STOCK PRIOR TO ITS INITIAL PUBLIC OFFERING On August 24, 1999, the Company issued 2,400 shares of its common stock to Imperial Bank for a total consideration of $8.00 and 600 shares of common stock to Beranson Holdings, Inc. for a total consideration of $2.00. The Company relied on the exemption under Section 4(2) of the Securities Act of 1933, as amended, because it was an offer made by an issuer not involving a public offering. In connection with the merger of U.S. Audiotex, LLC into the Company, which was effected as of September 30, 1999, the limited liability company interests of Imperial Bank and Beranson Holdings, Inc. in U.S. Audiotex, LLC were exchanged for 11,997,600 and 2,999,400 shares of the Company's common stock, respectively. The merger was an internal corporate reorganization solely involving the existing members of U.S. Audiotex, LLC in order to convert the Company's corporate form into a C corporation in anticipation of its initial public offering. On November 5, 1999, the Company sold 512,820 shares of its common stock to E*TRADE Group, Inc. for $9.75 per share - resulting in total consideration of $5 million. E*TRADE Group, Inc. is a sophisticated qualified institutional buyer. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the financial statements and the notes to the financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations," which are included elsewhere in this report. YEARS ENDED DECEMBER 31, ------------------------------------ 2000 1999 1998 1997 -------- ------- -------- ---------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Revenues: Transaction fees.................. $ 25,793 $ 8,592 $ 2,076 $ 935 Other revenues.................... 291 249 293 267 -------- ------- -------- -------- Total Revenues............... 26,084 8,841 2,369 1,202 -------- ------- -------- -------- Cost of revenues: Cost of transaction fees.......... 14,943 4,072 442 232 Cost of transaction fees to related party............................ 5,858 2,069 515 153 Cost of other revenues............ 106 204 71 284 -------- ------- -------- -------- Total cost of revenues....... 20,907 10,345 1,028 669 -------- ------- -------- -------- Gross profit........................... 5,177 2,564 1,341 533 -------- ------- -------- -------- Operating expenses: Sales and marketing............... 9,212 1,301 356 330 Development costs................. 2,953 1,032 608 206 General and administrative........ 10,042 2,692 590 463 Depreciation expenses............. 1,716 288 57 30 Amortization of deferred stock-based compensation 15,728 7,940 --- --- -------- ------- -------- -------- Total operating expenses..... 39,651 13,253 1,611 1,029 -------- ------- -------- -------- Loss from operations................... (34,474)(10,757) (270) (496) Other income (expense), net............ 4,436 357 (55) (6) -------- ------- -------- -------- Net loss............................... (30,038)(10,757) (325) (502) ======== ======= ======== ======== Basic and diluted net loss per share... $ (1.40)$ (0.66)$ (0.02)$ (0.03) ======== ======= ======== ======== Weighted-average shares used in computing basic and diluted net loss per share......................... 21,421 15,677 15,000 15,000 ======== ======= ======== ======== BALANCE SHEET DATA: Cash and short-term investments... $ 65,898 $80,825 $ 631 $ 182 Working capital (deficit)......... 61,502 80,150 392 (221) Total assets...................... 76,263 84,300 1,747 764 Total debt including current portion 1,184 597 810 389 Stockholders' equity (deficit).... 68,453 81,561 184 (91) ---------- See note 1 of Notes to Financial Statements for an explanation of the determination of the number of shares used to compute basic and diluted net income (loss) per share. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the financial condition and results of operations of the Company should be read in conjunction with "Selected Financial Data" and the Company's financial statements and related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to, the risks discussed in the Company's other SEC filings. OVERVIEW Official Payments is a leading provider of electronic payment options to government entities, enabling consumers to use their credit cards to pay, through the Internet or by telephone, personal federal and state income taxes, sales and use taxes, property taxes, tuition payments, motor vehicles fees, fines for traffic violations and parking citations and other government-imposed taxes and fees. The Company commenced current operations on June 26, 1996, initially offering its credit card payment services for the payment of fines for traffic violations, parking citations and property taxes. As of December 31, 2000, the Company offered approximately 1,151 services to approximately 742 government entities. In mid- 1998, the Company signed a credit card payment contract with the IRS to provide its services for the balance due payment by telephone of personal federal income taxes, and for the 1999 tax year, the Company began processing estimated and extension tax payments, as well. In March 2000, the IRS awarded Official Payments a contract to accept via the Internet and telephone balance due and estimated tax payments for the 2000 tax year, as well as estimated payments for the 2001 tax year. This new contract has an initial one-year term, with the IRS having the option to renew the contract for one additional year. The IRS exercised this renewal option in March 2001. The Company began providing services for the payment of personal state income taxes in California in December 1998 and in New Jersey and the District of Columbia in 1999. In addition to continuing to provide its services for these three government entities, in 2000, the Company began providing, or had entered into contracts to provide (and was in the process of implementing), its payment services to the states of Alabama, Arkansas, Connecticut, Illinois, Kansas, Maryland, Minnesota, New York, Ohio, Oklahoma, Virginia, Washington, and West Virginia. In the first quarter of 2001, the Company entered into agreements to provide its payment services for the states of Wisconsin, Iowa and Mississippi. Consumers can make payments to these states through the Company's IVR system and Web site. The Company's revenues consist primarily of convenience fees, which are transaction fees paid by consumers for using its credit card payment services. For the year ended December 31, 2000, the convenience fees ranged from 2.7% to 8.9% of the amount paid by the consumer per transaction. For processing many payments (including, personal federal and state income tax payments, sales and use tax payments and property tax payments), the amount of the convenience fee charged varies based on the specific amount of the government obligation. For processing other types of payments (including, fines for traffic violations and parking citations), the amount of the convenience fee charged is fixed, regardless of the specific amount of the government obligation. Total revenues have increased significantly since the Company started providing services in January 1999 for personal federal income tax payments. For the 2000 fiscal year, convenience fees from payments to the IRS accounted for approximately 69% of the Company's total revenues. The Company's primary cost of revenues are the merchant discount fees paid to its credit card processors, which, during the year ended December 31, 2000, ranged from 1.5% to 3.0% of the total amount paid by the consumer, depending on the credit card used and the type of transaction. The Company also incurs variable telecommunications costs and IVR license royalty fees of approximately $0.51 per completed transaction through its telephone conduit. Although there are no telecommunications costs associated with payments made through the Internet conduit, the Company pays a third party license fee of $0.13 per completed transaction for certain technology used in its Internet conduit. The Company's total cost of revenues has increased significantly since January 1999 because of the large number of personal federal income tax payments processed, which has a lower gross margin as compared to other payment services. Processing fines for traffic violations and parking citations produce a higher gross margin than processing income tax, sales and use tax and property tax payments because the convenience fee as a percentage of fines processed is significantly higher. Operating expenses include sales and marketing expenses, development costs, general and administrative expenses, depreciation expenses, and allocated expenses from a related party. The largest component of these expenses was related to the amortization of deferred stock compensation, which amounted to $15.7 million in the year ended December 31, 2000. Sales and marketing expenses consist primarily of advertising expenses and salaries and commissions for sales and marketing personnel. Development costs consist primarily of salaries for engineering personnel and consulting expenses relating to research and development activities. General and administrative expenses consist primarily of salaries and other compensation expenses for executive, customer service, finance and administrative personnel. The Company has incurred significant losses since inception and expects to continue to incur losses for the foreseeable future. As of December 31, 2000, the Company had an accumulated deficit of approximately $41.4 million. The Company recorded on its balance sheet deferred stock compensation totaling $42.9 million in the third and fourth quarters of 1999. This deferred charge consists of an amount of $10.0 million, representing the guaranteed value of options granted to Thomas R. Evans, the Company's Chairman and Chief Executive Officer, and an amount of $32.9 million, representing the value of the common stock underlying options granted to certain other officers and employees of the Company in August, September and November of 1999 in excess of the exercise prices of those options. The $10.0 million deferred charge related to Mr. Evans' options and $32.9 million of deferred charges related to new options granted to other officers and employees was initially intended to be amortized over a three-year vesting period, beginning in the third quarter of 1999. However, as a result of the acceleration of options under the Company's 1999 Stock Incentive Plan due to Comerica's acquisition of Imperial Bancorp on January 30, 2001, the unamortized portion of this charge will be recognized by the Company in the first quarter of 2001. In addition, $4.5 million of deferred compensation related to option grants to the Company's former Chief Financial Officer, Brian W. Nocco, which beginning in the third quarter of 1999 were being amortized over a three-year vesting period. Mr. Nocco's employment with the Company terminated during the second quarter of 2000, and in connection therewith and pursuant to Mr. Nocco's previously existing employment contract, the vesting of a number of Mr. Nocco's options was accelerated and the unamortized portion of the deferred stock-based compensation relating to Mr. Nocco was recognized during the second quarter of 2000. The Company also recorded on its balance sheet deferred stock-based compensation totaling $633,000 in the second quarter of 2000. This deferred charge represented the fair market value of restricted shares of common stock granted to employees as performance-based awards and also in replacement of, and in exchange for, cancelled unvested stock options with exercise prices in excess of the current market value. Beginning in June 2000, this deferred charge was amortized on a straight-line basis over a one-year vesting period. As a result of the acceleration of options under the Company's 2000 Stock Incentive Plan due to Comerica's acquisition of Imperial Bancorp, the unamortized portion of this charge will be recognized by the Company in the first quarter of 2001. RECENT EVENTS In March 2001, Official Payments reached an agreement with the State of Mississippi pursuant to which the Company will begin collecting delinquent taxes by credit card through its IVR and Internet payment platforms. In March 2001, Official Payments entered into a cooperative advertising agreement with American Express for $255,000. The Company will utilize these funds for an advertising campaign related to its federal income tax payment program with the IRS, which will run in March and April 2001. In March 2001, Official Payments entered into an agreement with the State of Iowa under which the Company will provide a service enabling Iowa citizens to pay a variety of delinquent tax and fee payments by credit card through the Company's IVR and Internet payment platforms. In March 2001, the IRS exercised its option to extend its existing contract with Official Payments for an additional calendar year. This renewal covers the 2001 tax year for personal federal balance due and extension payments, as well as estimated personal federal taxes for the 2002 tax year. In February 2001, the State of Oklahoma renewed and expanded the Company's existing contract with the state. The Company's previous agreements gave Oklahoma taxpayers the ability to pay their individual return balance-due personal state income tax payments by credit card through the Company's Web site. The new award adds the IVR option and six new tax payment categories: Corporate Income Tax, Corporate Estimated Tax, Individual Estimated Tax, Income Withholding, Income Tax Franchise, and Sales and Use Tax. On January 30, 2001, Imperial Bancorp, the parent holding company of Imperial Bank (which then owned approximately 55% of the Company's outstanding common stock), was acquired by Comerica in a tax-free, stock-for-stock transaction. Consummation of the merger resulted in the acceleration of various employee stock options and restricted stock granted under the Company's 2000 Stock Incentive Plan and 1999 Stock Incentive Plan. In addition, under the respective employment agreements for Messrs. Evans, Presto and Barrett, this change of control event enables each of them to terminate his employment with the Company for "good reason" after July 30, 2001 and in connection therewith to continue receiving payment of his base salary and benefits for one year following such date. Mr. DiMaria's employment agreement contains a similar provision, but he is only eligible to terminate his employment for good reason due to this event between April 30, 2001 and May 30, 2001. In March 2001, Imperial Bank transferred ownership of all of its shares of the Company's common stock to its new parent holding company, Comerica. In January 2001, the State of Connecticut renewed and expanded the Company's existing contract with the state. The Company's previous agreements gave Connecticut taxpayers the ability to pay their individual return balance-due personal state income tax payments by credit card over the Company's interactive telephone system. The new award adds the Company's Internet payment option and two new payment categories: 2000 Extension Tax and 2001 Estimated Tax. In January 2001, Official Payments announced its new contract with the State of Wisconsin which authorizes the Company to work directly with any Wisconsin state agency to provide a service for the collection of various taxes, fees, fines, licenses, and tuition payments by credit card via the Company's Web site and IVR. Currently, the Company has arranged to collect personal balance due income taxes and is in the process of contacting a number of state agencies to offer its services under the general state authorization contract. RESULTS OF OPERATIONS The following table sets forth, for the periods illustrated, certain statements of operations data expressed as a percentage of total revenues. The data has been derived from the financial statements contained in this report. The operating results for any period should not be considered indicative of results for any future period. This information should be read in conjunction with the consolidated financial statements included in this report. YEARS ENDED DECEMBER 31, ------------------------ 2000 1999 1998 ---- ---- ---- STATEMENT OF OPERATIONS DATA: Revenues: Transaction fees................................. 99% 97% 88% Other revenues................................... 1 3 12 -------- -------- ------- Total revenues............................... 100 100 100 Cost of revenues: Cost of transaction fees......................... 57 46 19 Cost of transaction fees to related party........ 23 24 22 Cost of other revenues........................... -- 2 3 -------- ------- ------- Total cost of revenues....................... 80 72 44 -------- ------- ------- Gross profit....................................... 20 28 56 -------- ------- ------- Operating expenses: Sales and marketing.............................. 36 15 15 Development costs................................ 11 12 26 General and administrative....................... 38 31 25 Depreciation expenses............................ 7 3 2 Amortization of deferred stock-based compensation 60 89 -- -------- -------- ------- Total operating expenses..................... 152 150 68 -------- -------- ------- Loss from operations............................... (132) (122) (12) Other income (expense), net........................ 17 4 (2) -------- -------- ------- Net loss........................................... (115)% (118)% (14)% ======== ======== ======= COMPARISON OF THE YEARS ENDED DECEMBER 31, 2000 AND 1999 REVENUES Total Revenues. Total revenues increased $17.3 million to $26.1 million for the year ended December 31, 2000 from $8.8 million for the year ended December 31, 1999, an increase of 195%. This increase is primarily attributable to revenues generated from additional payment options added to the Company's existing IRS contract, and additional state and municipal/county ("local") clients added during 2000 which resulted in increases in revenue from processing state and local property taxes. Federal Transaction Fees. Federal transaction revenues consist of fees earned in connection with processing payments related to personal federal balance due, extension and estimated income taxes. Federal transaction fees increased $13.7 million to $18.0 million for the year ended December 31, 2000 from $4.3 million for the year ended December 31, 1999, an increase of 316%. The increase in revenues is primarily related to the two new payment services added during 2000: extension and estimated payments. The Company only offered one payment service, balance-due, during the prior fiscal year. The increase is also attributable to the increase in the utilization from the prior fiscal year. Federal revenues represented 69% and 49% of total revenues for the years ended December 31, 2000 and 1999, respectively. The Company processed approximately 157,300 transactions totaling $439.1 million during the year ended December 31, 2000 compared to 44,800 transactions totaling $174.0 million during the prior fiscal year for balance due payments. The Company also processed 17,900 transactions totaling $88.5 million and 21,700 transactions totaling $123.1 million during the year ended December 31, 2000 for extension and estimated tax payments, respectively. State Transaction Fees. State transaction revenues consist of fees earned in connection with processing payments for balance due, extension, estimated and delinquent personal state income taxes, sales and use taxes, and other state fees on behalf of the Company's state clients. State revenues increased $1.9 million to $2.5 million for the year ended December 31, 2000 from $557,000 for the year ended December 31, 1999, an increase of 341%. The increase from the prior year is primarily due to the increase in the number of clients and payment services added during the 2000 fiscal year. State revenues represented 10% and 6% of total revenues for the years ended December 31, 2000 and 1999, respectively. The Company processed approximately 64,200 transactions totaling $84.8 million during the year ended December 31, 2000 compared to 16,500 transactions totaling $15.7 million during the prior fiscal year. Local Transaction Fees. Local transaction revenues consist of fees earned in connection with processing payments for property taxes, traffic violations, parking citations, fax filing fees, and utility bills for the Company's municipal and county clients. Local transaction fees increased $1.7 million to $5.4 million for the year ended December 31, 2000 from $3.7 million for the year ended December 31, 1999, an increase of 46%. Revenues from processing property tax payments increased $1.2 million to approximately $3.0 million for the year ended December 31, 2000 from $1.8 million for the year ended December 31, 1999, an increase of 67%. The increase is primarily attributable to an increase in the number of transactions processed and new municipal and county clients added during 2000. Revenues from processing fines for traffic violations, moving violations and other transactions increased $495,000 to $2.4 million for the year ended December 31, 2000 from $1.9 million for the year ended December 31, 1999, an increase of 26%. The increase is primarily attributable to an increase in the number of transactions processed. Local revenues represented 21% and 42% of total revenues for the years ended December 31, 2000 and 1999, respectively. Other Revenues. Other revenues increased $42,000 to $291,000 for the year ended December 31, 2000 from $249,000 for the year ended December 31, 1999, an increase of 17%. COST OF REVENUES Cost of Transaction Fees. Cost of transaction fees increased $14.6 million to $20.9 million for the year ended December 31, 2000 from $6.3 million for the year ended December 31, 1999, an increase of 232%. The largest component of cost of transaction fees, merchant discount fees, increased $13.2 million to $19.0 million for the year ended December 31, 2000 from $5.8 million for the year ended December 31, 1999, an increase of 228%. The cost of telephone charges for the Company's IVR system increased $1.2 million to $1.5 million for the year ended December 31, 2000 from $318,000 for the year ended December 31, 1999, an increase of 377%. These increases were due to the corresponding increase in revenue. Cost of transaction fees was 80% of total revenues for the year ended December 31, 2000 compared to 69% for the year ended December 31, 1999. The increase is due to the lower gross margins for personal federal income tax payment services as compared to other payment services. The increase is also attributable to the increase in Internet costs from the prior fiscal year, which is consistent with the increase in the number of Internet transactions processed during the year ended December 31, 2000. Cost of Other Revenues. Cost of other revenues decreased $98,000 to $106,000 for the year ended December 31, 2000 from $204,000 for the year ended December 31, 1999, a decrease of 48%. OPERATING EXPENSES Sales and Marketing. Sales and marketing expenses increased $7.9 million to $9.2 million for the year ended December 31, 2000 from $1.3 million for the year ended December 31, 1999, an increase of 608%. This increase is primarily attributable the Company's marketing campaign for its payment services which totaled $5.2 million for the year ended December 31, 2000. Advertising expenses totaled $69,000 in the prior fiscal year. The increase is also attributable to an increase in the number of sales and marketing personnel to handle additional growth in business and in anticipation of future growth. An increase in commission payments to the Company's sales employees also contributed to the increase in sales and marketing expenses from the prior fiscal year. Sales and marketing expenses represented 36% of total revenues for the year ended December 31, 2000 compared to 15% for the year ended December 31, 1999. Development Costs. Development costs increased $2.0 million to $3.0 million for the year ended December 31, 2000 from $1.0 million for the year ended December 31, 1999, an increase of 200%. The increase is primarily attributable to consultants hired during the current fiscal year to assist in the testing and data conversion of the Company's Web site. The increase is also attributable to an increase in the number of engineering personnel resulting in an increase in salary and other employee related costs. Development costs represented 11% of total revenues for the year ended December 31, 2000 compared to 12% for the year ended December 31, 1999. General and Administrative. General and administrative expenses increased $7.3 million to $10.0 million for the year ended December 31, 2000 from $2.7 million for the year ended December 31, 1999, an increase of 270%. This increase is primarily attributable to the significant hiring of additional general and administrative personnel, including customer service, finance and corporate officers during the current fiscal year. This increase is also attributable to the hiring of additional temporary customer service personnel and the rental of temporary office space in San Diego, California during the current 2000 peak tax-filing season. The Company also expensed $522,000 for severance, relocation and other contractual obligations paid to the Company's former chief financial officer in connection with the termination of his employment in 2000. General and administrative expenses represented 38% of total revenues for the year ended December 31, 2000 compared to 31% for the year ended December 31, 1999. Depreciation Expenses. Depreciation expenses increased $1.4 million to $1.7 million for the year ended December 31, 2000 from $288,000 for the year ended December 31, 1999, an increase of 486%. The increase is primarily related to an increase in IVR equipment purchased during the first quarter of 2000 in preparation and handling of the higher volume of federal and state tax payments. The increase is also related to the additional office equipment and furniture and fixtures purchased during the Company's move to its new headquarters in Stamford, Connecticut and the expansion of its offices in San Ramon, California. Amortization of deferred stock-based compensation. Amortization of deferred stock-based compensation increased from $7.8 million to $15.7 million for the year ended December 31, 2000 from $7.9 million for the year ended December 31, 1999, an increase of 99%. This increase is primarily attributable to the full year of amortization taken during 2000 versus partial years' worth of amortization taken in 1999. In addition, the increase is attributable to $3.6 million in acceleration of vesting of stock options previously granted the Company's former chief financial officer, which occurred in connection with the termination of his employment. Amortization of deferred stock-based compensation represented 60% of total revenues for the year ended December 31, 2000 compared to 89% for the year ended December 31, 1999. OTHER INCOME, NET Other income, net, which consists of interest income, interest expense and other non- operating expenses, increased primarily due to interest income resulting from investment of the proceeds from the Company's initial public offering in November 1999. PROVISION FOR INCOME TAXES For federal income tax purposes, the Company has net operating loss ("NOL") carryforwards of approximately $23.6 million and $1.1 million for the year ended December 31, 2000 and 1999, respectively, expiring in 2019 and 2020. The U.S. Tax Reform Act of 1986 contains provisions that limit the NOL carryforwards available to be used in any given year upon the occurrence of certain events, including a significant change of ownership. Management believes that a change in ownership occurred in connection with Comerica's acquisition of Imperial Bancorp and, as a result, the ability of the Company to utilize the NOL's to offset income in the future could be limited. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning in making these assessments. Due to the Company's operating losses, there is uncertainty surrounding whether the Company will ultimately realize its deferred tax assets. Prior to September 30, 1999, the Company was a California limited liability company. Accordingly, all tax operating losses prior to September 30, 1999 have been used by the members of such limited liability company. COMPARISON OF THE YEARS ENDED DECEMBER 31, 1999 AND 1998 REVENUES Total Revenues. Total revenues increased $6.4 million to $8.8 million for the year ended December 31, 1999 from $2.4 million for the year ended December 31, 1998, an increase of 267%. This increase is primarily attributable to revenues generated from first-time processing of personal, federal and state income tax payments in the year ended December 31, 1999, as well as increases in revenue from processing property taxes. Federal Transaction Fees. Federal transaction revenues consist of fees earned in connection with processing payments solely related to personal federal balance due income taxes. Federal transaction fees were $4.3 million for the year ended December 31, 1999, representing 49% of the Company's total revenues. The Company processed approximately 44,800 transactions totaling $174.0 million during the year ended December 31, 1999. State Transaction Fees. State transaction revenues consist of fees earned in connection with processing payments for balance due, extension, estimated and delinquent personal state income taxes, sales and use taxes, and/or other state fees on behalf of the Company's state clients. A significant portion of revenues earned during the fiscal year related to processing delinquent personal state tax payments. State revenues were $557,000 for the year ended December 31, 1999, representing 6% of total revenues. The Company processed approximately 16,500 transactions totaling $15.7 million. Local Transaction Fees. Local transaction revenues consist of fees earned in connection with processing property taxes, traffic violations, parking citations, fax filing, and utility payments for the Company's county and municipal clients. Local transaction fees increased $1.6 million to $3.7 million for the year ended December 31, 1999 from $2.1 million for the year ended December 31, 1998, an increase of 76%. Revenues from processing property tax payments increased $1.0 million to approximately $1.8 million for the year ended December 31, 1999 from $765,000 for the year ended December 31, 1998, an increase of 131%. The increase is primarily attributable to an increase in the number of property tax transactions processed during the year ended December 31, 1999 and the introduction of the Company's Internet payment option during the third quarter of 1999. Revenues from processing fines for traffic violations, moving violations and other transactions increased $600,000 to $1.9 million for the year ended December 31, 1999 from $1.3 million for the year ended December 31, 1998, an increase of 46%. The increase is primarily attributable to an increase in the number of transactions processed and new county and municipal clients added during 1999. Other Revenues. Other revenues decreased $44,000 to $249,000 for the year ended December 31, 1999 from $293,000 for the year ended December 31, 1998, a decrease of 15%. COST OF REVENUES Cost of Transaction Fees. Cost of transaction fees increased $5.3 million to $6.3 million for the year ended December 31, 1999 from $1.0 million for the year ended December 31, 1998, an increase of 530%. The largest component of cost of transaction fees, merchant discount fees, increased $5.0 million to $5.8 million for the year ended December 31, 1999 from $792,000 for the year ended December 31, 1998, an increase of 631%. The cost of telephone charges for the Company's IVR system increased $219,000 to $318,000 for the year ended December 31, 1999 from $99,000 for the year ended December 31, 1998, an increase of 221%. These increases were due to the corresponding increase in revenue. Cost of transaction fees was 71% of total revenues for the year ended December 31, 1999 compared to 44% for the year ended December 31, 1998. The increase is due to the lower gross margins for personal federal income tax payment services as compared to other payment services. Cost of Other Revenues. Cost of other revenues increased $133,000 to $204,000 for the year ended December 31, 1999 from $71,000 for the year ended December 31, 1998, an increase of 187%. OPERATING EXPENSES Sales and Marketing. Sales and marketing expenses increased $944,000 to $1.3 million for the year ended December 31, 1999 from $356,000 for the year ended December 31, 1998, an increase of 265%. This increase is primarily attributable to an increase in the number of sales and marketing personnel and an increase in commission payments. Sales and marketing expenses represented 15% of total revenues for the years ended December 31, 1999 and 1998. Development Costs. Development costs increased $392,000 to $1.0 million for the year ended December 31, 1999 from $608,000 for the year ended December 31, 1998, an increase of 64%. This increase is primarily attributable to an increase in the number of engineering personnel and development of the IVR and Internet payment conduits. Development costs represented 12% of total revenues for the year ended December 31, 1999 compared to 26% for the year ended December 31, 1998. General and Administrative. General and administrative expenses increased $2.1 million to $2.7 million for the year ended December 31, 1999 from $590,000 for the year ended December 31, 1998, an increase of 356%. This increase is primarily attributable to the hiring of additional general and administrative personnel, including executive officers and other administrative personnel. General and administrative expenses represented 31% of total revenues for the year ended December 31, 1999 compared to 25% for the year ended December 31, 1998. Depreciation Expenses. Depreciation expenses increased $231,000 to $288,000 for the year ended December 31, 1999 from $57,000 for the year ended December 31, 1998, an increase of 405%. The increase is primarily related to IVR equipment purchased during the year in response to increased utilization and increase in office equipment purchased during the year due to the increase in personnel. Amortization of deferred stock-based compensation. Amortization of deferred stock- based compensation was $7.9 million for the year ended December 31, 1999. This was due to the vesting of stock options granted to certain employees to purchase shares of the Company's common stock at exercise prices below the fair market value of the common stock on the date such options were granted. Amortization of deferred stock-based compensation represented 89% of total revenues for the year ended December 31, 1999. OTHER INCOME, NET Other income, net, which consists of interest income, interest expense and other non- operating expenses, increased primarily due to interest income resulting from investment of the proceeds from the Company's initial public offering. PROVISION FOR INCOME TAXES The Company incurred operating losses during the period of its incorporation from September 30, 1999 through December 31, 1999. The Company has recorded a valuation allowance for the full amount of net deferred tax assets, as the future realization of the tax benefit is not currently likely. As of December 31, 1999, the Company had net operating loss carry-forwards for federal tax purposes of approximately $1.1 million and for California income tax purposes of approximately $534,000. These federal and California income tax loss carry-forwards are available to reduce future taxable income and expire at various dates. The federal net operating loss carryforward expires in year 2019. The California net operating loss carryforward expires in year 2004. Under the provisions of the Internal Revenue Code, certain substantial changes in the Company's ownership may limit the amount of net operating loss carry-forwards that could be utilized annually in the future to offset taxable income. There had not been any substantial changes in the Company's ownership through December 31, 1999. Prior to September 30, 1999, the Company was a California limited liability company. Accordingly, all tax operating losses prior to September 30, 1999 have been used by the members of such limited liability company. LIQUIDITY AND CAPITAL RESOURCES Since January 1997 and prior to the offering the Company financed its operations through private sales of common stock, with net proceeds of $5.0 million, and through shareholder loans. In November 1999, Official Payments completed the initial public offering of its common stock and realized net proceeds from the offering of approximately $78.7 million. As of December 31, 2000, the Company had $65.9 million in cash and short-term investments, and $61.5 million in working capital. The Company has experienced operating losses during all fiscal periods following the Company's initial public offering. The Company expects to continue to incur losses from operations for the foreseeable future. The Company's working capital deficit was $221,000 at December 31, 1997. In December 1998, there was a capital contribution of $600,000 and the working capital was $392,000 at December 31, 1998. In November 1999, the Company completed its initial public offering and realized net proceeds of approximately $78.7 million and the working capital was $80.2 million at December 31, 1999. Net cash used in operating activities was $9.6 million, $2.1 million, and $245,000 for the years ended December 31, 2000, 1999, and 1998, respectively. The cash used in operating activities for the years ended December 31, 2000 and 1999 was primarily the result of the Company's net loss and increases in accounts receivable, offset by non-cash expenses such as stock-based compensation amortization and depreciation and increases in accounts payable. The cash used in operating activities for the years ended December 31, 1998 was primarily the result of the Company's net loss and an increase in accounts receivable. Net cash from investing activities was $10.0 million for the year ended December 31, 2000. Net cash used in investing activities was $79.9 million and $298,000 for the years ended December 31, 1999 and 1998, respectively. Cash from investing activities primarily reflect proceeds from the sale of short- term investments, offset by purchases of property and equipment during the year ended December 31, 2000. Cash used in investing activities primarily reflects purchase of short-term investments during the year ended December 31, 1999, and purchases of property and equipment during the year ended December 31, 1998. Net cash provided by financing activities was $1.8 million, $83.0 million, and $992,000 for the years ended December 31, 2000, 1999 and 1998, respectively. The cash generated in 2000 was primarily related to stock option exercises and proceeds from a sale-leaseback transaction for IVR equipment. The cash generated in 1999 was primarily related to the proceeds of the Company's initial public offering and the sale of its common stock to E*Trade Group, Inc. Cash generated in 1999 was partially offset by repayments of bank loans, shareholder loans, and capital leases. The cash generated in 1998 was due to capital contributions by the Company's stockholders. The Company believes that, based on its current business plan, existing cash and investments will be sufficient to meet operating activities, capital expenditures and other obligations for at least the next two years. SEASONALITY AND FLUCTUATION OF QUARTERLY RESULTS The Company has generally experienced fiscal quarter over fiscal quarter revenue growth with some seasonal fluctuations, primarily in the second quarter. The fiscal quarter-over-fiscal quarter revenue growth is due to an increase in the number of government clients and payment services and an increase in utilization rates. The large increase in revenues in the second quarter is due to processing personal federal and state balance due income tax payments in the month of April. The Company expects that results for the second quarter of future years will continue to be impacted by the April 15 deadline for paying personal federal and state income taxes. In addition, the Company's revenues are also impacted by the timing of federal and state estimated personal income tax payments (which are made quarterly) and local property tax payments (which are made only once or twice per year in many jurisdictions). Cost of revenues as a percentage of total revenues were significantly higher in the second quarter than in previous quarters as a result of processing personal federal and state balance due income tax payments, which have significantly lower margins than certain other payment services. This is due to the fact that the convenience fee is generally lower as a percentage of large government payments, such as income taxes, while the primary cost of sales, which are merchant discount fees, are relatively constant as a percentage of the payment amount. The Company expects that its operating expenses will continue to increase as a result of increased personnel, marketing, technological and other infrastructure costs associated with the anticipated growth in the Company's government client base and transaction volume. However, the rate of increase of such expenses is currently expected to decline as the Company's infrastructure becomes more fully developed. If revenues in any quarter do not increase correspondingly with increases in operating expenses, the Company's results for that quarter would be materially and adversely affected. For the foregoing reasons, the Company believes that comparisons of its quarterly operating results are not necessarily meaningful and that the Company's operating results in any particular quarter should not be relied upon as necessarily indicative of future performance. In addition, it is possible that in some future quarters operating results will be below the expectations of research analysts and investors, and in that case, the price of the Company's common stock is likely to decline. RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") 101, Revenue Recognition in Financial Statements which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC. SAB 101 requires companies to report any changes in revenue recognition as cumulative change in accounting principle at the time of implementation in accordance with Accounting Principles Board Opinion 20, "Accounting Changes." SAB 101 also provides guidance as the recognizing revenue on the "gross" versus "net" basis. The Company adopted the provisions of SAB 101 during the first quarter of fiscal 2000 and SAB 101 does not have any impact on the Company's financial position or results of operations. In April 2000, the Financial Accounting Standards Board issued Interpretation No. 44, ("FIN 44"), Accounting for Certain Transactions Involving Stock Compensation-an Interpretation of APB 25. This Interpretation clarifies (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a non compensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in business combinations. This Interpretation became effective July 1, 2000, but certain conclusions in this Interpretation cover specific events that occur after either December 15, 1998, or January 12, 2000. The adoption of FIN 44 did not have a material impact on the Company's financial position or results of operations. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative financial instruments and hedging activities related to those instruments, as well as other hedging activities. The Company does not currently hold any derivative instruments and does not engage in hedging activities, the Company expects the adoption of SFAS No. 133 will not have a material impact on its financial position, results of operation or cash flows. The Company will be required to adopt SFAS No. 133 in fiscal 2001. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's exposure to market risk for changes in interest rates relates primarily to the Company's investment portfolio. The Company does not use derivative financial instruments in its investment portfolio. The primary objective of the Company's investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified investments, consisting primarily of investment grade securities. Due to the nature of the Company's investments, the Company believes that there is no material risk exposure. All investments are carried at market value, which approximates cost. The table below represents principal amounts and related weighted-average interest rates by year of maturity for the Company's investment portfolio. FY2001 FY2002 FY2003 FY2004 FY2005 Thereafter Total ------- ------ ------- ------ ------- ---------- ------- Money market fund and cash $ 3,783 $ - $ - $ - $ - $ - $ 3,783 Average interest rate 0.63% 0.00% 0.00% 0.00% 0.00% 0.00% ------- Investments 62,115 - - - - - 62,115 Average interest 6.51% 0.00% 0.00% 0.00% 0.00% 0.00% rate ------- ------- ------- ------ ------- -------- -------- Total cash and investment $ 65,898 $ - $ - $ - $ - $ - $65,898 ======== ======= ======= ====== ======= ======== ======== ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's financial statements and the related notes thereto, together with the Report of the Independent Auditor, are included or incorporated by reference elsewhere herein. Reference is made to the "Index to Financial Statements and Financial Statement Schedule" following the signature pages hereto. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained under the sections entitled "ELECTION OF DIRECTORS," "EXECUTIVE OFFICERS" and "SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE" in the Company's proxy statement for its Annual Meeting of Stockholders to be held on May 8, 2001 and to be filed with the Securities and Exchange Commission no later than 120 days after the close of the 2000 fiscal year (the "Proxy Statement") is incorporated herein by reference in response to this item. ITEM 11. EXECUTIVE COMPENSATION The information contained in the Proxy Statement under the sections entitled "ELECTION OF DIRECTORS-Compensation of Directors," "EXECUTIVE OFFICER COMPENSATION," "COMPENSATION COMMITTEE REPORT ON EXECUTIVE OFFICER COMPENSATION," "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" and "STOCK PERFORMANCE GRAPH" is incorporated herein by reference in response to this item. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information contained in the Proxy Statement under the section entitled "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" is incorporated herein by reference in response to this item. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information contained in the Proxy Statement under the section entitled "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS" is incorporated herein by reference in response to this item. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS PAGE NUMBER Independent Auditors' Report................................ F-2 Balance Sheets as of December 31, 2000 and 1999............. F-3 Statements of Operations for the years ended December 31, 2000 1999 and 1998......................................... F-4 Statements of Stockholders' Equity for the years ended December 31, 2000, 1999 and 1998...................... F-5 Statements of Cash Flows for the years ended December 31, 2000, 1999 and 1998......................................... F-6 Notes to Financial Statements............................... F-7 2. FINANCIAL STATEMENT SCHEDULES The following financial statement schedule of the Company for each of the years ended December 31, 2000, 1999 and 1998 should be read in conjunction with the Financial Statements, and related notes thereto, of the Company. PAGE NUMBER Schedule II--Valuation and Qualifying Accounts......... S-1 Schedules other than the one listed above have been omitted since they are either not required, not applicable, or the information has otherwise been included. 3. EXHIBITS The exhibits listed in the accompanying Index to Exhibits are filed as part of this Annual Report on Form 10-K. (b) REPORTS ON FORM 8-K No current reports on Form 8-K were filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 29, 2001 OFFICIAL PAYMENTS CORPORATION By: /s/ Thomas R. Evans ------------------------- Thomas R. Evans Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated on March 29, 2001. SIGNATURE TITLE /s/ Thomas R. Evans Chairman of the Board and Chief Executive ---------------------------------- Thomas R. Evans Officer /s/ Edward J. DiMaria Chief Financial Officer ---------------------------------- Edward J. DiMaria (Principal Financial Officer) /s/ Kenneth Stern President and Director ---------------------------------- Kenneth Stern /s/ Hyunjin F. Lerner Controller ---------------------------------- Hyunjin F. Lerner /s/ Andrew Cohan Director ---------------------------------- Andrew Cohan /s/ Christos M. Cotsakos Director ---------------------------------- Christos M. Cotsakos /s/ Norman P. Creighton Director ---------------------------------- Norman P. Creighton /s/ George L. Graziadio, Jr. Director ---------------------------------- George L. Graziadio, Jr. /s/ Vernon Loucks Jr. Director ---------------------------------- Vernon Loucks Jr. /s/ Lee E. Mikles Director ---------------------------------- Lee E. Mikles /s/ Bruce Nelson Director ---------------------------------- Bruce Nelson INDEX TO EXHIBITS EXHIBIT NO. DESCRIPTION ------------------ ---------------------------------------------------- 3.1 Certificate of Incorporation of the Registrant, incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 (No. 333-87325), dated September 17, 1999.* 3.1.1 Certificate of Amendment to the Certificate of Incorporation of the Registrant, filed as Exhibit 3.1.1 to Amendment No. 1 (dated October 26, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 3.2 Bylaws of the Registrant, incorporated by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1 (No. 333- 87325).* 4.1 Common Stock Specimen, incorporated by reference to Exhibit 4.1 to Amendment No. 4 (dated November 18, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 4.2 Stock Purchase Agreement dated as of November 3, 1999 between Official Payments Corporation and E*TRADE Group, Inc, filed as Exhibit 4.2 to Amendment No. 2 (dated November 5, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 4.2.2 Amendment No. 1 to Stock Purchase Agreement dated as of November 8,1999 among Official Payments Corporation, E*TRADE Group, Inc. and Imperial Bank, filed as Exhibit 4.2.2 to Amendment No. 3 (dated November 16, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 4.3 Registration Rights Agreement dated as of October 15, 1999 between Imperial Bank and U.S. Audiotex Corporation, filed as Exhibit 4.3 to Amendment No. 4 (dated November 18, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 4.4 Registration Rights Agreement dated as of October 15, 1999 between Beranson Holdings, Inc. and U.S. Audiotex Corporation, filed as Exhibit 4.4 to Amendment No. 4 (dated November 18, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 10.1 Amended Employment Agreement, dated as of September 14, 1999, by and among U.S. Audiotex Corporation, Imperial Bank and Thomas R. Evans, filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1 (No. 333-87325).* 10.2 Employment Agreement, dated August 24, 1999, between U.S. Audiotex Corporation and Kenneth Stern, filed as Exhibit 10.2 to the Company's Registration Statement on Form S-1 (No. 333- 87325).* 10.3 1999 Stock Incentive Plan, as amended, filed as Exhibit 10.2 to the Company's Form 10-Q for the period ended March 31, 2000.* 10.4 2000 Stock Incentive Plan, filed as Exhibit 4.4 to the Company's Registration Statement on Form S-8, dated June 2, 2000.* 10.5 Contract, between Internal Revenue Service and the Company, filed as Exhibit 10.1 to the Company's Form 10-Q for the period ended March 31, 2000.* 10.6 Subcontract with Novus Services, Inc., dated November 30, 1998, of the IVR Services Agreement with the California Franchise Tax Board, incorporated by reference to Exhibit 10.8 to Amendment No. 1 (dated October 26, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 10.7 Processing Agreement, dated as of July 16, 1995, by and between Imperial Bank and U.S. Audiotex LLC, incorporated by reference to Exhibit 10.9 to Amendment No. 1 (dated October 26, 1999)to the Company's Registration Statement on Form S-1 (No. 333-87325).* 10.8 Employment Agreement, dated September 30, 1999, between U.S. Audiotex Corporation and Michael Presto, incorporated by reference to Exhibit 10.12 to Amendment No. 2 (dated November 5, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 10.9 Employment Agreement, dated September 30, 1999, between U.S. Audiotex Corporation and Michael Barrett, incorporated by reference to Exhibit 10.13 to Amendment No. 2 (dated November 5, 1999) to the Company's Registration Statement on Form S-1 (No. 333-87325).* 10.10 Employment Agreement, dated August 9, 2000, between Edward J. DiMaria and Official Payments Corporation, filed as Exhibit 10.1 to the Company's Form 10-Q for the period ended June 30, 2000.* 23.1 Consent of KPMG LLP. ------------- * Previously filed OFFICIAL PAYMENTS CORPORATION INDEX TO FINANCIAL STATEMENTS PAGE NUMBER Independent Auditors' Report....................................... F-2 Balance Sheets as of December 31, 2000 and 1999.................... F-3 Statements of Operations for the years ended December 31, 2000, 1999 and 1998.................................................. F-4 Statements of Stockholders' Equity for the years ended December 31, 2000, 1999 and 1998............................................ F-5 Statements of Cash Flows for the years ended December 31, 2000, 1999 and 1998....................................................... F-6 Notes to Financial Statements...................................... F-7 Schedule II-Valuation and Qualifying Accounts for the years ended December 2000, 1999 and 1998................................... S-1 INDEPENDENT AUDITORS' REPORT To The Board of Directors and Stockholders of Official Payments Corporation: We have audited the accompanying balance sheets of Official Payments Corporation as of December 31, 2000 and 1999, and the related statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2000. In connection with our audit of the financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Official Payments Corporation at December 31, 2000 and 1999, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. 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. /s/ KPMG LLP New York, New York January 22, 2001 OFFICIAL PAYMENTS CORPORATION BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) DECEMBER 31, DECEMBER 31, 2000 1999 ----------- ----------- ASSETS Current assets: Cash and cash equivalents.......... $ 3,783 $ 1,643 Short-term investments............. 62,115 79,182 Accounts receivable, net of allowance for doubtful accounts of $111 and $52 in 2000 and 1999.................. 2,210 1,135 Prepaid expenses and other current assets............................. 600 538 --------- --------- Total current assets.......... 68,708 82,498 Property and equipment, net......... 7,511 1,802 Other assets....................... 44 -- --------- --------- Total assets.................. $ 76,263 $ 84,300 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable................... $ 1,023 $ 176 Accrued merchant discount fees..... 1,123 419 Accrued payroll.................... 454 551 Accrued expenses................... 3,961 931 Deferred revenues.................. 65 65 Current portion of capital lease obligations....................... 580 206 --------- --------- Total current liabilities.... 7,206 2,348 Long-term portion of capital lease obligations 604 391 --------- --------- Total liabilities............ 7,810 2,739 --------- --------- Stockholders' equity: Common stock, $.01 par value; 150,000,000 shares authorized; 21,505,770 and 21,262,820 shares issued and out- standing as of December 31, 2000 and 1999..................... 215 213 Additional paid-in capital........ 129,473 127,707 Deferred stock compensation....... (19,803) (34,965) Accumulated deficit............... (41,432) (11,394) --------- --------- Total stockholders' equity 68,453 81,561 --------- --------- Total liabilities and stockholder' equity.................. $ 76,263 $ 84,300 ========= ========= See accompanying notes to financial statements. OFFICIAL PAYMENTS CORPORATION STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) YEARS ENDED DECEMBER 31, ------------------------------ 2000 1999 1998 --------- --------- --------- Revenues: Transaction fees.............. $ 25,793 $ 8,592 $ 2,076 Other revenues................ 291 249 293 --------- --------- --------- Total revenues........... 26,084 8,841 2,369 --------- --------- --------- Cost of revenues: Cost of transaction fees...... 14,943 4,072 442 Cost of transaction fees to related party................ 5,858 2,069 515 Cost of other revenues........ 106 204 71 --------- --------- --------- Total cost of revenues... 20,907 6,345 1,028 --------- --------- --------- Gross profit....................... 5,177 2,496 1,341 --------- --------- --------- Operating expenses: Sales and marketing........... 9,212 1,301 356 Development costs............. 2,953 1,032 608 General and administrative.... 10,042 2,692 590 Depreciation expenses......... 1,716 288 57 Amortization of deferred stock- based compensation............. 15,728 7,940 -- --------- --------- --------- Total operating expenses. 39,651 13,253 1,611 --------- --------- --------- Loss from operations............... (34,474) (10,757) (270) Other income (expense), net........ 4,436 357 (55) --------- --------- --------- Net loss........................... (30,038)$ (10,400) $ (325) ========= ========= ========= Basic and diluted net loss per share.......................... $ (1.40)$ (0.66)$ (0.02) ========= ========= ========= Weighted-average shares used in computing basic and diluted net loss per share..................... 21,421 15,677 15,000 ========= ========= ========= See accompanying notes to financial statements. OFFICIAL PAYMENTS CORPORATION STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) ADDITION- DEFERRED ACCUMUL- TOTAL COMMON STOCK AL STOCK ATED STOCK- -------------- PAID-IN COMPENS- (DEFIC- HOLDERS' SHARES AMOUNT CAPITAL ATION IT) EQUITY ------ ------- ------- --------- ------- -------- Balance at December 31, 1997..................... 15,000 $ 150 $ 428 $ -- $ (669) $ (91) Capital contribution...... -- -- 600 -- -- 600 Net loss.................. -- -- -- -- (325) (325) ------ ------- ------- --------- ------- -------- Balance at December 31, 1998..................... 15,000 150 1,028 -- (994) 184 Deferred stock compensation............. -- -- 42,905 (42,905) -- -- Amortization of stock-based compensation.......... -- -- -- 7,940 -- 7,940 Services performed by stock holder................. -- -- 118 -- -- 118 Issuance of common stock.. 513 5 4,995 -- -- 5,000 IPO proceeds, net of issuance costs of $7,532.. 5,750 58 78,661 -- -- 78,719 Net loss.................. -- -- -- -- (10,400) (10,400) ------ ------- ------- --------- ------- -------- Balance at December 31, 1999..................... 21,263 213 127,707 (34,965)(11,394) 81,561 ------ ------- ------- --------- ------- -------- Deferred stock compensation 128 1 565 (566) -- -- Amortization of stock-based compensation.......... -- -- -- 15,728 -- 15,728 Exercise of stock options. 115 1 1,201 -- -- 1,202 Net loss.................. -- -- -- -- (30,038) (30,038) ------ ------- ------- --------- ------- -------- Balance at December 31, 2000..................... 21,506 $ 215 $129,473 $(19,803)$(41,432)$68,453 ====== ======= ======= ========= ======== ======== See accompanying notes to financial statements. OFFICIAL PAYMENTS CORPORATION STATEMENTS OF CASH FLOWS (IN THOUSANDS) YEARS ENDED DECEMBER 31, -------------------------------- 2000 1999 1998 ---------- --------- --------- OPERATING ACTIVITIES: Net loss................................ $ (30,038) $ (10,400) $ (325) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 1,716 288 57 Bad debt expense......... 59 47 5 Amortization of deferred stock- based compensation............. 15,728 7,940 -- Services performed by related party -- 118 -- Changes in operating assets and liabilities: Accounts receivable... (1,134) (628) (294) Prepaid expenses and other assets................ (106) (820) 25 Accounts payable accrued expenses.............. 4,183 1,423 250 Deferred revenues..... -- (34) 37 ---------- --------- --------- Net cash used in oper- ating activities.... (9,592) (2,066) (245) INVESTING ACTIVITIES: Net purchases (maturities) of short-term investments......................... 17,067 (78,871) -- Capital expenditures................... (7,094) (1,054) (298) ---------- --------- --------- Net cash provided (used in) investing activities... 9,973 (79,925) (298) FINANCING ACTIVITIES: Proceeds from issuance of common stock.................................. -- 83,719 -- Proceeds from stock option exercises.... 1,202 -- -- Capital contribution.................... -- -- 600 Repayment of notes payable to related party.................................. -- (3,300) -- Borrowing on sale-leaseback agreement... 857 -- -- Notes payable to related party.......... -- 2,800 500 Repayment of notes payable and capital leases................................. (300) (216) (108) ---------- --------- --------- Net cash provided by financing activities... 1,759 83,003 992 ---------- --------- --------- Net increase in cash................ 2,140 1,012 449 Cash at the beginning of the year... 1,643 631 182 ---------- --------- --------- Cash at the end of the year......... $ 3,783 $ 1,643 $ 631 ========== ========= ========= Supplemental disclosure of noncash activity: Interest paid........... $ 319 $ 185 $ 38 ========== ========= ========= Assets acquired through capital leases......... $ 968 $ 503 $ 41 ========== ========= ========= See accompanying notes to financial statements. OFFICIAL PAYMENTS CORPORATION NOTES TO FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DESCRIPTION OF BUSINESS Official Payments Corporation (the "Company" or "Official Payments") is a leading provider of electronic payment options to government entities, enabling consumers to use their credit cards and "pin- less" debit cards to pay, by the Internet or the telephone, personal federal and state income taxes, sales and use taxes, property taxes, tuition payments, motor vehicles fees, fines for traffic violations and parking citations and other government-imposed taxes and fees. The Company commenced operations on June 26, 1996, initially offering its credit card payment services for the payment of fines for traffic violations, parking citations and property taxes. In 1998, Official Payments signed a credit card payment contract with the Internal Revenue Service ("IRS") and in 1999 began providing its services for the balance-due payment of personal federal income taxes. In 2000, the Company extended its contract with the IRS, adding two additional payment services, extension and estimated personal federal income taxes. For the 2001 tax filing season, the Company has further extended its contract with the IRS, adding an Internet payment option to its existing automated interactive voice response telephone ("IVR") payment option for balance-due, extension, and estimated personal federal income taxes. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported results of operations during the reporting period. Actual results could differ from those estimates. RECLASSIFICATION Certain amounts in financial statements for prior years have been reclassified to conform to the current year's presentation. CASH AND CASH EQUIVALENTS Cash consists of demand deposits, money market funds and certificates of deposit with original maturities of three months or less. In December 1999, the Company entered into a letter of credit agreement to secure a facilities operating lease for the corporate headquarters located in Stamford, Connecticut. As part of this agreement, the Company is required to hold a 3-month certificate of deposit as a form of security for the letter of credit. As of December 31, 2000, the 3-month certificate of deposit amounted to $145,850, and this amount is included in cash and cash equivalents. SHORT-TERM INVESTMENTS As of December 31, 2000, the Company had investments of $62.1 million. The Company classifies its investments as "available-for-sale." Financial instruments classified as short-term investments include government securities and commercial paper (with a Standard and Poor's rating of A- 1 or better), mostly with remaining maturity dates of less than six months. Such investments are recorded at fair value based on quoted market prices, with unrealized gains and losses , which are de minimus for all periods presented recorded, net of tax, as a separate component of stockholders' equity. CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of cash, short-term investments and accounts receivable. The Company performs ongoing credit evaluations of its clients and generally does not require collateral. Uncollectible accounts have been insignificant to date. The Company had one client that accounted for greater than 10% of accounts receivable at December 31, 2000. In the year ended December 31, 2000 and 1999, transaction fees from IRS payments accounted for 69% and 49% of total revenues, respectively. The Company's agreements with the IRS covered credit card payments for 1999 and 1998 tax returns filed during the 2000 and 1999 tax filing seasons, respectively. The agreement was renewed for the 2000 tax returns for the 2001 tax filing season by mutual consent of both parties. INTERNALLY DEVELOPED SOFTWARE The Company has adopted Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use", which requires that certain costs for the development of internal use software should be capitalized, including the costs of coding, software configuration, upgrades and enhancements. Upon completion of the application and infrastructure development stage, the Company amortizes these costs on a straight-line basis over an estimated useful life of three years. In the 2000 and 1999 fiscal years, during the application and infrastructure development stage, the Company capitalized approximately $2.8 million and $200,000 of internally developed software costs, respectively. Virtually all of the costs that were capitalized during 2000 were for the development of the Company's Web site that allows consumers to pay their taxes via the Internet. The net book value of these costs is approximately $2.9 million and $94,000 as of December 31, 2000 and 1999, respectively. PROPERTY AND EQUIPMENT Property and equipment are stated at cost, less accumulated depreciation. Depreciation is calculated using the straight-line method over the estimated useful lives of the property and equipment, generally three years for purchased software and office equipment and five years for furniture and fixtures and IVR systems. Leasehold improvements are amortized using the straight-line method over the shorter of the respective lease term or the estimated useful life of the asset. IMPAIRMENT OF LONG-LIVED ASSETS In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," the Company periodically evaluates its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of any asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized in the current period is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Since June 26, 1996 (inception) through December 31, 2000, no impairment losses have been identified. STOCK-BASED COMPENSATION The Company uses the intrinsic value method of accounting for all of its employee stock-based compensation plans. Expense associated with stock-based compensation is being amortized on a straight- line basis over the vesting period of the individual award consistent with the method described in Accounting Principles Board (APB) Opinion No. 25. COMPREHENSIVE INCOME (LOSS) The Company has no material or significant components of other comprehensive income (loss). REVENUE RECOGNITION The Company's revenues are derived primarily from convenience fees paid by consumers for credit card payment services provided by the Company. Convenience fees are charged based on the amount of the payment processed and the type of government obligation being paid. Revenues are recognized in the period in which the services are provided. The revenues are presented net of a provision for convenience fees when the collection of the amount due is not reasonably assured but is estimated and established in the period in which the services are provided. ADVERTISING EXPENSE The cost of advertising is expensed as incurred. Such costs are included in selling and marketing expense on the statement of operations and totaled approximately $5.2 million, $69,000, and $28,000 for the years ended December 31, 2000, 1999, and 1998, respectively. In November 2000, the Company entered into a cooperative advertising agreement with MasterCard where MasterCard contributed $255,000 to the Company for use in the Company's 2001 advertising campaign. The Company will consider these funds as a reimbursement of costs incurred and will net the proceeds against sales and marketing expenses as incurred. ACCOUNTING FOR INCOME TAXES Income taxes are recorded using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded to reduce deferred tax assets reported if, based on the weight of the available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.. LOSS PER SHARE Net income (loss) per share is computed in accordance with SFAS No. 128, "Earnings per Share." Under the provisions of SFAS No. 128, basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted-average number of outstanding shares of common stock during the period. Diluted net loss per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, potential common shares from options to purchase common stock using the treasury stock method. Net loss per share for the year ended December 31, 2000 and 1999 does not include the effect of 4,870,423 and 6,146,743 options to purchase common stock with a weighted average exercise price of $1.51 and $4.66 per share, respectively, because the effects are anti-dilutive. RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") 101, Revenue Recognition in Financial Statements which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC. SAB 101 requires companies to report any changes in revenue recognition as cumulative change in accounting principle at the time of implementation in accordance with Accounting Principles Board Opinion 20, "Accounting Changes." SAB 101 also provides guidance as the recognizing revenue on the "gross" versus "net" basis. The Company adopted the provisions of SAB 101 during the first quarter of fiscal 2000 and SAB 101 does not have any impact on the Company's financial position or results of operations. In April 2000, the Financial Accounting Standards Board issued Interpretation No. 44, ("FIN 44"), Accounting for Certain Transactions Involving Stock Compensation-an Interpretation of APB 25. This Interpretation clarifies (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a non compensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in business combinations. This Interpretation became effective July 1, 2000, but certain conclusions in this Interpretation cover specific events that occur after either December 15, 1998, or January 12, 2000. The adoption of FIN 44 did not have a material impact on the Company's financial position or results of operations. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative financial instruments and hedging activities related to those instruments, as well as other hedging activities. The Company does not currently hold any derivative instruments and does not engage in hedging activities, the Company expects the adoption of SFAS No. 133 will not have a material impact on its financial position, results of operation or cash flows. The Company will be required to adopt SFAS No. 133 in fiscal 2001. 2. FINANCIAL STATEMENT COMPONENTS INVESTMENTS The following is a summary of available for sale securities (in thousands): DECEMBER 31, 2000 ------------------------- AMORTIZED COST FAIR VALUE ----------- ----------- Commercial paper........................... $ 62,007 $ 62,007 Government money market fund............... 108 108 ----------- ----------- $ 62,115 $ 62,115 =========== =========== Included in short-term investments......... $ 62,115 $ 62,115 ----------- ----------- $ 62,115 $ 62,115 =========== =========== The following is a summary of contractual maturities of the Company's available for sale securities as of December 31 (in thousands): 2000 -------- Amount maturing within one year......... $ 62,115 Amount maturing greater than one year... -- -------- Securities available for sale........... $ 62,115 ======== PROPERTY AND EQUIPMENT Property and equipment consisted of the following as of December 31 (in thousands): 2000 1999 -------- -------- Computer Equipment...................... $ 8,999 $ 1,836 Furniture and fixtures.................. 747 485 -------- -------- 9,746 2,321 Less: Accumulated depreciation and amortization 2,235 519 -------- -------- $ 7,511 $ 1,802 ======== ======== Certain computer equipment, software and office equipment are recorded under capital leases that aggregated $1.6 million and $567,000 as of December 31, 2000 and 1999, respectively. Accumulated amortization on the assets recorded under capital leases aggregated $513,000 and $62,000 as of December 31, 2000 and 1999, respectively. Depreciation and amortization expense was $1.7 million and $288,000 as of December 31, 2000 and 1999, respectively, which includes amortization expense for assets under capital leases of $452,000 and $42,000 as of December 31, 2000 and 1999, respectively. AMORTIZATION OF STOCK-BASED COMPENSATION Deferred stock-based compensation included as a component of stockholders equity is being amortized over the vesting period of the stock options. Such charges are non-cash and have been presented as a separate component of operating expenses in the Company's statement of operations. The following table shows the cost (in thousands) of such charges as allocated to sales and marketing, development costs and general and administrative expenses, which allocation is based on the functional responsibilities of the underlying employees in the years ended December 31: 2000 1999 1998 -------- -------- ------- Sales and marketing..................... $ 1,887 $ 2,250 --- Development costs....................... 85 1,089 --- General and administrative.............. 13,756 4,601 --- --------------------------- $ 15,728 $ 7,940 --- =========================== OTHER INCOME (EXPENSE), NET Other income (expense), net, consists of the following (in thousands): YEARS ENDED DECEMBER 31, --------------------------- 2000 1999 1998 -------- -------- ------- Interest income......................... $ 4,749 $ 468 $ 16 Interest expense........................ (319) (135) (38) Other income (expense).................. 6 24 (33) -------- -------- ------- $ 4,436 $ 357 $ (55) ======== ======== ======= 3. LEASE OBLIGATIONS AND COMMITMENTS In April 2000, the Company entered into a sale-leaseback agreement for approximately $968,000 in IVR equipment. The sale-leaseback transaction did not result in any profit or loss for the Company because the selling price of the equipment was equal to the cost on the closing date of the agreement. The term of the agreement is 36 months. The leased equipment was accounted for as a capital lease, in accordance with SFAS No. 13, "Accounting for Leases," and is included as computer equipment as of December 31, 2000. The Company is in compliance with all financial covenants under these leases as of December 31, 2000. Future minimum debt and capital lease payments as of December 31, 2000 were as follows (in thousands): YEAR ENDING DECEMBER 31, 2001.................................... $ 580 2002.................................... 543 2003.................................... 228 -------- Total minimum lease payments............ 1,351 Less: Amount representing imputed interest..................... 167 -------- Present value of minimum lease payments............................... 1,184 Less: current portion.................. 580 -------- Minimum lease payments, less current portion................................ $ 604 ======== Future minimum lease payments under non-cancellable operating leases as of December 31, 2000 were as follows (in thousands): YEAR ENDING DECEMBER 31, 2001.................................... $ 648 2002.................................... 670 2003.................................... 684 2004.................................... 698 2005.................................... 335 Thereafter.............................. -- -------- Total minimum lease payments. under $ 3,035 operating leases........................ ======== Rental expense under operating leases for the years ended December 31, 2000, 1999 and 1998 was $556,000, $206,000, and $75,000, respectively. 4. STOCKHOLDERS' EQUITY In January 1998, Imperial Bank for $3,010,000 purchased 9 million shares of common stock or 75% of the 12 million shares of common stock in the Company owned by Beranson Holdings, Inc. In addition, Imperial Ventures, a wholly owned subsidiary of Imperial Bank, transferred its 3 million shares of common stock in the Company to Imperial Bank. Imperial Bank and Beranson Holdings were the holders of 80% and 20% of the Company's common stock, respectively, as of December 31, 1998. In August 1999, the Company issued 2,400 shares of common stock to Imperial Bank for an aggregate consideration of $8.00, and 600 shares of common stock to Beranson Holdings for an aggregate consideration of $2.00. In connection with the merger of U.S. Audiotex, LLC into U.S. Audiotex Corporation, the limited liability company interests of Imperial Bank and Beranson Holdings in U.S. Audiotex, LLC were exchanged for 11,997,600 and 2,999,400 shares of the Company's common stock, respectively. In November 1999, the Company sold to E*Trade Group, Inc. (E*TRADE) 512,820 shares of common stock at a price of $9.75 per share for a total consideration of approximately $5 million. On November 29, 1999, the Company completed the initial public offering of its common stock. The Company sold 5,750,000 shares of common stock, including 750,000 shares sold in connection with the exercise of the underwriters' over-allotment option. The initial public offering price was $15.00 per share for an aggregate initial public offering of $86.2 million. The Company paid a total of $6.0 million in underwriting discounts and commissions and approximately $1.5 million has been incurred for other offering expenses. After deducting the underwriting discounts and commissions and the offering expenses the estimated net proceeds to the Company from the offering were approximately $78.7 million. STOCK SPLIT In October 1999, the Company's Board of Directors authorized a three-for-one split of all the outstanding shares of the Company's common stock. Shares and per share information has been restated for all periods presented to give effect to this stock split. 1999 STOCK INCENTIVE PLAN The Company's Board of Directors adopted the 1999 Stock Incentive Plan (the "1999 Plan") in August 1999. The 1999 Plan provides for the grant of stock options to employees, outside directors, consultants or independent advisors of the Company. A total of 7,650,000 shares of the Company's common stock are reserved for issuance under the 1999 Plan, 900,000 of which are available for grants to outside directors. Awards under the 1999 Plan are made at the discretion of the Compensation Committee of the Company's Board of Directors or the Board of Directors (in the case of awards made to outside directors). Options granted under the 1999 Plan may be designated as incentive stock options or non-qualified stock options at the discretion of the granting authority, with exercise prices for incentive stock options of not less than the fair value of the underlying stock at the date of grant. Options granted under the 1999 Plan typically vest over a maximum three-year period and expire ten years from the date of grant (provided the employee remains employed by the Company). As of December 31, 2000, there were 6,194,708 non- forfeited employee stock options and 503,750 non-forfeited outside director stock options granted under the 1999 Plan and 951,542 shares were available for future issuance. 2000 STOCK INCENTIVE PLAN The Company's Board of Directors adopted the 2000 Stock Incentive Plan (the "2000 Plan") in June 2000. The 2000 Incentive Plan provides for the grant of shares of restricted stock and non-qualified stock options to employees (excluding the Company's directors and executive officers), consultants and independent advisors. A total of 1,250,000 shares of the Company's common stock are reserved for issuance under the 2000 Incentive Plan. Awards under the 2000 Plan are made at the discretion of the Compensation Committee of the Company's Board of Directors. Options granted under the 2000 Plan typically vest over a three-year period and expire ten years from the date of grant (provided the employee remains employed by the Company). As of December 31, 2000, there were 127,950 non-forfeited shares of restricted stock and 203,000 non-forfeited stock options granted under the 2000 Incentive Plan, and 919,050 shares were available for future issuance. DEFERRED STOCK-BASED COMPENSATION The Company uses the intrinsic value method to account for its 1999 and 2000 Incentive Plans. Accordingly, compensation cost is recognized for stock options when, on the date of grant, the current market value of the underlying common stock exceeds the exercise price of the stock options at the date of grant. In the year ended December 31, 1999, the Company recorded deferred compensation of approximately $42.9 million for options granted to employees to purchase approximately 4,654,923 shares of the Company's common stock. In the year ended December 31, 2000, the Company recorded deferred compensation of approximately $633,000, representing the fair value of restricted stock granted to employees as performance based awards and also in replacement of, and in exchange for, cancelled, unvested stock options with exercise prices in excess of the fair market value of the Company's common stock at the time of grant. Unamortized deferred stock-based compensation recorded as a component of stockholders's equity on the Company's balance sheets was $19.8 million at December 31, 2000 and $34.9 million at December 31, 1999. A summary of the Company's stock plans are as follows for the year ended December 31: 2000 1999 --------------------------- ---------------------- SHARES WEIGHTED- WEIGHTED- AVERAGE AVERAGE EXERCISE EXERCISE PRICE SHARES PRICE -------------- ----------- ----------- ---------- Outstanding at the beginning of the period... 6,150,743 $4.68 -- -- Granted at fair value .... 1,216,000 $18.68 1,495,820 $15.12 Granted at less than fair value..................... -- -- 4,654,923 $1.33 Exercised................. (115,000) $10.25 -- -- Cancelled................. (465,285) $34.77 -- -- -------------- ----------- ----------- ---------- Outstanding at end of period 6,786,458 $5.02 6,150,743 $4.68 ============== =========== =========== Exercisable at end of period 3,039,424 $3.48 685,161 $1.33 ============== =========== =========== Weighted-average fair value of options granted during the period at fair value................. $11.56 $9.72 Weighted-average fair value of options granted during the period at less than fair value.................. -- $10.24 The following table summarizes information about stock options outstanding and exercisable as of December 31, 2000: OUTSTANDING EXERCISABLE ---------------------------------- ------------------ WEIGHTED- AVERAGE WEIGHTED- WEIGHTED- REMAINING AVERAGE AVERAGE RANGE OF EXERCISE NUMBER OF CONTRACTUAL EXERCISE NUMBER OF EXERCISE PRICES SHARES LIFE (YEARS) PRICE SHARES PRICE -------------------- --------- ------------- ---------- ----------- --------- $ 1.33 - $ 2.00... 4,614,923 8.73 $ 1.33 2,561,501 $ 1.33 $ 4.09 - $ 6.14... 230,500 9.36 $ 4.51 -- -- $ 6.63 - $ 9.95... 527,000 9.68 $ 7.28 -- -- $ 15.00 - $ 22.50... 1,334,035 8.88 $15.03 477,923 $15.00 $ 30.00 - $ 45.00... 80,000 9.13 $37.81 -- -- --------- ----------- 6,786,458 8.87 $ 5.02 3,039,424 $ 3.48 ========= =========== ACCOUNTING FOR STOCK-BASED COMPENSATION The Company uses the intrinsic value-based method of accounting for its employee stock-based compensation plans. Accordingly, no compensation cost is recognized for any of its stock options when the exercise price of each option equals or exceeds the fair value of the underlying common stock as of the grant date for each stock option. Had compensation cost been determined in accordance with the fair value approach set forth by SFAS No. 123 for all of the Company's stock-based compensation plans, net loss and net loss per share would have been reduced to the following pro forma amounts (in thousands, except per share data): YEARS ENDED DECEMBER 31, ----------------------------------- 2000 1999 1998 ----------- ------------- --------- Net loss: As reported............................ $ (30,038) $ (10,400) $ (325) Pro forma.............................. $ (35,132) $ (12,824) $ (325) Basic and diluted net loss per share:..... As reported............................ $ (1.40) $ (0.66) $ (0.02) Pro forma.............................. $ (1.64) $ (0.82) $ (0.02) For all option grants that were granted prior to the Company's initial public offering in November 1999, the fair value of these options was determined using the minimum value method, which assumes no volatility, and the following weighted-average assumptions: no dividend yield, risk-free interest rate of 5%, and expected lives of 4 years. For the remaining options granted in 1999 but subsequent to the Company's initial public offering, the fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions: zero dividend yield, expected volatility of 85%, risk-free interest rate of 5.00% and expected lives of 4 years. The fair value for the options granted in 2000 was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions: zero dividend yield, expected volatility of 100%, risk-free interest rate of 5.11%, and expected lives of 10 years. 5. INCOME TAXES Since its inception, the Company has incurred net operating losses and has incurred no federal or state income tax expense. The 2000 and 1999 income tax expense differed from the amounts computed by applying the federal income tax rate of 34% to pretax income as a result of the following (in thousands): 12/31/00 12/31/99 ----------- ----------- Federal tax at statutory rate................... ($10,213) ($3,536) State taxes, net of federal income tax benefit.. 1 1 Increase in valuation allowance................. 10,186 3,526 Non-deductible expenses......................... 26 9 ----------- ----------- Total tax expense............................... $ -- $ -- =========== =========== The types of temporary differences that give rise to significant portions of the Company's deferred tax assets and liabilities are set out below (in thousands): 12/31/00 12/31/99 ----------- ----------- Deferred tax assets: Accruals...................................... $ 130 $ 305 State income taxes............................ -- 300 Employee stock compensation.................... 6,485 3,402 Deferred revenue............................... 27 -- Net operating loss and credit carry-forwards.. 9,149 411 ----------- ----------- Gross deferred tax assets....................... 15,762 4,117 Valuation allowance............................. (15,721) (4,064) ----------- ----------- Total deferred tax assets....................... 41 53 Deferred tax liabilities: Plant and equipment........................... (41) (53) ----------- ----------- Total deferred tax liabilities.................. (41) (53) Net deferred tax assets (liabilities): $ -- $ -- =========== =========== For federal income tax purposes, the Company has net operating loss ("NOL") carryforwards of approximately $23.6 million and $1.1 million for the year ended December 31, 2000 and 1999, respectively, expiring in 2019 and 2020. The U.S. Tax Reform Act of 1986 contains provisions that limit the NOL carryforwards available to be used in any given year upon the occurrence of certain events, including a significant change of ownership. Management believes that a change in ownership occurred in connection with Comerica's acquisition of Imperial Bancorp and, as a result, the ability of the Company to utilize the NOL's to offset income in the future could be limited. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning in making these assessments. Due to the Company's operating losses, there is uncertainty surrounding whether the Company will ultimately realize its deferred tax assets. 6. SEGMENT INFORMATION The Company operates in a single operating segment. The Chief Executive Officer ("CEO") has been identified as the Chief Operating Decision Maker because he has final authority over resource allocation decisions and performance assessment. The CEO reviews financial information by disaggregated revenues by product for purposes of making operating decisions and assessing financial performance. The financial information reviewed by the CEO is consistent with the information presented in the accompanying statements of operations. YEARS ENDED DECEMBER 31, ------------------------------ 2000 1999 1998 --------- --------- --------- Revenues by product are: Transaction fees: Federal........................... $ 17,960 $ 4,343 $ -- State............................. 2,481 557 -- Local............................. 5,352 3,692 2,076 Other revenues......................... 291 249 293 --------- --------- --------- Total revenues......................... $ 26,084 $ 8,841 $ 2,369 ========= ========= ========= 7. RELATED PARTY TRANSACTIONS In January 1998, Imperial Bank increased its ownership interest of U.S. Audiotex LLC from 20% to 80% by purchasing a 60% membership interest, or 75% of Beranson Holdings, Inc.'s membership interest, from Beranson Holdings, Inc. for $3,010,000, of which $2,510,000 was immediately payable to Beranson Holdings, Inc. Upon the Company's formation on August 24, 1999, the balance of $500,000 and $82,000 of accrued interest, was paid to Beranson Holdings, Inc. U.S. Audiotex LLC was merged into the Company in September 1999, with the Company being the surviving entity. In 1999 Imperial Bank and Beranson Holdings, Inc. made advances to the Company under lines of credit in the combined amount of $2.8 million which bears interest at a floating rate equal to Imperial Bank's prime rate plus 2% per annum. The Company repaid the balance of all amounts outstanding, together with the accrued interest, prior to December 31, 1999. Imperial Bank is one of the merchant banks the Company uses to process credit card transactions and perform traditional merchant credit card settlement services. During 2000, 1999 and 1998, the Company paid Imperial Bank approximately $5.8 million, $2.1 million, and $515,000, respectively, for performing these processing and settlement services, which represent 31%, 33% and 51%, respectively, of the total merchant discount fees paid by the Company during those periods. Imperial Bank has provided other services to the Company. These services included payroll processing, benefits administration and employee recruiting. During the fiscal year ended December 31, 2000, the Company paid Imperial a fee of $135,000 for these services. During the fiscal year ended December 31, 1999, the Company incurred a fee of $151,000 for these services, of which $33,000 was paid for in cash by the Company and the remaining $118,000 was not paid for by the Company and, accordingly, was recorded as an expense and a contribution to capital. The Company did not pay any fees to Imperial Bank for these services in 1998. The Company expects related party expenses to decrease in 2001 since as of January 1, 2001, the Company began administering its payroll processing and benefits programs internally and through unaffiliated third-party vendors. Imperial Bank guarantees the performance of the Company's obligations under six equipment leases. These leases are comprised of a master lease agreement with one lessor for five leases for various furniture and computer equipment and a separate lease agreement for network equipment. Imperial Bank will continue to guarantee the six leases until the leases expire. Bruce Nelson, one of the Company's Board of Directors, provides certain consulting services in connection with the Company's marketing and advertising campaigns and corporate positioning strategies. 8. SIGNIFICANT EMPLOYMENT AGREEMENTS During the second quarter of 2000, the Company incurred approximately $4.1 million in severance and other related charges in conjunction with the departure of its former Chief Financial Officer, Brian W. Nocco, which are included in general and administrative expenses on the statement of operations. The largest of this expense was a non-cash deferred stock-based compensation charge of $3.6 million, representing the acceleration (in connection with the termination of Mr. Nocco's employment and pursuant to the terms of his employment agreement with the Company) of the vesting of stock options granted to Mr. Nocco in August, September and November 1999 at exercise prices below the fair market value of the Company's common stock at the date of grant. The remaining $522,000 is attributable to severance, relocation and other contractual obligations incurred in the second quarter of 2000. As of December 31, 2000, $130,000 remains unpaid and is included in accrued payroll and severance on the balance sheet. 9. SIGNIFICANT EMPLOYMENT AGREEMENTS In August 2000, the Company entered into an employment agreement with Edward J. DiMaria, the Company's Chief Financial Officer. The employment agreement provides for an annual base salary of $195,000, a one-time bonus of $60,000 (paid in August 2000), and a minimum annual bonus of $35,000 for 2001. If Mr. DiMaria's employment is terminated by the Company without "cause" or if he terminates his employment for "good reason," including a "change in control," as these terms are defined in the written employment agreement, the Company will be required to pay him his base salary and benefits for one year, and the number of unvested stock options that would have otherwise vested at the first anniversary date of his employment will vest upon such termination. 10. SELECTED QUARTERLY FINANCIAL DATA SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (dollars in thousands, except per share data) FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER -------- ------- -------- -------- YEAR 2000: Net revenue............................ $ 1,824 $17,715 $ 3,414 $ 3,131 Gross profit........................... 314 3,463 731 669 Net loss............................... (8,949) (8,928) (6,076) (6,085) Loss per share......................... $ 0.42 $ 0.42 $ 0.28 $ 0.28 YEAR 1999: Net revenue............................ $ 830 $ 5,283 $ 1,095 $ 1,633 Gross profit........................... 424 924 550 598 Net income/(loss)...................... (121) 61 (1,480) (8,860) Net income/(loss) per share............ $ (0.01)$ -- $ (0.10) $ (0.50) 11. SUBSEQUENT EVENTS (UNAUDITED) In March 2001, Official Payments entered into a cooperative advertising agreement with American Express for $255,000. The Company will utilize these funds for an advertising campaign related to its federal income tax payment program with the IRS, which will run in March and April 2001. On January 30, 2001, Imperial Bancorp, the parent holding company of Imperial Bank (which then owned approximately 55% of the Company's outstanding common stock), was acquired by Comerica in a tax-free, stock-for-stock transaction. Consummation of the merger resulted in the acceleration of various employee stock options and restricted stock granted under the Company's 2000 Stock Incentive Plan and 1999 Stock Incentive Plan. The acceleration of the employee stock options resulted in the Company recognizing in January 2001 a non-cash expense for previously deferred compensation of approximately 19.8 million. In addition, under the respective employment agreements for Messrs. Evans, Presto and Barrett, this event enables each of them to terminate his employment with the Company for "good reason" after July 30, 2001 and in connection therewith to continue receiving payment of his base salary and benefits for one year following such date. Mr. DiMaria's employment agreement contains a similar provision, but he is only eligible to terminate this employment for good reason due to this event between April 30, 2001 and May 30, 2001. In March 2001, Imperial Bank transferred ownership of its shares of Company common stock to its new parent holding company, Comerica. OFFICIAL PAYMENTS CORPORATION SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 BALANCE AT BALANCE AT END OF BEGINNING OF COSTS AND WRITE-OFFS CLASSIFICATION CLASSIFICATION PERIOD EXPENSES DEDUCTIONS PERIOD -------------- ------------ ---------- ---------- -------------- Year ended December 31, 2000 Allowance for doubtful accounts................... $52,000 $ 59,099 -- $ 111,099 Year ended December 31, 1999 Allowance for doubtful accounts................... 5,000 47,000 -- 52,000 Year ended December 31, 1998 Allowance for doubtful accounts................... -- 5,000 -- 5,000