iPayment, Inc. - Credit Card Processing

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(615) 665-1858

40 Burton Hills Boulevard, Suite 415

Nashville, TN 37215

www.ipaymentinc.com

Sales

$226 million

We are one of the fastest growing providers of credit and debit card-based payment processing services to small merchants. We provided our services to over 90,000 active small merchants located across the United States. We define a merchant as “active” if the merchant processes at least one Visa or MasterCard transaction in a given month. The small merchants we serve typically generate less than $250,000 of charge volume per year and typically have an average transaction value of approximately $75. These merchants have traditionally been underserved by larger payment processors due to the difficulty in identifying, servicing and managing the risks associated with them. As a result, these merchants have historically paid higher transaction fees than larger merchants.
iPayment's payment processing services enable merchants to process both traditional card-present, or “swipe,” transactions, as well as card-not-present transactions. A traditional card-present transaction occurs whenever a cardholder physically presents a credit or debit card to a merchant at the point-of-sale. A card-not-present transaction occurs whenever the customer does not physically present a payment card at the point-of-sale and may occur over the Internet, mail, fax or telephone.

We believe our experience and knowledge in providing payment processing services to small merchants gives us the ability to effectively evaluate and manage the payment processing needs and risks that are unique to small businesses. In order to identify small merchants, we market and sell our services primarily through 650 independent sales organizations, or ISOs, a non-employee, external sales force representing approximately 2,300 sales professionals. In addition, we believe that our acquisition of the agent bank portfolio of First Data Merchant Services, which strengthens our existing strategic relationship with First Data Merchant Services, will help to position us for future growth by adding new merchant accounts generated by approximately 170 small agent banks. Our relationships with the ISOs allows us to access a large and experienced sales force with a local presence providing access to small merchants over a broad geographic area without incurring the additional overhead costs associated with an internal sales force. ISOs may market and sell our services to merchants under their own brand name and directly approach merchants and enroll them for our services. We enable merchants to accept credit and debit cards as payment for their merchandise and services by providing processing, risk management, fraud detection, merchant assistance and support and chargeback services in connection with disputes with cardholders. In addition, we rely on third party processors to provide card authorization and data capture, and banks to sponsor us for membership in the Visa and MasterCard associations and to settle transactions with merchants. We believe that this structure allows us to maintain an efficient operating structure, and enables us to easily expand our operations without significantly increasing our fixed costs.

The Nilson Report, a publication specializing in consumer payment systems worldwide, listed us in its 2002 ranking of the top bank card acquirers, or owners of merchant card processing contracts, as one of the fastest growing providers of card-based payment processing services in the United States. In 2003, we continued to grow as our merchant processing volume, which represents the total value of transactions processed by us, increased by 125.9% to $6,478 million in 2003 from $2,868 million in 2002. During the same period, our revenues increased by 95.2% to $226.1 million in 2003 from $115.8 million in 2002. These increases were primarily attributable to our acquisitions since March 2002 of five businesses as well as several smaller portfolios of merchant accounts, which resulted in an aggregate increase in revenues of $85.8 million in 2003, representing 77.8% of our total growth in revenues over 2002. As we have grown, our net income increased to $15.6 million in 2003 from a net loss of $0.5 million in 2002. We believe our ability to recruit and retain ISOs, combined with our experience in identifying, completing and integrating acquisitions, provides us with significant opportunities for future growth.

Services

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

• Application Evaluation Underwriting. We recognize that there are varying degrees of risk associated with different merchants based on the nature of their businesses, processing volume and average transaction amounts. We apply varying levels of scrutiny in our application evaluation and underwriting of prospective merchants accounts, ranging from basic due diligence for merchants with a low risk profile to a more thorough and detailed review for higher risk merchants. The results of this review serve as the basis for our decision whether to accept or reject a merchant account and also provide the criteria for establishing reserve requirements, processing limits, average transaction amounts and pricing, which assist us in monitoring merchant transactions for those accounts that exceed pre-determined criteria.

• Merchant Set-up and Training. After we establish a contract with a merchant, we create the software configuration that is downloaded to the merchant’s credit card terminal or computer. This configuration includes the merchant identification number, which allows the merchant to accept Visa and MasterCard as well as any other payment cards such as American Express, Discover and Diners Club provided for in the contract. The configuration might also accommodate check verification and gift and loyalty programs. If a merchant requires a pin-pad to accept debit cards, the configuration allows for the terminal or computer to communicate with the peripheral device. After the download has been completed, we conduct a training session on use of the products.

• Card Transaction Processing. A transaction begins with authorization of the customer’s credit or debit card. The transaction data is captured by the processor and electronically transmitted to the issuer of the card, which then determines availability of credit or debit funds. The issuer then communicates an approval decision back to the merchant through the processor. This process typically takes less than five seconds. After the transaction is completed, the processor transmits the final transaction data to the card issuer for settlement of funds. Generally, we outsource these services to third party processors.

• Risk Management/Detection of Fraudulent Transactions. Our risk management staff relies on the criteria set by the underwriting department to assist merchants in identifying and avoiding fraudulent transactions by monitoring exceptions and providing access to other resources for fraud detection. By employing these and other risk management procedures, we enable our merchants to balance the risk of fraud against the loss of a valid transaction.

• Merchant Service and Support. We provide merchants with ongoing service and support. Customer service and support includes answering billing questions, responding to requests for supplies, resolving failed payment transactions, troubleshooting and repair of equipment, educating merchants on Visa and MasterCard compliance, and assisting merchants with pricing changes and purchases of additional products and services. We maintain a toll-free help-line, which is staffed by our customer service representatives. The information access and retrieval capabilities of our proprietary decision support systems provide our customer service representatives prompt access to merchant account information and customer call history. This data allows them to quickly respond to inquiries relating to fees, charges and funding of accounts as well as technical issues.

• Chargeback Service. In the event of a billing dispute between a cardholder and a merchant, we assist the merchant in investigating and resolving the dispute as quickly and as accurately as possible. Before instructing the cardholder’s bank to debit the merchant’s account for the chargeback, we provide the merchant with the opportunity to demonstrate that the transaction was valid. If the merchant is unable to demonstrate that the transaction was valid and the dispute is resolved in favor of the cardholder, the transaction is charged back to the merchant, and that amount is credited to the cardholder. For the year ended December 31, 2003, chargebacks as a percentage of our total charge volume was 0.30%.

• Merchant Reporting. We organize our merchants’ transaction data into various files for merchant accounting purposes. We use this data to provide merchants with information, such as charge volume, discounts, fees and funds held for reserves to help them track their account activity. Merchants may access this archived information through our customer service representatives or online through our Internet-based customer service system.

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

• Merchants. Merchants are the businesses that accept payment cards, including Visa and MasterCard, as payment for their merchandise and services.

• Sponsoring Banks. Sponsoring banks are financial institutions that are Visa and MasterCard association members and provide the funds on behalf of the card user, enabling merchants to accept payment cards.

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

Industry Overview

The use of card-based forms of payment, such as credit and debit cards, by consumers in the United States has steadily increased over the past ten years. According to The Nilson Report, total expenditures for transactions by U.S. consumers using card-based systems grew from $0.5 trillion in 1992 to $1.9 trillion in 2002. The proliferation of credit and debit cards has made the acceptance of card-based payment a necessity for businesses, both large and small, in order to remain competitive. Consumer expenditures using card-based payment methods are expected to grow to $4.6 trillion by 2012, or 50% of all U.S. payments, representing a compound annual growth rate of 9% from 2002 levels, according to The Nilson Report.

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

• Favorable Demographics. As consumers age, we expect that they will continue to use the payment technology to which they have grown accustomed. Consumers are beginning to use card-based and other electronic payment methods for purchases at an earlier age. According to Nellie Mae, the number of college students who have credit cards grew from 67% in 1998 to 82% in 2002. As these consumers who have witnessed the wide adoption of card products, technology and the Internet comprise a greater percentage of the population and increasingly enter the work force, we expect that purchases using card-based payment methods will comprise an increasing percentage of total consumer spending.

• Increased Card Acceptance by Small Businesses. Small businesses are a vital component of the U.S. economy and are expected to contribute to the increased use of card-based payment methods. In 1997, the U.S. Census Bureau estimated that approximately 20 million businesses which average less than $1.0 million in annual sales in the United States or which had no payroll, generated an aggregate of $1.7 trillion in annual sales. We believe that the lower costs associated with card-based payment methods are making these services more affordable to a larger segment of the small business market. In addition, we believe these businesses are experiencing increased pressure to accept card-based payment methods in order to remain competitive and to meet consumer expectations. As a result, many of these small businesses are seeking, and we expect many new small businesses to seek, to provide customers with the ability to pay for merchandise and services using credit or debit cards, including those in industries that have historically accepted cash and checks as the only forms of payment for their merchandise and services.

• Growth in Card-Not-Present Transactions. Market researchers expect dramatic growth in card-not-present transactions due to the rapid growth of the Internet. According to Jupiter Media Corporation, 94% of the dollar value of all merchandise and services ordered online by consumers in 2002 was purchased using card-based systems. In total, IDC, an independent market intelligence firm, expects U.S. consumer electronic commerce to grow from $70 billion in 2002 to $200 billion in 2007, representing a compound annual growth rate of 23%. In addition, IDC estimates that approximately two-thirds of all small businesses have online capabilities. The prevalence of the Internet makes having an online presence a basic consideration for those forming a new business today. In December 2003, approximately one-third of our charge volume resulted from card-not-present transactions.

Competitive Position

We believe our competitive strengths include the following:

• Strong Position and Substantial Experience in Our Target Market. As of December 31, 2003, including the acquisition of the agent bank portfolio of First Data Merchant Services, which did not contribute to our results of operations until January 2004, we were providing card-based payment processing to over 90,000 active small merchants located across the United States. We believe our understanding of the unique payment processing needs and risks of small merchants provides us with a competitive advantage over larger service providers that have a broader market perspective. We also believe that we have a competitive advantage over service providers of a similar or smaller size that may lack our extensive experience and resources.

• Large, Experienced, Efficient Sales Force. We market our services primarily through our contractual relationships with over 650 ISOs throughout the United States. Although it is not customary in our industry to obligate ISOs to refer their merchant applications to any one processing provider, many currently refer a majority of their new merchant applications to us as a result of our strong relationships with them. Our sales approach provides us with an experienced sales force of approximately 2,300 sales professionals who market our services, with minimal direct investment in sales infrastructure and management. We continually strive to strengthen these relationships by delivering superior service and support to our ISOs.

• Scalable, Efficient Operating Structure. Our scalable, efficient operating structure allows us to expand our operations easily and without significantly increasing our fixed costs. We conduct our customer service and risk management operations in-house, where we believe we can add the most value due to our management’s experience and expertise in these areas. We consider customer service and risk management highly important to our operations and overall success. Compensation expenses declined as a percentage of revenues to 6.2% in 2003 from 9.3% in 2002 reflecting improving efficiency. Total headcount declined to 256 at December 31, 2003, from 268 at December 31, 2002, despite revenue growth of 34% during the fourth quarter of 2003 as compared to the fourth quarter of 2002. We outsource our remaining processing services to third parties, including the evaluation and acceptance of card numbers and receipt and settlement of funds. By outsourcing these non-core services, we believe we are able to maintain a highly efficient operating structure. Larger economies of scale lead to lower costs for processing, which we outsource. Processing costs declined to $0.21 per transaction in 2003 from $0.26 per transaction in 2002. Processing costs include bank sponsorship costs along with front and back-end processing costs. We believe there is sufficient capacity among third parties to meet our current and future outstanding needs. Many of our contracts include pricing terms that are more favorable to us as the transaction volume generated by our merchant base increases.

• Proven Acquisition and Integration Strategy. We have significant experience acquiring providers of payment processing services as well as portfolios of merchant accounts, having acquired seven providers of payment processing services and five significant portfolios and several smaller portfolios of merchant accounts since January 2001. We have enhanced revenues and improved operating efficiencies of our acquired entities by improving the services, support and benefits we offer to the ISOs that serve the entities and merchant accounts we acquire. In addition, we have increased operating efficiencies of many of the businesses we have acquired by conducting profitability analyses of acquired merchant accounts and reducing processing fees and overhead.

• Comprehensive Underwriting and Risk Management System. Through our experience in assessing risks associated with providing payment processing services to small merchants, we have developed business procedures and systems that provide effective risk management and fraud prevention solutions. Through our underwriting processes, we evaluate merchant applicants and balance the risks of accepting a merchant against the benefit of the charge volume we anticipate such merchant will generate. We believe our systems and procedures enable us to identify potentially fraudulent activity and other questionable business practices quickly, thereby minimizing our losses and those of our merchants.

Strategy

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

• Expand in Existing Small Merchant Market. We believe we have an opportunity to grow our business by further penetrating the small merchant market through our relationships with our ISOs and agent banks. We intend to focus our efforts on merchants that are newly-established or whose businesses involve card-not-present transactions. We also intend to target industries that have not historically accepted electronic payment methods.

• Enhance Relationships with Existing Sales Groups and Establish Relationships with New ISOs. Through our superior customer service and our support of the marketing efforts of the more than 650 ISOs with which we have an existing relationship, we seek to increase the volume of merchant referrals from our ISOs, including ISOs affiliated with the providers of payment processing services that we acquire. In addition, the acquisition of the agent bank portfolio of First Data Merchant Services also strengthens our existing strategic relationship with First Data Merchant Services unit to expand future growth by adding new merchant accounts generated by approximately 170 small agent banks. We believe that our experience in this industry, coupled with our ability to evaluate and manage the risks related to providing payment processing services, allow us to accept a high rate of merchant applications and position us well to continue to increase the number of ISO relationships we maintain and the number of new applications our existing ISOs refer to us.

• Maintain a Stable and Recurring Revenue Base. By providing our merchants with a consistently high level of service and support, we strive to build merchant loyalty and limit merchant attrition. Through merchant retention and the benefit of increased card use, we strive to maintain our stable and recurring revenue base. In addition, we believe the low transaction volume of our individual merchants makes them less likely to change providers due to the inconvenience associated with transferring to another provider. By limiting merchant attrition, we believe that the increasing use of card-based payment systems will allow us to maintain a stable and recurring revenue base.

• Continue to Pursue Strategic Acquisitions. We intend to continue to expand our merchant base by acquiring other providers of payment processing services as well as portfolios of merchant accounts. The small merchant segment of the payment processing market is serviced by many independent providers of payment processing services that lack the resources to generate sufficient scale in this underserved market. We believe opportunities will exist for us to purchase these businesses when their resources begin to limit their ability to continue to grow independently. Other sources of portfolio acquisitions include commercial banks, which, in an effort to focus on their core competencies often sell or outsource their card-based payment processing operations, creating the opportunity for buyers to acquire their existing merchant portfolios.

We derive the majority of our revenues from fee income related to transaction processing, which is primarily comprised of a percentage of the dollar amount of each transaction we process, as well as a flat fee per transaction. The percentage we charge varies upon several factors, including the transaction amount, as well as whether the transaction process is a swipe transaction or a non-swipe transaction. On average, the gross revenue we generate from processing transactions equals approximately $3.00 for every $100 transaction we process, excluding costs and expenses. The following diagram illustrates the percentage of a typical transaction amount paid to the processing bank, the Visa and MasterCard card associations and us:

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

Relationships with Sponsors and Processors

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

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

Our agreement with JPMorgan Chase, which is our principal sponsor bank, grants Chase the right to approve our solicitation, application and qualification procedures for merchants, the terms of our agreements with merchants (including the processing fees that we charge), our customer service levels and our use of any independent sales organizations. In addition, we have agreed with Chase not to solicit any merchants that currently process through Chase or any merchants that belong to industries that are considered unacceptable due, in part, to image concerns, card association rules, legitimacy and level of risk. In the event that we request to transfer any of our interest in the merchant portfolio that we have migrated to Chase, we are required to pay to Chase $2.5 million if the transfer occurs during the first year following the initial transfer of merchants to Chase, $1.5 million if it occurs during the second year and $750,000 if it occurs during the third year.

Processors. We have agreements with several processors to provide to us on a non-exclusive basis transaction processing and transmittal, transaction authorization and data capture, and access to various reporting tools. These processors include First Data Merchant Service Corporation, Vital Processing Services, LLC, Global Payments Direct, Inc. and CardSystems Solutions, Inc. Certain of our agreements with processors require us to submit a minimum monthly number of transactions for processing. If we submit a number of transactions that is lower than the minimum, we are required to pay to the processor the fees that it would have received if we had submitted the required minimum number of transactions. The First Data Merchant Services Corporation, Vital Processing Services and Global Payments Direct agreements may be terminated by the processors if we materially breach certain sections of the agreements and we do not cure the breach within 30 days, if our membership with Visa or MasterCard terminates, if we enter bankruptcy or file for bankruptcy, or if applicable laws or regulations, including Visa and MasterCard regulations, change to prevent either the applicable processor or us from performing its services under this agreement. In addition, Global Payments Direct may terminate upon 60 days notice prior to the end of the current term.

Our Merchant Base

We serve a diverse portfolio of small merchants. As of December 31, 2003, including the acquisition of the agent bank portfolio of First Data Merchant Services, which did not contribute to our results of operations until January 1, 2004, we provided processing services to over 90,000 active small merchants located across the United States and engaged in a wide variety of businesses. We define a merchant as “active” if the merchant processes at least one Visa or MasterCard transaction in a given month. As of December 31, 2003, we also have agreements with over 40,000 non-active merchants who pay us monthly access fees, but do not generate sufficient transaction volume to be considered active.

Primary Merchant Categories Based on Our Charge Volume

No single merchant accounted for more than 2.0% of our aggregate transaction volume for 2003. We believe that this merchant diversification makes us less sensitive to shifting economic conditions in the industries or regions in which our merchants operate. We believe that the loss of any single merchant would not have a material adverse effect on our financial condition or results of operations.

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

Merchant attrition is expected in the payment processing industry in the ordinary course of business; however, we believe the low average transaction volume of the merchants whose accounts we service make them less likely to change providers because of the inconveniences associated with a transfer. During 2003, we experienced an average monthly attrition of approximately 1.0% to 1.5% of our total charge volume, taking into consideration each of the acquisitions during this period. Much of our attrition is related to newly formed small businesses that ultimately fail. Because the transaction volumes of these unsuccessful businesses typically never reach meaningful levels, they do not significantly contribute to the profitability of our business. Accordingly, our merchant attrition related to failed businesses does not significantly reduce our revenues.

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

Risk Management

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

We currently have a staff of approximately 36 employees dedicated to risk management operations, which encompasses underwriting new accounts, monitoring and investigating merchant account activity for suspicious transactions or trends and avoiding or recovering losses. Effective risk management helps us minimize merchant losses for the mutual benefit of our merchant customers and ourselves. Our risk management procedures also help protect us from fraud perpetrated by our merchants. We believe our knowledge and experience in dealing with attempted fraud, established as a result of our management’s extensive experience with higher risk market segments, has resulted in our development and implementation of highly effective risk management and fraud prevention systems and procedures.

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

• Underwriting. Our sales agents send new applications to our underwriting department for their review and screening. All of our underwriters have previous industry underwriting experience and have the authority to render judgment on new applications or to take additional actions such as adjusting processing limits, average charge per transaction or reserve requirements for new and existing merchants. We obtain a personal guaranty from most of the owners of new merchants we enroll.

• Proprietary Management Information Systems. Our proprietary systems automatically generate credit reports on new applicants, categorize risk based on all of the information provided and place the applications in a queue to be processed by our underwriting staff. The underwriting staff can access all of the collected information on a merchant online in order to render a decision on whether to approve or reject an application or whether to seek additional information.

• Merchant Monitoring. We provide several levels of merchant account monitoring to help us identify suspicious transactions and trends. Daily merchant activity is downloaded to our BAM system from our third-party processors such as First Data Merchant Services Corporation and is sorted into a number of customized reports by our proprietary systems. Our risk management team also receives daily reports from Card Commerce International, a risk management services company, that highlight all exceptions to the established daily merchant parameters such as average ticket size, total processing volume or expected merchandise returns.

• Risk Review Department. We have established an in-house risk review department that monitors the sales activities of all of the merchants that we service. Our risk review department focuses particular attention on fewer than 100 merchants in our portfolio, measured by volume, average ticket and other criteria, which accounted for approximately 2% of our total charge volume for December 31, 2003. The risk review department conducts background checks on these merchants, interviews merchants, anonymously purchases products and services, reviews sales records and follows developments in risk management procedures and technology. The risk review department reports to the risk committee, consisting of our President, Chief Executive Officer and Chief Financial Officer.

• Investigation and Loss Prevention. If a merchant exceeds any approved parameter as established by our underwriting and/or risk management staff or violates regulations established by the applicable card association or the terms of our agreement with the merchant, an investigator will identify the incident and take appropriate action to reduce our exposure to loss, as well as the exposure of our merchants. This action may include requesting additional transaction information, instructing the merchant acquirer/processor to retrieve, withhold or divert funds, verifying delivery of merchandise or even deactivating the merchant account.

• Reserves. We require some of our merchants to post reserves (cash deposits) that we use to offset against liabilities we incur. Our sponsoring banks hold reserves related to our merchant accounts as long as we are exposed to loss resulting from a merchant’s processing activity. In the event that a small company finds it difficult to post a cash reserve upon opening an account with us, we may build the reserve by retaining a percentage of each transaction the merchant performs. This solution permits the merchant to fund our reserve requirements gradually as its business develops. As of December 31, 2003, these reserves totaled approximately $43.5 million.