FIRST VIRTUAL HOLDINGS INC, 10-K405/A, 1998-10-20

FIRST VIRTUAL HOLDINGS INC
10-K405/A, 1998-10-20
SERVICES, NEC

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K/A

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

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

FOR THE PERIOD FROM
--------------- TO
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COMMISSION FILE NUMBER: 000-21751

FIRST VIRTUAL HOLDINGS INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S> <C>
DELAWARE 33-0612860
(STATE OR JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
INCORPORATION OR ORGANIZATION)
</TABLE>

11975 EL CAMINO REAL #300
SAN DIEGO, CA 92130
(ADDRESS, INCLUDING ZIP CODE, OF PRINCIPAL EXECUTIVE OFFICES)

(619) 793-2700
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF ACT: NONE

<TABLE>
<S> <C>
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED

NONE NONE
</TABLE>

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $.001 PAR VALUE
(TITLE OF CLASS)

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

Indicate by check mark if disclosure of delinquent filers in response to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this form 10-K or any
amendment to this form 10-K: [X]

As of January 30, 1997, there were outstanding 9,248,125 shares of the
Registrant's Common Stock, $.001 par value. As of that date, the aggregate
market value of the voting stock held by non-affiliates of the Registrant was
approximately $6,250,687 when the closing price of such stock, as reported on
the Nasdaq National Market was $1.81. Shares of Common Stock held by each
officer and director and each person who owns 5% or more of the of the
outstanding common stock have been excluded in that such persons may be
affiliates.

DOCUMENTS INCORPORATED BY REFERENCE

Certain information called for by Part III is incorporated by reference
from the Proxy Statement relating to the Annual Meeting of Stockholders of the
Registrant to be held on June 23, 1998.

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PART I

This 10-K report contains, in addition to historical information,
forward-looking statements that involve risks and uncertainties. The Company's
actual results may differ significantly from the results discussed in the
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those discussed in the subsection entitled "Factors
Affecting Operating Results and Market Price of Stock" commencing on page 17.
Certain sections and other sentences in this report have been identified as
containing forward-looking statements. The reader is cautioned that other
sections and other sentences not so identified may also contain forward-looking
information.

ITEM 1. BUSINESS

Founded in 1994, First Virtual Holdings Incorporated ("First Virtual" or
"the Company") is a leader in advanced marketing and customer service systems
for Internet commerce. The Company pioneered secure online payment systems and
is currently focused on developing and supplying an integrated system for
relationship-based transactive messaging using e-mail channels. First Virtual's
objective is to develop and provide market-leading interactive messaging
services for electronic commerce that integrates secure payment processing with
intelligent messaging and interactive transactional advertisements.

First Virtual completed its initial public offering ("IPO") in December
1996 (Nasdaq: FVHI), and announced the Interactive Messaging Platform in June
1997. The Company continues to operate the First Virtual Internet Payment System
("FVIPS"), a secure and easy-to-use payment system introduced in October 1994.
This was the Company's first application of the Company's VirtualPIN
architecture, a system which uses an alphanumeric sequence unique to each user
to allow the user to establish and maintain identity on the Internet in a
controlled and confidential manner. The VirtualPIN architecture facilitates
Internet commerce and is designed to facilitate other forms of interactive
Internet communications. The architecture and code for First Virtual's
interactive messaging technology was developed by digital messaging pioneers
Nathaniel Borenstein, Ph.D., who is the co-author of the MIME Internet mail
protocol that makes multimedia attachments in e-mail possible, and Marshall
Rose, Ph.D., who is the co-author of POP, the Internet e-mail protocol and also
co-author of SNMP, a major communications protocol used by routers on the
Internet.

INDUSTRY BACKGROUND

The Internet is a rapidly growing network of computers and computer
networks that permits communication among users throughout the world.
International Data Corporation ("IDC") estimates that 100 million people will
access the Internet in 1998.* The most widely used application of the Internet
is e-mail. The popularity of e-mail and the emergence of the Web and easy-to-use
browser software have fostered continued rapid growth in Internet use by
businesses and individuals.

The evolution of the Internet and the Web as vehicles for electronic
communications and commerce have led to the emergence of new media,
merchandising and transaction processing opportunities. Advertisers, for
example, can use newly provided demographic data to cost effectively target
individuals or narrowly defined groups. Internet commerce can reduce, and in
some cases eliminate, merchants' requirements for physical store premises,
warehouses and distribution centers, by permitting shipment directly from
manufacturer to consumer. Information products, such as news, data and research,
can be downloaded directly to a personal computer, minimizing the cost of
physical reproduction, packaging and distribution of these products. Buyers are
motivated to accept these new offerings because they improve the likelihood of
viewing information and receiving merchandise offers of specific interest to
them. The Internet provides consumers with the potential

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* This statement is a forward-looking statement reflecting current expectations.
There can be no assurance that the actual future results will meet the
Company's current expectations. Investors are strongly encouraged to review
the section entitled "Factors Affecting Operating Results and Market Price of
Stock" commencing on page 17, for a discussion of factors that could affect
future performance. The reader is cautioned that other sections not so
identified may also contain forward looking information.
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to conveniently locate and initiate purchases in a single marketplace which is
easily accessible from home or office. The Internet also presents new
opportunities for merchants and customers to easily communicate and establish
relationships, both before and after the sale.

BARRIERS TO INTERACTIVE INTERNET ADVERTISING AND MARKETING

The Company believes that successful interactive Internet advertising and
marketing faces a number of hurdles, including a general lack of effective
methods of e-mail based interactive Internet advertising to stimulate consumer
interest, the need for new direct marketing and merchandising capabilities
targeted to the interactive media, such as the Internet, and the need for a
secure and effective transaction processing system.

Effective methods of Internet advertising to stimulate consumer interest

Currently, merchandisers employing Internet advertising are generally
restricted to providing passive advertisements similar to those offered in
traditional media. The Company believes that the effectiveness of advertising on
the Internet would likely be increased substantially by the ability to
proactively present targeted advertising to specific Internet subscribers and to
incorporate interactive, stimulating images and sounds within Web page
advertisements.

Direct marketing and merchandising capabilities

The Company believes that merchandisers are becoming increasingly aware
that having a Web page does not, of itself, result in effective Internet
commerce. Currently, merchandisers on the Internet, lack the means of
effectively marketing directly to potential consumers who fit specific profiles.
Consumers have the burden of actively searching the vast information and
numerous Web pages on the Internet, often in inefficient and time consuming
ways, for specific products or services. In addition, a purchase transaction may
be more time consuming, require moving through multiple Web pages or
disconnecting from the Internet to place a toll-free call.

Secure and effective transaction processing system

The Company believes that an effective transaction processing system for
Internet commerce must successfully address the following:

- Lack of security. The Internet is a public network which potentially
allows third parties to gain unauthorized access to data as it is routed
to its intended destination over the Internet or stored in databases on
the Internet. Current solutions generally require encryption and
specialized hardware or software solutions which may be expensive,
difficult to use and susceptible to penetration by proficient and
determined hackers.

- Lack of privacy. The open and public nature of the Internet reduces the
ability of the consumer to maintain the privacy of the personal data
typically submitted and compiled in order to process a commercial
transaction.

- Difficulty of widespread system deployment and acceptance. The interface
which enables Internet commerce must be compatible with existing hardware
and software, inexpensive, and easy-to-use for the average consumer. The
payment systems must also interoperate with established financial
networks and protocols since financial institutions may be reluctant to
adopt and implement entirely new processing and payment methods.

FIRST VIRTUAL PRODUCTS AND SERVICES

The Company currently operates FVIPS, a secure and easy-to-use payment
system introduced in October 1994. This was the Company's first application of
the VirtualPIN architecture. In the fourth quarter of 1996, the Company
introduced the VirtualTAG. The VirtualTAG is an interactive advertising applet
embedded within a banner ad and is designed to allow consumers to initiate the
purchase and payment and arrange for the delivery of a product without leaving
the web page on which the advertisement appears.
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Currently, the Company is developing the Interactive Messaging Platform, a
family of products and services that enable the development and deployment of
interactive multimedia e-mail messaging solutions. The Interactive Messaging
Platform is being designed to be an extensible and scalable infrastructure for
online interactive communications, payment and data warehousing. The Interactive
Messaging Platform is designed to allow for intelligent e-mail communications to
take place between companies and their customers. It integrates customer service
and sales and marketing functions into transactional e-mail messages, that
includes the ability to provide a system for secure payments and the use of
highly graphical, animated and interactive elements. The system is expected to
be interoperable with primarily all e-mail platforms and protocols, and is
expected to integrate the Company's VirtualPIN, FVIPS, VirtualTAG,
VirtualRECEIPT, VirtualALERT and VirtualMAIL technologies. Although the Company
has completed development of most of the core technologies underlying the
Interactive Messaging Platform, finalization and implementation of the system
will depend on the timing of receipt of customer commitments, among other
factors.*

VirtualPIN

The Company developed, implemented and operates the VirtualPIN architecture
which facilitates Internet commerce and is designed to facilitate other forms of
interactive Internet communications. The VirtualPIN, an alphanumeric sequence
unique to each user, allows the user to establish and maintain identity on the
Internet in a controlled and confidential manner. FVIPS is the Company's first
application of the VirtualPIN architecture. To initiate a transaction using
FVIPS, the consumer transmits his or her VirtualPIN to the merchant, who accepts
it as a form of payment for the consumer's order and relays it to First Virtual
for verification. After the consumer responds affirmatively to the Company's
automated request for E-mail confirmation of the transaction, First Virtual
initiates financial settlement through the established and secure credit card
transaction processing networks.

Security and Privacy

By transmitting only a consumer's VirtualPIN over the Internet, using
e-mail verification and processing, and storing sensitive information off-line,
FVIPS offers a simple and effective transaction processing solution.
Confidential information, such as credit card numbers, are stored on servers
which cannot be accessed from the Internet and are never transmitted over the
Internet. All that is transmitted over the Internet is the non-confidential
VirtualPIN. Therefore, the Company believes that FVIPS virtually eliminates the
risk of credit card theft on the Internet. The consumer's e-mail address,
VirtualPIN and other personal information, that is willingly disclosed by the
consumer when registering, is stored on one of the Company's databases which is
protected by enhanced commercial fire-walls and by restricted log-in access.

VirtualTAG

In order to bring the retail environment to any Web page, the Company
introduced the VirtualTAG, its second application of the VirtualPIN architecture
in the fourth quarter of 1996. The VirtualTAG uses the Java programming language
to create a cross-platform multimedia environment with stimulating, interactive
advertisements embedded within a banner ad and is designed to allow consumers to
initiate the purchase and payment and arrange for the delivery of a product
being advertised without leaving the Web page on which the advertisement
appears. VirtualTAGs are also being designed to be embedded within an e-mail
message, allowing targeted interactive advertisements to be delivered directly
to the customers. The Company's VirtualTAG application is designed to provide an
interactive and engaging message by combining sound and motion, which is
activated by the consumer as the cursor is moved near or on the advertisement.

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VirtualMAIL, VirtualRECEIPT and VirtualALERT

The Company is currently enhancing the Interactive Messaging Platform with
these three new capabilities. VirtualMAIL is being designed to allow for
customized direct e-mail from merchants to consumers, that is tailored to the
individual profiles of the recipient consumer. The VirtualRECEIPT is being
designed to allow for electronic receipts to be generated and sent via e-mail,
to the consumer, regardless of whether the transaction originally took place in
the physical world or over the Internet. VirtualALERT is also an e-mail message
sent to the consumer that is being designed to notify the consumer of shipment,
billing or other critical information regarding a product or service. The
Company believes the VirtualMAIL, VirtualRECEIPT and VirtualALERT applications
will enable merchants to directly market and merchandise their products and
services to consumers.*

MARKETING STRATEGY

The Company's objective is to develop and provide market-leading
interactive messaging services for electronic commerce that integrates secure
payment processing with intelligent messaging and interactive transactional
advertisements.

The fastest growing medium in history is the Internet. Jupiter
Communications estimates that there were 21.9 million U.S. households on-line in
1997 and projects that this figure will increase to 36.5 million households by
the year 2000. Business Week estimated that in 1997, there were over 40 million
Internet users in the United States alone.

E-mail enables businesses to target their messages to a single customer or
a group of customers. To exploit the full power of the medium, the e-mail
message should provide perceived value to the customer and also engage the
customer with its interactive features. Properly designed, interactive,
intelligent e-messaging can serve the needs of almost any business.*

The Interactive Messaging Platform is designed to facilitate customer care,
direct marketing and advertising services and will offer numerous features
including electronic receipts or notifications; interface capability with
popular personal financial software (such as Intuit's Quicken and Microsoft
Money), automatic "click to respond" capability to outbound direct marketing;
embedded Java based full motion ad banners and a secure payment transaction
capability.*

Target customers for First Virtual's Interactive Messaging Platform will
include companies, who possess some degree of Internet savvy, with large
consumer databases, especially those who value the importance of loyalty
marketing and one-to-one relationships. These would include credit card issuers,
catalog companies, direct marketers and travel services, such as airlines,
rental car agencies and hotel operators. First Virtual is pursuing a
multi-channel sales strategy, which includes selling directly to prospective
companies and alliances, which include advertising and mail agencies, web
integrators and call centers.

First Virtual is developing the capability to provide high volume, high
quality, fully interactive messaging systems for innovative, one-to-one
marketing programs.* There are hundreds of e-mail software programs and new
e-mail software programs and upgrades are constantly coming on the market. Each
of these programs and upgrades has a wide variety of capabilities. First
Virtual's messaging system has the ability to track, analyze and determine the
capabilities of the end user's e-mail software applications and to automatically
provide that consumer with the richest content that their e-mail application can
accommodate.* In addition, the Interactive Messaging Platform is being designed
to provide a competitive advantage of sending personalized electronic mass
e-mail, which is the delivery of personalized and targeted messages to a large
number of recipients who have a pre-existing relationship with a business.

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CUSTOMER CARE

The Company's customer care activities are designed to provide timely, high
quality product and technical support to meet the diverse needs of First
Virtual's merchant and consumer customers. These support activities facilitate
the integration and use of First Virtual's products and services across the
Internet. The Company's customer care organization uses an e-mail monitoring
system 24 hours a day, seven days a week. In addition to e-mail and toll-free
telephone support, customers also have access to numerous self-help reference
materials at the Company's Web site.

The majority of inquiries and support requests to customer care are
received via e-mail and processed and responded to using the Company's e-mail
based customer support application. Customer care responses match the various
experience levels of First Virtual's growing customer base and are closely
monitored for accuracy and timeliness. An escalation procedure allows for urgent
issues to be resolved by Company personnel who are most knowledgeable about the
subject of inquiry. To ensure quality products and services, the Company's
customer care team also provides additional testing on all of the Company's new
product releases.

RESEARCH, DEVELOPMENT AND ENGINEERING

The Company's research, development and engineering activities are focused
primarily on the design and development of the Interactive Messaging Platform,
as well as on increasing the capacity and reliability of existing products and
services. The Company has devoted a significant portion of its resources to
research, development and engineering programs. The Company's research,
development and engineering expenses were $6,687,177, $4,652,582, and $530,809,
for the years ended December 31, 1997, 1996 and 1995, respectively. The Company
believes that significant research, development and engineering expenditures
will be required in order for the Company to remain competitive. Accordingly,
the Company expects that research, development and engineering expenses will
continue to constitute a significant portion of the Company's overall expenses
in the future.*

The Company believes that its expertise in software development is a
significant competitive advantage.* The Company has world-class expertise in
e-mail technology with particular emphasis on e-mail-based distributed services.
The Company also has substantial expertise in other key areas of
Internet-related technology, such as Java and cryptography, as well as in the
development of scalable and reliable distributed systems. The Company's research
and product development team includes, among others, Dr. Marshall Rose and Dr.
Nathaniel Borenstein, experts in a number of Internet technologies. The Company
believes its ability to attract and retain highly qualified employees will be
the principal determinant of its success in maintaining technological
leadership.*

The Company's ability to design, develop, test and support new software
products and enhancements on a timely basis that meet changing customer needs
and respond to technological developments and emerging industry standards is
critical to the Company's future success.* There can be no assurance that the
Company will be successful in developing and marketing new software products and
enhancements that meet changing customer needs and respond to such technological
changes or evolving industry standards. The Company's current services are
designed around certain widely used and accepted standards, including the MIME
and SMTP e-mail standards and upon process-based security via an e-mail
confirmation. Current and future use of the Company's services will depend, in
part, on industry acceptance of such standards and practices as they apply to
the Internet and Internet commerce.

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COMPETITION

The market for products and services that enable interactive messaging
capabilities and the sale of goods and services over the Internet is intensely
competitive, and, to the extent commercial activity over the Internet increases,
the Company expects competition to increase significantly. There are no
substantial barriers to entry into the Company's business, and the Company
expects established and new entities to enter the market for interactive
messaging services, Internet payment systems and interactive Internet
communications in the near future. It is possible that a single supplier will
dominate one or more market segments. Furthermore, since there are many
potential entrants to the field, it is extremely difficult to assess which
companies are likely to offer competitive products and services in the future,
and in some cases it is difficult to discern whether an existing service is
competitive with the Company's current services.

The Company's principal competitors in the interactive messaging services
arena include providers of e-mail based services such as PostX Corporation,
Axicom, ReplyNet, InfoBeat, Inc., Email Publishing Inc., Cyber Data Systems,
Inc., America Online, Inc. and Juno Online Services. The Company also competes
with Narrative Communication in the interactive advertising arena and with
BroadVision Inc., Intellipost Corporation and E-Care Group, Inc. for one-to-one
marketing, as well as with traditional advertising, merchandising and direct
marketing companies that use more conventional means of delivering information
and marketing messages to consumers. The Company's principal competitors in the
market for secure consumer-initiated purchase systems include providers of
encrypted credit card transaction systems such as CyberCash, Inc., BlueMoney,
Open Market, Inc. and VeriFone, Inc. and providers of electronic cash payment
systems such as DigiCash, Inc. The Company expects that credit card processors
and acquiring banks or third party companies will also offer credit card-based
payment systems if Secure Electronic Transaction ("SET") protocols proposed by
Visa, MasterCard, American Express, Microsoft Corporation and Netscape are
adopted and/or accepted as a standard for Internet commerce. SET comprises
openly published communication and process protocols intended to facilitate
encrypted credit card transactions over the Web. Further, the Company believes
that the credit card associations may provide Internet merchants with lower
transaction fees in order to encourage usage of SET. There can be no assurance
that the Company's payment system will receive the same treatment, and, as such,
the Company may be at a competitive disadvantage. For example, in July 1997,
Visa announced its intention to waive its transaction fees, beginning in April
1998 for a two year period, for credit card transactions over the Internet that
use the SET protocol.

The Company may experience additional competition from Internet service
providers and Internet directory companies who enter the market for both
interactive messaging services and Internet payment services. Companies such as
America Online, Microsoft Corp., IBM Corp., Integrion, AT&T, Hewlett-Packard
Company, and Netscape Communications Corporation which possess large, existing
customer databases or ready distribution channels, could develop, market or
resell a number of messaging services or payment alternatives. Such major
information technology providers may also choose to enter the market for
messaging services or secure Internet payments, by acquiring one of the
Company's existing competitors or by forming strategic alliances with such
competitors, either of which may impede the Company's ability to compete
effectively. For instance, in June 1997, Hewlett-Packard Company, acquired
VeriFone and now promotes VeriFone's Internet technologies. Netscape has
established relationships with VeriFone and CyberCash, and it announced in
February 1997 that it would recommend use of VeriFone's and CyberCash's secure
payment systems to Netscape commerce server users. Additionally, competitors
such as Checkfree Corporation may emerge to provide payment systems based on
alternative systems or methods other than credit cards or digital cash, such as
Internet checking transaction systems. The Company believes that mail order
companies and companies that sell from catalogues using "800" telephone numbers
also compete with Internet payment systems. As the Company delivers the
Interactive Messaging Platform and expands the applications of its VirtualPIN
architecture, it will compete with a broader range of companies including
traditional advertising, merchandising and direct marketing companies as well as
additional entrants into the interactive Internet communications market.
Moreover, to date the predominant method of reducing the risks associated with
transmission of credit card information over the Internet has been use of public
key encryption software provided by RSA Data Security, Inc. ("RSA"), a
subsidiary of Security Dynamics Technology, Inc. RSA's encryption technology
(Secure Socket Layer) is incorporated in Web server and browser products

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offered by Netscape, Microsoft and other vendors, and thus has the largest
installed base of any technology for payment security. In addition, credit card
information relating to commercial transactions over the Internet is frequently
directly transmitted in an unprotected form (i.e. "in the clear" transactions).

Several of the Company's current and potential competitors have longer
operating histories, greater name recognition, larger installed customer bases,
more diversified lines of products and services and significantly greater
financial, technical, marketing and other resources than the Company. Such
competitors may be able to undertake more extensive marketing campaigns, adopt
more aggressive pricing policies and make more attractive offers to individuals,
businesses and financial institutions. In addition, many of the Company's
current or potential competitors have broad distribution channels that may be
used to bundle competing products or services directly to end-users or
purchasers. If such competitors were to bundle competing products or services
for their customers, the demand, if any, for the Company's products and services
might be substantially reduced, and the ability of the Company to successfully
effect the distribution of its products and the utilization of its services
would be substantially diminished. As a result of the foregoing or other
factors, there can be no assurance that the Company will compete effectively
with current or future competitors or that the competitive pressures will not
have a material adverse effect on the Company's business, financial condition
and results of operations.

PROPRIETARY RIGHTS

The Company's success and ability to compete is dependent in part upon its
proprietary technology. The Company relies primarily upon copyright, trade
secret and trademark law to protect its technology. The Company has no patents.
The Company has applied for two U.S. patents on portions of its FVIPS system.
Additionally, in the first quarter, 1998, the Company filed four U.S. patent
applications covering portions of its multi-media technology. In the fourth
quarter, 1997, the Company received notices of allowance from the Patent and
Trademark Office ("PTO") with respect to both of the FVIPS patent applications
and these patent applications are expected to issue as patents in 1998.* There
is no assurance that the PTO will not withdraw the allowance of either or both
of these patent applications. There can be no assurance that patents will issue
from any pending applications, or that any patents, if granted, would survive a
legal challenge to their validity, or that any rights granted thereunder would
provide adequate protection. Also, there can be no assurance that any patents,
if granted, could not be circumvented. The Company generally enters into
confidentiality and assignment agreements with its employees, consultants and
vendors and generally controls access to and distribution of its software,
documentation and other proprietary information. Despite these precautions, it
may be possible for a third party to copy or otherwise obtain and use the
Company's services or technology without authorization or to develop similar
services or technology independently. In addition, effective copyright and trade
secret protection may be unenforceable or limited in certain foreign countries,
and the global nature of the Internet makes it difficult to control the ultimate
destinations of the Company's services. To license its software to merchants,
the Company often relies upon on-screen licenses that are not manually signed by
the end users and, therefore, may be unenforceable under the laws of certain
jurisdictions. Despite the Company's efforts to protect its proprietary rights,
third parties may attempt to copy aspects of the Company's products or services
or to obtain and use information that the Company regards as proprietary.
Policing unauthorized use of the Company's products and services is difficult,
particularly in a global environment in which the Company operates, and the laws
of other countries may afford the Company little or no effective protection of
its intellectual property. There can be no assurance the steps taken by the
Company will prevent misappropriation of its technology or that such agreements
will be enforceable. In addition, litigation may be necessary in the future to
enforce the Company's intellectual property rights, to protect the Company's
trade secrets, to determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or invalidity. Such
litigation, whether successful or unsuccessful, could result in

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substantial costs and diversions of resources, either of which could have a
material adverse effect on the Company's business, financial condition and
results of operations.

The Company is aware of patents held by independent third parties in the
area of Internet payment systems and electronic communications. No assurance can
be given as to the applicability of such patents to the Company's services and
technologies. The assertion of these patent rights, if successful, could result
in substantial cost to the Company. There can be no assurance that the Company's
services are not, or in the future will not be, within the scope of such patents
or any other existing or future patents, and any litigation arising thereunder,
even if successfully contested, could have a material adverse effect on the
Company's business, financial condition and results of operations. The Company
was named as a defendant in a patent infringement suit filed by E-data in August
1995. The suit was dismissed without prejudice in March 1996, and the Company
now holds an exclusive license under the Freeny patent for Internet payment
systems, E-data's applicable patent for Internet payment systems. In addition,
the Company from time to time has received, and may receive in the future, other
notices of claims of infringements of other parties' proprietary rights. There
can be no assurance that additional claims for infringement or invalidity (or
claims for indemnification resulting from infringement claims) will not be
asserted or prosecuted against the Company. If any such claims or actions are
asserted, the Company may again seek to obtain a license under a third party's
intellectual property rights. There can be no assurance that such a license
would be available on reasonable terms or at all, and the assertion or
prosecution of any such claims could have a material adverse effect on the
Company's business, financial condition and results of operations.

GOVERNMENT REGULATION

The Company believes it is not currently subject to direct regulation by
any government agency in the U.S., other than regulations generally applicable
to businesses, and there are currently few laws or regulations directly
applicable to access to, or commerce on, the Internet. However, no assurance can
be given that federal, state or foreign agencies will not attempt in the near
future to begin to regulate the market for Internet commerce. In addition, if a
government agency were to challenge the Company's position with respect to the
applicability of regulations to its activities, responding to such a challenge
could result in significant expenditures of the Company's financial and
management resources, which could have a material adverse effect on the
Company's business, financial condition and results of operations. More
generally, due to the increasing popularity and use of the Internet, it is
possible that a number of laws and regulations will be adopted with respect to
the Internet, covering issues such as user privacy, pricing, taxation and
characteristics and quality of products and services. For example, the
Telecommunications Reform Act of 1996 may subject certain Internet content
providers to criminal penalties for the transmission of certain information, and
could also result in liability to Internet service providers, Web hosting sites
and transaction facilitators such as the Company. Various foreign jurisdictions
have also moved to regulate access to the Internet and to strictly control Web
content. Even if the Company's business is not directly subject to regulation,
the adoption of any such laws or regulations may inhibit the growth of the
Internet, or the businesses of the users of the Company's products and services,
which could in turn adversely affect the Company's business, financial condition
and results of operations. Moreover, the applicability to the Internet of
existing laws governing issues such as property ownership, libel, taxation and
personal privacy is uncertain. Such uncertainty creates the risk that such laws
could be interpreted in a manner that could generally inhibit commerce on the
Internet and adversely impact the Company's business.

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that its current services are not subject to Regulation E, there is no assurance
that the Federal Reserve Board will not require all or certain of the Company's
services to comply with Regulation E, revise Regulation E or adopt new rules and
regulations affecting electronic commercial transactions. Other government
agencies in addition to the Federal Reserve Board, including the Federal Trade
Commission and the Federal Communications Commission, may promulgate rules and
regulations affecting the Company's activities or those of the users of its
products and services. Any or all of these potential actions could result in
increased operating costs for the Company or for the principal users of its
services and could also reduce the convenience and functionality of the
Company's services, possibly resulting in reduced market acceptance which would
have a material adverse effect on the Company's business, financial condition
and results of operations.

EMPLOYEES

As of December 31, 1997, the Company had a total of 70 full time employees
and 7 part time employees. Of these 77 employees, 37 were in research,
development and engineering, 26 were in marketing and sales and 14 were in
general and administration. In addition, the Company had under contract 6
consultants and/or contractors.

The Company's future success depends to a significant extent upon the
continued service of its key technical and senior management personnel and upon
its ability to attract and retain additional highly skilled creative, technical,
financial and strategic marketing personnel. Competition for such personnel is
intense. There can be no assurance that the Company will be successful in
attracting and retaining such personnel, and the failure to do so could have a
material adverse effect on the Company's business, financial condition and
results of operations. None of the Company's employees are represented by a
labor union. The Company has never experienced a work stoppage and believes that
its relationships with its employees are good.

ITEM 2. PROPERTIES

The Company's corporate facility consists of approximately 20,000 square
feet of leased space in San Diego, California. The primary facility lease
expires in September 2000. Of this space, approximately 2,400 square feet is
subleased to another tenant, through May 31, 1998. The Company is currently
considering alternative facilities which may be more appropriate for its current
level of operations. In addition, the Company leases space from Paymentech, Inc.
within its facilities in Dallas, Texas and Time Warner in San Diego, California.
In December 1997, the Company closed its Ann Arbor, Michigan site and was
released from its lease obligations at this site. The Company believes that
sufficient additional space in San Diego and elsewhere will be available as
needed.

The Company's operations are dependent in part upon its ability to protect
its operating systems against physical damage from fire, floods, earthquakes,
power loss, telecommunications failures, break-ins and similar events. The
Company does not presently have redundant, multiple site capacity in the event
of any such occurrence. Despite the implementation of network security measures
by the Company, its servers are also potentially vulnerable to computer viruses,
break-ins and similar disruptions from unauthorized tampering with the Company's
computer system. The occurrence of any of these events could result in
interruptions, delays or cessations in service to users of the Company's
products and services, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

ITEM 3. LEGAL PROCEEDINGS

On February 5, 1998, holders of certain promissory notes (the
"Noteholders") filed civil actions against the Company seeking to recover the
principal and interest which they allege is due. The action was commenced in the
Superior Court of the State of California, for the County of San Diego, and is
still pending. The court has allowed the plaintiffs to attach approximately $1.5
million of the funds of the Company until final determination of their claims.
The Company filed an answer to the Noteholders' complaint on March 11, 1998. If
the Company is unable to obtain significant financing, and if there is no
favorable resolution of the lawsuit or an acceptable settlement with the
Noteholders, the Company intends to file a petition for reorganization under
Chapter 11 of the U.S. Bankruptcy Code ("Chapter 11"), in order to protect the

10
<PAGE> 11

interests of its employees, stockholders and other constituents. Regardless of
whether the Company is compelled to seek protection under Chapter 11, the
Company's ability to continue to operate in accordance with its plan, or at all,
will be severely jeopardized as a result of the Noteholder lawsuit.

First Virtual is currently involved in a dispute which is pending for
resolution with the American Arbitration Association. The claimant filed a
complaint for breach of contract which seeks the sum of $66,488.71 from First
Virtual for financial investor relations work performed by the claimant. The
Company has cross-complained, via causes of action for negligence,
misrepresentation, breach of contract and fraud, claiming that work was billed
that was not performed and that the work product received was inadequate and
unprofessional. First Virtual seeks the sum of $40,768.75, which represents the
amount of fees paid to the claimant. The case is currently in a discovery phase,
with no date set for arbitration.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company did not submit any matters to a vote of security holders during
the quarter ended December 31, 1997.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

First Virtual's common stock commenced trading in the over-the-counter
market on December 13, 1996 and is quoted on the Nasdaq National Market under
the symbol "FVHI". The following table represents the high and low sales prices
for the Company's common stock on the Nasdaq National Market.

<TABLE>
<CAPTION>
1997 1996
--------------------- ---------------------
HIGH LOW HIGH LOW
-------- ------- -------- -------
<S> <C> <C> <C> <C>
First Quarter............... 9 1/2 6 3/4 N/A N/A
Second Quarter.............. 7 1/4 3 1/2 N/A N/A
Third Quarter............... 7 2 7/8 N/A N/A
Fourth Quarter.............. 5 7/8 2 1/16 9 1/2 9
</TABLE>

The Company has not paid any dividends on its Common Stock and does not
anticipate that it will do so in the foreseeable future. As of February 19,
1998, there were approximately 254 holders of record and 1,438 beneficial
holders of the Company's common stock.

The Company is currently actively seeking additional equity funding in
order to comply with the requirements for continued listing on the Nasdaq
National Market. Any failure by the Company to raise adequate equity funding by
March 31, 1998 may cause the Nasdaq Stock Market to discontinue the listing of
the Company's Common Stock on the Nasdaq National Market. Any such action by the
Nasdaq Stock Market would adversely affect the liquidity and market price of the
Common Stock. The Company has scheduled a hearing before a committee of the
Nasdaq Board of Governors on April 9, 1998 with respect to its listing status on
the Nasdaq National Market.

11
<PAGE> 12

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Financial Statements and related notes thereto appearing
elsewhere in this Form 10-K.

STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
MARCH 11, 1994
YEAR ENDED DECEMBER 31, (DATE OF INCEPTION)
----------------------------------------- THROUGH DECEMBER 31,
1997 1996 1995 1994
------------ ------------ ----------- --------------------
<S> <C> <C> <C> <C>
Revenue............................. $ 1,450,598 $ 695,866 $ 197,902 $ 3,580
Cost of revenues.................... 270,416 265,900 123,375 --
------------ ------------ ----------- ----------
Gross profit........................ 1,180,182 429,966 74,527 3,580
Operating expenses:
Marketing and sales................. 5,424,110 1,836,545 346,400 143,678
Research, development and
engineering....................... 6,687,177 4,652,582 530,809 307,315
General and administrative.......... 4,377,688 4,237,638 1,292,781 358,790
Depreciation and amortization....... 1,097,716 524,124 106,628 16,327
------------ ------------ ----------- ----------
Total operating
expenses................ 17,586,691 11,250,889 2,276,618 826,110
------------ ------------ ----------- ----------
Loss from operations................ (16,406,509) (10,820,923) (2,202,091) (822,530)
Interest income (expense)........... 459,227 130,983 (67,890) (13,149)
------------ ------------ ----------- ----------
Net loss............................ (15,947,282) (10,689,940) (2,269,981) (835,679)
Dividends imputed on preferred
stock............................. (1,250,000) -- -- --
------------ ------------ ----------- ----------
Net loss applicable to common
shares............................ $(17,197,282) $(10,689,940) $(2,269,981) $ (835,679)
============ ============ =========== ==========
Net loss per share, basic and
diluted........................... $ (1.94) $ (2.33) $ (0.54) $ (0.26)
Shares used in per share
computation, basic and diluted.... 8,842,367 4,588,262 4,170,231 3,185,606
</TABLE>

BALANCE SHEET DATA

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------------------------
1997 1996 1995 1994
---------- ----------- ---------- ---------
<S> <C> <C> <C> <C>
Cash, cash equivalents and short-term
investments(1)............................... $6,331,059 $17,327,971 $2,091,651 $ 14,847
Furniture, equipment, software and information
technology, net.............................. $1,878,893 $ 2,023,861 $ 417,653 $ 261,638
Total assets................................... $9,048,089 $19,692,557 $2,574,826 $ 320,421
Current liabilities............................ $4,769,952 $ 3,236,037 $ 622,403 $ 148,672
Notes and amounts payable to stockholders...... $1,692,500 $ 1,912,500 $1,200,000 $ 713,400
Series A convertible preferred stock(2)........ $4,687,500 $ -- $ -- $ --
Stockholders' equity (net capital
deficiency).................................. $ (571,869) $14,944,020 $ 752,423 $(541,651)
</TABLE>

- ---------------
(1) On February 5, 1998, a civil lawsuit filed against the Company has allowed
the plaintiffs in the suit to attach approximately $1.5 million of the
Company's available cash.

(2) See Note 6 in Notes to Financial Statements.

12
<PAGE> 13

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

This 10-K report contains, in addition to historical information,
forward-looking statements that involve risks and uncertainties. The Company's
actual results may differ significantly from the results discussed in the
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those discussed in the subsection entitled "Factors
Affecting Operating Results and Market Price of Stock" commencing on page 17.
Certain sections in this report have been identified as containing
forward-looking statements. The reader is cautioned that other sections and
other sentences not so identified may also contain forward-looking information.

The Company currently operates FVIPS, and is developing (i) the Interactive
Messaging Platform, an integrated electronic commerce solution; (ii) a
VirtualTAG software "toolkit" which allows users to build their own VirtualTAGs
and (iii) a "back end" technology used to monitor performance of VirtualTAGs.
The Interactive Messaging Platform is being designed to allow organizations to
take advantage of a sophisticated messaging system that facilitates relationship
marketing on the Internet and also provides a marketing system with an
integrated payment system.* The Interactive Messaging Platform represents the
integration of First Virtual's existing services and technology, which includes
FVIPS, the VirtualPIN architecture and the VirtualTAG. The Interactive Messaging
Platform has not been commercially released and has not generated any revenues
or customer commitments to date. The Company anticipates that development and
commercial introduction of the Interactive Messaging Platform will entail
significant research, development and engineering expenses and sales and
marketing expenses during the next four quarters.*

First Virtual has previously developed and implemented the VirtualPIN
architecture which facilitates Internet commerce and is designed to facilitate
other forms of interactive Internet communications. The VirtualPIN architecture
and the Interactive Messaging Platform use e-mail, which has the widest reach
and broadest use of any Internet application. FVIPS, a secure and easy-to-use
payment system introduced in October 1994, was the Company's first application
of the VirtualPIN architecture. In the fourth quarter of 1996, the Company
introduced VirtualTAG. The VirtualTAG is an interactive advertising applet
embedded within a banner ad and is designed to allow consumers to initiate the
purchase and payment and arrange for the delivery of a product without leaving
the web page on which the advertisement appears. The Company believes VirtualTAG
is one of the first solutions to take full advantage of the Internet's unique
attributes by combining advertising, selling and paying all in one application.*
In December 1996, the Company launched 1Virtual Place, an on-line Internet
retail environment. In late June 1997, the Company launched VPIN Central, a web
site that presented marketing opportunities for VirtualPIN merchants. In
December 1997, the Company decided to focus its efforts on the Interactive
Messaging Platform, FVIPS and VirtualTAG related products. As a result of this
decision, the Company closed 1 Virtual Place and VPIN Central.

The Company has incurred net operating losses in each quarter since
inception. As of December 31, 1997, the Company had an accumulated deficit of
approximately $29.7 million. To date, the Company has not generated significant
revenues. There can be no assurance that the Company's future revenues will
increase and the Company's ability to generate significant future revenues is
subject to substantial uncertainty. In addition, as a result of the anticipated
significant investments that the Company plans to make in its systems, sales,
marketing, research and development, customer support and administrative
infrastructure, the Company expects to continue to incur significant operating
losses on both a quarterly and an annual basis for the foreseeable future.

- ---------------

RESULTS OF OPERATIONS

Revenues

The Company generates revenues from FVIPS, merchandising, interactive
advertising development and consulting, as detailed in the table below:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------
1997 1996 1995
---------- -------- --------
<S> <C> <C> <C>
Internet payment system........................... $1,002,554 $532,134 $197,902
Merchandising..................................... 44,744 13,732 --
Interactive advertising development............... 115,000 -- --
Consulting........................................ 288,300 150,000 --
---------- -------- --------
Total revenues.......................... $1,450,598 $695,866 $197,902
========== ======== ========
</TABLE>

For the year ended December 31, 1997, revenues increased to $1,450,598 as
compared to $695,866 for the year ended December 31, 1996. This increase is
attributable to a general increase in all categories of revenue. Revenues from
FVIPS benefited from bulk sales of consumer and merchant registrations that
occurred at the end of the first quarter 1997. Also, in August 1997, the Company
increased the consumer registration fees for both new accounts and renewals.
Revenues from merchandising and interactive advertising development increased in
1997, as compared to the year ended December 31, 1996, as First Virtual began
selling on-line merchandise in December 1996 and VirtualTAGs in January 1997.
Consulting revenue increased for the year ended December 31, 1997 as First
Virtual experienced greater demand for Internet related consulting.

For the year ended December 31, 1996, revenues increased to $695,866 as
compared to $197,902 for the year ended December 31, 1995. The primary reason
for this growth was the increase in consumer and merchant FVIPS registration
fees and transaction processing fees as a result of an increase in the number of
consumer and merchant registrations and transactions. The Company also collected
$150,000 of consulting fees in 1996 and began selling merchandise through its
on-line shopping mall.

Cost of Revenues

The Company incurred cost of revenues from FVIPS, merchandising, and
interactive advertising development, as detailed in the table below:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Internet payment system............................ $182,563 $256,508 $123,375
Merchandising...................................... 41,853 9,392 --
Interactive advertising development................ 46,000 -- --
-------- -------- --------
Total cost of revenues................... $270,416 $265,900 $123,375
======== ======== ========
</TABLE>

For the year ended December 31, 1997, the cost of revenues related to FVIPS
decreased to 18% of FVIPS related revenues. For the years ended December 31,
1996 and 1995, FVIPS related cost of revenues were 48% and 62%, respectively. By
enhancing FVIPS with new capabilities and thus replacing services provided by
third parties, the Company has been able to reduce FVIPS cost of revenues. The
Company has also been able to negotiate more favorable processing agreements
with outside service providers, as the volume of FVIPS transactions increased.
For the year ended December 31, 1997, merchandising cost of revenues increased
to 94% of related revenues, as compared to 68% for the year ended December 31,
1996. This increase was primarily due to a reduction in the Company's margins in
order to stay competitive in the retail pricing of its goods. In December 1997,
the Company decided to close it merchandising segment and focus its efforts on
the Interactive Messaging Platform, FVIPS and VirtualTAG related products. For
the year ended December 31, 1997, the Company's interactive advertising
development cost of revenues were for the creation of VirtualTAGs.

14
<PAGE> 15

Operating Expenses

Operating expenses consist of marketing and sales, research, development
and engineering, and general and administrative expenses. The Company
anticipates that operating expenses will continue to be substantial due to
necessary research, development and engineering for the Interactive Messaging
Platform and other newly introduced or enhanced products and services, the need
for the Company's marketing and sales organization to introduce and promote such
products, and the need for the Company to support new and existing customers.*

Marketing and sales expenses. Marketing and sales expenses, which include
salaries and wages, consulting fees, advertising, trade show expenses, travel
and other marketing expenses, increased to $5.4 million for the year ended
December 31, 1997, as compared to $1.8 million for the year ended December 31,
1996. This increase resulted primarily from increases in salaries, wages and
payroll taxes of approximately $1.7 million, an increase in advertising and
promotional expenses of $785,000, a consulting expense increase of approximately
$580,000, a recruiting and relocation expense increase of approximately
$110,000, a travel expense increase of approximately $70,000, and a general
increase in spending of approximately $355,000 to support the Company's
expanding marketing and sales activities. The Company expects that marketing and
sales expenses will continue to increase in the future as the Company implements
its marketing plan to introduce its Interactive Messaging Platform.*

For the year ended December 31, 1996, marketing and sales expenses
increased to $1.8 million, as compared to $346,000 for the year ended December
31, 1995. This increase resulted primarily from an increase in salaries, wages
and payroll taxes of approximately $870,000, an increase in recruiting and
relocation costs of $80,000, a travel expense increase of $150,000, a consulting
expense increase of $240,000, and a general increase in spending of
approximately $114,000 to support the Company's expanding operations.

Research, development and engineering expenses. Research, development and
engineering expenses which include salaries and wages and consulting fees to
support the development, enhancement and maintenance of the Company's products
and services, increased to $6.7 million for the year ended December 31, 1997, as
compared to $4.7 million for the year ended December 31, 1996. This increase
resulted primarily from increases in salaries, wages and payroll taxes of
approximately $1.7 million, and a general increase in spending of approximately
$720,000 to support the expansion of the Company's research, development and
engineering activities in San Diego, California, which included the
establishment of a second data processing center, offset by a decrease in
consulting expenses of approximately $420,000. To date, all of the Company's
software development costs have been expensed as incurred. The Company
anticipates that research, development and engineering expenses will increase in
future periods as the Company leverages the VirtualPIN architecture to offer new
products and services, such as the Interactive Messaging Platform, along with
enhancing the functionality of FVIPS and VirtualTAGs.*

For the year ended December 31, 1996 research and development expenses
increased to $4.7 million, as compared to $531,000 for the year ended December
31, 1995. This increase resulted in part from the Company expensing
approximately $1.7 million in software development costs paid to consultants for
the year ended December 31, 1996, as compared to approximately $77,000 for the
year ended December 31, 1995. The Company also had an increase in salaries,
wages and payroll taxes of approximately $1.7 million, an increase in travel
expense of approximately $285,000 and a general increase in spending of
approximately $561,000 to support the Company's expansion, which included the
establishment of an office in Ann Arbor, Michigan, in October 1996.

General and administrative expenses. General and administrative expenses
consist primarily of salaries and wages, professional and consulting fees and
other expenses associated with the general management and

- ---------------

administration of the Company. For the year ended December 31, 1997, general and
administrative expenses increased to $4.4 million as compared to $4.2 million
for the year ended December 31, 1996. This increase resulted primarily from
increases in salaries, wages and payroll taxes of approximately $730,000, and an
increase of approximately $520,000 in promotional expenses, offset by a $1.0
million, one-time charge that the Company incurred for the year ended December
31, 1996, relating to a payment to Paymentech Merchant Services, Inc. in
consideration for the waiver of certain exclusive processing rights and a
general reduction in spending of approximately $50,000.

For the year ended December 31, 1996, general and administrative expenses
increased to $4.2 million, as compared to $1.3 million for the year ended
December 31, 1995. This increase resulted primarily from increases in salaries,
wages and payroll taxes of approximately $1.1 million, a consulting expense
increase of approximately $435,000 and an increase in spending of approximately
$365,000 to support the general activities of the Company's corporate office. In
addition, the Company incurred a one-time charge of $1.0 million for the year
ended December 31, 1996, in connection with payment of certain fees to
Paymentech Merchant Services, Inc. in consideration for the waiver of certain
exclusive merchant processing rights.

The Company expects to experience significant fluctuations in its future
quarterly operating results.* These fluctuations will be due to several factors,
many of which are beyond the control of the Company, including, among others,
market response to the Company's Interactive Messaging Platform; difficulties
encountered in the development or deployment of products or services, including
interactive messaging; market acceptance of Internet commerce in general and
FVIPS and the VirtualPIN architecture in particular; fluctuating market demand
for the Company's products and services; the monthly volume and average dollar
amount of transactions using FVIPS; the degree of acceptance of the Internet as
an advertising and merchandising medium; the fees charged to the Company by
third party processors and financial institutions; the timing and effectiveness
of collaborative marketing efforts initiated by the Company's strategic
partners; the timing of the introduction of new products and services offered by
the Company; the timing of the release of enhancements to the Company's products
and services; product introductions and service offerings by the Company's
competitors; the mix of the products and services provided by the Company; the
timing and rate at which the Company increases its expenses to support projected
growth; the cost of compliance with applicable government regulations;
competitive conditions in the Company's marketplace; and general economic
conditions. In addition, the fees charged by the Company for consumer and
merchant registration, advertising, messaging, consulting services, transaction
processing and co-marketing are subject to change as the Company introduces its
Interactive Marketing Platform, develops its VirtualTAG software "toolkit", and
assesses its marketing strategy and competitive position.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 1997, the Company had $6.3 million in cash and cash
equivalents. In February 1998, pursuant to a civil lawsuit filed against the
Company, $1.5 million of the Company's available cash has been attached. The
Company is currently actively seeking additional equity financing. Should
adequate funds not be secured, the Company's ability to operate in accordance
with its plans, or at all, will be severely jeopardized. If additional funds are
raised through the issuance of equity securities, the percentage ownership of
the Company's stockholders will be diluted and such equity securities may have
rights, preferences or privileges senior to those of the holders of the
Company's Common Stock. There can be no assurance that additional financing will
be available or that, if available, such financing will be obtained with terms
favorable to the Company or its stockholders. If adequate funds are not
available on acceptable terms, the Company may be compelled to severely curtail
its operations, may be unable to develop or enhance its products and services,
or

- ---------------

take advantage of opportunities or respond to competition, any of which could
have a material adverse effect on the Company's ability to continue as a going
concern.

In October 1997, the Company received net proceeds of $4.9 million from a
private placement of securities. Prior to the October private placement, the
Company financed its operations primarily through the approximate $15 million
net proceeds that was raised in its IPO on December 13, 1996. The Company, prior
to the IPO, had raised $13.7 million from the sale and issuance of its Preferred
Stock, Common Stock and warrants, and $1.2 million of principal under
stockholder lines of credit.

Holders of certain promissory notes (the "Noteholders") filed civil actions
against the Company seeking to recover the principal and interest which they
allege is due. If the Company is unable to obtain significant new financing, and
if there is no favorable resolution of the lawsuit or an acceptable settlement
with the Noteholders, the Company intends to seek relief under Chapter 11 of the
U.S. Bankruptcy Code ("Chapter 11"), in order to protect the interests of its
employees, stockholders and other constituents. Regardless of whether the
Company is compelled to seek protection under Chapter 11, the Company's ability
to continue to operate in accordance with its plan, or at all, will be severely
jeopardized as a result of the Noteholder lawsuit. See "Item 3 -- Legal
Proceedings."

Operating activities used cash of $15.1 million during the year ended
December 31, 1997. Net cash used during this period was primarily to fund net
operating expenses of $14.8 million (excluding depreciation and amortization),
reduce accounts payable and other accrued liabilities by $162,700, pay down
amounts due to stockholders of $220,000 and increase prepaid expenses, deposits
and accounts receivable by $525,500, offset by increases in deferred revenue of
$473,000 and accrued interest of $93,500.

Capital expenditures have been, and future capital expenditures are
expected to be, primarily for facilities, furniture and capital equipment to
support the expansion of the Company's operations and management information
systems.* Capital expenditures were $930,000 and $2.1 million for the years
ended December 31, 1997 and 1996, respectively. Furniture and equipment are
stated at cost and depreciated over three to five years using the straight line
method.

Year 2000 Compliance

Many currently installed computer systems and software products are coded
to accept only two-digit entries in date code fields. Beginning in the year
2000, these date code fields will need to accept four-digit entries to
distinguish 21st century dates from 20th century dates. As a result, in
approximately 1 1/4 years, computer systems and/or software used by many
companies may need to be upgraded to comply with such "Year 2000" requirements.
Significant uncertainty exists concerning the potential effects associated with
compliance. Although the Company believes that the Company's Interactive
Messaging Platform is Year 2000 compliant, there can be no assurance that coding
errors or other defects will not be discovered in the future. While the
Interactive Messaging Platform was designed to be Year 2000 compliant, the
Company has not yet undertaken a systematic effort to identify any Year 2000
compliance problems in the various components of the Interactive Messaging
Platform. The Company believes that compliance testing will require
approximately 200-300 man-hours, and intends to complete such testing in 1999.

Several collateral software and communications systems provided by third
parties are required for the operation of the Interactive Messaging System, any
of which may contain coding which is not Year 2000 compliant. These collateral
systems include server software used to operate the Company's network servers,
software controlling routers, switches and other components of the Company's
data network, disk management software used to control the Company's data disk
arrays, firewall, security, monitoring and back-up software used by the Company,
as well as desktop PC applications software. In each case, the Company employs
widely available software applications from leading third party vendors, and
expects that such vendors

- ---------------

will provide any required upgrades or modifications in a timely fashion.
However, any failure of third party software suppliers to provide Year 2000
compliant versions of the software used by the Company could result in a
temporary disruption of Interactive Messaging Platform service or otherwise
disrupt the Company's operations.

Year 2000 compliance problems could also undermine the general
infrastructure necessary to support the Company's operations. For instance, the
Company depends on third party Internet service providers (ISPs) for
connectivity to the Internet and to customers' information systems. Any
interruption of service from the Company's ISPs could result in a temporary
interruption of the Company's interactive messaging and other services. the
Company has attempted to address this risk by obtaining redundant service
capacity from multiple ISPs. In addition, the Company relies on a third-party
data center to house certain of its servers and communications systems. Any
interruption in the security, access, monitoring or power systems at the third
party data center could result in an interruption of the Company's services.
Moreover, the effects of Year 2000 compliance deficiencies on the integrity and
stability of the Internet are difficult to predict. A significant disruption in
the ability of businesses and consumers to reliably access the Internet would
have an adverse effect on demand for the Company's services and adversely impact
the Company's business, financial condition and results of operations.

Failure of the Company's customers to ensure that their software systems
are Year 2000 compliant could also adversely affect the Company's operations.
The Interactive Messaging Platform is designed to interface with customer
databases and communications systems in order to retrieve relevant information
from customers' electronic commerce systems or customer databases and in order
to allow customers to independently control certain features of the service
including the content of transmitted messages. the Company cannot assess or
control the degree of Year 2000 compliance in its customers' information
systems. Disruptions in the information systems of significant customers could
temporarily prevent such customers from accessing or using the Interactive
Messaging Platform, which could materially affect the Company's operating
results. In order to address the risk of disruptions in customer information
systems, the Company has designed the Interactive Messaging Platform to include
redundant manual control features which can be used by such customers.
Nevertheless, certain customers may elect to discontinue use of the Company's
interactive messaging services until such customers' internal information
technology problems have been alleviated, which would adversely affect the
Company's business, financial condition and results of operations. Moreover, the
spending patterns of current or potential customers may be affected by Year 2000
issues as companies expend significant resources to correct or update their
systems for Year 2000 compliance. These expenditures may result in reduced funds
available for such customers to pay for the Company's services, which could have
a material adverse affect on the Company's business, financial condition and
results of operations.

18
<PAGE> 19

FACTORS AFFECTING OPERATING RESULTS AND MARKET PRICE OF STOCK

First Virtual operates in a rapidly changing environment that involves a
number of uncertainties, some of which are beyond the Company's control. In
addition to the uncertainties described elsewhere in this report, these
uncertainties include:

HISTORY OF OPERATING LOSSES AND ANTICIPATED FUTURE LOSSES; LIMITED OPERATING
HISTORY

The Company has incurred net operating losses in each quarter since its
inception in March 1994. As of December 31, 1997, the Company had an accumulated
deficit of approximately $29.7 million. To date, the Company has not generated
significant revenues. There can be no assurance that the Company's revenues will
increase in the future. In addition, as a result of the anticipated significant
investment that the Company is making and plans to continue to make in its
systems, sales, marketing, research, development and engineering, customer care
and administrative infrastructure over the near term, the Company expects to
continue to incur significant operating losses on both a quarterly and an annual
basis for the foreseeable future. For these and other reasons, there can be no
assurance that the Company will ever achieve or be able to sustain
profitability. The Company and its business prospects must be considered in
light of the risks, expenses and difficulties frequently encountered by
companies in the new and rapidly evolving market for Internet products and
services. There can be no assurance that the Company will succeed in addressing
any or all of these risks, and the failure to do so would have a material
adverse effect on the Company's business, financial condition and results of
operations.

The Company commenced operations in March 1994, and accordingly the Company
has a limited operating history upon which to base an evaluation of its business
and prospects. To date, substantially all of the Company's revenues have been
attributable to the receipt of registration fees from consumers and merchants,
transaction processing fees, merchandising fees, sales of VTAGs and consulting
fees associated with FVIPS. While the Company has historically devoted its
efforts to developing and marketing FVIPS, the Company has recently determined
to dedicate substantial resources to developing and implementing its Interactive
Messaging System and related services and technologies. The Company's future
financial performance will depend significantly on the successful development,
introduction and customer acceptance of the Interactive Messaging Platform and
other new and enhanced products and services. Demand for new product categories
such as the Interactive Messaging System is inherently difficult to predict, and
the Company believes that its prior experience in developing and operating FVIPS
does not offer a meaningful basis to assess the future prospects of the
Interactive Messaging System and related products and services. Accordingly,
there is no assurance that a significant market for the Interactive Messaging
System, or for any other technologies or services of the Company, will develop,
or that the Company will be successful in marketing the Interactive Messaging
Platform, FVIPS or any new or enhanced products or services.

Need for Additional Capital

The Company will need to raise additional funds to fund its operations, as
well as to develop new or enhanced services, to respond to competitive pressures
or to acquire complementary businesses or technologies. If adequate funds cannot
be obtained or are not available on acceptable terms, the Company may be unable
to develop or enhance its products and services, take advantage of important
opportunities or respond to competitive pressures, any of which could have a
material adverse effect on the Company's business, financial condition and
results of operations. Also, as additional funds are raised through the issuance
of equity securities, the percentage ownership of the stockholders of the
Company will be further reduced, stockholders may experience significant
additional dilution and such equity securities may also have rights, preferences
or privileges senior to those of the holders of the Company Common Stock.
Although the Company believes that it has sufficient capital to fund its
operations through the end of 1998, the Company may elect to raise up to $15
million through a private placement of capital stock of the Company before the
end of 1998.

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<PAGE> 20

Uncertainty of Nasdaq National Market Listing

The Company anticipates that it will need to raise additional funds from
time to time to ensure that the Company remains in compliance with the
requirements of the Nasdaq National Market for continued listing. If Nasdaq in
the future decides to discontinue the listing of the Company Common Stock, such
actions by Nasdaq would adversely affect the liquidity and market price of the
Company Common Stock.

If the Company should continue to experience losses from operations, it may
be unable to maintain the standards for continued quotation on the Nasdaq
National Market, and the shares of the Company Common Stock could be subject to
removal from the Nasdaq National Market. Trading, if any, in the Company Common
Stock would therefore be conducted on the Nasdaq SmallCap Market, which is a
significantly less liquid market than the Nasdaq National Market. As a result, a
stockholder could find it more difficult to dispose of the Company Common Stock.
Nasdaq has recently promulgated new rules which make continued listing of
companies on both the Nasdaq National Market and the Nasdaq SmallCap Market more
difficult and has significantly increased its enforcement efforts with regard to
the standards for such listing. In addition, if the Company Common Stock were
removed from the Nasdaq National Market and does not qualify for listing on the
Nasdaq SmallCap Market, the Company Common Stock could be subject to the
so-called "penny stock" rules that impose additional sales practice and market
making requirements on broker-dealers who sell and/or make a market in such
securities. Consequently, failure to qualify for listing on, or removal from,
the Nasdaq SmallCap Market, if it were to occur, could affect the ability or
willingness of broker-dealers to sell and/or make a market in the Company Common
Stock and the ability of the Company stockholders to sell their securities in
the secondary market. In addition, if the market price of the Company Common
Stock is less than $5.00 per share, the Company may become subject to certain
penny stock rules even if still quoted on the Nasdaq SmallCap Market. Such rules
may further limit the market liquidity of the Company Common Stock and the
ability of the Company stockholders to sell such the Company Common Stock in the
secondary market. Furthermore, under such circumstances, if the Company was
deemed to be an issuer of "penny stock," forward-looking statements of the
Company would not be subject to Section 27A of the Securities Act and Section
21E of the Exchange Act.

ANTICIPATED FLUCTUATIONS IN QUARTERLY OPERATING RESULTS

As a result of the early stage of development of Internet commerce and the
Interactive Messaging Platform, and the relatively recent dates of commercial
introduction of FVIPS, VirtualTAGs and the Company's limited operating history,
the Company's revenue expectations are based almost entirely on internal
estimates of future demand and not on actual experience. In particular, it is
difficult to forecast revenue expectations for the Interactive Messaging
Platform, since currently, the Interactive Messaging Platform strategy is under
development. Moreover, the Company has only limited historical financial data
for quarterly or annual periods on which to base planned operating expenses. The
Company's expense levels have been established in large part due to its current
expectations for future revenues and its expected development and marketing
requirements. In the event market demand and revenues do not meet expectations,
the Company may be unable to adjust its spending levels on a timely basis to
compensate for unexpected revenue shortfalls. To a certain extent, the Company
has encountered this problem to date. As a result, the Company has not and may
not be able to take advantage of revenue opportunities as quickly as it would
hope, because of an effort to scale down its infrastructure to match lower than
expected revenues. There can be no assurance that revenues associated with use
of the Interactive Messaging Platform, FVIPS or Internet related consulting will
increase significantly, or at all. Any material shortfall of demand for the
Company's products and services would have a material adverse effect on the
Company's business and financial condition and could cause significant
fluctuations in the Company's results of operations.

The Company expects its future operating results over both the short and
the long term will be subject to annual and quarterly fluctuations due to
several factors, many of which are beyond the control of the Company, including,
among others, market response to the Company's Interactive Messaging Platform;
difficulties encountered in the development or deployment of products or
services, including interactive messaging; market acceptance of Internet
commerce in general and FVIPS and the VirtualPIN and VirtualTAG concept in
particular; fluctuating market demand for the Company's products and services
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<PAGE> 21

including the rate of merchant and consumer registrations; the monthly volume
and average dollar amount of transactions using FVIPS; the degree of acceptance
of the Internet as an advertising and merchandising medium; the fees charged to
the Company by third party processors and financial institutions; the timing and
effectiveness of collaborative marketing efforts initiated by the Company's
strategic partners; the timing of the introduction of new products and services
offered by the Company; the timing of the release of enhancements to the
Company's products and services; product introductions and service offerings by
the Company's competitors; the mix of the products and services provided by the
Company; the timing and rate at which the Company increases its expenses to
support projected growth; the cost of compliance with applicable government
regulations; competitive conditions in the Company's marketplace; and general
economic conditions. In addition, the fees charged by the Company for consumer
and merchant registration, advertising, messaging, consulting services,
transaction processing and co-marketing are subject to change as the Company
introduces its Interactive Marketing Platform, introduces its VirtualTAG
software "toolkit", and assesses its marketing strategy and competitive
position. The Company believes that period-to-period comparisons of its
operating results are not meaningful and should not be relied upon as any
indication of future performance. Due to the foregoing factors, among others, it
is probable and possible, that the Company's future quarterly or annual
operating results from time to time will not meet the expectations of market
analysts or investors, which may have a material adverse effect on the price of
the Company's Common Stock.

RISKS RELATED TO PRODUCT TRANSITION

The Company has derived substantially all of it revenues to date from
FVIPS, VirtualTAGs and related services. In the second quarter of fiscal 1997,
the Company determined to refocus it resources on developing and commercializing
the Interactive Messaging Platform. Since development of the technologies
underlying the Interactive Messaging Platform has not been completed, and since
the Interactive Messaging Platform has not yet been implemented other than on a
test basis, no assurance can be given that development of the Interactive
Messaging Platform will be successfully completed or that the cost of
development will not exceed future revenues generated by the Interactive
Messaging Platform. In addition, there is no assurance that the Company's
current server capacity and communications systems will be adequate to support
high volumes of Interactive Messaging Platform usage. A key element of the
Company's strategy is to generate a high volume of messages and associated
transactions through the Interactive Messaging Platform and FVIPS. Accordingly,
the performance of the Company's products and services is critical to the
Company's ability to achieve market acceptance and continued use of these
products and services. Significant increases in the volume of messages processed
by the Company's systems could strain the capacity of the Company's software or
hardware, which could lead to slower response time or system failures. Any
additional investment in enhancing the capacity of the Company's server and
communications systems may adversely affect the Company's financial condition
and operating results, and may result in service delays and interruptions that
would adversely impact the Company's revenues and reputation. Moreover, the
development and introduction of the Interactive Messaging Platform has required
the Company to substantially curtail the resources devoted to development and
enhancement of FVIPS and related technologies and services, and has limited the
ability of the Company's management and marketing and sales staff to pursue the
Company's goal of increasing FVIPS usage, sales of VirtualTAGs and merchant and
consumer registrations. Unless the Interactive Messaging Platform is
successfully introduced and marketed, and unless revenues from the Interactive
Messaging Platform are sufficient to return the cost of its development and to
compensate for adverse effect on FVIPS-related and VirtualTAG-related revenues,
the Company's business, financial condition and results of operation will be
materially and adversely affected.

UNCERTAIN ACCEPTANCE OF INTERACTIVE MESSAGING SERVICES

The Company's future success depends to a significant degree on the
Company's ability to successfully market the Interactive Messaging Platform and
related services. The Interactive Messaging Platform has not yet been
commercially introduced and the Company has to date not secured any significant
customer commitments to license, use or implement the Interactive Messaging
Platform. Moreover, market demand for new product and service categories such as
interactive messaging is inherently uncertain. The Interactive messaging
platform represents a departure from the traditional methods of marketing and
information
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<PAGE> 22

exchange employed by the Company's target customers, who have typically relied
predominantly on advertising and direct mail to attract new customers and
maintain customer relationships. Acceptance of the Interactive Messaging
Platform will require a transition to new ways of conducting business by
enterprises that have already made substantial investments in other means of
conducting commerce and exchanging information. Accordingly, the market
prospects for the Interactive Messaging Platform are highly uncertain. Moreover,
although the Company believes that the Interactive Messaging Platform will prove
to be an efficient and cost-effective marketing and relationship-management
vehicle for a broad variety of customers, there is no assurance that prospective
customers will be able to implement the Interactive Messaging Platform without
substantial additional cost, or that the cost-efficiency of the Interactive
Messaging Platform will compare favorably with traditional methods of marketing
and information exchange for most customers. Failure of the Interactive
Messaging System to meet customers' demands for efficacy and cost-efficiency may
result in a decline in use of the Company's interactive messaging services over
time and would materially adversely affect the Company's business, financial
condition and results of operations.

DEPENDENCE ON DISTRIBUTION RELATIONSHIPS, COLLATERAL SYSTEMS AND EXPANSION OF
DIRECT SALES FORCE

A key element of the Company's current business and marketing strategy is
to establish, develop and maintain relationships with credit card issuers,
catalog companies, direct marketers, travel services, which include airlines,
rental cars agencies and hotel operators, to promote the Company's products and
services to their merchant and consumer customers. Although the Company has
established relationships with such entities in an effort to enhance the
Company's ability to penetrate the market for interactive messaging and Internet
payment services, such relationships are nonexclusive and have not resulted in
any comprehensive or measurable increase in the Company's revenues to date. For
instance, in 1997 the Company granted certain equity incentives to First Data
Corporation ("FDC") and General Electric Capital Corporation ("GECC"), in order
to induce FDC and GECC to meet certain goals for promoting FVIPS usage. FDC and
GECC did not meet the performance targets and the equity incentives expired. No
assurance can be given that the Company will be able to develop strategic
relationships or that any such relationship will prove to be effective in
creating demand for the Interactive Messaging Platform or in expanding the
Company's merchant and consumer base. In addition, there can be no assurance
that the Company's existing or potential marketing partners, most of whom have
significantly greater financial and marketing resources than the Company, will
not change their business strategies or discontinue their relationships with the
Company, develop and market products and services that compete with the
Company's products and services in the future or form collaborative marketing
relationships with one or more of the Company's competitors that offer
alternative Internet commerce solutions.

The operation of the Interactive Messaging Platform and FVIPS is dependent
on the continued availability and reliability of collateral telecommunications.
FVIPS is also dependent on the continued availability and reliability of
information processing and financial clearance systems. In particular, the
Company is substantially dependent on Paymentech Inc., Northern Trust Company
and Electronic Data Systems, Inc. for certain financial transactions services
relating to the operation of FVIPS. In addition, the Company is substantially
dependent on MCI Communications Corp. and WorldCom Inc. for collateral
telecommunication services. There can be no assurance that these companies will
continue to provide collateral services to the Company without disruptions in
service, at the current cost, or at all. Although the Company believes that such
services could be obtained from other sources in due course if required,
reengineering the Company's computer systems and telecommunications
infrastructure to accommodate a new service provider could only be accomplished
at significant cost and with significant delay. Any interruption of service by a
collateral services provider also would be likely to result in the disruption of
the operation of the Interactive Messaging Platform and FVIPS, with an attendant
loss of revenues and potential loss of customers. Such losses could have a
material adverse effect on the Company's business, financial condition and
results of operations.

In order to promote the use of the Interactive Messaging Platform and to
increase market acceptance of FVIPS, the Company will be required to
significantly expand its direct sales force and marketing organization and
manage such personnel effectively. Establishing required marketing and sales
capability will require

22
<PAGE> 23

substantial efforts and significant management and financial resources. The
Company's management has very limited experience in recruiting, developing or
managing a marketing and sales force. There can be no assurance that the Company
will be able to recruit and retain direct marketing and sales personnel in order
to build an effective marketing and sales organization, that building such a
marketing and sales organization will be cost effective or that the Company's
marketing and sales efforts will be successful.

UNDEVELOPED AND RAPIDLY CHANGING MARKETS

The markets for the Company's products and services are at a very early
stage of development, are rapidly changing and are characterized by an
increasing number of market entrants that have introduced or are developing
competing products and services for use on the Internet and the Web. As is
typical for a new and rapidly evolving industry, demand for and market
acceptance of recently introduced products and services are subject to a high
level of uncertainty and risk. Acceptance and usage of the Interactive Messaging
Platform is dependent on continued growth in use of e-mail as a primary means of
communications by businesses and consumers. Increased usage of interactive
messaging is also contingent on acceptance of e-mail as a vehicle for targeted
marketing of products and services, and on the ability of the Company to
successfully differentiate its services from random mass e-mailing products and
services which have encountered substantial resistance from consumers.
Similarly, increased usage of FVIPS is contingent on substantial and sustained
growth in sales of consumer products and services on the Web. Businesses that
already have invested substantial resources in traditional or other methods of
conducting business may be reluctant to adopt new commercial methodologies or
strategies that may limit or compete with their existing businesses. Individuals
with established patterns of purchasing goods and services may be reluctant to
alter those patterns. Accordingly, it is not assured that sufficient demand for
the Company's products and services will develop to sustain the Company's
business.

The Company's success is critically dependent on the significant expansion
of the Internet infrastructure in order to provide adequate Internet access, the
proper management of Internet traffic and a substantial amount of public
education to, among other things, increase confidence in the integrity and
security of Internet commerce. There can be no assurance that use of e-mail as a
primary method of communication or commerce over the Internet will become
widespread, that a market for the Company's products and services will emerge or
that the Interactive Messaging Platform, FVIPS or other applications using the
VirtualPIN architecture will be generally adopted. If the market fails to
develop, or develops more slowly than expected, if the Internet infrastructure
is not adequately expanded or managed, or if the Company's products and services
do not achieve market acceptance by a significant number of individuals,
businesses and financial institutions, then the Company's business, financial
condition and results of operations will be materially and adversely affected.

DEPENDENCE ON INCREASED USAGE AND STABILITY OF THE INTERNET

The future of the Internet as a center for commerce will depend in
significant part on continued rapid growth in the number of households and
commercial, educational and government institutions with access to the Internet,
in the level of usage by individuals and in the number and quality of products
and services designed for use on the Internet. In particular, future growth of
e-mail as a pre-eminent method of communication, depends on growing user
preference of e-mail over traditional means of communication, and on widespread
access to reliable and affordable e-mail services by individuals, businesses and
other organizations. Because usage of the Internet as a medium for on-line
exchange of information, advertising, merchandising and entertainment is a
recent phenomenon, it is difficult to predict whether the number of users drawn
to the Internet will continue to increase and whether any significant market for
the Interactive Messaging Platform, VirtualTAGs, financial transactions over the
Internet, or any substantial commercial use of the Internet, will develop. There
can be no assurance that Internet usage patterns, and reliance on e-mail
communication in particular, will continue to grow and will not decline as the
novelty of the medium recedes. In addition, it is uncertain whether the cost of
Internet access will decline. Failure of the Internet or e-mail communication to
achieve increased acceptance and be accessible to a broad audience at moderate
costs would jeopardize the viability of Internet commerce and the market for the
Company's products and services.

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<PAGE> 24

Accordingly, there can be no assurance that e-mail messaging or Internet
commerce will become widespread or that sustainable markets for the Company's
products and services will develop. If such markets fail to develop, develop
more slowly than expected or become dominated by one or more competitors, the
Company's business, financial condition and results of operations will be
materially and adversely affected. Furthermore, if the Internet becomes unable
to support the demands of its users, the Internet could lose its viability due
to delays in the development or adoption of new standards and protocols or due
to increased governmental regulation. If the necessary infrastructure,
complementary services or facilities are not developed, or if the Internet does
not become a viable commercial marketplace, the Company's business, financial
condition and results of operations will be materially and adversely affected.

COMPETITION

The market for products and services that enable interactive messaging
capabilities and the sale of goods and services over the Internet, is intensely
competitive, and, to the extent that commercial activity over the Internet
increases, the Company expects competition to increase significantly. There are
no substantial barriers to entry into the Company's business, and the Company
expects established and new entities to enter the market for interactive
messaging services, Internet payment systems and interactive Internet
communications in the near future. It is possible that a single supplier will
dominate one or more market segments. Furthermore, since there are many
potential entrants to the field, it is extremely difficult to assess which
companies are likely to offer competitive products and services in the future,
and in some cases it is difficult to discern whether an existing service is
competitive with the Company's current services.

The Company's principal competitors in the interactive messaging services
arena include providers of e-mail based services such as PostX Corporation,
Axicom, ReplyNet, InfoBeat, Inc., Email Publishing Inc., Cyber Data Systems,
Inc., America Online, Inc. and Juno Online Services. The Company also competes
with Narrative Communication in the interactive advertising arena and with
BroadVision Inc., Intellipost Corporation and E-Care Group, Inc. for one-to-one
marketing, as well as with traditional advertising, merchandising and direct
marketing companies that use more conventional means of delivering information
and marketing messages to consumers. The Company's principal competitors in the
market for secure consumer-initiated purchase systems include providers of
encrypted credit card transaction systems such as CyberCash, Inc., Bluemoney,
Open Market, Inc. and VeriFone, Inc. and providers of electronic cash payment
systems such as DigiCash, Inc. The Company expects that credit card processors
and acquiring banks or third party companies will also offer credit card-based
payment systems if Secure Electronic Transaction ("SET") protocols proposed by
Visa, MasterCard, American Express, Microsoft Corporation and Netscape are
adopted and/or accepted as a standard for Internet commerce. SET comprises
openly published communication and process protocols intended to facilitate
encrypted credit card transactions over the Web. Further, the Company believes
that the credit card associations may provide Internet merchants with lower
transaction fees in order to encourage usage of SET. There can be no assurance
that the Company's payment system will receive the same treatment, and as such
the Company may be at a competitive disadvantage. For example, in July 1997,
Visa announced its intention to waive its transaction fees, beginning in April
1998 for a two-year period, for credit card transactions over the Internet that
use the SET protocol.

The Company may experience additional competition from Internet service
providers, advertising and direct marketing agencies and other large established
businesses who enter the market for either interactive messaging services and
Internet payment services. Companies such as America Online, Microsoft Corp.,
IBM Corp., Integrion, AT&T, Hewlett-Packard Company, Netscape Communications
Corporation, Harte-Hanks Data Technology, ADVO, The Interpublic Group of
Companies, Inc. and Foote, Cone and Belding, which possess large, existing
customer bases, substantial financial resources and established distribution
channels, could develop, market or resell a number of messaging services or
payment alternatives. Such potential competitors may also choose to enter the
market for messaging services or secure Internet payments, by acquiring one of
the Company's existing competitors or by forming strategic alliances with such
competitors, either of which may impede the Company's ability to compete
effectively. Moreover, FVIPS competes with public key encryption software
provided by RSA Data Security, Inc. ("RSA"), a subsidiary of Security Dynamics
Technology, Inc., the predominant method of reducing the risks associated with
transmission of

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<PAGE> 25

credit card information over the Internet. RSA's encryption technology (Secure
Socket Layer) is incorporated in Web server and browser products offered by
Netscape, Microsoft and other vendors, and thus has the largest installed base
of any technology for payment security. In addition, credit card information
relating to commercial transactions over the Internet is frequently directly
transmitted in an unprotected form (i.e. "in the clear" transactions).

DEPENDENCE UPON PRODUCT AND SERVICE DEVELOPMENT; RISKS OF TECHNOLOGICAL CHANGE
AND EVOLVING INDUSTRY STANDARDS

The Company's success depends upon its ability to develop the Interactive
Messaging Platform and other new products and services that satisfy evolving
customer requirements including potential applications for Internet advertising,
merchandising and direct marketing. The market for the Company's services is
characterized by rapidly changing technology, emerging industry standards and
customer requirements that have been changing every few months. There can be no
assurance that the Company will successfully identify new product and service
opportunities and develop and bring to market new products and services in a
timely manner. Failure of the Company, for technological or other reasons, to
develop and introduce the Interactive Messaging Platform and other new products
and services that are compatible with emerging industry standards and that
satisfy customer requirements would have a material adverse effect on the
Company's business, financial condition and results of operations. In addition,
the Company or its competitors may announce enhancements to existing products or
services, or new products or services embodying new technologies, emerging
industry standards or customer requirements that render the Company's existing
products and services obsolete and unmarketable. There can be no assurance that
the announcement or introduction of new products or services by the Company or
its competitors or any change in emerging industry standards will not cause
customers to terminate use of the Company's existing products and services,
which could have a material adverse effect on the Company's business, financial
condition and results of operations.

The Company's products and services are designed around current technical
standards, and the Company's current and future revenues are dependent on
continued industry acceptance of such standards. While the Company intends to
provide compatibility with the standards promulgated by leading industry
participants and groups, widespread adoption of a proprietary or closed standard
could preclude the Company from effectively doing so. There can be no assurance
that the Company's products and services will achieve market acceptance, that
the Company will be successful in developing and introducing new products and
services that meet changing customer needs and respond to technological changes
or emerging industry standards in a timely manner, if at all, that the standards
upon which the Company's products and services are or will be based will be
accepted by the industry or that products, services or technologies developed by
others will not render the Company's products and services noncompetitive or
obsolete. The inability of the Company to respond to changing market conditions,
technological developments, emerging industry standards or changing customer
requirements or the development of competing technologies or products that
render the

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<PAGE> 26

Company's products and services noncompetitive or obsolete would have a material
adverse effect on the Company's business, financial condition and results of
operations.

RISKS OF DEFECTS AND DEVELOPMENT DELAYS

Products and services based on sophisticated software and computing systems
often encounter development delays, and the underlying software may contain
undetected errors and failures when introduced or when usage increases. The
Company may experience delays in the development of the software and computing
systems underlying the Company's services. In addition, there can be no
assurance that, despite testing by the Company and its clients, errors will not
be found in the underlying software or that the Company will not experience
development delays, resulting in delays in the commercial release of its
products and services or in the market acceptance of its products and services,
each of which could have a material adverse effect on the Company's business,
financial condition and results of operations.

RISK OF CAPACITY CONSTRAINTS

A key element of the Company's strategy is to generate a high volume of
messages and associated transactions through the company's Interactive Messaging
Platform and FVIPS. Accordingly, the performance of the Company's products and
services is critical to the Company's ability to achieve market acceptance and
continued use of these products and services. Significant increases in the
volume of messages and transactions could strain the capacity of the Company's
software or hardware, which could lead to slower response time or system
failures. As of this filing, the Company has not yet released the Interactive
Messaging Platform commercially and has no experience as to the strain that
large volumes of messages might have on its systems. The Company has and intends
to make substantial investments to increase its server capacity by adding new
servers and upgrading its software, when necessary. As the number of Web and
Internet users increases, there can be no assurance that the Company's products
and services will be able to meet this demand. The Company and its customers are
also dependent upon Web browsers, e-mail clients and Internet and online service
providers for access to its services, and users have experienced difficulties
due to system failures unrelated to the Company's system, products or services.
To the extent that the capacity constraints described above are not effectively
addressed by the Company, such constraints could have a material adverse effect
on the Company's business, financial condition and results of operations.

MANAGEMENT OF POTENTIAL GROWTH; RISKS ASSOCIATED WITH NEW MANAGEMENT TEAM

The rapid development necessary for the Company to exploit the market
opportunity for the Interactive Messaging Platform, VirtualTAGs, FVIPS and its
other services requires an effective planning and management process. As of
December 31, 1997, the Company had five executive officers. Two officers were
replaced during the second quarter of 1997. The Company accepted resignations
from both Michael Schauer, President of Financial Services, and Thomas Daniel,
Vice President of Merchant Services, and the Company hired as officers Keith
Kendrick, Vice President of Marketing and Dr. Carolyn Turbyfill, Vice President
of Engineering and Operations. In October 1997, Mr. Kendrick was promoted to
President. In January 1998, the Company accepted a resignation from Philip Bane,
Secretary and General Counsel. Also in January 1998, Nathaniel Borenstein
relinquished his officer position, but continues to serve as a scientist to the
Company. At the time of this filing, these two officer positions will not be
replaced. In addition, John M. Stachowiak, the Company's Vice President, Finance
and Administration and Chief Financial Officer, has informed the Company that he
intends to cease full-time employment with the Company during the next fiscal
quarter. The Company has not designated a successor for Mr. Stachowiak. In
February 1998, the Company hired David Ehrenthal, Vice President of Marketing
and Sales. The Company's success depends to a significant extent on the ability
of its executive officers and other members of its management to operate
effectively, both individually and as a group. There can be no assurance that
the Company will satisfactorily allocate responsibilities and that the new
executive team will succeed in these roles in a timely and efficient manner. The
Company has experienced some difficulty, and most likely in the future, will
continue to experience difficulty in integrating or replacing members of
management's team from a variety of industry backgrounds. It is uncertain
whether all members of the current management team can be successfully
assimilated or replaced. Furthermore, the

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<PAGE> 27

continued success of the Company is largely dependent on the personal efforts
and abilities of its senior management and certain other key personnel and on
the Company's ability to retain current management and to attract and retain
qualified personnel in the future. The Company's failure to assimilate
executives, or the failure of any of the executives to perform effectively, or
the loss of any such executive, could have a material adverse effect on the
Company's business, financial condition and results of operations.

In addition, the Company believes that its future success will depend upon
its continuing ability to identify, attract, train and retain other highly
skilled managerial, engineering, sales and marketing and other personnel.
Competition for such personnel is intense. There can be no assurance that the
Company will be successful in identifying, attracting, training and retaining
the necessary personnel, and the failure to do so could have a material adverse
effect on the Company's business, financial condition and results of operations.

The introduction of the Interactive Messaging Platform, the development of
the VirtualTAG software "toolkit" and the Company's efforts to grow the
Company's customer base and transaction volume, has placed, and is expected to
continue to place, a significant strain on its managerial, operational and
financial resources. There can be no assurance that the Company will be able to
effectively manage the expansion of its operations, that the Company's systems,
procedures and controls will be adequate to support the Company's operations or
that Company's management will be able to achieve the rapid execution necessary
to exploit the market opportunity for the Company's products and services. Any
inability of the Company to effectively manage available resources, could have a
material adverse effect on the Company's business, financial condition and
results of operations.

DEPENDENCE ON REPEATED CUSTOMER USE OF FVIPS

The future success of FVIPS and related services is dependent on its
ability to expand its base of merchants and consumers and to increase the number
of transactions that are conducted using FVIPS. The Company believes that an
increase in the number of FVIPS transactions depends primarily on the repeated
usage of the VirtualPIN by consumers. There can be no assurance that the
Company's historic rate of VirtualPIN use per consumer will continue or
increase, even if the Company is successful in increasing the variety and
quality of goods and services available over FVIPS. In addition, the Company
anticipates that it may need to modify consumer and merchant registration and
renewal fees from time to time in the future and may need to modify its
transaction rates charged to merchants. In late August 1997, the Company
increased new consumer registration and renewal fees. At the time of this
filing, both the number of new consumer registrations and the number of consumer
renewals have declined, as a result of the Company implementing its new fee
structure. Because the fee change was only implemented in late 1997, there can
be no assurance as to the aggregate effect of the fee change on the Company's
operating results. Any further modification in the fee structure may result in
further significant consumer and merchant attrition or reduce future consumer
and merchant registrations. Significant consumer or merchant attrition or the
failure of the Company to substantially increase the number of active users of
FVIPS would materially and adversely affect the Company's business, financial
condition and results of operations.

Certain merchants employing FVIPS have in the past reduced their use of the
system. Although the Company has very limited information regarding merchant
usage of FVIPS, the Company believes that declining usage of FVIPS by merchants
can occur when merchants cease to maintain their Web pages, discontinue product
or service offerings on their Web sites or find other sufficient payment means,
without using FVIPS, to satisfy their business needs. Such discontinuation could
have a material adverse effect on the Company's business, financial condition
and results of operations. The Company also faces the risk of losing merchants
that choose to employ alternative payment mechanisms or experience a decline in
transactions using FVIPS. Any significant decline in the usage of FVIPS by
merchants or increase in the rate of merchant attrition could have a material
adverse effect on the Company's business, financial condition and results of
operations.

27
<PAGE> 28

RISKS OF SYSTEMS FAILURES; LACK OF INSURANCE AND SECURITY RISKS

The Company's services are dependent on the Company's ability to protect
its computer equipment and the information stored in its data centers against
loss or damage that may be caused by system overloads, fire, power loss,
telecommunications failures, unauthorized intrusion, infection by computer
viruses and similar events. The Company's data center and servers are currently
located in San Diego, California, and at a facility in Dallas, Texas. There can
be no assurance that a system failure at either of these locations would not
materially and adversely affect the Company's ability to provide its products
and services.

The Company currently retains highly confidential customer financial
information, including bank account and credit card information, in a secure
database server that the Company believes to be isolated from the Internet.
Although the server is protected by firewalls and proprietary, one-way batch
protocols along with regular Company reviews of the system for security
weaknesses, there can be no assurance that unauthorized individuals could not
obtain access to this database server. Any unauthorized penetration of the
Company's servers which are not directly connected to the Internet could result
in the theft of bank account and credit card information, E-mail addresses, and
comprehensive transaction histories. Any unauthorized penetration of the
Company's servers which are connected to the Internet could result in the theft
of VirtualPIN numbers, e-mail addresses and recent transaction histories.
Unauthorized penetration could lead to attempts to use such information to
effect fraudulent purchases, including the introduction of fabricated
transactions into the Company's financial processors. Although the Company
believes that the VirtualPIN architecture should thwart attempts to use
misappropriated account information, widespread attempts to effect such
transactions would require the Company to devote substantial resources to
counteracting such attempts and could result in a compromise of the system or
the interruption of the Company's ability to provide its products and services
and may result in adverse publicity to the Company and consequently have a
material adverse effect on the Company's business, financial condition and
results of operations. It is also possible that an employee of the Company could
attempt to divert customer funds or otherwise misuse confidential customer
information, exposing the Company to legal liability. In addition, although the
Company believes that the potential for the unauthorized interception of
information transmitted over the Internet through FVIPS is not likely to result
in the fraudulent use of VirtualPINs, there can be no assurance that
unauthorized use of such information will not occur and, if it does occur, that
it will not result in a financial loss or significant inconvenience to the
VirtualPIN holder. Furthermore, although the Company employs disclaimers and
limitation of warranty provisions in its customer agreements to attempt to limit
its liability to customers, including liability arising out of systems failure
or failure of security precautions, there can be no assurance that such
provisions will be enforceable, or will otherwise prove effective in limiting
the Company's exposure to damage claims.

Although the Company carries property, errors and omissions, crime and
business interruption insurance, its coverage may not be adequate to compensate
the Company for all losses that may occur. The Company is in the process of
increasing its server capacity, improving its security mechanisms and taking
other precautions to protect itself and its customers from events that could
interrupt delivery of the Company's products and services or result in a loss of
transaction or customer data. However, these measures will not eliminate a
significant risk to the Company's operations from a natural disaster or systems
failure. There can be no assurance that these measures would protect the Company
from an organized effort to inundate the Company's servers with massive
quantities of e-mail or other Internet message traffic which could overload the
Company's systems and result in a significant interruption of service. In August
1995, the Company experienced a 78-hour disruption in its systems which resulted
in interruption of service to all merchants and consumers for such period. In
addition, in July 1997, the Company experienced a situation that required
unscheduled database maintenance to be performed. As a result, transactions were
held in a queue for 4 hours until the database maintenance was complete. Any
systems failure that causes a significant interruption to or increases response
time of the Company's products and services could reduce use of the Company's
products and services and would reduce the attractiveness of the Company's
products and services to current and future customers. The Company's business
interruption insurance would not fully compensate the Company for lost revenues,
income, additional costs or increased costs experienced by the Company during
the occurrence of any disruption of its computer systems, nor is there any
assurance that the Company will be able to obtain such coverage on reasonable
terms or at all in the future. Significant service interruptions could also
damage

28
<PAGE> 29

the Company's reputation and result in the loss of a significant portion of its
merchants and consumers, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

LIMITED INTELLECTUAL PROPERTY

The Company relies on a combination of trade secret, copyright and
trademark laws, nondisclosure agreements, and other contractual provisions and
technical measures to protect its proprietary rights. The Company believes that,
due to the rapid pace of technological innovation for Internet products, the
Company's ability to establish and maintain a position of technology leadership
in the industry depends more on the skills of its development personnel than
upon the legal protections afforded its existing technology. There can be no
assurance that trade secret, copyright and trademark protections will be
adequate to safeguard the proprietary software underlying the Company's products
and services, or that its agreements with employees, consultants and others who
participate in the development of its software will not be breached, that the
Company will have adequate remedies for any breach or that the Company's trade
secrets will not otherwise become known. Moreover, notwithstanding the Company's
efforts to protect its intellectual property, there is no assurance that
competitors will not be able to develop functionally equivalent interactive
messaging technologies or Internet payment services without infringing any of
the Company's intellectual property rights. Despite the Company's efforts to
protect its proprietary rights, unauthorized parties may attempt to copy or
otherwise obtain and use products or technology that the Company considers
proprietary, and third parties may attempt to develop similar technology
independently. In addition, effective protection of intellectual property rights
may be unavailable or limited in certain countries. Accordingly, there can be no
assurance that the Company's means of protecting its proprietary rights will be
adequate or that the Company's competitors will not independently develop
similar technology.

As the volume of Internet commerce increases, and the number of products
and service providers that support Internet commerce increases, the Company
believes that Internet commerce technology providers may become increasingly
subject to infringement claims. There can be no assurance that infringement
claims will not be filed by plaintiffs in the future. Any such claims, with or
without merit, could be time consuming, result in costly litigation, disrupt or
delay the enhancement or shipment of the Company's products and services or
require the Company to enter into royalty or licensing agreements. Such royalty
or licensing agreements, if required, may not be available on terms acceptable
or favorable to the Company, which could have a material adverse effect on the
Company's business, financial condition and results of operations. In addition,
the Company may initiate claims or litigation against third parties for
infringement of the Company's proprietary rights or to establish the validity of
the Company's proprietary rights. Litigation to determine the validity of any
claims could result in significant expense to the Company and divert the efforts
of the Company's technical and management personnel from productive tasks,
whether or not such litigation is determined in favor of the Company. In the
event of an adverse ruling in any such litigation, the Company may be required
to pay substantial damages, discontinue the use and sale of infringing products,
expend significant resources to develop non-infringing technology or obtain
licenses to infringing technology. The failure of the Company to develop or
license a substitute technology could have a material adverse effect on the
Company's business, financial condition and results of operations.

GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES

29
<PAGE> 30

and quality of products and services. For example, the Telecommunications Reform
Act of 1996 may subject certain Internet content providers to criminal penalties
for the transmission of certain information, and could also result in liability
to Internet service providers, Web hosting sites and transaction facilitators
such as the Company. Various foreign jurisdictions have also moved to regulate
access to the Internet and to strictly control Web content. Even if the
Company's business is not directly subject to regulation, the adoption of any
such laws or regulations may inhibit the growth of the Internet, or the
businesses of the users of the Company's products and services, which could in
turn adversely affect the Company's business, financial condition and results of
operations. Moreover, the applicability to the Internet of existing laws
governing issues such as property ownership, libel, taxation and personal
privacy is uncertain. Such uncertainty creates the risk that such laws could be
interpreted in a manner that could generally inhibit commerce on the Internet
and adversely impact the Company's business.

Due to the growth of Internet commerce, Congress has considered regulating
providers of services and transactions in this market, and federal or state
authorities could enact laws, rules or regulations affecting the Company's
business or operations. Senior officials from several regulatory agencies,
including the Board of Governors of the Federal Reserve System (the "Federal
Reserve Board") and the Office of the Comptroller of the Currency, have
indicated that those agencies have refrained from promulgating regulations in
order to encourage continued development of electronic commerce, but will
monitor this area closely in the future. For example, the Electronic Fund
Transfer Act and Regulation E, promulgated by the Federal Reserve Board, govern
certain electronic funds transfers made by regulated financial institutions from
a consumer's account, and govern providers of access devices and electronic
funds transfer services. Although the Company believes that its current services
are not subject to Regulation E, there is no assurance that the Federal Reserve
Board will not require all or certain of the Company's services to comply with
Regulation E, revise Regulation E or adopt new rules and regulations affecting
electronic commercial transactions. Other government agencies in addition to the
Federal Reserve Board, including the Federal Trade Commission and the Federal
Communications Commission, may promulgate rules and regulations affecting the
Company's activities or those of the users of its products and services. Any or
all of these potential actions could result in increased operating costs for the
Company or for the principal users of its services and could also reduce the
convenience and functionality of the Company's services, possibly resulting in
reduced market acceptance which would have a material adverse effect on the
Company's business, financial condition and results of operations.

EVOLVING FINANCIAL INDUSTRY POLICIES FOR INTERNET COMMERCE

The Company currently relies on credit cards as the payment method for
FVIPS transactions. Credit card associations are still in the process of
drafting operating regulations governing many credit card transactions on the
Internet. In some cases, the Company's access to the payment systems of credit
card associations and other payment providers may be conditioned on its
compliance, and the compliance of associated processors such as Paymentech Inc.,
with interim regulations.

The Company's operations have been reviewed by MasterCard and Visa which
currently are the sole payment methods accepted by the Company. Visa has issued
to Paymentech Inc., several conditions which govern Paymentech Inc.'s processing
of transactions for the Company over the Visa system. These conditions, among
other things, establish a maximum dollar amount and aging of small-dollar
transactions that the Company can accumulate before they are submitted to the
Visa system for processing, and establish procedures for handling chargebacks
involving such bundled transactions. The Company does not believe that these
conditions materially burden the Company's current operations. The conditions
were initially issued pursuant to an oral communication and were due to expire
on December 31, 1995. The conditions were renewed until the later of the
adoption of industry-wide operating regulations addressing Internet transactions
or December 31, 1997. At December 31, 1997, the Internet transaction operating
regulations had not been adopted, thus, the conditions were renewed until
December 31, 1998, with Visa's concurrence. To date, MasterCard has not issued
any conditions that are specific to the Company's operations. While the Company
hopes that it will be able to comply with Visa's future operating regulations
and regulations issued by any other credit card association, there can be no
assurance that it will be able to do so or that compliance will not have a
material adverse effect on its business, financial condition or results of
operations. In addition, there can be

30
<PAGE> 31

no assurance, if the operating regulations have not been adopted, that the
conditions agreement between Paymentech Inc. and Visa, or related agreements
between Paymentech Inc. and the Company and other payment providers, will be
issued or extended, if at all, on terms that do not have a material adverse
effect on the Company's business, financial condition and results of operations.

RISK OF LOSS FROM RETURNED TRANSACTIONS, MERCHANT FRAUD OR ERRONEOUS
TRANSACTIONS

Because the Company acts as an intermediary and facilitator for credit card
transactions, the Company may be subject to the risks borne by merchants
generally in the use of credit card payment systems, primarily the risk that the
consumer's payment will be "charged back" because of unauthorized use of the
consumer's credit card, disputes over the goods or services purchased by the
consumer, erroneous transmission of information by the Company, or fraud by the
merchant or consumer. The Company's customer agreements provide for the
allocation of the risk of chargebacks (other than chargebacks caused by
erroneous transmission by the Company) to merchants, but such agreements may not
be enforceable. In addition, even if the Company has an enforceable right to
charge a merchant's account for the amount of a chargeback, the Company is
subject to the risk that the merchant may not have a sufficient positive balance
of net proceeds from other FVIPS transactions to cover the chargeback and may
otherwise be unable or unwilling to pay.

The Company manages these risks through its risk management systems and
internal controls The Company currently requires explicit authorization by
consumers prior to initiating a charge of the consumer's credit card, holds
funds for 91 days for merchants who do not qualify for accelerated settlement
terms and subjects merchants who attempt to so qualify to a screening process,
and holds qualified merchants' funds for three to five business days. As a
result, the Company believes that the risks associated with widespread
chargebacks by customers are minimized, but there can be no assurance that
chargebacks will not increase significantly in the future as the volume of FVIPS
transactions increases and as more merchants of goods and services requiring
physical delivery begin to use FVIPS. There also can be no assurance that the
Company will not change FVIPS in a manner that increases the risk of exposure to
chargebacks, or that the Company's reserves will be sufficient to protect the
Company from increased chargebacks. A significant increase in chargebacks could
materially and adversely affect the Company's business, financial condition and
results of operations.

RISK OF CHANGES IN CONSUMER PERCEPTIONS

The Company's future is in part dependent on the development of demand for
products and services that support transactions processed by FVIPS over the
Internet and, in particular, use credit card-based payment mechanisms. Demand
for secure payment solutions, including FVIPS, has been fueled in part by
wide-spread fears of the risks associated with the potential theft of credit
card account numbers transmitted over the Internet and other manifestations of
Internet-based credit card fraud. Such consumer perceptions of the risks
associated with credit card-based Internet transactions have received
substantial media attention, but may lack empirical support. In addition, the
Company believes that most consumers may be unaware that the potential liability
resulting from fraudulent charges to their credit card accounts is limited by
federal laws that limit the liability of cardholders for unauthorized use of
their card to no more than $50. Any change in consumer perception of the
incidence of credit card account number theft over the Internet, or the
potential liability attendant to such fraud, could impact the demand for
Internet security mechanisms, including FVIPS. Any such decline in the perceived
need for the security which the Company believes to be a principal feature of
FVIPS could have a material adverse effect on the Company's business, financial
condition and results of operations.

INTEGRATION OF POTENTIAL ACQUISITIONS

As a part of its business strategy, the Company may make acquisitions of,
or significant investments in, complementary companies, products or
technologies. Any such future acquisitions would be accompanied by the risks
commonly encountered in acquisitions of companies. Such risks include, among
other things, the difficulty of assimilating the operations and personnel of the
acquired companies, the potential disruption of the Company's ongoing business,
the inability of management to maximize the financial and strategic position
31
<PAGE> 32

of the Company through the successful incorporation of acquired technology and
rights into the Company's products and services, additional expense associated
with amortization of acquired intangible assets, the maintenance of uniform
standards, controls, procedures and policies and the impairment of relationships
with employees and customers as a result of any integration of new management
personnel. There can be no assurance that the Company would be successful in
overcoming these risks or any other problems encountered in connection with such
acquisitions.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by Item 8 is incorporated by reference herein from
Part IV, Item 14 (a) (1) and (2).

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
the Company's officers and directors, and persons who own more than ten percent
of a registered class of the Company's equity securities ("10% Stockholders") to
file reports of ownership on Form 3 and changes in ownership on Form 4 or 5 with
the Securities and Exchange Commission (the "SEC") and the National Association
of Securities Dealers. Such officers, directors and 10% Stockholders are also
required by SEC rules to furnish the Company with copies of Section 16(a) forms
that they file.

Based solely on its review of the copies of such forms received by it, the
Company believes that, during the fiscal year ended December 31, 1997, all
Section 16(a) filing requirements applicable to its officers, directors and 10%
Stockholders were satisfied.

The Company's Board of Directors currently consists of four persons,
divided into three classes serving staggered terms of office. Currently there
are two directors in Class I and one director in each of Class II and Class III.
All Class I directors are to be elected at the Annual Meeting. The Directors
elected at the Annual Meeting will serve for a three-year term, or until his or
her successor has been duly elected and qualified. The executive officers and
directors of the Company and their ages as of December 31, 1997 are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Lee H. Stein............... 44 Chairman of the Board and Chief Executive Officer
Marshall T. Rose........... 36 Technical Advisor, Office of the Chairman
John M. Stachowiak......... 45 Vice President, Finance and Administration and Chief
Financial Officer
Keith S. Kendrick.......... 40 President
Carolyn Turbyfill.......... 43 Vice President, Engineering and Operations
Scott Loftesness(2)........ 50 Director
Pamela H. Patsley(1)(2).... 41 Director
Stephen C. Marcus(1)....... 65 Director
</TABLE>

- ---------------

(1) Member of the Audit Committee

(2) Member of the Compensation Committee

Mr. Stein, a founder of the Company, has served as Chairman of the Board of
the Company since January 1996 and as a director and Chief Executive Officer of
the Company since March 1994. Since 1980, Mr. Stein has also been Chairman of
Stein & Stein Incorporated, a firm which has provided advisory and management
services to a selected clientele of high net worth and entertainment industry
individuals, and

32
<PAGE> 33

which is the general partner of The Stein Company, Ltd., an investment
partnership. Mr. Stein is a director of Scripps Foundation for Medicine and
Science, a former director of the American Cancer Society and former chairman of
Jack Murphy Stadium Authority, City of San Diego. Mr. Stein is a member of the
bar of the State of California and the Commonwealth of Pennsylvania.

Dr. Rose, a founder of the Company, has served as Technical Advisor, Office
of the Chairman of the Company since July 1996. From March 1994 to July 1996,
Dr. Rose was a consultant to the Company. Dr. Rose has also been a Principal and
owner of Dover Beach Consulting, Inc., an Internet consulting company, since
August 1991. From January 1990 to May 1991, Dr. Rose was the principal
scientist, and, from April 1989 to December 1989, a senior scientist at PSI,
Inc. (formerly NYSERNet, Inc.), an Internet services company.

Mr. Stachowiak has served as the Company's Vice President, Finance and
Administration and Chief Financial Officer since October 1996. From August 1996
to October 1996, Mr. Stachowiak served as Chief Administrative Officer of the
Company. Mr. Stachowiak also served as a consultant to the Company from May 1996
to August 1996. Mr. Stachowiak served as Vice President, Finance and
Administration and Chief Financial Officer of NeoPath, Inc., a medical device
company, from October 1994 to April 1996. Mr. Stachowiak served as Vice
President, Administration and Process Improvement of US West New Vector Group,
Inc. from January 1991 to October 1994 and as Vice President, Finance and
Administration and Chief Financial Officer from July 1987 to December 1990.

Mr. Kendrick served as Vice President of Marketing from May 1997 until
October 1997, when he was promoted to President of the Company. From May 1992 to
May 1997, Mr. Kendrick served as a Senior Vice President of AT&T, and was
instrumental in developing their "smart card" technology and other forms of
electronic commerce. While at AT&T, Mr. Kendrick sat on the US Founder's Council
of Mondex, where he worked to develop the business plan for this
multi-corporation alliance. Mr. Kendrick served as a Senior Vice President for
MasterCard International Incorporated from August 1985 to May 1992.

Dr. Carolyn Turbyfill has served as Vice President, Engineering and
Operations since June 1997. From July 1996 to June 1997, Dr. Turbyfill served as
a Vice President at Pretty Good Privacy (PGP), where she was responsible for
leading development efforts, international sales and strategy for PGP's security
and encryption products. Dr. Turbyfill directed The Internet Commerce Group for
Sun Microsystems from January 1994 to July 1996, who developed the SunScreen
SPF-100 product, the SKIP protocol for IP layer encryption and a certifying
authority for SunScreen customers.

Mr. Loftesness has served as a director of the Company since November 1996.
Mr. Loftesness is Group Executive of First Data Merchant Systems group of First
Data Corporation. First Data Merchant Systems is responsible for service
management, product and systems development and systems and network operations
for all of First Data's merchant payment processing activities. Prior to joining
First Data in 1994, Mr. Loftesness held a series of payment systems, systems
development and business development positions at Visa International from 1985
to 1989 and 1991 to 1994, Fidelity Investments from 1989 to 1991 and IBM from
1969 to 1985. Mr Loftesness is also a director of Com21, Inc.

Ms. Patsley has served as a director of the Company since December 1995.
Ms. Patsley has been President, Chief Executive Officer and a director of
Paymentech, Inc. since December 1995. She has also served as President and Chief
Executive Officer of Paymentech Merchant Services, Inc., a wholly-owned
subsidiary of Paymentech, Inc., since December 1991, Executive Vice President
and Manager since July 1990, and as Chairman of the Board of First USA Financial
Services, Inc., a wholly-owned subsidiary of Paymentech, Inc., since August
1994. Ms. Patsley has also served as Executive Vice President and Secretary of
First USA, Inc. from July 1989 until June 1997 and as Chief Financial Officer
from January 1987 to April 1994. Ms. Patsley is also a Director of Adolf Coors
Company and Coors Brewing Company.

Mr. Marcus has served as a director of the Company since December 1997. Mr.
Marcus founded Mars Graphic Services, Inc. ("Mars") in 1973, growing it into a
leading commercial printing company with direct mail and telemarketing
divisions. Mars went public in 1986 and subsequently completed a reverse
acquisition of DiMark Inc., a major direct marketing firm. Dimark was acquired
by Harte-Hanks Communications in

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<PAGE> 34

1995. Mr. Marcus served on the board of Harte-Hanks and Rodale Press. Prior to
founding Mars, Mr. Marcus was a senior executive with Mid-City Press and
Liess-Marcus Company.

The Board of Directors is divided into three classes with each director
serving a three-year term and one class being elected at each year's annual
meeting of stockholders. There are no family relationships between any directors
or executive officers of the Company.

Directors of the Company receive reimbursement of expenses for attending
meetings of the Board of Directors. During fiscal 1997, Stephen Marcus received
a fully-vested option to purchase 5,000 shares of the Company's common stock at
an exercise price of $4.375 per share upon joining the Board in November 1997.
Each of Tawfiq N. Khoury, John A. McKinley, Scott J. Loftesness, Pamela H.
Patsley and Jon M. Rubin received an option to purchase 2,000 shares of the
Company's common stock at an exercise price of $6.375 on June 20, 1997. In
January 1998, the Board determined that, in the future, non-employee directors
shall receive an option to purchase 20,000 shares of the Company's common stock
upon such directors election to the Board ("the Initial Grant") and an option to
purchase 10,000 shares of the Company's common stock immediately following each
of the Company's annual meeting of the stockholder ("the Annual Grant"). Initial
Grants and Annual Grants shall be made under the Company's 1995 Stock Plan and
shall vest over a four-year period.

Mr. Loftesness has notified the Company that he holds the aforementioned
option for the benefit of his employer, First Data Corporation.

ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth certain information regarding compensation
paid by the Company for services rendered during the fiscal year ended December
31, 1997 by the Chief Executive Officer of the Company and each of the four
other most highly compensated executive officers of the Company ("Named
Executive Officers"), based upon salary and bonus earned by such executive
officers in fiscal 1997:

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
LONG TERM
COMPENSATION
--------------
SECURITIES
ANNUAL COMPENSATION UNDERLYING
NAME AND ----------------------------- OPTIONS ALL OTHER
PRINCIPAL POSITION YEAR SALARY BONUS (# OF SHARES) COMPENSATION
------------------ ---- -------- ------- -------------- ------------
<S> <C> <C> <C> <C> <C>
Lee H. Stein..................... 1997 $240,000 $ -- -- $ --
Chairman and Chief Executive 1996 240,000(1) -- 725,000 --
Officer 1995 -- -- -- --
Michael D. Schauer(2)............ 1997 183,344 45,834 -- 28,173(3)
Former President 1996 260,626(4) -- 225,000 97,554(5)
Nathaniel S. Borenstein(6)....... 1997 200,000 -- 55,000 --
Former Chief Scientist 1996 224,000 -- 114,500 --
1995 130,000 -- 16,700 --
Marshall T. Rose................. 1997 200,000 -- 81,964 --
Technical Advisor to the 1996 188,750(7) -- 100,000 --
Chairman 1995 39,241 -- 4,555 --
John M. Stachowiak............... 1997 200,000 -- 55,000 63,056(9)
Vice President, Finance and 1996 164,447(8) -- 125,000 --
Administration, Chief Financial
Officer
</TABLE>

- ---------------

(1) Mr. Stein first received a salary on January 1, 1996 with fifty percent of
his compensation deferred. Mr. Stein's deferred wages were paid out in the
first quarter of 1997. The deferred amount accrued interest at an annual
rate of 7.0%.

(2) Mr. Schauer's full-time employment with the Company terminated in June 3,
1997.

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<PAGE> 35

(3) Consists of severance payment in connection with termination of Mr.
Schauer's employment with the Company.

(4) Includes deferred bonuses paid out in the first quarter of 1997.

(5) Consists of reimbursement for relocation expenses.

(6) Effective January 16, 1998, Dr. Borenstein relinquished his officer position
with the Company, but continues to serve as a scientist to the Company.

(7) Includes $88,750 in consulting fees. Dr. Rose served as a consultant to the
Company until July 1996 when he joined the Company as an employee.

(8) Includes $117,000 in consulting fees and $7,863 in reimbursable living
expenses. Mr. Stachowiak joined the Company as an employee in October 1996.

(9) Consists of reimbursement of living expenses.

OPTION GRANTS IN FISCAL 1997

The following table sets forth information with respect to stock options
granted to Named Executive Officers in the fiscal year ended December 31, 1997.

<TABLE>
<CAPTION>
NUMBER OF % OF TOTAL POTENTIAL REALIZABLE
SECURITIES OPTIONS EXERCISE VALUE AT ASSUMED
UNDERLYING GRANTED TO PRICE PER ANNUAL RATES OF STOCK
OPTIONS EMPLOYEES IN SHARE EXPIRATION APPRECIATION FOR OPTION
NAME GRANTED(#)(1) FISCAL YEAR(2) ($)(3) DATE(4) TERM(5)
---- -------------- -------------- ---------- ---------- -----------------------
5% 10%
---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Lee H. Stein........... -- --% $ n/a n/a $ n/a $ n/a
Michael D. Schauer..... -- --% n/a n/a n/a n/a
Nathaniel S.
Borenstein........... 55,000 4.99% 4.88 10/13/07 168,794 427,759
John M. Stachowiak..... 45,000 4.08% 3.94 08/15/07 111,502 282,570
10,000 0.91% 1.00 08/15/07 6,288 25,937
Marshall T. Rose....... 100,000 9.07% 4.88 10/13/07 306,898 777,745
</TABLE>

- ---------------
(1) Options to purchase shares of common stock granted under the 1995 Stock Plan
which provide for vesting as to 25% of the underlying common stock one year
after the date of grant, then ratably over 36 months thereafter.

(2) Options to purchase an aggregate of 1,102,050 shares of common stock of the
Company were granted to employees during the fiscal year ended December 31,
1997.

(3) Options were granted at an exercise price equal to 100% of the fair market
value of the Company's common stock on the date of grant, as determined by
the closing price of the common stock on the Nasdaq National Market on the
date of grant.

(4) Options may terminate before their expiration dates if the optionee's status
as an employee or consultant is terminated, upon the optionee's death or
disability or upon an acquisition of the Company.

(5) This column shows the hypothetical gains or option spreads for the option
granted based on assumed annual compound stock appreciation rates of 5% and
10% over the full ten-year term of the option. The assumed rates of
appreciation are mandated by the rules of the Securities and Exchange
Commission and do not represent the company's estimate or projection of
future Common Stock prices.

35
<PAGE> 36

AGGREGATE STOCK OPTION EXERCISES IN FISCAL 1997 AND FISCAL YEAR-END VALUES

No options to purchase shares of the Company's common stock were exercised
by Named Executive Officers during fiscal 1997.

FISCAL YEAR-END OPTION VALUES

<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED OPTIONS
AT FISCAL YEAR-END AT FISCAL YEAR-END(1)
------------------------------ ----------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Lee H. Stein............................. 177,083 72,917 $499,374 $205,625
Michael D. Schauer....................... 112,500 -- -- --
Nathaniel S. Borenstein.................. 207,675 155,000 610,658 --
John M. Stachowiak....................... 83,125 96,875 3,750 6,250
Marshall T. Rose......................... 4,550 200,000 13,468 --
</TABLE>

- ---------------
(1) Based on the last stock price of the Company's common stock as of December
31, 1997 ($3.00) as reported by the Nasdaq National Market.

BENEFIT PLANS

1995 Stock Plan.

The 1995 Stock Plan of the Company provides for the grant of stock options
to employees, officers, directors and consultants of the Company and any
subsidiaries. Under the 1995 Stock Plan, the Company may grant options that are
intended to qualify as incentive stock options within the meaning of Section 422
of the Code and options not intended to qualify as incentive stock options.
Incentive stock options may only be granted to employees of the Company and any
subsidiaries. Under the 1995 Stock Plan, 3,000,000 shares of common stock have
been reserved for issuance upon exercise of granted options, of which 1,102,050
shares of common stock were subject to outstanding options as of December 31,
1997.

The 1995 Stock Plan is administered by the Board of Directors or a
committee thereof. Subject to the provisions of the 1995 Stock Plan, the Board
or committee has the authority to select the persons to whom awards are granted
and determine the terms of each award, including (i) the number of shares of
common stock covered by the award, (ii) when the award becomes exercisable
subject to certain limitations, (iii) the exercise price of the award and (iv)
the duration of the option (which may not exceed ten years and five years in the
case of incentive options granted to stockholders who hold more than ten percent
of the Company's capital stock). Generally, 25% of shares subject to an option
vest at the end of the first year and 1/48 of the shares subject to such option
vests each month thereafter. Generally, options must also be exercised upon the
earlier of (i) 90 days after the termination of the Optionee's employment or
(ii) ten years. All options are non-transferable other than by will or the laws
of descent and distribution.

The 1995 Stock Plan provides that in the event of a merger of the Company
with or into another corporation, the options may be assumed or an equivalent
option substituted by the successor corporation or a parent or subsidiary of
such successor corporation. If the options are not so assumed or substituted
for, the options shall automatically become fully vested and exercisable. In the
event of a proposed dissolution or liquidation of the Company, unexercised
options shall terminate immediately prior to the consummation of such
dissolution or liquidation.

Under a compensation reduction plan adopted by Board of Directors in
January 1998 (the "Cash Compensation Reduction Plan"), certain employees can
elect to reduce the amount of cash compensation that the employee will receive
from the Company, and in consideration therefor receive options to purchase
common stock of the Company under the 1995 Stock Plan. Under the compensation
reduction plan, an employee will receive options to purchase shares of common
stock with a value of $3.00 for each dollar by

36
<PAGE> 37

which cash compensation is reduced. The options granted in connection with the
Compensation Reduction Plan will vest in monthly increments over a twelve month
period and will remain exercisable for ten years.

Employee Stock Purchase Plan

The Company's Employee Stock Purchase Plan (the "Purchase Plan") provides
for the purchase by eligible employees of shares of the Company's common stock.
A total of 100,000 shares of common stock have been reserved for issuance under
the Purchase Plan. The Purchase Plan, which is intended to qualify under Section
423 of the Code, is administered by the Compensation Committee of the Board of
Directors. Employees (including officers and employee directors) of the Company
or any subsidiary of the Company designated by the Board for participation in
the Purchase Plan are eligible to participate in the Purchase Plan if they are
customarily employed for more than 20 hours per week and more than five months
per calendar year. The Purchase Plan will be implemented during concurrent 24
month offering periods each of which will initially be divided into four
consecutive six-month purchase periods, subject to change by the Board of
Directors. Offering periods generally begin in January and July of each year.
The Purchase Plan terminates on the earliest of (i) the last business day of
December 2006; (ii) the date on which all shares available for issuance have
been sold or (iii) the date on which all purchase rights are exercised in
connection with an acquisition or change in control of the Company. The Purchase
Plan permits eligible employees to purchase Common Stock through payroll
deductions. which may not exceed 20% of an employee's compensation during a
purchase period. Shares are purchased on the last day of each purchase period.
The price at which stock may be purchased under the Purchase Plan is equal to
85% of the lower of the fair market value of the Company's common stock on the
first day of the offering period or the last day of the purchase period.
Employees may end their participation in the offering at any time during the
offering period, and participation ends automatically on termination of
employment with the Company. In addition, participants generally may not
purchase stock having a value greater than $25,000 in any calendar year.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The Company's Compensation Committee was formed in January 1996 to review
and approve the compensation and benefits for the Company's executive officers,
administer the Company's stock option plans and employee stock purchase plan and
make recommendations to the Board of Directors regarding such matters. The
committee is currently composed of Ms. Patsley and Mr. Loftesness. Ms. Patsley
serves as President and Chief Executive Officer of Paymentech Merchant Services,
Inc., a beneficial owner of more than 5% of the Company's capital stock. See
"Security Ownership of Certain Beneficial Owners and Management." No
interlocking relationship exists between the Company's Board of Directors or
Compensation Committee and the board of directors or compensation committee of
any other company, nor has any such interlocking relationship existed in the
past.

EMPLOYMENT AGREEMENTS AND CHANGE-IN CONTROL ARRANGEMENTS

In January 1996, the Company entered into an employment agreement with Lee
H. Stein, the Chief Executive Officer and Chairman of the Company's Board of
Directors. The employment agreement provides that Mr. Stein shall receive a
salary of $240,000 annually (subject to increases by the Company's Board of
Directors). The employment agreement further provides that, upon the termination
or upon the occurrence of a Change of Control of the Company Mr. Stein's service
as Chairman of the Company's Board of Directors (a) Mr. Stein shall receive
either $20,000 per month for a period of twelve months following the Triggering
Event or a lump-sum payment of $200,000, (b) Mr. Stein shall further receive all
deferred salary and interest accrued on such deferred salary, and (c) all
options granted to Mr. Stein pursuant to his employment agreement shall fully
vest and become exercisable. "Change of Control" is defined as a sale of
fifty-one per cent (51%) or more of the outstanding shares of stock of the
Company in a single transaction.

In July 1996, the Company entered into a two-year employment agreement with
Marshall T. Rose, Technical Advisor to the Chairman with the Company holding an
option for one additional year of service on the same terms. The employment
agreement provides that Mr. Rose shall receive a salary of $200,000 per annum.
37
<PAGE> 38

In October 1996, the Company entered into an employment agreement with John
M. Stachowiak, Vice President of Finance and Administration and Chief Financial
Officer of the Company. Under the agreement, Mr. Stachowiak is entitled to an
annual salary of $200,000 and travel expenses of up to $50,000 per year for the
first two years of the agreement. The employment agreement, as amended, provides
that, if Mr. Stachowiak's position as Vice President of Administration and
Finance is eliminated, all options previously granted to Mr. Stachowiak shall
fully vest and become exercisable.

In April 1997, the Company entered into an employment agreement with Keith
Kendrick, President of the Company. The employment agreement, as amended,
provides (i) Mr. Kendrick receive an annual salary of $215,000, (ii) a bonus of
$83,000 for the 1997 fiscal year, (iii) a signing bonus of $15,000 and certain
relocation expenses and (iv) that, if upon a Change of Control (as defined
above) Mr. Kendrick's duties with the Company are significantly changed such
that he no longer has primary responsibility for the marketing of the Company's
products and services he may terminate his employment with the Company. Upon a
termination under such circumstances, all options previously granted to Mr.
Kendrick shall fully vest and become exercisable. In addition, the employment
agreement provides that if the Company's cash or marketable securities with a
maturity of less than 12 months fall below $1,500,000, the Company shall pay Mr.
Kendrick $100,000 within ten days of Mr. Kendrick's request for payment under
the employment agreement.

REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS

Notwithstanding anything to the contrary set forth in any of the Company's
previous filings under the Securities Act of 1933, as amended, or the Securities
Exchange Act of 1934, as amended, that might incorporate future filings,
including this Proxy Statement, in whole or in part, the following report shall
not be incorporated by reference into any such filings.

COMPENSATION COMMITTEE REPORT

The following report is submitted by the Compensation Committee. Each
member of the Compensation Committee is a non-employee director. The
Compensation Committee is responsible for establishing the direction for the
Company's executive compensation strategy. Underlying the Compensation
Committee's decisions is the firm belief that the actions of the Company's
executive officers directly impact the short-term and long-term performance of
the Company, and such officers should be rewarded in a manner consistent with
the Company's financial and non-financial results.

EXECUTIVE COMPENSATION PHILOSOPHY

The Company's executive compensation program has been designed to provide
competitive levels of compensation that are linked to the performance of the
Company, recognize achievement of annual and long-term goals, reward above
target performance and help attract and retain qualified executives. Consistent
with this philosophy, the executive compensation program provides annual cash
compensation through base salary and in some cases an annual bonus, and a
long-term component through stock options. The program supports a
performance-oriented environment by providing incentive compensation that
changes in a consistent and measurable way with both the financial performance
of the Company and management performance in support of strategic objectives.

The Compensation Committee determines annual salaries, bonuses and
long-term incentives for senior executive officers. Salaries are based primarily
on experience, responsibility and individual performance. Equity-based
compensation is oriented toward the achievement of increasing stockholder value
over the long term and is determined pursuant to the 1995 Stock Plan.

BASE SALARY

The Compensation Committee establishes base salaries each year at a level
intended to be competitive with comparable companies. In addition to the
competitive market range, many factors are considered in determining actual base
salaries, including the duties and responsibilities assumed by the executive,
the scope

38
<PAGE> 39

of the executive's position, length of service, individual performance, internal
equity considerations and special expertise beneficial to the Company. The
Compensation Committee also reviews relevant financial results and the success
of the management team in areas of performance that are not easily captured
through accounting measures, such as business strategies and introductions of
new products and services.

ANNUAL ASSESSMENT OF EXECUTIVE OFFICERS

The Compensation Committee makes an assessment of performance of each
executive officer on an annual basis by considering such factors as the economic
environment, performance comparisons against competitors, the quality of
earnings, the balance between short- and long-term objectives and the stability
of the Company.

CHIEF EXECUTIVE OFFICER COMPENSATION

During fiscal 1997, the Company's Chairman and Chief Executive Officer, Lee
H. Stein, earned $240,000. As a participant in the Company's Compensation
Reduction Plan, Mr. Stein on April 29, 1998 elected to reduce his cash
compensation by 50%, and in consideration will receive options to purchase
Common Stock of the Company. The Compensation Committee's approach to
establishing Mr. Stein's compensation is to be competitive with comparable
companies and to have a significant portion of his compensation depend on the
achievement of financial and non-financial performance criteria. All
compensation actions relating to Mr. Stein are subject to the approval of the
Board of Directors.

CONCLUSION

The Compensation Committee believes the mix of market-based salaries and
the potential for equity-based rewards for long-term performance represents an
appropriate balance of total compensation. This balanced executive compensation
program provides a competitive and motivational compensation package to the
executive officer team required to produce the results the Company strives to
achieve in the future. The Compensation Committee further believes that the
executive compensation program strikes an appropriate balance between the
interest of the stockholders, the needs of the Company in operating its business
and the executive team.

COMPENSATION COMMITTEE

Pamela H. Patsley

Scott Loftesness

39
<PAGE> 40

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth the beneficial ownership of Common Stock of
the Company as of the February 19, 1998, (i) each person known by the Company to
beneficially own more than 5% of the Company's Common Stock, (ii) each director,
(iii) the Named Executive Officers, and (iv) all directors and executive
officers as a group:

<TABLE>
<CAPTION>
SHARES OF COMMON STOCK
BENEFICIALLY OWNED(1)
------------------------
PERCENT
NAME OF BENEFICIAL OWNER NUMBER OF TOTAL(2)
------------------------ --------- -----------
<S> <C> <C>
Lee H. Stein(3)............................................. 2,230,083 21.97%
11975 El Camino Real, Suite 300
San Diego, CA 92130-2542
Paymentech Merchant Services, Inc.(4)....................... 1,645,217 15.88%
1601 Elm Street
Dallas, TX 75201
Tawfiq N. Khoury(5)......................................... 1,357,000 14.13%
2505 Congress Street, Suite 200
San Diego, CA 92110
Next Century Communications Corp.(6)........................ 1,382,000 14.35%
1400 Key Boulevard, First Floor
Arlington, VA 22209
First USA Financial(7)...................................... 940,734 9.43%
Nathaniel Borenstein(8)..................................... 287,805 2.96%
Marshall T. Rose(9)......................................... 256,425 2.70%
Stephen Marcus(10).......................................... 62,600 *
John M. Stachowiak(11)...................................... 93,125 *
Scott Loftesness(12)........................................ 227,194 2.34%
Pamela H. Patsley(13)....................................... 1,645,217 15.88%
All directors & officers as a group (10 persons)(14)........ 4,802,764 42.39%
</TABLE>

- ---------------
* Less than 1%.

(1) Except pursuant to applicable community property laws or as indicated in
the footnotes to this table, to the Company's knowledge, each stockholder
identified in the table possesses sole voting and investment power with
respect to all shares of common stock shown as beneficially owned by such
stockholder.
(2) Based on 9,496,233 shares of common stock outstanding as of February 19,
1998.
(3) Includes 652,083 shares subject to options exercisable within 60 days of
February 19, 1998 and 577,600 shares held by June L. Stein, Mr. Stein's
spouse, for her own account. Also includes 64,800 shares held in trusts for
the benefit of Mr. Stein's children and 358,000 shares held by The Stein
Company, Ltd., of which Stein & Stein Incorporated is the general partner.
Mr. Stein and his spouse are the sole shareholders of Stein & Stein
Incorporated.
(4) Includes 852,272 shares issuable upon exercise of warrants exercisable in
full within 60 days of February 19, 1998 at an exercise price of $0.01 per
share. Paymentech Merchant Services, Inc. is a wholly-owned subsidiary of
Paymentech Inc. Pamela H. Patsley, a director of First Virtual, is Chief
Executive Officer and a director of Paymentech Inc. Includes 7,000 shares
issuable upon exercise of an option exercisable within 60 days of February
19, 1998 and 2,000 common shares held by Ms. Patsley.
(5) Includes 107,000 shares issuable upon exercise of options exercisable
within 60 days of February 19, 1998 and 312,500 shares held by the TNKRGK
Family Trust dated December 23, 1997, of which Mr. Khoury is a beneficiary.
Also includes 937,500 shares held by three separate trusts, each being for
the sole benefit of one of Mr. Khoury's three children. Mr. Khoury
disclaims beneficial ownership of these shares.
(6) Includes 137,000 shares subject to options exercisable within 60 days of
February 19, 1998. Includes 250,000 shares held by Jon M. Rubin, President
of NCCC. Based solely on information in NCCC's

40
<PAGE> 41

report on Form 13G dated February 17, 1998 and 95,000 shares subject to
options exercisable within 60 days of February 19, 1998.
(7) Includes 475,734 shares issuable upon exercise of warrants exercisable in
full within 60 days of February 19, 1998 at an exercise price of $0.01 per
share.
(8) Includes 226,505 shares issuable upon exercise of an option exercisable
within 60 day of February 19, 1998.
(9) Includes 4,550 shares issuable upon exercise of an option exercisable
within 60 day of February 19, 1998.
(10) Include 1,000 shares issuable upon exercise of an option exercisable within
60 day of February 19, 1998.
(11) Includes 83,125 shares issuable upon exercise of an option exercisable
within 60 day of February 19, 1998.
(12) Includes 7,000 shares issuable upon exercise of an option exercisable
within 60 days of February 19, 1998. Also includes 220,194 shares held by
First Data Corporation ("First Data"), as to which Mr. Loftesness disclaims
beneficial ownership. Mr. Loftesness is Group Executive of First Data
Merchant Systems, a subsidiary of First Data.
(13) Includes 7,000 shares issuable upon exercise of an option exercisable
within 60 days of February 19, 1998 and 2,000 common shares. Also includes
783,945 shares held by Paymentech Merchant Services, Inc. and 852,272
shares issuable upon exercisable of warrants held by Paymentech Merchant
Services, Inc., as to which Ms. Patsley disclaims beneficial ownership. Ms.
Patsley is President and Chief Executive Officer of Paymentech, Inc., of
which Paymentech Merchant Services, Inc. is a wholly-owned subsidiary, and
may therefore be deemed to share voting and investment power with respect
to such shares.

(14) Includes 1,833,525 shares subject to options exercisable within 60 days of
February 19, 1998. Excludes shares held by Paymentech Merchant Services,
Inc., First Data, First USA Financial and NCCC.

The following table sets forth the beneficial ownership of Series A
Preferred Stock of the Company as of February 19, 1998 by each person known by
the Company to be the beneficial owner of more than 5% of the Company's Series A
Preferred Stock, Named Executive Officers or director held shares of Series A
Preferred Stock as of such date.

<TABLE>
<CAPTION>
SHARES OF
PREFERRED STOCK
BENEFICIALLY OWNED(1)
----------------------
NO. OF PERCENT OF
NAME OF BENEFICIAL OWNER SHARES CLASS(2)
------------------------ ------- -----------
<S> <C> <C>
Seth Joseph Antine........................................ 60 7.3%
2120 Bay Avenue
Brooklyn, NY 11230
Huberfeld Bodner Family Foundation........................ 400 48.8%
152 West 57th Street
54th Floor
New York, NY 10019
Millenco LP............................................... 178 21.7%
111 Broadway
New York, NY 10006
Murray Huberfeld/David Bodner Partnership................. 65 7.9%
152 West 57th Street
54th Floor
New York, NY 10019
</TABLE>

- ---------------
(1) Except as noted below, the persons named in the table, to the Company's
knowledge, have sole voting and investment power with respect to all shares
of Preferred Stock shown as beneficially owned by them, subject to community
property laws where applicable.

(2) Based on 819 shares of Series A Preferred Stock outstanding as of February
19, 1998.

41
<PAGE> 42

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

First Data Transaction

On August 26, 1996, the Company and First Data Corporation ("First Data")
entered into a Securities Purchase Agreement, pursuant to which First Data
purchased 200,000 shares of the Company's Series D Preferred Stock at a price of
$15.00 per share for an aggregate purchase price of $3.0 million. First Data
also received a warrant (the "First Data Warrant") to purchase up to an
additional 1,500,000 shares of the Common Stock of the Company at an exercise
price ranging from $2.23 to $5.00 per share of Common Stock. The right to
exercise the First Data Warrant and the exercise price were conditioned upon
First Data securing the registration of a certain number of VirtualPINs.

The Company and First Data agreed to an amendment to the First Data Warrant
in March 1997. Pursuant to such amendment, the deadlines for First Data securing
registration of VirtualPINs (on which the exercisability of First Data Warrant
is contingent) were altered, and the range of exercise prices for the First Data
Warrant was reduced to $1.50 to $4.50 per share. In March 1997, the Company and
First Data also entered into a VirtualPIN License Agreement, pursuant to which
First Data licensed from the Company 350,000 VirtualPINs, which First Data is
permitted to re-license to consumers. The Company received $700,000 in license
fees from First Data.

Services Arrangements

Since September 12, 1994, Paymentech Merchant Services, Inc. has provided
credit card transaction acquisition services to the Company pursuant to a
Merchant Credit Card Agreement between the Company and Paymentech Merchant
Services, Inc. dated as of that date. The Company paid Paymentech Merchant
Services, Inc. $151,284 for the year ended December 31, 1997 pursuant to this
agreement.

In addition, pursuant to a Shareholder Rights Agreement dated December 22,
1995 (the "Shareholder Rights Agreement") among the Company and certain of its
stockholders, including Paymentech Merchant Services, Inc., the Company agreed,
for a period of four years, not to enter into an agreement with, or otherwise
utilize, a payment card transaction acquirer other than Paymentech Merchant
Services, Inc. for provision of payment processing services that Paymentech
Merchant Services, Inc. is willing and capable of providing at a commercially
reasonable price (the "Processing Right"). In August 1996, in connection with
the amendment and restatement of the Shareholder Rights Agreement, the Company
entered into an agreement with Paymentech Merchant Services, Inc. for the waiver
of the Processing Right. In exchange for such waiver, the Company agreed to pay
Paymentech Merchant Services, Inc. facility fees totaling $500,000 and
transaction surcharges of no less than $500,000 during the forty month period
beginning September 1, 1996, depending upon the number of transactions processed
through merchant acquirers other than Paymentech Merchant Services, Inc. The
Company paid in fees and surcharges pursuant to such agreement in the year ended
December 31, 1997.

The Company believes that the payments for services provided Paymentech
Merchant Services, Inc. were no less favorable to the Company than would be
charged for similar services by unrelated third parties. Any future transaction
between the Company and its executive officers, directors and their affiliates
will be on terms no less favorable to the Company than can be obtained from
unaffiliated third parties, and any material transactions with such persons will
be approved by a majority of the disinterested members of the Board of
Directors.

Indemnification Agreements

The Company has entered into indemnification agreements with each of its
directors and executive officers. Such agreements require the Company to
indemnify such individuals to the fullest extent permitted by law.

42
<PAGE> 43

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K

(A) (1) INDEX TO THE FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Ernst & Young LLP, Independent Auditors........... 46
Balance Sheets as of December 31, 1997 and 1996............. 47
Statements of Operations for the years ended December 31,
1997, 1996 and 1995....................................... 48
Statements of Stockholders' Equity (Net Capital Deficiency)
for the years ended December 31, 1997, 1996 and 1995...... 49
Statements of Cash Flows for the years ended December 31,
1997, 1996 and 1995....................................... 50
Notes to Financial Statements............................... 51
</TABLE>

(A) (2) INDEX TO THE FINANCIAL STATEMENT SCHEDULES

None required.

(A) (3) INDEX TO EXHIBITS

<TABLE>
<CAPTION>
NUMBER EXHIBIT TITLE
------ -------------
<S> <C>
3.1* Amended and Restated Certificate of Incorporation of the
Company.
3.2* Bylaws of the Company.
3.3*** Certificate of Designation of Series A Preferred Stock date
October 23, 1997.
10.1* Form of Indemnification Agreement entered into between
Company and its officers and directors.
10.2* The Company's 1994 Incentive and Non-Statutory Stock Option
Plan.
10.3* The Company's 1995 Stock Plan.
10.4* The Company's Employee Stock Purchase Plan.
10.5* Lee H. Stein Employment Agreement.
10.6* Nathaniel S. Borenstein Employment Agreement.
10.7* Marshall T. Rose Employment Agreement.
10.8* John M. Stachowiak Employment Agreement.
10.9* Series A Preferred Stock Purchase Agreement dated as of May
22, 1995 between the Company and the purchasers named
therein.
10.10* Series B Preferred Stock Purchase Agreement dated as of
December 22, 1995 between the Company and Paymentech
Merchant Services, Inc.
10.11* Securities Purchase Agreement between the Company and
General Electric Capital Corporation, dated July 3, 1996.
10.12* Warrant to Purchase 47,619 shares of Common Sock, issued to
General Electric Capital Corporation as of July 3, 1996.
10.13* Series D Preferred Stock Purchase Agreement between the
Company and First Data Corporation, dated August 26, 1996.
10.14* Amended and Restated Shareholder Rights Agreement dated
August 26, 1996 between the Company and First Data
Corporation.
10.15* Warrant to purchase 852,272 shares of Series A Preferred
Stock, issued to Paymentech, Inc.
10.16* Warrant to purchase 475,734 shares of Series B Preferred
Stock, issued to Paymentech, Inc.
10.17* Lease Agreement dated as of February 1, 1996 by and between
Company and Carmel Valley Partners I (now Spieker
Properties, L.P.), as amended.
</TABLE>

43
<PAGE> 44

<TABLE>
<CAPTION>
NUMBER EXHIBIT TITLE
------ -------------
<S> <C>
10.18* Sublease Agreement dated as of June 15, 1996 by and between
Company and Integrated Medical Systems.
10.19* Lease Agreement dated as of April 18, 1996 by and between
Company and KMD Foundation.
10.20* Facilities Agreement dated as of August 14, 1996 between the
Company and Paymentech, Inc.
10.21* Waiver and Amendment dates as of August 20, 1996 between the
Company and Paymentech, Inc.
10.22* Merchant Credit Card Agreement dated as of September 12,
1994, between the Company and Paymentech, Inc., as amended.
10.23* Agreement for Information Technology Services dated as of
October 12, 1994 between the Company and Electronic Data
Systems Corporation , as amended.
10.24* Consulting and Development Agreement dated as of August 16,
1996 between the Company and Sybase, Inc.
10.25* Master Lease Agreement dated as of October 24, 1996 between
the Company and ComDisco, Inc.
10.26* Software License Agreement dated March 20, 1997 between the
Company and Sybase, Inc.
10.27** Amended Agreement between the Company and First Data
Corporation, dated March 31, 1997.
10.28**** Keith Kendrick Employment Agreement.
10.29**** Carolyn Turbyfill Employment Agreement.
10.30**** Amendment to Keith Kendrick Employment Agreement.
10.31*** Form of Private Placement Purchase Agreement dated October
20, 1997, between First Virtual Holdings Incorporated and
certain investors.
11.1**** Statement re: Computation of Per Share Earnings.
23.1 Consent of Ernst & Young, Independent Auditors.
27.1**** Financial Data Schedule.
27.2**** Restated Financial Data Schedule for year ended 1996.
</TABLE>

- ---------------
* Previously filed as exhibits to the Company's Registration Statement on
Form S-1 (SEC File #333-14573).

** Previously filed as exhibit to the Company's Form 10-Q, March 31, 1997 (SEC
File #000-21751).

*** Previously filed as exhibit to the Company's Form 8-K, October 22, 1997
(SEC File #000-21751).

**** Previously filed as exhibit to the Company's Form 10-K, December 31, 1997
(SEC File #000-21751).

(B) REPORTS ON FORM 8-K

A Form 8-K report, dated October 22, 1997, was filed on October 23, 1997,
reporting information under Item 5 of Form 8-K. The following exhibits were
filed as part of the Form 8-K:

Exhibit 99.1 -- Press release dated October 23, 1997.

Exhibit 99.2 -- Certificate of Designation of Series A Preferred Stock
dated October 15, 1997.

Exhibit 99.3 -- Form of Private Placement Purchase Agreement dated October
20, 1997, between First Virtual Holdings Incorporated and certain investors.

See (a)(3) above.

(D) FINANCIAL STATEMENT SCHEDULES

See (a)(2) above

44
<PAGE> 45

SIGNATURE

Pursuant to the requirements of section 13 or 15 (d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

FIRST VIRTUAL HOLDINGS INCORPORATED

Dated: March 26, 1998 By: /s/ LEE H. STEIN

------------------------------------
Lee H. Stein
Chairman of the Board and
Chief Executive Officer

POWER OF ATTORNEY

By signing this Form 10-K, I hereby appoint each of Lee H. Stein and John
M. Stachowiak as my attorneys-in-fact to sign all amendments to this Form 10-K
on my behalf, and file this Form 10-K (including all exhibits and other
documents related to the Form 10-K) with the Securities and Exchange Commission.
I authorize each of my attorneys-in-fact to (1) appoint a substitute
attorney-in-fact for himself and (2) perform any actions that he believes are
necessary or appropriate to carry out the intention and purpose of this Power of
Attorney. I ratify and confirm all lawful actions taken directly or indirectly
by my attorneys-in-fact and by any properly appointed substitute
attorneys-in-fact.

Pursuant to the requirements of the Securities Act of 1934, this Report has
been signed by the following persons in the capacities and dates indicated.

<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>

/s/ LEE H. STEIN Chairman of the Board Chief March 26, 1998
- ------------------------------------------------ Executive Officer (Principal
Lee H. Stein Executive Officer)

/s/ JOHN M. STACHOWIAK Vice President, Finance and March 26, 1998
- ------------------------------------------------ Administration and Chief Financial
John M. Stachowiak Officer (Principal Financial and
Accounting Officer)

/s/ SCOTT LOFTESNESS Director March 26, 1998
- ------------------------------------------------
Scott Loftesness

/s/ PAMELA H. PATSLEY Director March 26, 1998
- ------------------------------------------------
Pamela H. Patsley

/s/ STEPHEN C. MARCUS Director March 26, 1998
- ------------------------------------------------
Stephen C. Marcus
</TABLE>

45
<PAGE> 46

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors
First Virtual Holdings Incorporated

We have audited the accompanying balance sheets of First Virtual Holdings
Incorporated as of December 31, 1997 and 1996, and the related statements of
operations, stockholders' equity (net capital deficiency), and cash flows for
each of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of First Virtual Holdings
Incorporated at December 31, 1997 and 1996, and the results of its operations
and its cash flows for each of the three years in the period ended December 31,
1997, in conformity with generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note 1, the
Company has incurred recurring operating losses and has insufficient working
capital to finance its planned operations through 1998. These conditions raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plan as to this matter is described in Note 1. The financial
statements do not include any adjustments to reflect the possible future effects
on the recoverability and classification of assets or the amounts and
classification of liabilities that may result from the outcome of this
uncertainty.

ERNST & YOUNG LLP

San Diego, California
January 16, 1998
except for the first paragraph of Note 6 and Note 10, for which the date is
March 20, 1998

46
<PAGE> 47

FIRST VIRTUAL HOLDINGS INCORPORATED

BALANCE SHEETS

ASSETS

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------
1997 1996
------------ ------------
<S> <C> <C>
Current assets:
Cash and cash equivalents(1).............................. $ 6,331,059 $ 17,127,971
Short-term investment, available-for-sale................. -- 200,000
Accounts receivable....................................... 207,985 88,278
Prepaid expenses and other................................ 418,615 83,840
------------ ------------
Total current assets................................. 6,957,659 17,500,089
Furniture, equipment and software, net (Note 2)............. 1,859,048 1,964,635
Information technology, net (Note 5)........................ 19,845 59,226
Organization and other costs, net........................... 77,630 105,798
Deposits and other.......................................... 133,907 62,809
------------ ------------
Total assets......................................... $ 9,048,089 $ 19,692,557
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable.......................................... $ 1,440,224 $ 1,626,198
Accrued compensation and related liabilities.............. 370,741 372,739
Accrued interest.......................................... 289,903 196,340
Deferred revenue.......................................... 537,790 64,683
Current portion, due to stockholders (Note 3)............. 1,530,000 400,000
Directors and officers insurance payable.................. 275,415 --
Other accrued liabilities................................. 325,885 576,077
------------ ------------
Total current liabilities............................ 4,769,958 3,236,037
Amount due to stockholder (Note 3).......................... 162,500 312,500
Notes payable to stockholders (Note 3)...................... -- 1,200,000
------------ ------------
Total long term liabilities.......................... 162,500 1,512,500
Commitments (Note 5)
Series A convertible preferred stock (Note 6)............... 4,687,500 --
Stockholders' equity (net capital deficiency) (Note 7):
Series A convertible preferred stock, $0.001 par value;
1,000 shares authorized and outstanding at December 31,
1997; liquidation preference of $5,000,000(2).......... 1 --
Preferred stock, 5,000,000 shares authorized, none
outstanding at December 31, 1997 and 1996.............. -- --
Common stock, $0.001 par value; 40,000,000 shares
authorized, 8,903,855 and 8,794,812 shares issued and
outstanding at December 31, 1997 and 1996,
respectively........................................... 8,904 8,795
Additional paid-in-capital................................ 26,300,228 25,758,015
Warrants.................................................. 3,017,115 3,017,115
Deferred compensation..................................... (155,235) (44,305)
Accumulated deficit....................................... (29,742,882) (13,795,600)
------------ ------------
Total stockholders' equity (net capital
deficiency)....................................... (571,869) 14,944,020
------------ ------------
Total liabilities and stockholders' equity (net
capital deficiency)............................... $ 9,048,089 $ 19,692,557
============ ============
</TABLE>

- ---------------
(1) Pursuant to a civil lawsuit filed against the Company in February 1998, $1.5
million of the Company's available cash has been attached. (Note 10).

(2) 750 shares of the Series A convertible preferred stock have been classified
outside of stockholders' equity (net capital deficiency).
See accompanying notes.
47
<PAGE> 48

FIRST VIRTUAL HOLDINGS INCORPORATED

STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Revenues......................................... $ 1,450,598 $ 695,866 $ 197,902
Cost of revenues................................. 270,416 265,900 123,375
------------ ------------ ------------
Gross profit..................................... 1,180,182 429,966 74,527
Operating expenses:
Marketing and sales............................ 5,424,110 1,836,545 346,400
Research, development and engineering.......... 6,687,177 4,652,582 530,809
General and administrative(1).................... 4,377,688 4,237,638 1,292,781
Depreciation and amortization.................... 1,097,716 524,124 106,628
------------ ------------ ------------
Total operating expenses............... 17,586,691 11,250,889 2,276,618
------------ ------------ ------------
Loss from operations............................. (16,406,509) (10,820,923) (2,202,091)
Interest income.................................. 554,587 235,560 20,259
Interest expense................................. (95,360) (104,577) (88,149)
------------ ------------ ------------
Net loss......................................... $(15,947,282) $(10,689,940) $ (2,269,981)
Dividend imputed on preferred stock(2)........... (1,250,000) -- --
------------ ------------ ------------
Net loss applicable to common shares............. $(17,197,282) $(10,689,940) $ (2,269,981)
============ ============ ============
Net loss per share, basic and diluted............ $ (1.94) $ (2.33) $ (0.54)
Shares used in per share computation, basic
and diluted.................................... 8,842,367 4,588,262 4,170,231
</TABLE>

- ---------------

(1) The year ended December 31, 1996 includes $1,000,000 of expense in
connection with obtaining a waiver of an exclusivity provision of an
agreement with a stockholder.

(2) The year ended December 31, 1997 includes an imputed dividend on the Series
A convertible preferred stock totaling $1,250,000 for discounted conversion
terms.

See accompanying notes.
48
<PAGE> 49

FIRST VIRTUAL HOLDINGS INCORPORATED

STATEMENT OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
<TABLE>
<CAPTION>

PREFERRED STOCK COMMON STOCK ADDITIONAL
--------------------- --------------------- PAID-IN DEFERRED
SHARES AMOUNT SHARES AMOUNT CAPITAL WARRANTS COMPENSATION
----------- ------- ----------- ------- ----------- ---------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994....... -- $ -- 4,083,350 $ 4,083 $ 289,945 $ -- $ --
Issuance of common stock for
services......................... -- -- 135,400 135 5,281 -- --
Issuance of Series A convertible
preferred stock at $1.76 per
share for cash, net of issuance
costs of $71,791................. 551,500 552 -- -- 898,297 -- --
Issuance of Series A convertible
preferred stock at $1.76 per
share for retirement of notes
payable, net of issuance costs of
$7,257........................... 142,044 142 -- -- 242,598 -- --
Issuance of Series B convertible
preferred stock at $3.189 per
share, net of issuance costs of
$100,390......................... 783,945 784 -- -- 2,398,826 -- --
Issuance of common stock for
services......................... -- -- 54,500 55 17,385 -- --
Net loss........................... -- -- -- -- -- -- --
----------- ------- ----------- ------- ----------- ---------- ---------
Balance at December 31, 1995....... 1,477,489 1,478 4,273,250 4,273 3,852,332 -- --
Issuance of common stock for cash
and services..................... -- -- 61,126 61 51,776 -- --
Issuance of Series B convertible
preferred stock at $3.189 per
share, net of issuance costs of
$117,110......................... 465,000 465 -- -- 1,365,310 -- --
Issuance of warrants............... -- -- -- -- -- 3,017,115 --
Issuance of Series C convertible
preferred stock at $15 per share
and shares of common stock at $5
per share, net of issuance costs
of $45,934....................... 130,952 131 107,144 107 2,453,828 -- --
Issuance of Series D convertible
preferred stock at $15 per share,
net of issuance costs of
$9,163........................... 200,000 200 -- -- 2,990,637 -- --
Deferred compensation related to
grant of certain stock options... -- -- -- -- 50,567 -- (50,567)
Amortization of deferred
compensation..................... -- -- -- -- -- -- 6,262
Issuance of common stock for IPO
net of issuance costs............ -- -- 2,000,000 2,000 14,991,067 -- --
Issuance of common stock for
converted preferred stock upon
IPO.............................. (2,273,441) (2,274) 2,273,441 2,274 -- -- --
Issuance of common stock for anti-
dilutive shares in preferred
stock conversion................. -- -- 59,876 60 (60) -- --
Issuance of common stock for
exercise of stock options........ -- -- 19,975 20 2,558 -- --
Net loss........................... -- -- -- -- -- -- --
----------- ------- ----------- ------- ----------- ---------- ---------
Balance at December 31, 1996....... -- -- 8,794,812 8,795 25,758,015 3,017,115 (44,305)
Deferred compensation and related
amortization..................... -- -- -- -- 128,888 -- (110,930)
Accelerated vesting of stock
options.......................... -- -- -- -- 52,137 -- --
Extension of warrants.............. -- -- -- -- 50,000 -- --
Issuance of Series A stock, net of
issuance cost.................... 250 1 -- -- 1,137,999 -- --
Employee stock purchase plan....... -- -- 22,160 22 74,958 -- --
Issuance of common stock for
services rendered................ -- -- 1,193 1 8,052 -- --
Issuance of common stock for
exercise of stock options........ -- -- 85,690 86 27,679 -- --
Dividend imputed on Series A
convertible preferred stock,
classified outside of
stockholders' equity (net capital
deficiency)...................... -- -- -- -- (937,500) -- --
Net loss........................... -- -- -- -- -- -- --
----------- ------- ----------- ------- ----------- ---------- ---------
Balance at December 31, 1997....... 250 $ 1 8,903,855 $ 8,904 $26,300,228 $3,017,115 $(155,235)
=========== ======= =========== ======= =========== ========== =========

<CAPTION>
TOTAL
STOCKHOLDERS'
EQUITY (NET
ACCUMULATED CAPITAL
DEFICIT DEFICIENCY)
------------ -------------
<S> <C> <C>
Balance at December 31, 1994....... $ (835,679) $ (541,651)
Issuance of common stock for
services......................... -- 5,416
Issuance of Series A convertible
preferred stock at $1.76 per
share for cash, net of issuance
costs of $71,791................. -- 898,849
Issuance of Series A convertible
preferred stock at $1.76 per
share for retirement of notes
payable, net of issuance costs of
$7,257........................... -- 242,740
Issuance of Series B convertible
preferred stock at $3.189 per
share, net of issuance costs of
$100,390......................... -- 2,399,610
Issuance of common stock for
services......................... -- 17,440
Net loss........................... (2,269,981) (2,269,981)
------------ ------------
Balance at December 31, 1995....... (3,105,660) 752,423
Issuance of common stock for cash
and services..................... -- 51,837
Issuance of Series B convertible
preferred stock at $3.189 per
share, net of issuance costs of
$117,110......................... -- 1,365,775
Issuance of warrants............... -- 3,017,115
Issuance of Series C convertible
preferred stock at $15 per share
and shares of common stock at $5
per share, net of issuance costs
of $45,934....................... -- 2,454,066
Issuance of Series D convertible
preferred stock at $15 per share,
net of issuance costs of
$9,163........................... -- 2,990,837
Deferred compensation related to
grant of certain stock options... -- --
Amortization of deferred
compensation..................... -- 6,262
Issuance of common stock for IPO
net of issuance costs............ -- 14,993,067
Issuance of common stock for
converted preferred stock upon
IPO.............................. -- --
Issuance of common stock for anti-
dilutive shares in preferred
stock conversion................. -- --
Issuance of common stock for
exercise of stock options........ -- 2,578
Net loss........................... (10,689,940) (10,689,940)
------------ ------------
Balance at December 31, 1996....... (13,795,600) 14,944,020
Deferred compensation and related
amortization..................... -- 17,958
Accelerated vesting of stock
options.......................... -- 52,137
Extension of warrants.............. -- 50,000
Issuance of Series A stock, net of
issuance cost.................... -- 1,138,000
Employee stock purchase plan....... -- 74,980
Issuance of common stock for
services rendered................ -- 8,053
Issuance of common stock for
exercise of stock options........ -- 27,765
Dividend imputed on Series A
convertible preferred stock,
classified outside of
stockholders' equity (net capital
deficiency)...................... -- (937,500)
Net loss........................... (15,947,282) (15,947,282)
------------ ------------
Balance at December 31, 1997....... $(29,742,882) $ (571,869)
============ ============
</TABLE>

See accompanying notes.
49
<PAGE> 50

FIRST VIRTUAL HOLDINGS INCORPORATED

STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------
1997 1996 1995
------------ ------------ -----------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss.............................................. $(15,947,282) $(10,689,940) $(2,269,981)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization....................... 1,097,716 524,124 106,628
Loss on disposal of assets.......................... 11,249 -- --
Common stock issued for services.................... 60,191 20,000 22,856
Changes in operating assets and liabilities:
Accounts receivable.............................. (119,707) (88,278) --
Prepaid expenses and other....................... (334,775) (72,887) 1,047
Information technology charge.................... -- -- (100,000)
Deposits and other............................... (71,098) (58,809) (4,000)
Accounts payable................................. (185,974) 1,134,542 411,638
Accrued compensation and related liabilities..... (1,998) 364,569 (21,917)
Deferred revenue................................. 473,107 64,683 --
Accrued interest................................. 93,563 96,000 84,010
Due to stockholders.............................. (220,000) 712,500 --
Directors and officers insurance payable......... 275,415 -- --
Other accrued liabilities........................ (250,192) 576,077 --
------------ ------------ -----------
Net cash flows used in operating activities........... (15,119,785) (7,417,419) (1,769,719)
INVESTING ACTIVITIES
Additions to furniture and equipment.................. (929,641) (2,104,301) (151,148)
Proceeds from sales of fixed assets................... 11,769 -- --
Maturity/(purchase) of short-term investment.......... 200,000 (200,000) --
Organization and other costs.......................... -- (74,998) (30,128)
------------ ------------ -----------
Net cash flows used in investing activities........... (717,872) (2,379,299) (181,276)
FINANCING ACTIVITIES
Proceeds from issuance of Series A preferred stock,
net of issuance costs............................... 4,888,000 -- 1,141,589
Proceeds from issuance of Series B preferred stock,
net of issuance costs............................... -- 1,365,775 2,399,610
Proceeds from issuance of Series C preferred stock,
net of issuance costs............................... -- 1,928,189 --
Proceeds from issuance of Series D preferred stock,
net of issuance costs............................... -- 2,990,837 --
Proceeds from issuance of common stock, net of
issuance costs...................................... 102,745 15,531,122 --
Proceeds from issuance/extension of warrants.......... 50,000 3,017,115 --
Proceeds from borrowings from stockholders and bank... -- 486,111 486,600
Repayment of loan from bank........................... -- (486,111) --
------------ ------------ -----------
Net cash flows provided by financing activities....... 5,040,745 24,833,038 4,027,799
Net increase/(decrease) in cash and cash
equivalents......................................... (10,769,912) 15,036,320 2,076,804
Cash and cash equivalents at the beginning of year.... 17,127,971 2,091,651 14,847
------------ ------------ -----------
Cash and cash equivalents at the end of year.......... $ 6,331,059 $ 17,127,971 $ 2,091,651
============ ============ ===========
</TABLE>

See accompanying notes.
50
<PAGE> 51

FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and business activity

Founded in 1994, First Virtual Holdings Incorporated is a leader in
advanced marketing and customer service systems for Internet commerce. In
October 1994, the Company developed and implemented the FVIPS, a secure and
easy-to-use payment system. This was the Company's first application of the
VirtualPIN architecture. The VirtualPIN architecture facilitates Internet
commerce and is designed to facilitate other forms of interactive Internet
communications.

On August 11, 1995, the Company declared a twenty five-for-one stock split
of the Company's common stock and Series A convertible preferred stock. All
applicable share and stock option information have been restated to reflect the
split.

On July 3, 1996, the Company was reincorporated in Delaware. In connection
with the reincorporation, the Company is authorized to issue 40,000,000 shares
of common stock and 3,401,447 shares of preferred stock. In addition, on August
26, 1996 in connection with the sale of Series D preferred stock, the Company's
certificate of incorporation was amended to authorize the issuance of 3,601,447
shares of preferred stock. All of the accompanying financial statements have
been restated to reflect the reincorporation.

On December 13, 1996, the Company completed an initial public offering (the
"Offering") of 2,000,000 shares of its common stock. The offering price of all
shares sold in the Offering was $9.00 per share, resulting in gross proceeds of
$18.0 million and net proceeds (less the underwriters' discount and offering
expenses) of approximately $15.0 million. Upon completion of the offering, all
of the then outstanding preferred stocks were converted to common stock and the
Company amended its Articles of Incorporation and is authorized to issue
40,000,000 shares of common stock and 5,000,000 shares of preferred stock.

BASIS OF PRESENTATION

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The basis of accounting contemplates
the recovery of the Company's assets and the satisfaction of its liabilities in
the normal course of conducting business. The Company anticipates that its
existing available cash and cash equivalents and the related interest income
will not be adequate to satisfy its capital requirements through December 31,
1998. Management estimates that additional funding will be necessary to enable
the Company to fund its presently planned operations through the end of 1998.
Although the Company believes it has reasonable alternatives to meet the
financial needs of its operations, there can be no assurance that the requisite
fundings will be consummated in the necessary time frame or on terms that are
favorable to the Company. To fund the ongoing research, development and general
operating activities, the Company is dependent on raising additional funds from
the capital markets and corporate partners. In this regard, the Company is
presently in discussion with several companies about strategic alliances for the
deployment of the Interactive Messaging Platform. Should the Company be unable
to raise sufficient funds, it may be required to file for bankruptcy.

Cash and Cash Equivalents

The Company considers all highly liquid investments with an original
maturity of less than three months to be cash equivalents.

Short-Term Investment, Available-for-Sale

In accordance with Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Debt and Equity Securities," the Company's short-term
investment is classified as available-for-sale. Available-for-
51
<PAGE> 52
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

sale securities consist of certificates of deposit with maturities greater than
three months and are stated at cost, as the difference between cost and fair
value is immaterial.

Concentration of Credit Risk

Because the Company acts as an intermediary and facilitator for credit card
transactions, the Company is exposed to the credit risks associated with credit
card payment systems. These credit risks include returned transactions, merchant
fraud and transmission of erroneous information. Through December 31, 1997, the
Company has not incurred significant losses from these credit risks.

Furniture and Equipment

Furniture and equipment are stated at cost and depreciated over the
estimated useful lives of the assets (three to five years) using the
straight-line method.

Organization and Other Costs

Organization and other costs are being amortized over five years.
Accumulated amortization at December 31, 1997 and 1996 amounted to $59,431 and
$31,264, respectively.

Asset Impairment

The Company adopted Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of" (SFAS 121), effective January 1, 1996. SFAS 121 requires
impairment losses to be recorded on long-lived assets used in operations when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets' carrying amount. SFAS
121 also addresses the accounting for long-lived assets that are expected to be
disposed of. There was no effect on the financial statements from the adoption
of SFAS 121.

Stock-Based Compensation

The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25) and related
Interpretations in accounting for its employee stock options because, the
alternative fair value accounting provided for under Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS
123), requires use of option valuation models that were not developed for use in
valuing employee stock options. As a result, deferred compensation is recorded
for the excess of the fair value of the stock on the date of the option grant,
over the exercise price of the option. The deferred compensation is amortized
over the vesting period of the option.

Income Taxes

On May 24, 1995, in conjunction with the issuance of Series A Preferred
Stock, the Company changed its status for federal and state income tax purposes
from an S Corporation (whereby the Corporation's operating gains and losses
flowed through to the stockholders for tax purposes) to become a C Corporation
(whereby the Company is subject to federal and state income taxes). The Company
accounts for income taxes in accordance with Statement of Financial Accounting
Standards No. 109.

Revenue Recognition

First Virtual has four main sources of revenue: Internet payment system
(IPS), merchandising, interactive advertising development and consulting.
Internet payment system revenue consists of consumer
52
<PAGE> 53
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

and merchant registrations, transaction revenue, Infohaus revenue and marketing
revenue. Merchandising revenue consists of sales generated from JUNO On-line and
1 Virtual Place merchandise sales. Interactive advertising development consists
of sales of VTAGs. Consulting revenue consists of payments for Internet
consulting services provided.

Consumer registration fees and merchant registration fees are recognized
over a 12 month period. Also, the related direct costs of processing such
registrations and renewals are deferred and amortized over a 12-month period.
Consumer registration fees renew annually. Prior to July 1, 1996, revenues from
registration fees and related direct costs of processing registrations were
recognized in the month the consumer's or the merchandiser's registration fee
was processed and the VirtualPIN was issued. Transaction revenue and marketing
revenue are recognized when earned. InfoHaus revenue is recognized when it is
collected.

As part of processing certain transactions, the Company earns interest from
the time money is collected from consumers until the time payment is made to the
applicable merchants.

All other revenues are recognized upon delivery of goods or performance of
service.

Research and Development

Research and development costs are expensed in the period incurred.

Software Developments Costs

Financial accounting standards provide for the capitalization of certain
software development costs after technological feasibility of the software is
attained. No such costs have been capitalized to date.

Reclassification of Expenses

For the years ended December 31, 1996 and 1995, approximately $1,403,624
and $0 were reclassified as research, development and engineering expenses,
respectively, and approximately $265,900 and $123,375 were reclassified as cost
of revenues, respectively, which had previously been included in general and
administrative expenses. Such reclassification was done to be consistent with
current year presentation.

Net Loss Per Share

In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) 128, Earnings Per Share, which is
effective for the fiscal periods ending December 15, 1997. SFAS 128 includes a
new computation for earnings per share and presentation of basic and diluted
earnings per share. The Company retroactively adopted SFAS 128 in the fourth
quarter of 1997. Upon adoption, all loss per share amounts for all periods have
been represented, and where appropriate, restated to conform to the SFAS 128
requirements.

The Company's net loss per share calculations are based upon the weighted
average number of shares of common stock outstanding.

New Accounting Standards

In June 1997, the Financial Accounting Standards Board issued SFAS 130,
Reporting Comprehensive Income and SFAS 131, Segment Information. Both of these
standards are effective for the fiscal years beginning after December 15, 1997.
SFAS 130 requires that all components of comprehensive income,

53
<PAGE> 54
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

including net income, be reported in the financial statements in the period in
which they are recognized. The Company's comprehensive loss will not be
materially different than net loss as reported. SFAS 131 amends the requirements
for public enterprises to report financial and descriptive information about its
reportable operating segments. The Company currently operates in one business
and operating segment and does not believe adoption of this standard will have a
material impact on the Company's financial statements as reported.

Use of Estimates

The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and the
accompanying notes. Actual results could differ from those estimates.

2. FURNITURE AND EQUIPMENT

Furniture and equipment consists of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1997 1996
---------- ----------
<S> <C> <C>
Furniture, equipment and software................... $3,378,530 $2,481,307
Less accumulated depreciation....................... (1,519,482) (516,672)
---------- ----------
$1,859,048 $1,964,635
========== ==========
</TABLE>

3. RELATED PARTY TRANSACTIONS

In conjunction with the sale of 1,250,000 shares of common stock to a
stockholder on September 16, 1994 for $200,000, the Company obtained an
unsecured line of credit commitment from the stockholder for borrowings up to
$800,000. The Company also has an unsecured line of credit from a stockholder
which allows for maximum borrowings of $400,000. The borrowings plus interest at
8% are due upon the earlier of (i) January 31, 1998 or (ii) the closing of an
underwritten public offering (other than the IPO) of the Company's common stock.
At December 31, 1997, $1,200,000 has been drawn against these lines of credit.
See further discussion at Note 10.

The stockholders who have provided these lines of credit have agreed to
subordinate the debt to future institutional financing. Pursuant to these
agreements, no dividends will be paid by the Company until the borrowings are
paid in full and the lines of credit have been terminated.

On August 20, 1996, the Company entered into an agreement with the Series B
stockholder for the waiver of a previous agreement to use the Series B
stockholder as an exclusive services provider. In return for the waiver, the
Company agreed to pay the Series B stockholder facility fees totaling $500,000
and transaction surcharges of no less than $500,000 during the 40-month period
beginning September 1, 1996, dependent upon the number of transactions processed
through service providers other than the Series B stockholder. The Company
charged the $1,000,000 associated with this agreement to general and
administrative during 1996. At December 31, 1997, the Company had an outstanding
balance of $492,500 due to this stockholder. There is no interest being charged
on the outstanding balance.

The Company's credit card transaction services are provided by Paymentech,
Inc., a stockholder. Fees for these services amounted to $151,284, $123,622 and
$28,198 for the years ended December 31, 1997, 1996 and 1995, respectively.

54
<PAGE> 55
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

Certain marketing and technology consulting services were provided by a
company whose president was a director of the Company. No services were provided
during the years ended December 31, 1997 and 1996. Services amounted to $132,521
for the year ended December 31, 1995.

4. NOTE PAYABLE

On February 27, 1996, the Company entered into a promissory note to borrow
up to $500,000 at the prime rate plus 2% from a financial institution. The loan
was repaid in full in April 1996.

5. COMMITMENTS

Leases

The Company leases its office facilities and certain equipment under
non-cancelable operating lease agreements. The facility lease requires the
Company to pay standard common area maintenance fees and is subject to certain
minimum escalation provisions. Rent expense for all operating leases was
approximately $523,214, $210,000 and $38,400 for the years ended December 31,
1997, 1996 and 1995, respectively.

Future minimum operating lease payments as of December 31, 1997 are as
follows:

Information Service Agreement

In October 1994, the Company entered into a technology service agreement
with another company to receive information technology services from the other
company beginning in 1994. Minimum monthly payments of $5,000 for services
commenced upon full system implementation. The Company paid an implementation
charge of $150,000 which is being amortized over three years. Accumulated
amortization at December 31, 1997 and 1996 amounted to $130,155 and $90,774,
respectively. In June 1996, this agreement was amended, reducing the information
technology services to be received, and as a result, effective July 1, 1996,
minimum monthly charges no longer apply.

6. SERIES A CONVERTIBLE PREFERRED STOCK

On October 22, 1997, First Virtual completed a private placement of
preferred stock and received net proceeds of $4.9 million. Under the private
placement agreement, 1,000 shares of Series A convertible preferred stock were
issued at $5,000 per share. The Series A convertible preferred stock is
convertible into common stock at the option of the investors at a per share
conversion price equal to the lesser of $5.50 or 80% of the average closing bid
price of the common stock for the prior ten days. At December 31, 1997, the
Company recorded imputed dividends on the Series A preferred convertible stock
totaling $1,250,000 for discounted conversion terms. The Series A convertible
preferred stock may be redeemable for cash in the event that the Company's
stockholders do not approve the private placement at its upcoming Annual
Stockholders' meeting scheduled for June 23, 1998. However, the Company has
obtained proxies from a majority in interest of its stockholders which allow
executive officers of the Company to vote their shares for the approval of the
private placement. As of March 20, 1998, 250 shares of the Series A convertible
preferred stock have been converted into 953,269 shares of the Company's common
stock. The remaining 750 shares of Series A convertible preferred stock will
remain classified as mezzanine financing until they are converted or until
stockholders' vote approving the private placement has been obtained at the
Annual Stockholders' meeting.

55
<PAGE> 56
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

The Series A convertible preferred stock carries an annual dividend of 7%
payable quarterly in cash or shares of common stock at the option of the
Company.

In connection with the sale of Series A convertible preferred stock,
warrants to purchase up to 850,000 shares of common stock at $5.75 per share
were issued to the Series A convertible preferred stock stockholders. These
warrants will expire on October 15, 2001.

7. STOCKHOLDERS' EQUITY

Preferred Stock

In May 1995, the Company sold 551,500 shares of Series A preferred stock at
$1.76 per share. An additional 142,044 shares were issued at $1.76 per share to
retire certain notes payable in December 1995. In December 1995, the Company
sold 783,945 shares of Series B preferred stock at $3.189 per share.

On July 3, 1996, the Company sold 130,952 shares of Series C preferred
stock at $15.00 per share and 107,144 shares of common stock at $5.00 per share
for total proceeds of approximately $2,500,000.

In connection with the sale of the Series C preferred stock, the Company
issued a performance warrant to purchase 33,333 shares of the Company's common
stock at an exercise price of $15 per share. This warrant was extended to July
23, 1997 from July 3, 1997 in exchange for $50,000. The warrant expired on July
23, 1997.

On August 26, 1996, the Company sold 200,000 shares of Series D preferred
stock at $15.00 per share for total proceeds of approximately $3,000,000. In
connection with the sale of Series D preferred stock, the Company issued a
warrant to purchase shares of the Company's common stock. The number of shares
and exercise price are contingent upon the Series D stockholder achieving
certain performance criteria with respect to the issuance of VirtualPINs to its
customer base as outlined in the following schedule:

<TABLE>
<CAPTION>
INCREMENTAL EXERCISE PRICE
DEADLINE FOR ACHIEVING PERFORMANCE CRITERIA SHARES PER SHARE
------------------------------------------- ----------- --------------
<S> <C> <C>
May 31, 1997.......................................... 375,000 $5.00
August 31, 1997....................................... 375,000 3.33
October 31, 1997...................................... 375,000 2.50
December 30, 1997..................................... 375,000 2.23
</TABLE>

This performance warrant expired on September 29, 1997.

Total issuance costs for preferred stock issued prior to the Company's IPO
amounted to $351,645 and $179,438 at December 31, 1996 and December 31, 1995,
respectively.

On December 13, 1996, all outstanding preferred stock was converted into
common stock concurrent with the closing of the Company's underwritten initial
public offering. As a result of certain anti-dilution adjustments, the 2,273,441
shares of preferred stock outstanding prior to the offering were converted to
2,333,317 shares of common stock.

56
<PAGE> 57
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

Warrants

In connection with a sale of Series B preferred stock in December 1995 to a
financial institution, the Company issued warrants to purchase shares of Series
A and Series B preferred stock. In April 1996, the Series B preferred
stockholder partially exercised this warrant by purchasing 465,000 shares of
Series B preferred stock at $3.189 per share. In addition, the Series B
preferred stockholder paid the Company $3,017,115 for warrants to purchase
852,272 shares of Series A preferred stock and 475,734 shares of Series B
preferred stock at $0.01 per share. These warrants are currently exercisable as
to common stock of the same number of shares and will expire on March 4, 2001.
The Company received total proceeds of approximately $4.5 million in connection
with this transaction. Furthermore, all of the unexercised warrants originally
issued on December 22, 1995 have been canceled.

In connection with a consulting agreement, an incentive warrant to purchase
300,000 shares of common stock at $5.63 per share was issued on September 24,
1997 to a third party. When the third party receives $10 million of net sales
through the use of technology and services provided by the Company, 100,000
shares of common stock can be issued under this warrant. An additional 100,000
shares of common stock can be issued under this warrant when the third party
receives $25 million of net sales through the use of technology and services
provided by the Company and the remaining 100,000 shares of common stock can be
issued under this warrant when the third party receives $50 million of net sales
through the use of technology and services provided by the Company. This warrant
expires on December 20, 2003.

Under a certain consulting agreement, dated September 8, 1997, a warrant to
purchase 65,000 shares of common stock at $5.63 per share was granted to a third
party as payment for consulting services rendered. Under the terms of the
warrant agreement, 20,000 shares of common stock became available to be issued
when the third party completed its obligation to the Company in September 1997
(as defined in the agreement), with the remaining 45,000 common shares to be
issued under this warrant when the third party delivers to the Company, two
catalog merchants who execute agreements with the Company in regards to either
licensing of VirtualPINS or Interactive Messaging services. This warrant expires
on December 30, 2002. The Company estimated the fair value of the 20,000 common
shares issued under this warrant in September 1997 using the Black-Scholes
option pricing model. However, no value was allocated to the warrant as the
estimated fair value was nominal.

57
<PAGE> 58
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

Stock Option Plan

The Company's 1994 Incentive and Non-Statutory Stock Option Plan (1994
Plan), under which options to purchase 482,300 shares of common stock were
granted, was replaced with the 1995 Stock Plan (1995 Plan). Under the 1995 Plan,
the Company is authorized to issue up to 3,000,000 common shares to officers,
employees, directors and certain other individuals providing services to the
Company. Options granted under the 1995 Plan generally vest over four years and
are exercisable for a period of up to ten years from the date of grant.
Incentive stock options are granted at prices which approximate the fair value
of the shares at the date of grant as determined by the board of directors. The
following table summarizes stock option activity:

<TABLE>
<CAPTION>
WEIGHTED AVERAGE
SHARES EXERCISE PRICE
--------- ----------------
<S> <C> <C>
Balance at December 31, 1994..................... 288,875 $0.04
Options granted................................ 179,875 $0.07
---------
Balance at December 31, 1995..................... 468,750 $0.05
Options granted................................ 1,327,645 $6.43
Options exercised.............................. (19,975) $0.13
Options canceled............................... (33,250) $4.94
---------
Balance at December 31, 1996..................... 1,743,170 $4.82
Options granted................................ 1,115,600 $4.54
Options exercised.............................. (85,690) $0.32
Options canceled............................... (504,987) $7.49
---------
Balance at December 31, 1997..................... 2,268,093 $4.14
=========
</TABLE>

As of December 31, 1997, options to purchase 1,046,362 shares are
exercisable under the 1994 and 1995 plan and 1,108,542 shares are available for
future grant under the 1995 Plan.

The weighted average fair value of the options granted during 1997, 1996
and 1995 were $4.66, $2.83 and $0.13, respectively.

Exercise prices and weighted average remaining contractual life for the
options outstanding under the 1994 Plan and 1995 Plan as of December 31, 1997
are as follows:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
- ------------------------------------------------------------------------------- OPTIONS EXERCISABLE
WEIGHTED AVERAGE --------------------------------
RANGE OF NUMBER REMAINING WEIGHTED AVERAGE NUMBER WEIGHTED AVERAGE
EXERCISE PRICE OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- --------------------- ------------ ----------------- ----------------- ----------- -----------------
<S> <C> <C> <C> <C> <C>
$0.04 - $ 0.32 794,184 7.04 $ 0.12 670,471 $ 0.11
1.00 - 5.00 870,280 9.54 3.97 41,106 2.91
6.00 - 7.50 70,000 9.43 6.59 12,000 6.38
9.00 - 10.50 533,629 8.71 10.07 322,785 10.23
--------- ---------
2,268,093 1,046,362
========= =========
</TABLE>

Some of these options were granted at a per share value below the then
current fair market value of such shares. The Company recorded deferred
compensation expense for the difference between the exercise price and the fair
value of the Company's common stock for options granted during 1997 and 1996.
Deferred compensation expense aggregates to $128,888 and $50,567 for the years
ended December 31, 1997 and 1996, respectively.

Pursuant to the terms of the December 22, 1995 Series B Preferred Stock
Purchase Agreement, on April 11, 1996, the Company's board of directors granted
options to purchase 475,000 shares of common stock

58
<PAGE> 59
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

at $6.30 per share to an officer and director of the Company. The options vested
immediately and expire on April 11, 2006. Two directors of the Company were
granted options to purchase 225,000 and 100,000 shares under the same terms. In
addition, the board of directors granted options to purchase 200,000 shares of
common stock at $6.30 per share to two key employees of the Company. The options
to these two key employees vest on June 30, 1998 provided that each remains an
employee of the Company at that date and expire in ten years. These options to
purchase 1,000,000 shares were not granted under the 1995 Plan. No deferred
compensation was deemed appropriate for the April 1996 option grants. The fair
value of common stock was determined by an independent valuation.

Pro forma information regarding net loss is required by SFAS 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 the 1997
options was estimated at the date of grant, using the Black-Scholes option
pricing model, with the following assumptions: risk-free interest rates of
5.41%; dividend yields of 0%; and a weighted-average expected life of the option
of five years with a volatility factor of .50. The fair value for the 1996
options that were granted after the Company filed its initial filing of the
registration statement relating to the IPO, was estimated at the date of grant,
using the Black-Scholes option pricing model, with the following assumptions:
risk-free interest rates of 6.18%; dividend yields of 0%; and a weighted-average
expected life of the option of five years with a volatility factor of .75. The
fair value for the 1996 options granted before the Company filed its initial
filing of the registration statement relating to the IPO and the fair value of
the 1995 options, were estimated at the date of grant, using the "minimum value"
method for option pricing through the initial filing of the registration
statement relating to the IPO, with the following weighted-average assumptions:
risk-free interest rates of 6%; dividend yields of 0%; and a weighted-average
expected life of the option of seven years. The volatility factor was based upon
the Company's competitive situation, marketing dynamics and competitive
technology inherent in the Internet.

The Black-Scholes option valuation 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 valuation 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 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.

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The effects of
applying Statement 123 for pro forma disclosure purposes are not likely to be
representative of the effects on pro forma net income (loss) in the future years
because they do not take into consideration pro forma compensation expense
related to grants made prior to 1995. The Company's pro forma information
follows:

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1997 1996 1995
------------ ------------ -----------
<S> <C> <C> <C>
Pro forma net loss applicable to common
shares...................................... $(17,889,405) $(11,186,398) $(2,276,119)
Pro forma net loss per common share, basic and
diluted..................................... $(2.02) $(2.44) $(0.55)
</TABLE>

Employee Stock Purchase Plan

In 1996, the Company adopted an Employee Stock Purchase Plan (the "ESPP"),
whereby employees, at their option, can purchase shares of Company common stock.
This is done through a payroll deduction at the lower of 85% of the fair market
value on the first day of the ESPP offering period or the end of each six-month

59
<PAGE> 60
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

period. The ESPP expires at the earlier of December 31, 2006 or the date on
which all shares available for issuance have been sold. The Company has reserved
100,000 shares of common stock for issuance under the ESPP. At December 31, 1997
employees have purchased 22,160 shares through the ESPP and 77,840 shares are
available for future purchases.

Shares Reserved for Future Issuance

As of December 31, 1997, the Company has reserved shares of common stock
for future issuance as follows:

<TABLE>
<S> <C>
Stock options............................................ 3,376,635
Warrants................................................. 2,543,006
Series A convertible preferred stock..................... 4,608,294
Employee stock purchase plan............................. 77,840
----------
10,605,775
==========
</TABLE>

8. INCOME TAXES

Significant components of the Company's deferred tax assets as of December
31, 1997 and 1996 are shown below. Valuation allowances of $11,750,000 and
$5,063,000 have been recognized for 1997 and 1996, respectively, to offset the
net deferred tax assets, as realization of such assets is uncertain.

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1997 1996
------------ -----------
<S> <C> <C>
Deferred tax assets:
Net operating losses carryforwards....................... $ 10,280,000 $ 4,519,000
R & D credit............................................. 790,000 --
Other.................................................... 680,000 544,000
------------ -----------
11,750,000 5,063,000
Valuation allowance for deferred tax assets................ (11,750,000) (5,063,000)
------------ -----------
Net deferred tax assets.................................... $ -- $ --
============ ===========
</TABLE>

At December 31, 1997, the Company has federal and California tax net
operating loss carryforwards of approximately $26,730,000 and $16,100,000. These
federal and state carryforwards will begin to expire in 2010 and 2000,
respectively, unless previously utilized. The Company also has federal and state
research credit carryforwards of approximately $612,000 and $279,000,
respectively, which will begin expiring in 2010, unless previously utilized.

Pursuant to Internal Revenue Code Section 382 and 383, use of the Company's
net operating loss and tax credit carryforwards may be significantly limited if
a cumulative change in ownership of more than 50% occurs within a three year
period.

9. 401(K) PROFIT SHARING PLAN

The Company maintains a 401(k) profit sharing plan which allows
substantially all employees to contribute up to 15% of their salary, subject to
annual limitations. The Board of Directors, may at its sole discretion, approve
Company contributions. To date, there have been no Company contributions under
the plan.

60
<PAGE> 61
FIRST VIRTUAL HOLDINGS INCORPORATED

NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997

10. SUBSEQUENT EVENT

On February 5, 1998, two stockholders filed civil actions against the
Company seeking to recover the principal and interest due under the unsecured
lines of credit described in Note 3. The total amount of principal and interest
is approximately $1.5 million which is reflected as current liabilities in the
financial statements. Subsequently, on February 20, 1998, $1.5 million of the
Company's available cash was attached.

<PAGE> 1
EXHIBIT 23.1

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 333-24789) pertaining to the 1994 Incentive and Non-Statutory
Stock Option Plan, the 1995 Stock Plan and the Employee Stock Purchase Plan of
First Virtual Holdings Incorporated and in the Registration Statement (Form S-3
No. 333-42855) of First Virtual Holdings Incorporated and the related
Prospectus of our report dated January 16, 1998, except for the first paragraph
of Note 6 and Note 10, for which the date is March 20, 1998, including in the
Annual Report on Form 10-K of First Virtual Holdings Incorporated for the year
ended December 31, 1997, with respect to the financial statements, as amended,
included in this Form 10-K/A.

ERNST & YOUNG LLP
San Diego, California
October 19, 1998