UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington D.C., 20549








FORM 10-QSB








(Mark One)




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


For the quarterly period ended December 31, 2004




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


For the transition period ____________ to _____________







Commission file number: 001-15835




**US Dataworks, Inc.**


(Exact name of small business issuer as specified in its charter)




**Nevada**

**84-1290152**(State or other jurisdiction of
incorporation or organization)

(I.R.S. employer identification number)**5301 Hollister Road, Suite 250**
**Houston, Texas**

**77040**(Address of principal executive offices)

(Zip Code)





Issuers telephone number: (713) 934-3855




Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ]




Number of shares of Common Stock outstanding as of January 31, 2005: 28,777,866




Transitional Small Business Disclosure Format (Check one): YES [ ] NO [X]









**US DATAWORKS, INC.**





TABLE OF CONTENTS





FORM 10-QSB





QUARTERLY PERIOD ENDED DECEMBER 31, 2004





PagePART I -
FINANCIAL INFORMATION
1Item 1.
Financial Statements
1Item 2.
Managements Discussion and Analysis or Plan of Operation
16Item 3.
Controls and Procedures
23PART II -
OTHER INFORMATION
24Item 1.
Legal Proceedings
24Item 2.
Changes in Securities.
24Item 6.
Exhibits
24SIGNATURE
25













**PART I -** **FINANCIAL INFORMATION**




**Item 1.**  **Financial Statements**




**US DATAWORKS, INC.**

BALANCE SHEET
December 31, 2004

**(Unaudited)**  ASSETSCURRENT ASSETSCash and cash equivalents

$
2,734,134Accounts receivable, net of allowance for doubtful accounts of $0


640,080Prepaid expenses and other current assets


116,134Total current assets


3,490,348PROPERTY AND EQUIPMENT, net


717,002GOODWILL, net


14,133,629OTHER ASSETS


43,793TOTAL ASSETS

$
18,384,772








The accompanying notes are an integral part of these financial statements.









1








**US DATAWORKS, INC.**

BALANCE SHEET
December 31, 2004

**(Unaudited)**

LIABILITIES AND SHAREHOLDERS' EQUITY  CURRENT LIABILITIESNote payable - related party

$
39,000Deferred revenue


283,764Accounts payable


242,836Accrued expenses


189,151Interest payable


22,730Convertible promissory note


256,066Total current liabilities


1,033,547Convertible promissory note


512,133Deferred revenue


41,683Deferred compensation


94,600Total liabilitiesInterest payable


1,681,963COMMITMENTS AND CONTINGENCIESSHAREHOLDERS EQUITYConvertible Series B preferred stock, $0.0001 par value700,000 shares authorized, 549,667 shares issued and outstanding $0.75 liquidation preference, dividends of $159,352 in arrears


55Common stock, $0.0001 par value90,000,000 shares authorized and 28,777,366 shares issued and outstanding


2,878Common stock subscription


(129,375
)Additional paid-in capital


61,737,402Deferred compensation


(63,395
)Accumulated deficit


(44,844,756
)Total shareholders equity


16,702,809TOTAL LIABILITIES AND SHAREHOLDERS EQUITY

$
18,384,772







The accompanying notes are an integral part of these financial statements.







2









**US DATAWORKS, INC.**
STATEMENTS OF OPERATIONS
For the Three Months and Nine Months Ended December 31, 2004 and 2003  **For the Three Months Ended**
**December 30,**

**For the Nine Months Ended**
**December 30,****2004**

**2003**

**2004**

**2003**REVENUESSoftware licensing revenues

$
95,000

$
56,803

$
595,732

$
769,670Software maintenance revenues


246,455


66,999


706,383


181,143Professional service revenues


176,480


292,656


728,785


911,216Total revenues


517,935


416,458


2,030,900


1,862,029COST OF SALES


(147,689
)

(206,043
)

(666,337
)

(555,698
)Gross profit


370,246


210,415


1,364,563


1,306,331OPERATING EXPENSESGeneral and administrative


1,674,255


1,122,555


4,637,577


2,961,828Depreciation and amortization


81,727


70,069


237,499


206,700Total operating expense


1,755,982


1,192,624


4,875,076


3,168,528LOSS FROM OPERATIONS


(1,385,736
)

(982,209
)

(3,510,513
)

(1,862,197
)OTHER INCOME (EXPENSE)Financing costs


---


(135,814
)

(419,903
)

(1,345,102
)Interest expense


(22,730
)

(128,826
)

(187,686
)

(1,069,774
)Interest expense - related parties


---


---


---


(113,360
)Loss on extinguishment of debt


---


---


---


(635,259
)Loss on extinguishment of debt - related parties


---


---


---


(1,722,631
)Investor litigation settlement expense


75,800


---


(924,200
)

---Other income


12,761


3,635


30,449


3,635Total other income (expense)


65,831


(261,005
)

(1,501,340
)

(4,882,491
)LOSS BEFORE PROVISION FOR INCOME TAXES


(1,319,905
)

(1,243,214
)

(5,011,853
)

(6,744,688
)PROVISION FOR INCOME TAXES


---


---


---


---NET LOSS

$
(1,319,905
)
$
(1,243,214
)
$
(5,011,853
)
$
(6,744,688
)BASIC AND DILUTED LOSS PER SHARETotal basic and diluted loss per share

$
(0.05
)
$
(0.05
)
$
(0.19
)
$
(0.39
)BASIC AND DILUTED WEIGHTED-AVERAGE SHARESOUTSTANDING


27,800,238


22,772,365


26,725,216


17,388,793







The accompanying notes are an integral part of these financial statements.





3





**US DATAWORKS, INC.**




**STATEMENTS OF SHAREHOLDERS EQUITY**


**for the Nine Months ended December 31, 2004**




Preferred Stock
Convertible Series B

Common Stock

Common Stock

Additional Paid-In

Deferred

AccumulatedShares

Amount

Shares

Amount

Subscription

Capital

Compensation

Deficit

TotalBalance, March 31, 2004


629,666

$
63


22,997,136

$
2,300


--

$
55,135,232

$
--

$
(39,832,903
)
$
15,304,692Warrants and options issued to third parties for services rendered


--


--


--


--


--


57,132


--


--


57,132Warrants granted in settlement
of litigation


--


--


--


--


--


126,000


--


--


126,000Grant of deferred compensation


--


--


--


--


--


--


(94,600
)

--


(94,600
)Amortization of deferred compensation


--


--


--


--


--


--


31,205


--


31,205Common stock issued forCash


--


--


2,888,201


289


--


4,081,211


--


--


4,081,500Subscription receivable (Note 8)


--


--


143,750


14


(129,375
)

129,361


--


--


--Exercise of warrants and options


--


--


1,505,044


150


--


1,042,833


--


--


1,042,983Notes payable conversion


--


--


1,090,376


109


--


940,641


--


--


940,750Conversion of Series B preferred stock


(79,999
)

(8
)

15,998


2


--


6


--


--


--Stock issued for equity line of credit extinguishment (Note 8)


--


--


136,861


14


--


224,986


--


--


225,000Net loss


--


--


--


--


--


--


--


(5,011,853
)

(5,011,853
)Balance, December 31, 2004


549,667

$
55


28,777,366

$
2,878

$
(129,375
)
$
61,737,402

$
(63,395
)
$
(44,844,756
)
$
16,702,809







The accompanying notes are an integral part of these financial statements






4





**US DATAWORKS, INC.**





STATEMENTS OF CASH FLOW


For the Nine Months Ended December 31,





**(Unaudited)**





**2004**

**2003****Cash flows from operating activities**Net loss from continuing operations

$
(5,011,853
)
$
(6,744,688
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization of property and equipment


237,499


206,700Loss on extinguishment of debt


--


635,259Loss on extinguishment of debt - related party


--


1,722,631Amortization of note discount and beneficial conversion features on convertible promissory notes


343,824


819,551Amortization of deferred compensation expense


31,205


--Issuance of stock for interest


15,750


77,261Issuance of stock for services rendered


--


73,830Issuance of stock for extinguishment of equity credit line facility


225,000


--Issuance of warrants for extension of notes payable due date


--


1,084,505Issuance of warrants for settlement of dispute


--


262,755Issuance of warrants for services


--


96,750Issuance of warrants for stock cancellation agreement


--


45,693Issuance of warrants for convertible promissory note conversions


--


12,528Issuance of warrants for litigation settlement


126,000


--Issuance of options to third party for services


57,132


--Issuance of promissory note for litigation settlement


768,199


--(Increase) decrease inAccounts receivable


589,021


125,897Prepaid expenses and other current assets


638


35,618Other assets


(16,347
)

(5,021
)Increase (decrease) inDeferred revenue


164,995


(159,247
)Accounts payable


(108,401
)

(410,505
)Accrued expenses


(242,251
)

(427,405
)Accrued expenses - related parties


--


(43,000
)Interest payable


(14,521
)

18,051Interest payable - related parties


--


(94,075
)Net cash used in operating activities


(2,834,110
)

(2,666,912
)**Cash flows from investing activities**Purchase of property and equipment


(259,628
)

(62,304
)Net cash used in investing activities


(259,628
)

(62,304
)







The accompanying notes are an integral part of these financial statements.





5





**US DATAWORKS, INC.**





STATEMENTS OF CASH FLOW


For the Nine Months Ended December 31,





**(Unaudited)**





**2004**

**2003****Cash flows from financing activities**Payments on capital lease obligations


--


(6,728
)Proceeds from notes payable


--


10,000Repayment of notes payable


--


(602,989
)Proceeds from convertible promissory notes


--


2,190,000Repayment of convertible promissory notes


(500,000
)

(225,000
)Repayment of note payable related to discontinued operations


--


(151,442
)Proceeds from stock sale


4,650,000


3,650,000Stock issuance costs


(568,500
)

(244,954
)Proceeds from exercise of stock options


69,575


2,875Proceeds from exercise of warrants


973,408


19,760Net cash provided by financing activities


4,624,483


4,641,522Net increase in cash and cash equivalents


1,530,745


1,912,306Cash and cash equivalents, beginning of period


1,203,389


8,564Cash and cash equivalents, end of period

$
2,734,134

$
1,920,870Supplemental disclosures of cash flow informationInterest paid

$
31,035

$
83,151





The accompanying notes are an integral part of these financial statements.








6





US DATAWORKS, INC.




NOTES TO UNAUDITED FINANCIAL STATEMENTS





**1.**
**Organization and Business**




US Dataworks, Inc, a Nevada corporation (the Company), develops, markets, and supports payment processing software for the financial services industry. Its customer base includes many of the largest financial institutions as well as credit card companies, government institutions, and high-volume merchants in the United States. The Company was formerly known as Sonicport, Inc.




**2.**
**Summary of Significant Accounting Policies**




**Revenue Recognition**




The Company recognizes revenues in accordance with the provisions of the American Institute of Certified Public Accountants Statement of Position 97-2, Software Revenue Recognition. The Company licenses its software products under nonexclusive, nontransferable license agreements. These arrangements do not require significant production, modification, or customization, therefore, revenue is recognized when a license agreement has been signed, delivery of the software product has occurred, the related fee is fixed or determinable, and collectibility is probable. If professional services were provided in conjunction with the installation of the software licensed, revenue is recognized when these services have been provided.




For license agreements that include a separately identifiable fee for contracted maintenance services, such revenues are recognized on a straight-line basis over the life of the maintenance agreement noted in the agreement, but following any installation period of the software.




**Cash and Cash Equivalents**




For the purpose of the statements of cash flows, the Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents.




**Property and Equipment**




Property and equipment are recorded at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over estimated useful lives as follows:




Furniture and fixtures


5 yearsAutomobile


3 yearsTelephone equipment


5 to 10 yearsComputer equipment


5 yearsComputer software


5 yearsLeasehold improvements


Shorter of initiallease period oruseful life of asset




Maintenance and minor replacements are charged to expense as incurred. Gains and losses on disposals are included in the results of operations.




**Impairment of Long-Lived Assets**




The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to future net cash flows expected to be generated by the assets. If the assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets.




7


****


**Goodwill**




The Company follows Statement of Financial Accounting Standards (SFAS) No. 142 Goodwill and Other Intangible Assets to account for its goodwill.




SFAS No. 142 requires goodwill to be tested annually and between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of the entity below its carrying amount. The Company did not have an impairment of goodwill to record for the fiscal years ended March 31, 2003 or March 31, 2004.




**Fair Value of Financial Instruments**




The Company measures its financial assets and liabilities in accordance with generally accepted accounting principles in the United States. For certain of the Companys financial instruments, including cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, and accrued expenses, the carrying amounts approximate fair value due to their short maturities. The amounts shown for notes payable - related parties also approximate fair value because current interest rates offered to the Company for debt of similar maturities are substantially the same or the difference is immaterial.




**Stock Options**




SFAS No. 123, Accounting for Stock-Based Compensation, establishes and encourages the use of the fair value based method of accounting for stock-based compensation arrangements under which compensation cost is determined using the fair value of stock-based compensation determined as of the date of grant and is recognized over the periods in which the related services are rendered. The statement also permits companies to elect to continue using the current intrinsic value accounting method specified in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), to account for stock-based compensation. The Company has elected to use the implicit value based method and has disclosed the pro forma effect of using the fair value based method to account for its stock-based compensation.




The Company has elected to follow APB 25 and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123 requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Companys employee stock options is greater than or equals the market price of the underlying stock on the date of grant, no compensation cost has been recognized during the three or nine months ended December 31, 2004 and December 31, 2003 or for the years ended March 31, 2004 and March 31, 2003.




Pro forma information regarding net income and earnings per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model.




The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions including the expected stock price volatility. Because the Companys employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.





8





For purposes of pro forma disclosure, the estimated fair value of the options is included in expense over the options vesting period or expected life. The Companys pro forma information for the three and nine months ended December 31, 2004 and 2003 is as follows:





**For the Three Months Ended**
**December 31,**

**For the Nine Months Ended**
**December 31,****2004**

**2003**

**2004**

**2003**Net loss as reported

$
(1,319,905
)
$
(1,243,214
)
$
(5,011,853
)
$
(6,744,688
)Add stock-based employee compensation expense included in net loss as reported, net of related tax effects


0


0


0


0Deduct stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects

$
(320,948
)
$
(468,525
)
$
(998,573
)
$
(1,265,769
)Net loss; pro forma

$
(1,640,853
)
$
(1,711,739
)
$
(6,010,426
)
$
(8,010,457
)Basic and diluted loss per share, as reported

$
(0.05
)
$
(0.05
)
$
(0.19
)
$
(0.39
)Basic and diluted loss per share, pro forma

$
(0.06
)
$
(0.08
)
$
(0.22
)
$
(0.46
)




The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for the three months ended December 31, 2004 and 2003, and nine months ended December 31, 2004 and 2003: dividend yields of 0%; expected volatility of 69%, 150%, 74% and 150%, respectively; risk-free interest rates of 2.99%, 2.00%, 2.82% and 2.00%, respectively; and expected lives of 3 years. The per-share weighted average fair values of stock options granted during the three months ended December 31, 2004 and 2003, and nine months ended December 31, 2004 and 2003 were $0.56, $0, $0.58 and $1.13, respectively.





**Income Taxes**




The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period-end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. The provision for income taxes, if applicable, represents the tax payable for the period and the change during the period in deferred tax assets and liabilities.




**Loss per Share**




The Company calculates loss per share in accordance with SFAS No. 128, Earnings per Share. Basic loss per share is computed by dividing the net loss by the weighted-average number of common shares outstanding. Diluted loss per share is computed in a similar manner to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common stock equivalents had been issued and if the additional common shares were dilutive.




9





The following potential common stock equivalents have been excluded from the computation of diluted net loss per share for the periods presented because the effect would have been anti-dilutive (options and warrants typically convert on a one-for-one basis, see conversion details of the preferred stock stated below for the common stock shares issuable upon conversion):




**For the Nine Months Ended**
**December 31,****2004**

**2003**Options outstanding under the Companys stock option plans


3,868,115


2,391,500Options granted outside the Companys stock option plans


1,163,000


713,100Warrants issued in conjunction with convertible Series B preferred stock


0


0Warrants issued in conjunction with private placements


3,602,495


1,286,251Warrants issued as a financing cost for notes payableand convertible notes payable


2,223,037


2,341,137Warrants issued in conjunction with lock-up agreements


0


12,000Warrants issued for services rendered


177,800


447,800Warrants issued as part of the US Dataworks, Inc. acquisition


67,200


67,200Convertible Series A preferred stock (a)


0


0Convertible Series B preferred stock (b)


109,933


125,933





(a) From May through October 2003, in four separate partial conversions, all outstanding shares of Series A preferred stock were converted pursuant to their existing terms into 1,994,286 shares of common stock. The Series A preferred stock was convertible into shares of common stock as determined by dividing $2.50 by 60% of the average closing bid price of the Companys common stock for the 10 trading days prior to each conversion.





(b) The Series B preferred stock is convertible into shares of common stock at a conversion price of $3.75 per share.





**Estimates**




The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.




**Concentrations of Credit Risk**




The Company sells its products throughout the United States and extends credit to its customers. It also performs ongoing credit evaluations of such customers. The Company does not obtain collateral to secure its accounts receivable. The Company evaluates its accounts receivable on a regular basis for collectibility and provides for an allowance for potential credit losses as deemed necessary.




Three of our customers accounted for 30%, 25% and 12% of our net revenues for the three months ended December 31, 2004. Four of our customers accounted for 31%, 18%, 17% and 14%, respectively, of our net revenue for the nine months ended December 31, 2004. Three customers of the Company accounted for 44%, 20% and 13% of the Companys net revenues for the three months ended December 31, 2003. Three customers of the Company accounted for 33%, 25% and 11% respectively, of the Companys net revenues for the nine months ended December 31, 2003. Additionally, the Companys strategic resellers accounted for 37% and 55% of the Companys net revenues for the nine months ended December 31, 2004 and 2003, respectively.




As of December 31, 2004, amounts due from two strategic resellers and two significant customers accounted for 20%, 19%, 21% and 14%, respectively, of accounts receivable.




10


****


**Recently Issued Accounting Pronouncements**




SFAS 123R




In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004) *Share-Based Payments* (SFAS 123R). The statement requires that the Company record stock option expense in its financial statements based on a fair value methodology beginning no later than the first fiscal quarter beginning after December 15, 2005, the Companys fourth quarter of the next fiscal year ending March 31, 2006. The Company is evaluating the impact of the new standard and the method and timing of adoption. Although we have not completed our analysis, we anticipate that the expense would not exceed the amounts disclosed in Note 2 had the Company been expensing under the new rule.




**3.**
**Property and Equipment**




Property and equipment as of December 31, 2004 consisted of the following:




Furniture and fixtures

$
84,745Automobile


15,072Office and telephone equipment


90,237Computer equipment


371,275Computer software


1,232,114Leasehold improvements


62,9971,856,440Less accumulated depreciation and amortization


(1,139,438
)TOTAL

$
717,002




Depreciation and amortization expense for the three and nine months ended December 31, 2004 and 2003 was $81,727, $70,069, $237,499 and $206,700, respectively.




**4.**
**Notes Payable - Related Parties**




On January 22, 2001, the Company entered into a note payable with an advisory board member and shareholder for $50,000. The note is non-interest-bearing, is unsecured, and is due on demand. As of December 31, 2004, the outstanding balance on the note payable was $39,000.




**5.**
**Convertible Promissory Note**




Convertible promissory notes at December 31, 2004 consisted of the following:




Convertible promissory notes, interest at 10% perannum, unsecured,due in three equal annual instalmentsbeginning September 15, 2005 (see Note 6)

$
768,199Less current portion


(256,066
)Long-term portion

$
512,133




**6.**
**Litigation Settlement Expense**




During the three months ended December 31, 2004, the Company incurred a non-recurring, non-cash charge of $924,200 related to costs necessary to settle a lawsuit filed by an investor. In the lawsuit filed December 12, 2003 in the Los Angeles Superior Court, the investor alleged that the Company made an oral agreement in connection with the investors conversion of his promissory notes in April 2000. The plaintiff claimed that the oral agreement granted him the right to receive additional shares from the Company if he sold certain shares of the Companys common stock at a price less than $15 per share. The investor alleged that in March 2000, as partial consideration under the alleged oral agreement, he converted three promissory notes with an aggregate principal amount of $725,000 into 77,856 shares of the Companys common stock.




11





On November 12, 2004, the Company and the investor entered into a Settlement Agreement and Mutual Release wherein the parties agreed to dismiss the lawsuit and the Company agreed to pay the investor (1) a $768,199 convertible promissory note payable with interest at 10% per annum in three equal annual installments beginning September 15, 2005, (2) a warrant to purchase 160,000 shares of the Companys common stock at a purchase price of $0.75 per share, which warrant expires on November 10, 2006 and (3) reimbursement of the plaintiffs legal fees and expenses. The note is convertible at anytime, at the holders election, into shares of the Companys common stock at a per share conversion price of $1.10, subject to standard antidilution provisions.




Using the Black-Scholes pricing model the Company has determined the value of the warrants issued in connection with the settlement to be $126,000. This amount, together with the value of the convertible promissory note, the value of the plaintiffs legal expense reimbursement and the companys legal costs incurred in connection with the settlement totals $924,200 and has been recorded as Investor litigation settlement expense at December 31, 2004. As of September 30, 2004, the Company had estimated these settlement expenses and had accrued $1,000,000. Accordingly, for the three months ended December 31, 2004, the Company has reduced its previously recorded expenses by $75,800.




7.
**Commitments and Contingencies**




**Employment Agreements**




On April 2, April 2, May 13 and September 26, 2003, the Company entered into employment agreements with its President and Chief Operating Officer, Senior Vice President and Chief Technology Officer, Chief Executive Officer and Chairman of the Board, and Vice President of Business Development and General Counsel, respectively. Each employment agreement is for a term of three years. Annual base salaries for these four members of senior management are $175,000, $165, 000, $200,000 and $150,000, respectively.




On August 2, 2004, the Company entered into an employment agreement with its Vice President Sales - Remittance Processing Division. The employment agreement is for a term of three years with an annual base salary of $150,000 and, during the first twelve months of the agreement, an advance of future commissions of $75,000, payable in semi-monthly installments. The advance is non-recoverable; however, any commissions earned during the first twenty-four months of the agreement will be reduced by the amount of the advance.




**8.**
**Stockholders Equity**




**Preferred Stock**




The Company has 10,000,000 authorized shares of $0.0001 par value preferred stock. The preferred stock may be issued in series, from time to time, with such designations, rights, preferences, and limitations as the Board of Directors may determine by resolution.




**Convertible Series B Preferred Stock**




The Company has 700,000 authorized shares of $0.0001 par value convertible Series B preferred stock.




In August and October 2000, the Company issued 509,333 and 133,666 units respectively, in a private placement for gross proceeds of $382,000 and $100,250, respectively. Each unit consisted of one share of the Companys voting convertible Series B preferred stock (the Series B) and a warrant, exercisable through October 2003, to purchase one share of the Companys common stock. The Series B has a liquidation preference of $0.75 per share and carries a 10% cumulative dividend payable each March 1 and September 1. The Company has the right to redeem the Series B at any time after issuance at a redemption price of $0.83 per share, plus any accrued but unpaid dividends. The Series B is convertible upon issuance into common stock at $3.75 per share. The warrant entitles the holder to purchase one share of the Companys common stock at $6.25 per share, which represents 115% of the market value of the Companys stock at the closing date.




12





In May 2001, an investor in the Series B rescinded its acquisition and returned to the Company 13,333 shares and warrants for the purchase of 2,667 shares of common stock in exchange for the return of its investment of $10,000.




In August 2004, an investor in the Series B elected to convert his 79,999 shares and accordingly was issued 15,998 shares of the Companys common stock.




At December 31, 2004, there were accumulated, undeclared dividends in arrears of $159,352 or $0.29 per share.




**Common Stock**




**Financing Agreement**




On June 30, 2003, the Company entered into an agreement with an institutional investor for an equity line financing of up to $4,000,000. The Company may sell up to $4,000,000 of its common stock, with a minimum commitment of $1,500,000, to the institutional investor under the equity line on trading days on which our closing price per share is $0.50 or more.




In May 2004, the Company and the institutional investor agreed to terminate the equity line financing in consideration of the Company issuing to the investor $225,000 of unregistered shares of common stock. Based upon the closing market price of the Companys common stock on the date of the termination agreement, the Company issued 136,861 shares of common stock to the investor in May 2004.




**Common Stock and Warrants**




During the three and nine months ended December 31, 2004, the Company completed the following:




Sale of Common Stock and Warrants




In April 2004, the Company completed a private placement of $4.65 million, less direct issuance expenses of $568,500, with certain major institutional investment funds. Under terms of the agreement, the Company issued 2.89 million shares of common stock. In addition, the Company issued warrants to purchase up to 3.61 million shares of common stock at an exercise price of $1.61 per share.




Exercise of Warrants and Options




On December 14, 2004, the Company entered into an Amended Warrants Agreement wherein certain investors accelerated the exercise of previously issued common stock warrants at a reduced exercise price of $0.90 per share. A total of 1,214,007 warrants were exercised for cash proceeds of $963,232 and a subscription receivable of $129,375. Direct issuance expenses were $20,124.




The proceeds from one of the investors exercising his Amended Warrants Agreement for 143,750 warrants with an exercise amount of $129,375 was not received until January 5, 2005 and accordingly is shown as common stock subscription receivable at December 31, 2004.




In accordance with the terms of existing agreements, other previously issued warrants and stock options totaling 434,787 shares were exercised during the nine months ended December 31, 2004 for proceeds of $99,875.




Conversions of Convertible Promissory Notes




In June 2004, two accredited investors elected to convert their notes totaling $100,000 in aggregate principal amount of convertible notes and $10,000 of aggregate accrued interest and were issued 244,446 shares of common stock in accordance with the terms of the notes.




In August 2004, four accredited investors elected to convert their notes totaling $250,000 and were issued 555,556 shares of common stock in accordance with the terms of the notes.




In September 2004, the Company exercised its option to convert $575,000 in aggregate principal amount of convertible notes and $5,750 of accrued interest at 1% per annum due October 2, 2004 into common stock at a conversion price of $2.00 per share. Accordingly, as of September 30, 2004, the Company issued the note holder 290,375 shares of common stock.




13


****


**Stock Options**




In August 1999, the Company implemented its 1999 Stock Option Plan (the 1999 Plan). In August 2000, the Companys Board of Directors approved the 2000 Stock Option Plan (the 2000 Plan), which amends and restates the 1999 Plan. Under the 2000 Plan, the maximum aggregate number of shares which may be granted is 6,000,000. The exercise price must not be less than the fair market value on the date of grant of the option. The options vest in varying increments over varying periods and expire 10 years from the date of vesting. In the case of incentive stock options granted to any 10% owners of the Company, the exercise price must not be less than 100% of the fair market value on the date of grant. Such incentive stock options vest in varying increments and expire five years from the date of vesting.





During the nine months ended December 31, 2004 and 2003, the Company granted 1,994,502 and 2,694,000 stock options, respectively, to certain employees that may be exercised at prices ranging between $1.49 and $0.90, and $2.95 and $0.55, respectively.




The following table summarizes certain information relative to stock options:




2000 Stock Option Plan

Outside of PlanShares

Weighted-Average
Exercise Price

Shares

Weighted-Average Exercise PriceOutstanding, March 31, 2004


2,493,750

$
1.95


713,100

$
3.65Granted


1,414,502

$
1.02


580,000

$
1.49Exercised


(40,137
)
$
0.55


(19,000
)
$
1.08Forfeited/canceled


--


--


(111,100
)
$
19.99Outstanding, December 31, 2004


3,868,115

$
1.62


1,163,000

$
1.07Exercisable, December 31, 2004


1,723,950

$
1.65


3,000

$
21.72




The weighted-average remaining life and the weighted-average exercise price of all of the options outstanding at December 31, 2004 were 8.8 years and $1.50, respectively. The exercise prices for the options outstanding at December 31, 2004 ranged from $0.55 to $22.58, and information relating to these options is as follows:




Range of Exercise Prices

Stock Options Outstanding

Stock Options Exercisable

Weighted-Average Remaining Contractual Life

Weighted-Average Exercise Price

Weighted-Average Exercise Price of Options Exercisable$0.55 - 2.00


3,831,615


1,233,613


8.94 years

$
0.94

$
0.77$2.01 - 3.00


1,050,500


344,337


8.75 years

$
2.79

$
2.81$3.01- 22.58


149,000


149,000


6.06 years

$
6.68

$
6.685,031,115


1,726,950




**Details of Issuance**




On April 2, 2003, the Company entered into employment agreements with Terry Stepanik and Mario Villarreal, pursuant to which Mr. Stepanik is employed as President and Chief Operating Officer and Mr. Villarreal as Chief Technology Officer. Pursuant to these employment agreements, on April 26, 2004, both Mr. Stepanik and Mr. Villarreal were granted options to purchase 290,000 shares of the Companys common stock outside the 2000 Plan at an exercise price of $1.49 which was the closing market price of the Companys common stock on the date of grant. Each of these options will vest as to 145,000 shares on March 31, 2005 and the remaining shares will vest on March 31, 2006.





14





On May 10, 2004, John Reiland, the Companys Chief Financial Officer, was granted an option to purchase 200,000 shares of the Companys common stock under the 2000 Plan, at an exercise price of $1.36 per share which was the closing market price of the Companys common stock on the date of grant. Mr. Reilands option vests as to 66,666 shares on May 10, 2005, 66,667 shares on May 10, 2006 and the remaining 66,667 shares vest on May 10, 2007.





During the nine months ended December 31, 2004, the Company issued options to certain other employees and non-employee directors to purchase a total of 1,214,502 shares of its common stock under the 2000 Plan, at exercise prices ranging from $0.90 to $1.36 per share which in each case was the closing market price of the Companys common stock on the date of grant. All of the options are exercisable over a ten year life, generally vest equally over a period of three years, and generally terminate 90 days after the date the optionee ceases to be an employee or a director of the Company.








**Deferred compensation**




On April 12, 2004, the Company granted a deferred compensation award to Mr. Reiland. The award provides for a payment equal to the product of 200,000 multiplied by an amount equal to (a) the Companys average 20 day trailing stock price on the third anniversary date of his employment (March 17, 2006) less (b) $0.55 (the Companys stock price on the date of his employment). In no event may the payment amount exceed $430,000. The payment amount, if any, is cancelable in the event of Mr. Reilands voluntary termination or termination by the Company for Cause (as defined).












15





**Item 2.**  **Managements Discussion and Analysis** **or Plan of Operation.**




The following discussion and analysis of our financial condition and results of operations should be read with the consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-QSB.





When used in this Quarterly Report on Form 10QSB, the words expects, anticipates, believes, plans, will and similar expressions are intended to identify forward-looking statements. These are statements that relate to future periods and include, but are not limited to, statements regarding our critical accounting policies, adequacy of cash, expectations regarding net losses and cash flow, statements regarding our growth and profitability, investments in marketing and promotion, our need for future financing, our dependence on personnel and our ability to respond to rapid technological change. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those discussed below, as well as risks related to our ability to develop and timely introduce products that address market demand, the impact of alternative technological advances and competitive products, market fluctuations, our ability to obtain future financing, and the risks set forth below under Factors That May Affect Our Results. These forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.





**Critical Accounting Policies**





The following discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to revenue recognition and concentration of credit risk. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.





We believe that of the significant accounting policies used in the preparation of our financial statements (see Note 2 to the Financial Statements), the following are critical accounting policies, which may involve a higher degree of judgment, complexity and estimates.





*Revenue Recognition*





We recognize revenues in accordance with the provisions of the American Institute of Certified Public Accountants Statement of Position 97-2, Software Revenue Recognition. We license our software products under non-exclusive, non-transferable license agreements. These arrangements do not require significant production, modification or customization, therefore revenue is recognized when the license agreement has been signed, delivery of the software product has occurred, the related fee is fixed or determinable and collectibility is probable. If professional services are provided in conjunction with the installation of the software licensed, revenue is recognized when those services have been provided.





For license agreements that include a separately identifiable fee for contracted maintenance services, such revenues are recognized on a straight-line basis over the life of the maintenance agreement noted in the license agreement, but following any installation period of the software.





*Concentrations of Credit Risk*





We extend credit to our customers and perform ongoing credit evaluations of our customers. We do not obtain collateral from our customers to secure our accounts receivable. We evaluate our accounts receivable on a regular basis for collectibility and provide for an allowance for potential credit losses as deemed necessary.





16





Three of our customers accounted for 30%, 25% and 12% of our net revenues for the three months ended December 31, 2004. Four of our customers accounted for 31%, 18%, 17% and 14% of our net revenues for the nine months ended December 31, 2004. Three of our customers accounted for 44%, 20% and 13% of our net revenues for the three months ended December 31, 2003. Three of our customers accounted for 33%, 25% and 11% respectively, of our net revenues for the nine months ended December 31, 2003. Additionally, our strategic resellers accounted for 37% and 55% of our net revenues for the nine months ended December 31, 2004 and 2003, respectively.





At December 31, 2004, amounts due from two strategic resellers and two significant customers accounted for 20%, 19%, 21% and 14%, respectively, of accounts receivable.





**Results of Operations**




The results of operations reflected in this discussion include our operations for the three and nine month periods ended December 31, 2004 and 2003.




*Revenues*




Revenues totaled $517,935 for the three months ended December 31, 2004 compared to revenues of $416,458 for the three months ended December 31, 2003, an increase of $101,477 or 24%. The increase in revenues was primarily attributable to an increase in maintenance revenues of $179,456 or 268%, an increase in licensing revenues of $38,197 or 67% and offset by a decrease in service revenues of $116,176 or 40%. Maintenance revenues increased in the third quarter of the current fiscal year compared to the same period in the prior year principally as a result of previously installed customers subject to transactional fees increasing their utilization of our software solutions. Transactional revenues increased to approximately $156,000 in the current quarter compared to $35,000 of such revenue in the corresponding period of the prior year. Service revenues decreased in the third quarter compared to the same period in the prior year principally due to an installation project being completed in the prior year period for one of our larger customers without a similar large installation project in the current year.




Revenues totaled $2,030,900 for the nine months ended December 31, 2004 compared to revenues of $1,862,029 for the nine months ended December 31, 2003, an increase of $168,871 or 9%. The increase in revenues was primarily attributable to an increase in maintenance revenues of $525,240 or 290%, offset by a decrease in licensing revenues of $173,938 or 23% and a decrease in service revenues of $182,431 or 20%. Maintenance revenues increased in the first nine months of the current fiscal year compared to the same period in the prior year principally as a result of previously installed customers subject to transactional fees increasing their utilization of our software solutions. Transactional revenues increased to approximately $444,000 in the first nine months of the current fiscal year compared to approximately $56,000 of such revenue in the corresponding period of the prior year. The decrease in license fees is principally due to (a) the initiation of a direct sales effort and the hiring of five experienced sales representatives within the last six months, (b) the transition of our sales effort to a transactional sales model as opposed to a license fee sales model, and (c) significant upfront license revenues received in the prior fiscal year from two large credit card processing companies with no similar large upfront license transactions in the current year. These two customers accounted for 43% of our total revenue for the first nine months of the prior fiscal year. The decrease in service revenues in the current nine month period as compared to the same period in the prior year is also the result of fewer license transactions in the current year and the associated training and installation services.




*Cost of Sales*




Costs of sales principally include the cost of personnel who perform the services associated with our software maintenance, support, training and installation activities. Cost of sales decreased by $58,354 or 28% to $147,689 for the three months ended December 31, 2004 from $206,043 for the three months ended December 31, 2003. Cost of sales as a percentage of combined maintenance and services revenues for the current quarter was 35% as compared to 57% in the prior year. This decrease in cost of sales as a percentage of combined maintenance and services revenues is principally due to a lower level of professional service revenues in the current quarter compared to the same period in the prior year.




17





Cost of sales increased by $110,639 or 20% to $666,337 for the nine months ended December 31, 2004 from $555,698 for the nine months ended December 31, 2003. Cost of sales as a percentage of combined maintenance and services revenues for the current nine month period were 46% as compared to 51% in the prior year. The increase in the dollar amount of cost of sales for the nine months ended December 31, 2004 as compared to the same period in the prior year is due to the higher combined level of maintenance and services revenues. However, the decrease as a percentage of combined maintenance and services revenues is a result of the increase in less labor intensive transactional revenues and the decrease in services revenues that require a higher level of labor costs.




*Operating Expenses*




Total operating expenses increased by $563,358 or 47% to $1,755,982 for the three months ended December 31, 2004 from $1,192,624 for the three months ended December 31, 2003. The increase in operating expenses was principally attributable to a $550,000 increase in personnel costs primarily due to an increase in our headcount to 38 at December 31, 2004 compared to 20 at December 31, 2003. Additionally, marketing and advertising expenses increased $141,000 in the third quarter compared to the same period in the prior year. These increases were offset by a $198,000 decrease in legal and accounting fees. In the prior year period we incurred an unusually high level of capital restructuring transactions and the associated high level of legal, accounting and consulting expenses.




Total operating expenses increased by $1,706,548 or 54% to $4,875,076 for the nine months ended December 31, 2004 from $3,168,528 for the nine months ended December 31, 2003. The increase in operating expenses for the nine month period was principally attributable to a $1,573,000 increase in personnel costs primarily due to an increase in our headcount to 38 at December 31, 2004 compared to 20 at December 31, 2003. Additionally, marketing and advertising expenses increased $735,000 in the nine month period ended December 31, 2004 compared to the same period in the prior year. These increases were offset by a $635,000 decrease in legal and accounting fees. In the prior year period we incurred an unusually high level of capital restructuring transactions and the associated high level of legal, accounting and consulting expenses.




*Other Expenses*




Other expenses, including interest expense and financing costs, decreased $326,836 or 125% to an income amount of $65,831 for the three months ended December 31, 2004 from an expense amount of $261,005 for the three months ended December 31, 2003. The income amount in the current quarter is due to the reversal of an estimate made in the prior quarter of the costs to settle a lawsuit filed by an investor. During the three months ended September 30, 2004, we recorded a non-recurring, non-cash charge of $1,000,000 related to managements estimates of costs necessary to settle a lawsuit filed by an investor (see Note 6). In November 2004, we settled the lawsuit and incurred costs of $924,200 which resulted in the $75,800 income amount in the current quarter.




Other expenses, including interest expense and financing costs, decreased $3,381,151 or 69% to $1,501,340 for the nine months ended December 31, 2004 from $4,882,491 for the nine months ended December 31, 2003. The decrease was primarily due to the non-recurring, non-cash financing charges incurred in our capital restructuring transactions in the prior year offset by the costs of the lawsuit settlement discussed above recorded in the current fiscal year.




*Net Loss*




Net loss increased by $76,691 or 6% to a net loss of $1,319,905 for the three months ended December 31, 2004 from $1,243,214 for the three months ended December 31, 2003.




Net loss decreased by $1,732,835 or 26% to a net loss of $5,011,853 for the nine months ended December 31, 2004 from $6,744,688 for the nine months ended December 31, 2003.




18


****


**Liquidity and Capital Resources**




Cash and cash equivalents increased by $1,530,745 to $2,734,134 at December 31, 2004 from $1,203,389 at March 31, 2004. Cash used for operating activities was $2,834,110 in the nine months ended December 31, 2004 compared to $2,666,912 in the same period in the prior year. Net loss from continuing operations reduced cash by $5,011,853 and $6,744,688 in the nine months ended December 31, 2004 and 2003, respectively.




Cash used for investing activities of $259,628 and $62,304 in the nine months ended December 31, 2004 and December 31, 2003, respectively, was due to equipment purchases.




Financing activities provided cash of $4,624,483 in the nine months ended December 31, 2004 compared to $4,641,522 in the nine months ended December 31, 2003. Financing activities in the current nine month period included the repayment of $500,000 of convertible promissory notes and the receipt of $4,650,000, less direct issuance expenses of $568,500, from the sale of 2.89 million shares of our common stock and warrants to purchase up to 3.61 million shares of our common stock at an exercise price of $1.61 per share. Additionally, in the current nine month period, we received net proceeds of $973,408 from the exercise of outstanding warrants to purchase our common stock.




As a result of our recent capital raising transactions and the level of revenues achieved in the nine months ended December 31, 2004 and in the fiscal year ended March 31, 2004, we believe we currently have adequate resources to fund our anticipated cash needs through June 30, 2005. However, an adverse business or legal development could require us to raise additional financing sooner than anticipated. We recognize that we may be required to raise such additional capital, at times and in amounts, which are uncertain, especially under current capital market conditions. If we are unable to acquire additional capital or are required to raise it on terms that are less satisfactory than we desire, it may have a material adverse effect on our financial condition. In the event we raise additional equity financings, these financings may result in dilution to existing shareholders.





*Off Balance Sheet Arrangements*




During the year ended March 31, 2004, we guaranteed a bank loan extended to one of our executive officers in the amount of $150,000 related to the officers expenses in relocating from California to Houston, Texas. This loan was fully repaid by the officer and the guarantee was released in May 2004.




**Factors That May Affect Our Results**





**We have a general history of losses and may not operate profitably in the**  **future.**





We have incurred losses for the last three fiscal years. Our net losses and negative cash flow may continue for the foreseeable future. As of December 31, 2004, our accumulated deficit was $44,844,756. We believe that our planned growth and profitability will depend in large part on our ability to promote our brand name, gain clients and expand our relationships with clients for whom we would provide licensing agreements and system integration. Accordingly, we intend to invest heavily in marketing, strategic partnership, development of our client base, and development of our marketing technology and operating infrastructure. If we are not successful in promoting our brand name and expanding our client base, it will have a material adverse effect on our financial condition and our ability to continue to operate our business.





19


****


**If we are unsuccessful in raising additional capital in the future, we may be**  **unable to continue to operate.**





We believe we currently have adequate cash to fund anticipated cash needs through June 30, 2005. In April 2004, we raised an additional $4,650,000 of equity capital in a private placement with major institutional investors. In December 2004, we amended the terms of certain existing warrant agreements and raised an additional $1,092,607. However, we may need to raise additional capital in the future. Any equity financing may be dilutive to shareholders, and debt financing, if available, will increase expenses and may involve restrictive covenants. We may be required to raise additional capital, at times and in amounts, which are uncertain, especially under the current capital market conditions. Under these circumstances, if we are unable to obtain additional capital or are required to raise it on undesirable terms, it may have a material adverse effect on our financial condition, which could require us to:





·
curtail our operations significantly;





·
sell significant assets;





·
seek arrangements with strategic partners or other parties that may require us to relinquish significant rights to products, technologies or markets; or





·
explore other strategic alternatives including our merger or sale.





**Our operating results are subject to fluctuations caused by many factors which**  **could cause us to fail to achieve our revenue or profitability expectations,**  **which in turn could cause our stock price to decline.**





Our operating results can vary significantly depending upon a number of factors, many of which are outside our control. Factors that may affect our quarterly operating results include:





·
market acceptance of and changes in demand for our products and services;





·
gain or loss of clients or strategic relationships;





·
announcement or introduction of new software, services and products by us or by our competitors;





·
our ability to build brand recognition;





·
timing of sales to customers;





·
price competition;





·
our ability to upgrade and develop systems and infrastructure to accommodate growth;





·
our ability to attract and integrate new personnel in a timely and effective manner;





·
our ability to introduce and market products and services in accordance with market demand;





·
changes in governmental regulation;





·
reduction in or delay of capital spending by our clients due to the effects of terrorism, war and political instability; and





·
general economic conditions, including economic conditions specific to the financial services industry.





In addition, each quarter we derive a significant portion of our revenue from agreements signed at the end of the quarter. Our operating results could suffer if the timing of these agreements is delayed. Depending on the type of agreements we enter into, we may not be able to recognize revenue under these agreements in the quarter in which they are signed. Some or all of these factors could negatively affect demand for our products and services, and our future operating results.





Most of our operating expenses are relatively fixed in the short-term. We may be unable to adjust spending rapidly to compensate for any unexpected sales shortfall, which could harm our quarterly operating results. Because of the emerging nature of the markets in which we compete, we do not have the ability to predict future operating results with any certainty. Because of the above factors, you should not rely on period-to-period comparisons of results of operation as an indication of future performances.





20


****


**Because a small number of customers have historically accounted for and may in**  **future periods account for substantial portions of our revenue, our revenue**  **could decline because of delays of customer orders or the failure to retain**  **customers.**





We have a small number of customers that account for a significant portion of our revenue. Our revenue could decline because of a delay in signing agreements with a single customer or the failure to retain an existing customer. We may not obtain additional customers. The failure to obtain additional customers and the failure to retain existing customers will harm our operating results.





**If general economic and business conditions do not improve, we may experience**  **decreased revenue or lower growth rates.**





The revenue growth and profitability of our business depends on the overall demand for computer software and services in the product segments in which we compete. Because our sales are primarily to major banking and government customers, our business also depends on general economic and business conditions. A softening of demand caused by a weakening of the economy may result in decreased revenue or lower growth rates. As a result, we may not be able to effectively promote future license revenue growth in our application business.





**We may not be able to attract, retain or integrate key personnel, which may**  **prevent us from successfully operating our business.**





We may not be able to retain our key personnel or attract other qualified personnel in the future. Our success will depend upon the continued service of key management personnel. The loss of services of any of the key members of our management team or our failure to attract and retain other key personnel could disrupt operations and have a negative effect on employee productivity and morale and harm our financial results.





**We operate in a market that is intensely and increasingly competitive, and if**  **we are unable to compete successfully, our revenue could decline and we may be**  **unable to gain market share.**





The market for financial services software is relatively new and highly competitive. Our future success will depend on our ability to adapt to rapidly changing technologies, evolving industry standards, product offerings and evolving demands of the marketplace.





Some of our competitors have:





·
longer operating histories;





·
larger installed customer bases;





·
greater name recognition and longer relationships with clients; and





·
significantly greater financial, technical, marketing and public relations resources than us.





Our competitors may also be better positioned to address technological and market developments or may react more favorably to technological changes. We compete on the basis of a number of factors, including:





·
the breadth and quality of services;





·
creative design and systems engineering expertise;





·
pricing;





·
technological innovation; and





·
understanding clients strategies and needs.





21





Competitors may develop or offer strategic services that provide significant technological, creative, performance, price or other advantages over the services we offer. If we fail to gain market share or lose existing market share, our financial condition, operating results and business could be adversely affected and the value of the investment in us could be reduced significantly. We may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully.





**We may be responsible for maintaining the confidentiality of our clients**  **sensitive information, and any unauthorized use or disclosure could result in**  **substantial damages and harm our reputation.**





The services we provide for our clients may grant us access to confidential or proprietary client information. Any unauthorized disclosure or use could result in a claim against us for substantial damages and could harm our reputation. Our contractual provisions attempting to limit these damages may not be enforceable in all instances or may otherwise fail to adequately protect us from liability for damages.





**Future sales of our common stock may cause the market price of our common stock**  **to decline.**





As of January 31, 2004, there were approximately 28,777,866 shares of common stock outstanding, of which at least 9,120,139 are restricted securities under the Securities Act, a minority of which are held by our affiliates. These restricted securities will be eligible for sale from time to time upon expiration of applicable holding periods under Rule 144 under the Securities Act. If these holders sell in the public market, these sales could cause the market price of our common stock to decline. This also could make it more difficult for us to raise funds through future offerings of our common stock.





**If we do not adequately protect our intellectual property, our business may**  **suffer, we may lose revenue or we may be required to spend significant time and**  **resources to defend our intellectual property rights.**





We rely on a combination of patent, trademark, trade secrets, confidentiality procedures and contractual procedures to protect our intellectual property rights. If we are unable to adequately protect our intellectual property, our business may suffer from the piracy of our technology and the associated loss in revenue. Any patents that we may hold may not sufficiently protect our intellectual property and may be challenged by third parties. Our efforts to protect our intellectual property rights may not prevent the misappropriation of our intellectual property. These infringement claims or any future claims could cause us to spend significant time and money to defend our intellectual property rights, redesign our products or develop or license a substitute technology. We may be unsuccessful in acquiring or developing substitute technology and any required license may be unavailable on commercially reasonable terms, if at all. In the event of litigation to determine the validity of any third party claims or claims by us against such third party, such litigation, whether or not determined in our favor, could result in significant expense and divert the efforts of our technical and management personnel, regardless of the outcome of such litigation. Furthermore, other parties may also independently develop similar or competing products that do not infringe upon our intellectual property rights.









22





**Item 3.**  **Controls and Procedures**




**Evaluation of Disclosure Controls and Procedures**




We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our "disclosure controls and procedures" (as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this quarterly report. Based on the evaluation, such officers have concluded that these disclosure controls and procedures are effective in ensuring that the information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Security and Exchange Commission rules and forms and is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussions regarding required disclosure.





There has been no change in our internal control over financial reporting (as defined in Rules 13a-13(f) and 15d-15(f) of the Exchange Act) that occurred during the period covered by this quarterly report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.







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**PART II -**  **OTHER INFORMATION**




**Item 1.**  **Legal Proceedings**




On November 12, 2004, we settled a lawsuit filed in the Los Angeles Superior Court by one of our investors. The lawsuit alleged that in March 2000, as partial consideration under an alleged oral agreement he converted three promissory notes with an aggregate principal amount of $725,000 into 77,856 shares of our common stock. In the lawsuit, the investor alleged that the oral agreement granted him the right to receive additional shares from us in the event that he should sell certain shares of our common stock at a price less than $15 per share.





Under the terms of the settlement agreement, we agreed to give the investor (1) a $768,199 convertible promissory note payable with interest at 10% per annum in three equal annual installments beginning September 15, 2005 (2) a warrant to purchase 160,000 shares of our common stock at a purchase price of $0.75 per share which warrant expires on November 10, 2006, and (3) reimbursement of the plaintiffs legal fees and expenses. At anytime at the holders election any portion of the unpaid principal and interest of the promissory note may be converted into shares of our common stock at a per share conversion price of $1.10, subject to standard antidilution provisions.





**Item 2.**  **Changes in Securities**




On December 14, 2004, we entered into an Amended Warrants Agreement wherein certain investors accelerated the exercise of previously issued common stock warrants at a reduced exercise price of $0.90 per share. A total of 1,214,008 warrants were exercised for cash proceeds of $963,232 and a subscription receivable of $129,375. Direct issuance expenses were $20,124.





The proceeds from one of the investors exercising his Amended Warrants Agreement for 143,750 warrants with an exercise amount of $129,375 was not received until January 5, 2005 and accordingly is shown as common stock subscription receivable at December 31, 2004.





In accordance with the terms of existing agreements, other previously issued warrants and stock options totaling 434,787 shares were exercised during the nine months ended December 31, 2004 for proceeds of $99,875.




The issuances disclosed in were made to accredited investors and were deemed to be exempt from registration under the Securities Act in reliance upon Section 4(2) of the Securities Act or Regulation D promulgated thereunder.





**Item 6.**  **Exhibits**




The exhibits listed below are required by Item 601 of Regulation S-B.




**Exhibit****Number**

**Description of Document**4.1

U.S. Dataworks, Inc. Amended Warrants Agreement dated December 6, 2004 by and between the Registrant and the undersigned warrant holders (incorporated by reference to Exhibit 99.2 to the Registrants Current Report on Form 8-K filed with the SEC on December 8, 2004).4.2

First Amendment to U. S. Dataworks, Inc. Amended Warrants Agreement dated December 9, 2004 by and between the Registrant and the undersigned warrant holders (incorporated by reference to Exhibit 99.1 to the Registrants Current Report on Form 8-K filed with the SEC on December 13, 2004).4.3

Registration Agreement dated as of November 12, 2004, between the Registrant and Peter Simons (incorporated by reference to Exhibit 4.3 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).4.4

Common Stock Purchase Warrant to purchase up to 160,000 shares of the Registrant Common Stock issued to Peter Simons (incorporated by reference to Exhibit 4.4 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).4.5

10% Convertible Debenture issued by the Registrant for the benefit of Peter Simons dated effective September 15, 2004 (incorporated by reference to Exhibit 99.2 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).10.1

Settlement Agreement and Mutual Release dated November 12, 2004, by and between the Registrant and Peter Simons (incorporated by reference to Exhibit 99.1 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).31.1

Section 302 Certification of Chief Executive Officer.31.2

Section 302 Certification of Chief Financial Officer.32.1

Section 906 Certification of Chief Executive Officer.32.2

Section 906 Certification of Chief Financial Officer.







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****


**SIGNATURE**







In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.




**US DATAWORKS, INC.**Date: February 14, 2005
By:
/s/ John S. ReilandJohn S. ReilandChief Financial Officer(Principal Financial and Accounting Officer and Duly Authorized Officer)














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EXHIBIT INDEX




**Exhibit****Number**

**Description of Document**4.1

U.S. Dataworks, Inc. Amended Warrants Agreement dated December 6, 2004 by and between the Registrant and the undersigned warrant holders (incorporated by reference to Exhibit 99.2 to the Registrants Current Report on Form 8-K filed with the SEC on December 8, 2004).4.2

First Amendment to U. S. Dataworks, Inc. Amended Warrants Agreement dated December 9, 2004 by and between the Registrant and the undersigned warrant holders (incorporated by reference to Exhibit 99.1 to the Registrants Current Report on Form 8-K filed with the SEC on December 13, 2004).4.3

Registration Agreement dated as of November 12, 2004, between the Registrant and Peter Simons (incorporated by reference to Exhibit 4.3 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).4.4

Common Stock Purchase Warrant to purchase up to 160,000 shares of the Registrant Common Stock issued to Peter Simons (incorporated by reference to Exhibit 4.4 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).4.5

10% Convertible Debenture issued by the Registrant for the benefit of Peter Simons dated effective September 15, 2004 (incorporated by reference to Exhibit 99.2 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).10.1

Settlement Agreement and Mutual Release dated November 12, 2004, by and between the Registrant and Peter Simons (incorporated by reference to Exhibit 99.1 to Registration Statement on Form S-3 (File No. 333-121951) filed by the Registrant on January 11, 2005).31.1

Section 302 Certification of Chief Executive Officer.31.2

Section 302 Certification of Chief Financial Officer.32.1

Section 906 Certification of Chief Executive Officer.32.2

Section 906 Certification of Chief Financial Officer.





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