Exhibit
      10.7

     

    SECURITY
      AGREEMENT

     

    THIS
      SECURITY AGREEMENT (this “Agreement”)
      is
      made as of November 14, 2007, among SMART ONLINE, INC., a Delaware corporation
      (the “Company”),
      and
      Doron Roethler, as agent for the Investors (as defined below) (together with
      its
      successors and assigns in such capacity, “Collateral
      Agent”).

     

    RECITALS

     

    A. Company,
      Collateral Agent and certain purchasers (each an “Investor”,
      and
      collectively, the “Investors”)
      have
      entered into a Convertible Secured Subordinated Note Purchase Agreement, dated
      as of the date hereof (the “Purchase
      Agreement”),
      pursuant to which Company has issued convertible promissory notes, dated as
      of
      the date hereof (as amended, modified or otherwise supplemented from time to
      time, each a “Note”
and
      collectively, the “Notes”).

     

    B. In
      order
      to induce each Investor to extend the credit evidenced by the Notes, Company
      has
      agreed to enter into this Security Agreement and to grant Collateral Agent,
      for
      the benefit of itself and the Investors, the security interest in the Collateral
      described below.

     

    AGREEMENT

     

    NOW,
      THEREFORE, in consideration of the above recitals and for other good and
      valuable consideration, the receipt and adequacy of which are hereby
      acknowledged, Company hereby agrees with Collateral Agent and the Investors
      as
      follows:

     

    1.  Definitions
      and Interpretation.
      When
      used in this Security Agreement, the following terms have the following
      respective meanings:

     

    “Collateral”
has
      the
      meaning given to that term in Section
      2
      hereof.

     

    “Excluded
      Investment Property”
means
      any and all right, title and interest of the
      Company
      in and
      to 100 shares of the capital stock of Smart Commerce, Inc., a Delaware
      corporation (“Smart
      Commerce”),
      issued to the Company, and respectively evidenced by stock certificate no.
      1 and
      all
      rights incident thereto, and in and to any additional interest in Smart Commerce
      hereafter acquired by the Company including all the Company’s now existing or
      hereafter acquired shares of stock or other equity security (including any
      interests, rights and other securities however evidenced which are convertible
      to stock or any other equity security of Smart Commerce and all rights incident
      thereto), including the right to vote the foregoing interests during the
      continuation of an event of default, and further including, but not limited
      to,
      the Company’s interest in, and rights to: (x) the profits, surplus,
      distributions and dividends, whether in cash or in kind (and including, but
      not
      limited to, any distributions of the proceeds of the liquidation of the assets
      of Smart Commerce made in connection with, as a result of, or pursuant to,
      a
      dissolution of Smart Commerce), and (y) the assets of Smart
      Commerce.

     

    
      
        
        

      

      
        
        

        
          

        

      

      
        
        

      

    

     

    “Obligations”
means
      all loans, advances, debts, liabilities and obligations, howsoever arising,
      owed
      by Company to Collateral Agent and the Investors of every kind and description
      (whether or not evidenced by any note or instrument and whether or not for
      the
      payment of money), now existing or hereafter arising under or pursuant to the
      terms of the Notes and the other Transaction Documents, including all interest,
      fees, charges, expenses, attorneys’ fees and costs and accountants’ fees and
      costs chargeable to and payable by Company hereunder and thereunder, in each
      case, whether direct or indirect, absolute or contingent, due or to become
      due,
      and whether or not arising after the commencement of a proceeding under Title
      11
      of the United States Code (11 U.S.C. Section 101 et seq.), as amended from
      time
      to time (including post-petition interest) and whether or not allowed or
      allowable as a claim in any such proceeding.

     

    “Permitted
      Liens”
means
      (a) Liens granted to secure indebtedness of Company permitted under the Purchase
      Agreement and incurred to finance the acquisition (whether by purchase or
      capitalized lease) of tangible assets (other than Inventory), but only on the
      assets acquired with the proceeds of such indebtedness, (b) Liens for taxes,
      assessments or other governmental charges or levies not at the time delinquent
      or thereafter payable without penalty or being contested in good faith by
      appropriate proceedings and for which adequate reserves in accordance with
      GAAP
      shall have been set aside on its books, (c) Liens incurred in connection with
      the extension, renewal or refinancing of the indebtedness secured by Liens
      existing on the date of the Notes or of Liens described in clause (a) above,
      provided
      that any
      extension, renewal or replacement Lien shall be limited to the property
      encumbered by the existing Lien and the principal amount of indebtedness being
      extended, renewed or refinanced does not increase, (d) statutory Liens of
      landlords and Liens of carriers, warehousemen, mechanics and materialman and
      other similar Liens arising in favor of a person imposed without action by
      such
      person, in each case that are incurred in the ordinary course of business for
      sums not overdue or being contested in good faith by appropriate proceedings
      and
      for which adequate reserves in accordance with GAAP shall have been set aside
      on
      its books, (e) Liens (other than Liens arising under the Employee Retirement
      Income Security Act of 1974, as amended, or Section 412(n) of the Internal
      Revenue Code of 1986, as amended) incurred in the ordinary course of business
      in
      connection with workers’ compensation, unemployment insurance, social security
      or other forms of governmental insurance or benefits, or to secure performance
      of tenders, statutory obligations, leases and contracts (other than for borrowed
      money) entered into in the ordinary course of business or to secure obligations
      on surety or appeal bonds, (f) judgment Liens in existence less than 60 days
      after the entry thereof or with respect to which execution has been stayed
      in an
      amount not to exceed $500,000 singly or in the aggregate and (g) Liens existing
      on the date hereof and described on Attachment
      2
      hereto.

     

    “Senior
      Obligations”
means
      all indebtedness and obligations of Smart Commerce to Fifth Third Bank evidenced
      by that certain promissory note issued by Smart Commerce to Fifth Third Bank
      on
      October 17, 2006 under that certain Business Loan Agreement dated October 17,
      2006 between Smart Commerce and Fifth Third Bank and any amendment, restatement,
      modification, renewal, extension or refinance thereof.

     

    “UCC”
means
      the Uniform Commercial Code as in effect in the State of California from time
      to
      time.

     

    
      
        
        

      

      
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    All
      capitalized terms not otherwise defined herein shall have the respective
      meanings given in the Notes. Unless otherwise defined herein or in the Notes,
      all terms used herein that are defined in the UCC, whether capitalized or not,
      have the respective meanings given to those terms in the UCC. 

     

    2.  Grant
      of Security Interest.
      To
      secure prompt payment and performance of the Obligations, Company hereby pledges
      to Collateral Agent and grants to Collateral Agent, for the benefit of
      Collateral Agent and the Investors, a security interest in all right, title
      and
      interests of Company in and to the property described in Attachment
      1
      hereto,
      whether now existing or hereafter from time to time acquired (collectively,
      the
“Collateral”).
      Such
      security interest shall be prior to all Liens other than Permitted Liens.
      Notwithstanding the foregoing, the security interest granted herein shall not
      extend to and the term “Collateral” shall not include any equipment or other
      property financed by a third party, provided
      that
      such third party’s Liens are Liens of the type described in clause (a) of the
      definition of Permitted Liens; provided,
      further,
      that
      such equipment or other property shall be deemed “Collateral” hereunder if such
      third party’s Lien is released or otherwise terminated or if the agreement
      governing such Lien does not prohibit the Lien granted hereunder. For avoidance
      of doubt, so long as the Senior Obligations are outstanding, the security
      interest granted herein shall not extend to and the term “Collateral” shall not
      include the Excluded Investment Property and upon the indefeasible satisfaction
      of the Senior Obligations in full, the security interest granted herein shall
      automatically extend to and the term “Collateral” shall include the Excluded
      Investment Property effective as of the date such Senior Obligations are
      satisfied in full.

     

    3.  General
      Representations and Warranties.
      Company
      represents and warrants to Collateral Agent and the Investors that
      (a) Company is the owner of the Collateral (or, in the case of (i)
      after-acquired Collateral, at the time Company acquires rights in the
      Collateral, or (ii) the Excluded Investment Property, at the time the Excluded
      Investment Property becomes subject to the security interested granted herein,
      will be the owner thereof) and that no other Person has (or, in the case of
      (i)
      after-acquired Collateral, at the time Company acquires rights in the
      Collateral, or (ii) the Excluded Investment Property, at the time the Excluded
      Investment Property becomes subject to the security interested granted herein,
      will have) any right, title, claim or interest (by way of Lien or otherwise)
      in,
      against or to the Collateral, other than Permitted Liens; (b) this Security
      Agreement creates a valid security interest in favor of Collateral Agent, for
      the benefit of Collateral Agent and the Investors, in the Collateral of Company,
      to the extent a security interest therein can be created under the UCC; (c)
      upon
      the filing of UCC-1 financing statements in the filing office listed on
Attachment
      3
      hereto,
      Collateral Agent has (or in the case of (i) after-acquired Collateral, at the
      time Company acquires rights in the Collateral, or (ii) the Excluded Investment
      Property, at the time the Excluded Investment Property becomes subject to the
      security interested granted herein, will have) a perfected security interest
      in
      the Collateral, prior to all Liens other than Permitted Liens, to the extent
      that a security interest in the Collateral can be perfected by such filing,
      except for Permitted Liens; (d) with respect to any Collateral consisting
      of a Deposit Account, Securities Entitlement or held in a Securities Account,
      upon execution and delivery by Company, the applicable depository bank or
      Securities Intermediary and Collateral Agent of an authenticated agreement
      granting control in accordance with the UCC to Collateral Agent over such
      Collateral, Collateral Agent shall have a valid and perfected, security interest
      in such Collateral, prior to all Liens other than Permitted Liens; (e) all
      Inventory has been (or, in the case of hereafter produced Inventory, will be)
      produced in compliance with applicable laws, including the Fair Labor Standards
      Act; and (f) all accounts receivable and payment intangibles are genuine
      and enforceable against the party obligated to pay the same; 

     

    
      
        
        

      

      
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    4.  Covenants
      Relating to Collateral.
      Company
      covenants and agrees with Collateral Agent and Investors that from and after
      the
      date of this Security Agreement and until the date of termination of this
      Security Agreement in accordance with the terms hereof:

     

    (a)  Company
      shall (i) perform all acts that may be necessary to maintain, preserve and
      protect the Collateral and to maintain, preserve, protect and perfect the Lien
      granted to Collateral Agent therein and the perfection and priority (subject
      to
      Permitted Liens) of such Lien; (ii) not use or permit any Collateral to be
      used (A) in violation in any material respect of any applicable law, rule
      or regulation, or (B) in violation of any policy of insurance covering the
      Collateral; (iii) pay promptly when due all taxes and other governmental
      charges, all obligations to which any Lien is related and all other charges
      and
      other obligations now or hereafter imposed upon or affecting any Collateral;
      (iv) not, without 30 days prior written notice to Collateral Agent,
      (A)  change Company’s name or place of business (or, if Company has more
      than one place of business, its chief executive office), or the office in which
      Company’s records relating to accounts receivable and payment intangibles are
      kept or (B) change Company’s state of incorporation, entity type or state
      organizational number, (v) procure,
      execute and deliver from time to time any endorsements, assignments, financing
      statements and other writings reasonably deemed necessary or appropriate by
      Collateral Agent to perfect, maintain and protect its Lien hereunder and the
      priority thereof and to deliver promptly upon the request of Collateral Agent
      all originals of Collateral consisting of instruments.

     

    (b)  Company
      covenants and agrees that upon the acquisition of any fee interest in real
      property it will promptly (and in any event within five (5) business days of
      acquisition) notify Collateral Agent of the acquisition of such real property
      and will grant to Collateral Agent, for the benefit of Collateral Agent and
      the
      Investors, a mortgage or other real property security instrument on each fee
      interest in real property now or hereafter owned by Company and shall deliver
      such other documentation and opinions, in form and substance satisfactory to
      Collateral Agent, in connection with the grant of such mortgage or security
      instrument as Collateral Agent shall request, including title insurance
      policies, financing statements, fixture filings and environmental audits and
      Company shall pay all recording costs, intangible taxes and other fees and
      costs
      (including reasonable attorneys fees and expenses) incurred in connection
      therewith. Such mortgage or other real property security instrument shall be
      prior to all Liens other than Permitted Liens. Company acknowledges and agrees
      that, to the extent permitted by applicable law, all of the Collateral shall
      remain personal property regardless of the manner of its attachment or
      affixation to real property.

     

    (c)  Company
      shall promptly (and in any event within five (5) business days of receipt
      thereof), notify Collateral Agent in writing upon incurring or otherwise
      obtaining a Commercial Tort Claim after the date hereof against any third party
      and, upon request of Collateral Agent, authorize the filing of additional
      financing statements or amendments to existing financing statements and do
      such
      other acts or things deemed necessary or desirable by Collateral Agent to give
      Collateral Agent, perfected security interest in any such Commercial Tort Claim,
      prior to all Liens other than Permitted Liens.

     

    
      
        
        

      

      
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    (d)  Company
      shall promptly (and in any event within five (5) business days of acquiring
      or
      obtaining such Collateral) notify Collateral Agent in writing upon (i) acquiring
      or otherwise obtaining any Collateral after the date hereof consisting of
      Trademarks, Patents, Copyrights, licenses with respect to any of the foregoing,
      Investment Property, Chattel Paper (electronic, tangible or otherwise),
      Documents, Instruments or Letter-of-Credit Rights or (ii) any amount payable
      under or in connection with any of the Collateral being or becoming evidenced
      after the date hereof by any Chattel Paper, Documents or Instruments and, in
      each such case upon the request of Collateral Agent and in accordance with
      Section 6 hereof, promptly execute such other documents, or if applicable,
      deliver such Chattel Paper, Documents, Instruments, other possessory collateral
      or certificates evidencing any Investment Property (other than the Excluded
      Investment Property) in accordance with Section 6 hereof and do such other
      acts
      or things reasonably deemed necessary or desirable by Collateral Agent to
      protect Collateral Agent’s Lien therein.

     

    (e)  At
      the
      request of Collateral Agent, Company shall obtain an authenticated control
      agreement, in form and substance satisfactory to Collateral Agent, from each
      bank holding a Deposit Account for Company and each issuer of uncertificated
      securities, securities intermediary, or commodities intermediary issuing or
      holding any financial assets or commodities to or for Company.

     

    (f)  Company
      shall not (i) sell, assign (by operation of law or otherwise) or otherwise
      dispose of, or grant any option with respect to, any of the Collateral, except
      (A) expressly permitted by the Purchase Agreement, (B) sales, assignments or
      other dispositions of inventory in the ordinary course of business, (C) sales,
      assignments or other dispositions of worn-out or obsolete equipment no longer
      used or useful in the business of Company in the ordinary course of business,
      (D) licenses of intellectual property pursuant to a non-exclusive license
      granted to others not interfering in any material respect with the business
      of
      Company, and (E) licenses of intellectual property pursuant to an exclusive
      license with respect to geographic location, limited time duration or field
      of
      use granted to others not interfering in any material respect with the business
      of Company, or (ii) create or permit to exist any Lien upon or with respect
      to
      any of the Collateral, except for Permitted Liens. The inclusion of proceeds
      in
      the Collateral shall not be deemed to constitute Collateral Agent’s consent to
      any sale or other disposition of any of the Collateral except as expressly
      permitted in this Security Agreement or the Purchase Agreement.

     

    5.  Authorized
      Action by Collateral Agent.
      Company
      hereby appoints Collateral Agent as its attorney-in-fact (which appointment
      is
      coupled with an interest) and agrees that Collateral Agent may perform (but
      Collateral Agent shall not be obligated to and shall incur no liability to
      Company or any third party for failure so to do) any act which Company is
      obligated by this Security Agreement to perform, exercise such rights and powers
      as Company might exercise with respect to the Collateral, and take any other
      action and execute any instrument which Collateral Agent may deem necessary
      or
      advisable to accomplish the purposes of this Security Agreement, including
      the
      right to (a) collect by legal proceedings or otherwise and endorse, receive
      and receipt for all dividends, interest, payments, proceeds and other sums
      and
      property now or hereafter payable on or on account of the Collateral;
      (b) enter into any extension, reorganization, deposit, merger,
      consolidation or other agreement pertaining to, or deposit, surrender, accept,
      hold or apply other property in exchange for the Collateral; (c) make any
      compromise or settlement, and take any action it deems advisable, with respect
      to the Collateral; (d) insure, process and preserve the Collateral;
      (e) pay any indebtedness of Company relating to the Collateral; and (f) to
      perform any and all of the obligations of Company contained in any contract,
      lease, or other agreement and exercise any and all rights of Company therein
      contained as fully as Company itself could; and (g) execute other
      documents, instruments and agreements required hereunder; provided,
      however,
      that
      Collateral Agent shall not exercise any such powers granted pursuant to
      subsections (a) through (f) prior to the occurrence of an Event of Default
      and
      shall only exercise such powers during the continuance of an Event of Default.
      Company agrees to reimburse Collateral Agent upon demand for any costs and
      expenses, including reasonable attorneys’ fees, Collateral Agent may incur while
      acting as Company’s attorney-in-fact hereunder, all of which costs and expenses
      are included in the Obligations. It is further agreed and understood between
      the
      parties hereto that such care as Collateral Agent gives to the safekeeping
      of
      its own property of like kind shall constitute reasonable care of the Collateral
      when in Collateral Agent’s possession; provided,
      however,
      that
      Collateral Agent shall not be required to make any presentment, demand or
      protest, or give any notice and need not take any action to preserve any rights
      against any prior party or any other person in connection with the Obligations
      or with respect to the Collateral. To the extent permitted by law, Company
      hereby ratifies all that such attorney-in-fact shall lawfully do or cause to
      be
      done by virtue hereof and within the limits set forth above. This power of
      attorney is coupled with an interest and shall be irrevocable until this
      Security Agreement is terminated.

     

    
      
        
        

      

      
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    6.  Further
      Assurances.
      

     

    (a)  Company
      agrees that from time to time, at its own expense, Company will promptly execute
      and deliver all further endorsements, assignments, instruments, documents and
      other writings, and take all further action, that may be necessary or that
      Collateral Agent may reasonably request, in order to perfect, protect and
      maintain any Lien granted or purported to be granted hereby or to enable
      Collateral Agent to exercise and enforce its rights and remedies hereunder
      with
      respect to any of the Collateral. 

     

    (b)  Company
      authorizes the filing by Collateral Agent financing or continuation statements,
      or amendments thereto, and Company will execute and deliver to Collateral Agent
      such other instruments or notices as may be necessary or as Collateral Agent
      may
      reasonably request, in order to perfect and preserve the Lien granted or
      purported to be granted hereby. 

     

    (c)  Company
      authorizes Collateral Agent at any time and from time to time to file, transmit,
      or communicate, as applicable, financing statements and amendments (i)
      describing the Collateral as “all personal property of debtor” or “all assets of
      debtor” or words of similar effect, (ii) describing the Collateral as being of
      equal or lesser scope or with greater detail, or (iii) that contain any
      information required by part 5 of Article 9 of the UCC for the sufficiency
      or
      filing office acceptance. Company also hereby ratifies any and all financing
      statements or amendments previously filed by Collateral Agent in any
      jurisdiction. 

     

    (d)  Company
      acknowledges that it is not authorized to file any financing statement or
      amendment or termination statement with respect to any financing statement
      filed
      in connection with this Security Agreement without the prior written consent
      of
      Collateral Agent, subject to Company’s rights under Section 9-509(d)(2) of the
      UCC.

     

    
      
        
        

      

      
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    7.  Default
      and Remedies.
      

     

    (a)  Default.
      Company
      shall be deemed in default under this Security Agreement upon the occurrence
      and
      during the continuance of an Event of Default (as defined in the Notes).


     

    (b)  General
      Remedies.
      Upon
      the occurrence of an Event of Default and during continuation thereof,
      Collateral Agent shall have, in addition to the rights and remedies provided
      herein, in the Transaction Documents, in any other documents relating to the
      Obligations, or by applicable law (including, but not limited to, levy of
      attachment, garnishment and the rights and remedies set forth in the UCC of
      the
      jurisdiction applicable to the affected Collateral), the rights and remedies
      of
      a secured party under the UCC (regardless of whether the UCC is the law of
      the
      jurisdiction where the rights and remedies are asserted and regardless of
      whether the UCC applies to the affected Collateral), and further, Collateral
      Agent may, with or without judicial process or the aid and assistance of others,
      (i) enter on any premises on which any of the Collateral may be located and,
      without resistance or interference by Company, take possession of the
      Collateral, (ii) dispose of any Collateral on any such premises, (iii) require
      Company to assemble and make available to Collateral Agent at the expense of
      Company any Collateral at one or more locations where Company regularly
      maintains inventory, (iv) remove any Collateral from any such premises for
      the
      purpose of effecting sale or other disposition thereof, and/or (v) without
      notice, except as provided below, which Company hereby waives to the fullest
      extent permitted by law, at any place and time or times, sell and deliver any
      or
      all Collateral held by or for it at public or private sale, at any exchange
      or
      broker’s board or elsewhere, by one or more contracts, in one or more parcels,
      for cash, upon credit or otherwise, at such prices and upon such terms as
      Collateral Agent deems advisable, in its sole discretion (subject to any and
      all
      mandatory legal requirements). Company acknowledges that any such private sale
      may be at prices and on terms less favorable to the seller than the prices
      and
      other terms which might have been obtained at a public sale and, notwithstanding
      the foregoing, agrees that such private sale shall be deemed to have been made
      in a commercially reasonable manner. Neither Collateral Agent’s compliance with
      applicable law nor its disclaimer of warranties relating to the Collateral
      shall
      be considered to adversely affect the commercial reasonableness of any sale.
      Company agrees that to the extent notice of sale shall be required by law,
      any
      requirement of reasonable notice shall be met if such notice, specifying the
      place of any public sale or the time after which any private sale is to be
      made,
      is personally served on or mailed, postage prepaid, to Company in accordance
      with the notice provisions of this Security Agreement at least 10 days before
      the time of sale or other event giving rise to the requirement of such notice.
      Collateral Agent shall not be obligated to make any sale or other disposition
      of
      the Collateral regardless of notice having been given. To the extent permitted
      by applicable law, Collateral Agent or any Investor may be a purchaser at any
      such sale. To the extent permitted by applicable law, Company hereby waives
      all
      of its rights of redemption with respect to any such sale. Subject to the
      provisions of applicable law, Collateral Agent may postpone or cause the
      postponement of the sale of all or any portion of the Collateral by announcement
      at the time and place of such sale, and such sale may, without further notice,
      to the extent permitted by law, be made at the time and place to which the
      sale
      was postponed, or Collateral Agent may further postpone such sale by
      announcement made at such time and place.

     

    (c)  Intellectual
      Property License.
      In
      furtherance of Collateral Agent’s rights hereunder, Company hereby grants to
      Collateral Agent an irrevocable, non-exclusive license, exercisable without
      royalty or other payment by Collateral Agent, and in connection with the
      exercise of remedies hereunder, to use, license or sublicense any patent,
      trademark, trade name, copyright or other intellectual property in which Company
      now or hereafter has any right, title or interest, together with the right
      of
      access to all media in which any of the foregoing may be recorded or
      stored.

     

    
      
        
        

      

      
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    (d)  Access.
      In
      addition to the rights and remedies hereunder, upon the occurrence of an Event
      of Default and during the continuance thereof, Collateral Agent shall have
      the
      right to enter and remain upon the various premises of Company without cost
      or
      charge to Collateral Agent, and use the same, together with materials, supplies,
      books and records of Company for the purpose of collecting and liquidating
      the
      Collateral, or for preparing for sale and conducting the sale of the Collateral,
      whether by foreclosure, auction or otherwise. In addition, upon the occurrence
      and during the continuation of an Event of Default, Collateral Agent may remove
      Collateral, or any part thereof, from such premises and/or any records with
      respect thereto, in order to effectively collect or liquidate such
      Collateral.

     

    (e)  Nonexclusive
      Nature of Remedies.
      Failure
      by Collateral Agent or the Investors to exercise any right, remedy or option
      under this Security Agreement, any other Transaction Document, any other
      document relating to the Obligations, or as provided by applicable law, or
      any
      delay by Collateral Agent or the holders of the Obligations in exercising the
      same, shall not operate as a waiver of any such right, remedy or option. To
      the
      extent permitted by law, neither Collateral Agent, the Investors, nor any party
      acting as attorney for Collateral Agent or the Investors, shall be liable
      hereunder for any acts or omissions or for any error of judgment or mistake
      of
      fact or law other than their gross negligence or willful misconduct hereunder.
      The rights and remedies of Collateral Agent and the Investors under this
      Security Agreement shall be cumulative and not exclusive of any other right
      or
      remedy which Collateral Agent or the Investors may have.

     

    (f)  Marshaling.
      Collateral Agent shall not be required to marshal any present or future
      collateral security (including but not limited to the Collateral) for, or other
      assurances of payment of, the Obligations or any of them or to resort to such
      collateral security or other assurances of payment in any particular order,
      and
      all of its rights and remedies hereunder and in respect of such collateral
      security and other assurances of payment shall be cumulative and in addition
      to
      all other rights and remedies, however existing or arising. To the extent that
      it lawfully may, Company hereby agrees that it will not invoke any law relating
      to the marshaling of collateral which might cause delay in or impede the
      enforcement of Collateral Agent’s rights and remedies under this Security
      Agreement or under any other instrument creating or evidencing any of the
      Obligations or under which any of the Obligations is outstanding or by which
      any
      of the Obligations is secured or payment thereof is otherwise assured, and,
      to
      the extent that it lawfully may, Company hereby irrevocably waives the benefits
      of all such laws.

     

    (g)  Application
      of Collateral Proceeds.
      The
      proceeds and/or avails of the Collateral, or any part thereof, and the proceeds
      and the avails of any remedy hereunder (as well as any other amounts of any
      kind
      held by Collateral Agent at the time of, or received by Collateral Agent after,
      the occurrence of an Event of Default) shall be paid to and applied as
      follows:

     

    
      
        
        

      

      
        8

        
          

        

      

      
        
        

      

    

     

    (i)  First,
      to the
      payment of costs and expenses, including all amounts expended to preserve the
      value of the Collateral, of foreclosure or suit, if any, and of such sale and
      the exercise of any other rights or remedies, and of all proper fees, expenses,
      liability and advances, including reasonable legal expenses and attorneys’ fees,
      incurred or made hereunder by Collateral Agent;

     

    (ii)  Second,
      to the
      payment to each Investor of the interest due, owing or unpaid on such Investor’s
      Note, and in case such proceeds shall be insufficient to pay in full the whole
      amount due, owing or unpaid upon such Note, then its Pro Rata Share of the
      amount remaining to be distributed;

     

    (iii)  Third,
      to the
      payment to each Investor of the principal amount due, owing or unpaid on such
      Investor’s Note, and in case such proceeds shall be insufficient to pay in full
      the whole amount due, owing or unpaid upon such Note, then its Pro Rata Share
      of
      the amount remaining to be distributed;

     

    (iv)  Fourth,
      to the
      payment of other amounts payable to Collateral Agent and each Investor under
      any
      of the Transaction Documents, and in case such proceeds shall be insufficient
      to
      pay in full the whole amount due, owing or unpaid under such Transaction
      Documents, the amount remaining to be distributed shall be distributed pro
      rata
      in accordance with such other amounts payable; and

     

    (v)  Fifth,
      to the
      payment of the surplus, if any, to Company, its successors and assigns, or
      to
      whomsoever may be lawfully entitled to receive the same.

     

    For
      purposes of this Security Agreement, the term “Pro Rata Share” shall mean, when
      calculating a Investor’s portion of any distribution or amount, that
      distribution or amount (expressed as a percentage) equal to a fraction (i)
      the
      numerator of which is the outstanding principal amount of such Investor’s
      Note(s) and (ii) the denominator of which is the aggregate outstanding principal
      amount of all Notes issued under the Purchase Agreement. In the event that
      an
      Investor receives payments or distributions in excess of its Pro Rata Share,
      then such Investor shall hold in trust all such excess payments or distributions
      for the benefit of the other Investors and shall pay such amounts held in trust
      to such other Investors upon demand by such Investors in accordance with the
      Pro
      Rata Shares of such Investors.

     

    (h)  Deficiency.
      In the
      event that the proceeds of any sale, collection or realization are insufficient
      to pay all amounts to which Collateral Agent or the Investors are legally
      entitled, Company shall be liable for the deficiency, together with interest
      thereon at the rate of interest set forth in the Notes the costs of collection
      and the reasonable fees, charges and disbursements of counsel. Any surplus
      remaining after the full payment and satisfaction of the Obligations shall
      be
      returned to Company or to whomsoever a court of competent jurisdiction shall
      determine to be entitled thereto.

     

    8.  Miscellaneous.

     

    (a)  Notices.
      Except
      as otherwise provided herein, all notices, requests, demands, consents,
      instructions or other communications to or upon Company or Collateral Agent
      under this Security Agreement shall be in writing and faxed, mailed or delivered
      to each party to the facsimile number or its address set forth below (or to
      such
      other facsimile number or address as the recipient of any notice shall have
      notified the other in writing). All such notices, requests, demands, consents,
      instructions or other communications will be deemed effectively given the
      earlier of (i) when received, (ii) when delivered personally, (iii) one business
      day after being delivered by facsimile (with receipt of appropriate
      confirmation), (iv) one business day after being deposited with an overnight
      courier service of recognized standing or (v) four days after being deposited
      in
      the U.S. mail, first class with postage prepaid.

     

    
      
        
        

      

      
        9

        
          

        

      

      
        
        

      

    

     

    Collateral
      Agent:

     

    Doron
      Roethler

     

    c/o
      Michal Raviv, Adv.

    Gibor
      Sport House (28th floor)

    7,
      Menahem Begin (Betzalel) St.

    Ramat
      Gan
      52521, Israel

    Tel.: 
      +972 (3) 575-5525 ext. 111

    Fax:
      +972
      (3) 575-5526 

     

    Company:
      

    Smart
      Online, Inc

    2530
      Meridian Parkway, 2nd
      Floor

    Durham,
      NC 27713

    Attention:
      James Gayton, Corporate Counsel

    Telephone:
      (919) 765-5000

    Facsimile:
      (919) 765-5020

     

    with
      a
      copy to:

    Smith,
      Anderson, Blount, Dorsett, 

    Mitchell
      & Jernigan, LLP

    2500
      Wachovia Capitol Center

    Raleigh,
      North Carolina 27602-2611

    Attention:
      Margaret N. Rosenfeld

    Telephone: (919)
      821-6714

    Facsimile:
      (919) 821-6800

     

    (b)  Termination
      of Security Interest.
      

     

    (i)  Upon
      the
      payment in full of all Obligations to the satisfaction of Collateral Agent
      and
      the Investors, the security interest granted herein shall terminate. Upon such
      termination Collateral Agent shall, upon the request and at the expense of
      Company, forthwith release all of its liens and security interests hereunder
      and
      shall execute and deliver all UCC termination statements and/or other documents
      reasonably requested by Company evidencing such termination.

     

    
      
        
        

      

      
        10

        
          

        

      

      
        
        

      

    

     

    (ii)  This
      Security Agreement shall continue to be effective or be automatically
      reinstated, as the case may be, if at any time payment, in whole or in part,
      of
      any of the Obligations is rescinded or must otherwise be restored or returned
      by
      Collateral Agent or any Investor as a preference, fraudulent conveyance or
      otherwise under any federal, state or foreign bankruptcy, reorganization,
      insolvency or similar law, all as though such payment had not been made;
      provided that in the event payment of all or any part of the Obligations is
      rescinded or must be restored or returned, all reasonable costs and expenses
      (including without limitation any reasonable legal fees and disbursements)
      incurred by Collateral Agent or any Investor in defending and enforcing such
      reinstatement shall be deemed to be included as a part of the Obligations.
      

     

    (c)  Nonwaiver.
      No
      failure or delay on Collateral Agent’s part in exercising any right hereunder
      shall operate as a waiver thereof or of any other right nor shall any single
      or
      partial exercise of any such right preclude any other further exercise thereof
      or of any other right.

     

    (d)  Amendments
      and Waivers.
      This
      Security Agreement may not be amended or modified, nor may any of its terms
      be
      waived, except by written instruments signed by Company and Collateral Agent.
      Each waiver or consent under any provision hereof shall be effective only in
      the
      specific instances for the purpose for which given.

     

    (e)  Assignments.
      This
      Security Agreement shall be binding upon and inure to the benefit of Collateral
      Agent and Company and their respective successors and assigns; provided,
      however,
      that
      Company may not sell, assign or delegate rights and obligations hereunder
      without the prior written consent of Collateral Agent.

     

    (f)  Cumulative
      Rights, etc.
      The
      rights, powers and remedies of Collateral Agent under this Security Agreement
      shall be in addition to all rights, powers and remedies given to Collateral
      Agent by virtue of any applicable law, rule or regulation of any governmental
      authority, any Transaction Document or any other agreement, all of which rights,
      powers, and remedies shall be cumulative and may be exercised successively
      or
      concurrently without impairing Collateral Agent’s rights hereunder. Company
      waives any right to require Collateral Agent to proceed against any person
      or
      entity or to exhaust any Collateral or to pursue any remedy in Collateral
      Agent’s power.

     

    (g)  Payments
      Free of Taxes, Etc.
      All
      payments made by Company under the Transaction Documents shall be made by
      Company free and clear of and without deduction for any and all present and
      future taxes, levies, charges, deductions and withholdings. In addition, Company
      shall pay upon demand any stamp or other taxes, levies or charges of any
      jurisdiction with respect to the execution, delivery, registration, performance
      and enforcement of this Security Agreement. Upon request by Collateral Agent,
      Company shall furnish evidence satisfactory to Collateral Agent that all
      requisite authorizations and approvals by, and notices to and filings with,
      governmental authorities and regulatory bodies have been obtained and made
      and
      that all requisite taxes, levies and charges have been paid.

     

    (h)  Partial
      Invalidity.
      If at
      any time any provision of this Security Agreement is or becomes illegal, invalid
      or unenforceable in any respect under the law or any jurisdiction, neither
      the
      legality, validity or enforceability of the remaining provisions of this
      Security Agreement nor the legality, validity or enforceability of such
      provision under the law of any other jurisdiction shall in any way be affected
      or impaired thereby.

     

    
      
        
        

      

      
        11

        
          

        

      

      
        
        

      

    

     

    (i)  Construction.
      Each of
      this Security Agreement and the other Transaction Documents is the result of
      negotiations among, and has been reviewed by, Company, the Investors, Collateral
      Agent and their respective counsel. Accordingly, this Security Agreement and
      the
      other Transaction Documents shall be deemed to be the product of all parties
      hereto, and no ambiguity shall be construed in favor of or against Company,
      Investors or Collateral Agent.

     

    (j)  Entire
      Agreement.
      This
      Security Agreement taken together with the other Transaction Documents
      constitute and contain the entire agreement of Company, Investors and Collateral
      Agent and supersede any and all prior agreements, negotiations, correspondence,
      understandings and communications among the parties, whether written or oral,
      respecting the subject matter hereof.

     

    (k)  Other
      Interpretive Provisions.
      References in this Security Agreement and each of the other Transaction
      Documents to any document, instrument or agreement (a) includes all
      exhibits, schedules and other attachments thereto, (b) includes all
      documents, instruments or agreements issued or executed in replacement thereof,
      and (c) means such document, instrument or agreement, or replacement or
      predecessor thereto, as amended, modified and supplemented from time to time
      and
      in effect at any given time. The words “hereof,” “herein” and “hereunder” and
      words of similar import when used in this Security Agreement or any other
      Transaction Document refer to this Security Agreement or such other Transaction
      Document, as the case may be, as a whole and not to any particular provision
      of
      this Security Agreement or such other Transaction Document, as the case may
      be.
      The words “include” and “including” and words of similar import when used in
      this Security Agreement or any other Transaction Document shall not be construed
      to be limiting or exclusive.

     

    (l)  Governing
      Law.
      This
      Security Agreement shall be governed by and construed in accordance with the
      laws of the State of Delaware without reference to conflicts of law rules
      (except to the extent governed by the UCC).

     

    (m)  Counterparts.
      This
      Security Agreement may be executed in any number of counterparts, each of which
      shall be an original, but all of which together shall be deemed to constitute
      one instrument. Delivery of an executed counterpart of this Security Agreement
      by telefacsimile or other electronic method of transmission shall be equally
      as
      effective as delivery of an original executed counterpart of this Security
      Agreement. 

     

    (n)  Collateral
      Agent’s Duties.
      The
      powers conferred on Collateral Agent hereunder are solely to protect Collateral
      Agent’s interest in the Collateral, for the benefit of Collateral Agent and the
      Investors, and shall not impose any duty upon Collateral Agent to exercise
      any
      such powers. Except for the safe custody of any Collateral in its actual
      possession and the accounting for moneys actually received by it hereunder,
      Collateral Agent shall have no duty as to any Collateral or as to the taking
      of
      any necessary steps to preserve rights against prior parties or any other rights
      pertaining to any Collateral. Collateral Agent shall be deemed to have exercised
      reasonable care in the custody and preservation of any Collateral in its actual
      possession if such Collateral is accorded treatment substantially equal to
      that
      which Collateral Agent accords its own property.

     

    
      
        
        

      

      
        12

        
          

        

      

      
        
        

      

    

     

    (o)  Collateral
      Agent May Perform.
      After
      the occurrence and during the continuation of an Event of Default, if Company
      fails to perform any agreement contained herein, Collateral Agent may itself
      perform, or cause performance of, such agreement, and the reasonable expenses
      of
      Collateral Agent incurred in connection therewith shall be payable by
      Company.

     

    [The
      remainder of this page is intentionally left blank]

     

     

     

     

    
      
        
        

      

      
        13

        
          

        

      

      
        
        

      

    


     

    IN
      WITNESS WHEREOF, Company has caused this Security Agreement to be executed
      as of
      the day and year first above written.

     

    SMART
      ONLINE, INC.

     

    By:
      /s/ David E.
      Colburn                                         

    Name: David
      E.
      Colburn                                       
  

    Title:
      President and
      CEO                                         


     

    


     

    DORON
      ROETHLER

     

    As
      Collateral Agent

    


    /s/
      Doron
      Roethler                                                    


    


    Name:
      Doron Roethler

    
[Signature
      page to Security
      Agreement]

     

     

    
      
        
        

      

      
        14

        
          

        

      

      
        
        

      

    

     

    ATTACHMENT
      1

     

    TO
      SECURITY AGREEMENT

     

    All
      right, title, interest, claims and demands of Company in and to the following
      property in full:

     

    (i)  All
      Accounts;

     

    (ii)  All
      Chattel Paper;

     

    (iii)  All
      Commercial Tort Claims listed on Exhibit
      A;

     

    (iv)  All
      Deposit Accounts and cash;

     

    (v)  All
      Documents;

     

    (vi)  All
      Equipment;

     

    (vii)  All
      General Intangibles;

     

    (viii)  All
      Goods;

     

    (ix)  All
      Instruments;

     

    (x)  All
      Intellectual Property;

     

    (xi)  All
      Inventory;

     

    (xii)  All
      Investment Property;

     

    (xiii)  All
      Letter-of-Credit Rights; and

     

    (xiv)  To
      the
      extent not otherwise included, all Supporting Obligations, Proceeds and products
      of any and all of the foregoing, and all accessions to, substitutions and
      replacements for, and rents and profits of each of the foregoing. 

     

    Provided,
      however,
      Collateral does not include the Excluded Investment Property until such time
      as
      the Senior Obligations have been indefeasibly satisfied in full; provided,
      further, however
      upon the
      indefeasible satisfaction of the Senior Obligations in full, Collateral does
      include the Excluded Investment Property.

     

    
      
        
        

      

      
        
        

        
          

        

      

      
        
        

      

    

     

    The
      term
“Intellectual
      Property”
      means
      all
      intellectual and similar property of every kind and nature now owned or
      hereafter acquired by Company, including inventions, designs, patents (whether
      registered or unregistered), copyrights (whether registered or unregistered),
      trademarks (whether registered or unregistered), trade secrets, domain names,
      confidential or proprietary technical and business information, know-how,
      methods, processes, drawings, specifications or other data or information and
      all memoranda, notes and records with respect to any research and development,
      software and databases and all embodiments or fixations thereof whether in
      tangible or intangible form or contained on magnetic media readable by machine
      together with all such magnetic media and related documentation, registrations
      and franchises, and all additions, improvements and accessions to, and books
      and
      records describing or used in connection with, any of the
      foregoing.

     

    All
      capitalized terms used in this Attachment
      1
      and not
      otherwise defined herein shall have the respective meanings given to such terms
      in the Uniform Commercial Code of the State of California as in effect from
      time
      to time.

    
      
        
        

      

      
        2

        
          

        

      

      
        
        

      

    


     

    ATTACHMENT
      2

     

    TO
      SECURITY AGREEMENT

     

    


     

    Loan
      Agreement dated as of November 14, 2006 between the Company and Wachovia Bank,
      N.A. and Security Agreement dated as of November 14, 2006 between the Company
      and Wachovia Bank, N.A.

     

     

     

     

     

    
      
        
        

      

      
        3

        
          

        

      

      
        
        

      

    



     

    ATTACHMENT
      3

     

    TO
      SECURITY AGREEMENT

     

    State
      of
      Delaware