**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**ý**** ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT OF 1934**

 

**For thequarterly period ended June 30, 2005**

 

**or**

 

**o**** ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For thetransition period from                      to                      **

 

**Commission file number: 1-14355**

 

**24/7 RealMedia, Inc.**

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITSCHARTER)

 
| **Delaware**                                               | ** ** | **13-3995672**                     |
|------------------------------------------------------------|------------|------------------------------------|
| (STATE OR OTHER  JURISDICTION OF                           |       | (IRS EMPLOYER  IDENTIFICATION NO.) |
| INCORPORATION OR  ORGANIZATION)                            |       |                               |
|                                                       |       |                               |
| **132 West  31st Street, New York, NY 10001**              |
| (ADDRESS OF PRINCIPAL  EXECUTIVE OFFICES)                  |
|                                                       |       |                               |
| **(212) 231-7100**                                         |
| (REGISTRANT’S TELEPHONE  NUMBER, INCLUDING AREA CODE) |

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15 (d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. YES ý NO o

 

Indicateby check mark whether the registrant is an accelerated filer Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). YES ý NO o

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 
| **CLASS**                              | ** ** | **OUTSTANDING AT JUNE 30,  2005** |
|----------------------------------------|------------|----------------------------------------|
| Common Stock, par value $.01 per share |       | 45,174,742 Shares                      |

 

 

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**24/7 RealMedia, Inc.**

**June 30,2005**

**FORM 10-Q**

**INDEX**

 
| Part I. Financial  Information                                                                                | 3      |
|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. Consolidated  Financial Statements                                                                         | 3      |
| Consolidated Balance  Sheets as of June 30, 2005 (unaudited) and December 31, 2004                       | 3      |
| Consolidated  Statements of Operations for the three and six months ended  June 30, 2005 and 2004 (unaudited) | 4      |
| Consolidated  Statements of Cash Flows for the six months ended  June 30, 2005 and 2004 (unaudited)           | 5      |
| Notes to Unaudited Interim Consolidated  Financial Statements                                                      | 6      |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations               | 22     |
| Item 3. Quantitative and  Qualitative Disclosures about Market Risk                                                | 46     |
| Item 4. Controls and Procedures                                                                                    | 46     |
|                                                                                                               |   |
| Part II. Other Information                                                                                    | 48     |
| Item 1. Legal Proceedings                                                                                          | 48     |
| Item 2. Unregistered Sales  of Equity Securities and Use of Proceeds                                               | 48     |
| Item 3. Defaults Upon Senior  Securities                                                                           | 48     |
| Item 4. Submission of  Matters to a Vote of Security Holders                                                       | 48     |
| Item 5. Other Information                                                                                          | 48     |
| Item 6. Exhibits                                                                                                   | 48     |
| Signatures                                                                                                         | 49     |

 

 

Open AdStream® is a registered trademark of 24/7 Real Media, Inc.and Open AdSystemTM, Open AdvertiserTM, Insight XETM, Insight ACTTM andDecide DNATM are pending trademarks of 24/7 Real Media, Inc. All otherbrand names or trademarks appearing herein are the property of their respectiveholders.

 

2

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PART I. FINANCIALINFORMATION

 

ITEM1. CONSOLIDATED FINANCIAL STATEMENTS

 

**24/7 REALMEDIA, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(inthousands, except share data)**

 
| ** **                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                               | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                               |       |              |       |                  |       |
| Current assets:                                                                                                                                                          |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                |       | $                 | 28,347     |                  | $          | 27,690 |   |
| Short-term investments                                                                                                                                                   |       | 2,345             |       | 3,876                 |       |
| Accounts receivable, less  allowances of $2,062 and $1,727, respectively                                                                                                 |       | 29,921            |       | 28,224                |       |
| Prepaid expenses and other  current assets                                                                                                                               |       | 2,874             |       | 2,710                 |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total current assets                                                                                                                                                     |       | 63,487            |       | 62,500                |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Property and equipment, net                                                                                                                                              |       | 6,367             |       | 4,783                 |       |
| Goodwill                                                                                                                                                                 |       | 34,573            |       | 34,573                |       |
| Intangible assets, net                                                                                                                                                   |       | 11,112            |       | 12,676                |       |
| Other assets                                                                                                                                                             |       | 6,617             |       | 6,866                 |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total assets                                                                                                                                                             |       | $                 | 122,156    |                  | $          | 121,398 |   |
|                                                                                                                                                                     |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                           |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                     |       |              |       |                  |       |
| Accounts payable                                                                                                                                                         |       | $                 | 13,418     |                  | $          | 16,425 |   |
| Accrued liabilities                                                                                                                                                      |       | 15,202            |       | 11,808                |       |
| Deferred revenue                                                                                                                                                         |       | 2,918             |       | 3,222                 |       |
| Subordinated convertible  debentures, 2%, due 2006                                                                                                                       |       | 7,500             |       | 7,500                 |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total current liabilities                                                                                                                                                |       | 39,038            |       | 38,955                |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Subordinated convertible  debentures, 2%, due 2006                                                                                                                       |       | 6,736             |       | 6,431                 |       |
| Warrant liability                                                                                                                                                        |       | 476               |       | 516                   |       |
| Other long-term liabilities                                                                                                                                              |       | 446               |       | 228                   |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total liabilities                                                                                                                                                        |       | 46,696            |       | 46,130                |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Commitments and  contingencies                                                                                                                                           |       |              |       |                  |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                                                               |       |              |       |                  |       |
| Preferred stock; $.01 par  value; 10,000,000 shares authorized, 53,000 and 78,000 shares issued and  outstanding, respectively (liquidation preference of $10 per share) |       | 1                 |       | 1                     |       |
| Common stock; $.01 par  value; 350,000,000 shares authorized; 45,174,742 and 44,797,067 shares issued  and outstanding, respectively                                     |       | 452               |       | 448                   |       |
| Additional paid-in capital                                                                                                                                               |       | 1,174,941         |       | 1,173,765             |       |
| Deferred stock-based  compensation                                                                                                                                       |       | (6                | )          | (17                   | )          |
| Accumulated other  comprehensive income                                                                                                                                  |       | 1,060             |       | 1,463                 |       |
| Accumulated deficit                                                                                                                                                      |       | (1,100,988        | )          | (1,100,392            | )          |
| Total stockholders’ equity                                                                                                                                          |       | 75,460            |       | 75,268                |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total liabilities and  stockholders’ equity                                                                                                                         |       | $                 | 122,156    |                  | $          | 121,398 |   |

 

See accompanying notes to unaudited interimconsolidated financial statements.

 

3

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**24/7 REALMEDIA, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(inthousands, expect share and per share data)**

 
| ** **                                                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | **(unaudited)**                      | ** ** | **(unaudited)**                    | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| Revenues:                                                                        |       |                                 |       |                               |       |   |   |   |   |
| Media                                                                            |       | $                                    | 16,684     |                               | $          | 12,358 |   | $ | 30,913 |   | $ | 22,381 |   |
| Search                                                                           |       | 11,710                               |       | 2,533                              |       | 21,332 |   | 5,549 |   |
| Technology                                                                       |       | 5,492                                |       | 4,706                              |       | 10,711 |   | 9,048 |   |
| Total  revenues                                                                  |       | 33,886                               |       | 19,597                             |       | 62,956 |   | 36,978 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Cost of  revenues:                                                               |       |                                 |       |                               |       |   |   |   |   |
| Media                                                                            |       | 11,327                               |       | 8,823                              |       | 20,954 |   | 15,806 |   |
| Search                                                                           |       | 7,747                                |       | 1,664                              |       | 14,379 |   | 4,122 |   |
| Technology                                                                       |       | 1,177                                |       | 879                                |       | 2,169 |   | 1,701 |   |
| Total cost  of revenues                                                          |       | 20,251                               |       | 11,366                             |       | 37,502 |   | 21,629 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Gross profit                                                                     |       | 13,635                               |       | 8,231                              |       | 25,454 |   | 15,349 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Operating  expenses:                                                             |       |                                 |       |                               |       |   |   |   |   |
| Sales and  marketing                                                             |       | 5,731                                |       | 3,893                              |       | 11,021 |   | 7,209 |   |
| General and  administrative                                                      |       | 4,988                                |       | 3,019                              |       | 9,572 |   | 6,001 |   |
| Product  development                                                             |       | 1,366                                |       | 1,095                              |       | 2,608 |   | 2,146 |   |
| Amortization  of intangible assets and deferred financing costs                  |       | 1,139                                |       | 1,414                              |       | 2,279 |   | 2,202 |   |
| Stock-based  compensation (a)                                                    |       | 441                                  |       | 298                                |       | 954 |   | 497 |   |
| Restructuring  costs                                                             |       | —                               |       | 501                                |       | 973 |   | 501 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Total  operating expenses                                                        |       | 13,665                               |       | 10,220                             |       | 27,407 |   | 18,556 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Loss from  operations                                                            |       | (30                                  | )          | (1,989                             | )          | (1,953 | ) | (3,207 | ) |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Interest  expense, net                                                           |       | (54                                  | )          | (96                                | )          | (142 | ) | (278 | ) |
| Change in  fair value of warrant liability                                       |       | (110                                 | )          | 881                                |       | 40 |   | 1,809 |   |
| Recovery of  investment                                                          |       | —                               |       | —                             |       | 2,100 |   | — |   |
| Impairment  of marketable securities                                             |       | —                               |       | —                             |       | (588 | ) | — |   |
| Gain on sale  of maketable securities                                            |       | 7                                    |       | —                             |       | 7 |   | — |   |
| Gain on  legal settlement                                                        |       | —                               |       | 2,896                              |       | — |   | 2,896 |   |
| Other income  (expense), net                                                     |       | 6                                    |       | (69                                | )          | (40 | ) | 111 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Income  (loss) before provision for income taxes                                 |       | (181                                 | )          | 1,623                              |       | (576 | ) | 1,331 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Provision  for income taxes                                                      |       | (9                                   | )          | (32                                | )          | (20 | ) | (132 | ) |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Net income  (loss)                                                               |       | $                                    | (190       | )                                  | $          | 1,591 |   | $ | (596 | ) | $ | 1,199 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Dividends on  preferred stock                                                    |       | (10                                  | )          | (104                               | )          | (22 | ) | (222 | ) |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Net income  (loss) attributable to common stockholders                           |       | $                                    | (200       | )                                  | $          | 1,487 |   | $ | (618 | ) | $ | 977 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Basic net  income (loss) per share attributable to common stockholders           |       | $                                    | 0.00       |                               | $          | 0.04 |   | $ | (0.01 | ) | $ | 0.03 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Weighted  average shares outstanding used in basic net income (loss) per share   |       | 44,976,378                           |       | 34,054,489                         |       | 44,904,167 |   | 29,836,259 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Diluted net  income (loss) per share attributable to common stockholders         |       | $                                    | 0.00       |                               | $          | 0.04 |   | $ | (0.01 | ) | $ | 0.03 |   |
|                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Weighted  average shares outstanding used in diluted net income (loss) per share |       | 44,976,378                           |       | 43,886,508                         |       | 44,904,167 |   | 39,845,899 |   |

 

----

(a) Stock-based compensation charges are excluded from thefollowing operating expense categories:

 
| Cost of  revenues           |   | $   | 8      |   | $      | — |   | $   | 16     |   | $ | — |   |
|-----------------------------|--------|-----|--------|--------|--------|--------|--------|-----|--------|--------|---|--------|--------|
| Sales and  marketing        |   | 86  |   | 186    |   | 206    |   | 210 |   |
| General and  administrative |   | 297 |   | 92     |   | 632    |   | 263 |   |
| Product  development        |   | 50  |   | 20     |   | 100    |   | 24  |   |
|                        |   | $   | 441    |   | $      | 298    |   | $   | 954    |   | $ | 497    |   |

 

See accompanying notes tounaudited interim consolidated financial statements.

 

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**24/7 REALMEDIA, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                                           | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                           | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **                                                                                           | ** ** | **(unaudited)**                    | ** ** | **(unaudited)** | ** ** |
| Cash flows  from operating activities:                                                               |       |                               |       |   |   |
| Net income  (loss)                                                                                   |       | $                                  | (596       | ) | $ | 1,199 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                               |       |   |   |
| Depreciation  and amortization                                                                       |       | 1,318                              |       | 945 |   |
| Provision  for doubtful accounts and sales reserves                                                  |       | 1,122                              |       | 349 |   |
| Amortization  of intangible assets and deferred financing costs                                      |       | 2,279                              |       | 2,202 |   |
| Amortization  of warrants                                                                            |       | 305                                |       | 306 |   |
| Non-cash  compensation                                                                               |       | 954                                |       | 497 |   |
| Accrued  interest on notes payable                                                                   |       | 149                                |       | 149 |   |
| Change in  fair value of warrant liability                                                           |       | (40                                | )          | (1,809 | ) |
| Gain on sale  of marketable securities                                                               |       | (7                                 | )          | — |   |
| Impairment  of marketable securities                                                                 |       | 588                                |       | — |   |
| Recovery of  investment                                                                              |       | (2,100                             | )          | — |   |
| Gain on  legal settlement                                                                            |       | —                             |       | (2,896 | ) |
| Changes in  operating assets and liabilities, net of effect of acquisitions and  dispositions:       |       |                               |       |   |   |
| Accounts  receivable                                                                                 |       | (2,819                             | )          | (3,563 | ) |
| Prepaid  expenses and other current assets                                                           |       | (164                               | )          | (126 | ) |
| Other assets                                                                                         |       | (466                               | )          | (4,433 | ) |
| Accounts  payable and accrued liabilities                                                            |       | 1,557                              |       | 2,131 |   |
| Deferred  revenue                                                                                    |       | (304                               | )          | 282 |   |
|                                                                                                 |       |                               |       |   |   |
| Net cash  provided by (used in) operating activities                                                 |       | 1,776                              |       | (4,767 | ) |
|                                                                                                 |       |                               |       |   |   |
| Cash flows  from investing activities:                                                               |       |                               |       |   |   |
| Recovery of  investment                                                                              |       | 2,100                              |       | — |   |
| Proceeds  from sale / maturities of short-term investments                                           |       | 648                                |       | — |   |
| Proceeds  from sale of marketable securities                                                         |       | 211                                |       | — |   |
| Capital  expenditures, including capitalized software                                                |       | (3,893                             | )          | (819 | ) |
| Cash paid  for acquisitions, net                                                                     |       | —                             |       | (1,958 | ) |
|                                                                                                 |       |                               |       |   |   |
| Net cash  used in investing activities                                                               |       | (934                               | )          | (2,777 | ) |
|                                                                                                 |       |                               |       |   |   |
| Cash flows  from financing activities:                                                               |       |                               |       |   |   |
| Proceeds  from issuance of common stock, net                                                         |       | —                             |       | 37,364 |   |
| Proceeds  from exercise of stock options                                                             |       | 143                                |       | 587 |   |
| Payment of  capital lease obligations                                                                |       | (16                                | )          | (24 | ) |
|                                                                                                 |       |                               |       |   |   |
| Net cash  provided by financing activities                                                           |       | 127                                |       | 37,927 |   |
|                                                                                                 |       |                               |       |   |   |
| Net change  in cash and cash equivalents                                                             |       | 969                                |       | 30,383 |   |
| Effect of  foreign currency on cash                                                                  |       | (312                               | )          | 483 |   |
| Cash and  cash equivalents at beginning of year                                                      |       | 27,690                             |       | 21,645 |   |
|                                                                                                 |       |                               |       |   |   |
| Cash and  cash equivalents at end of period                                                          |       | $                                  | 28,347     |   | $ | 52,511 |   |

 

See accompanying notes tounaudited interim consolidated financial statements.

 

5

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**NOTE 1 –ORGANIZATION AND NATURE OF OPERATIONS**

 

24/7 Real Media, Inc. (the “Company”) together with itssubsidiaries provides advertising services and software solutions for theonline advertising needs of Web publishers and advertisers, including advertisingsales, search engine marketing services, online advertisement serving,analytics and audience management. As of June 30, 2005, the Companyprincipally operated in North America, Europe, South Korea and Australia andprovided the following products and services:

 

*Media*, collectivelymarketed as the 24/7 Web Alliance, a global alliance of Web sites representedby the Company, through which advertisers can place campaign orders directlywith the Company.

 

*Search*primarilyconsisting of full budget management services, including paid-inclusion serviceand pay-per-click bid management, optimization services and search engine andconsulting services, including natural search engine optimization servicesdesigned to help advertisers promote their Web site in or in association withrelevant search results displayed by the Company’s partner search engines andto optimize their search marketing budgets.

 

*Technology*primarilyconsisting of Open AdStream and Open Advertiser Internet advertisement deliveryand management software and services, the Insight XE web analytics and audiencemanagement software and services and the Insight ACT behavioral targetingservice. The Company licenses software products to customers that are hostedlocally and provides services from software hosted centrally on its servers asan application service provider.

 

**NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

#### (a) Basisof Presentation

####  

The accompanying consolidated financial statements include the accountsof the Company and its majority-owned and controlled subsidiaries from theirrespective dates of acquisition. The interest of shareholders other than thoseof the Company is recorded as minority interest in the accompanyingconsolidated statements of operations and consolidated balance sheets. Whenlosses applicable to minority interest holders in a subsidiary exceed theminority interest in the equity capital of the subsidiary, these losses areincluded in the Company’s results, as the minority interest holder has noobligation to provide further financing to the subsidiary. The Company does nothave significant minority interest holders. All significant intercompanytransactions and balances have been eliminated in consolidation.

 

Theaccompanying interim consolidated financial statements are unaudited. In theCompany’s opinion, the unaudited consolidated financial statements have beenprepared on the same basis as the annual consolidated financial statements andreflect all adjustments, which include only normal recurring adjustments,necessary to present fairly the financial position and the results of theoperations and cash flows of the Company for the interim periods presented. Thefinancial statements, financial data and other information disclosed in thesenotes to the consolidated results are not necessarily indicative of the resultsexpected for the full fiscal year or any future period.

 

6

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Theaccompanying consolidated financial statements should be read in conjunctionwith the audited consolidated financial statements for the year ended December 31,2004. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted pursuant to the Securities and Exchange Commission’s rules andregulations.

 

###### (b) Useof Estimates

######  

The preparation ofconsolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the consolidated financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ fromthose estimates. On an ongoing basis, the Company evaluates its estimates,including those related to revenue recognition, accruals, allowance fordoubtful accounts, fair value of acquired intangible assets and goodwill,useful lives of intangible assets and property and equipment, among others. TheCompany bases its estimates on historical experience and on various otherassumptions that are believed to be reasonable, the results of which form thebasis for making judgments about the carrying values of assets and liabilities.

 

###### (c) Cashand Cash Equivalents

######  

The Company considers all highly liquid securities, with originalmaturities of three months or less from the balance sheet date, to be cashequivalents. Cash and cash equivalents consist principally of money marketaccounts.

 

The Company maintains letters of credit, secured by cash, related toits office leases. Letters of credit with maturities of one year or less fromthe balance sheet date are classified as other current assets and letters ofcredit with maturities greater than one year from the balance sheet date areclassified as other assets on the consolidated balance sheets.

 

(d) Investments

 

Investments consist of securities with statedmaturities of three months or more and marketable securities consisting ofregistered corporate equity securities. The Company classifies themarketable securities as available-for-sale in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*.Available-for-sale securities are carried at fair value, with the unrealizedgains or losses, net of tax, reported as a separate component of stockholders’equity. Realized gains and losses and the cost of available-for-sale securitiessold are computed on the basis of the specific identification method. Realizedgains and losses and declines in value judged to be other-than-temporary, areincluded in impairment of marketable securities.

 

Investments in non-marketable equity securities ofcompanies in which the Company owns less than 20% of a company’s stock and doesnot have the ability to exercise significant influence are accounted for on thecost basis. On an ongoing basis, the Company assesses the need to recordimpairment losses on investments and records such losses when the impairment isdetermined to be other-than-temporary.

 

7

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(e) Accounts Receivable

 

Accounts receivable are recorded at the invoiced amount net ofallowance for doubtful accounts and sales allowance. The Company does notrequire collateral. The Company maintains an allowance for doubtful accounts toreserve for potentially uncollectible receivables and a sales allowance toreserve for potential credits issued to customers. The allowances are estimatescalculated based on an analysis of current business and economic risks,customer credit-worthiness, specific identifiable risks such as bankruptcies,terminations or discontinued customers, or other factors that may indicate apotential loss.

 

As a normal part of the business, the Company has receivables that areinvoiced in the month following the completion of the earnings process. Allunbilled receivables are billed within 30 days after each month-end.

 

(f) Concentration of Credit Risk

 

Financial instruments that potentially subject the Company toconcentrations of credit risk consist principally of cash equivalents, accountsreceivable and debentures. The fair value of cash equivalents and accountsreceivable instruments approximate their financial statement amount because ofthe short-term maturity of these instruments. The fair value of the debenturesapproximates their financial statement carrying value based on interest ratesfor similar borrowing.

 

At times, cash may exceed the federally insured limits. In addition,the majority of the cash is managed by one financial institution.

 

(g) Significant Customers and Suppliers

 

No single customeraccounted for greater than 10% of net revenues for the three or six monthperiods ended June 30, 2005 and 2004.

 

Substantially all Media revenue is generated from advertising inventoryprovided by partner Web sites and all Search revenue is generated from searchengine distribution partners. In each case, with the exception of Lycos,arrangements with the Company’s partners are often short-term or subject totermination upon short notice. The Company may not be successful in renewingany of these agreements, or if they are renewed, they may not be on terms asfavorable as current agreements. The Company may not be successful in enteringinto agreements with new distribution partners on commercially acceptableterms. Substantially all Search revenue is generated from relationships withtwo search engine distribution partners.

 

On a geographic basis, the Company may also experience significantconcentration among our customers or partners. The Company examines thisconcentration on a country-by-country basis.

 

(h) Property and Equipment; Capitalized Software

 

Property and equipment are recorded at cost and are depreciated usingthe straight-line method over the shorter of the estimated useful lives of therelated assets, generally three to five years, or the lease term.

 

In accordance with Statement of Position (“SOP”) No. 98-1, *Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use*, software development costsincurred during the application development stage are capitalized. Costsincurred during the preliminary project and post implementation stages of aninternal use software project are expensed as incurred. The capitalized cost ofinternal use software is charged over the estimated useful life of two to threeyears.

 

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As required by SFAS No. 86, *Accountingfor the Costs of Computer Software To Be Sold, Leased, or Otherwise Marketed*,the Company requires certain product development costs to be capitalized when aproduct’s technological feasibility has been established by completion of aworking model of the product and ending when a product is available for generalrelease to customers. Capitalized software is depreciated using the greater ofthe amount computed using (a) the ratio that current gross revenues for aproduct bears to the total of current and anticipated future gross revenue forthat product or (b) the straight-line method over the remaining estimatedeconomic life of the software, generally four years.

 

(i) Business Combinations

 

TheCompany’s acquisitions are accounted for as purchase business combinations inaccordance with SFAS No. 141, *BusinessCombinations*, and SFAS No. 142, *Goodwill and Other Intangible Assets*. The Companyallocates the purchase price to tangible and intangible assets and records asgoodwill the excess of the purchase price over the fair value of theidentifiable net assets acquired. Intangible assets include trademarks, customer relationships, acquiredtechnology and covenants not to compete. Such intangible assets are amortizedon a straight-line basis over their estimated useful lives, which are generallyfour to seven years.

 

(j) Impairment of Long-Lived Assets

 

Long-lived assets, including property and equipment, goodwill and otherintangible assets are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount may not be fully recoverable.Conditions that would necessitate an impairment assessment include asignificant decline in the observable market value of an asset, a significantchange in the extent or manner in which an asset is used, or a significantadverse change that would indicate that the carrying amount of an asset orgroup of assets is not recoverable. The Company assesses impairment inaccordance with the requirements of SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. The Company assesses the impairment of goodwilland intangible assets in accordance with the provisions of SFAS No. 142, *Goodwill and Other Intangible Assets*. TheCompany determines the recoverability of the assets by comparing the carryingamount of the assets to net future cash flows that the asset is expected togenerate. The impairment recognized is the amount by which the carrying amountexceeds the fair market value of the asset.

 

(k) Revenue Recognition; Cost of Revenues; DeferredRevenue

 

*Media*

 

Media revenues aregenerated by delivering advertising impressions for a fixed fee to third-partyWeb sites. Agreements are primarily short-term and revenues are recognized asservices are delivered provided that no significant Company obligations remainoutstanding and collection of the resulting receivable is probable. The Companybecomes obligated to make payments to third-party Web sites which havecontracted with the Company, in the period the advertising impressions aredelivered. Such expenses are classified as cost of revenues in the accompanyingconsolidated statements of operations.

 

*Search*

 

Search revenues are derived from attracting clicks on clientadvertisers Web listings in search results. Agreements are primarily short-termand revenues are recognized as services are delivered provided that nosignificant Company obligations remain outstanding and collection of theresulting receivable is probable. The Company becomes obligated to makepayments to search engine distribution partners,

 

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which have contracted with the Company, in the period the clicks occur.Such expenses are classified as cost of revenues in the accompanyingconsolidated statements of operations.

 

In specific circumstances, when the Company provides search marketingservices as an agent for a fixed commission, or otherwise in transactionsin which it does not have principal risk and reward, the Company recognizesrevenue on a net basis.

 

*Technology*

 

Technology revenues are derived primarily from licensing of oursoftware, hosted advertisement serving, and software maintenance and technicalsupport services. Revenue from software licensing agreements is recognized inaccordance with SOP No. 97-2, *SoftwareRevenue Recognition*, and Staff Accounting Bulletin (“SAB”) No. 104,*Revenue Recognition*, upondelivery of the software, which is generally when the software is madeavailable for download, there is persuasive evidence of an arrangement,collection is reasonably assured, the fee is fixed or determinable, andvendor-specific objective evidence exists to allocate the total fees to allelements of the arrangement. Contracts that bundle the software license withmaintenance and technical support are recognized ratably over the contractterm. Revenue from advertisement serving is recognized upon delivery. Revenuefrom software maintenance and technical support contracts is recognized ratablyover the term of the agreement, which typically does not exceed one year.

 

Expenses from Technology revenues are primarily payroll costs incurredto deliver and support the software, hosting, bandwidth and license fees paidto third-party software vendors. These expenses are classified as cost ofrevenues in the accompanying consolidated statements of operations.

 

*Deferred Revenue*

 

Revenues that are billed or collected in advance of services beingcompleted are deferred until the conclusion of the period of the service forwhich the advance billing or collection relates. Deferred revenues are includedon the consolidated balance sheets as a current liability until the service isperformed and then recognized in the period in which the service is completed.The Company’s deferred revenues primarily consist of billings in advance forsoftware license subscriptions and software maintenance and technical supportservices.

 

(l) Stock-Based Compensation

 

The Company accounts for stock-based employee compensation arrangementsin accordance with provisions of Accounting Principles Board (“APB”) Opinion No. 25,“*Accounting for Stock Issued to Employees*,”and Financial Accounting Standards Board (“FASB”) interpretation No. 44, “*Accounting for Certain Transactions Involving Stock Compensation—aninterpretation of APB Opinion No. 25*,” and complies with thedisclosure provisions of SFAS No. 123, “*Accountingfor Stock-Based Compensation*” and SFAS No. 148, “*Accounting for Stock-Based Compensation—Transition and Disclosure*.”Under APB No. 25, compensation cost is recognized based on the difference,if any, on the date of grant between the fair value of the Company’s commonstock and the amount an employee must pay to acquire the common stock. SFAS No. 148requires more prominent and more frequent disclosures in both interim andannual financial statements about the method of accounting for stock-basedcompensation and the effect of the method used on reported results. We adoptedthe disclosure provisions of SFAS No. 148 as of December 31, 2002 andcontinue to apply the measurement provisions of APB No. 25.

 

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Had the Company determined compensation cost based on the fair value atthe grant date for its stock options under SFAS No. 123, the Company’s netincome (loss) would have been adjusted to the pro forma amounts indicatedbelow:

 
| ** **                                                                                                                           | ** ** | **Three Months Ended  June 30,**         | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                                      | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                           | ** ** | **(in thousands, except per share  amounts)** | ** ** |
| Net income  (loss) attributable to common stockholders:                                                                              |       |                                          |       |                                |       |   |   |   |   |
| As reported                                                                                                                          |       | $                                             | (200       | )                                   | $          | 1,487 |   | $ | (618 | ) | $ | 977 |   |
| Deduct:  Total stock-based employee compensation expense determined under  fair-value-based method for all awards, net of tax effect |       | (1,428                                        | )          | (1,400                              | )          | (2,916 | ) | (3,168 | ) |
| Pro forma                                                                                                                            |       | $                                             | (1,628     | )                                   | $          | 87 |   | $ | (3,534 | ) | $ | (2,191 | ) |
|                                                                                                                                 |       |                                          |       |                                |       |   |   |   |   |
| Basic net  income (loss) per share attributable to common stockholders:                                                              |       |                                          |       |                                |       |   |   |   |   |
| As reported                                                                                                                          |       | $                                             | —     |                                | $          | 0.04 |   | $ | (0.01 | ) | $ | 0.03 |   |
| Pro forma                                                                                                                            |       | (0.04                                         | )          | —                              |       | (0.08 | ) | (0.07 | ) |
|                                                                                                                                 |       |                                          |       |                                |       |   |   |   |   |
| Diluted net  income (loss) per share attributable to common stockholders:                                                            |       |                                          |       |                                |       |   |   |   |   |
| As reported                                                                                                                          |       | $                                             | —     |                                | $          | 0.04 |   | $ | (0.01 | ) | $ | 0.03 |   |
| Pro forma                                                                                                                            |       | (0.04                                         | )          | 0.01                                |       | (0.08 | ) | (0.05 | ) |

 

The per share weighted-average fair value of stockoptions granted during the three and six month periods ended June 30, 2005was $3.04 and $2.50, respectively, and was $5.77 and $4.83 for the three andsix month periods ended June 30, 2004, respectively, on the date of grantusing the Black-Scholes method with the following weighted average assumptions:

 
| ** **                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                      |       |                                  |       |                                |       |   |   |   |   |
| Expected  dividend yield  |       | 0                                     | %          | 0                                   | %          | 0 | % | 0 | % |
| Risk-free  interest rate  |       | 3.33                                  | %          | 2.59                                | %          | 3.05 | % | 2.30 | % |
| Expected  life (in years) |       | 3.0                                   |       | 3.0                                 |       | 2.5 |   | 2.6 |   |
| Volatility                |       | 124                                   | %          | 136                                 | %          | 103 | % | 132 | % |

 

In December 2004, the FASB issued the revisedSFAS No. 123, *Share-Based Payment*(“SFAS 123R”), which addresses the accounting for share-based paymenttransactions in which the Company obtains employee services in exchange for (a) equityinstruments of the Company or (b) liabilities that are based on the fairvalue of the Company’s equity instruments or that may be settled by theissuance of such equity instruments. Under SFAS 123R, the Company is requiredto report expensing of stock options and other equity awards issued toemployees and directors as of the first interim or annual reporting periodbeginning after June 15, 2005. However, the Securities and ExchangeCommission (“SEC”) amended the compliance dates to the next fiscal year after June 15,2005 (January 1, 2006 for the Company).

 

SFAS 123R applies to all awards granted or modifiedafter the effective date. In addition, compensation cost for the unvestedportion of previously granted awards that remain outstanding on the effectivedate

 

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shall be recognized on or after the effective date,as the related services are rendered, based on the awards’ grant-date fairvalue as previously calculated for the pro-forma disclosure under SFAS 123.

 

The Company expects that upon the adoption of SFAS123R it will apply the modified prospective application transition method, aspermitted by the statement. Under such transition method, upon the adoption ofSFAS 123R, the Company’s financial statements for periods prior to theeffective date of the statement will not be restated.

 

(m) Restructuring Estimates

 

Restructuring activities are accounted for in accordancewith SFAS No. 146, *Accounting For CostsAssociated with Exit or Disposal Activities*. Restructuring-relatedliabilities include estimates for, among other things, involuntary terminationsof employees and disposition of lease obligations. Key variables in determiningsuch estimates include timing of sublease rentals, estimates of sublease rentalpayment amounts and tenant improvement costs, and estimates for brokerage andother related costs. The Company periodically evaluates and, if necessary,adjusts the estimates based on currently available information.

 

(n) Warrant Liability

 

Warrant liability is presented in accordance withEITF 00-19, *Accounting for DerivativeFinancial Instruments Indexed To, And Potentially Settled In, a Company’s OwnStock*. EITF 00-19 requires freestanding contracts that are settledin a Company’s own stock, including common stock warrants, to be designated asan equity instrument, asset or liability. Under the provisions of EITF 00-19, acontract designated as an asset or a liability must be carried at fair valueuntil exercised or expired, with any changes in fair value recorded in theresults of operations. A contract designated as an equity instrument must beincluded within equity, and no fair value adjustments are required. Theclassification of a contract should be reviewed at each balance sheet date.

 

(o) Basic and Diluted Net Income (Loss) Per Share

 

Netincome (loss) per share is presented in accordance with the provisions of SFAS No. 128,*Earnings Per Share* (“EPS”). BasicEPS excludes dilution for potentially dilutive securities and is computed bydividing income (loss) available to common shareholders by the weighted averagenumber of common shares outstanding for the period. Diluted EPS reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock were exercised or converted into common stock and resulted in theissuance of common stock. Potential common shares consist of incremental commonshares issuable upon the exercise of stock options and warrants (using thetreasury stock method), the conversion of subordinated convertible debenturesand preferred stock (using the if-converted method) and the vesting ofrestricted stock.

 

Diluted EPS is equal tobasic EPS for the three and six month period ended June 30, 2005 since allpotentially dilutive securities are antidilutive. The computation of net lossper share for the three and six month periods ended June 30, 2005 excludesoutstanding options of 7.9 million to purchase shares of common stock, theeffects of 0.6 million shares issuable upon the exercise or conversion ofcommon stock warrants, 0.4 million shares issuable upon the conversion ofpreferred stock, 1.7 million shares issuable upon the conversion of thesubordinated convertible debentures, and 0.9 million shares of unvestedrestricted stock, since their inclusion would have an antidilutive effect.

 

The computation ofdiluted net income per share for the three and six month period ended June 30,2004 excludes outstanding options of approximately 2.2 million to purchaseshares of common stock and the

 

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effects of 0.4 millionshares issuable upon the exercise or conversion of common stock warrants, sincetheir inclusion would have an antidilutive effect.

 

**NOTE 3 - ACQUISITIONS AND UNAUDITED PRO FORMA SUMMARY**

 

(a) Acquisition of Decide Holdings Pty Limited(“Decide”)

 

OnAugust 19, 2004, the Company completed its acquisition of Decide, aleading provider of search engine marketing in Australia and Europe. Theacquisition combined our global audience and Decide’s search technology toallow the Company to create a more relevant, comprehensive and higher qualitysearch offering. Pursuant to the acquisition agreements, the Company acquiredall of the outstanding shares of Decide for $15.0 million in cash,approximately 4.5 million shares of its common stock, valued at $12.6 million,and approximately $1.1 million in transaction fees. Additionally, the Companyis required to pay up to an additional $2.5 million in cash and issue $7.5million in shares of common stock (up to a maximum of 2.3 million shares) tothe selling shareholders of Decide if Decide achieves certain performancetargets.

 

Thepurchase price in excess of fair value of net tangible liabilities assumed of$28.8 million has been allocated as follows: $20.0 million to goodwill and $8.8million to intangible assets.

 

Ofthe $8.8 million of intangible assets, $1.1 million was assigned to trademarksthat are not subject to amortization. The remaining $7.7 million of intangibleassets have a weighted-average useful life of approximately five years. Theintangible assets that make up that amount include acquired technology of $6.6million (five year weighted-average useful life), customer relationships of$1.0 million (five year weighted-average useful life) and non-competeagreements of $0.1 million (two year weighted-average useful life).

 

The$20.0 million of goodwill was assigned to the Search segment and of thatamount, none is deductible for tax purposes.

 

Thenet tangible liabilities assumed consist of the following:

 

| **Asset / Liability**      | ** ** | **Amount** | ** ** |
|----------------------------|------------|------------|------------|
|                       |       |       |       |
| Cash and  cash equivalents |       | $          | 305        |   |
| Other  current assets      |       | 1,692      |       |
| Fixed assets               |       | 616        |       |
| Other assets               |       | 180        |       |
| Accrued liabilities        |       | (2,838     | )          |
| Long-term  liabilities     |       | (21        | )          |
|                       |       | $          | (66        | ) |

 

(b) Acquisition of Real Media Korea (“RMK”)

 

On January 6, 2004, the Company completed its acquisition of RMK,a leader in interactive marketing in the Republic of South Korea, by acquiringthe approximately 90.4% of the outstanding shares of RMK that the Company didnot already own. The Company believes that the combined assets will further itsposition as a global leader in interactive marketing. The Company paid totalconsideration of $20.1 million in exchange for the RMK shares, whichconsisted of $5.0 million in cash, approximately

 

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2.1 million shares of the Company’s common stock valued at$14.6 million and approximately $0.5 million in transaction costs.Approximately 0.9% of the outstanding shares of RMK are held in an employeestock union established under Korean law. The employee shareholders agreed totransfer their RMK shares to the Company upon vesting in accordance with theterms and conditions of the stock union and Korean law. For accountingpurposes, the effective date of the acquisition is January 1, 2004. Therewas no material activity between the effective date and the acquisition date.In 2005, the Company changed the name of RMK to 24/7 Real Media, Inc.

 

The purchase price in excess of fair value of net tangible assetsacquired of $16.1 million has been allocated as follows: $11.9 million togoodwill and $4.2 million to intangible assets.

 

Ofthe $4.2 million of intangible assets, $0.7 million was assigned to trademarksthat are not subject to amortization. The remaining $3.5 million of intangibleassets have a weighted-average useful life of approximately six years. Theintangible assets that make up that amount include acquired technology of $0.5million (six year weighted-average useful life), customer relationships of $2.4million (seven year weighted-average useful life) and a non-compete agreementof $0.6 million (five year weighted-average useful life).

 

The$11.9 million of goodwill was assigned to the Media and Technology segments inthe amounts of $11.2 million and $0.7 million, respectively. Of that totalamount, none is deductible for tax purposes.

 

The net tangible assets acquired consist of the following:

 

| **Asset/ Liability**       | ** ** | **Amount** | ** ** |
|----------------------------|------------|------------|------------|
|                       |       |       |       |
| Cash and  cash equivalents |       | $          | 3,469      |   |
| Other  current assets      |       | 5,151      |       |
| Fixed assets               |       | 170        |       |
| Non-current  assets        |       | 384        |       |
| Accrued  liabilities       |       | (5,159     | )          |
|                       |       | $          | 4,015      |   |

 

(c) Unaudited ProForma Summary

 

The results of operationsof Decide and RMK have been included in the Company’s consolidated statementsof operations since the completion of the acquisitions. The following unauditedpro forma information presents a summary of the results of operations of theCompany assuming the acquisitions of Decide and RMK at the beginning of eachperiod presented:

 

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| ** **                                                                | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Six Months Ended  June 30, 2004** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                | ** ** | **(in thousands except per share  data)**  | ** ** |
|                                                                      |       |                                       |       |                                     |       |
| Total  revenue                                                            |       | $                                          | 21,256     |                                     | $          | 42,359 |   |
| Net income  attributable to common stockholders                           |       | 1,276                                      |       | 785                                      |       |
| Basic net  income attributable to common stockholders per share           |       | $                                          | 0.03       |                                     | $          | 0.02 |   |
| Weighted  average common shares used in basic per share calculation (1)   |       | 38,518,775                                 |       | 34,370,647                               |       |
| Diluted net  income attributable to common stockholders per share         |       | $                                          | 0.03       |                                     | $          | 0.03 |   |
| Weighted  average common shares used in diluted per share calculation (1) |       | 48,389,066                                 |       | 45,034,283                               |       |

 

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(1) Theweighted average shares used to compute pro forma basic and diluted net lossper share for the three and six month periods ended June 30, 2004 includethe 4.5 million and 2.1 million shares of common stock issued for Decide andRMK, respectively, as if the shares were issued at the beginning of each periodpresented.

 

The pro forma summary isnot necessarily indicative of the operating results that would have beenachieved had the transactions been in effect as of the beginning of the periodspresented and should not be construed as being representative of futureresults.

 

**NOTE 4 – BALANCE SHEET COMPONENTS**

 

(a) Short-termInvestments

 

Short-term investments as of June 30, 2005 and December 31,2004 consisted of $1.4 million and $2.1 million in certificate of deposits withoriginal maturities greater than three months from the balance sheet date,respectively, and $0.9 million and $1.8 million in available-for-salesecurities, respectively. Proceeds from the sale of marketable securities were$0.2 million for the six month period ended June 30, 2005 and realized gainswere immaterial. During 2005, the Company determined the decline in the marketvalue of the securities to be other-than-temporary and recorded a loss of $0.6million.  Subsequently, the price hascontinued to decline resulting in an additional unrealized loss of $0.1 millionat June 30, 2005 which is included in accumulated other comprehensiveincome on the consolidated balance sheet.

 

(b) Property and Equipment

 

As of June 30, 2005 and December 31, 2004,property and equipment included capitalized software of $0.2 million and $0.4million, respectively. Approximately $0.1 and $0.2 million was amortized duringthe three and six month periods ended June 30, 2005, respectively.

 

(c) Goodwill

 

The$34.6 million in goodwill as of June 30, 2005 and December 31,2004 related $20.0 million to Decide, $12.0 million to RMK,$1.1 million to 24/7 Canada (formerly ClickThrough), $1.1 million toReal Media and $0.4 million to 24/7 Search (formerly Website Results).

 

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(d) Intangible Assets, Net

 

The$11.1 million in intangible assets, net as of June 30, 2005 related $7.4million to Decide, $3.4 million to RMK and $0.3 million to Real Media. The $12.7 million in intangible assets,net as of December 31, 2004 related $8.2 million to Decide,$3.7 million to RMK and $0.8 million to Real Media.

 

**NOTE 5 – RESTRUCTURING**

 

Duringthe first quarter of 2005, the Company recorded a restructuring charge of $1.0 million relatingto its former New York headquarters.

 

Thefollowing sets forth the activities in the Company’s restructuring reserve forthe six month period ended June 30, 2005, which is included in accruedliabilities in the consolidated balance sheet (in thousands):

 
| ** **                     | ** ** | **Beginning  Balance** | ** ** | **Current Year  Provision** | ** ** | **Current Year  Utilization** | ** ** | **Ending Balance** | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------------|------------|-------------------------------|------------|--------------------|------------|
| Employee  termination benefits |       | $                      | 369        |                        | $          | —                        |       | $                  | 324        |   | $ | 45 |   |
| Office  closing costs          |       | 529                    |       | 973                         |       | 200                           |       | 1,302              |       |
|                           |       | $                      | 898        |                        | $          | 973                           |       | $                  | 524        |   | $ | 1,347 |   |

 

**NOTE 6 - 2% SUBORDINATED CONVERTIBLE DEBENTURES**

 

On September 26,2003, the Company completed the placement to an institutional accreditedinvestor of $15.0 million of subordinated convertible debentures due September 2006(“Debentures”). The Debentures are convertible into shares of the Company’scommon stock at $8.75 per share. Interest on the Debentures at the rate of 2%is due semi-annually starting in January 2004. The investor also acquireda five-year warrant (the “Warrants”) to purchase 0.4 million shares of theCompany’s common stock at $9.5685 per share.

 

The maturity date of theDebentures is subject to extension, and the conversion price is subject toadjustment, on the terms and conditions set forth in the Debentures. Inaddition, the Company may elect to pay the principal of and interest on theDebentures in shares of its common stock rather than cash. If the Companyelects to pay the principal amount due under the Debentures at maturity inshares of its common stock, rather than in cash, the maturity date conversionprice will be equal to 90% of the average of the daily volume-weighted averageprices of the Company’s common stock on the Nasdaq SmallCap Market for thefifteen consecutive trading days immediately preceding the maturity date. Ifthe Company elects to make interest payments due under the Debentures in sharesof its common stock, rather than in cash, the interest conversion price will beequal to 90% of the average of the daily volume-weighted average prices of theCompany’s common stock on the Nasdaq SmallCap Market for the five consecutivetrading days immediately preceding the interest payment date. Interest expenseon the debentures amounted to approximately $0.1 million and $0.2 millionfor each of the three and six month periods ended June 30, 2005 and 2004.

 

Additionally, if thespecific conditions set forth in the Debentures are satisfied, the Company mayrequire the holder to convert the Debentures into shares of the Company’scommon stock, at the conversion rate then in effect, or the Company may prepaythe Debentures prior to the maturity date, for an amount in cash equal to 150%of the amount prepaid. In addition, if at any time on or after the secondanniversary of the initial issuance date, the weighted average price of thecommon stock is less than $8.75 on any five

 

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consecutive trading daysafter such second anniversary, the holder shall have the right, in its solediscretion, to require that the Company redeem up to $7.5 million principalamount of these Debentures in cash, which are being classified as short-termdebt on the consolidated balance sheet. The redemption right constitutes an embedded derivative. The value ofthis embedded derivative at June 30, 2005 is immaterial to the financialposition of the Company. The Company reviews the value of the derivative on aquarterly basis, in accordance with SFAS No. 149, *Amendment of Statement 133 on DerivativeInstruments and Hedging Activities*.

 

The Company valued theWarrants at $1.8 million using a Black-Scholes pricing model with thefollowing factors: risk free interest rate of 1.48%, volatility of 143%,dividend yield of 0% and a life of 2.5 years. The aggregate fair marketvalue of the Warrants was reflected as a reduction of the face amount of theDebentures on the consolidated balance sheet and is being amortized over threeyears, the initial term of the Debentures, using the effective interest method.Accordingly, the carrying value of the Debentures will be increased over theinitial term. Pursuant to EITF Issue No. 00-19, since the effectiveregistration of the securities underlying the warrants was an event outside thecontrol of the Company, the Company recorded the fair value of the warrants aslong-term liabilities. In connection with the amendment to the registrationrights agreement entered into during 2004, the Company reclassified the valueof the warrants (approximately $1.0 million) on the amendment date toadditional paid in capital. Interest expense attributable to the amortizationof the warrants amounted to approximately $0.1 million and $0.3 millionfor each of the three and six month periods ended June 30, 2005 and 2004.

 

In connection with theissuance of the Debentures and Warrants, the Company incurred placement agentfees, legal fees and other expenses of approximately $1.2 million to bepaid in cash. In addition to the placement fees, the Company issued warrants tothe placement agent. The warrants to purchase 86,000 shares of common stock atan exercise price of $10.068 are in the same form and on the same terms andconditions as the Warrants issued to the investor. The Company included thevalue of the warrants, $0.4 million, using the factors above, and the cashplacement fees of $1.2 million in other assets on the consolidated balancesheet. Collectively, the debt issuance costs of $1.6 million are beingamortized over three years, the initial term of the Debentures. For each of thethree and six month periods ended June 30, 2005 and 2004, approximately$0.1 million and $0.2 million of the deferred financing costs are included inamortization expense.

 

**NOTE 7 -****EQUITY INSTRUMENTS**

 

(a) Preferred Stock

 

In the six month periodended June 30, 2005, 25,000 shares of Series C Preferred Stock wereconverted into 0.2 million shares of the Company’s common stock. Preferredshares outstanding at June 30, 2005 were 53,000 shares.

 

The Company’s preferredstock accrue and cumulate dividends at a rate of 6% per year, compoundedmonthly, payable when, as and if declared by the Company’s Board of Directors.Accordingly, the accrued dividends are reflected as “Preferred stock dividends”on the consolidated statements of operations. Accrued dividends must be paidbefore any dividends may be declared or paid on the common stock, and shall bepaid as an increase in the liquidation preference of the preferred stockpayable upon a sale, merger, liquidation, dissolution or winding up of theCompany. Accrued but unpaid dividends are cancelled upon conversion of thepreferred stock. As of June 30, 2005, there are approximately$0.1 million of accrued but unpaid dividends.

 

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(b) Common Stock

 

*Additional Paid-in Capital*

 

*During the six month period ended June 30, 2005, theCompany’s additional paid-in capital increased by $1.2 million primarily due to$1.0 million in stock-based compensation issued to employees and $0.2 millionfrom exercise of stock options.*

* *

**NOTE 8 - STOCK INCENTIVE PLANS**

 

*In January 2005, the Company entered into agreements togrant 1.7 million shares, subsequently adjusted to 1.5 million shares forforfeitures, of restricted stock to certain employees. Approximately 0.9million will be granted and vested annually over a three year period contingentupon employment with the Company on the vesting dates. Approximately 0.6million will be granted and vested contingent upon the attainment of aperformance milestone of the Company’s stock. In accordance with APB 25,no expense related to these shares is recorded until the Company’s pricereaches the milestone. If the Company’s stock price reaches themilestone, the Company will incur approximately $6.1 million in stock-basedcompensation expense.*

* *

For the six month period ended June 30, 2005, the Company granted4.0 million stock options under the 2002 Stock Incentive Plan to employees atexercise prices based on the fair market value of the Company’s common stock atthe respective dates of grant.

 

On January 1, 2005, in accordance with the terms of the 2002 StockIncentive Plan, shares reserved for issuance under the Plan were increased by0.6 million.

 

**NOTE 9 – RECOVERY OF INVESTMENT**

 

In January 2005, the Company received $2.1 million as a return oninvestment in Bidland. The return on investment was a result of the settlementof pending litigation between Bidland and Telefonica S.A. and the subsequentliquidation of Bidland. A portion of the settlement proceeds have been retainedby Bidland until all tax issues are resolved at which time any remainingproceeds will be distributed. The Company does not expect future distributions,if any, to be material. In 2000, Bidland ceased operations and, accordingly,the Company recorded an impairment charge related to the cost-based investment.

 

**NOTE 10 -****SUPPLEMENTAL CASH FLOWINFORMATION**

 

Inthe six month period ended June 30, 2005, the Company paid $1.1 millionfor computer equipment capitalized at December 31, 2004.

 

Forthe six month periods ended June 30, 2005 and 2004, the amount of cashpaid for interest was $0.2 million and $0.1 million, respectively.

 

**NOTE 11 – SEGMENTS**

 

TheCompany’s business is comprised of three reportable segments: Media, Search andTechnology. As a result of the Company’s acquisition of Decide in August 2004,the Company is reporting Search as a

 

18

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separatesegment from Media. The Company measures segments based on segment income(loss) from operations. The Company adjusted prior period segment disclosuresto conform to the current presentation. The summarized segment information atand for the three and six month periods ended June 30, 2005 and 2004, isas follows:

 
| ** **                                                           | ** ** | **Three Month Period Ended June 30, 2005**        | ** ** | **Six Month Period Ended June 30, 2005** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                           | ** ** | **Media**                                              | ** ** | **Search**                                    | ** ** | **Technology** | ** ** | **Total** | ** ** | **Media** | ** ** | **Search** | ** ** | **Technology** | ** ** | **Total** | ** ** |
| ** **                                                           | ** ** | **(in thousands)**                                     | ** ** | **(in thousands)**                            | ** ** |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues                                                             |       | $                                                      | 16,684     |                                          | $          | 11,710 |   | $ | 5,492 |   | $ | 33,886 |   | $ | 30,913 |   | $ | 21,332 |   | $ | 10,711 |   | $ | 62,956 |   |
| Depreciation                                                         |       | 117                                                    |       | 166                                           |       | 437 |   | 720 |   | 242 |   | 340 |   | 736 |   | 1,318 |   |
| Amortization of intangible assets and deferred  financing costs      |       | 495                                                    |       | 395                                           |       | 249 |   | 1,139 |   | 990 |   | 790 |   | 499 |   | 2,279 |   |
| Stock-based compensation                                             |       | 140                                                    |       | 119                                           |       | 182 |   | 441 |   | 269 |   | 297 |   | 388 |   | 954 |   |
| Restructuring                                                        |       | —                                                 |       | —                                        |       | — |   | — |   | 252 |   | 228 |   | 493 |   | 973 |   |
| Segment income (loss) from operations                                |       | 851                                                    |       | (464                                          | )          | (417 | ) | (30 | ) | 579 |   | (1,675 | ) | (857 | ) | (1,953 | ) |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ** **                                                           | ** ** | **Three Month Period Ended June 30,  2004 ** | ** ** | **Six Month Period Ended June 30, 2004** | ** ** |
| ** **                                                           | ** ** | **Media**                                              | ** ** | **Search**                                    | ** ** | **Technology** | ** ** | **Total** | ** ** | **Media** | ** ** | **Search** | ** ** | **Technology** | ** ** | **Total** | ** ** |
| ** **                                                           | ** ** | **(in thousands)**                                     | ** ** | **(in thousands)**                            | ** ** |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues                                                             |       | $                                                      | 12,358     |                                          | $          | 2,533 |   | $ | 4,706 |   | $ | 19,597 |   | $ | 22,381 |   | $ | 5,549 |   | $ | 9,048 |   | $ | 36,978 |   |
| Depreciation                                                         |       | 156                                                    |       | 41                                            |       | 260 |   | 457 |   | 358 |   | 95 |   | 492 |   | 945 |   |
| Amortization of intangible assets and deferred  financing costs      |       | 869                                                    |       | 216                                           |       | 329 |   | 1,414 |   | 1,112 |   | 432 |   | 658 |   | 2,202 |   |
| Stock-based compensation                                             |       | 132                                                    |       | 68                                            |       | 98 |   | 298 |   | 323 |   | 76 |   | 98 |   | 497 |   |
| Restructuring                                                        |       | 136                                                    |       | 97                                            |       | 268 |   | 501 |   | 136 |   | 97 |   | 268 |   | 501 |   |
| Segment loss from operations                                         |       | (1,117                                                 | )          | (661                                          | )          | (211 | ) | (1,989 | ) | (1,518 | ) | (1,415 | ) | (274 | ) | (3,207 | ) |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total assets:**                                                    |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| June 30, 2005                                                   |       | $                                                      | 70,429     |                                          | $          | 41,491 |   | $ | 10,236 |   | $ | 122,156 |   |   |   |   |   |   |   |   |   |
| December 31, 2004                                               |       | 72,910                                                 |       | 36,849                                        |       | 11,639 |   | 121,398 |   |   |   |   |   |   |   |   |   |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ** **                                                           | ** ** | **United**                                             | ** ** | **United**                                    | ** ** | **South** | ** ** | **Other-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                           | ** ** | **States**                                             | ** ** | **Kingdom**                                   | ** ** | **Korea** | ** ** | **International** | ** ** | **Total** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                           | ** ** | **(in thousands) **                               | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues for the three month period period ended June 30,  2005 |       | $                                                      | 15,364     |                                          | $          | 7,178 |   | $ | 3,501 |   | $ | 7,843 |   | $ | 33,886 |   |   |   |   |   |   |   |
| Revenues for the six month period period ended June 30,  2005   |       | 29,232                                                 |       | 13,309                                        |       | 5,860 |   | 14,555 |   | 62,956 |   |   |   |   |   |   |   |
| Long-lived assets as of June 30, 2005                           |       | 12,216                                                 |       | 665                                           |       | 16,152 |   | 29,636 |   | 58,669 |   |   |   |   |   |   |   |
|                                                                 |       |                                                   |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues for the three month period ended June 30,  2004        |       | $                                                      | 9,947      |                                          | $          | 2,912 |   | $ | 3,365 |   | $ | 3,373 |   | $ | 19,597 |   |   |   |   |   |   |   |
| Revenues for the three month period ended June 30,  2004        |       | 18,370                                                 |       | 6,192                                         |       | 6,517 |   | 5,899 |   | 36,978 |   |   |   |   |   |   |   |
| Long-lived assets as of December 31, 2004                       |       | 11,603                                                 |       | 351                                           |       | 16,512 |   | 30,432 |   | 58,898 |   |   |   |   |   |   |   |

 

**NOTE 12 - COMMITMENTS AND CONTINGENCIES**

 

(a) Commitments

 

*Lycos, Inc. Services Agreements*

 

On February 11, 2004, the Company entered into a five-yeararrangement with Lycos, Inc. (“Lycos”), including an advertising servicesagreement to provide media sales, a technology services agreement to provideadvertisement serving and analytics technology services to Lycos’ U.S. Webproperties, and a transition services agreement to transition personnel andother services to the Company. The Company and Lycos amended the advertisingservices agreement and the technology services agreement on December 7,2004 and, as amended, Lycos effectively may terminate the media servicesagreement on January 1, 2007.

 

The amended media services agreement provides that Lycos will have theexclusive right to sell advertising, and for the billing and collection of alladvertising, on Wired.com and Quote.com, on July 1,

 

19

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2005and January 1, 2006, respectively. On or prior to the respective transition dates, the Company willidentify twenty advertising accounts (“24/7 Accounts”) to which it has soldadvertising on Wired.Com and Quote.com.

 

Theagreement provides that Lycos will pay the Company transition commissions basedon advertising sales revenue minus bad debt (“net advertising sales revenue”)as follows:

 

•                  35%of net advertising sales revenue generated from the 24/7 Accounts on Wired.comfor each of July and August 2005, payable on or prior to October 15,2005, provided that the transition commission is capped at 35% of the averagemonthly gross revenues generated from the 24/7 Accounts during the period from January 1,2005 to June 30, 2005;

 

•                  17.5%of net advertising sales revenue generated from the 24/7 Accounts on Wired.comfor each of September and October 2005, payable on or prior to December 15,2005, provided that the transition commission is capped at 17.5% the averagemonthly gross revenues generated from the 24/7 Accounts during the period from January 1,2005 to June 30, 2005;

 

•                  35%of net advertising sales revenue generated from the 24/7 Accounts on Quote.comfor each of January and February 2006, payable on or prior to April 15,2006, provided that the transition commission is capped at 35% of the averagemonthly gross revenues generated from the 24/7 Accounts during the period from July 1,2005 to December 31, 2005; and

 

•                  17.5%of net advertising sales revenue generated from the 24/7 Accounts on Quote.comfor each of March and April 2006, payable on or prior to June 15,2006, provided that the transition commission is capped at 17.5% of the averagemonthly gross revenues generated from the 24/7 Accounts during the period from July 1,2005 to December 31, 2005.

 

Theamended media services agreement reconciled past royalty payments and requiresthe Company to pay quarterly royalties for advertising inventory made availableby Lycos as follows:

 

•                  Inceptionthrough December 31, 2004: $6.2 million, which was paid in installmentsof $5.7 million in 2004 and $0.5 million in February 2005;

 

•                  January 1,2005 through March 31, 2005: 65% of net advertising sales revenue;

 

•                  April 1,2005 through June 30, 2005: 65% of the greater of (i) of netadvertising sales revenue generated during the period and (ii) the minimumcost-per-thousand (“CPM”) revenue for such period;

 

•                  July 1,2005 through December 31, 2005: 62.5% of the greater of (i) of netadvertising sales revenue generated during the period and (ii) the minimumCPM revenue for such period; and

 

•                  January 1,2006 through the expiration or termination of the media services agreement:62.5% of net advertising sales revenue.

 

Pursuant to the mediaservices agreement minimum CPM revenue is determined on a quarterly basis by multiplyingLycos’ projected advertisement impression level for that quarter by specificCPM prices for advertising inventory in specific category and unit types.

 

20

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In addition to the royalties, the Company paid Lycosa $4.5 million transition fee which the Company recorded as an other assetand is amortizing the fee over the term of the agreement of five years.Amortization related to the transition fee was $0.2 million and $0.5 millionfor each of the three and six month periods ended June 30, 2005 and 2004.In accordance with SFAS 144, the Company periodically evaluates therecoverability of this asset.

 

*Acquisition Earn-Out Payments*

 

The Company has contingent obligations related toour acquisitions of Decide. Decide stockholders may receive up to an additional$10.0 million, in a combination of cash and common stock, subject toachievement of earn-out targets relating to Decide’s operating performance in2005.

 

*Indemnifications*

 

Whilethe Company has various indemnification obligations included in contracts inthe normal course of business, these indemnities do not represent significantcommitments or contingent liabilities of the indebtedness of others.Accordingly, the Company has not recorded a liability related toindemnification provisions.

 

(b) Litigation

 

The Company is involved in various claims and legal actions arising inthe ordinary course of business. In the opinion of management, the ultimatedisposition of these matters will not have a material effect on the Company’sfinancial position, results of operations or liquidity.

 

*Litigation with Brian Anderson*

 

On July 15, 2001, Brian Anderson, former Chief Executive Officerof our AwardTrack, Inc. subsidiary, served the Company with notice of alawsuit filed in Superior Court for the State of California in and for theCounty of Santa Cruz, alleging breach of contract, fraud, intentionalinfliction of emotional distress and breach of fiduciary duty, in connectionwith the acquisition of AwardTrack and subsequent events. The Company removedthe lawsuit to federal court in California and moved to dismiss the complaintin its entirety. The motion was granted in part, with leave to amend, anddenied in part. The plaintiff subsequently refiled the complaint and theCompany filed a counterclaim. In June 2005, the Company settled with Mr. Andersonfor the release of all claims and termination of all litigation matters.

 

21

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS

 

This report includesforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. This Act provides a “safe harbor” forforward-looking statements to encourage companies to provide prospectiveinformation about themselves so long as they identify these statements asforward looking and provide meaningful cautionary statements identifyingimportant factors that could cause actual results to differ from the projectedresults. All statements other than statements of historical fact, includingstatements regarding industry prospects and future results of operations orfinancial position, made in this Quarterly Report are forward looking. We usewords such as “anticipates,” “believes,” “expects,” “future” and “intends” andsimilar expressions to identify forward-looking statements. Forward-lookingstatements reflect management’s current expectations, plans or projections andare inherently uncertain. Our actual results may differ significantly frommanagement’s expectations, plans or projections. Readers are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date hereof. Certain risks and uncertainties that could cause our actualresults to differ significantly from management’s expectations are described inthe section entitled “Factors that Could Affect Future Results” andelsewhere in this Quarterly Report. We undertake no obligation to publiclyrelease any revisions to these forward-looking statements that may be made toreflect events or circumstances after the date hereof or to reflect theoccurrence of unanticipated events. Readers are urged, however, to review therisk factors set forth in reports that we file from time to time with theSecurities and Exchange Commission. Unless the context requires otherwise inthis Quarterly Report the terms “24/7 Real Media,” the “Company,” “we,” “us”and “our” refer to 24/7 Real Media, Inc. and its subsidiaries, andreferences to “24/7 Search” refer to 24/7 Search, Inc., formerly 24/7Website Results, Inc., and Decide Holdings Pty Limited, each a whollyowned subsidiary of 24/7 Real Media, Inc.

 

### **GENERAL**

###  

24/7 Real Media is apioneer in the Internet industry, providing online advertising and searchmarketing strategies since 1995. We have three distinct lines ofbusiness, Media, Search and Technology, and operate in over a dozen countries.Our 24/7 Media business helps advertisers increase their reach through sophisticatedtargeting and a network of more than 800 Web sites.  24/7 Search enables marketers to maximizetheir search engine marketing spend and achieve optimum return on investment.Our 24/7 Technology business develops and licenses our powerful technology,which serves as the underlying engine for everything we do.

 

*Media*

 

We sell advertising space for Web publishers through the 24/7 WebAlliance, a network of Web sites with brand names, quality content and globalreach. Web publishers join the 24/7 Web Alliance to increase advertisingrevenues from the available advertising space on their Web sites. We solicitadvertisers seeking online strategies to target audiences, build their brandsand generate customer response. Advertisers purchase space through the 24/7 WebAlliance to make one purchase across several Web sites and to increase thereturn on their advertising spending. We also use targeting technology to bestselect advertising space made available in the 24/7 Web Alliance and to improvethe performance of under-utilized advertising space for Web publishers.

 

We generate Media revenue from fees paid by client advertisers foradvertising space. We typically sell advertising space on acost-per-thousand-impressions (“CPM”) basis, enabling a client advertiser topay a fee based on the number of times its advertisement is viewed. Wetypically count an advertising impression each time a user’s Web browserrequests our computer servers to transmit an advertisement.

 

22

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We may charge higher CPMs to advertisers that purchase ouradvanced targeting solutions, such as our behavioral targeting solution, incomparison to those that purchase advertising space that requires less advancedtargeting.

 

We pay Web publishers included in the 24/7 Web Alliance a royalty fortheir advertising space. The royalty generally does not exceed 65% of the grossadvertising revenue we generate from a Web publisher’s advertising space, butmay be more if a Web publisher’s advertising space is viewed by a larger orbetter quality audience, among other factors.

 

On a very limited basis, we have generated revenue from e-mailadvertisements and marketing.

 

*Search*

 

We provide search marketing services that connect advertisers withconsumers using search engines to find information, products and services. Weleverage our relationships and understanding of search engine algorithms tohelp advertisers optimize their Web pages and achieve better placement inalgorithmic search engines. We also create Web site listings for advertisersand submit their listings into the databases of pay-for-placement (“P4P”) andpaid-inclusion (“PI”) search engine platforms. We help advertisers determinethe keywords most relevant to their products and services and use advanced technologyto manage keyword bidding simultaneously across P4P search platforms. Ourtechnology shows advertisers which keywords lead users from search engines totheir Web sites and helps them optimize advertising spending to convertclick-throughs into sales.

 

We generate Search revenue primarily fromcost-per-click (“CPC”) fees paid by client advertisers when search engine usersclick-through to their Web sites as a result of Web site listings submitted byus into search engine databases. To a lesser extent, we also generate revenuefrom fees paid by advertisers for consulting services and search engineoptimization services and from fees paid by search engines that employ us tooptimize the relevancy of Web site listings and report on advertising campaignsfor their advertisers. We develop direct relationships with P4P and algorithmicsearch engines in order to enhance the services we provide to our clientadvertisers. We refer to search engines we work with as search enginedistribution partners.

 

*Technology*

 

We provide online advertisement serving and analytics software tocustomers from software hosted locally on the customers’ servers or fromsoftware hosted centrally on our servers. Our technology products and servicesare all based on our proprietary Open AdSystem platform. We generate Technologyrevenue in the following ways:

 

*Open AdStream Central Service.*We charge service fees to Web publishers for operating our Open AdStream (“OAS”)online advertisement serving software centrally from our servers. We typicallycharge a service fee determined by multiplying an agreed CPM by the number ofadvertising impressions served using OAS. The service fee may vary based on theforecasted number of advertising impressions a Web publisher will serve usingour software, the use of advanced software modules and the term, among otherfactors. Service fees typically are billed monthly.

 

*Open AdStream Local Software.* Wecharge fees to Web publishers for operating our OAS software locally from theirown servers. Our license agreements typically provide for a license fee,software maintenance and technical support services fee and a training fee. Weoften base license fees on the forecasted number of advertising impressions aWeb publisher will serve using our software, the use of advanced softwaremodules and the license term.

 

23

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*Open Advertiser Service.* Wecharge service fees to advertisers and agencies for operating our OpenAdvertiser (“OAD”) advertisement serving software centrally from our servers.Our service is determined by multiplying the CPM by the number of advertisingimpressions delivered. Service fees typically are billed monthly.  The service fee may vary based on the forecastednumber of advertising impressions a Web publisher will serve using oursoftware, the use of advanced software modules and the term, among otherfactors. In the fourth quarter of 2004, we made the strategic decision tointegrate OAD functionalities into OAS. As a result, we expect OAD servicerevenue to decline.

 

*Insight XE Software and Service.*  OurInsight XE solution offers Web publishers active campaign reporting andmarketing intelligence and helps advertisers measure, analyze and manage onlineaudiences. We charge service fees to Web publishers for operating our XEsoftware centrally on our servers. Our service fee is determined by multiplyingan agreed CPM by the number of page views measured by our Insight XEsoftware.

 

*Insight ACT Software.* Our Insight ACT software, which requiresour OAS and Insight XE software solutions, enables Web publishers to identifyand target segments of their audiences based on user activity. We generaterevenue from Insight Act on the same basis as the associated OAS and Insight XEarrangements. As of June 30, 2005, we have not generated significantrevenue from Insight ACT.

 

To a lesser extent, we generate revenue by providingprofessional services charged at an hourly rate and from fees paid by Webpublishers for trafficking their advertisements. Trafficking advertisementsrefers to entering advertisement creative material and campaign specificationsinto our OAS software.

 

# **RESULTS OF OPERATIONS**

#  

### Thefollowing table compares the results of operations for the three and six monthperiods ended June 30, 2005 to the results of operations for the three andsix month periods ended June 30, 2004 (in thousands):

 

24

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| ** **                                                      | ** ** | **Three Months Ended June 30,** | ** ** | ** **      | ** ** | **Six Months Ended June 30,** | ** ** | ** **      | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------|------------|-----------------|------------|------------------------------------|------------|-----------------|------------|
| ** **                                                      | ** ** | **2005**                             | ** ** | **2004**        | ** ** | **$ Var**                     | ** ** | **2005**        | ** ** | **2004** | ** ** | **$ Var** | ** ** |
| ** **                                                      | ** ** | **(unaudited)**                      | ** ** | **(unaudited)** | ** ** | ** **                         | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Revenues:                                                       |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Media                                                           |       | $                                    | 16,684     |            | $          | 12,358                             |       | $               | 4,326      |   | $ | 30,913 |   | $ | 22,381 |   | $ | 8,532 |   |
| Search                                                          |       | 11,710                               |       | 2,533           |       | 9,177                              |       | 21,332          |       | 5,549 |   | 15,783 |   |
| Technology                                                      |       | 5,492                                |       | 4,706           |       | 786                                |       | 10,711          |       | 9,048 |   | 1,663 |   |
| Total  revenues                                                 |       | 33,886                               |       | 19,597          |       | 14,289                             |       | 62,956          |       | 36,978 |   | 25,978 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Cost of  revenues:                                              |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Media                                                           |       | 11,327                               |       | 8,823           |       | 2,504                              |       | 20,954          |       | 15,806 |   | 5,148 |   |
| Search                                                          |       | 7,747                                |       | 1,664           |       | 6,083                              |       | 14,379          |       | 4,122 |   | 10,257 |   |
| Technology                                                      |       | 1,177                                |       | 879             |       | 298                                |       | 2,169           |       | 1,701 |   | 468 |   |
| Total cost  of revenues                                         |       | 20,251                               |       | 11,366          |       | 8,885                              |       | 37,502          |       | 21,629 |   | 15,873 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Gross profit                                                    |       | 13,635                               |       | 8,231           |       | 5,404                              |       | 25,454          |       | 15,349 |   | 10,105 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Operating  expenses:                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Sales and  marketing                                            |       | 5,731                                |       | 3,893           |       | 1,838                              |       | 11,021          |       | 7,209 |   | 3,812 |   |
| General and  administrative                                     |       | 4,988                                |       | 3,019           |       | 1,969                              |       | 9,572           |       | 6,001 |   | 3,571 |   |
| Product  development                                            |       | 1,366                                |       | 1,095           |       | 271                                |       | 2,608           |       | 2,146 |   | 462 |   |
| Amortization  of intangible assets and deferred financing costs |       | 1,139                                |       | 1,414           |       | (275                               | )          | 2,279           |       | 2,202 |   | 77 |   |
| Stock-based  compensation                                       |       | 441                                  |       | 298             |       | 143                                |       | 954             |       | 497 |   | 457 |   |
| Restructuring  costs                                            |       | —                               |       | 501             |       | (501                               | )          | 973             |       | 501 |   | 472 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Total  operating expenses                                       |       | 13,665                               |       | 10,220          |       | 3,445                              |       | 27,407          |       | 18,556 |   | 8,851 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Loss from  operations                                           |       | (30                                  | )          | (1,989          | )          | 1,959                              |       | (1,953          | )          | (3,207 | ) | 1,254 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Interest  expense, net                                          |       | (54                                  | )          | (96             | )          | 42                                 |       | (142            | )          | (278 | ) | 136 |   |
| Change in  fair value of warrant liability                      |       | (110                                 | )          | 881             |       | (991                               | )          | 40              |       | 1,809 |   | (1,769 | ) |
| Recovery of  investment                                         |       | —                               |       | —          |       | —                             |       | 2,100           |       | — |   | 2,100 |   |
| Impairment  of marketable securities                            |       | —                               |       | —          |       | —                             |       | (588            | )          | — |   | (588 | ) |
| Gain on sale  of maketable securities                           |       | 7                                    |       | —          |       | 7                                  |       | 7               |       | — |   | 7 |   |
| Gain on  legal settlement                                       |       | —                               |       | 2,896           |       | (2,896                             | )          | —          |       | 2,896 |   | (2,896 | ) |
| Other income  (expense), net                                    |       | 6                                    |       | (69             | )          | 75                                 |       | (40             | )          | 111 |   | (151 | ) |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Income  (loss) before provision for income taxes                |       | (181                                 | )          | 1,623           |       | (1,804                             | )          | (576            | )          | 1,331 |   | (1,907 | ) |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Provision  for income taxes                                     |       | (9                                   | )          | (32             | )          | 23                                 |       | (20             | )          | (132 | ) | 112 |   |
|                                                            |       |                                 |       |            |       |                               |       |            |       |   |   |   |   |
| Net income  (loss)                                              |       | $                                    | (190       | )               | $          | 1,591                              |       | $               | (1,781     | ) | $ | (596 | ) | $ | 1,199 |   | $ | (1,795 | ) |

 

**Revenues; Cost of Revenuesand Gross Profit**

** **

*Media*

 

*Revenue*. We generateMedia revenue primarily from our 24/7 Web Alliance. 24/7 Web Alliance revenuewas $16.7 million and $30.9 million for the three and six month periods ended June 30,2005, respectively, as compared to $12.4 million and $22.4 million for thethree and six month periods ended June 30, 2004, respectively, an increaseof 35.0% and 38.1%, respectively. The increase is primarily related to anincrease in advertising impressions sold. The number of advertising impressionsdelivered through the 24/7 Web Alliance increased from approximately 14.3billion in 2004 to 21.8 billion in 2005.

 

*Cost Of Revenues*.****Mediacost of revenues consisted primarily of fees paid to Web publishers in our 24/7Web Alliance. Cost of revenues also included advertisement serving costs, whichis an intercompany charge from the Technology segment based on a fixed CPM.

 

Gross Profit. Gross profit margins for Media were32.1% and 32.2% for the three and six month periods ended June 30, 2005,respectively, and 28.6% and 29.4% for the three and six month periods ended June 30,2004, respectively. The increase is a result of the increase in the number anddiversity of Web publishers in the 24/7 Network which has decreased the averageroyalty percentage paid to Web publishers and an increase in run of networkcampaigns delivered. Advertisement serving costs were $0.4 million and $0.8million for the three and six month periods ended June 30, 2005,respectively, representing 3.6% and 4.0% of total Media cost of revenues,respectively.

 

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Advertisement serving costs were $0.3 million and$0.6 million for the three and six month periods ended June 30, 2004,respectively, representing 3.6% and 3.9% of total Media cost of revenues,respectively.

 

*Search*

 

*Revenue*. Search revenue was $11.7 million and $21.3million for the three and six month periods ended June 30, 2005,respectively, as compared to $2.5 million and $5.5 million for the three andsix month periods ended June 30, 2004, respectively, an increase of 362.3%and 284.4% respectively.  The increase isdue to the use of the Decide DNA technology acquired in August 2004 acrossall of our accounts as well as the additional advertiser accounts from theacquisition. In addition, the growth in the Search marketplace leads to growthin the businesses of our search engine distribution partners.  We also believe the foregoing factors,combined with our sales efforts and improved operational controls, havecontributed to an increase in the average revenue per account.

 

*Cost Of Revenues*. Search cost of revenues consisted primarilyof fees paid to our search engine distribution partners, which are calculatedas a percentage of revenues for algorithmic search engines and a fixed CPC forpay-for-placement search engines. Search cost of revenues also included hostingand bandwidth charges associated with the infrastructure.

 

*Gross Profit*.Gross profit margins for Search were 33.8% and 32.6% for the three and sixmonth periods ended June 30, 2005, respectively, and 34.3% and 25.7% forthe three and six month periods ended June 30, 2004, respectively. Theincrease was due to a change in product mix primarily as a result of theaddition of high margin optimization services for both advertisers and searchengine distribution partners acquired with Decide.

 

*Technology*

 

*Revenue*.****Technologyrevenue was $5.5 million and $10.7 million for the three and six month periodsended June 30, 2005, as compared to $4.7 million and $9.0 million for thethree and six month periods ended June 30, 2004, respectively,representing an increase of 16.7% and 18.4%, respectively. The increaseprimarily reflects expanded usage by customers of Open AdStream Central andusage by new customers. In particular, Open AdStream Central delivered 42.8billion paid impressions in 2005, up from 19.1 billion in the same period in2004.

 

*Cost of Revenues*.Technology cost of revenues consisted of costs for hosting, bandwidth,third-party license and support fees, support and maintenance of theinfrastructure, including salaries and benefits of related technical personnel.The cost of revenues is offset by fees charged to our Media segment for advertisementserving.

 

*Gross Profit*.Gross profit margins for Technology remained consistent at approximately 78.6%and 79.7% in the three and six month periods ended June 30, 2005,respectively, and 81.3% and 81.2% for the three and six month periods ended June 30,2004, respectively. The decrease is due to an increase in hosting and bandwidthcosts as a result of increased usage.

 

**Sales and Marketing Expenses**

 

Sales and marketing expenses consisted primarily of compensation andpersonnel related expenses for sales, account management, business development,affiliate relations and marketing; and marketing costs such as advertising,trade shows and public and investor relations firms.

 

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Salesand marketing expenses were $5.7 million and $11.0 million for the three andsix month periods ended June 30, 2005, respectively, and $3.9 million and$7.2 million for the three and six month periods ended June 30, 2004,respectively. The increase was primarily due to additional personnel-relatedcosts and an increase in marketing activities. Sales and marketing expenses decreased as apercentage of revenue from 19.9% to 16.9% for the three month periods ended June 30,2004 and 2005, respectively, and from 19.5% to 17.5% for the six month periodsended June 30, 2004 and 2005, respectively, as we were able to gainoperating leverage. The number of employees included in sales and marketingincreased from 141 at June 30, 2004 to 195 at June 30, 2005.

 

**General and Administrative Expenses**

 

General and administrative expenses consisted primarily of compensationand related expenses for executive and administrative personnel; costs relatedto leasing, maintaining and operating our facilities and systems; insurance;bad debts; fees for professional services; fees associated with the reportingand other obligations of a public company; depreciation and other general andadministrative services. Fees for professional services included payments toexternal lawyers, accountants, and other professionals in connection withoperating our business, compliance and evaluating and pursuing newopportunities.

 

Generaland administrative expenses were $5.0 million and $9.6 million for the threeand six month periods ended June 30, 2005, respectively, and $3.0 millionand $6.0 million for the three and six month periods ended June 30, 2004.The increase was due primarily to an increase in employee headcount from 47 at June 30,2004 to 58 at June 30, 2005 and increased compliance costs. As apercentage of revenue, the expenses decreased from 15.4% to 14.7% for the threemonth periods ended June 30, 2004 and 2005, respectively, and from 16.2%to 15.2% for the six month period ended June 30, 2004 and 2005,respectively, showing increased leverage of these expenses over a largerrevenue base.

 

**Product Development Expenses**

 

Product development expenses consisted primarily of compensation andrelated expenses for personnel responsible for the development and maintenanceof features, enhancements and functionality and quality assurance for oursoftware and services and development of new products.

 

Productdevelopment expenses were $1.4 million and $2.6 million for the three and sixmonth periods ended June 30, 2005, respectively, and $1.1 million and $2.2million for the three and six month periods ended June 30, 2004,respectively. The number of employees included in product developmentincreased from 40 at June 30, 2004 to 44 at June 30, 2005.

 

**Amortization of Intangible Assets and DeferredFinancing Costs**

 

Amortizationexpense relates to intangible assets acquired with 24/7 Search in August 2000,Real Media in October 2001, Insight First in January 2003, RMK in January 2004and Decide in August 2004; deferred financing costs associated with thesubordinated convertible debenture offering in September 2003; and thetransition payment to Lycos in February 2004.

 

Forthe six month period ended June 30, 2005, amortization expense related$1.2 million to acquired technology, $0.4 million to other intangible assets, $0.2million to deferred financing costs and $0.5 million to the transition paymentto Lycos. For the six month period ended June 30, 2004, amortizationexpense related $1.1 million to acquired technology, $0.5 million to otherintangible assets, $0.3 million to deferred financing costs and $0.3 million tothe transition payment to Lycos.

 

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**Stock-Based Compensation**

 

Stock-basedcompensation was $0.4 million and $0.9 million for the three and six monthperiods ended June 30, 2005, respectively. Stock-based compensation in2005 related primarily to the amortization of deferred compensation forrestricted shares to be issued to certain employees. Stock-based compensationin 2004 consisted of $0.3 million accrued for potential performance incentivesand $0.2 million in amortization of deferred compensation for restricted sharesissued to certain employees.

 

**Restructuring Costs**

 

Duringthe three month period ended March 31, 2005, we recorded a restructuring charge of $1.0 million relatingto our former New York headquarters.

 

Duringthe second quarter of 2004, the Company took additional steps to align itssales, development and administrative organization and reduce corporateoverhead to position itself for profitable growth in the future. This involvedthe involuntary termination of approximately seven employees, as well ascharges for excess real estate space, primarily at our Germany office. TheCompany recorded a restructuring charge of approximately $0.5 million.

 

**Interest Expense, Net**

 

Interestexpense, net relates to our long-term debt and capital lease obligations offsetby interest income related to our cash and cash equivalents. Interest expensein both years primarily related to subordinated convertible debentures issuedon September 26, 2003 of which a portion of the interest incurred relatesto a cash payment due and a portion related to the amortization of warrantsissued with the debentures. Interest expense in both periods was offset byinterest income from cash in overnight deposits and money market accounts.

 

**Change in Fair Value of Warrant Liability**

 

Ourliability relates to warrants outstanding from our preferred stock andsubordinated convertible debenture offerings and is adjusted to fair value atthe end of each reporting period. The gain for the six month period ended June 30,2005 is due to a decrease in the fair value of the warrants outstanding whichreduced the corresponding liability. The decrease in the fair value wasprimarily due to the lower fair market value of our stock compared to when thewarrants were issued.

 

**Recovery of Investment**

 

In January 2005, we received $2.1 million as areturn on investment in Bidland. The return on investment was a result of thesettlement of pending litigation between Bidland and Telefonica S.A and thesubsequent liquidation of Bidland. A portion of the settlement proceeds havebeen retained by Bidland until all tax issues are resolved at which time anyremaining proceeds will be distributed. We do not expect future distributions,if any, to be material. In 2000, Bidland ceased operations and, accordingly, werecorded an impairment charge related to the cost-based investment.

 

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**Impairment of Marketable Securities**

 

Duringthe first quarter of 2005, we wrote down our available-for-sale investment inchinadotcom and recognized an impairment charge of approximately$0.6 million for other-than-temporary declines in the value of theinvestment.

 

**Gain on Sale of Marketable Securities**

 

Inthe second quarter of 2005, the Company sold 65,000 shares of its chinadotcomcommon stock, which resulted in proceeds of approximately $0.2 million and arealized gain of $7,000.

 

**Gain on Legal Settlement**

 

The$2.9 million for the six month period ended June 30, 2004 related to ourlegal settlement with chinadotcom corporation received in the form of 0.4million shares of chinadotcom common stock, valued at the market price on thedate of settlement.

 

**Other Income (Expense), Net**

 

Otherincome (expense), net in 2005 primarily relate to legal fees associated with aformer subsidiary that was shut down. The amount in 2004 primarily related toamounts recovered from a former subsidiary that was shut down.

 

**Dividends On Preferred Stock**

 

### Ourpreferred stock accrue and accumulate dividends at a rate of 6% per year,compounded monthly, payable when, as and if declared by our Board of Directors.All accrued dividends must be paid before any dividends may be declared or paidon the common stock, and shall be paid as an increase in the liquidationpreference of the preferred stock payable upon a sale, merger, liquidation,dissolution or winding up of the Company. Accrued but unpaid dividends cancelupon conversion of the preferred stock.

###  

**LIQUIDITY AND CAPITAL RESOURCES**

 

Cash flow for the six month periods ended June 30,2005 and 2004 were as follows (in thousands):

 

| ** **                                           | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                           | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Net cash  provided by (used in) operating activities |       | $                                  | 1,776      |   | $ | (4,767 | ) |
| Net cash used  in investing activities               |       | $                                  | (934       | ) | $ | (2,777 | ) |
| Net cash  provided by financing activities           |       | $                                  | 127        |   | $ | 37,927 |   |

 

Sinceour inception we have financed our operations through equity financings andlong-term debt. Net cash provided by operating activities was $1.8 millionduring the six month period ended June 30, 2005. We used approximately$4.8 million of cash in operating activities during the six month period ended June 30,2004. Cash provided by (used in) operating activities is generally as a resultof our net operating losses, adjusted for certain non-cash items included inour operating results as well as changes in various components of workingcapital, particularlyaccounts receivable. We generally pay our search engine distributionpartners and some of our Web sites in advance of receiving paymentsfrom our customers.

 

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Netcash used in investing activities was approximately $0.9 million during the sixmonth period ended June 30, 2005. Investing activities in the six monthperiod ended June 30, 2005 consisted of $0.6 million of proceeds frommaturities of short-term investments, $0.2 million of proceeds from the sale ofmarketable securities and $2.1 million from the recovery of an investmentoffset by $3.8 million in capital expenditures for operational purposes. Netcash used in investing activities was approximately $2.8 million during the sixmonth period ended June 30, 2004. Investing activities during the sixmonth period ended June 30, 2004 related $2.0 million to the acquisitionof RMK and $0.8 million to capital expenditures for general operationalpurposes.

 

Financingactivities provided $0.1 million and $37.9 million in the six month periodsended June 30, 2005 and 2004, respectively. Financing activities duringthe six month period ended June 30, 2005 related to proceeds from exerciseof common stock options. Financing activities during the six month period endedJune 30, 2004 primarily related $37.4 million to net proceeds from oursecondary offering of common stock and $0.6 million to the exercise of stockoptions.

 

On September 26, 2003, we completed the placement to aninstitutional accredited investor of $15.0 million of subordinatedconvertible debentures due September 2006 (“Debentures”). If at any timeon or after September 26, 2005, the second anniversary of the initialissuance date, the weighted average price of our common stock is less than$8.75 on any five consecutive trading days after such second anniversary, theholder has the right, in its sole discretion, to require that we redeem up to$7.5 million principal amount of the Debentures in cash. Management believesthe holder may exercise its right to require redemption. Management believesexisting cash and investments will be sufficient to meet the obligation toredeem should the holder exercise its right.

 

Wecontinue to increase capital expenditures and operating lease commitments,which is consistent with our increased staffing and operational expansion, andwe anticipate this will continue in the future as business conditionsmerit. Additionally, we will continue to evaluate possible acquisitionsof, or investments in businesses, products, and technologies that arecomplementary to our business, which may require the use of cash. Managementbelieve existing cash and investments will be sufficient to meet operatingrequirements for at least the next twelve months; however, we may selladditional equity or debt securities or obtain credit facilities to furtherenhance our liquidity position. The sale of additional securities could resultin further dilution to our stockholders.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

We did not have any relationships with unconsolidated entities orfinancial partnerships, such as entities often referred to as structuredfinance or special purpose entities, which would have been established for thepurpose of facilitating off-balance sheet financial arrangements or othercontractually narrow or limited purposes at June 30, 2005. Accordingly, weare not materially exposed to any financing, liquidity, market or credit riskthat could arise if we had engaged in such relationships.

 

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**CRITICAL ACCOUNTING POLICIES**

 

Ourconsolidated financial statements are prepared in conformity with accountingprinciples generally accepted in the United States of America. As such, we arerequired to make certain estimates, judgments and assumptions that managementbelieves are reasonable based upon the information available. These estimates,judgments and assumptions affect the reported amounts of assets and liabilitiesand the disclosure of contingent assets and liabilities at the dates of theconsolidated financial statements and the reported amounts of revenues andexpenses during the reporting periods.

 

Thesignificant accounting policies which we believe are the most critical to aidin fully understanding and evaluating the reported consolidated financialresults include the following:

 

***Revenue Recognition; Cost ofRevenues***

*** ***

*Media*

 

Our Media revenues are generated from fees paid by client advertisersfor advertising impressions. We typically offer advertisers a pricing modelbased on CPM, which enables client advertisers to pay a fee based on the numberof times its advertisement is viewed. Agreements are primarily short-term andrevenues are recognized as services are delivered provided that no significantobligations remain outstanding and collection of the resulting receivable isprobable. We become obligated to make royalty payments to Web sites that havecontracted with us, in the period the advertising impressions or e-mails aredelivered. Such expenses are classified as cost of revenues in the consolidatedstatements of operations.

 

*Search*

 

We generate revenue from our Search segment primarily from fees paid byclient advertisers when users click-through to their Web sites as a result ofour submission of their Web site listings into search engines databases. To alesser extent, we also generate revenue from fees paid by search engines thatemploy us to optimize the submission of Web site listings and report onadvertising campaigns for their advertisers. Agreements are primarilyshort-term and revenues are recognized as services are delivered provided thatno significant obligations remain outstanding and collection of the resultingreceivable is probable. We become obligated to make payments to search enginedistribution partners, which have contracted us, in the period the clicks aredelivered. Such expenses are classified as cost of revenues in the consolidatedstatements of operations. In specific circumstances, when we provide searchmarketing services as an agent for a fixed commission or otherwise intransactions in which we do not have principal risk and reward, we recognizerevenue on a net basis.

 

*Technology*

 

Our Technology revenues are derived primarily from licensing oursoftware, hosted advertisement serving, and software maintenance and technicalsupport services. Revenue from software licensing agreements is recognized inaccordance with Statements of Position (“SOP”) No. 97-2, *Software Revenue Recognition*, and StaffAccounting Bulletin (“SAB”) No. 104, *RevenueRecognition*, upon delivery of the software, which is generally whenthe software is made available for download, there is persuasive evidence of anarrangement, collection is reasonably assured, the fee is fixed ordeterminable, and vendor-specific objective evidence exists to allocate thetotal fees to all elements of the arrangement. Contracts that bundle thesoftware license with software maintenance and technical support are recognizedratably over the contract term. Revenue from advertisement serving isrecognized upon delivery. Revenue from software maintenance and technicalsupport contracts is recognized ratably over the life of the agreement, whichtypically does not exceed one year.

 

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Expenses related to our Technology revenues are primarily payroll costsincurred to deliver and support the software, hosting, bandwidth and licensefees paid to third-party software vendors. These expenses are classified ascost of revenues in the consolidated statements of operations.

 

*Deferred Revenue*

 

Revenues that are billed or collected in advance of services beingcompleted are deferred until the conclusion of the period of the service forwhich the advance billing or collection relates. Deferred revenues are includedon the consolidated balance sheets as a current liability until the service isperformed and then recognized in the period in which the service is completed.Our deferred revenues primarily consist of billings in advance for softwarelicense subscriptions and software maintenance and technical support services.

 

**Allowance for Doubtful Accounts;Sales Allowance**

 

We maintain an allowance for doubtful accounts to reserve forpotentially uncollectible receivables and a sales allowance to reserve forpotential credits issued to customers. The allowances are estimates calculatedbased on an analysis of current business and economic risks, customercredit-worthiness, specific identifiable risks such as bankruptcies,terminations or discontinued customers, or other factors that may indicate apotential loss.

 

**Valuation of Goodwill, IntangibleAssets and Long-Lived Assets**

 

Effective January 1, 2002, we adopted Statement of FinancialStandards (“SFAS”) No. 142, *Goodwilland Other Intangible Assets* and SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. SFAS 142 eliminates the amortization ofgoodwill and indefinite-lived intangible assets, addresses the amortization ofintangible assets with finite lives and addresses impairment testing andrecognition for goodwill and intangible assets. SFAS No. 144 establishes asingle model for the impairment of long-lived assets.

 

Goodwill and intangible assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount may not befully recoverable. Conditions that would necessitate an impairment assessment includea significant decline in the observable market value of an asset, a significantchange in the extent or manner in which an asset is used, or a significantadverse change that would indicate that the carrying amount of an asset orgroup of assets is not recoverable. For long-lived assets to be held and used,the Company recognizes an impairment loss only if its carrying amount is notrecoverable through its undiscounted cash flows and measures the impairmentloss based on the difference between the carrying amount and fair value.Long-lived assets held for sale are reported at the lower of cost or fair valueless costs to sell.

 

**Business Combinations**

 

Ouracquisitions are accounted for as purchase business combinations in accordancewith SFAS No. 141, *BusinessCombinations*, and SFAS No. 142, *Goodwill and Other Intangible Assets*. We allocate thepurchase price of tangible and intangible assets, and record as goodwill, theexcess of purchase price over the fair value of the identifiable net assetsacquired. Intangible assets include trademarks, customer relationships,acquired technology and covenants not to compete. Such intangible assets areamortized on a straight-line basis over their estimated useful lives, which aregenerally four to seven years.

 

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**Contingencies and Litigation**

 

We evaluate contingent liabilities including threatened or pendinglitigation in accordance with SFAS No. 5, *Accountingfor Contingencies*, and record accruals when the outcome of thesematters is deemed probable and the liability is reasonably estimable. We makethese assessments based on the facts and circumstances and in some instancesbased in part on the advice of outside legal counsel.

 

**Restructuring Activities**

 

Restructuring activities are accounted for inaccordance with SFAS No. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*.Restructuring-related liabilities include estimates for, among other things,involuntary terminations of employees and disposition of lease obligations. Keyvariables in determining such estimates include timing of sublease rentals,estimates of sublease rental payment amounts and tenant improvement costs, andestimates for brokerage and other related costs. The Company periodicallyevaluates and, if necessary, adjusts the estimates based on currently availableinformation.

 

**Short-Term Investments**

 

SFAS 115, *Accountingfor Certain Investments in Debt and Equity Securities*, andSecurities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”)59, *Accounting for Non-current MarketableEquity Securities,*provide guidance on determining when aninvestment is other-than-temporarily impaired. Investments are reviewedquarterly for indicators of other-than-temporary impairment. This determinationrequires significant judgment. In making this judgment, we evaluate, amongother factors, the duration and extent to which the fair value of an investmentis less than its cost; the financial health of the investee; and our intent andability to hold the investment. Investments with an indicator are furtherevaluated to determine the likelihood of a significant adverse effect on thefair value and amount of the impairment as necessary. If market, industryand/or investee conditions deteriorate, we may incur future impairments.

 

**MARKET FOR COMPANY’S COMMON EQUITY**

 

We have notdeclared or paid any dividends on our capital stock since our inception and donot anticipate paying dividends in the foreseeable future. Our current policyis to retain earnings, if any, to finance the expansion of our business. Inaddition, our subordinated convertible debentures restrict our ability to paycash dividends on our capital stock. The future payment of dividends willdepend on the results of operations, financial condition, capital expenditureplans and other factors that we deem relevant and will be at the solediscretion of our Board of Directors.

 

Since our initialpublic offering on August 13, 1998 until June 2002, our common stocktraded on the NASDAQ National Market under the symbol “TFSM.”  In June 2002, we transferred our commonstock to the NASDAQ SmallCap Market, where it currently trades under that samesymbol.

 

**FACTORS THAT COULD AFFECT FUTURERESULTS**

 

Because of the following factors, as well as othervariables affecting our operating results, past financial performance may notbe a reliable indicator of future performance, and historical trends should notbe used to anticipate results or trends in future periods.

 

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**RISKSRELATED TO 24/7 REAL MEDIA, INC.**

 

WE HAVE A HISTORY OF LOSSES AND MAY NEVERACHIEVE PROFITABILITY.

 

We have not achieved profitability in accordance with generallyaccepted accounting principles, or GAAP, in any reporting period in ourhistory, except as the result of non-recurring gains, and we may not be able toachieve or sustain profitability in the future. We incurred net losses of $0.2million and $0.6 million for the three and six month periods ended June 30,2005. We may incur net losses for the foreseeable future. Even if we do achieveprofitability, we may not sustain profitability on a consistent basis in thefuture.

 

WE HAVE SUBSTANTIAL DEBT, AND WE MAY NOT GENERATE SUFFICIENT CASHFLOW TO MEET OUR DEBT SERVICE AND REPAYMENT OBLIGATIONS.

 

In September 2003, we issued to a single holder a 2% subordinatedconvertible debenture in the principal amount of $15.0 million thatmatures in September 2006. The amount of our debt could have importantconsequences, including:

 

•                  impairingour ability to obtain additional financing for working capital, capitalexpenditures, acquisitions or general corporate purposes;

 

•                  requiringus to dedicate a substantial portion of any operating cash flow that wegenerate to paying principal and interest on indebtedness, thereby reducing thefunds available for operations;

 

•                  limitingour ability to grow and make capital expenditures due to the covenantscontained in our debt arrangements;

 

•                  impairingour ability to adjust rapidly to changing market conditions, invest in new ordeveloping technologies, or take advantage of significant businessopportunities that may arise;

 

•                  placingus at a competitive disadvantage compared to our competitors that have lessdebt; and

 

•                  makingus more vulnerable if there is an economic downturn or if our businessexperiences difficulties.

 

If we cannot generate sufficient additional cash flow, we may not beable to meet our debt service obligations, repay our debt when due, or complywith other covenants in the subordinated convertible debentures. If we breachthe debentures, the investor could require repayment of all amounts owed, andwe may not have sufficient cash reserves to repay such amounts.

 

WE MAY BE UNABLE TO RAISE THE FUNDS NECESSARY TO REPAY OR REFINANCEOUR INDEBTEDNESS. THE ISSUANCE OF STOCK UPON REDEMPTION OF OUR SUBORDINATEDCONVERTIBLE DEBENTURES MAY SUBSTANTIALLY DILUTE THE INTERESTS OF OTHERSECURITY HOLDERS.

 

We are obligated to make semi-annual interest payments on January 1and July 1 of each year and the entire principal face amount of thedebentures is due and payable on September 26, 2006. We may elect to payinterest in cash, in shares of our common stock or in additional debentures. Wemay elect to repay the principal amount of the debentures in cash or in sharesof our common stock. If we so elect, payment in shares shall be based upon 90%of the average of the volume weighted average price of our common

 

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stock on the principal market as reported by Bloomberg Financial L.P.during the five trading days immediately prior to the interest payment date, inthe case of an interest payment, or during the 15 trading days immediatelyprior to the maturity date, in the case of the repayment of the principalamount of the debentures. Stockholders could experience substantial dilutionresulting from our election to pay the semi-annual accrued interest due incommon stock or repay the principal amount in common stock. In addition, if, atany time after September 26, 2005, the price of our common stock does notexceed the conversion price ($8.75 per share of our common stock) of thedebentures for any five trading days we may be required to immediatelyrepurchase $7.5 million in principal amount of the debentures in cash.

 

If we repay any principal in cash we may need additional capital tofund this obligation. Our ability to arrange financing and the cost of thisfinancing will depend upon many factors, including: general economic andcapital market conditions generally, and in particular the non-investment gradedebt market; credit availability from banks or other lenders; investorconfidence in our industry generally and our company specifically; andprovisions of tax and securities law that are conducive to raising capital. Ifwe need additional funds and are unable to raise them, our inability to raisethem will have an adverse effect on our operations. If we decide to raiseadditional funds by incurring debt, we may become subject to additional or morerestrictive financial covenants and ratios.

 

WE MAY NEED TO RAISE ADDITIONAL FUNDS TO CONTINUE OPERATIONS.

 

An unforeseen reduction in our revenues, an unexpected impairment ofour receivables, or an unbudgeted increase in expenses or capital expendituresmay require us to raise additional funds to continue operations. To the extentwe encounter additional opportunities to raise cash, we may sell additionalequity or debt securities, which would result in further dilution of ourstockholders. Stockholders may experience extreme dilution due to our currentstock price and the amount of financing we may need to raise and thesesecurities may have rights senior to those of holders of our common stock.Access to the capital markets has been unpredictable in the past, especiallyfor unprofitable companies such as ours. The amount of capital that a companysuch as ours is able to raise often depends on variables that are beyond ourcontrol, such as the share price of our stock and its trading volume. As a result,efforts to secure financing on terms attractive to us may not be successful,and we may not be able to secure additional financing on any terms.

 

OUR ACQUISITIONS, WHICH HAVE BEEN CRITICAL TO OUR GROWTH, MAY NOTBE SUCCESSFUL AND COULD AFFECT OUR ABILITY TO PROJECT RESULTS.

 

We were formed in February 1998 to consolidate three Internetadvertising companies and have since acquired many other companies. We maycontinue pursuing selective acquisitions of businesses, technologies andproduct lines as a key component of our growth strategy. If we acquireadditional companies, we will continue to face risks of integrating andimproving our financial and management controls, advertisement servingtechnology, reporting systems and procedures, and expanding, training andmanaging our work force. This process of integration may take a significantperiod of time and will require the dedication of management and otherresources, which may distract management’s attention from our other operations.Any future acquisition or investment may result in the use of significantamounts of cash, potentially dilutive issuances of equity securities,incurrence of debt and amortization expenses related to intangible assets. Inaddition, acquisitions involve numerous risks, including:

 

•                  thedifficulties in the integration and assimilation of the operations,technologies, products and personnel of an acquired business;

 

•                  thediversion of management’s attention from other business concerns;

 

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•                  theavailability of favorable acquisition financing for future acquisitions; and

 

•                  thepotential loss of key senior managers or employees of any acquired business.

 

Our inability to successfully integrate any acquired company, orfailure to achieve any expected synergies, could adversely affect our business.

 

OUR FUTURE REVENUES AND RESULTS OF OPERATIONS MAY BE DIFFICULT TOFORECAST AND RESULTS IN PRIOR PERIODS MAY NOT BE INDICATIVE OF FUTURERESULTS.

 

At times in the past and in certain segments, our revenues have grownsignificantly and also have decreased during certain periods and in certainsegments. Accurate predictions of future revenues are difficult because of therapid changes in our markets.

 

Our results of operations have fluctuated and may continue to fluctuatesignificantly in the future as a result of a variety of factors, many of whichare beyond our control. These factors include:

 

•                  theaddition of new or loss of existing clients;

 

•                  changesin fees paid by advertisers or other clients;

 

•                  changesin royalties payable by us to owners of Web sites;

 

•                  thedemand by advertisers and Web publishers for our advertising solutions;

 

•                  theintroduction of new Internet marketing services by us or our competitors;

 

•                  variationsin the levels of capital or operating expenditures and other costs relating tothe maintenance or expansion of our operations, including personnel costs;

 

•                  seasonality,which generally results in lower revenue for the Company in the first and thirdquarter of each year;

 

•                  changesin results of operations brought about by newly acquired businesses, which maybe exceedingly difficult to predict due to management’s lack of history withsuch businesses;

 

•                  changesin governmental regulation of the Internet; and

 

•                  generaleconomic conditions.

 

Our future revenues and results of operations may be difficult toforecast due to the above factors. In addition, our expense levels are based inlarge part on our investment plans and estimates of future revenues. Anyincreased expenses may precede or may not be followed by increased revenues, aswe may be unable to, or may elect not to, adjust spending in a timely manner tocompensate for any unexpected revenue shortfall. As a result, we believe thatperiod-to-period comparisons of our results of operations may not bemeaningful.

 

OUR TECHNOLOGY SOLUTIONS MAY NOT FUNCTION AS DESIGNED AND MAY CAUSEBUSINESS DISRUPTION.

 

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Open AdSystem is our proprietary advertisement serving technology thatserves as our sole advertisement serving solution. We have developed a varietyof products to work on or with this platform. Some of these products, such asInsight ACT has only recently been made widely available. We must, among otherthings, ensure that the technology will function efficiently at high volumes,interact properly with our database, offer the functionality demanded by ourcustomers and assimilate our sales and reporting functions. We must furthercomplete development of our beta products. This development effort could failtechnologically or could take more time than expected. Customers may becomedissatisfied by any system failure that interrupts our ability to provide ourservices to them, including failures affecting our ability to deliveradvertisements or report on advertisement delivery without significant delay.Sustained or repeated system failures would reduce the attractiveness of oursolutions to advertisers, advertising agencies and Web publishers and result incontract terminations, fee rebates and make-goods, thereby reducing ourrevenue. Our Media Solutions business utilizes our Open AdSystem technology,and thus any performance issues with Open AdSystem will also impact MediaSolutions. Slower response time or system failures may also result fromstraining the capacity of our deployed software or hardware due to an increasein the volume of advertising delivered through our servers. To the extent thatwe do not effectively address any capacity constraints or system failures, ourbusiness, results of operations and financial condition could be materially andadversely affected.

 

OUR REVENUE COULD DECLINE IF WE FAIL TO EFFECTIVELY MANAGE ADVERTISINGINVENTORY MADE AVAILABLE TO US AND OUR GROWTH COULD BE IMPEDED IF WE FAIL TOACQUIRE ACCESS TO NEW ADVERTISING INVENTORY.

 

Our success depends in part on our ability to effectively manageadvertising inventory made available to us. The Web publishers that list theirunsold advertising inventory with us are not bound by long-term contracts. Inaddition, Web publishers can change the amount of inventory they make availableto us at any time. If a Web publisher decides not to make advertising spacefrom its Web sites available to us, we may not be able to replace thisadvertising space with advertising space from other Web sites that havecomparable traffic patterns and user demographics quickly enough to fulfill ouradvertisers’ requests. This would result in lost revenue. We expect that ourcustomers’ requirements will become more sophisticated as the Web matures as anadvertising medium. If we fail to manage our existing advertising spaceeffectively to meet our customers’ changing requirements, our revenue coulddecline. Our growth also depends on our ability to expand our advertisinginventory. To attract new advertisers, we must maintain a consistent supply ofattractive advertising space. We intend to expand our advertising inventory byselectively adding to our network new Web publishers that offer attractivedemographics, innovative and quality content and large audiences. Our abilityto attract new Web publishers to our network and to retain Web publisherscurrently in our network will depend on various factors, some of which arebeyond our control. These factors include our ability to introduce new andinnovative product lines and services, our ability to efficiently manage ourexisting advertising inventory, our pricing policies and the cost-efficiency toWeb publishers of outsourcing all or part of their advertising sales. Inaddition, the number of competing intermediaries that purchase advertisinginventory from Web publishers continues to increase. The size of our inventorymay not increase or even remain constant in the future.

 

WE COULD LOSE CUSTOMERS OR ADVERTISING INVENTORY IF WE FAIL TO MEASUREIMPRESSIONS, CLICKS AND ACTIONS ON ADVERTISEMENTS IN A MANNER THAT ISACCEPTABLE TO OUR ADVERTISERS AND WEB PUBLISHERS.

 

We earn advertising revenue and make payments to Web publishers basedon the number of impressions, clicks and actions from advertisements deliveredon our network. Advertisers’ and Web publishers’ willingness to use ourservices and join our network will depend on the extent to which they perceiveour measurements of clicks to be accurate and reliable. Advertisers and Webpublishers often maintain their

 

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own technologies and methodologies for counting clicks, and from timeto time we have had to resolve differences between our measurements and theirs.Further, search advertisers are paying closer attention to allegations of clickfraud in the industry generally and have become more willing to inquire aboutor challenge click counts related to search marketing services.  Any significant dispute over the proper measurementof clicks or other user responses to advertisements could cause us to losecustomers or advertising inventory.

 

WE DISCLOSE PRO FORMA INFORMATION, WHICH MAY EXCLUDE ITEMS THATARE IMPORTANT TO AN INVESTOR’S UNDERSTANDING OF OUR RESULTS OF OPERATIONS.

 

We prepare and release quarterly unaudited financial statementsprepared in accordance with GAAP. We also disclose and discuss certain proforma and other non-GAAP information in the related earnings release andinvestor conference call. This pro forma financial information excludes or mayexclude certain special charges and other costs. We believe the disclosure ofthe pro forma financial information helps investors more meaningfully evaluatethe results of our ongoing operations. However, we urge investors to carefullyreview the GAAP financial information included as part of our Quarterly Reportson Form 10-Q, our Annual Reports on Form 10-K, and our quarterlyearnings releases, and to compare the GAAP financial information with the proforma financial results disclosed in our quarterly earnings releases andinvestor calls.

 

OUR NET OPERATING LOSS CARRYFORWARDS MAY BE LIMITED.

 

Due to the “change in ownership” provisions of the Internal RevenueCode, the availability of our net operating loss and credit carryforwards maybe subject to an annual limitation against taxable income in future periods,which could substantially limit the eventual utilization of thesecarryforwards.

 

WE COULD BE ADVERSELY AFFECTED BY AN IMPAIRMENT OF A SIGNIFICANT AMOUNTOF GOODWILL AND/OR INTANGIBLE ASSETS ON OUR BALANCE SHEET.

 

In the course of our operating history, we have acquired and disposedof numerous assets and businesses. Some of our acquisitions have resulted inthe recording of a significant amount of goodwill and/or intangible assets onour financial statements. The goodwill and/or intangible assets were recordedbecause the fair value of the net assets acquired was less than the purchaseprice. We may not realize the full value of the goodwill and/or intangibleassets. As such, we evaluate on at least an annual basis whether events andcircumstances indicate that all or some of the carrying value of goodwilland/or intangible assets are no longer recoverable, in which case we wouldwrite off the unrecoverable portion as a charge to our earnings.

 

To improve our operating performance, we may determine to acquire otherassets or businesses complementary to our business and, as a result, we mayrecord additional goodwill and/or intangible assets in the future. The possiblewrite-off of the goodwill and/or intangible assets could negatively impact ourfuture earnings. We will also be required to allocate a portion of the purchaseprice of any acquisition to the value of any intangible assets that meet thecriteria specified in the Statement of Financial Accounting Standards No. 141,“*Business Combinations*,” such asmarketing, customer or contract-based intangibles. The amount allocated tothese intangible assets could be amortized over a fairly short period. As aresult, our earnings and the market price of our common stock could benegatively affected.

 

THE SUCCESS OF OUR 24/7 SEARCH OPERATIONS DEPENDS ON A FEW SEARCHENGINE DISTRIBUTION PARTNERS, AND THE LOSS OF ONE OF THEM COULD RESULT IN ASUBSTANTIAL DECREASE IN OUR 24/7 SEARCH REVENUE.

 

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We have generated the majority of our global search revenue from clicksoriginating on Google and Overture, which is a subsidiary of Yahoo!, throughrelationships in many countries in which we operate. We expect that thesesearch engines will continue to generate a majority or more of our 24/7 Searchrevenue for the foreseeable future. The interruption or loss of ourrelationship with Google or Overture would cause a significant decrease insearch revenue. As a result of consolidation among search engines, and othersearch marketing companies, we could lose one or more of our clients or faceincreased competition from clients that internally develop or acquirecapabilities similar to our service. In addition, as our search engine clients’operations continue to evolve, we may be required to adjust our businessstrategy to maintain relationships with our clients, which could have amaterial adverse effect on our search revenue.

 

OUR CUSTOMERS AND PARTNERS MAY EXPERIENCE ADVERSE BUSINESSCONDITIONS THAT COULD ADVERSELY AFFECT OUR BUSINESS.

 

As a result of unfavorable conditions in the capital markets, some ofour customers may have difficulty raising sufficient capital to support their long-termoperations. As a result, these customers have reduced their spending onInternet advertising, which has materially and adversely affected our business,financial condition and results of operations. In addition, we have enteredinto a strategic business relationship with Lycos, and may enter into similarrelationships with other companies. These companies may experience similaradverse business conditions that may render them unable to meet ourexpectations for the strategic business relationship or to fulfill theircontractual obligations to us. Such an event could have a material adverseimpact on our business, financial condition and results of operations.

 

IF WE LOSE OUR CEO OR OTHER SENIOR MANAGERS, OUR BUSINESS WILL BEADVERSELY AFFECTED.

 

Our success depends, to a significant extent, upon our seniormanagement and key sales and technical personnel, particularly our ChiefExecutive Officer.  The loss of theservices of one or more of these persons could materially and adversely affectour ability to develop our business.  Oursuccess also depends on our ability to attract and retain qualified technical,sales and marketing, customer support, financial and accounting, and managerialpersonnel.  We may be unable to retainour key personnel or attract, integrate or retain other highly qualifiedpersonnel in the future.  We haveexperienced in the past, and may continue to experience in the future,difficulty in hiring and retaining candidates with appropriate qualifications,especially in sales and marketing positions.

 

OUR OPERATIONS ARE VULNERABLE TO NATURAL DISASTERS AND OTHER EVENTS,INCLUDING TERRORIST ATTACKS, BECAUSE WE HAVE LIMITED BACKUP SYSTEMS.

 

We have limited backup systems and have experienced system failures andelectrical outages from time to time in the past, which have disrupted ouroperations. We have a limited disaster recovery plan in the event of damagefrom fire, floods, typhoons, earthquakes, power loss, telecommunicationsfailures, break-ins and similar events. Our operations are dependent on ourability to protect our computer systems against these unexpected adverseevents.

 

If any of the foregoing occurs, we may experience a complete systemshutdown. Any business interruption insurance that we carry is unlikely to besufficient to compensate us for loss of business in the event of a significantcatastrophe.

 

In addition, interruptions in our services could result from thefailure of our telecommunications providers to provide the necessary datacommunications capacity in the time frame we require. Our Open AdSystem

 

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technology resides on computer systems located in our data centershoused by Savvis in the United States and Level 3 Communications in Europe.These systems’ continuing and uninterrupted performance is critical to oursuccess, as a substantial portion of the revenue depend on the continuingavailability of these systems. Despite precautions that we have taken,unanticipated problems affecting our systems have from time to time in the pastcaused, and in the future could cause, interruptions in the delivery of oursolutions. Our business, results of operations and financial condition could bematerially and adversely affected by any damage or failure that interrupts ordelays our operations. To improve the performance and to prevent disruption ofour services, we may have to make substantial investments to deploy additionalservers or one or more copies of our Web sites to mirror our online resources.Although we believe we carry property insurance with adequate coverage limits,our coverage may not be adequate to compensate us for all losses, particularlywith respect to loss of business and reputation, that may occur.

 

In addition, terrorist acts or acts of war may cause damage to ouremployees, facilities, clients, our clients’ customers and vendors, which couldsignificantly impact our revenues, costs and expenses and financial position.The potential for future terrorist attacks, the national and international responsesto terrorist attacks or perceived threats to national security, and other actsof war or hostility have created many economic and political uncertainties thatcould adversely affect our business and results of operations in ways thatcannot be presently predicted. We are predominantly uninsured for losses andinterruptions caused by terrorist acts and acts of war.

 

OUR NETWORK OPERATIONS MAY BE VULNERABLE TO HACKING, VIRUSES ANDOTHER DISRUPTIONS, WHICH MAY MAKE OUR PRODUCTS AND SERVICES LESS ATTRACTIVEAND RELIABLE.

 

Internet usage could decline if anywell-publicized compromise of security occurs. “Hacking” involves efforts togain unauthorized access to information or systems or to cause intentionalmalfunctions or loss or corruption of data, software, hardware or othercomputer equipment.   Hackers have mademany attempts to breach the security of our network operations, with minimaldisruption to date. If hackers are successful in the future, could misappropriateproprietary information or cause substantial disruptions in our service. We maybe required to expend capital and other resources to protect our Web siteagainst hackers. Any measures we may take may not be effective. In addition,the inadvertent transmission of computer viruses could expose us to a materialrisk of loss or litigation and possible liability, as well as materially damageour reputation and decrease our user traffic.

 

WE DEPEND ON PROPRIETARY RIGHTS, AND WE FACE THE RISK OF INFRINGEMENT.

 

Our success and ability to compete are substantially dependent on ourinternally developed technologies and trademarks, which we protect through acombination of patent, copyright, trade secret and trademark law. We havereceived two patents in the United States, and have filed and intend to fileadditional patent applications in the United States. In addition, we apply toregister our trademarks in the United States and internationally. Our patentapplications and trademark applications may not be approved. Even if they areapproved, such patents or trademarks may be successfully challenged by othersor invalidated. If our trademark registrations are not approved because thirdparties own such trademarks, our use of such trademarks will be restrictedunless we enter into arrangements with such third parties that may beunavailable on commercially reasonable terms.

 

We generally enter into confidentiality or license agreements with ouremployees, consultants and corporate partners, and generally control access toand distribution of our technologies, documentation and other proprietaryinformation. Despite our efforts to protect our proprietary rights fromunauthorized use or disclosure, parties may attempt to disclose, obtain or useour solutions or technologies. The steps

 

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we have taken may not prevent misappropriation of our solutions ortechnologies, particularly in many foreign countries in which we operate, wherelaws or law enforcement practices may not protect our proprietary rights as fullyas in the United States.

 

We have from time to time licensed, and we may license in the future,elements of our trademarks, trade dress and similar proprietary rights to thirdparties. While we attempt to ensure that the quality of our brand is maintainedby these business partners, such partners may take actions that couldmaterially and adversely affect the value of our proprietary rights or ourreputation. The value of our proprietary rights could decline in the futuresince the validity, enforceability and scope of protection of certainproprietary rights in Internet-related industries is uncertain and stillevolving.

 

We have, from time to time, been, and may in the future be, subject toclaims of alleged infringement of the trademarks and other intellectualproperty rights of third parties by us or the Web publishers with Web sites inthe 24/7 Network, or by customers who employ our Technology solutions, whom wemay be required, or may elect, to indemnify against such claims. Such claimsand any resultant litigation could subject us to significant liability fordamages and could result in the invalidation of our proprietary rights. Inaddition, even if we prevail, such litigation could be time-consuming andexpensive to defend, and could result in the diversion of our time andattention, any of which could materially and adversely affect our business,results of operations and financial condition. Any claims or litigation fromthird parties may also result in limitations on our ability to use the trademarksand other intellectual property subject to such claims or litigation unless weenter into arrangements with the third parties responsible for such claims orlitigation, which may be unavailable on commercially reasonable terms.

 

From time to time, we may selectively pursue claims of infringement ofour patents and other intellectual property rights by third parties. Suchclaims and any resultant litigation present the risk that a court coulddetermine, either preliminarily or finally, that some of our patents or otherintellectual property rights are not valid, which may make it difficult to sellour technology solutions and may lead to a loss of and an inability to generatelicensing revenue from our patents. In addition, even if we prevail, such litigationcould be time-consuming and expensive to pursue, and could result in thediversion of our time and attention, any of which could materially andadversely affect our business, results of operations and financial condition.

 

OUR INTERNATIONAL OPERATIONS FACE LEGAL AND CULTURAL CHALLENGES.

 

We have operations in a number of international markets, includingAsia, Canada and Europe, and we currently derive more than half our revenuefrom non-U.S. markets. To date, we have limited experience in marketing, sellingand distributing our solutions internationally. International operations aresubject to other risks, including:

 

•                  changesin regulatory requirements;

 

•                  reducedprotection for intellectual property rights in some countries;

 

•                  potentiallyadverse tax consequences;

 

•                  generalimport/export restrictions relating to encryption technology and/or privacy;

 

•                  difficultiesand costs of staffing and managing foreign operations;

 

•                  politicaland economic instability;

 

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•                  fluctuationsin currency exchange rates; and

 

•                  seasonalreductions in business activity during the summer months in Europe and certainother parts of the world.

 

**RISKSRELATED TO THE MARKET FOR OUR COMMON STOCK.**

 

WEHAVE A VERY SUBSTANTIAL OVERHANG OF COMMON STOCK AND FUTURE SALES OF OUR COMMONSTOCK WILL CAUSE SUBSTANTIAL DILUTION AND MAY NEGATIVELY AFFECT THE MARKETPRICE OF OUR COMMON STOCK.

 

As of June 30, 2005, there were approximately 45.2 million sharesof our common stock outstanding. As of that date, we also had an aggregate ofapproximately 11.6 million shares of common stock that may be sold intothe market in the future, including approximately 7.9 million shares ofour common stock issuable upon exercise of options, 0.6 million shares ofour common stock issuable upon conversion of our outstanding preferred stockand exercise of the related warrants, approximately 0.9 million shares of ourcommon stock upon vesting of restricted shares, and 2.2 million shares ofour common stock issuable upon conversion of the debentures and exercise of therelated warrants. In addition, if we undertake an additional acquisitions orfinancing involving securities convertible into shares of our common stock, theaggregate number of shares into which those securities are convertible willfurther increase our overhang.

 

We cannot predict the effect, if any, that future sales of shares ofour common stock into the market, or the availability of shares of common stockfor future sale, will have on the market price of our common stock. Sales ofsubstantial amounts of common stock (including shares issued upon the exerciseof stock options or conversion of shares of preferred stock), or the perceptionthat such sales could occur, may materially and adversely affect prevailingmarket prices for our common stock.

 

OUR SHARE PRICE MAY BE VOLATILE AND COULD DECLINE SUBSTANTIALLY.

 

The market price of our common stock has fluctuated in the past and maycontinue to be volatile. In addition, the stock market has experienced extremeprice and volume fluctuations. The market prices of the securities ofInternet-related companies have been especially volatile. Investors may beunable to resell their shares of our common stock at or above the purchaseprice. In the past, following periods of volatility in the market price of aparticular company’s securities, securities class action litigation has oftenbeen brought against that company. Many companies in our industry have beensubject to this type of litigation in the past. We may also become involved inthis type of litigation. Litigation is often expensive and diverts management’sattention and resources, which could materially and adversely affect ourbusiness, financial condition and results of operations.

 

THE POWER OF OUR BOARD OF DIRECTORS TO DESIGNATE AND ISSUE SHARES OFSTOCK COULD HAVE AN ADVERSE EFFECT ON HOLDERS OF OUR COMMON STOCK.

 

We are authorized to issue up to 350,000,000 shares of common stock,which may be issued by our Board of Directors for such consideration as theymay consider sufficient without seeking stockholder approval. The issuance ofadditional shares of common stock in the future will reduce the proportionateownership and voting power of current stockholders. Our Certificate ofIncorporation also authorizes us to issue up to 10,000,000 shares of preferredstock, the rights and preferences of which may be designated by our Board ofDirectors. These designations may be made without stockholder approval. Thedesignation and issuance of preferred stock in the future could createadditional securities that would have dividend and

 

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liquidation preferences prior in right to the outstanding shares ofcommon stock. These provisions could also impede a change in control.

 

We also believe that one or more unaffiliated groups have purchasedsignificant quantities of our common stock.

 

EFFECTS OF ANTI-TAKEOVER PROVISIONS COULD INHIBIT THE ACQUISITION OFOUR COMPANY.

 

Some of the provisions of our Certificate of Incorporation, our Bylawsand Delaware law could, together or separately:

 

•                  discouragepotential acquisition proposals;

 

•                  delayor prevent a change in control;

 

•                  impedethe ability of our stockholders to change the composition of our board of directorsin any one year; and

 

•                  limitthe price that investors might be willing to pay in the future for shares ofour common stock.

 

WE DO NOT INTEND TO PAY FUTURE CASH DIVIDENDS.

 

We currently do not anticipate paying cash dividends on our commonstock at any time in the near future. We may never pay cash dividends ordistributions on our common stock. In addition, our subordinated convertibledebentures restrict our ability to pay cash dividends on our common stock.Whether we pay cash dividends in the future will be at the discretion of ourBoard of Directors and will be dependent upon our financial condition, resultsof operations, capital requirements, contractual restrictions and any otherfactors that the Board of Directors decides is relevant.

 

**RISKSRELATED TO OUR INDUSTRY**

 

OUR FAILURE TO COMPETE SUCCESSFULLY MAY HINDER OUR GROWTH.

 

The markets for Internet advertising and related products and servicesare intensely competitive and such competition is expected to increase. Ourfailure to compete successfully may hinder our growth. We believe that ourability to compete depends upon many factors both within and beyond ourcontrol, including:

 

•                  thedevelopment of new online advertising media and methods;

 

•                  thetiming and market acceptance of new products and enhancements of existingservices developed by us and our competitors;

 

•                  changingdemands regarding customer service and support;

 

•                  shiftsin sales and marketing efforts by us and our competitors; and

 

•                  theease of use, performance, price and reliability of our services and products.

 

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Some of our competitors have longer operating histories, greater namerecognition, larger customer bases and significantly greater financial,technical and marketing resources than ours. In addition, current and potentialcompetitors have established or may establish cooperative relationships amongthemselves or with third parties to increase the ability of their products orservices to address the needs of our prospective clients.  In addition, most online advertisingcompanies are seeking to broaden their business models, so that companies thatdo not currently compete directly with us may decide to compete more directlywith us in the future. We may be unable to compete successfully against currentor future competitors.

 

CHANGES IN GOVERNMENT REGULATION COULD DECREASE OUR REVENUES ANDINCREASE OUR COSTS.

 

Laws and regulations directly applicable to Internet communications,commerce and advertising are becoming more prevalent, and new laws andregulations are under consideration by the United States Congress and statelegislatures. Any legislation enacted or restrictions arising from current orfuture government investigations or policy could dampen the growth in use ofthe Internet generally and decrease the acceptance of the Internet as acommunications, commercial and advertising medium. State governments orgovernments of foreign countries might attempt to regulate our transmissions orlevy sales or other taxes relating to our activities. The laws governing theInternet, however, remain largely unsettled, even in areas where there has beensome legislative action. It may take years to determine whether and howexisting laws such as those governing intellectual property, privacy, libel andtaxation apply to the Internet and Internet advertising. In addition, thegrowth and development of Internet commerce may prompt calls for more stringentconsumer protection laws, both in the United States and abroad, that may imposeadditional burdens on companies conducting business over the Internet. Ourbusiness, results of operations and financial condition could be materially andadversely affected by the adoption or modification of laws or regulationsrelating to the Internet.

 

CHANGES IN LAWS AND STANDARDS RELATING TO DATA COLLECTION AND USEPRACTICES AND THE PRIVACY OF INTERNET USERS, OR RELATED LITIGATION, COULD HARMOUR BUSINESS.

 

The U.S. federal and various state governments have recently proposedlimitations on the collection and use of information regarding Internet users.In 2004 and 2005, the U.S. Congress proposed several new pieces of legislationthat would limit the use of technologies deemed to be “spyware”, which somebills have defined to include cookies, Web beacons and javascript, which arerequired by our products and services. The effectiveness of our Open AdSystemproducts and services could be significantly limited by federal and stateregulations limiting the collection or use of information regarding Internetusers. Since many of the proposed federal and state laws or regulations arebeing developed, we cannot yet determine the impact these regulations may haveon its business. In addition, growing public concern about privacy and thecollection, distribution and use of personal information has led toself-regulation of these practices by the Internet advertising and directmarketing industry and to increased federal and state regulation.  Lastly, a number of civil actions have beenbrought by federal and state authorities against companies alleged to havedistributed “spyware” without proper consent of users. The Network AdvertisingInitiative, of which we are a member, has developed self-regulatory principlesfor online preference marketing. We are also subject to various federal andstate regulations concerning the collection, distribution and use of personalinformation. These laws include the Children’s Online Privacy Protection Act,and state laws that limit or preclude the use of voter registration and driverslicense information, as well as other laws that govern the collection and useof consumer credit information. While we monitor legislative initiatives, inthe event that more onerous federal or state laws or regulations are enacted or

 

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applied to us or our clients, our business, financial condition andresults of operations could be materially and adversely affected.

 

PRIVACY CONCERNS MAY PREVENT US FROM COLLECTING USER DATA.

 

Growing concerns about the use of cookies and data collection may limitour ability to develop user profiles. Web sites typically place small files ofinformation, commonly known as “cookies”, on a user’s hard drive, generallywithout the user’s knowledge or consent. Cookie information is passed to theWeb site through the Internet user’s browser software. Our Open AdSystemtechnology targets advertising to users through the use of cookies and othernon-personally-identifying information. Open AdSystem enables the use of cookiesto deliver targeted advertising and to limit the frequency with which anadvertisement is shown to a user. Most currently available Internet browsersallow users to modify their browser settings to prevent cookies from beingstored on their hard drive, and a small minority of users are currentlychoosing to do so. Users can also delete cookies from their hard drive ormodify them at any time. Some Internet commentators and privacy advocates havesuggested limiting or eliminating the use of cookies. Any reduction orlimitation in the use of cookies could limit the effectiveness of our sales andmarketing efforts and impair our targeting capabilities. Microsoft Corporationhas changed the design and instrumentation of its Web browser in such a way asto give users the option to accept or reject third party cookies. Giving usersthe option to decline such cookies could result in a reduction of the number ofInternet users that we can profile anonymously. Such changes also couldadversely affect our ability to determine the reach of advertising campaignssold and delivered by us and the frequency with which users of sites in the24/7 Network see the same advertisement.

 

If the use or effectiveness of cookies is limited, we would likely haveto switch to other technology that would allow us to gather demographic andbehavioral information. While such technology currently exists, it issubstantially less effective than cookies. Replacement of cookies could requiresignificant engineering time and resources, might not be completed in time toavoid negative consequences to our business, financial condition or results ofoperations, and might not be commercially feasible.

 

WE FACE RISKS ASSOCIATED WITH TECHNOLOGICAL CHANGE.

 

The Internet and Internet advertising markets are characterized byrapidly changing technologies, evolving industry standards, frequent newproduct and service introductions and changing customer demands. Our futuresuccess will depend on our ability to adapt to rapidly changing technologies andto enhance existing solutions and develop and introduce a variety of newsolutions to address our customers’ changing demands. We may experiencedifficulties that could delay or prevent the successful design, development,introduction or marketing of our solutions. In addition, our new solutions orenhancements must meet the requirements of our current and prospectivecustomers and must achieve significant market acceptance. Material delays inintroducing new solutions and enhancements may cause customers to foregopurchases of our solutions and purchase those of our competitors.

 

In addition, the development of commercial software and technology thatblocks, eliminates or otherwise screens out Internet advertising may reduce thevalue of advertising inventory on our 24/7 Web Alliance and the benefits of ourtechnology solutions to our customers. We cannot guarantee that a new commercial software or technology, forend-users or enterprises, will not be capable of eliminating a portion or allof the advertisement formats, including banners, pop-ups, pop-unders and otherformats, that we utilize through our 24/7 Web Alliance or that we currentlydeliver through our technology solutions. To the extent that our customers refuse to pay for advertisements thatare blocked, or if the use of blocking software exceeds our expectations, ourbusiness, results of operations and financial condition may be materially andadversely affected.

 

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ITEM 3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

**INTEREST RATE RISK**

 

The primary objective of our investment activities is to preservecapital. Cash and cash equivalents are investments with original maturities ofthree months or less. Therefore, changes in the market’s interest rates do notaffect the value of the investments as recorded by 24/7 Real Media. Thefollowing table presents the amounts of our financial instruments that aresubject to interest rate risk by expected maturity and average interest ratesas of June 30, 2005 (in thousands):

 
| ** **                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **Thereafter** | ** ** | **TOTAL** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Cash and  cash equivalents |       | $        | 28,347     |     | $          | —   |       | $              | —     |      | $          | — |   | $ | 28,347 |   |
| Average  interest rate     |       | 2.77     | %          |     |       |     |       |           |       | 2.77      | %          |
|                       |       |     |       |     |       |     |       |           |       |      |       |
| Loan payable               |       | $        | 7,500      |     | $          | 7,500    |       | $              | —     |      | $          | — |   | $ | 15,000 |   |
| Loan payable               |       | 2.00     | %          | 2.00     | %          |     |       |           |       | 2.00      | %          |

 

The 2% subordinated convertible debentures due 2006 contain a provisionthat gives the holder the ability to call a portion of the note upon thesatisfaction of a trading price condition. This condition constitutes anembedded derivative. The value of this embedded derivative at June 30,2005 is immaterial to our financial position. We review the value of thederivative on a quarterly basis, in accordance with SFAS No. 149, *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities*. At June 30, 2005, we did not hold anyother derivative financial instruments.

 

**FOREIGN CURRENCY RISK**

 

We transact business in a variety of foreign countries and are thussubject to exposure from adverse movements in foreign currency exchange rates.This exposure is primarily related to revenue and operating expenses. Theeffect of foreign exchange rate fluctuations for the three and six monthperiods ended June 30, 2005 and 2004 were not material. We do not use derivativefinancial instruments to limit our foreign currency risk exposure. At June 30,2005, we had $6.3 million in cash and cash equivalents denominated inforeign currencies.

 

ITEM 4. CONTROLSAND PROCEDURES

 

*Evaluation of Controls and Procedures*

 

As of the end of the period covered by this Form 10-Q, anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures was carried out by us under the supervision and withthe participation of our management, including our Chief Executive Officer andChief Financial Officer. Based on that conclusion, our Chief Executive Officerand Chief Financial Officer concluded that our disclosure controls andprocedures have been designed and are being operated in a manner that providesreasonable assurance that the information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowtimely decisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, our management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the

 

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desired control objectives, and our management necessarily is requiredto apply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

 

In 2004, as a complement to our existing overall program of internalcontrol, we initiated a company-wide review of our internal control over financialreporting as part of the process for compliance with Section 404 of theSarbanes-Oxley Act of 2002. As a result of the review, we have madeimprovements to the design and effectiveness of our internal control throughthe six month period ended June 30, 2005. We have recently commenceda review of the design and effectiveness of our internal controls of our DecideInteractive subsidiary. We anticipate that improvements will continue to bemade.

 

*Changes in Internal Control*

 

There has been no change in our internal control over financialreporting during our most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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PART II.  OTHER INFORMATION

 

ITEM1.  LEGAL PROCEEDINGS

 

We are involved in various claims and legal actions arising in theordinary course of business.  In theopinion of management, the ultimate disposition of these matters will not havea material effect on our financial position, results of operations orliquidity.

 

ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM3.  DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

 

None.

 

ITEM5.  OTHER INFORMATION

 

None.

 

ITEM 6.  EXHIBITS

 

**Exhibits**

 
| Exhibit 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                      |
|-------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|              |                                                                                                                                                          |
| Exhibit 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                      |
|              |                                                                                                                                                          |
| Exhibit 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003.* |
|              |                                                                                                                                                          |
| Exhibit 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003.* |

 

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(*)                                 This certification accompanies this QuarterlyReport on Form 10-Q, is not deemed filed with the SEC and is not to beincorporated by reference into any filing of the Company under the SecuritiesAct of 1933, as amended, or the Securities Exchange Act of 1934, as amended(whether made before or after the date of this Quarterly Report on Form 10-Q),irrespective of any general incorporation language contained in such filing.

 

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Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
|                      | 24/7 REAL MEDIA, INC. |
|---------------------------|-----------------------|
|                      | *(Registrant)*        |
|                      |                  |
|                      |                  |
| Date: August 9, 2005 | By:                   |  /s/ DAVID J. MOORE |   |
|                      |                  | David J.  Moore |
|                      |                  | *Chairman and Chief Executive Officer  (Principal Executive Officer)* |

 

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