UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K/A

(Amendment No. 




2)

(Mark One)

þANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: December 31, 2008

OR

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

For the transition period from __________________ to _____________________

INUVO, INC.

(Exact name of registrant as specified in its charter)



|                                                               |                        |                                     
|-------------------------------------------------------------- | ---------------------- | ------------------------------------
|Nevada                                                         | 001-32442              | 87-0450450                          
|(State or other jurisdiction
of incorporation or organization) | Commission
file number | (I.R.S. Employer
Identification No.)



15550 Lightwave Drive, Third Floor, Clearwater, FL     33760

(Address of principal executive offices)     (Zip Code)

(727) 324-0046

(Registrant's telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ̈Yes þ No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    ̈Yes þ No

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company:

Large accelerated filer    ̈     Accelerated filer    ̈     Non-accelerated filer    ̈     Smaller reporting company   þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    Yes  ̈  No þ

The aggregate market value of the outstanding common stock, other than shares held by persons who may be deemed affiliates of the registrant, computed by reference to the closing sales price for the registrants common stock on June 30, 2008 (the last business day of the registrants most recently completed second quarter), as reported on the NYSE Amex Equities, was approximately $28,793,000. As of March 20, 2009, there were 65,608,068 shares of common stock, par value $.001 per share, of the registrant outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2009 Annual Meeting of Stockholders (the Proxy Statement), to be filed within 120 days of the year ended December 31, 2008, are incorporated by reference in Part III hereof. Except with respect to information specifically incorporated by reference in this Form 10-K, the Proxy Statement is not deemed to be filed as part hereof.













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EXPLANATORY NOTE

On December 2, 2009 we filed Amendment No. 1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2008 of Inuvo, Inc. (formerly known as Kowabunga! Inc.) for the sole purpose of correcting a clerical error in the original filing. In the Form 10-K as originally filed on March 31, 2009, the report of Blackman Kallick, LLP dated March 30, 2008 on our internal control over financial reporting as of December 31, 2007 (the ICFR Report) inadvertently appeared on page 34 and the report of Blackman Kallick, LLP dated March 30, 2008 on our consolidated balance sheet at December 31, 2007 the related consolidated statements of operations, shareholders equity and cash flows for the year ended December 31, 2007 (the Audit Report) was inadvertently omitted. Amendment No. l deleted the ICFR Report in its entirety and substituted the Audit Report which was included in Part IV of Amendment No. 1.

This Amendment No. 2 to the Form 10-K for the fiscal year ended December 31, 2008 contains the entire Item 15. Financial Statements which appeared in the original 10-K as filed on March 31, 2009 together with the Audit Report as included in Amendment No. 1. There have been no changes in Item 15. Financial Statements other than to substitute the Audit Report for the ICFR Report. This Amendment No. 2 also contains currently dated certifications as Exhibits 31.1, 31.2, 32.1 and 32.2. No attempt has been made in this Amendment No. 2 to the Form 10-K for the fiscal year ended December 31, 2008 to modify or update any other information presented in the Form 10-K as previously filed nor does this Amendment No. 2 reflect events occurring after the filing of the original Form 10-K or modify or update those disclosures that may be affected by subsequent events. Accordingly, this Amendment No. 2 should be read in conjunction with the Form 10-K previously filed and the registrant’s other filings with the SEC.



2



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PART IV



Item 15.

EXHIBITS, AND FINANCIAL STATEMENT SCHEDULES

(a)

Documents filed as part of this report



| |                                                                                                                 |  |     
| | --------------------------------------------------------------------------------------------------------------- |  | ----
| |                                                                                                                 |  | Page
| | Financial statements                                                                                            |  |     
| | ● Report of Independent Registered Public Accounting Firm                                                       |  | 4   
| | ● Consolidated Balance Sheets December 31, 2008 and December 31, 2007                                           |  | 6   
| | ● Consolidated Statements of Operations Years Ended December 31, 2008 and 2007                                  |  | 7   
| | ● Consolidated Statements of Stockholders’ Equity and Comprehensive Loss Years Ended December 31, 2008 and 2007 |  | 8   
| | ● Consolidated Statements of Cash Flows Years Ended December 31, 2008 and 2007                                  |  | 9   
| | ● Notes to Consolidated Financial Statements                                                                    |  | 10  
| |                                                                                                                 |  |     
| |                                                                                                                 |  |     



The exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of this report.





3



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Shareholders of

Kowabunga! Inc.



We have audited the accompanying consolidated balance sheet of Kowabunga! Inc. (a Nevada corporation) and subsidiaries as of December 31, 2008, and the related consolidated statements of operations, stockholders equity and comprehensive loss, and cash flows for the year then ended.These financial statements are the responsibility of the Companys management.Our responsibility is to express an opinion on these financial statements based on our audit.



We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting.Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting.Accordingly, we express no such opinion.An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kowabunga! Inc. and subsidiaries as of December 31, 2008, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.



/s/ GRANT THORNTON LLP



Tampa, Florida

March 30, 2009





4



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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Kowabunga! Inc.

We have audited the accompanying consolidated balance sheet of Kowabunga! Inc. as of December 31, 2007 and the related consolidated statements of operations, shareholders equity and cash flows for the year then ended. The consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on the consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kowabunga! Inc. as of December 31, 2007, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 to the consolidated financial statements, the Company has changed its method of applying an accounting principle for the annual goodwill impairment test by changing the impairment test date effective December 31, 2007. As discussed in Note 10 to the consolidated financial statements, the Company has also changed its method of accounting for stock-based compensation effective January 1, 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 30, 2008, expressed an adverse opinion on the effectiveness of the Companys internal control over financial reporting.

/s/ Blackman Kallick, LLP

Chicago, Illinois

March 30, 2008





5



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Kowabunga! Inc.

Consolidated Balance Sheets

December 31, 2008 and 2007



|                                                                                                                                                         |  |      |             |   |      |   |             |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                                                                                         |  | 2008 |             |   | 2007 |  
|Assets                                                                                                                                                   |  |      |             |   |      |  
|Current Assets                                                                                                                                           |  |      |             |   |      |  
|Cash and Cash Equivalents                                                                                                                                |  | $    | 360,315     |   |      | $ | 2,578,246   |  
|Restricted Cash                                                                                                                                          |  |      | 992,074     |   |      |   | 1,668,302   |  
|Accounts Receivable  Net of Allowance of $874,347 and $97,170, respectively                                                                             |  |      | 8,429,258   |   |      |   | 8,302,782   |  
|Unbilled Revenue                                                                                                                                         |  |      | 55,792      |   |      |   | 124,653     |  
|Refundable Corporate Income Taxes                                                                                                                        |  |      | 137,846     |   |      |   | 436,522     |  
|Prepaid Expenses and Other Current Assets                                                                                                                |  |      | 284,859     |   |      |   | 217,201     |  
|Current Assets of Discontinued Operations                                                                                                                |  |      | 2,440,630   |   |      |   | 6,412,597   |  
|Total Current Assets                                                                                                                                     |  |      | 12,700,774  |   |      |   | 19,740,303  |  
|Property and Equipment, Net                                                                                                                              |  |      | 5,468,990   |   |      |   | 4,679,541   |  
|Other Assets                                                                                                                                             |  |      |             |   |      |   |             |  
|Goodwill                                                                                                                                                 |  |      | 3,351,405   |   |      |   | 41,229,930  |  
|Intangible Assets                                                                                                                                        |  |      | 5,100,314   |   |      |   | 9,395,056   |  
|Other Assets                                                                                                                                             |  |      | 89,099      |   |      |   | 198,151     |  
|Other Assets of Discontinued Operations                                                                                                                  |  |      | 2,509,226   |   |      |   | 45,882,532  |  
|Total Other Assets                                                                                                                                       |  |      | 11,050,044  |   |      |   | 96,705,669  |  
|Total Assets                                                                                                                                             |  | $    | 29,219,808  |   |      | $ | 121,125,513 |  
|Liabilities And Shareholders Equity                                                                                                                     |  |      |             |   |      |   |             |  
|Current Liabilities                                                                                                                                      |  |      |             |   |      |   |             |  
|Notes Payable  Current Portion                                                                                                                          |  | $    | 1,648,970   |   |      | $ | 1,301,537   |  
|Notes Payable  Related Party                                                                                                                            |  |      |            |   |      |   | 37,326      |  
|Accounts Payable                                                                                                                                         |  |      | 5,149,681   |   |      |   | 3,102,229   |  
|Deferred Revenue                                                                                                                                         |  |      | 18,676      |   |      |   | 41,190      |  
|Deferred Tax Liabilities                                                                                                                                 |  |      |            |   |      |   | 470,205     |  
|Accrued Expenses and Other Current Liabilities                                                                                                           |  |      | 1,306,736   |   |      |   | 1,250,756   |  
|Current Liabilities of Discontinued Operations                                                                                                           |  |      | 2,471,951   |   |      |   | 5,089,019   |  
|Total Current Liabilities                                                                                                                                |  |      | 10,596,014  |   |      |   | 11,292,262  |  
|Long-Term Liabilities                                                                                                                                    |  |      | 9,056,813   |   |      |   | 14,188,265  |  
|Shareholders Equity                                                                                                                                     |  |      |             |   |      |   |             |  
|Preferred Stock, $.001 Par Value:                                                                                                                        |  |      |             |   |      |   |             |  
|Authorized Shares  5,000,000  None Issued Or Outstanding                                                                                               |  |      |            |   |      |   |            |  
|Common Stock, $.001 Par Value:                                                                                                                           |  |      |             |   |      |   |             |  
|Authorized Shares  200,000,000
Issued Shares  71,125,024 in 2008 and 69,795,024 in 2007
Outstanding Shares  65,608,068 in 2008 and 67,146,350 in 2007 |  |      | 71,125      |   |      |   | 70,295      |  
|Additional Paid In Capital                                                                                                                               |  |      | 105,804,740 |   |      |   | 106,524,393 |  
|Accumulated Deficit                                                                                                                                      |  |      | (94,095,817 | ) |      |   | (11,245,536 | )
|Accumulated Other Comprehensive (loss) Income                                                                                                            |  |      | (116,961    | ) |      |   | 1,139,715   |  
|Treasury Stock                                                                                                                                           |  |      | (2,096,106  | ) |      |   | (843,881    | )
|Total Shareholders Equity                                                                                                                               |  |      | 9,566,981   |   |      |   | 95,644,986  |  
|Total Liabilities and Shareholders Equity                                                                                                               |  | $    | 29,219,808  |   |      | $ | 121,125,513 |  



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





6



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Kowabunga! Inc.

Consolidated Statements of Operations

Years Ended December 31, 2008 and 2007



|                                                                                 |  |      |             |   |      |   |            |  
|-------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ---------- | -
|                                                                                 |  | 2008 |             |   | 2007 |  
|Net Revenue                                                                      |  | $    | 51,572,595  |   |      | $ | 27,795,714 |  
|Cost of Revenue                                                                  |  |      | 32,768,558  |   |      |   | 10,621,678 |  
|Gross Profit                                                                     |  |      | 18,804,037  |   |      |   | 17,174,036 |  
|Operating Expenses                                                               |  |      |             |   |      |   |            |  
|Selling, General and Administrative                                              |  |      | 22,730,585  |   |      |   | 18,626,506 |  
|Impairment of Goodwill and Intangible Assets                                     |  |      | 40,201,639  |   |      |   |           |  
|Amortization of Purchased Intangibles                                            |  |      | 2,029,755   |   |      |   | 2,254,706  |  
|Operating Loss from Continuing Operations                                        |  |      | (46,157,942 | ) |      |   | (3,707,176 | )
|Other Income (Expenses)                                                          |  |      |             |   |      |   |            |  
|Interest Income                                                                  |  |      | 14,142      |   |      |   | 23,894     |  
|Interest Expense                                                                 |  |      | (750,452    | ) |      |   | (881,050   | )
|Other (Expense) Income, Net                                                      |  |      | (22,543     | ) |      |   | 37,450     |  
|Net Loss from Continuing Operations before Income Taxes                          |  |      | (46,916,795 | ) |      |   | (4,526,882 | )
|Income Tax Benefit                                                               |  |      | (1,980,051  | ) |      |   | (1,403,333 | )
|Net Loss from Continuing Operations                                              |  |      | (44,936,744 | ) |      |   | (3,123,549 | )
|Net (Loss) Profit from Discontinued Operations net of Income Taxes (see Note 14) |  |      | (37,913,537 | ) |      |   | 2,015,724  |  
|Net Loss                                                                         |  | $    | (82,850,281 | ) |      | $ | (1,107,825 | )
|                                                                                 |  |      |             |   |      |   |            |  
|Per Common Share Data:                                                           |  |      |             |   |      |   |            |  
|Basic                                                                            |  |      |             |   |      |   |            |  
|Net Loss from Continuing Operations                                              |  | $    | (0.68       | ) |      | $ | (0.05      | )
|Net (Loss) Profit from Discontinued Operations                                   |  | $    | (0.56       | ) |      | $ | 0.03       |  
|Net Loss                                                                         |  | $    | (1.24       | ) |      | $ | (0.02      | )
|Diluted                                                                          |  |      |             |   |      |   |            |  
|Net Loss from Continuing Operations                                              |  | $    | (0.68       | ) |      | $ | (0.05      | )
|Net (Loss) Profit from Discontinued Operations                                   |  | $    | (0.56       | ) |      | $ | 0.03       |  
|Net Loss                                                                         |  | $    | (1.24       | ) |      | $ | (0.02      | )
|                                                                                 |  |      |             |   |      |   |            |  
|Weighted Average Shares (Basic and Diluted)                                      |  |      | 66,549,326  |   |      |   | 67,122,669 |  



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





7



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Kowabunga! Inc.

Consolidated Statement of Shareholders Equity and Comprehensive Loss



|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|------------------------------------------------------------------ |  | ------------ | ---------- | ----- | ------------------- | -------------------------- | - | -------------- | ----------- | --------------------------------------------- | - | ----------- | -------------------------- | - | ---------- | - | - | ---------- | - | - | ----------- | -
|                                                                   |  |              |            |       |                     |                            |   |                |             | Accumulated Other Comprehensive Income (loss) |   |             |                            |   |           
|                                                                   |  |              |            |       |                     | Additional Paid in Capital |   |                |             |                                               |   |             | Total Shareholders Equity |  
|                                                                   |  | Common Stock |            |       | Accumulated Deficit |                            |   | Treasury Stock |             |                                              
|                                                                   |  | Shares       |            | Stock |                     |                            |   |                |             |                                              
|Balance, January 1, 2007                                           |  |              | 64,228,120 |       | $                   | 66,877                     |   | $              | 100,206,078 |                                               | $ | (10,137,711 | )                          | $ | 172,678    |   | $ | (843,881   | ) | $ | 89,464,041  |  
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Options and Warrants Exercised, Net                                |  |              | 918,230    |       |                     | 918                        |   |                | 255,218     |                                               |   |             |                            |   |            |   |   |            |   |   | 256,136     |  
|Issuance Costs                                                     |  |              |            |       |                     |                            |   |                | (26,291     | )                                             |   |             |                            |   |            |   |   |            |   |   | (26,291     | )
|Conversions of Redeemable Preferred                                |  |              | 2,500,000  |       |                     | 2,500                      |   |                | 4,127,307   |                                               |   |             |                            |   |            |   |   |            |   |   | 4,129,807   |  
|Stock Based Compensation                                           |  |              |            |       |                     |                            |   |                | 1,065,940   |                                               |   |             |                            |   |            |   |   |            |   |   | 1,065,940   |  
|Other Stock Based Expenses                                         |  |              |            |       |                     |                            |   |                | 41,946      |                                               |   |             |                            |   |            |   |   |            |   |   | 41,946      |  
|Tax Benefit of Options Exercised                                   |  |              |            |       |                     |                            |   |                | 989,722     |                                               |   |             |                            |   |            |   |   |            |   |   | 989,722     |  
|Accretion of Redeemable Preferred                                  |  |              |            |       |                     |                            |   |                | (135,527    | )                                             |   |             |                            |   |            |   |   |            |   |   | (135,527    | )
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Other Comprehensive Loss:                                          |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Net Loss                                                           |  |              |            |       |                     |                            |   |                |             |                                               |   | (1,107,825  | )                          |   |            |   |   |            |   |   | (1,107,825  | )
|Unrealized Gain on Securities (net of reclassification adjustment) |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   | 4,673      |   |   |            |   |   | 4,673       |  
|Foreign Currency Translation Adjustments                           |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   | 962,364    |   |   |            |   |   | 962,364     |  
|Comprehensive Loss                                                 |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   | (140,788    | )
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Balance, December 31, 2007                                         |  |              | 67,646,350 |       |                     | 70,295                     |   |                | 106,524,393 |                                               |   | (11,245,536 | )                          |   | 1,139,715  |   |   | (843,881   | ) |   | 95,644,986  |  
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Adjustment for Contingent Shares                                   |  |              | (500,000   | )     |                     | (500                       | ) |                | (999,500    | )                                             |   |             |                            |   |            |   |   |            |   |   | (1,000,000  | )
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Options and Warrants Exercised, Net                                |  |              | 100,000    |       |                     | 100                        |   |                | 12,900      |                                               |   |             |                            |   |            |   |   |            |   |   | 13,000      |  
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Purchases of Treasury Stock                                        |  |              | (212,700   | )     |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   | (160,375   | ) |   | (160,375    | )
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Stock Based Compensation                                           |  |              | 1,230,000  |       |                     | 1,230                      |   |                | 266,947     |                                               |   |             |                            |   |            |   |   |            |   |   | 268,177     |  
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Settlement Agreement                                               |  |              | (2,655,582 | )     |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   | (1,091,850 | ) |   | (1,091,850  | )
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Other Comprehensive Loss:                                          |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Net Loss                                                           |  |              |            |       |                     |                            |   |                |             |                                               |   | (82,850,281 | )                          |   |            |   |   |            |   |   | (82,850,281 | )
|Unrealized Loss on Securities                                      |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   | (11,591    | ) |   |            |   |   | (11,591     | )
|Fair Value Adjustment for Derivatives                              |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   | (101,943   | ) |   |            |   |   | (101,943    | )
|Foreign Currency Translation Adjustments                           |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   | (1,143,142 | ) |   |            |   |   | (1,143,142  | )
|Comprehensive Loss                                                 |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   | (84,106,957 | )
|                                                                   |  |              |            |       |                     |                            |   |                |             |                                               |   |             |                            |   |            |   |   |            |   |   |             |  
|Balance, December 31, 2008                                         |  |              | 65,608,068 |       | $                   | 71,125                     |   | $              | 105,804,740 |                                               | $ | (94,095,817 | )                          | $ | (116,961   | ) | $ | (2,096,106 | ) | $ | 9,566,981   |  



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





8



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Kowabunga! Inc.

Consolidated Statements of Cash Flows

Years Ended December 31, 2008 and 2007



|                                                                                |  |      |             |      |   |             |  
|------------------------------------------------------------------------------- |  | ---- | ----------- | ---- | - | ----------- | -
|                                                                                |  | 2008 |             | 2007 |  
|Operating Activities                                                            |  |      |             |      |   |             |  
|Net Loss                                                                        |  | $    | (82,850,281 | )    | $ | (1,107,825  | )
|Adjustments to Reconcile Net Loss to Net Cash provided by Operating Activities: |  |      |             |      |   |             |  
|Depreciation and Amortization                                                   |  |      | 8,210,433   |      |   | 8,748,398   |  
|Impairment of Goodwill and Intangible Assets                                    |  |      | 80,624,119  |      |   |            |  
|Provision for Doubtful Accounts                                                 |  |      | 1,850,279   |      |   | 784,994     |  
|Deferred Income Taxes                                                           |  |      | (3,022,347  | )    |   | (1,623,801  | )
|Excess Tax Benefits from Options Exercised                                      |  |      |            |      |   | (950,133    | )
|Stock Based Settlement                                                          |  |      | (1,091,850  | )    |   |            |  
|Stock Based Compensation                                                        |  |      | 268,177     |      |   | 1,065,940   |  
|Gain on Disposal (1)                                                            |  |      | (557,984    | )    |   |            |  
|Other                                                                           |  |      | 136,385     |      |   | 118,272     |  
|Change in Operating Assets and Liabilities:                                     |  |      |             |      |   |             |  
|Restricted Cash                                                                 |  |      | 676,228     |      |   | (503,454    | )
|Accounts Receivable                                                             |  |      | 403,443     |      |   | (3,125,697  | )
|Prepaid Expenses and Other Assets                                               |  |      | 555,016     |      |   | (516,293    | )
|Refundable Corporate Income Taxes                                               |  |      | 298,676     |      |   | 279,292     |  
|Accounts Payable                                                                |  |      | 2,167,685   |      |   | (601,019    | )
|Deferred Revenue                                                                |  |      | (530,707    | )    |   | (808,376    | )
|Accrued Expenses and Other Current Liabilities                                  |  |      | (1,081,366  | )    |   | 2,221,660   |  
|Net Cash Provided by Operating Activities                                       |  |      | 6,055,906   |      |   | 3,981,958   |  
|                                                                                |  |      |             |      |   |             |  
|Investing Activities                                                            |  |      |             |      |   |             |  
|Purchases of Property and Equipment                                             |  |      | (2,230,173  | )    |   | (2,450,853  | )
|Purchases of Names Database                                                     |  |      | (3,257,911  | )    |   | (3,266,891  | )
|Other                                                                           |  |      | 9,082       |      |   | (89,418     | )
|Net Cash Used in Investing Activities                                           |  |      | (5,479,002  | )    |   | (5,807,162  | )
|Financing Activities                                                            |  |      |             |      |   |             |  
|Principal Payments Made on Installment Notes                                    |  |      | (1,454,295  | )    |   | (253,203    | )
|Payments on Line of Credit                                                      |  |      | (41,288,000 | )    |   | (18,427,000 | )
|Advances from Line of Credit                                                    |  |      | 40,101,228  |      |   | 19,128,000  |  
|Proceeds from Equity Transactions, net of issuance costs                        |  |      | 13,000      |      |   | 229,845     |  
|Treasury Shares Repurchased                                                     |  |      | (160,375    | )    |   |            |  
|Dividends Paid on Redeemable Preferred                                          |  |      |            |      |   | (279,917    | )
|Excess Tax Benefits from Options Exercised                                      |  |      |            |      |   | 950,133     |  
|Net Cash (Used In) Provided by Financing Activities                             |  |      | (2,788,442  | )    |   | 1,347,858   |  
|Effect of exchange rate changes on cash and cash equivalents                    |  |      | (6,393      | )    |   | 24,104      |  
|Net Cash Change                                                                 |  |      | (2,217,931  | )    |   | (453,243    | )
|Cash and cash equivalents Balance, Beginning of Year                            |  |      | 2,578,246   |      |   | 3,031,488   |  
|Cash and Cash Equivalents Balance, End of Year                                  |  | $    | 360,315     |      | $ | 2,578,246   |  
|                                                                                |  |      |             |      |   |             |  
|Supplemental Information                                                        |  |      |             |      |   |             |  
|Interest Paid                                                                   |  | $    | 780,892     |      | $ | 884,390     |  
|Income Taxes Refunded                                                           |  | $    | (288,018    | )    | $ | (113,219    | )



(1)

Gain on dissolution of reporting unit based in the United Kingdom

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



Non Cash Investing and Financing Activities



The Company purchased equipment totaling $682,729 under capital lease arrangements during the year ended December 31, 2008.





9



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements

December 31, 2008 and 2007

Note 1  Organization and Business

Company Overview

Kowabunga! Inc, f/k/a Think Partnership Inc, (the Company) is a Nevada corporation headquartered in Clearwater, Florida. Through their wholly-owned direct and indirect subsidiaries it provides world class marketing and technology solutions to businesses and individuals. The Company is organized into three segments: Network, Direct, and Advertising. During the second quarter of 2008 the Company made the decision to divest all the assets in its Advertising Segment as well as Cherish and iLead within its Direct Segment. As a result of this decision, these units are reported as discontinued operations in the Companys financial statements.

The Company was incorporated in the State of Nevada in October 1987. As of March 20, 2009 the Company employed, through its operating subsidiaries, 125 people. At the end of 2008 the Company was operating in three locations across the United States. The Companys principal executive offices are located at 15550 Lightwave Drive, 3rd floor, Clearwater, Florida 33760. The Companys telephone number is (727) 324-0046. The address of its website is www.kowabunga.com.

Products and Services

Network Segment

The Companys Network Segment, which is comprised of its wholly-owned subsidiaries, Primary Ads Inc, Litmus Media, Inc, Ozona Online Networks Inc and Kowabunga! Inc, provides performance-based marketing and technology solutions to assist advertisers in driving traffic, obtaining leads and increasing conversions through affiliate marketing, search engine marketing, lead generation and PPC (pay-per-click) ad networks.

Affiliate Network

PrimaryAdsTM (www.primaryads.com or www.primaryads.co.uk) is a leading CPA (cost per action) Affiliate Network matching high-converting, high-paying offers from advertisers to high-quality traffic and leads through a network of select affiliates. The Company’s email, search and website affiliates earn some of the industry’s highest commissions while driving traffic to various types of offers, including many exclusive offers.

Search Network

ValidClick AdExchangeTM (www.validclick.com) is an open, quality controlled PPC marketplace where clicks are dynamically priced based on FeedPatrol Click Fraud Technology and Fair Isaac Click Conversion Scoring. This exclusive technology alliance is leading the way to fair market pricing for PPC advertisers based on quality and conversions.

Software Solutions

ValidClick DirectAds is a PPC platform that allows you to offer keyword or category based PPC text ads on your web site through an interface thats branded to match your websites look and feel.

Second Bite® (www.secondbite.com) is a unique patent-pending order abandonment recovery technology that provides a full circle solution to recover lost revenue due to shopping cart abandonment. Using automated email messages and phone calls from helpful customer service agents, Second Bite reaches out to shoppers who have abandoned their online shopping cart and encourages them to complete their purchases.

MyAPTM (www.myap.com) is a complete Affiliate Tracking and Management Software solution. It provides merchants the ability to sign up, manage and track the activities of their affiliates through a scalable, reliable, easy-to-use, and privately branded platform with full data transparency.

Kolimbo (www.kolimbo.com) is a traditional affiliate network that provides the ability to partner with top merchants in retail, B2B and niche categories.



10



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Hosting Arrangements



Ozona provides start-to-finish web design, customized web-based applications, database systems, managed and shared hosting solutions and e-commerce.



Direct Segment



The Company operates its Direct Segment through its wholly-owned subsidiaries, Morex Marketing Group LLC (Morex) and Real Estate School Online, Inc (RESO).



Lead Sales



Through Morex, the company provides life stage lead generation services that focus on marketing to expectant mothers and new parents. Morex focuses on generating leads both online and over the phone and markets those leads to consumer package goods (CPG) manufacturers and advertisers.



Online Education



The Company provides accredited real estate licensing courses through RESO.



Discontinued Operations



During the second quarter of 2008, the Company made a decision to divest its MarketSmart Advertising, Inc. (MSA) operations and ceased operations of its Web Diversity Ltd. (Web Diversity) subsidiary which in total comprised its Advertising Segment. The Company also made a decision to divest its Cherish, Inc. (Cherish), Vintacom Florida Inc (Vintacom) and Ilead Media, Inc. (iLead) operations which comprised the Internal Offers reporting unit. On February 17, 2009, the Company concluded the sale of Cherish.



Internal Offers - Discontinued



The Company provides subscription website memberships for a variety of offers including home business opportunities and online dating portals. Through iLead the Company provides home business opportunities for individuals throughout the United States through membership in its programs by providing information and resources for the resale of goods online, access to overstock and dollar-shop goods through iLeads inventories and through goods available from drop-ship partners. Through Cherish and Vintacom the Company offers a wide variety of online dating communities designed to allow individuals to search for friends, partners and future spouses using interactive websites. Some of Cherishs websites also display adult content, and encourage the exploration of alternative lifestyles, in addition to providing dating and relationship services. Revenues from internal offers are generated from monthly membership fees which allow users to obtain complete access to website portals associated with the offers.



Advertising Segment-Discontinued



The Company provides traditional off-line advertising services including branding, collateral advertising, public relations, television advertising, and radio advertising services in seven states and the District of Columbia through MSA. It also offers interactive marketing solutions designed to help businesses increase revenues from their websites by utilizing a variety of interactive marketing channels, such as search engine optimization, paid search and affiliate marketing. The Company provided paid search management and organic search optimizations services in the United Kingdom through its subsidiary Web Diversity until May of 2008 at which time the Company ceased operations in the United Kingdom.





11



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Note 2  Summary of Significant Accounting Policies



a) Basis of presentation



The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation.



b) Cash and cash equivalents



The Company considers all highly liquid investments with an original maturity of three months or less at the time of purchase to be cash equivalents. The Companys cash deposits exceeded FDIC-insured limits at various financial institutions on December 31, 2008 and 2007 by $0.63 million and $1.35 million, respectively, as reported before adjustment for outstanding checks. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.



The Company has restricted cash on deposit with its merchant processors. The majority of these funds are in non-interest bearing accounts. As of December 31, 2008 and 2007, the Company had $992,074 and $1,668,302, respectively, of restricted cash. Of this amount, the Company is currently receiving interest on $104,397 of the balance at a nominal rate.



c) Reclassification



For comparability, the 2007 financial statements reflect reclassifications where appropriate to conform to the financial statement presentation used in 2008. Certain prior period amounts have been reclassified to conform to the current presentation related to discontinued operations.



d) Revenue recognition



The Company recognizes revenue in accordance with Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial Statements(SAB No. 104). Under SAB No. 104, the Company recognizes revenue when the following criteria have been met: persuasive evidence of an arrangement exists, the fees are fixed and determinable, no significant obligations remain and collection of the related receivable is reasonably assured.



Network Segment



Affiliate Network - consistent with the provisions of Emerging Issues Task Force (EITF) Issue No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, the Company recognizes revenue as an agent in affiliate marketing transactions in which the Company is not the primary obligor. Accordingly, service fee revenue is recognized on a net basis because any affiliate expenses are the responsibility of the Companys advertising customer. In certain instances, the Company assumes the position of primary obligor and thus recognizes revenue on a gross basis. Revenue is recognized when the related services are performed.



Search Network - In accordance with EITF Issue 99-19, the Company records as revenue the gross amount received from advertisers and the amount paid to the publishers placing the advertisements as cost of sales. Revenue from company owned networks are based on per click basis and is recognized once the action is taken.



Affiliate Software  The Company recognizes revenue the month in which the software is utilized. Customers are invoiced on the first of the month for the monthly services. All overages for the month are billed at the end of the month and are included in the Companys accounts receivable.



Hosting Arrangements The Company recognizes revenue through a monthly hosting fee and additional usage fees as provided.





12



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Direct Segment



Online Membership Income  The Company recognizes revenue from online memberships when payment is received and the service date of providing membership benefits has taken place.



Lead Sales - For lead sales, the Companys revenue recognition varies depending on the arrangement with the purchaser. Where the arrangement provides for delivery only, revenue is recognized when the lead information is provided to the purchaser. Where the arrangement provides for compensation based on sales generated by the purchaser from the lead, the Company recognizes revenue in the period that the purchasing company makes a sale that was derived from the lead.



Product Sales - For product sales, the Company recognizes revenue when payment is received and the goods are shipped.



List Management Services - Substantially all of the Companys revenue is recorded at the net amount of its gross billings less pass-through expenses charged to a customer. In most cases, the amount that is billed to customers exceeds the amount of revenue that is earned and reflected in our financial statements, because of various pass-through expenses. In compliance with EITF 99-19, the Company assesses whether the Company or a third-party supplier is the primary obligor. The Company has evaluated the terms of its customer agreements and considered other key indicators such as latitude in establishing price, discretion in supplier selection and credit risk to the vendor as part of this assessment. Accordingly, the Company generally records revenue net of pass-through charges.



Subscription Income  The Company recognizes revenue on monthly and multi-monthly subscription contracts on a straight-line basis over the term of the contract.



Advertising Segment



Search Engine Enhancement Services -The Company sells services previously packaged as separate products in our Search Engine Enhancement business, and now treat each product as a separate deliverable in accordance with EITF Issue No. 00-21 Revenue Arrangements with Multiple Deliverables. As such, each deliverable is treated as a separate product or deliverable. The Company, therefore, recognizes revenue for each deliverable either on a straight line basis over the term of the contract, or when value is provided to the customer, as appropriate.



Pay Per Click Management Fees The Company recognizes revenue on pay per click management services in the month the services are performed.



Advertising Services  The Company recognizes revenue in the period in which services are performed.



e)Trade Accounts Receivable



Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Companys best estimate of the amount of probable credit losses on the Companys existing accounts receivable. The Company reviews its allowance for doubtful accounts quarterly. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. In determining past due or delinquent status of a customer, the aged trial balance is continually reviewed by collections and generally any accounts older than 120 days are considered delinquent.



f) Advertising expenses



The Company expenses advertising costs as incurred. Advertising costs for the years ended December 31, 2008 and 2007, respectively, were $4,729,218 and $6,648,907.



g) Property, plant and equipment



13



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Property and equipment are stated at cost. Major renewals and improvements are capitalized, while replacements, maintenance and repairs which do not improve or extend the life of the respective assets are expensed currently. Costs of assets sold or retired and the related accumulated depreciation and amortization are eliminated from accounts and the net gain or loss is reflected in the statement of operations within selling, general and administrative expenses.



h) Depreciation and amortization



Property and equipment are depreciated on the straight-line basis at 8 to 10 years for improvements, 3 years for equipment, 5 to 7 years for furniture and fixtures and 3 to 5 years for software. Leasehold improvements are amortized over the terms of the leases inasmuch as such improvements have useful lives of at least the terms of the respective leases. Depreciation expense for the years ended December 31, 2008 and 2007, respectively, was $2,039,716 and 1,662,739.



i) Capitalized Software Costs



The Company capitalizes certain costs related to the acquisition and internally developed software and amortizes these costs using the straight-line method over the estimated useful life of the software. The Company utilizes all developed software. The Company does not sell developed software. Certain development costs not meeting the criteria for capitalization are expensed as incurred.



j) Goodwill and other intangible assets



Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets(SFAS 142), the Company tests goodwill for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis or more frequently if the Company believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying value, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting units fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting units goodwill with the carrying value of that goodwill.



The Company amortizes its identifiable intangible assets, which result from acquisitions accounted for under the purchase method of accounting, using the straight-line method over their estimated useful lives. Tradenames are not amortized as they are believed to have an indefinite life. Tradenames are reviewed annually for impairment under SFAS No. 142.



k) Taxes on income



The Company utilizes the liability method of accounting for income taxes as set forth in SFAS No. 109, Accounting for Income Taxes(SFAS 109). Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In assessing the need for a valuation allowance the Company must project future levels of taxable income. This assessment requires significant judgment. We examine evidence related to the history of taxable losses or income, the economic conditions in which we operate, organizational characteristics, our forecasts and projections, as well as factors affecting liquidity.





14



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109 (FIN 48). This statement clarifies the criteria that an individual tax position must satisfy for some or all of the benefits of that position to be recognized in a companys financial statements. FIN 48 prescribes a recognition threshold of more-likelythan-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order to be recognized in the financial statements.



l) Impairment of long-lived assets



In accordance with FAS No. 144, Accounting for Impairment or Disposal of Long-lived Assets, long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of the asset is measured by comparison of its carrying amount to future net cash flows the asset is expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds its fair value.



m) Share-based compensation



The Company recognizes share based compensation at fair value pursuant to SFAS No. 123 (revised 2003) Share-Based Payments (SFAS 123R), which is a revision of SFAS No. 123, using the modified prospective transition method. The fair value of restricted stock units is determined using market value of the common stock on the date of the grant. The fair value of stock options is determined using the Black-Scholes valuation model. The Company estimates the fair value of all stock option awards as of the grant date by applying the Black-Scholes-Merton option pricing model. The use of this valuation model involves assumptions that are judgmental and highly sensitive in the determination of compensation expense and include the expected life of the option, stock price volatility, risk-free interest rate, dividend yield, exercise price, and forfeiture rate. Under SFAS 123 (R), forfeitures are estimated at the time of valuation and reduce expense ratably over the vesting period. The forfeiture rate, which is currently estimated at a weighted average of 25 percent of unvested options outstanding, is adjusted periodically based on the extent to which actual forfeitures differ, or are expected to differ, from the previous estimate.



n) Treasury Stock



The cost method was used in recording the purchase of the treasury stock.



o) Earnings per share



Historical basic per share data is based on the weighted average number of shares outstanding. Historical diluted per share data is reconciled by adding to weighted average shares outstanding the dilutive impact of the exercise of outstanding stock options and warrants.



p) Comprehensive income



FAS No. 130 Reporting Comprehensive Income requires disclosure of total comprehensive income. Other comprehensive income (loss) is defined as the change in equity during a period, from transactions and other events, excluding changes resulting from investments by owners (e.g., supplemental stock offering) and distributions to owners (e.g., dividends).



q) Operating segments



FAS No. 131 Disclosures about Segments of an Enterprise and Related Information requires disclosures of certain information about operating segments, products and services, geographic areas in which the Company operates, and their major customers. The Company has evaluated the effect of this standard and has determined that currently it operates in two segments, as defined in this statement.



15



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



r) Concentration of Credit Risk



Financial instruments that potentially expose the Company to concentrations of risk consist primarily of cash and cash equivalents, interest rate swap agreement and accounts receivable, which are generally not collateralized. The Companys policy is to place its cash and cash equivalents with high credit quality financial institutions in order to limit the amount of credit exposure. The counterparty on its interest rate swap agreements is also a large financial institution. The Company does not require collateral from its customers, but its credit extension and collection policies include monitoring payments and aggressively pursuing delinquent accounts. The Company maintains allowances for potential credit losses.



s) Risks and concentrations



When assessing credit risk the Company considers whether the credit risk exists at both the individual and group level. Consideration is given to the activity, region and economic characteristics when assessing if there exists a group concentration risk. At December 31, 2008 the Company has one individual customer with accounts receivable balances greater than 10% of the total accounts receivable. This customer owed $5,017,000 or approximately 58.3% of the total accounts receivable balance at December 31, 2008. At December 31, 2008 the accounts receivable balances for the Companys five largest customers totaled $6,115,000 or approximately 71.0% of the total accounts receivable balance. At December 31, 2007 the accounts receivable balances for the Companys five largest customers totaled $4,063,000 or approximately 29.6% of the total accounts receivable balance. The Companys largest customer for the year ended December 31, 2008 had net sales of approximately $24,728,000 or approximately 30.7% of total net sales for the Company. The Companys five largest customers for the year ended December 31, 2008 had net sales of approximately $42,608,000 or approximately 53.2% of total net sales for the Company. The Companys largest customer for the year ended December 31, 2007 had net sales of approximately $9,274,000 or approximately 12.6% of total net sales for the Company. The Companys five largest customers for the year ended December 31, 2007 had net sales of approximately $27,436,000 or approximately 37.3% of total net sales for the Company.



t) Fair value of financial instruments



Effective January 1,2008, the Company adopted SFAS No. 157 for our financial assets and liabilities. Management uses the fair value hierarchy of SFAS No. 157 , Fair-Value Measurements, which gives the highest priority to quoted prices in active markets. The fair value of financial instruments is estimated based on market trading information, where available. Absent published market values for an instrument or other assets, management uses observable market data to arrive at its estimates of fair value. Management believes that the carrying amount of cash and cash equivalents, accounts receivable, accrued liabilities and long -term debt approximate far value.



SFAS No. 157 defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, SFAS No. 157 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. The three levels of inputs used to measure fair value are as follows:



Level 1

Quoted prices in active markets for identical assets or liabilities.



Level 2

Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted price for identical or similar assets and liabilities in markets that are not active; or other input that are observable or can be corroborated by observable market data.



Level 3

Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.



16



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2008, segregated among the appropriate levels within the fair value hierarchy:

|                   |  |                                                    |   |                                     |   |                          |  |   |   | 
|------------------ |  | -------------------------------------------------- | - | ----------------------------------- | - | ------------------------ |  | - | - | 
|                   |  | Fair Value Measurements at December 31, 2008 with: |  
|(in thousands)     |  | Quoted prices in active
markets for identical      |   | Significant other
observable inputs |   | Significant
unobservable | 
|                   |  | (Level 1)                                          |   | (Level 2)                           |   | (Level 3)                | 
|Liabilities        |  |                                                    |   |                                     |   |                          |  |   |   | 
|Interest rate swap |  | $                                                  |  |                                     | $ | 102,000                  |  | $ |  | 



The Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities (SFAS 159) on January 1, 2008. SFAS 159 permits companies to make an election to carry certain eligible financial assets and liabilities at fair value, even if fair value measurement has not historically been required for such assets and liabilities under U.S. GAAP. Upon adoption of SFAS 159, the Company made no elections to record assets and liabilities at fair market value.



u) Derivative financial instruments



The Company accounts for its interest rate swap agreements in accordance with Statement of Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities asamended by SFAS No. 137, No. 138 and No. 149. This standard requires the Company to recognize all derivatives on the balance sheet at fair value. Our interest rate swap agreement qualifies as a cash flow hedge. Therefore, the effective portion of the fair value change is recorded through other comprehensive income, a component of share equity while any ineffectiveness is recorded in the statement of operations.



v) Use of estimates



The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements and the reported amounts of net revenue and expenses in the reporting period. The Company regularly evaluates estimates and assumptions related to allowances for doubtful accounts, useful lives of property and equipment, goodwill and purchased intangible asset valuations and lives, derivatives and deferred income tax asset valuation allowances. The Company bases its estimates and assumptions on current facts, historical experience and on various other factors that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The actual results experienced by the Company may differ materially and adversely from managements estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected.



w) Litigation and Settlement Costs



From time to time, the Company is involved in disputes, litigation and other legal actions. In accordance with SFAS No. 5, Accounting for Contingencies, the Company records a charge equal to at least the minimum estimated liability for a loss contingency when both of the following conditions are met:



(i) information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred as of the date of the financial statements and (ii) the range of loss can be reasonably estimated.





17



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

x)Contingent Consideration

In connection with certain of the Companys previous acquisitions, if certain future internal performance goals are satisfied, the aggregate consideration for the respective acquisition will be increased. As of December 31, 2008, all additional consideration, if earned, will be paid in the form of cash and stock. Any additional consideration paid in stock will be allocated to goodwill and stock-based compensation expense. The measurement, recognition and allocation of contingent consideration are accounted for using the following principles:

Measurement and Recognition

In accordance with SFAS No. 141, Business Combinations(SFAS 141) contingent consideration is recorded when a contingency is satisfied and additional consideration is issued or becomes issuable. The Company records the additional consideration issued or issuable in connection with the relevant acquisition when a specified internal performance goal is met.

Amount Allocated to Goodwill

In accordance with EITF Issue No. 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination(EITF 95-8) and FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation  an interpretation of APB Opinion No. 25, the portion of additional consideration issuable to holders of unrestricted (i.e., not subject to risk of forfeiture) common stock and fully vested options as of the acquisition date is recorded as additional purchase price, as the consideration is unrelated to continuing employment with the Company. Such portion is allocated to goodwill.

Amount Allocated to Stock-Based Compensation Expense

In accordance with EITF 95-8, the value associated with additional consideration related to stock or options that vest between the acquisition date and the date at which the contingency is satisfied is recorded as an immediate charge to stock-based compensation expense at the time of vesting because the consideration is related to continuing employment with the Company.

y) Recent accounting pronouncements

In December 2007, FASB issued SFAS No. 141 (revised 2007), Business Combinations(SFAS 141R). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree the goodwill acquired and any adjustments to income tax expense for the changes in acquirers existing valuation allowances or uncertain tax positions that result from a business combination. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. This statement is effective beginning January 1, 2009. The Company is currently evaluating the potential impact of the adoption of SFAS 141R on its consolidated financial position, results of operations and cash flows.

In March 2008, the FASB released SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities. SFAS No. 161 requires additional disclosures related to the use of derivative instruments, the accounting for derivatives and the financial statement impact of derivatives. SFAS No. 161 is effective for fiscal years beginning after November 15, 2008. The Company is currently assessing the impact the adoption of SFAS No. 161 will have on the Companys consolidated financial statements.

In April 2008, the FASB issued FSP SFAS 142-3, Determination of the Useful Life of Intangible Assets (FSP 142-3). This guidance is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets(SFAS 142), and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R when the underlying arrangement includes renewal or extension of terms that would require substantial costs or result in a material modification to the asset upon renewal or extension. Companies estimating the useful life of a recognized intangible asset must now consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, must consider assumptions that market participants would use about renewal or extension as adjusted for SFAS 142s entity-



18



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

specific factors. FSP 142-3 is effective for us beginning January 1, 2009. The Company is currently evaluating the potential impact of the adoption of FSP 142-3 on its consolidated financial position, results of operations and cash flows.

Note 3  Allowance for Doubtful Accounts Receivable:

The activity in the allowance for doubtful accounts receivable was as follows:

|                                 |  |      |           |   |      |   |          |  
|-------------------------------- |  | ---- | --------- | - | ---- | - | -------- | -
|                                 |  | 2008 |           |   | 2007 |  
|Balance at the beginning of year |  | $    | 97,170    |   |      | $ | 68,920   |  
|Provision for bad debts          |  |      | 1,109,972 |   |      |   | 170,542  |  
|Charge-offs                      |  |      | (336,865  | ) |      |   | (142,292 | )
|Recoveries                       |  |      | 4,070     |   |      |   |        |  
|Balance at the end of year       |  | $    | 874,347   |   |      | $ | 97,170   |  

Note 4 Property and Equipment

The net carrying value of property and equipment at December 31, 2008 and 2007 was:

|                                                      |  |                   |           |  |                   |   |           | 
|----------------------------------------------------- |  | ----------------- | --------- |  | ----------------- | - | --------- | 
|                                                      |  | December 31,
2008 |           |  | December 31,
2007 |  
|Furniture & Fixtures                                  |  | $                 | 659,206   |  |                   | $ | 641,187   | 
|Equipment                                             |  |                   | 2,505,611 |  |                   |   | 1,531,739 | 
|Software                                              |  |                   | 3,093,722 |  |                   |   | 2,020,687 | 
|Leasehold Improvements                                |  |                   | 258,846   |  |                   |   | 25,764    | 
|Assets Not Yet in Service                             |  |                   | 497,344   |  |                   |   |          | 
|Subtotal                                              |  |                   | 7,014,729 |  |                   |   | 4,219,377 | 
|Less: Accumulated Depreciation and Amortization       |  |                   | 2,724,552 |  |                   |   | 1,199,277 | 
|Net Property & Equipment from Continuing Operations   |  | $                 | 4,290,177 |  |                   | $ | 3,020,100 | 
|Net Property & Equipment from Discontinued Operations |  | $                 | 1,178,813 |  |                   | $ | 1,659,441 | 

Note 5  Intangible Assets and Goodwill

Since 2004, the Company has entered into fourteen purchase agreements in which it allocated a total of $103.4 million of the purchase price to intangible assets, including goodwill. During 2006 and 2007, the Company consolidated certain subsidiaries containing similar products, services and customer classes into three segments.

As a result of the consolidation, our Network Segment, which previously contained four separate reporting units, was consolidated into one operating unit. Also as a result of the consolidation the Direct Segment, which previously contained six reporting units, was consolidated into three reporting units containing similar economic characteristics. The Advertising Segment consisted of two reporting units based on their geographic region. The goodwill associated with the reporting unit based in the United Kingdom was tested for impairment during the first quarter of 2008 as the operations of that unit were being discontinued. The Company determined that it had an impairment of goodwill associated with the United Kingdom based reporting unit within the Advertising Segment at that time. During the second quarter of 2008 the Company made the decision to divest the remaining assets within its Advertising Segment as well as two of the units within its Direct Segment. As a result of the Companys plan to divest certain assets and due to declines in the Companys stock price and market capitalization, the Company tested all of its reporting units as of June 30, 2008 for impairment. When completing step 1 of the impairment tests the Company determined that the carrying values of five of the Companys reporting units had indicators of impairment. During this process the Company determined that the following five reporting units were impaired, internal offers, online dating, domestic advertising, lead generation and our online education properties. Of these five two are included in the Companys continuing operations with the remaining three included in discontinued operations. The Company proceeded to complete step 2 of the analysis required by SFAS No. 142 and recorded impairment charges during the second and third quarters. Due to continued declines in the Companys market capitalization and deterioration in the overall markets that the Company operates in the Company again tested its goodwill for impairment as of



19



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

December 31, 2008. During the process the Company determined that all of its reporting units were impaired and the Company recorded additional impairment charges in the fourth quarter of 2008. Overall, during 2008 the Company recognized impairment charges of $40,201,639 relating to the Companys continuing operations. The Company recognized impairment charges of $40,422,483 relating to reporting units included in discontinued operations.



The following is a schedule of the Companys intangible assets from its continuing operations, by segment, as of December 31, 2008:

Network Segment

|                             |  |            |  |               |            |            |    |                          |   |   |                    |   |  |   |           | 
|---------------------------- |  | ---------- |  | ------------- | ---------- | ---------- | -- | ------------------------ | - | - | ------------------ | - |  | - | --------- | 
|                             |  | Term       |  | Initial Value |            | Impairment |    | Accumulated
Amortization |   |   | Net
Carrying
Value |  
|Employment Agreements        |  | 3-4 Years  |  | $             | 1,025,011  |            | ($ | (129,140                 | ) | $ | (895,871           | ) |  | $ |          | 
|Customer Relations           |  | 5 Years    |  |               | 3,400,000  |            |    |                         |   |   | (2,418,889         | ) |  |   | 981,111   | 
|Website Code and Development |  | 5 Years    |  |               | 4,210,000  |            |    |                         |   |   | (2,426,729         | ) |  |   | 1,783,271 | 
|Trademarks                   |  | Indefinite |  |               | 590,000    |            |    |                         |   |   |                   |   |  |   | 590,000   | 
|Goodwill                     |  |            |  |               | 18,519,088 |            |    | (16,742,544              | ) |   |                   |   |  |   | 1,776,544 | 
|Totals                       |  |            |  | $             | 27,744,099 |            | $  | (16,871,684              | ) | $ | (5,741,489         | ) |  | $ | 5,130,926 | 



Direct Segment  Continuing Operations

|                      |  |            |  |               |             |            |   |                          |   |   |                    |   |  |   |           | 
|--------------------- |  | ---------- |  | ------------- | ----------- | ---------- | - | ------------------------ | - | - | ------------------ | - |  | - | --------- | 
|                      |  | Term       |  | Initial Value |             | Impairment |   | Accumulated
Amortization |   |   | Net
Carrying
Value |  
|Employment Agreements |  | 3-5 Years  |  | $             | 569,000     |            | $ | (193,054                 | ) | $ | (375,946           | ) |  | $ |          | 
|Names Database (1)    |  | 1-2 Years  |  |               | 9,703,454   |            |   | (1,378,000               | ) |   | (6,921,598         | ) |  |   | 1,403,856 | 
|Customer Relations    |  | 5 Years    |  |               | 495,000     |            |   | (121,792                 | ) |   | (332,133           | ) |  |   | 41,075    | 
|Software              |  | 5 Years    |  |               | 95,000      |            |   | (29,292                  | ) |   | (65,708            | ) |  |   |          | 
|Vendor Relations      |  | 3 Years    |  |               | 82,000      |            |   | (1,139                   | ) |   | (80,861            | ) |  |   |          | 
|Reference Materials   |  | 4 Years    |  |               | 571,000     |            |   | (130,698                 | ) |   | (431,302           | ) |  |   | 9,000     | 
|Tradenames            |  | Indefinite |  |               | 632,000     |            |   | (340,000                 | ) |   |                   |   |  |   | 292,000   | 
|Goodwill              |  |            |  |               | 22,710,842  |            |   | (21,135,981              | ) |   |                   |   |  |   | 1,574,861 | 
|Totals                |  |            |  | $             | 34, 858,296 |            | $ | (23,329,956              | ) | $ | (8,207,548         | ) |  | $ | 3,320,792 | 



Company Totals

|                            |  |               |            |            |   |                          |   |   |                    |   |  |   |           | 
|--------------------------- |  | ------------- | ---------- | ---------- | - | ------------------------ | - | - | ------------------ | - |  | - | --------- | 
|                            |  | Initial Value |            | Impairment |   | Accumulated
Amortization |   |   | Net
Carrying
Value |  
|Goodwill                    |  | $             | 41,229,930 |            | $ | (37,878,525              | ) | $ |                   |   |  | $ | 3,351,405 | 
|Indefinite Life Intangibles |  | $             | 1,222,000  |            | $ | (340,000                 | ) | $ |                   |   |  | $ | 882,000   | 
|Other Intangibles           |  | $             | 20,150,465 |            | $ | (1,983,115               | ) | $ | (13,949,036        | ) |  | $ | 4,218,314 | 



(1)

Amortization of Names Database included in cost of revenue for the years ended December 31, 2008 and 2007 was $3,199,785 and $2,853,632, respectively.



The Companys amortization expense over the next five years is as follows:

|      |  |   |           | 
|----- |  | - | --------- | 
|2009  |  | $ | 2,685,366 | 
|2010  |  |   | 1,319,178 | 
|2011  |  |   | 213,770   | 
|2012  |  |   |          | 
|2013  |  |   |          | 
|Total |  | $ | 4,218,314 | 



20



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



The following is a schedule of the Companys intangible assets from its discontinued operations, by segment, as of December 31, 2008:



Direct Segment  Discontinued Operations

|                      |  |            |  |               |            |                                   |   |                          |   |                    |            |   |   |           | 
|--------------------- |  | ---------- |  | ------------- | ---------- | --------------------------------- | - | ------------------------ | - | ------------------ | ---------- | - | - | --------- | 
|                      |  |            |  |               |            |                                   |   |                          |   |                    |           
|                      |  | Term       |  | Initial Value |            | Impairment
& Currency
Translation |   | Accumulated
Amortization |   | Net Carrying
Value |           
|Employment Agreements |  | 3-5 Years  |  | $             | 940,000    |                                   | $ | (415,721                 | ) | $                  | (524,279   | ) | $ |          | 
|Customer Relations    |  | 5 Years    |  |               | 99,000     |                                   |   |                         |   |                    | (99,000    | ) |   |          | 
|Software              |  | 5 Years    |  |               | 3,140,584  |                                   |   | (377,919                 | ) |                    | (1,795,727 | ) |   | 966,938   | 
|Client Lists          |  | 7 Years    |  |               | 416,000    |                                   |   |                         |   |                    | (217,595   | ) |   | 198,405   | 
|Vendor Relations      |  | 3 Years    |  |               | 2,600,000  |                                   |   | (1,505,833               | ) |                    | (1,094,167 | ) |   |         | 
|Tradenames            |  | Indefinite |  |               | 300,000    |                                   |   | (300,000                 | ) |                    |           |   |   |          | 
|Goodwill              |  |            |  |               | 32,420,756 |                                   |   | (31,878,756              | ) |                    |           |   |   | 542,000   | 
|Totals                |  |            |  | $             | 39,916,340 |                                   | $ | (34,478,229              | ) | $                  | (3,730,768 | ) | $ | 1,707,343 | 



Advertising Segment  Discontinued Operations

|                      |  |            |  |               |           |                                   |   |            |                          |  |   |                    |   |  |   |         | 
|--------------------- |  | ---------- |  | ------------- | --------- | --------------------------------- | - | ---------- | ------------------------ |  | - | ------------------ | - |  | - | ------- | 
|                      |  |            |  |               |           |                                   |   |            |                          |  |   |                    |  
|                      |  | Term       |  | Initial Value |           | Impairment
& Currency
Translation |   |            | Accumulated
Amortization |  |   | Net Carrying
Value |  
|Employment Agreements |  | 4 Years    |  | $             | 725,000   |                                   | $ | (169,249   | )                        |  | $ | (555,751           | ) |  | $ |        | 
|Customer Relations    |  | 8 Years    |  |               | 1,890,000 |                                   |   | (288,125   | )                        |  |   | (826,875           | ) |  |   | 775,000 | 
|Supplier Relations    |  | 3 Years    |  |               | 28,000    |                                   |   | (10,832    | )                        |  |   | (17,168            | ) |  |   |        | 
|Software Tools        |  | 5 Years    |  |               | 175,000   |                                   |   | (32,083    | )                        |  |   | (142,917           | ) |  |   |        | 
|Trademarks            |  | Indefinite |  |               | 941,000   |                                   |   | (941,000   | )                        |  |   |                   |   |  |   |        | 
|Goodwill (2)          |  |            |  |               | 4,252,863 |                                   |   | (4,252,863 | )                        |  |   |                   |   |  |   |        | 
|Totals                |  |            |  | $             | 8,011,863 |                                   | $ | (5,694,152 | )                        |  | $ | (1,542,711         | ) |  | $ | 775,000 | 



(2)

See Note 11.

Note 6 - Notes Payable



The following table summarizes the Companys notes payable balance as of December 31, 2008 and 2007:

|                                       |  |          |  |                       |  |      |           |      |   |            | 
|-------------------------------------- |  | -------- |  | --------------------- |  | ---- | --------- | ---- | - | ---------- | 
|                                       |  |          |  |                       |  |      |           |      |   |            | 
|Lender                                 |  | Due Date |  | Interest Rate         |  | 2008 |           | 2007 |  
|Wachovia Bank  Installment Note       |  | 03/10    |  | 5.9%                  |  | $    | 3,700,855 |      | $ |           | 
|Wachovia Bank  Line of Credit         |  | 03/10    |  | 1-month LIBOR + 2.50% |  |      | 6,214,228 |      |   | 12,401,000 | 
|Totals                                 |  |          |  |                       |  |      | 9,915,083 |      |   | 12,401,000 | 
|Less: Current portion of notes payable |  |          |  |                       |  |      | 1,648,970 |      |   | 1,301,537  | 
|Non-Current Portion                    |  |          |  |                       |  | $    | 8,266,113 |      | $ | 11,099,463 | 



Principal Payments Due



Principal payments due for the next five years are as follows:

|       |  |   |           | 
|------ |  | - | --------- | 
|       |  |   |           | 
|2009   |  | $ | 1,648,970 | 
|2010   |  |   | 8,266,113 | 
|2011   |  |   |          | 
|TOTALS |  | $ | 9,915,083 | 



21



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Wachovia Line of Credit and Installment Note Payable (see Note 21  Subsequent Events)



On February 27, 2008, the Company amended and restated its loan agreements (the Loan Agreements) with Wachovia Bank, National Association (Wachovia). Pursuant to the Loan Agreements the Company borrowed $15 million from Wachovia evidenced by a revolving credit promissory note (the Revolving Credit Note) and $5.0 million, evidenced by a term promissory note (the Term Note). The Companys obligations under the Loan Agreements are secured by a first priority lien, in favor of Wachovia, on all of the assets of the Company, including the stock of each of the Companys operating subsidiaries and are subject to certain financial covenants. Further, each of the Companys operating subsidiaries has guaranteed the performance of the Companys obligations under the Loan Agreements (each, a Guarantor) and the guaranty is secured by a first priority lien on each Guarantors assets. Interest on the unpaid principal balance of the Revolving Credit Note accrues at a range from LIBOR Market Index Rate plus 1.50% to LIBOR Market Index Rate plus 2.50% as such rate may change from day to day dependent on the amounts drawn on the loan on the quarterly calculation date compared to the Companys trailing EBIDTA, as defined in the Loan Agreements. Amounts due under the Revolving Credit Note are payable in consecutive monthly payments of accrued interest only until maturity at which time all principal and any accrued but unpaid interest is due and payable. The Revolving Credit Note matures on February 15, 2011. Interest on the unpaid principal balance of the Term Note accrues at the LIBOR Market Index Rate plus 2.50% as such rate may change from day to day. Amounts due under the Term Note are payable in 36 consecutive monthly payments with the final payment due on February 15, 2011, the Term Notes maturity. Concurrently the Company entered into an interest rate swap agreement with Wachovia in which it effectively fixed the rate of the term note at 5.9%.



On June 25, 2008 the Company entered into a Master Consent to Loan Documents and First Amendment to Loan Agreement and Amended and Restated Revolving Credit Promissory Note with Wachovia Bank, N.A. This amendment increased the Companys availability under the line of credit from 1.75 times to 2.00 times the trailing twelve month adjusted EBIDTA through December 31, 2008. The amendment also addresses the use of proceeds from any Guarantor sale over the term of the Loan Agreements.



Per the amended loan agreement with Wachovia, the Company is required to calculate its borrowing base monthly on a rolling twelve month basis. As of December 31, 2008 the Companys availability under its Wachovia line of credit was approximately $0.8 million. The Companys outstanding balance as of December 31, 2008 was approximately $6.9 million which includes approximately $0.7 million under a letter of credit with our landlord. As of December 31, 2008, the Company was in technical default of the Total Debt to EBITDA and maximum annual capital expenditure covenants, for which the Company received a waiver.



On March 18, 2009, the Company entered into a Second Amendment to Amended and Restated Loan Agreement (the Loan Amendment) with Wachovia Bank, N.A.. The Loan Amendment amended the Loan Agreements dated as of February 27, 2008 between Wachovia and the Company and First Amendment to Amended and Restated Loan Agreement dated June 25, 2008. The Loan Amendment also amended the Term Note in the original amount of $5,000,000 dated as of February 27, 2008. The Loan Amendment reduces the maximum available credit under revolving loan facility to $8 million on the effective date and further reduces the maximum available under the revolving credit facility to $6 million on October 1, 2009. The maturity date of the Loan Agreements and the Term Note was changed from February 27, 2011 to March 31, 2010.



Repayment Terms; Interest Rates. Interest on the unpaid principal balance of the revolving loan accrues at a rate between LIBOR Market Index Rate plus 4% until October 1, 2009 at which time the rate increases to LIBOR Market Index Rate plus 7%, provided further that the interest rate shall in no event be less than 7%. The revolving loan matures on March 31, 2010. Interest on the unpaid principal balance of the Term Note accrues at the LIBOR Market Index Rate plus 4% until October 1, 2009 at which time the rate increases to LIBOR Market Index Rate plus 7%, provided further that the interest rate shall in no event be less than 7%. Amounts due under the Term Note are payable in 36 consecutive monthly payments with any remaining principal due on March 31, 2010, the Term Notes maturity. Concurrently, the Company terminated early the interest rate swap agreement with Wachovia which it entered into concurrent with the Term Note. The principal amount of the Term Note will be reduced by the net proceeds to the Company upon the sale of MarketSmart Advertising, Inc.



22



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Covenants. As detailed further in the Loan Amendment, the Company is limited to borrowings under the revolving facility equal to 2.0 times its trailing pro forma adjusted EBITDA until the earlier of the sale of MarketSmart Advertising, Inc or October 1, 2009, at which time the borrowings are limited to 1.5 times its trailing pro forma adjusted EBITDA. Further, so long as there remain any amounts outstanding under the credit facility, the Company is required to maintain: (1) a Total Debt to EBITDA Ratio of not less than 2.00 to 1.00, calculated quarterly on a rolling four quarters basis; and (2) a Fixed Charge Coverage Ratio of not less than 2.50 to 1.00, calculated quarterly on a rolling four quarters basis. In addition, the Company may not: (a) make capital expenditures during any year exceeding $500,000; (b) incur any additional indebtedness unless approved by Wachovia; (c) declare or pay dividends unless approved by Wachovia; and (d) arrange for return, cancellation, termination, or replacement of letters of credit on or before August 21, 2009. Additionally, so long as the credit facility remains in effect, the Company may not acquire or invest in, directly or indirectly, any business unless approved by Wachovia. The Company may not purchase, redeem, retire or otherwise acquire, directly or indirectly, any stock, securities, or evidence of indebtedness, unless approved by Wachovia.



Note 7 - Derivatives and Hedging Transactions



In the normal course of business, the Company is exposed to the impact of interest rate changes. The Company limits these risks by following established risk management policies and procedures, including the use of derivatives. Derivatives are used to align rate movements associated with its financing debt and manage the related cost of debt. The Company does not use derivative financial instruments for purposes other than hedging underlying commercial or financial exposures of the Company.



The Company has entered into an interest swap agreement to reduce the impact of changes in interest rates on its floating rate long-term debt. At December 31, 2008, the Company had outstanding an interest rate swap agreement with Wachovia, having a total notional amount of $5,000,000. This agreement effectively changes the Companys interest rate exposure on its $5,000,000 floating rate note due February 15, 2011 to a fixed interest rate of 5.9%. The interest rate swap agreement matures at the time the related note matures. The Company is exposed to credit loss in the event of nonperformance by Wachovia in the interest rate swap agreement; however, the Company does not anticipate nonperformance and the related note is held by Wachovia. The Company has designated its interest rate swap as a cash flow hedge for accounting purposes. As a result, changes in the fair value of the swap are recorded as a component of other comprehensive income. At December 31, 2008, a loss of approximately $102,000 was recorded in Other Comprehensive Income (Loss) and is included in other long-term liabilities.



Changes in fair value on interest rate swaps are initially recorded in Other Comprehensive Income (Loss) and are subsequently reclassified to interest expense in the same period in which the variable cash flows affect earnings. Any ineffectiveness in the hedging relationship is recognized immediately in earnings. For the period ending December 31, 2008, there were no gains or losses recognized in earnings due to hedge ineffectiveness because the hedge was 100 percent effective. On March 18, 2009, the Company terminated the interest rate swap early as part of the Loan Amendment between the Company and Wachovia



Note 8  Accrued Expenses and Other Current Liabilities



The accrued expenses and other current liabilities consist of the following as of December 31, 2008 and 2007:

|                                |  |      |           |  |      |   |           | 
|------------------------------- |  | ---- | --------- |  | ---- | - | --------- | 
|                                |  |      |           |  |      |  
|                                |  | 2008 |           |  | 2007 |  
|Accrued Expenses                |  | $    | 525,069   |  |      | $ | 379,405   | 
|Accrued Affiliate Payments      |  |      | 185,508   |  |      |   | 652,973   | 
|Accrued Payroll Liabilities     |  |      | 288,044   |  |      |   | 218,378   | 
|Capital Lease  Current Portion |  |      | 308,115   |  |      |   |          | 
|Total                           |  | $    | 1,306,736 |  |      | $ | 1,250,756 | 





23



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

Note 9 - Long-Term Liabilities

The long-term liabilities consist of the following as of December 31, 2008 and 2007:

|                                                 |  |      |           |  |      |   |            | 
|------------------------------------------------ |  | ---- | --------- |  | ---- | - | ---------- | 
|                                                 |  |      |           |  |      |  
|                                                 |  | 2008 |           |  | 2007 |  
|Notes Payable  Net of Current Portion           |  | $    | 8,266,112 |  |      | $ | 11,099,463 | 
|Capital Lease  Net of Current Portion           |  |      | 262,248   |  |      |   | 0          | 
|Deferred Income Tax Payable                      |  |      | 0         |  |      |   | 2,494,539  | 
|Deferred Rent                                    |  |      | 214,875   |  |      |   | 140,944    | 
|Other                                            |  |      | 101,943   |  |      |   | 0          | 
|Long Term Liabilities of Discontinued Operations |  |      | 211,635   |  |      |   | 453,319    | 
|Total                                            |  | $    | 9,056,813 |  |      | $ | 14,188,265 | 

Note 10  Adjustment for Contingent Shares

In April of 2006, the Company completed the acquisition of Web Diversity. As part of the acquisition the Company issued 500,000 shares to the former shareholder of Web Diversity. These shares were held in escrow pending certain performance goals to be reached over the following three year period. At the time of the acquisition the Company incorrectly applied SFAS 141, as it related to the shares that were held in escrow. The Company believed that the release of the shares held in escrow was probable at the time of acquisition; however, it could not be determined beyond a reasonable doubt as stated in SFAS 141. The Company based this assumption on its extremely successful domestic pay-per-click business model and viewed the market in the United Kingdom as being poised for similar growth. The Company has followed guidance from SFAS No. 154, Accounting Changes and Error Correctionsa replacement of APB Opinion No. 20 and FASB Statement No. 3 and SAB No. 108, Section N Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements in considering the proper presentation and disclosures in our current filings. The Company determined that the effect of the improper application was immaterial to the Companys financial statements and therefore the Company has elected to modify the current period presentation.

Note 11  Income Taxes

Provision (Benefit) for Income Taxes

The provision for income taxes consists of the following:

|                                |  |      |            |      |   |            |  
|------------------------------- |  | ---- | ---------- | ---- | - | ---------- | -
|                                |  |      |            |      |   |            |  
|                                |  | 2008 |            | 2007 |  
|Current Tax Provision           |  | $    | 0          |      | $ | (144,852   | )
|Deferred Tax(Benefit) Provision |  |      | (1,980,051 | )    |   | (1,258,481 | )
|Total Tax (Benefit) Provision   |  | $    | (1,980,051 | )    | $ | (1,403,333 | )



The current provision for income taxes to actual cash paid does not reflect the benefit reflected under GAAP for the exercise of the stock options.



A reconciliation of the expected Federal statutory rate of 34% to the Companys actual rate as reported for each of the periods presented is as follows:

|                                             |  |      |     |    |      |  |     |   
|-------------------------------------------- |  | ---- | --- | -- | ---- |  | --- | --
|                                             |  |      |     |    |      | 
|                                             |  | 2008 |     |    | 2007 | 
|Expected statutory rate                      |  |      | (34 | )% |      |  | (34 | )%
|State Income tax rate, ne of federal benefit |  |      | (4  | )% |      |  | (4  | )%
|Permanent Differences                        |  |      | 0   | %  |      |  | 7   | % 
|Impairment Differences                       |  |      | 16  | %  |      |  | 0   | % 
|Valuation Allowance                          |  |      | 18  | %  |      |  | 0   | % 
|                                             |  |      | (4  | )% |      |  | (31 | )%





24



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Deferred Income Taxes



Deferred income taxes are the result of timing differences between book and tax basis of certain assets and liabilities, timing of income and expense recognition of certain items and net operating loss carry-forwards.



Pursuant to SFAS No. 109, the Company assesses temporary differences resulting from different treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded in our consolidated balance sheets. The Company evaluates the realizability of its deferred tax assets and assess the need for a valuation allowance on an ongoing basis. In evaluating its deferred tax assets, the Company considers whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of deferred tax assets depends upon generating sufficient future taxable income prior to the expiration of the tax attributes. In assessing the need for a valuation allowance the Company must project future levels of taxable income. This assessment requires significant judgment. The Company examined the evidence related to a recent history of tax losses, the economic conditions in which it operates, recent organizational changes, its forecasts and projections, as well as the recent changes in its financing agreement with Wachovia. As a result, the Company was unable to support a conclusion that it is more likely than not that any of its deferred tax assets will be realized. The Company therefore has recorded a valuation for the net deferred tax assets as of December 31, 2008. There was no valuation allowance at December 31, 2007. The Company will continue to evaluate its deferred tax assets to determine whether any changes in circumstances could affect the realization of their future benefit. If it is determined in future periods that portions of the Companys deferred income tax assets satisfies the realization standard of SFAS No. 109, the valuation allowance will be reduced accordingly.



The following is a schedule of the deferred tax assets and liabilities as of December 31, 2008 and 2007:

|                                        |  |      |            |  |      |   |            |   | 
|--------------------------------------- |  | ---- | ---------- |  | ---- | - | ---------- | - | 
|                                        |  |      |            |  |      |   |           
|                                        |  | 2008 |            |  | 2007 |   |           
|Deferred Tax Assets                     |  |      |            |  |      |   |           
|Net Operating Loss Carry Forwards       |  | $    | 2,578,098  |  |      | $ | 791,872    |   | 
|Intangible Assets                       |  |      | 8,787,180  |  |      |   | 489,644    |   | 
|Deferred Rent                           |  |      | 162,591    |  |      |   | 149,759    |   | 
|Allowance for Doubtful Accounts         |  |      | 507,862    |  |      |   | 146,227    |   | 
|Stock Based Expenses                    |  |      | 283,183    |  |      |   | 549,774    |   | 
|Other                                   |  |      | 17,188     |  |      |   | 20,331     |   | 
|Subtotal                                |  |      | 12,336,102 |  |      |   | 2,147,607  |   | 
|Less Valuation Allowance                |  |      | 9,847,766  |  |      |   |           |   | 
|Total                                   |  |      | 2,488,336  |  |      |   | 2,147,607  |   | 
|Less: Current portion                   |  |      |           |  |      |   | 873,961    |   | 
|Non-Current portion                     |  | $    | 2,488,336  |  |      | $ | 1,273,646  |   | 
|Deferred Tax Liabilities                |  |      |            |  |      |   |            |   | 
|Depreciation                            |  | $    | 707,350    |  |      | $ | 669,454    |   | 
|Intangibles                             |  |      | 1,780,986  |  |      |   | 4,442,897  |   | 
|Total                                   |  |      | 2,488,336  |  |      |   | 5,112,351  |   | 
|Less: Current portion                   |  |      |           |  |      |   | 1,344,166  |   | 
|Non-Current portion                     |  | $    | 2,488,336  |  |      | $ | 3,768,185  |   | 
|Total Deferred Tax Assets (Liabilities) |  | $    |           |  |      | $ | (2,964,744 | ) | 





25



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

For balance sheet presentation the Company nets its current deferred tax assets and liabilities and non-current deferred tax assets and liabilities. The following table summarizes the presentation:

|                                                |  |      |   |  |      |   |            |   | 
|----------------------------------------------- |  | ---- | - |  | ---- | - | ---------- | - | 
|Balance Sheet Presentation                     
|                                                |  | 2008 |   |  | 2007 |   |           
|Net current deferred tax assets (liabilities)   |  | $    |  |  |      | $ | (470,205   | ) | 
|                                                |  |      |   |  |      |   |            |   | 
|Net long-term deferred tax assets (liabilities) |  | $    |  |  |      | $ | (2,494,539 | ) | 

As of December 31, 2008 the Company has net operating loss carry forwards remaining from the years ended December 31, 2002, 2003 and 2008 in the amounts of $341,675, $1,987,360 and $4,474,047, respectively. Under the Internal Revenue Code of 1986, as amended, these losses can be carried forward twenty years. The Company has $2,820,294 of carry forward deductions from 2006 relating to stock options exercised as of December 31, 2008.

As described in footnote 1, effective January 1, 2007, the Company adopted FIN 48 and did not record any adjustments resulting from the adoption.

The Company is currently open to audit under the statute of limitations by the Internal Revenue Service for the years ending December 31, 2004 through 2007. The Companys 2004 income tax return was reviewed by the Internal Revenue Service. No material items were discovered and the review was finalized in 2006. The Company and its subsidiaries state income tax returns are open to audit under the statute of limitations for the years ending December 31, 2004 through 2007.

The Company recognizes interest and penalties related to income taxes in income tax expense. The Company had incurred no penalties and interest for the years ended December 31, 2008 and 2007.

Note 12 - Stock-based compensation plans

The stock option program is a long-term retention program that is intended to attract, retain and provide incentives for talented employees, officers and directors, and to align stockholder and employee interests. We consider our option programs critical to our operation and productivity. Currently, the Company grants options and restricted stock units from the 2005 Long-Term Incentive Plan. Option and restricted stock unit vesting periods are generally zero to three years.

As of December 31, 2008, we had reserved 10.0 million shares of common stock for issuance under our 2005 Long-Term Incentive Plan. As of December 31, 2008, we had 2.5 million shares available for grant under our 2005 Long-Term Incentive Plan.

During 2008, the Company granted 830,000 restricted stock units. Unrecognized compensation cost related to restricted stock units of $228,019 will be recognized over the weighted average remaining contractual term of 2.39 years.

The Company recorded stock-based compensation expense for all equity incentive plans of $268,177 and $1,065,940 for the years ended December 31, 2008 and 2007.

During 2008, the Company recalculated its projected forfeiture rate as it applies to stock-based compensation based on an analysis of historical data and recent trends. The forfeiture rate was changed from 9.25% to 25.0% of all non-vested stock options. The impact of this change in estimate was to reduce operating expenses and increase net income for the year by $76,594, which did not change both basic and diluted earnings per share. Actual results, and future changes in estimates, may differ substantially from the Companys current estimates.

During 2008, the Company realized a benefit from actual forfeiture experience that was higher than previously estimated for unvested stock options and restricted common stock, resulting primarily from executive departures from the Company. The impact of these events was a reduction in operating expenses and increase in net income of approximately $474,214 for 2008.



26



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



At December 31, 2008, the aggregate intrinsic value of all outstanding options was $0 with a weighted average remaining contractual term of 4.91 years, of which 1,378,181 of the outstanding options are currently exercisable with an aggregate intrinsic value of $0, a weighted average exercise price of $1.75 and a weighted average remaining contractual term of 5.48 years. The total intrinsic value of options exercised during the years ended December 31, 2008 and 2007 was $34,000 and $2,260,344, respectively. The total compensation cost at December 31, 2008 related to non-vested awards not yet recognized was $661,941 with an average expense recognition period of 2.22 years. The total fair value of options vested during 2008 and 2007 was $114,550 and $967,203, respectively.



The following table summarizes information about stock option activity during the twelve months ended December 31, 2008 and 2007, respectively.

|                               |  |         |            |   |                                 |   |      |         |  |  |                                 |   |  |   |      | 
|------------------------------ |  | ------- | ---------- | - | ------------------------------- | - | ---- | ------- |  |  | ------------------------------- | - |  | - | ---- | 
|                               |  |         |            |   |                                 |   |      |         |  |  |                                 |  
|                               |  | 2008    |            |   | 2007                            |  
|                               |  | Options |            |   | Weighted
Average
Exercise Price |   |      | Options |  |  | Weighted
Average
Exercise Price |  
|Outstanding, Beginning of Year |  |         | 3,604,647  |   |                                 | $ | 1.86 |         |  |  | 4,092,982                       |   |  | $ | 1.70 | 
|Granted                        |  |         | 5,604,223  |   |                                 | $ | 0.53 |         |  |  | 1,090,000                       |   |  | $ | 1.88 | 
|Forfeited or Expired           |  |         | (2,378,465 | ) |                                 | $ | 1.55 |         |  |  | (816,385                        | ) |  | $ | 2.70 | 
|Exercised                      |  |         | (100,000   | ) |                                 | $ | 0.13 |         |  |  | (761,950                        | ) |  | $ | 0.13 | 
|Outstanding, End of Year       |  |         | 6,730,405  |   |                                 | $ | 0.89 |         |  |  | 3,604,647                       |   |  | $ | 1.86 | 
|Exercisable, End of Year       |  |         | 1,378,181  |   |                                 | $ | 1.75 |         |  |  | 1,621,480                       |   |  | $ | 1.53 | 



The weighted average grant date fair value of options granted during 2008 and 2007 were $0.17 and $0.99, respectively.



Cash received from option and warrant exercises under all share-based payment arrangements for the years ended December 31, 2008 and 2007 was $13,000 and $256,136, respectively.



The following table summarizes information about stock options outstanding as of December 31, 2008:

|                        |  |        |           |                                                     |  |                                 |  |   |      |  | 
|----------------------- |  | ------ | --------- | --------------------------------------------------- |  | ------------------------------- |  | - | ---- |  | 
|                        |  |        |           |                                                     |  |                                 |  |   |      |  | 
|Range of
Exercise Price |  | Shares |           | Weighted Average Remaining
Contractual Life (Years) |  | Weighted Average
Exercise Price |  |  
|$0.00-$0.50             |  |        | 2,513,575 |                                                     |  | 4.71                            |  | $ | 0.23 |  | 
|$0.51-$1.00             |  |        | 2,651,332 |                                                     |  | 4.44                            |  | $ | 0.69 |  | 
|$1.01-$2.00             |  |        | 636,299   |                                                     |  | 5.50                            |  | $ | 1.81 |  | 
|$2.01-$3.00             |  |        | 797,465   |                                                     |  | 6.58                            |  | $ | 2.22 |  | 
|$3.01-$4.00             |  |        | 3,834     |                                                     |  | 2.85                            |  | $ | 3.32 |  | 
|$4.01-$5.25             |  |        | 127,900   |                                                     |  | 4.96                            |  | $ | 5.07 |  | 
|Total                   |  |        | 6,730,405 |                                                     |  | 4.90                            |  | $ | 0.89 |  | 



In accordance with SFAS 123 (R), the fair values of options granted prior to adoption and determined for purposes of disclosure under SFAS 123 have not been changed. The fair value of options granted was estimated assuming the following weighted averages:

|                        |  |      |      |   |      |  |      |  
|----------------------- |  | ---- | ---- | - | ---- |  | ---- | -
|                        |  |      |      |   |      | 
|                        |  | 2008 |      |   | 2007 | 
|Expected Life(in years) |  |      | 3.50 |   |      |  | 3.50 |  
|Volatility              |  |      | 0.88 |   |      |  | 0.77 |  
|Risk Free Interest Rate |  |      | 2.23 | % |      |  | 4.03 | %
|Dividend Yield          |  |      | 0.00 | % |      |  | 0.00 | %



Expected volatility is based on the historical volatility of the Companys common stock over the period commensurate with or longer than the expected life of the options.





27



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Note 13  Stockholders Equity



Significant Equity Transactions



Treasury Stock



The Company has 5,516,956 shares of stock in its treasury at a combined total value of $2,096,107. The cost method was used in recording the purchase of the treasury stock.



Warrants Outstanding



As of December 31, 2008 and 2007, the Company had outstanding warrants for the potential issuance of 8,345,452 shares of common stock. Exercise price ranges from $1.00 to $4.00 on December 31, 2007. These warrants were primarily issued in connection with private placements and debt issuances (see significant equity transactions). The Company issued no warrants in 2008 and 2007. All of these warrants are exercisable for five years.



Warrants issued in 2005 and 2004 are primarily exercisable in 2 to 3 years. Warrants issued in prior years are primarily exercisable over a ten year period ending in the year 2010 through 2013.



The following table summarizes information about stock warrants outstanding as of December 31, 2008:

|                        |  |        |           |                                                     |  |                                 |  |   |      | 
|----------------------- |  | ------ | --------- | --------------------------------------------------- |  | ------------------------------- |  | - | ---- | 
|                        |  |        |           |                                                     |  |                                 |  |   |      | 
|Range of
Exercise Price |  | Shares |           | Weighted Average Remaining
Contractual Life (Years) |  | Weighted Average
Exercise Price | 
|$1.00-$1.99             |  |        | 44,939    |                                                     |  | 1.48                            |  | $ | 1.00 | 
|$2.00-$2.49             |  |        | 100,500   |                                                     |  | 2.39                            |  | $ | 2.00 | 
|$2.50-$2.99             |  |        | 5,200,000 |                                                     |  | 2.26                            |  | $ | 2.50 | 
|$3.01-$3.99             |  |        | 2,000,007 |                                                     |  | 2.99                            |  | $ | 3.05 | 
|$4.00-$4.00             |  |        | 1,000,006 |                                                     |  | 2.26                            |  | $ | 4.00 | 
|Total                   |  |        | 8,345,452 |                                                     |  | 2.43                            |  | $ | 2.80 | 



Note 14  Discontinued Operations:



During 2008, the Company made a decision to cease operations at its Web Diversity Ltd subsidiary in the United Kingdom and divest its MarketSmart Advertising operations which comprised its Advertising Segment. The Company also decided to divest its Online Dating and Ilead Media operations which were a portion of its Direct Segment. As a result, the related assets are classified as held for sale and their respective carrying values have been adjusted down to their estimated fair value less selling costs. The write down to fair value resulted in a charge to loss from discontinued operations of approximately $36.9 million, net of tax benefit for year ended December 31, 2008. Additionally, the results of operations of these reporting units have been reported as a profit or loss from discontinued operations in the consolidated statements of operations. The table below summarizes financial results for the assets classified as held for sale:

|                                                               |  |      |             |   |      |   |            | 
|-------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ---------- | 
|                                                               |  |      |             |   |      |  
|                                                               |  | 2008 |             |   | 2007 |  
|Net sales                                                      |  | $    | 29,065,654  |   |      | $ | 45,781,036 | 
|(Loss) Profit from discontinued operations before income taxes |  | $    | (38,958,841 | ) |      | $ | 2,916,828  | 
|Income Tax (Benefit) Expense                                   |  |      | (1,045,304  | ) |      |   | 901,104    | 
|(Loss) Profit from discontinued operations                     |  | $    | (37,913,537 | ) |      | $ | 2,015,724  | 





28



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007

Note 15 - Net Loss Per Common Share.

Net loss per share (basic) is calculated by dividing net income by the weighted average number of shares of common stock outstanding during the year. Net loss per share (diluted) is calculated by adjusting outstanding shares, assuming any dilutive effects of options and warrants using the treasury stock method.

The following reconciles the denominators of basic and diluted earnings per share:

|                                                            |  |      |            |      |            |  
|----------------------------------------------------------- |  | ---- | ---------- | ---- | ---------- | -
|                                                            |  |      |            |      |            |  
|                                                            |  | 2008 |            | 2007 |           
|Denominator  Shares                                        |  |      |            |      |            |  
|Basic weighted-average shares                               |  |      | 66,549,326 |      | 67,122,669 |  
|Stock Options and other contingently issuable shares        |  |      | 362,477    |      | 1,277,415  |  
|Antidilutive stock options and contingently issuable shares |  |      | (362,477   | )    | (1,277,415 | )
|Diluted weighted-average shares                             |  |      | 66,549,326 |      | 67,122,669 |  



Note 16  Pension Costs



The Company sponsors a defined contribution plan to help eligible employees provide for retirement. The Company began matching employees contributions in April of 2007. The Company currently matches 50% of employee contributions up to 6% of eligible contributions. The Companys total matching contributions in 2008 and 2007 were $163,375 and $136,722, respectively.

Note 17 - Leasing Commitments and Contingencies

Operating Leases

The Company leases certain office space and equipment. As leases expire, it can be expected that, in the normal course of business, certain leases will be renewed or replaced.

Rent expense was $1,748,250 and $1,443,032 for the years ended December 31, 2008 and 2007, respectively.

Minimum lease payments under non-cancelable operating leases for the next five years are:

|           |  |   |           | 
|---------- |  | - | --------- | 
|           |  |   |           | 
|2009       |  | $ | 1,128,168 | 
|2010       |  |   | 1,116,865 | 
|2011       |  |   | 1,095,529 | 
|2012       |  |   | 1,132,462 | 
|2013       |  |   | 1,170,703 | 
|Thereafter |  |   | 1,641,981 | 



Contingent Consideration



In connection with its prior acquisitions, the merger consideration may be increased as the former shareholders of each entity are entitled to earn payments in cash or stock contingent upon the satisfaction of certain future internal performance goals set forth in the applicable merger and amended merger agreements. Future consideration which may be earned by the former shareholders of each entity will be treated as additional purchase price and allocated to goodwill. The respective maximum amounts of such future consideration of known dollar amounts which may be earned by the former shareholders of the acquired entities are as follows:

|                          |  |                                   |           |                                                 |   |                                         |  |   |            | 
|------------------------- |  | --------------------------------- | --------- | ----------------------------------------------- | - | --------------------------------------- |  | - | ---------- | 
|Acquired Entity           |  | Maximum
Future
Cash
Consideration |           | Maximum
Future
Stock
Consideration
($ value(1)) |   | Maximum
Earnout
Consideration
($ value) | 
|Morex Marketing Group LLC |  | $                                 | 6,426,926 |                                                 | $ | 6,426,926                               |  | $ | 12,853,852 | 





29



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



The earnout period for the acquisition of Real Estate School Online, Inc. expired on September 30, 2008. The financial results for this entity were not sufficient to trigger any earnout payments and therefore no further compensation was paid to the former shareholder of the entity.



The earnout period for the acquisition of Morex Marketing Group LLC expired on December 31, 2008 for three of the four parties involved in the transaction. In the first quarter of 2008 the earnout period for one of the former members was extended one year as consideration for amending their employment agreement. The financial results for this entity were not sufficient to trigger any earnout payments as of December 31, 2008.



During August 2006, the Company restructured the earnout provisions for five of its prior merger agreements. All of the restructured agreements provide for the potential earnout payments to be made solely in the Companys common stock. The table below lists the maximum number of shares that the previous shareholders will be entitled to under the restructured agreements.

|                     |  |                                                |           | 
|-------------------- |  | ---------------------------------------------- | --------- | 
|Acquired Entity      |  | Maximum Future
Stock Consideration
(Shares)(2) |          
|KowaBunga!           |  |                                                | 62,267    | 
|PrimaryAds           |  |                                                | 2,016,320 | 
|Litmus Media, Inc.   |  |                                                | 3,138,241 | 
|WebDiversity, Ltd.   |  |                                                | 290,578   | 
|iLead Media, Inc.(3) |  |                                                | 269,104   | 
|Totals               |  |                                                | 5,776,510 | 



As of December 31, 2008, there are no liabilities under any other earnout agreements.



In addition, the former shareholders of the above acquisitions were granted a total of 955,000 options which were allocated to the purchase price.



(1) The number of shares is dependent on future prices of the Companys common stock.



(2) Value of shares is dependent on future prices of the Companys common stock.



(3) Two of the former shareholders of iLead Media, Inc. forfeited their rights to their earnout shares per settlement agreements dated June 27, 2008 and September 5, 2008.



Note 18  Related Party



Note Payable



On December 31, 2007, the Company had outstanding notes payable totaling $37,326 related to debt to Scott Mitchell assumed by the Company upon the acquisition of Ozline Networks in 2005. These amounts were fully paid in 2008



Separation Agreement



Effective as of April 24, 2008, the Company and Scott P. Mitchell entered into a Separation Agreement and a Consulting Agreement, pursuant to which Mr. Mitchell resigned as a member of its Board of Directors, effective April 24, 2008. On April 18, 2008, Mr. Mitchell resigned his position as the Chief Executive Officer and President of the Company.





30



---





Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Pursuant to the Agreements, the Company granted Mr. Mitchell, under the Companys 2005 Long Term Incentive Plan, 400,000 unrestricted shares of the Companys common stock, $.001 par value per share, in consideration for providing consulting services to the Company for six months. The Company recorded a charge of $328,000 during the second quarter relating to the fair value of the stock. Mr. Mitchells Employment Agreement with the Company, dated August 3, 2006, was terminated. All of his options and warrants received directly from the Company, whether vested or unvested, were forfeited. Mr. Mitchell had a total of 725,000 options and warrants with exercise prices ranging from $1.69 to $2.40 per share. Mr. Mitchell and the Company exchanged releases. Mr. Mitchell agreed not to sell more than 50,000 shares of the stock grant he received under the Agreements in any weekly period on the open market, and for 12 months he agreed not to engage in any business that competes with the Company in the U.S. and in certain foreign jurisdictions or solicit any of the Companys employees or customers.



Settlement Agreement



On June 27, 2008, the Company entered into a Settlement Agreement and Mutual Release with Brady Whittingham, a former Company executive. The Agreement settled the litigation and claims which the Company brought against Mr. Whittingham in U.S. District Court for the District of Utah. Pursuant to the Agreement, the Company received 2,359,406 shares of the Companys common stock owned by Mr. Whittingham; all his vested stock options were forfeited; all claims to any earnout payments, which he acquired from the April 27, 2006 sale of iLead Media, Inc. to the Company, were forfeited; and a Company subsidiarys lease of office premises from an affiliate of Mr. Whittingham was terminated early. Mr. Whittingham further agreed for one year not to engage in any business that competes with certain businesses of the Company or to solicit any of the Companys employees and not to interfere with any business relationships between the Company and its customers or vendors. He agreed to provide limited consulting services for six months. Mr. Whittingham and the Company exchanged full general releases excepting only claims that arise out of or relate to the Agreement. The stock was recorded at its fair value on June 27. The Company offset legal fees directly related to the lawsuit against the value of the stock when presenting the gain from the settlement which is included in discontinued operations.



On September 5, 2008, the Company entered into a Settlement Agreement and Mutual Release with David Nelson, a former Company executive. The Agreement settled the litigation and claims which the Company brought against Mr. Nelson in U.S. District Court for the District of Utah. Pursuant to the Agreement, the Company received 296,176 shares of the Companys common stock owned by Mr. Nelson; $100,000 in immediately available funds; and all his vested stock options were forfeited; all claims to any earnout payments, which he acquired from the April 27, 2006 sale of iLead Media, Inc. to the Company, were forfeited.. Mr. Nelson further agreed for eighteen months not to engage in any business that competes with certain businesses of the Company or to solicit any of the Companys employees and not to interfere with any business relationships between the Company and its customers or vendors. Mr. Nelson and the Company exchanged full general releases excepting only claims that arise out of or relate to the Agreement. The stock was recorded at its fair value on September 5. The Company offset legal fees directly related to the lawsuit against the value of the stock when presenting the gain from the settlement which is included in discontinued operations.



Note 19 - Segment Analysis



The Companys operations are divided into operating segments using individual products or services or groups of related products and services. During the second quarter of 2007, the Company consolidated its Direct and Consumer Services segments under one Executive Officer. During the second quarter of 2008, the Company made a decision to divest its MarketSmart Advertising operations and ceased operations of its Web Diversity subsidiary which in total comprised its Advertising Segment. The Company also made a decision to divest its Online Dating and Ilead Media operations which were a portion of its Direct Segment. All prior periods have been adjusted for the new presentation. The Chief Executive Officer of each of the Companys subsidiaries reports to the Chief Executive Officer of the Company, who makes decisions about performance assessment and resource allocation for all segments. The Company had two operating segments as of December 31, 2008: network and direct The Company evaluates the performance of each segment using pre-tax income or loss from operations.



31



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Listed below is a presentation of revenue, gross profit and operating profit or loss for all reportable segments. The Company currently only tracks certain assets at the segment level and therefore assets by segment are not presented below. The corporate category in the (Loss) Income before Income Taxes by Industry Segment table consists of corporate expenses not allocated to any segment.



Net Revenue by Industry Segment

|              |  |        |            |         |        |        |   |            |   |        |    |  | 
|------------- |  | ------ | ---------- | ------- | ------ | ------ | - | ---------- | - | ------ | -- |  | 
|              |  |        |            |         |        |        |   |            |   |        |   
|              |  | 2008   |            | 2007    |       
|Segment       |  | Amount |            | Percent |        | Amount |   | Percent    |  
|Network       |  | $      | 42,747,991 |         | 82.89  | %      | $ | 19,009,046 |   | 68.39  | % 
|Direct        |  |        | 9,977,801  |         | 19.35  | %      |   | 10,095,439 |   | 36.32  | % 
|Elimination   |  |        | (1,153,197 | )       | (2.24  | )%     |   | (1,308,771 | ) | (4.71  | )%
|Total Revenue |  | $      | 51,572,595 |         | 100.00 | %      | $ | 27,795,714 |   | 100.00 | % 

Gross Profit by Industry Segment

|            |  |      |            |   |      |   |            |  
|----------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|            |  |      |            |   |      |  
|Segment     |  | 2008 |            |   | 2007 |  
|Network     |  | $    | 13,410,248 |   |      | $ | 11,327,503 |  
|Direct      |  |      | 5,811,806  |   |      |   | 6,164,681  |  
|Elimination |  |      | (418,017   | ) |      |   | (318,148   | )
|Total       |  | $    | 18,804,037 |   |      | $ | 17,174,036 |  

(Loss) Profit before Income Taxes by Industry Segment

|          |  |      |             |      |   |            |  
|--------- |  | ---- | ----------- | ---- | - | ---------- | -
|          |  |      |             |      |   |            |  
|Segment   |  | 2008 |             | 2007 |  
|Network   |  | $    | (15,213,426 | )    | $ | 2,366,897  |  
|Direct    |  |      | (24,405,102 | )    |   | 473,469    |  
|Corporate |  |      | (7,298,267  | )    |   | (7,367,248 | )
|Total     |  | $    | (46,916,795 | )    | $ | (4,526,882 | )

Note 20  Subsequent Events

In the first quarter of 2009, the Company made the decision to continue operating iLead on a long-term basis and to remove iLead from the discontinued operations of the Company. Future periodic reports will report the results of operations of iLead as part of continuing operations. The Company also made the decision to realign the reporting and management of the business units under the segments comprised of Exchange, Direct, and Media & Publishing. The Exchange segment incorporates the AdExchange, Secondbite, MyAP and ValidClick products with revenue generation activity across PPC and CPA advertising. The Direct segment encompasses Primary Ads, Kolimbo, iLead and Real Estate School online with revenue generating activity focused on developing and marketing continuity based direct to consumer offers and products. The Media & Publishing segment encompasses the Morex operations and concentrates on revenue generation through the development and operation of various online specialty websites, primarily www.babytobee.com.

On February 17, 2009, we concluded the sale of the Cherish subsidiary. The proceeds of the sale were used to partially offset the term note with Wachovia Bank, N.A.

On March 18, 2009, the Company entered into a Second Amendment to Amended and Restated Loan Agreement (the Loan Amendment) with Wachovia Bank, N.A.. The Loan Amendment amended the Loan Agreements dated as of February 27, 2008 between Wachovia and the Company and First Amendment to Amended and Restated Loan Agreement dated June 25, 2008. The Loan Amendment also amended the Term Note in the original amount of $5,000,000 dated as of February 27, 2008. The Loan Amendment reduces the maximum available credit under revolving loan facility to $8 million on the effective date and further reduces the maximum available under the revolving credit facility to $6 million on October 1, 2009. The maturity date of the Loan Agreements and the Term Note was accelerated from February 27, 2011 to March 31, 2010.



32



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Kowabunga! Inc.

Footnotes to Consolidated Financial Statements (Continued)

December 31, 2008 and 2007



Repayment Terms; Interest Rates. Interest on the unpaid principal balance of the revolving loan accrues at a rate between LIBOR Market Index Rate plus 4% until October 1, 2009 at which time the rate increases to LIBOR Market Index Rate plus 7%, provided further that the interest rate shall in no event be less than 7%. The revolving loan matures on March 31, 2010. Interest on the unpaid principal balance of the Term Note accrues at the LIBOR Market Index Rate plus 4% until October 1, 2009 at which time the rate increases to LIBOR Market Index Rate plus 7%, provided further that the interest rate shall in no event be less than 7%. Amounts due under the Term Note are payable in 36 consecutive monthly payments with any remaining principal due on March 31, 2010, the Term Notes maturity. Concurrently, the Company terminated early the interest rate swap agreement with Wachovia which it entered into concurrent with the Term Note. The principal amount of the Term Note will be reduced by the net proceeds to the Company upon the sale of MarketSmart Advertising, Inc.



Covenants. As detailed further in the Loan Amendment, the Company is limited to borrowings under the revolving facility equal to 2.0 its trailing pro forma adjusted EBITDA until the earlier of the sale of MarketSmart Advertising, Inc or October 1, 2009, at which time the borrowings are limited to 1.5 times its trailing pro forma adjusted EBITDA. Further, so long as there remain any amounts outstanding under the credit facility, the Company is required to maintain: (1) a Total Debt to EBITDA Ratio of not less than 2.00 to 1.00, calculated quarterly on a rolling four quarters basis; and (2) a Fixed Charge Coverage Ratio of not less than 2.50 to 1.00, calculated quarterly on a rolling four quarters basis. In addition, the Company may not: (a) make capital expenditures during any year exceeding $500,000; (b) incur any additional indebtedness unless approved by Wachovia; (c) declare or pay dividends unless approved by Wachovia; and (d) arrange for return, cancellation, termination, or replacement of letters of credit on or before August 21, 2009. Additionally, so long as the credit facility remains in effect, the Company may not acquire or invest in, directly or indirectly, any business unless approved by Wachovia. The Company may not purchase, redeem, retire or otherwise acquire, directly or indirectly, any stock, securities, or evidence of indebtedness, unless approved by Wachovia.









33



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Exhibit Index



|            |  |                                                                 
|----------- |  | ----------------------------------------------------------------
|Exhibit
No. |  | Description                                                     
|31.1        |  | Rule 13a-14(a)/15d-14(a)certificate of Chief Executive Officer *
|31.2        |  | Rule 13a-14(a)/15d-14(a)certificate of Chief Financial Officer *
|32.1        |  | Section 1350 certification of Chief Executive Officer *         
|32.2        |  | Section 1350 certification of Chief Financial Officer*          



*

filed herewith



34



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SIGNATURES

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



|                              |             |                                        
|----------------------------- | ----------- | ---------------------------------------
|                              | Inuvo, Inc.
|                              |             |                                        
|                              |             |                                        
|Date: December 

4,




 2009 | By:         | /s/ RICHARDK. HOWE                     
|                              |             | Richard K. Howe
Chief Executive Officer



Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                   |  |                                                  |  |                        
|------------------ |  | ------------------------------------------------ |  | -----------------------
|Signature          |  | Title                                            |  | Date                   
|                   |  |                                                  |  |                        
|/s/ MITCH TUCHMAN  |  | Chairman of the Board of Directors               |  | December 

4,




 2009
|Mitch Tuchman      |  |                                                  |  |                        
|                   |  |                                                  |  |                        
|/s/ RICHARDK. HOWE |  | Chief Executive Officer and director, principal  |  | December 

4,




 2009
|Richard K. Howe    |  | executive officer                                |  |                        
|                   |  |                                                  |  |                        
|/s/ GAIL L. BABITT |  | Chief Financial Officer, principal financial and |  | December 

4,




 2009
|Gail L. Babitt     |  | accounting officer                               |  |                        
|                   |  |                                                  |  |                        
|/s/ CHARLES POPE   |  | Director                                         |  | December 

4,




 2009
|Charles Pope       |  |                                                  |  |                        
|                   |  |                                                  |  |                        
|/s/ JACK BALOUSEK  |  | Director                                         |  | December 

4,




 2009
|Jack Balousek      |  |                                                  |  |                        
|                   |  |                                                  |  |                        
|/s/ CHARLES MORGAN |  | Director                                         |  | December 

4,




 2009
|Charles Morgan     |  |                                                  |  |                        







35