UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
  
  FORM
10-Q
  
 (Mark
One)
 x
Quarterly
report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
 
 For
the quarterly period ended September 30, 2010
 
 OR
 
  ̈
Transition
report pursuant to Section 13 of 15(d) of the Securities Exchange Act of
1934
 
 Commission
File Number: 001-32634
  
 SMART
ONLINE, INC.
 (Exact
name of registrant as specified in its charter)
 
 Delaware
              95-4439334(State
      or other jurisdiction of
              (I.R.S.
      Employerincorporation
      or organization)
              Identification
      No.)
 
 4505
      Emperor Blvd., Ste. 320
                  Durham,
      North Carolina
                27703(Address
      of principal executive offices)
                (Zip
      Code)
 
 (919)
765-5000
 (Registrant’s
telephone number, including area code)
  
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days: Yes x No  ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
 Large accelerated filer
               ̈
              Accelerated filer
               ̈Non-accelerated filer
               ̈
       (Do not check if a smaller reporting company)
              Smaller reporting company
              x
 
 Indicate by check mark whether the registrant is a shell
company (as defined in Rule 12b-2 of the Exchange Act). Yes  ̈ No x
 As of
November 11, 2010, there were 18,343,542 shares of the registrant’s common
stock, par value $0.001 per share, outstanding.
  
  SMART
ONLINE, INC.
 
 FORM
10-Q
 For the
Quarterly Period Ended September 30, 2010
 
 TABLE
OF CONTENTS
 
 Page No.PART
      I  – FINANCIAL INFORMATIONItem
      1.
                          
                          Financial
      Statements
                          
                          3Consolidated
      Balance Sheets as of September 30, 2010 (unaudited) and December 31,
      2009
                          
                          3Consolidated
      Statements of Operations (unaudited) for the three and nine months ended
      September 30, 2010 and 2009
                          
                          4Consolidated
      Statements of Cash Flows (unaudited) for the nine months ended September
      30, 2010 and 2009
                          
                          5Notes
      to Consolidated Financial Statements (unaudited)
                          
                          6Item
      2.
                          
                          Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                          
                          20Item
      3.
                          
                          Quantitative
      and Qualitative Disclosures About Market Risk
                          
                          34Item
      4.
                          
                          Controls
      and Procedures
                          
                          34PART
      II  – OTHER INFORMATIONItem
      1.
                          
                          Legal
      Proceedings
                          
                          34Item
      1A.
                          
                          Risk
      Factors
                          
                          36Item
      2.
                          
                          Unregistered
      Sales of Equity Securities and Use of Proceeds
                          
                          37Item
      6.
                          
                          Exhibits
                          
                          37Signatures
                          
                          38
  Page
2 of 38
  PART
I – FINANCIAL INFORMATION
 Item 1.     Financial
Statements
 SMART
ONLINE, INC.
 CONSOLIDATED
BALANCE SHEETS
  September 30,
                    
                    
                    December 31,2010
                    
                    
                    2009(unaudited)ASSETSCurrent
      Assets:Cash
      and Cash Equivalents
                    
                    $
                    56,686
                    
                    
                    $
                    119,796Accounts
      Receivable, Net
                    
                    
                    -
                    
                    
                    
                    13,056Note
      Receivable
                    
                    
                    -
                    
                    
                    
                    -Prepaid
      Expenses
                    
                    
                    203,339
                    
                    
                    
                    240,840Total
      current assets
                    
                    
                    260,025
                    
                    
                    
                    373,692Property
      and equipment, net
                    
                    
                    216,399
                    
                    
                    
                    258,450Capitalized
      software, net
                    
                    
                    -
                    
                    
                    
                    450,782Note
      Receivable, non-current
                    
                    
                    -
                    
                    
                    
                    -Prepaid
      expenses, non-current
                    
                    
                    -
                    
                    
                    
                    110,700Intangible
      assets, net
                    
                    
                    150,000
                    
                    
                    
                    150,000Other
      assets
                    
                    
                    5,000
                    
                    
                    
                    2,496TOTAL
      ASSETS
                    
                    $
                    631,424
                    
                    
                    $
                    1,346,120LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesAccounts
      payable
                    
                    $
                    537,928
                    
                    
                    $
                    518,309Notes
      payable (See Note 3)
                    
                    
                    2,124,678
                    
                    
                    
                    1,964,281Deferred
      revenue (See Note 2)
                    
                    
                    27,561
                    
                    
                    
                    40,115Accrued
      liabilities – Nouri
                    
                    
                    1,400,000
                    
                    
                    
                    1,802,379Accrued
      liabilities (See Note 2)
                    
                    
                    2,266,165
                    
                    
                    
                    2,623,959Total
      current liabilities
                    
                    
                    6,356,332
                    
                    
                    
                    6,949,043Long-term
      liabilities:Long-term
      portion of notes payable (See Note 3)
                    
                    
                    12,370,367
                    
                    
                    
                    9,785,255Deferred
      revenue (See Note 2)
                    
                    
                    1,153
                    
                    
                    
                    5,601Total
      long-term liabilities
                    
                    
                    12,371,520
                    
                    
                    
                    9,790,856Total
      liabilities
                    
                    
                    18,727,852
                    
                    
                    
                    16,739,899Commitments
      and contingencies (See Note 4)Stockholders'
      equity (deficit):Preferred stock, 0.001 par value,
      5,000,000 shares authorized, no shares issued and outstanding at
      September 30, 2010 and December 31, 2009Common Stock, $.001 par value,
      45,000,000 shares authorized, 18,342,542 and 18,332,542 shares
      Issued and Outstanding at September 30, 2010 and December
      31, 2009 respectively.
                    
                    
                    18,343
                    
                    
                    
                    18,333Additional
      paid-in capital
                    
                    
                    67,059,722
                    
                    
                    
                    67,036,836Accumulated
      deficit
                    
                    
                    (85,174,493
                    )
                    
                    
                    (82,448,948
                    )Total
      Stockholders’ Deficit
                    
                    
                    (18,096,428
                    )
                    
                    
                    (15,393,779
                    )TOTAL
      LIABILITIES AND STOCKHOLDERS’ DEFICIT
                    
                    $
                    631,424
                    
                    
                    $
                    1,346,120
  The
accompanying notes are an integral part of these financial
statements.
  Page
3 of 38
  SMART
ONLINE, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (Unaudited)
  Three Months Ended
                  
                  
                  Nine Months EndedSeptember30,
                    2010
                  
                  
                  September30,
                    2009
                  
                  
                  September30,
                    2010
                  
                  
                  September30,
                    2009REVENUES:Subscription
      fees
                  
                  $
                  119,152
                  
                  
                  $
                  159,149
                  
                  
                  $
                  378,556
                  
                  
                  $
                  610,751Professional
      service fees
                  
                  
                  12,600
                  
                  
                  
                  63,200
                  
                  
                  
                  82,425
                  
                  
                  
                  261,699License
      fees
                  
                  
                  65,850
                  
                  
                  
                  11,250
                  
                  
                  
                  224,500
                  
                  
                  
                  33,750Hosting
      fees
                  
                  
                  37,722
                  
                  
                  
                  33,751
                  
                  
                  
                  119,716
                  
                  
                  
                  139,007Other
      revenue
                  
                  
                  25,644
                  
                  
                  
                  26,300
                  
                  
                  
                  79,389
                  
                  
                  
                  100,777Total
      revenues
                  
                  
                  260,968
                  
                  
                  
                  293,650
                  
                  
                  
                  884,586
                  
                  
                  
                  1,145,984COST
      OF REVENUES
                  
                  
                  344,156
                  
                  
                  
                  430,967
                  
                  
                  
                  1,046,400
                  
                  
                  
                  1,125,901GROSS
      PROFIT (LOSS)
                  
                  
                  (83,188
                  )
                  
                  
                  (137,317
                  )
                  
                  
                  (161,814
                  )
                  
                  
                  20,083OPERATING
      EXPENSES:General
      and administrative
                  
                  
                  408,004
                  
                  
                  
                  2,355,353
                  
                  
                  
                  1,469,892
                  
                  
                  
                  4,112,993Sales
      and marketing
                  
                  
                  181,132
                  
                  
                  
                  180,759
                  
                  
                  
                  513,408
                  
                  
                  
                  707,289Research
      and development
                  
                  
                  7,695
                  
                  
                  
                  36,406
                  
                  
                  
                  50,080
                  
                  
                  
                  540,232Loss
      on impairment
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  438,286(Gain)
      loss on disposal of assets, net
                  
                  
                  398,962
                  
                  
                  
                  (12,307
                  )
                  
                  
                  398,962
                  
                  
                  
                  (22,574
                  )Total
      operating expenses
                  
                  
                  995,793
                  
                  
                  
                  2,560,211
                  
                  
                  
                  2,432,342
                  
                  
                  
                  5,776,226LOSS
      FROM OPERATIONS
                  
                  
                  (1,078,981
                  )
                  
                  
                  (2,697,528
                  )
                  
                  
                  (2,594,156
                  )
                  
                  
                  (5,756,143
                  )OTHER
      INCOME (EXPENSE):Interest
      expense, net
                  
                  
                  (244,189
                  )
                  
                  
                  (169,609
                  )
                  
                  
                  (687,909
                  )
                  
                  
                  (455,951
                  )Gain
      on legal settlements, net
                  
                  
                  2,547
                  
                  
                  
                  -
                  
                  
                  
                  556,517
                  
                  
                  
                  6,000Other
      Income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  10,267Total
      other expense
                  
                  
                  (241,642
                  )
                  
                  
                  (169,609
                  )
                  
                  
                  (131,392
                  )
                  
                  
                  (439,684
                  )NET
      LOSS
                  
                  $
                  (1,320,623
                  )
                  
                  $
                  (2,867,137
                  )
                  
                  $
                  (2,725,548
                  )
                  
                  $
                  (6,195,827
                  )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                  
                  $
                  (0.07
                  )
                  
                  $
                  (0.16
                  )
                  
                  $
                  (0.15
                  )
                  
                  $
                  (0.34
                  )WEIGHTED-AVERAGE
      NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
    SHAREBasic
      and fully diluted
                  
                  
                  18,342,542
                  
                  
                  
                  18,332,542
                  
                  
                  
                  18,342,542
                  
                  
                  
                  18,332,542
  The
accompanying notes are an integral part of these financial
statements.
  Page
4 of 38
  SMART
ONLINE, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (Unaudited)
 
 Nine Months
                  
                  
                  Nine MonthsEnded
                  
                  
                  EndedSeptember 30,
                    2010
                  
                  
                  September 30,
                    2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      Loss
                  
                  $
                  (2,725,548
                  )
                  
                  $
                  (6,195,827
                  )Adjustments
      to reconcile let loss to net cash used in operating
      activities:Depreciation
      and amortization
                  
                  
                  100,892
                  
                  
                  
                  462,761Bad
      debt expense
                  
                  
                  377,348
                  
                  
                  
                  2,207,685Stock-based
      compensation expense
                  
                  
                  22,884
                  
                  
                  
                  88,235Loss
      on impairment of intangible assets
                  
                  
                  
                  
                  
                  
                  438,228(Gain)
      loss on disposal of assets
                  
                  
                  398,962
                  
                  
                  
                  (22,574
                  )Changes
      in assets and liabilities:Accounts
      receivable
                  
                  
                  (309,404
                  )
                  
                  
                  213,010Notes
      receivable
                  
                  
                  (54,888
                  )
                  
                  
                  (3,228,038
                  )Prepaid
      expenses
                  
                  
                  148,204
                  
                  
                  
                  126,005Other
      assets
                  
                  
                  (2,504
                  )
                  
                  
                  (352
                  )Deferred
      revenue
                  
                  
                  (17,002
                  )
                  
                  
                  (188,170
                  )Accounts
      payable
                  
                  
                  19,619
                  
                  
                  
                  1,768,181Accrued
      and other expenses
                  
                  
                  (760,173
                  )
                  
                  
                  1,627,739Net
      cash used in operating activities
                  
                  
                  (2,801,610
                  )
                  
                  
                  (2,703,117
                  )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of furniture and equipment
                  
                  
                  (7,009
                  )
                  
                  
                  (14,565
                  )Capitalized
      software
                  
                  
                  -
                  
                  
                  
                  (206,835
                  )Proceeds
      from sale of furniture and equipment
                  
                  
                  -
                  
                  
                  
                  45,362Net
      Cash used in investing activities
                  
                  
                  (7,009
                  )
                  
                  
                  (176,038
                  )CASH
      FLOWS FROM FINANCING ACTIVITIES:Repayments
      on notes payable
                  
                  
                  (4,261,620
                  )
                  
                  
                  (5,068,063
                  )Debt
      borrowings
                  
                  
                  7,007,129
                  
                  
                  
                  7,947,365Net
      cash provided by financing activities
                  
                  
                  2,745,509
                  
                  
                  
                  2,879,302NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                  
                  
                  (63,110
                  )
                  
                  
                  147CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
                  
                  
                  119,796
                  
                  
                  
                  18,602CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                  
                  $
                  56,686
                  
                  
                  $
                  18,749Supplemental
      disclosures of cash flow information:Cash
      paid during the period for:Interest
                  
                  $
                  173,818
                  
                  
                  $
                  461,360Taxes
                  
                  $
                  -
                  
                  
                  $
                  -
 
 The
accompanying notes are an integral part of these financial
statements.
  Page
5 of 38
  SMART
ONLINE, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
 1.   SUMMARY OF BUSINESS AND SIGNIFICANT
ACCOUNTING POLICIES
 Description of
Business - Smart Online, Inc. (the “Company”) was incorporated in the
State of Delaware in 1993. The Company develops and markets software products
and services targeted to small businesses that are delivered via a
Software-as-a-Service (“SaaS”) model. The Company sells its SaaS products and
services primarily through private-label marketing partners. In addition, the
Company provides sophisticated and complex website consulting and development
services, primarily in the e-commerce retail and direct-selling organization
industries. The Company maintains a website that offers additional information
about these capabilities as well as certain corporate information at
www.smartonline.com.
 
 Basis of
Presentation - The financial statements as of and for the three and nine
months ended September 30, 2010 and 2009 included in this Quarterly Report
on Form 10-Q are unaudited. The balance sheet as of December 31, 2009 is
obtained from the audited financial statements as of that date. The accompanying
statements should be read in conjunction with the audited financial statements
and related notes, together with management’s discussion and analysis of
financial condition and results of operations, contained in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2009 filed with the
Securities and Exchange Commission (the “SEC”) on April 15, 2010 (the “2009
Annual Report”).
 
 The
financial statements have been prepared in accordance with United State
Generally Accepted Accounting Principles (“US GAAP”). In the opinion of the
Company’s management, the unaudited statements in this Quarterly Report on Form
10-Q include all normal and recurring adjustments necessary for the fair
presentation of the Company’s statement of financial position as of September
30, 2010, and its results of operations and cash flows for the three and nine
months ended September 30, 2010 and 2009. The results for the three and nine
months ended September 30, 2010 are not necessarily indicative of the results to
be expected for the fiscal year ending December 31, 2010.
 
 The
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. During the three and nine months ended
September 30, 2010 and 2009, the Company incurred net losses as well as negative
cash flows and had deficiencies in working capital. In addition, the Company was
involved in the settlement of a class action lawsuit (See Note 7 “Commitments
and Contingencies,” in the 2009 Annual Report), and the settlement of a lawsuit
for legal fees advanced on behalf of former officers and employees who were
convicted in Federal Court. These factors indicate that the Company may be
unable to continue as a going concern.
 
 The
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts or
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. At November 10, 2010, the Company does
have a commitment from its convertible secured subordinated noteholders to
purchase up to an additional $2.6 million in convertible notes upon approval and
call by the Company’s Board of Directors. There can be no assurance that, if the
noteholders do not purchase the $2.6 million in convertible notes, the Company
will be able to obtain alternative funding. There can be no assurance that the
Company’s efforts to raise capital or increase revenue will be successful. If
these efforts are unsuccessful, the Company may have to cease operations and
liquidate the business. The Company’s plans include the development of
additional new products and applications, and further enhancement of its
existing small-business applications and tools. The Company’s continuation as a
going concern depends upon its capability to generate sufficient cash flows to
meet its obligations on a timely basis, to obtain additional financing as may be
required, and ultimately to attain profitable operations and positive cash
flows.
 
 Significant
Accounting Policies - In the opinion of the Company’s management, the
significant accounting policies used for the three and nine months ended
September 30, 2010 are consistent with those used for the years ended December
31, 2009 and 2008. Accordingly, please refer to the 2009Annual Report for the
Company’s significant accounting policies.
 
 Use of Estimates
- The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions in the Company’s financial
statements and notes thereto. Significant estimates and assumptions made by
management include the determination of the provision for income taxes, the fair
market value of stock awards issued, and the period over which revenue is
generated. Actual results could differ materially from those
estimates.
  Page
6 of 38
  Fair Value of
Financial Instruments -US GAAP requires disclosures of fair value
information about financial instruments, whether or not recognized in the
balance sheet, for which it is practical to estimate that value. Due to the
short period of time to maturity, the carrying amounts of cash equivalents,
accounts receivable, accounts payable, accrued liabilities, and notes payable
reported in the financial statements approximate the fair value.
 
 Reclassifications
- Certain prior year and comparative period amounts have been reclassified to
conform to current year presentation. These reclassifications had no effect on
previously reported net income or stockholders’ equity.
  Segments -
Segmentation is based on an entity’s internal organization and reporting of
revenue and operating income based upon internal accounting methods commonly
referred to as the “management approach.” Operating segments are defined as
components of an enterprise about which separate financial information is
available that is evaluated regularly by the chief operating decision maker in
deciding how to allocate resources and in assessing performance. The Company’s
chief operating decision maker is its Interim Chief Executive Officer, who
reviews financial information presented on a consolidated basis. Accordingly,
the Company has determined that it has a single reporting segment and operating
unit structure.
 
 Concentration of
Credit Risk - Financial instruments that potentially subject the Company
to concentrations of credit risk consist primarily of cash and accounts
receivable. At times, cash balances may exceed the Federal Deposit Insurance
Corporation (“FDIC”) insurable limits. See Note 6, “Major Customers and
Concentration of Credit Risk,” for further discussion of risk within accounts
receivable.
 
 Allowance for
Doubtful Accounts - The Company maintains an allowance for doubtful
accounts for estimated losses resulting from the inability, failure, or refusal
of its customers to make required payments. The need for an allowance for
doubtful accounts is evaluated based on specifically identified amounts that
management believes to be potentially uncollectible. If actual collections
experience changes, revisions to the allowance may be required.
 
 From time
to time, the Company, as part of its negotiated contracts, has granted extended
payment terms to its strategic partners. As payments become due under the terms
of the contract, they are invoiced and reclassified as accounts receivable.
Based on these criteria, management determined that at September 30, 2010, an
allowance for doubtful accounts of $1,199,859 was required, comprising the full
outstanding balance of a direct-selling organization customers’ account and
contract receivable.
 
 Intangible
Assets - Intangible assets consist primarily of assets obtained
through the acquisitions of iMart Incorporated (“iMart”) in 2005 and includes
the trade name. The iMart trade name is deemed by management to have an
indefinite life and is not amortized.
  Revenue
Recognition - The Company derives revenue primarily from subscription
fees charged to customers accessing its SaaS applications; the perpetual or term
licensing of software platforms or applications; and professional services,
consisting of consulting, development, hosting, and maintenance services. These
arrangements may include delivery in multiple-element arrangements if the
customer purchases a combination of products and/or services. Because the
Company licenses, sells, leases, or otherwise markets computer software, it uses
the residual method pursuant to the US GAAP, as amended. This method allows the
Company to recognize revenue for a delivered element when such element has
vendor specific objective evidence (“VSOE”) of the fair value of the delivered
element. If VSOE cannot be determined or maintained for an element, it could
impact revenues as all or a portion of the revenue from the multiple-element
arrangement may need to be deferred.
  Page
7 of 38
  If
multiple-element arrangements involve significant development, modification, or
customization or if it is determined that certain elements are essential to the
functionality of other elements within the arrangement, revenue is deferred
until all elements necessary to the functionality are provided by the Company to
a customer. The determination of whether the arrangement involves significant
development, modification, or customization could be complex and require the use
of judgment by management.
 
 Under US
GAAP, provided the arrangement does not require significant development,
modification, or customization, revenue is recognized when all of the following
criteria have been met:
 
 1.  
persuasive evidence of an arrangement exists
 
 2.  
delivery has occurred
 
 3.  
the fee is fixed or determinable
 
 4.  
collectability is probable
 
 If at the
inception of an arrangement the fee is not fixed or determinable, revenue is
deferred until the arrangement fee becomes due and payable. If collectability is
deemed not probable, revenue is deferred until payment is received or collection
becomes probable, whichever is earlier. The determination of whether fees are
collectible requires judgment of management, and the amount and timing of
revenue recognition may change if different assessments are made.
 
 Under the
provisions of US GAAP, consulting, website design fees, and application
development services are accounted for separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, revenues are recognized as the services are rendered
for time and material contracts, and when milestones are achieved and accepted
by the customer for fixed-price or long-term contracts. The majority of the
Company’s consulting service contracts are on a time and material basis and are
typically billed monthly based upon standard professional service
rates.
 
 Application
development services are typically fixed price and of a longer term. As such,
they are accounted for as long-term construction contracts that require revenue
recognition to be based on estimates involving total costs to complete and the
stage of completion. The assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, the associated costs of such
projects are capitalized and included in costs in excess of billings on the
balance sheet until such time that revenue recognition is
permitted.
 
 Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user. Any payments received in advance of the subscription period are accrued as
deferred revenue and amortized over the subscription period. In the past, we recognized
all subscription revenue on a gross basis and in accordance with our policy to
periodically review our accounting policies we identified the fact that certain
contracts required the reporting of subscription revenue on a gross basis and
others on a net basis according to US GAAP. On that basis, we continue to report
subscription revenue from certain contracts on a gross basis and others on a net
basis. The net effect of this reclassification of expenses only impacts gross
revenue and certain gross expenses; it does not change our net
income.Because our customers generally do not have the contractual right
to take possession of the software we license or market at any time, we
recognize revenue on hosting and maintenance fees as the services are provided
in accordance with US GAAP that includes the right to use software stored on
another entity’s hardware.
 
 Deferred
Revenue -Deferred revenue consists of billings or payments
received in advance of revenue recognition, and it is recognized as the revenue
recognition criteria are met. Deferred revenue also includes certain
professional service fees and license fees where all the criteria of US GAAP
were not met. Deferred revenue that will be recognized over the succeeding
12-month period is recorded as current and the remaining portion is recorded as
non-current.
 
 Cost of
Revenues - Cost of revenues primarily is composed of costs related
to third-party hosting services, salaries and associated costs of customer
support and professional services personnel, credit card processing,
depreciation of computer hardware and software used in revenue-producing
activities, domain name and e-mail registrations, and allocated development
expenses and general and administrative overhead.
  Page
8 of 38
  The
Company allocates development expenses to cost of revenues based on time spent
by development personnel on revenue-producing customer projects and support
activities. The Company allocates general and administrative overhead such as
rent and occupancy expenses, depreciation, general office expenses, and
insurance to all departments based on headcount. As such, general and
administrative overhead expenses are reflected in cost of revenues and each
operating expense category.
 
 Software
Development Costs - Current US GAAP requires capitalization of certain
software development costs subsequent to the establishment of technological
feasibility, with costs incurred prior to this time expensed as research and
development. Technological feasibility is established when all planning,
designing, coding, and testing activities that are necessary to establish that
the product can be produced to meet its design specifications have been
completed. Historically, the Company had not developed detailed design plans for
its SaaS applications, and the costs incurred between the completion of a
working model of these applications and the point at which the products were
ready for general release had been insignificant. These factors, combined with
the historically low revenue generated by the sale of the applications that do
not support the net realizable value of any capitalized costs, resulted in the
continued expensing of underlying costs as research and
development.
 
 On a
continuing basis, we review the value of all assets of the Company. During the
quarter ending September 30, 2010, we wrote off the entire value of the
previously capitalized software for the Onebiz® product since there were no
customers and the product was not competitive with similar offerings in the
marketplace. In addition, management has changed the focus of sales and
marketing efforts away from the OneBiz® product.
 
 Advertising
Costs - The Company expenses all advertising costs as they are incurred.
The amounts charged to sales and marketing expense during the third quarter of
2010 and 2009 were $47,480 and $3,000, respectively. During the first nine
months of 2010 and 2009, these amounts were $97,088 and $42,364,
respectively.
 
 Net Loss Per
Share - Basic net loss per share is computed using the weighted-average
number of common shares outstanding during the relevant periods. Diluted net
loss per share is computed using the weighted-average number of common and
dilutive common equivalent shares outstanding during the relevant periods.
Common equivalent shares consist of convertible notes, stock options, and
warrants that are computed using the treasury stock method.
 
 Stock-Based
Compensation  -  The Company adopted US
GAAP provisions related to share-based payments which requires companies to
expense the value of employee stock options, restricted stock, and similar
awards and applies to all such securities outstanding and vested.
 
 In
computing the impact of stock-based compensation expense, the fair value of each
award is estimated on the date of grant based on the Black-Scholes
option-pricing model utilizing certain assumptions for a risk-free interest
rate, volatility, and expected remaining lives of the awards. The assumptions
used in calculating the fair value of share-based payment awards represent
management’s best estimates, but these estimates involve inherent uncertainties
and the application of management’s judgment. As a result, if factors change and
the Company uses different assumptions, the Company’s stock-based compensation
expense could be materially different in the future. In addition, the Company is
required to estimate the expected forfeiture rate and only recognize expense for
those shares expected to vest. In estimating the Company’s forfeiture rate, the
Company analyzed its historical forfeiture rate, the remaining lives of unvested
options, and the amount of vested options as a percentage of total options
outstanding. If the Company’s actual forfeiture rate is materially different
from its estimate, or if the Company reevaluates the forfeiture rate in the
future, the stock-based compensation expense could be significantly different
from what the Company has recorded in the current period.
 
 The
following is a summary of the Company’s stock-based compensation expense for the
periods indicated:
 
 Three Months Ended
                  
                  
                  Nine Months EndedSeptember 30,
                    2010
                  
                  
                  September 30,
                    2009
                  
                  
                  September 30,
                    2010
                  
                  
                  September 30,
                    2009Compensation
      expense included in G&A expense related to stock
    options
                  
                  $
                  8,393
                  
                  
                  $
                  5,191
                  
                  
                  $
                  17,184
                  
                  
                  $
                  40,155Compensation
      expense included in G&A expense related to restricted stock
      awards
                  
                  
                  2,850
                  
                  
                  
                  560
                  
                  
                  
                  5,700
                  
                  
                  
                  48,080Total
      expense
                  
                  $
                  11,243
                  
                  
                  $
                  5,751
                  
                  
                  $
                  22,884
                  
                  
                  $
                  88,235
  Page
9 of 38
  The fair
value of option grants under the Company’s equity compensation plan and other
stock option issuances during the three months and nine months ended September
30, 2010 and 2009 were estimated using the Black-Scholes option-pricing model
with the following weighted-average assumptions:
 
 Three Months Ended
                  
                  
                  Nine Months EndedSeptember 30,
                    2010
                  
                  
                  September 30,
                    2009
                  
                  
                  September 30,
                    2010
                  
                  
                  September 30,
                    2009Dividend
      yield
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %Expected
      volatility
                  
                  
                  97
                  %
                  
                  
                  70
                  %
                  
                  
                  97
                  %
                  
                  
                  69
                  %Risk-free
      interest rate
                  
                  
                  1.27
                  %
                  
                  
                  2.37
                  %
                  
                  
                  1.9
                  %
                  
                  
                  2.3
                  %Expected
      lives (years)
                  
                  
                  4.0
                  
                  
                  
                  4.0
                  
                  
                  
                  4.0
                  
                  
                  
                  4.0
 
 The
expected lives of the options represent the estimated period of time until
exercise or forfeiture and are based on historical experience of similar awards.
Expected volatility is partially based on the historical volatility of the
Company’s common stock since the end of the prior fiscal year as well as
management’s expectations for future volatility. The risk-free interest rate is
based on the published yield available on U.S. treasury issues with an
equivalent term remaining equal to the expected life of the option.
 
 The
following is a summary of the stock option activity for the nine months ended
September 30, 2010:
 
 Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      PriceBALANCE,
      December 31, 2009
                    
                    
                    132,500
                    
                    
                    $
                    4.43Granted
                    
                    
                    125,000
                    
                    
                    
                    1.14Forfeited
                    
                    
                    (42,500
                    )
                    
                    
                    3.31Exercised
                    
                    
                    -
                    
                    
                    
                    -BALANCE,
      September 30, 2010
                    
                    
                    215,000
                    
                    
                    $
                    2.74
 
 Recently Issued
Accounting Pronouncements -. The current US GAAP pronouncements
concerning the life of intangible assets require entities to consider their own
historical experience in renewing or extending similar arrangements when
developing assumptions regarding the useful lives of intangible assets and also
mandates certain related disclosure requirements.
 
 All other
new and recently issued, but not yet effective, accounting pronouncements have
been deemed to be not relevant to the Company and therefore are not expected to
have any impact once adopted.
 
 2.   ASSETS &
LIABILITIES
 
 Prepaid
Expenses
 In July
2008, the Company entered into a 36-month sublease agreement with Advantis Real
Estate Services Company for approximately 9,837 square feet of office space in
Durham, North Carolina, into which the Company relocated its headquarters in
September 2008. The agreement included the conveyance of certain furniture to
the Company without a stated value and required a lump-sum, upfront payment of
$500,000 that was made in September 2008. Management has assessed the fair
market value of the furniture to be approximately $50,000, and this amount was
capitalized and is subject to depreciation in accordance with the Company’s
fixed asset policies. The remainder of the payment was recorded as prepaid
expense; with the portion relating to rent for periods beyond the next twelve
months classified as non-current, and is being amortized to rent expense over
the term of the lease.  The Company’s prepaid sublease with Advantis
Real Estate Services Company includes an expiration date of September
2011.
  Page
10 of 38
  Intangible
Assets
  The
following table summarizes information about intangible assets at September 30,
2010:
 Asset Category
                                                  
                                                  Value
                                                    Assigned
                                                  
                                                  
                                                  Residual
                                                    Value
                                                  
                                                  
                                                  Weighted
                                                    Average
                                                    Amortization
                                                    Period
                                                    (in Years)
                                                  
                                                  
                                                  Accumulated
                                                    Amortization
                                                  
                                                  
                                                  Carrying
                                                    ValueTrade
      name
                                                  
                                                  $
                                                  150,000
                                                  
                                                  
                                                  
                                                  N/A
                                                  
                                                  
                                                  
                                                  N/A
                                                  
                                                  
                                                  
                                                  N/A
                                                  
                                                  
                                                  $
                                                  150,000Totals
                                                  
                                                  $
                                                  150,000
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  
                                                  
                                                  
                                                  $
                                                  150,000
 
 Intangible
assets acquired were valued using the standard of “fair value” defined in US
GAAP related to business combinations , as “the amount at which an asset (or
liability) could be bought (or incurred) or sold (or settled) in a current
transaction between willing parties, that is, other than in a forced or
liquidation sale.”
  Accrued
Liabilities
 At
September 30, 2010, the Company had accrued liabilities totaling $3,666,165.
This amount consisted primarily of $1,400,000 related to legal reserves for the
settlement of legal fees on behalf of former officers and employees, Michael
Nouri and Eric Reza Nouri, both of whom were convicted on criminal charges
brought by the US Department of Justice; $126,030 of liability accrued related
to the development of the Company’s custom accounting application; $1,974,500
related to settlement costs and legal expenses associated with the Company’s
class action settlement agreement  (see Note 4, “Commitments and
Contingencies”); $22,946 of accrued payroll; $136,929 of convertible note
interest payable and other liabilities of $5,760.
 
 At
September 30, 2009, the Company had accrued liabilities totaling $2,107,751.
This amount consisted primarily of $117,102 of liability accrued related to the
development of the Company’s custom accounting application; $1,804,207 related
to legal expenses associated with the settlement of claims brought by the
Company’s former officers and employees  (see Note 4, “Commitments and
Contingencies”); $24,518 for tax-related liabilities associated with the vesting
of restricted stock; $10,043 of loss estimated on a long-term customer contract;
$25,685 of accrued payroll; $87,688 of convertible note interest payable and
other liabilities of $36,617.
 
 Deferred
Revenue
 
 Deferred
revenue comprises the following items:
 
 ·
              Subscription
      Fees - short-term and long-term portions of cash received related to one-
      or two-year subscriptions for domain names and/or email
      accounts
 
 ·
              License
      Fees - licensing revenue where customers did not meet all the criteria of
      US GAAP. Such deferred revenue will be recognized as cash is delivered or
      collectability becomes probable.
 
 The
components of deferred revenue for the periods indicated were as
follows:
 
 September 30,
                        2010
                      
                      
                      December 31,
                        2009Subscription
      fees
                      
                      $
                      28,714
                      
                      
                      $
                      40,115License
      fees
                      
                      
                      -
                      
                      
                      
                      5,601Totals
                      
                      $
                      28,714
                      
                      
                      $
                      45,716Current
      portion
                      
                      $
                      27,561
                      
                      
                      $
                      40,115Non-current
      portion
                      
                      
                      1,153
                      
                      
                      
                      5,601Totals
                      
                      $
                      28,714
                      
                      
                      $
                      45,716
  Page
11 of 38
  3.   NOTES PAYABLE
 
 Convertible
Notes
 
 As of
September 30, 2010, the Company had $12.2 million aggregate principal amount of
convertible secured subordinated notes due November 14, 2013 (the “notes”)
outstanding, after the $200,000 reduction of such current outstanding debt on
account of the sale-leaseback described in item 4, Commitments and
Contingencies, below. The convertible notes have been sold as
follows:
 
 Through the Quarter ending September
                                              30, 2010Note Buyer
                                            
                                            Date of Purchase
                                            
                                            Amount of
                                              Convertible
                                              Note
                                            
                                            
                                            Interest
                                              Rate
                                            
                                            Original
                                              Due Date
                                            
                                            Restated
                                              due DateAtlas
      Capital
                                            
                                            November
      14, 2007
                                            
                                            $
                                            2,050,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Crystal
      Management
                                            
                                            November
      14, 2007
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013William
      Furr
                                            
                                            November
      14, 2007
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Blueline
      Fund
                                            
                                            November
      14, 2007
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            August
      12, 2008
                                            
                                            $
                                            1,250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Crystal
      Management
                                            
                                            August
      12, 2008
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013UBP,
      Union Bancaire Privee
                                            
                                            November
      21, 2008
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013HSBC
      Private Bank (Suisse), SA
                                            
                                            November
      21, 2008
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            January
      6, 2009
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            February
      24, 2009
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            April
      3, 2009
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            June
      2, 2009
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            July
      16, 2009
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            August
      26, 2009
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            September
      8, 2009
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            October
      5, 2009
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013UBP,
      Union Bancaire Privee
                                            
                                            October
      9, 2009
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            November
      6, 2009
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            December
      23, 2009
                                            
                                            $
                                            750,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            February
      11, 2010
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2010
                                            
                                            11/14/2013Atlas
      Capital
                                            
                                            April
      1, 2010
                                            
                                            $
                                            350,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013Atlas
      Capital
                                            
                                            June
      2, 2010
                                            
                                            $
                                            600,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013Atlas
      Capital
                                            
                                            July
      1, 2010
                                            
                                            $
                                            250,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013Atlas
      Capital
                                            
                                            August
      13, 2010
                                            
                                            $
                                            100,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013Atlas
      Capital
                                            
                                            August
      30, 2010
                                            
                                            $
                                            200,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013Atlas
      Capital
                                            
                                            September
      14, 2010
                                            
                                            $
                                            300,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013Atlas
      Capital
                                            
                                            September
      30, 2010
                                            
                                            $
                                            300,000
                                            
                                            
                                            
                                            8
                                            %
                                            11/14/2013
 
 On August
12, 2008, the Company exercised its option to sell $1.5 million aggregate
principal amount of notes (the “Additional Notes”) with substantially the same
terms and conditions as the initial subordinated notes sold in November 2007
(the “Initial Notes”). In connection with the sale of the Additional Notes, the
noteholders holding a majority of the aggregate principal amount of the notes
then outstanding agreed to increase the aggregate principal amount of notes that
they are committed to purchase from $8.5 million to $15.3 million.
 
 On
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that the Company may sell up to $6
million aggregate principal amount of notes to new investors or existing
noteholders at any time on or before December 31, 2009 with a maturity date of
November 14, 2010 or later. In addition, the maturity date definition for each
of the notes was changed from November 14, 2010 to the date upon which the note
is due and payable, which is the earlier of (1) November 14, 2010, (2) a change
of control, or (3) if an event of default occurs, the date upon which
noteholders accelerate the indebtedness evidenced by the notes.
 
 The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and set at the lowest “applicable conversion
price,” as described below.
  The
Company is obligated to pay interest on the notes at an annualized rate of 8%
payable in quarterly installments commencing three months after the purchase
date of the notes. The Company is not permitted to prepay the notes without
approval of the holders of at least a majority of the principal amount of the
notes then outstanding.
 On March
5, 2010, the Company entered into the Fourth Amendment with the holders of a
majority of the aggregate outstanding principal amount of the notes issued by
the Company under the Convertible Subordinated Secured Note Purchase Agreement,
dated November 14, 2007 (the “Note Purchase Agreement’).  The Fourth
Amendment extended the original maturity date of the notes from November 14,
2010 to November 14, 2013, and amended the Note Purchase Agreement, the notes
and the Registration Rights Agreement, dated November 14, 2007, to reflect this
maturity date extension.
 
 On the
earlier of November 14, 2013 or a merger or acquisition or other transaction
pursuant to which existing stockholders of the Company hold less than 50% of the
surviving entity, or the sale of all or substantially all of the Company’s
assets, or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:
 
 ·
              convert the principal then
      outstanding on its notes into shares of the Company’s common stock,
      or
 
 ·
              receive immediate repayment in
      cash of the notes, including any accrued and unpaid
      interest.
 
 If a
noteholder elects to convert its notes under these circumstances, the conversion
price for each note will be the lowest “applicable conversion price” determined
for all of the notes. The “applicable conversion price” for each note shall be
calculated by multiplying 120% by the lowest of:
 
 ·
              the average of the high and low
      prices of the Company's common stock on the OTC Bulletin Board averaged
      over the five trading days prior to the closing date of the issuance of
      such note,
 
 ·
              if the Company's common stock is
      not traded on the Over-The-Counter market, the closing price of the common
      stock reported on the Nasdaq National Market or the principal exchange on
      which the common stock is listed, averaged over the five trading days
      prior to the closing date of the issuance of such note,
      or
  Page
12 of 38
  ·
              the closing price of the
      Company's common stock on the OTC Bulletin Board, the Nasdaq National
      Market or the principal exchange on which the common stock is listed, as
      applicable, on the trading day immediately preceding the date such note is
      converted,
  in each
case as adjusted for stock splits, dividends or combinations, recapitalizations
or similar events.
 
 Payment
of the notes will be automatically accelerated if the Company enters voluntary
or involuntary bankruptcy or insolvency proceedings.
 
 The notes
and the common stock into which they may be converted have not been registered
under the Securities Act of 1933, as amended (the “Securities Act”), or the
securities laws of any other jurisdiction. As a result, offers and sales of the
notes were made pursuant to Regulation D of the Securities Act and only made to
accredited investors. The investors in the Initial Notes include (i) The
Blueline Fund, which originally recommended Philippe Pouponnot, a former
director of the Company, for appointment to the Company’s Board of Directors;
(ii) Atlas Capital SA (“Atlas”), an affiliate of the Company that originally
recommended Shlomo Elia, one of the Company’s current directors, for appointment
to the Board of Directors; (iii) Crystal Management Ltd. (“Crystal”), which is
owned by Doron Roethler, as the former Chairman of the Company’s Board of
Directors and former Interim President and Chief Executive Officer of the
Company,  who serves as the noteholders’ bond representative; and (iv)
William Furr, who is the father of Thomas Furr, who, at the time, was one of the
Company’s directors and executive officers. The noteholders in the additional
notes are Atlas and Crystal. The noteholders of the new notes are not affiliated
with the Company. .
  If the
Company proposes to file a registration statement to register any of its common
stock under the Securities Act in connection with the public offering of such
securities solely for cash, subject to certain limitations, the Company shall
give each noteholder who has converted its notes into common stock the
opportunity to include such shares of converted common stock in the
registration. The Company has agreed to bear the expenses for any of these
registrations, exclusive of any stock transfer taxes, underwriting discounts,
and commissions.
 
 No fees
to third parties are payable in connection with the sale of notes.
 
 Line
of Credit
 
 On
February 20, 2008, the Company entered into a $2.47 million revolving credit
arrangement with Paragon Commercial Bank (“Paragon”) that was renewable on an
annual basis subject to mutual approval to be used for general working capital.
Any advances made on the line of credit were to be paid off no later than
February 19, 2009, subject to extension due to renewal, with monthly payments
being applied first to accrued interest and then to principal. Interest accrued
on the unpaid principal balance at the Wall Street Journal’s published Prime
Rate minus one half percent. The line of credit was secured by an
irrevocable standby letter of credit in the amount of $2.5 million issued by
HSBC with Atlas as account party with an original expiration date of February
18, 2010. The Company also agreed with Atlas that in the event of a default by
the Company in the repayment of the line of credit that results in the letter of
credit being drawn, the Company shall reimburse Atlas any sums that Atlas is
required to pay under such letter of credit.  At the sole discretion
of Atlas, these payments may be made in cash or by issuing shares of the
Company’s common stock at a set per-share price of $2.50.
 
 On
February 19, 2009, the Company renewed its revolving credit arrangement with
Paragon. Any advances made on the line of credit were required to be paid off no
later than February 19, 2010 with interest accruing on the unpaid principal
balance at the Wall Street Journal's published Prime Rate, with a floor at
5.5%.
  On
February 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to the
Paragon Note, delivered by the Company to Paragon in the maximum principal
amount of $2,500,000.  The Modification Agreement (i) extended
the maturity date of the Paragon Note from February 11, 2010 to August 11,
2010, and (ii) changed the interest rate from a variable annual rate equal
to The Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual
rate of 6.50%.   On August 19, 2010, the Paragon Note was further
extended to October 10, 2010. Effective January 28, 2010, the expiration
date of the standby letter of credit in the amount of $2,500,000 issued by HSBC
securing the Paragon Note was extended from February 18, 2010 to
October 17, 2010 and the expiration date of the letter of credit was
subsequently extended through December 17, 2010.  We are currently
finalizing a new credit facility with a New York City based bank that we
anticipate will provide approximately $6 million of term loans that will be due
eighteen months from the date of the definitive agreements.  The loans
would be collateralized by letters of credit provided by UBS and HSBC to
the bank on behalf of Atlas. A representative of the bank has informed us that
the bank has completed its approval process for the proposed credit
facility. The credit facility is anticipated to be available subject to
execution of definitive agreements.
  As of
November 10, 2010, the Company had an outstanding balance of $2.05 million under
the line of credit.  As of September 30, 2010, the Company had notes
payable totaling $14,495,045. The detail of these notes is as
follows:
  Page
13 of 38
  Note Description
                                        
                                        Short-Term
                                          Portion
                                        
                                        
                                        Long-Term
                                          Portion
                                        
                                        
                                        TOTAL
                                        
                                        Maturity
                                        
                                        RateParagon
      Commercial Bank credit line
                                        
                                        $
                                        2,069,821
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        2,069,821
                                        
                                        Oct
      ‘10
                                        
                                        
                                        6.5
                                        %Various
      capital leases
                                        
                                        
                                        22,472
                                        
                                        
                                        
                                        170,367
                                        
                                        
                                        
                                        192,839
                                        
                                        Various
                                        
                                        
                                        8-19
                                        %Insurance
      premium note
                                        
                                        
                                        32,385
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        32,385
                                        
                                        Jul
      ‘11
                                        
                                        
                                        5.4
                                        %Convertible
      notes
                                        
                                        
                                        -
                                        
                                        
                                        
                                        12,200,000
                                        
                                        
                                        
                                        12,200,000
                                        
                                        Nov
      ‘13
                                        
                                        
                                        8.0
                                        %TOTAL
                                        
                                        $
                                        2,124,678
                                        
                                        
                                        $
                                        12,370,367
                                        
                                        
                                        $
                                        14,495,045
 
 4.           COMMITMENTS
AND CONTINGENCIES
 
 Lease
Commitments
 
 The
Company leases computer and office equipment under capital lease agreements that
expire through August 2019. Total amounts financed under these capital leases
were $192,838 and $222,794 at September 30, 2010 and December 31, 2009,
respectively, net of accumulated amortization of $55,376 and $69,608,
respectively. The current and non-current portions of the capital leases have
been recorded in current and long-term portions of notes payable on the balance
sheets as of September 30, 2010 and December 31, 2009. See also Note 3, “Notes
Payable.”
 
 In 2008,
the Company entered into a non-cancelable sublease, subsequently restructured as
a lease with the primary landlord, with a remaining term of 36 months to
relocate its headquarters to another facility near Research Triangle Park, North
Carolina. As described in Note 2, “Assets and Liabilities,” the Company prepaid
the lease and purchased existing furniture and fixtures for a lump-sum payment
of $500,000, of which $450,080 was allocated to rent and is being amortized
monthly over the remaining term of the lease. The Company also had a lease
through October 2009 for an apartment near its headquarters that was utilized by
its out of town executives and members of its Board of Directors. The lease was
terminated as of August 4, 2009.
 
 On
September 4, 2009, the Company entered into a sale-leaseback agreement with the
current bondholders.  The bondholders paid a market rate cost of
$200,000 through the reduction of current outstanding debt in exchange for all
of the Company’s office furniture, equipment and computers.  The
bondholders then leased all furniture, equipment and computers back to the
company over a ten (10) year period.  The monthly lease payment under
the agreement is $2,427.
 
 Rent
expense for the nine months ended September 30, 2010 and 2009 was $163,059 and
$129,572 respectively.
 
 Development
Agreement
 
 In August
2005, the Company entered into a software assignment and development agreement
with the developer of a customized accounting software application. In
connection with this agreement, the developer would be paid up to $512,500 and
issued up to 32,395 shares of the Company’s common stock based upon the
developer attaining certain milestones. This agreement was modified on
March 26, 2008 to adjust the total number of shares issuable under the agreement
to 29,014. As of September 30, 2010, the Company had paid $470,834 and issued
3,473 shares of common stock related to this obligation.
 
 Legal
Proceedings
 
 The
Company is subject to claims and suits that arise from time to time in the
ordinary course of business.
 
 On
October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in the
United States District Court for the Middle District of North Carolina naming
the Company, certain of its current and former officers and directors, Maxim
Group, LLC, Jesup & Lamont Securities Corp. and Sherb & Co. (our former
independent registered  accounting firm) as defendants. The lawsuit
was filed on behalf of all persons other than the defendants who purchased the
Company’s securities from May 2, 2005 through September 28, 2007 and were
damaged. The complaint asserted violations of federal securities laws, including
violations of Section 10(b) of the Securities Exchange Act of 1934, as
amended, and Rule 10b-5. The complaint asserted that the defendants made
material and misleading statements with the intent to mislead the investing
public and conspired in a fraudulent scheme to manipulate trading in the
Company’s stock, allegedly causing plaintiffs to purchase the stock at an
inflated price. The complaint requested certification of the plaintiff as class
representative and seeks, among other relief, unspecified compensatory damages
including interest, plus reasonable costs and expenses including counsel fees
and expert fees. On June 24, 2008, the court entered an order appointing a lead
plaintiff for the class action. On September 8, 2008, the plaintiff filed an
amended complaint that added additional defendants who had served as directors
or officers of the Company during the class period as well as the Company’s
independent auditor.
  Page
14 of 38
  On June
18, 2010, the Company entered into a Stipulation and Agreement of Settlement
(the "Stipulation") with the lead plaintiff in the pending securities class
action. Also included in the settlement are all the current and former officers,
directors, shareholders and employees of the Company who had also been named as
defendants in the securities class action, as well as Maxim Group. The
Stipulation provides for the settlement of the securities class action on the
terms described below. The settlement is subject to preliminary and final
approval of the United States District Court for the Middle District of North
Carolina, which the Company anticipates will occur in the fourth quarter of this
year.
  The
Stipulation provides for the certification of a class consisting of all persons
who purchased the Company's publicly-traded securities between May 2, 2005 and
September 28, 2007, inclusive. The settlement class will receive total
consideration of a cash payment of $350,000 to be made by the Company, a cash
payment of $112,500 to be made by Maxim Group, the transfer from Henry Nouri to
the class of 25,000 shares of Company common stock and the issuance by the
Company to the class of 1,475,000 shares of Company common stock. Under the
terms of the Stipulation, counsel for the settlement class may sell some or all
of the common stock received in the settlement before distribution to the class,
subject to the limitation that it cannot sell more than 10,000 shares on one day
or 50,000 shares in 30 calendar days. Subject to the terms of the Stipulation,
we paid the lead plaintiff $75,000 on July 14, 2010 and $100,000 on September
15, 2010. In addition, the terms of the stipulation call for the payment of
$100,000 on December 14, 2010 and $75,000 on March 14, 2011.
 
 All
claims against the settling defendants will be dismissed with
prejudice. The claims of the lead plaintiff against Jesup & Lamont
Securities Corp. and the Company’s former independent registered public
accounting firm, Sherb & Co., are not being dismissed and will continue. The
Stipulation contains no admission of fault or wrongdoing by the Company or the
other settling defendants.
 
 On July
2, 2009, Dennis Michael Nouri, a former officer of the Company, and Reza
Eric Nouri, a former employee of the Company (together, the “Nouris”), were
convicted of nine counts of criminal activity in a federal criminal action
brought against them in the United States District Court for the Southern
District of New York involving a fraudulent scheme to manipulate the
Company’s stock price. On May 19, 2010, Dennis Michael Nouri was sentenced
to eight years incarceration and two years supervised release; he filed a notice
of appeal on June 1, 2010. On May 10, 2010, Reza Eric Nouri was sentenced to 18
months incarceration and 24 months supervised release; he filed a notice of
appeal on May 27, 2010 and was allowed to remain out on bail pending
appeal.
 
 On
September 24, 2009, the Nouris filed a motion in the Court of Chancery of
the State of Delaware against the Company seeking the appointment of a
receiver for the Company for the purpose of collecting a judgment in the
amount of $826,798 entered against it by order of the Court of Chancery on
August 6, 2009 (the “Order”) for the advancement of legal expenses incurred by
the Nouris in their defense of criminal proceedings brought against them by the
United States, and in their defense of civil proceedings brought against them by
the Securities and Exchange Commission and the Company’s stockholders. Such
legal expenses were in addition to legal fees and costs totaling $3 million
that were paid out by the Company’s insurance carrier under the Company’s
insurance policy, which exhausted the insurance coverage. The terms of the Order
were previously reported in the Form 10-Q filed by the Company for the quarterly
period ended June 30, 2009. The Company has recorded a total of unpaid legal
expense obligations of $1,798,595 for this matter based on invoices received
from the Nouris’ law firms through March 31, 2010, which figure does not include
invoices generated but not yet received.
 
 On June
18, 2010, the Company entered into a Settlement Agreement (the "Settlement
Agreement") with Dennis Michael Nouri, Reza Eric Nouri, Henry Nouri
and Ronna Loprete Nouri (collectively, the “Nouri Parties”). The Settlement
Agreement provides for the payment by the Company of up to $1,400,000. Of that
amount, $500,000 is payable within ten days after the date (the “Effective
Date”) of preliminary judicial approval of the class action settlement described
above (“Class Action Preliminary Judicial Approval”), and $900,000 is payable in
twelve fixed monthly installments of $75,000 commencing 60 days after the
Effective Date, with the last four scheduled installments totaling $300,000
subject to reduction to the extent that fees and disbursements for the
Nouris’ appeal are below certain levels or if the appeal is not taken to final
adjudication. The Settlement Agreement provides for the exchange of mutual
releases by the parties.
 
 The
Settlement Agreement is contingent upon Class Action Preliminary Judicial
Approval.
 
 On March
2, 2010, Nottingham Hall LLC, the primary landlord for the office space occupied
by the Company under a sublease between our Company and Advantis Real Estate
Services Company (Advantis), filed a Complaint in Summary Ejectment against
Advantis and our Company. The suit sought to recoup the funds not paid by
Advantis over term of the original lease between Nottingham Hall LLC and
Advantis in the sum of approximately $121,000.  Representatives for
Nottingham Hall LLC indicated that Advantis had defaulted on the terms of the
lease and Nottingham Hall pursued our Company for the differential in rent
between our prepaid negotiated amount and the total actually due from
Advantis.
 
 On May
11, 2010 we reached an agreement with Nottingham Hall LLC that required the
payment of the rent differential for the period August 2009 through May 2010 and
the monthly payment of the rent differential ($4,900) for the remainder of the
lease period through September 30, 2011.  The Company entered into a
lease with the primary landlord for the remaining lease term.
 
 Please
refer to Part I, Item 3 of our annual report on Form 10-K for the fiscal year
ending December 31, 2009 for a further description of material legal
proceedings.
  Page
15 of 38
  5.   STOCKHOLDERS’
EQUITY
  Preferred
Stock
 
 The Board
of Directors is authorized, without further stockholder approval, subject to the
approval of the Noteholders, to issue up to 5,000,000 shares of $0.001 par value
preferred stock in one or more series and to fix the rights, preferences,
privileges, and restrictions applicable to such shares, including dividend
rights, conversion rights, terms of redemption, and liquidation preferences, and
to fix the number of shares constituting any series and the designations of such
series. There were no shares of preferred stock outstanding at September 30,
2010.
 
 Common
Stock
 
 The
Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
value per share. As of September 30, 2010, it had 18,342,542 shares of common
stock outstanding. Holders of common stock are entitled to one vote for each
share held.
 
 Warrants
 
 The
Company entered into a Stock Purchase Warrant and Agreement (the “Warrant
Agreement”) with Atlas on January 15, 2007. Under the terms of the Warrant
Agreement, Atlas received a warrant containing a provision for cashless exercise
to purchase up to 444,444 shares of the Company’s common stock at $2.70 per
share at the termination of the line of credit or if the Company is in default
under the terms of the line of credit with Wachovia. The fair value of the
warrant was $734,303 as measured using the Black-Scholes option pricing model at
the time the warrant was issued. This amount was recorded as deferred financing
costs and was amortized to interest expense. In consideration for Atlas
providing the Paragon line of credit (see Note 3, “Notes Payable”), the Company
agreed to amend the Warrant Agreement to provide that the warrant is exercisable
within 30 business days of the termination of the Paragon line of credit or if
the Company is in default under the terms of the line of credit. If the warrant
is exercised in full for cash, it will result in gross proceeds to the Company
of approximately $1.2 million.
 
 As part
of the commission paid to Canaccord Adams, Inc. (“CA”), the Company’s placement
agent in the 2007 private placement transaction, CA was issued a warrant to
purchase 35,000 shares of the Company’s common stock at an exercise price of
$2.55 per share. This warrant contains a provision for cashless exercise and
must be exercised by February 21, 2012.
 
 As of
September 30, 2010, warrants to purchase up to 1,655,915 shares were
outstanding.
  Page
16 of 38
  Equity
Compensation Plans
 
 The
Company adopted its 2004 Equity Compensation Plan (the “2004 Plan”) as of March
31, 2004. The 2004 Plan provides for the grant of incentive stock options,
non-statutory stock options, restricted stock, and other direct stock awards to
employees (including officers) and directors of the Company as well as to
certain consultants and advisors. In June 2007, the Company temporarily limited
the issuance of shares of its common stock reserved under the 2004 Plan to
awards of restricted or unrestricted stock and in June 2008 again made options
available for grant under the 2004 Plan. The total number of shares of common
stock reserved for issuance under the 2004 plan is 5,000,000 shares, subject to
adjustment in the event of a stock split, stock dividend, recapitalization, or
similar capital change.
 
 Restricted Stock – During the
second quarter of 2010, we issued 10,000 restricted shares of stock to Mr.
Shlomo Elia for his services as a member of the Board of Directors. No other
shares of restricted stock were issued. There were no shares of restricted stock
canceled during the first three quarters of 2010 due to terminations and
payment of employee tax obligations resulting from share vesting. At September
30, 2010, there was $5,700 of unvested expense yet to be recorded related to all
restricted stock outstanding.
 
 Stock Options – The exercise
price for incentive stock options granted under the 2004 Plan is required to be
no less than the fair market value of the common stock on the date the option is
granted, except for options granted to 10% stockholders, which are required to
have an exercise price of not less than 110% of the fair market value of the
common stock on the date the option is granted. Incentive stock options
typically have a maximum term of ten years, except for option grants to 10%
stockholders, which are subject to a maximum term of five years. Non-statutory
stock options have a term determined by either the Board of Directors or the
Compensation Committee. Options granted under the 2004 Plan are not
transferable, except by will and the laws of descent and
distribution.
 
 The
following is a summary of the stock option activity for the six months ended
September 30, 2010:
 
 Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      PriceBALANCE, December
      31, 2009
                    
                    
                    132,500
                    
                    
                    $
                    4.43Granted
                    
                    
                    125,000
                    
                    
                    
                    1.14Exercised
                    
                    
                    -
                    
                    
                    
                    -Canceled
                    
                    
                    (42,500
                    )
                    
                    
                    3.31BALANCE,
      September 30, 2010
                    
                    
                    215,000
                    
                    
                    $
                    2.74
 
 The
following table summarizes information about stock options outstanding at
September 30, 2010:
 
 Currently ExercisableExercise Price
                        
                        Number of
                          Options
                          Outstanding
                        
                        
                        Average
                          Remaining
                          Contractual
                          Life (Years)
                        
                        
                        Weighted
                          Average
                          Exercise
                          Price
                        
                        
                        Number of
                          Shares
                        
                        
                        Weighted
                          Average
                          Exercise
                          Price$1.14
                        
                        
                        125,000
                        
                        
                        
                        4.0
                        
                        
                        
                        1.14From
      $2.50 to $3.50
                        
                        
                        45,000
                        
                        
                        
                        4.8
                        
                        
                        $
                        3.31
                        
                        
                        
                        85,000
                        
                        
                        $
                        3.14$5.00
                        
                        
                        25,000
                        
                        
                        
                        2.3
                        
                        
                        $
                        5.00
                        
                        
                        
                        25,000
                        
                        
                        $
                        5.00From
      $8.61
                        
                        
                        20,000
                        
                        
                        
                        2.5
                        
                        
                        $
                        8.61
                        
                        
                        
                        20,000
                        
                        
                        $
                        8.73Totals
                        
                        
                        215,000
                        
                        
                        
                        3.4
                        
                        
                        $
                        6.10
                        
                        
                        
                        130,000
                        
                        
                        $
                        6.10
 
 At
September 30, 2010, there remains $67,361 of unvested expense yet to be recorded
related to all options outstanding.
 
 Dividends
 
 The
Company has not paid any cash dividends through September 30, 2010.
 
 6.   MAJOR CUSTOMERS AND CONCENTRATION OF
CREDIT RISK
 
 Financial
instruments that potentially subject the Company to credit risk principally
consist of trade receivable. The Company believes the concentration of credit
risk in its trade receivables is substantially mitigated by ongoing credit
evaluation processes, relatively short collection terms, and the nature of the
Company’s customer base, primarily mid- and large-size corporations with
significant financial histories. Collateral is not generally required from
customers. The need for an allowance for doubtful accounts is determined based
upon factors surrounding risk of specific customers, historical trends, and
other information.
 
 A
significant portion of revenues is derived from certain customer relationships.
The following is a summary of customers that represent greater than 10% of total
revenues:
  Page
17 of 38
  Three Months Ended
                    September 30, 2010Revenue Type
                  
                  Revenues
                  
                  
                  % of Total
                    RevenuesCustomer A
                  Subscription fees
                  
                  $
                  102,117
                  
                  
                  
                  39.13
                  %Customer
      C
                  Subscription
      fees
                  
                  
                  39,622
                  
                  
                  
                  15.18
                  %Customer
      D
                  Professional
      service fees
                  
                  
                  90,000
                  
                  
                  
                  34.49
                  %Customer
      E
                  Professional
      service fees
                  
                  
                  28,731
                  
                  
                  
                  11.01
                  %Others
                  Various
                  
                  
                  498
                  
                  
                  
                  .19
                  %Total
                  
                  
                  $
                  260,968
                  
                  
                  
                  100
                  %
 
 Three Months Ended
                    September 30, 2009Revenue Type
                  
                  Revenues
                  
                  
                  % of Total
                    RevenuesCustomer A
                  Subscription
      fees
                  
                  $
                  106,499
                  
                  
                  
                  36.27
                  %Customer
      C
                  Subscription
      fees
                  
                  
                  74,465
                  
                  
                  
                  25.36
                  %Customer
      D
                  Professional
      service fees
                  
                  
                  75,150
                  
                  
                  
                  25.59
                  %Customer
      E
                  Professional
      service fees
                  
                  
                  37,632
                  
                  
                  
                  12.82
                  %Others
                  Various
                  
                  
                  -96
                  
                  
                  
                  -0.04
                  %Total
                  
                  
                  $
                  293,650
                  
                  
                  
                  100
                  %
 
 Nine Months Ended
                                  September 30, 2010Revenue Type
                                
                                Revenues
                                
                                
                                % of Total
                                  RevenuesCustomer A
                                Subscription
      fees
                                
                                $
                                309,572
                                
                                
                                
                                35.00
                                %Customer
      C
                                Subscription
      fees
                                
                                
                                136,981
                                
                                
                                
                                15.49
                                %Customer
      D
                                Professional
      service fees
                                
                                
                                305,000
                                
                                
                                
                                34.48
                                %Others
                                Various
                                
                                
                                133,033
                                
                                
                                
                                15.03
                                %Total
                                
                                
                                $
                                884,586
                                
                                
                                
                                100
                                %
  Nine Months Ended
                        September 30, 2009Revenue Type
                      
                      Revenues
                      
                      
                      % of Total
                        RevenuesCustomer A
                      Subscription
      fees
                      
                      $
                      322,314
                      
                      
                      
                      28.13
                      %Customer
      B
                      Professional
      service fees
                      
                      
                      222,725
                      
                      
                      
                      19.44
                      %Customer
      C
                      Subscription
      fees
                      
                      
                      291,819
                      
                      
                      
                      25.46
                      %Customer
      D
                      Professional
      service fees
                      
                      
                      120,578
                      
                      
                      
                      10.52
                      %Customer
      E
                      Professional
      service fees
                      
                      
                      114,328
                      
                      
                      
                      9.98
                      %Others
                      Various
                      
                      
                      74,220
                      
                      
                      
                      6.47
                      %Total
                      
                      
                      $
                      1,145,984
                      
                      
                      
                      100
                      %
 
 As of
September 30, 2010, two customers accounted for 59% and 41% of accounts
receivable, respectively, before consideration of the allowance for doubtful
accounts.  As
of December 31, 2009, two customers accounted for 62% and 38% of accounts
receivable, respectively.
  Page
18 of 38
  7.   SUBSEQUENT EVENTS
 
 The
information for this section has been updated through November 11,
2010.
 
 The
Company sold convertible secured subordinated notes as follows:
 
 Note Buyer
                        
                        Date of Purchase
                        
                        Amount of
                          Convertible
                          Note
                        
                        
                        Interest
                          Rate
                        
                        l Due DateAtlas
      Capital
                        
                        November
      9, 2010
                        
                        
                        300,000
                        
                        
                        
                        8
                        %
                        11/14/2013
  Page
19 of 38
  On
February 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to the
Paragon Note, delivered by the Company to Paragon in the maximum principal
amount of $2,500,000.  The Modification Agreement (i) extended
the maturity date of the Paragon Note from February 11, 2010 to August 11,
2010, and (ii) changed the interest rate from a variable annual rate equal
to The Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual
rate of 6.50.   On August 19, 2010, the Paragon Note was further
extended to October 10, 2010. Effective January 28, 2010, the expiration
date of the standby letter of credit in the amount of $2,500,000 issued by HSBC
securing the Paragon Note was extended from February 18, 2010 to
October 17, 2010 and the expiration date of the letter of credit was
subsequently extended through December 17, 2010.  We are currently
finalizing a new credit facility with a New York City based bank that we
anticipate will provide approximately $6 million of term loans, that will be due
eighteen-month from the date of the definitive agreements.  The loans would
be collateralized by letters of credit provided by UBS and HSBC to the bank
on behalf of Atlas Capital.  A representative of the bank has informed us
that the bank has completed its approval process for the proposed credit
facility. The credit facility will be available subject to execution of
definitive agreements.
  During
the October 21, 2010 Board of Directors meeting, the Board approved the grant of
additional options to current employees who have been with the Company for six
months or longer as of October 1, 2010,. The number of options, representing the
right to purchase an aggregate of 76,000 shares, varied by employee,
responsibility and length of service.
 
 Item 2.    
Management’s Discussion and
Analysis of Financial Condition and Results of Operations
 
 Information
set forth in this Quarterly Report on Form 10-Q contains various forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, or
the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or
the Exchange Act. Forward-looking statements consist of, among other things,
trend analyses, statements regarding future events, future financial
performance, our plan to build our business and the related expenses, our
anticipated growth, trends in our business, the effect of interest rate
fluctuations on our business, the potential impact of current litigation or any
future litigation, the potential availability of tax assets in the future and
related matters, and the sufficiency of our capital resources, all of which are
based on current expectations, estimates, and forecasts, and the beliefs and
assumptions of our management. Words such as “expect,” “anticipate,” “project,”
“intend,” “plan,” “estimate,” variations of such words, and similar expressions
also are intended to identify such forward-looking statements. These
forward-looking statements are subject to risks, uncertainties, and assumptions
that are difficult to predict. Therefore, actual results may differ materially
and adversely from those expressed in any forward-looking statements. Readers
are directed to risks and uncertainties identified under Part II, Item 1A, “Risk
Factors,” and elsewhere in this report, for factors that may cause actual
results to be different than those expressed in these forward-looking
statements. Except as required by law, we undertake no obligation to revise or
update publicly any forward-looking statements for any reason.
 
 The
following discussion is designed to provide a better understanding of our
unaudited financial statements, including a brief discussion of our business and
products, key factors that impacted our performance, and a summary of our
operating results. The following discussion should be read in conjunction with
the unaudited financial statements and the notes thereto included in Part I,
Item 1 of this Quarterly Report on Form 10-Q, and the consolidated financial
statements and notes thereto and Management’s Discussion and Analysis of
Financial Condition and Results of Operations contained in our Annual Report on
Form 10-K for the year ended December 31, 2009. Historical results and
percentage relationships among any amounts in the financial statements are not
necessarily indicative of trends in operating results for any future
periods.
  Overview
  We
develop and market software products and services targeted to small businesses
that are delivered via a Software-as-a-Service, or SaaS, model. We also provide
website consulting and custom software development services, primarily in the
e-commerce retail and direct-selling organization industries. We believe these
relationships provide a cost- and time-efficient way to market to a diverse and
fragmented yet very sizeable small-business sector. We also offer our products
directly to end-user small businesses through our OneBiz® branded
website.
  We are
developing a core industry-standard platform for small business and
not-for-profit organizations with an architecture designed to integrate with a
virtually unlimited number of other applications, services, and existing
infrastructures. These applications include not only our own small-business
applications, but also other applications we expect to arise from collaborative
partnerships with third-party developers and service providers. In addition, we
identified emerging-market opportunities using our Loyalty ClicksTM application
suite targeted to not-for –profit organizations that leverage social media and
smart-phone technology to provide increased engagement and fundraising online.
We are refining and integrating the core platform in an effort to meet
anticipated customer need. We believe, but cannot assure, this platform and
associated applications will provide opportunities for new sources of revenue,
including an increase in our subscription fees.
  Page
20 of 38
  Sources
of Revenue
 
 We derive
revenues from the following sources:
 
 ·
              Subscription fees – monthly fees
      charged to customers for access to our SaaS
      applications
 
 ·
              Professional service fees – fees
      related to consulting services, some of which complement our other
      products and applications
 
 ·
              License fees – fees charged for
      perpetual or term licensing of platforms or
      applications
 
 ·
              Hosting fees – fees charged to
      customers for the hosting of platforms or
    applications
 
 ·
              Other revenue – revenues
      generated from non-core activities such as maintenance fees; original
      equipment manufacturer, or OEM, contracts; and miscellaneous other
      revenues
 
 Our
current primary focus is to target those established companies that have both a
substantial base of small-business customers as well as a recognizable and
trusted brand name in specific market segments. Our goal is to enter into
partnerships with these established companies whereby they private label our
products and offer them to their small-business customers. We believe, but
cannot assure, the combination of the magnitude of their customer bases and
their trusted brand names and recognition will help drive our subscription
volume.
 
 Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. Applications for which subscriptions
are available vary from our own internal development to applications provided to
us by our partners. Subscriptions are generally payable on a monthly basis
and are typically paid via credit card of the individual end user. We are
focusing our efforts on enlisting new channel partners as well as diversifying
with vertical intermediaries in various industries.
 
 We
generate professional service fees from our consulting and custom software
development services. For example, a customer may request that we re-design its
website to better accommodate our products or to improve its own website
traffic. We typically bill professional service fees on a time and material
basis.
 
 License
fees consist of perpetual or term license agreements for the use of the Smart
Online platform or any of our applications.
 
 Because
we retain ownership to our platform and applications, we provide hosting
services to our customers and typically charge a monthly fee based on the number
of users accessing the programs and the bandwidth consumed.
 
 Other
revenue primarily consists of non-core revenue sources such as maintenance fees,
miscellaneous web services, and OEM revenue generated through sales of our
applications bundled with products offered by other manufacturers.
 
 Cost
of Revenues
 
 Cost of
revenues primarily is composed of costs related to third-party hosting services,
salaries and associated costs of customer support and professional services
personnel, credit card processing, depreciation of computer hardware and
software used in revenue-producing activities, domain name and e-mail
registrations, and allocated development expenses and general and administrative
overhead.
 
 We
allocate development expenses to cost of revenues based on time spent by
development personnel on revenue-producing customer projects and support
activities. We allocate general and administrative overhead such as rent and
occupancy expenses, depreciation, general office expenses, and insurance to all
departments based on headcount. As such, general and administrative overhead
expenses are reflected in cost of revenues and each operating expense
category.
 
 Operating
Expenses
 
 We are
devoting resources to the sale and marketing of our SaaS based applications
including Loyalty ClicksTM and iMart® products, through both channel partners and
direct sales efforts.  Additionally, we have placed renewed emphasis
on marketing our consulting and software development capabilities (iMart®) to
support companies who require sophisticated and complex e-commerce
websites.
 
 Sales and Marketing – Sales
and marketing expenses are composed primarily of costs associated with our sales
and marketing activities and consist of salaries and related compensation costs
of our sales and marketing personnel, travel and other costs, and marketing,
public relations and advertising expenses. Historically, we spent limited funds
on marketing, advertising, and public relations, particularly due to our
business model of partnering with established companies with extensive
small-business customer bases. In June 2008, we engaged a public relations firm
and, as a result, our public relations expenses increased during the latter part
of 2008. As we continue to execute our sales and marketing strategy, we expect
associated costs to increase throughout 2010 due to targeting new partnerships,
development of channel partner enablement programs, advertising campaigns,
additional sales and marketing personnel, and the various percentages of
revenues we may be required to pay to future partners as marketing fees or
pursuant to revenue share arrangements.
 
 Research and Development –
Research and development expenses include costs associated with the development
of new products, enhancements of existing products, and general technology
research. These costs are composed primarily of salaries and related
compensation costs of our research and development personnel as well as outside
consultant costs.
 
 US GAAP
concerning accounting for the costs of computer software to be sold, leased, or
otherwise marketed requires capitalization of certain software development costs
subsequent to the establishment of technological feasibility, with costs
incurred prior to this time expensed as research and development. Technological
feasibility is established when all planning, designing, coding, and testing
activities that are necessary to establish that the product can be produced to
meet its design specifications have been completed. Historically, we had not
developed detailed design plans for our SaaS applications, and the costs
incurred between the completion of a working model of these applications and the
point at which the products were ready for general release had been
insignificant. As a result of these factors, combined with the historically low
revenue generated by the sale of the applications that do not support the net
realizable value of any capitalized costs, we continued the expensing of
underlying costs as research and development.
 
 Beginning
in May 2008, we determined that it was strategically desirable to develop an
industry-standard platform and to enhance our current SaaS applications. A
detailed design plan indicated that the product was technologically feasible. In
July 2008, we commenced development, and from that point in time, we have
capitalized all related costs in accordance with US GAAP. Because of our
scalable and secure multi-user architecture, we are able to provide all
customers with a service based on a single version of our application. As a
result, we do not have to maintain multiple versions, which means we do not have
to incur certain development costs as do those companies who
develop traditional enterprise software business models. As we further the
development of our new applications throughout 2010, we expect that future
research and development expenses will decrease in both absolute and relative
dollars.
  Page
21 of 38
  General and Administrative –
 General and administrative expenses are composed primarily of costs
associated with our executive, finance and accounting, legal, human resources,
and information technology personnel and consist of salaries and related
compensation costs; professional services (such as outside legal counsel fees,
audit, and other compliance costs); depreciation and amortization; facilities
and insurance costs; and travel and other costs. We anticipate general and
administrative expenses will decrease slightly in 2010 as part of the objectives
identified by current management.  However, we are obligated to pay a
material amount of indemnification costs in 2010 under settlement agreement
described in detail in Part I, Item 3, “Legal Proceedings,” in our Annual Report
on Form 10-K for the year ended December 31, 2009 and in Note 4. “Commitments
and Contingencies” Legal Proceedings, above, which would significantly increase
our general and administrative expenses.
 
 Stock-Based Expenses – Our
operating expenses include stock-based expenses related to options, restricted
stock awards, and warrants issued to employees and non-employees that are
recognized at their fair market value utilizing the Black Sholes Model. These
charges have been significant and are reflected in our historical financial
results. In June 2007, we limited the issuance of awards under our 2004 Equity
Compensation Plan, or the 2004 Plan, to awards of restricted or unrestricted
stock. In June 2008, we made options available for grant under the 2004 Plan
once again, primarily due to the adverse tax consequences to recipients of
restricted stock upon the lapsing of restrictions.
 
 Critical
Accounting Policies and Estimates
 
 Our
discussion and analysis of financial condition and results of operations are
based upon our financial statements, which we prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues, and expenses and
related disclosures of contingent assets and liabilities. “Critical accounting
policies and estimates” are defined as those most important to the financial
statement presentation and that require the most difficult, subjective, or
complex judgments. We base our estimates on historical experience and on various
other factors that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying value of
assets and liabilities that are not readily apparent from other sources. Under
different assumptions and/or conditions, actual results of operations may
materially differ. We periodically reevaluate our critical accounting policies
and estimates, including those related to revenue recognition, provision for
doubtful accounts, expected lives of customer relationships, useful lives of
intangible assets and property and equipment, provision for income taxes,
valuation of deferred tax assets and liabilities, and contingencies and
litigation reserves. We believe the following critical accounting policies
involve the most significant judgments and estimates used in the preparation of
our financial statements.
 
 Revenue Recognition – We
derive revenue primarily from subscription fees charged to customers accessing
our SaaS applications; professional service fees, consisting primarily of
consulting and custom software development; the perpetual or term licensing of
software platforms or applications; and hosting and maintenance services. These
arrangements may include delivery in multiple-element arrangements if the
customer purchases a combination of products and/or services. Because we
license, sell, lease, or otherwise market computer software, we use the residual
method pursuant to American Institute of Certified Public Accountants concerning
Software Revenue Recognition. This method allows us to recognize revenue for a
delivered element when such element has vendor specific objective evidence, or
VSOE, of the fair value of the delivered element. If we cannot determine or
maintain VSOE for an element, it could impact revenues, as we may need to defer
all or a portion of the revenue from the multiple-element
arrangement.
  Page
22 of 38
  If
multiple-element arrangements involve significant development, modification, or
customization, or if we determine that certain elements are essential to the
functionality of other elements within the arrangement, we defer revenue until
we provide to the customer all elements necessary to the functionality. The
determination of whether the arrangement involves significant development,
modification, or customization could be complex and require the use of judgment
by our management.
 
 Under US
GAAP, provided the arrangement does not require significant development,
modification, or customization, we recognize revenue when all of the following
criteria have been met:
 
 1.     persuasive
evidence of an arrangement exists
 
 2.     delivery
has occurred
 
 3.     the
fee is fixed or determinable
 
 4.     collection
is probable
 
 If at the
inception of an arrangement the fee is not fixed or determinable, we defer
revenue until the arrangement fee becomes due and payable. If we deem
collectability is not probable, we defer revenue until we receive payment or
collection becomes probable, whichever is earlier. The determination of whether
fees are collectible requires judgment of our management, and the amount and
timing of revenue recognition may change if different assessments are
made.
 
 Under the
provisions of US GAAP concerning, Revenue Arrangements with Multiple
Deliverables , we account for consulting, website design fees, and application
development services separately from the license of associated software
platforms when these services have value to the customer and there is objective
and reliable evidence of fair value of each deliverable. When accounted for
separately, we recognize revenue as the services are rendered for time and
material contracts, and when milestones are achieved and accepted by the
customer for fixed-price or long-term contracts. The majority of our consulting
service contracts are on a time and material basis, and we typically bill our
customers monthly based upon standard professional service rates.
 
 Application
development services are typically fixed in price and of a longer term. As such,
we account for them as long-term construction contracts that require us to
recognize revenue based on estimates involving total costs to complete and the
stage of completion. Our assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, we capitalize the associated costs
of such projects and include them in costs in excess of billings on the balance
sheet until such time that we are permitted to recognize
revenue.
  Page
23 of 38
  Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user or the aggregating entity. Any payments received in advance of the
subscription period are accrued as deferred revenue and amortized over the
subscription period. In the past, we recognized
all subscription revenue on a gross basis and in accordance with our policy to
periodically review our accounting policies we identified the fact that certain
contracts required the reporting of subscription revenue on a gross basis and
others on a net basis according to US GAAP. On that basis, we continue to report
subscription revenue from certain contracts on a gross basis and others on a net
basis. The net effect of this reclassification of expenses only impacts gross
revenue and certain gross expenses; it does not change our net
income
 
 Because
our customers generally do not have the contractual right to take possession of
the software we license or market at any time, we recognize revenue on hosting
and maintenance fees as we provide the services in accordance with US GAAP
concerning thearrangements that
include the right to use software stored on another entity’s
hardware.
  Page
24 of 38
  Provision for Doubtful Accounts
– We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability, failure, or refusal of our customers to make
required payments. We evaluate the need for an allowance for doubtful accounts
based on specifically identified amounts that we believe to be potentially
uncollectible. Although we believe that, our allowances are adequate, if the
financial conditions of our customers deteriorate, resulting in an impairment of
their ability to make payments, or if we underestimate the allowances required,
additional allowances may be necessary, which will result in increased expense
in the period in which we make such determination.
 
 Impairment of Long-Lived
Assets – We record our long-lived assets, such as property and equipment,
at cost. We review the carrying value of our long-lived assets for possible
impairment at the earlier of annually in the fourth quarter or whenever events
or changes in circumstances indicate that the carrying amount of assets may not
be recoverable in accordance with the provisions of US GAAP. We measure the
recoverability of assets to be held and used by comparing the carrying amount of
the asset to future net undiscounted cash flows expected to be generated by the
asset. If we consider such assets to be impaired, we measure the impairment as
the amount by which the carrying amount exceeds the fair value, and we recognize
it as an operating expense in the period in which the determination is
made.
 
 We report
assets to be disposed of at the lower of the carrying amount or fair value less
costs to sell. Although we believe that the carrying values of our long-lived
assets are appropriately stated, changes in strategy or market conditions or
significant technological developments could significantly impact these
judgments and require adjustments to recorded asset balances.
 
 In
addition to the recoverability assessment, we also routinely review the
remaining estimated useful lives of our long-lived assets. Any reduction in the
useful-life assumption will result in increased depreciation and amortization
expense in the period when such determinations are made, as well as in
subsequent periods.
 
 Income Taxes – We are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This involves estimating our current tax liabilities in each
jurisdiction, including the impact, if any, of additional taxes resulting from
tax examinations, as well as making judgments regarding our ability to realize
our deferred tax assets. Such judgments can involve complex issues and may
require an extended period to resolve. In the event we determine that we will
not be able to realize all or part of our net deferred tax assets, we would make
an adjustment in the period we make such determination. We recorded no income
tax expense in the first, second or third quarter of 2010, or in 2009 and 2008,
as we have experienced significant operating losses to date. If utilized, we may
apply the benefit of our total net operating loss carryforwards to reduce future
tax expense. Since our utilization of these deferred tax assets is dependent on
future profits, which are not assured, we have recorded a valuation allowance
equal to the net deferred tax assets. These carryforwards would also be subject
to limitations, as prescribed by applicable tax laws.
 
 As a
result of prior equity financings and the equity issued in conjunction with
certain acquisitions, we have incurred ownership changes, as defined by
applicable tax laws. Accordingly, our use of the acquired net operating loss
carryforwards may be limited. Further, to the extent that any single-year loss
is not utilized to the full amount of the limitation, such unused loss is
carried over to subsequent years until the earlier of its utilization or the
expiration of the relevant carryforward period.
 
 Overview
of Results of Operations for the Three Months Ended September 30, 2010 and
September 30, 2009
 
 Total
revenues were $260,968 for the three months ended September 30, 2010 compared to
$293,650 for the same period in 2009, representing a decrease of $32,682, or
11%. Gross Loss decreased $54,129, or 39%, to Gross Loss $83,188 from Gross Loss
$137,317. Operating expenses decreased $1,564,418 or 61%, to 995,793 from
$2,560,211. Net loss decreased $1,546,514, or 54%, to $1,320,623 from
$2,867,137.
  Page
25 of 38
  The
following table sets forth our consolidated statements of operations data
expressed as a percentage of revenues for the periods indicated:
 
 Three Months EndedSeptember 30,
                      2010
                    
                    
                    % of
                      Revenue
                    
                    
                    September 30,
                      2009
                    
                    
                    % of
                      RevenueREVENUESSubscription
      Fees
                    
                    $
                    119,152
                    
                    
                    
                    45.66
                    %
                    
                    $
                    159,149
                    
                    
                    
                    54.2
                    %Professional
      service fees
                    
                    
                    12,600
                    
                    
                    
                    4.83
                    %
                    
                    
                    63,200
                    
                    
                    
                    21.52
                    %License
      fees
                    
                    
                    65,850
                    
                    
                    
                    25.23
                    %
                    
                    
                    11,250
                    
                    
                    
                    3.83
                    %Hosting
      Fees
                    
                    
                    37,722
                    
                    
                    
                    14.45
                    %
                    
                    
                    33,751
                    
                    
                    
                    11.49
                    %Other
      revenue
                    
                    
                    25,644
                    
                    
                    
                    9.83
                    %
                    
                    
                    26,300
                    
                    
                    
                    8.96
                    %Total
      Revenues
                    
                    
                    260,968
                    
                    
                    
                    100.0
                    %
                    
                    
                    293,650
                    
                    
                    
                    100.0
                    %COST
      OF REVENUES
                    
                    
                    344,156
                    
                    
                    
                    131.88
                    %
                    
                    
                    430,967
                    
                    
                    
                    146.76
                    %GROSS
      PROFIT (LOSS)
                    
                    
                    (83,188
                    )
                    
                    
                    -31.88
                    %
                    
                    
                    (137,317
                    )
                    
                    
                    -46.76
                    %OPERATING
      EXPENSESGeneral
      and administrative
                    
                    
                    408,004
                    
                    
                    
                    156.34
                    %
                    
                    
                    2,355,353
                    
                    
                    
                    802.10
                    %Sales
      and marketing
                    
                    
                    181,132
                    
                    
                    
                    69.41
                    %
                    
                    
                    180,759
                    
                    
                    
                    61.56
                    %Research
      and development
                    
                    
                    7,695
                    
                    
                    
                    2.95
                    %
                    
                    
                    36,406
                    
                    
                    
                    12.4
                    %(Gain)/
      Loss disposal of assets
                    
                    
                    398,962
                    
                    
                    
                    152.88
                    %
                    
                    
                    (12,307
                    )
                    
                    
                    -4.19
                    %Total
      operating expenses
                    
                    
                    995,793
                    
                    
                    
                    381.58
                    %
                    
                    
                    2,560,211
                    
                    
                    
                    871.86
                    %Total
      other income (expense)Interest
      Expense (net)
                    
                    
                    (244,189
                    )
                    
                    
                    -93.57
                    %
                    
                    
                    (169,609
                    )
                    
                    
                    -57.76
                    %Gain
      on legal settlements (net)
                    
                    
                    2,547
                    
                    
                    
                    0.98
                    %
                    
                    
                    -
                    
                    
                    
                    %Total
      Other Income (Expense)
                    
                    
                    (241,642
                    )
                    
                    
                    -92.59
                    %
                    
                    
                    (169,609
                    )
                    
                    
                    -57.76
                    %NET(LOSS)
                    
                    $
                    (1,320,623
                    )
                    
                    
                    -506.05
                    %
                    
                    $
                    (2,867,137
                    )
                    
                    
                    -976.38
                    %
 
 Comparison
of the Results of Operations for the Three Months Ended September 30, 2010 and
September 30, 2009
 
 Revenues. Total revenues for
the three months ended September 30, 2010 were $260,968 compared to $293,650 for
the same period in 2009, representing a decrease of $32,682, or 11%. This
overall decrease in revenues was primarily attributable to decreases in
subscription fees, and professional service fees.
  Subscription Fees -
Subscription fees for the three months ended September 30, 2010 were $119,152
compared to $159,149 for the same period in 2009, representing a decrease of
$39,997, or 25%. This decrease is primarily due to a decrease in active
subscribers to whom we provide e-commerce, domain name, email services, and
related event ticket sale services for use as members of one of our primary
customers, a direct-selling organization.
 
 Professional Service Fees -
Professional service fees for the three months ended September 30, 2010 were
$12,600 compared to $63,200 for the same period in 2009, representing a decrease
of $50,600, or 80%. This decrease is primarily due to the decrease in the number
of customers to whom we provided professional services.
 
 License Fees - License fees
for the three months ended September 30, 2010 were $65,850 compared to $11,250
for the same period in 2009, representing an increase of $54,600, or 485%. This
increase is primarily due to the fact that we continue to bill a customer for
license services since January 2010 while the customer’s project was in the
development phase during the third quarter of 2009.
 
 Hosting Fees – Hosting fees
for the three months ended September 30, 2010 were $37,722 compared to $33,751
for the same period in 2009, representing an increase of $3,900, or 12%. This
increase is primarily due to increased hosting services provided during the
third quarter of 2010.
 
 Other Revenue - Other revenue
for the three months ended September 30, 2010 totaled $25,644 compared to
$26,300 for the same period in 2009. This revenue is generated from non-core
activities. We expect these revenue streams to continue to be insignificant in
the future as we continue our strategy of focusing on the growth of our
subscription and license revenues.
 
 Cost
of Revenues
 
 Cost of
revenues for the three months ended September 30, 2010 was $344,156 compared to
$430,967 for the same period in 2009, representing a decrease of $86,811, or
20%. This decrease is primarily due to a reduction in domain name registrations,
credit card processing fees, and business card printing for members of our
direct-selling organization customers.
  Page
26 of 38
  Operating
Expenses
 
 Operating
expenses for the three months ended September 30, 2010 were $995,793 compared to
$2,560,211 for the same period in 2009, representing a decrease of 1,564,418, or
61%. This decrease was primarily attributable to the fact that we had a
significant write-off of approximately $1.8 million related to the reserve for
uncollectable amounts due from the advancement of legal fees for the defense in
criminal proceedings against Dennis Michael Nouri and Reza Eric Nouri, a former
officer and employee of the Company during the third quarter of 2009 and no
similar item in the third quarter of 2010.
 
 General and Administrative -
General and administrative expenses for the three months ended September 30,
2010 were $408,004 compared to $2,355,353 for the same period in 2009,
representing an decrease of $1,947,349, or 83%. The decrease was primarily
attributable to the establishment of a $1,804,763 bad-debt reserve for the
estimated uncollectable amounts due from the advancement of legal fees for the
defense in criminal proceedings against Dennis Michael Nouri and Reza Eric
Nouri, a former officer and employee of the Company during the third quarter of
2009 while we had no such occurrence in the third quarter of 2010.
  Sales and Marketing - Sales
and marketing expenses for the three months ended September 30, 2010 were
$181,132 compared to $180,759 for the same period in 2009, representing an
increase of $373, or .02%. This increase is primarily attributable to the
decrease in revenue sharing expense.
 
 Research and Development -
Research and development expenses for the three months ended September 30, 2010
were $7,695 compared to $36,406 for the same period in 2009, representing a
decrease of $28,711, or 79%. This decrease is primarily due to the fact that the
ongoing development expenses are now classified as part of the cost of
operations.
 
 (Gain) loss on disposal of
assets – The loss on disposal of assets for the three months ended
September 30, 2010 was $398,962 compared to a gain of $12,307 for the same
period in 2009, representing an increase of $411,269 or 3,341%. This increase is
due to the fact that we wrote off the previously capitalized software
development costs for OneBiz® during the third quarter of 2010 since the product
value could not be justified.
 
 Other
Income (Expense)
 
 We
incurred net interest expense of $244,189 for the three months ended September
30, 2010 compared to net interest expense of $169,609 for the same period in
2009, representing an increase of $74,580, or 44%. During the three months ended
September 30, 2010, we carried a higher balance on our line of credit with
Paragon Commercial Bank and borrowed additional funds from the bond
noteholders.
 
 Overview
of Results of Operations for the Nine Months Ended September 30, 2010 and
September 30, 2009
 
 Total
revenues were $884,586 for the nine months ended September 30, 2010 compared to
$1,145,984 for the same period in 2009, representing a decrease of $261,398, or
23%. Gross profit decreased $181,897, to Gross (Loss) $(161,814) from Gross
Profit of $20,083. Operating expenses decreased $3,343,885, or 58%, to
$2,432,342 from $5,776,226. Net loss decreased $3,470,279 or 56%, to $2,725,548
from $6,195,827.
 
 The
following table sets forth our consolidated statements of operations data
expressed as a percentage of revenues for the periods indicated:
 
 Nine Months EndedSeptember 30,
                      2010
                    
                    
                    % of
                      Revenue
                    
                    
                    September 30,
                      2009
                    
                    
                    % of
                      RevenueREVENUESSubscription
      Fees
                    
                    $
                    378,556
                    
                    
                    
                    42.79
                    %
                    
                    $
                    610,751
                    
                    
                    
                    53.29
                    %Professional
      service fees
                    
                    
                    82,425
                    
                    
                    
                    9.32
                    %
                    
                    
                    261,699
                    
                    
                    
                    22.84
                    %License
      fees
                    
                    
                    224,500
                    
                    
                    
                    25.38
                    %
                    
                    
                    33,750
                    
                    
                    
                    2.95
                    %Hosting
      Fees
                    
                    
                    119,716
                    
                    
                    
                    13.53
                    %
                    
                    
                    139,007
                    
                    
                    
                    12.13
                    %Other
      revenue
                    
                    
                    79,389
                    
                    
                    
                    8.97
                    %
                    
                    
                    100,777
                    
                    
                    
                    8.79
                    %Total
      Revenues
                    
                    
                    884,586
                    
                    
                    
                    100.0
                    %
                    
                    
                    1,145,984
                    
                    
                    
                    100.0
                    %COST
      OF REVENUES
                    
                    
                    1,046,400
                    
                    
                    
                    118.29
                    %
                    
                    
                    1,125,901
                    
                    
                    
                    98.25
                    %GROSS
      PROFIT (LOSS)
                    
                    
                    (161,814
                    )
                    
                    
                    -18.29
                    %
                    
                    
                    20,083
                    
                    
                    
                    1.75
                    %OPERATING
      EXPENSESGeneral
      and administrative
                    
                    
                    1,469,892
                    
                    
                    
                    166.17
                    %
                    
                    
                    4,112,993
                    
                    
                    
                    358.90
                    %Sales
      and marketing
                    
                    
                    513,408
                    
                    
                    
                    58.04
                    %
                    
                    
                    707,289
                    
                    
                    
                    61.72
                    %Research
      and development
                    
                    
                    50,080
                    
                    
                    
                    5.66
                    %
                    
                    
                    540,232
                    
                    
                    
                    47.14
                    %(Gain)/
      Loss on impairment of assets
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    438,286
                    
                    
                    
                    38.25(Gain)/
      Loss disposal of assets
                    
                    
                    398,962
                    
                    
                    
                    45.10
                    %
                    
                    
                    -
                    
                    
                    
                    -
                    %Total
      operating expenses
                    
                    
                    2,432,342
                    
                    
                    
                    274.97
                    %
                    
                    
                    5,776,226
                    
                    
                    
                    504.04
                    %Total
      other income (expense)Interest
      Expense (net)
                    
                    
                    (687,909
                    )
                    
                    
                    -77.77
                    %
                    
                    
                    (455,951
                    )
                    
                    
                    -39.79
                    %Gain
      on legal settlements (net)
                    
                    
                    556,517
                    
                    
                    
                    62.91
                    %
                    
                    
                    6,000
                    
                    
                    
                    0.52
                    %Other
      income
                    
                    
                    
                    
                    
                    
                    -
                    
                    
                    
                    10,267
                    
                    
                    
                    0.89
                    %Total
      Other Income (Expense)
                    
                    
                    (131,392
                    )
                    
                    
                    -14.85
                    %
                    
                    
                    (439,684
                    )
                    
                    
                    -38.73
                    %NET
      (LOSS)
                    
                    $
                    (2,725,548
                    )
                    
                    
                    -308.16
                    %
                    
                    $
                    (6,195,827
                    )
                    
                    
                    -540.66
                    %
  Page
27 of 38
  Comparison
of the Results of Operations for the Nine Months Ended September 30, 2010 and
September 30, 2009
 
 Revenues. Total revenues for
the nine months ended September 30, 2010 were $884,586 compared to $1,145,984
for the same period in 2009, representing a decrease of $261,398, or 23%. This
overall decrease in revenues was primarily attributable to a decrease in
subscription and professional service fees.
  Subscription Fees –
Subscription fees for the nine months ended September 30, 2010 were $378,556
compared to $ 610,751 for the same period in 2009, representing a decrease of
$232,195, or 54%. This decrease was due to a reduction in membership revenue
from a multi-level marketing organization that terminated its relationship with
our Company in 2009.
 
 Professional Service Fees -
Professional service fees for the nine months ended September 30, 2010 were
$82,425 compared to $261,699 for the same period in 2009, representing a
decrease of $179,274, or 68%. This decrease was due to the loss of a major
customer reported in 2009.
 
 License Fees - License fees
for the nine months ended September 30, 2010 were $224,500 compared to $33,750
for the same period in 2009, representing an increase of $190,750, or 565%. The
increase in license revenue for the first nine months of 2010 relates to
invoicing pursuant to a license agreement upon the completion of development
work for one of our customers.
 
 Hosting Fees – Hosting fees
for the nine months ended September 30, 2010 were $119,716 as compared to $
139,007 for the same period in 2009, representing a decrease of $19,289 or
14%.  The decrease relates to the reduction in hosting services
required by the customer that no longer uses our Company’s services as described
in Professional Service fees above.
 
 Other Revenue - Other revenue
for the nine months ended September 30, 2010 totaled $79,389 compared to
$100,777 for the same period in 2009. This revenue is generated from non-core
activities. We expect these revenue streams to continue to be insignificant in
the future as we continue our strategy of focusing on the growth of our
subscription and license revenues.
 
 Cost
of Revenues
 
 Cost of
revenues for the nine months ended September 30, 2010 was $1,046,400 compared to
$1,125,901 for the same period in 2009, representing a decrease of $79,501, or
7%. This decrease was primarily the result of the decrease of development
personnel previously involved with the development and servicing of the major
customer that left the Company during 2010
 
 Operating
Expenses
 
 Operating
expenses for the nine months ended September 30, 2010 were $2,432,342 compared
to $ 5,776,226 for the same period in 2009 representing a decrease of
$3,343,884, or 58%. This decrease was primarily attributable to a decrease in
general and administrative expenses due to the accrual of expenses associated
with the Nouri legal issues in the third quarter of 2009.
  Page
28 of 38
  General and Administrative -
General and administrative expenses for the nine months ended September 30, 2010
were $1,469,892 compared to $4,112,993 for the same period in 2009, representing
a decrease of $2,643,101, or 64%. The decrease was primarily attributable to the
fact that in 2009 we had established a $1,804,763 bad-debt reserve for the
estimated uncollectable amounts due from the advancement of legal fees for the
defense in criminal proceedings against Dennis Michael Nouri and Reza Eric
Nouri, a former officer and employee of the Company and we did not require any
additional reserve in 2010.   In addition, we had a reduction in
salaries since our Chairman of the Board was functioning as our interim Chief
Executive Officer without any additional compensation.
 
 Sales and Marketing - Sales
and marketing expenses for the nine months ended September 30, 2010 were
$513,408 compared to $707,289 for the same period in 2009, representing a
decrease of $193,881, or 27%. The decrease is primarily attributable to $144,000
decrease in payroll and benefit expense, and a decrease in revenue sharing costs
with customers of $53,000 and offset by a minor increase in other
expenses.
 
 Research and Development -
Research and development expenses for the nine months ended September 30, 2010
were $50,080 compared to $540,232 for the same period in 2009, representing a
decrease of $490,152, or 91%. This decrease is primarily due to the reduction of
ongoing development expense and the continuing maintenance and upgrade expense
is now treated as part of the Cost of Revenues.
 
 Impairment
of  Assets – During the nine month period ending September 30,
2010, the Company did not recognize any reduction in the value of intangibles
while in the same nine month period ending September 30, 2009 we recognized a
loss from the reduction of the value of an intangible asset in the amount of
$438,286.
 
 (Gain) loss on disposal of
assets – the loss on disposal of assets for the nine months ended
September 30, 2010 was $398,962 compared to a gain of $22,574 for the same
period in 2009, representing an increase of $421,536 or 1,867%. This increase is
due to the fact that we wrote off the previously capitalized software
development costs for Onebiz during the third quarter of 2010 since the product
value could not be justified
 
 Other
Income (Expense)
 
 We
incurred net interest expense of $687,909 for the nine months ended September
30, 2010 compared to net interest expense of $455,951 for the same period in
2009, representing a decrease of $231,958, or 51%. Interest expense totaled
$764,574 and $494,582 and interest income totaled $76,665 and $38,631 during the
first nine months of 2010 and 2009, respectively. Interest expense decreased as
a result of the use of cash flow during the nine-month period to reduce the
outstanding balance on the line of credit whenever possible.
 
 During
the first nine months of 2010, we recognized $556,517 in other income from a
gain due to legal settlements, as compared to net gain of  $6,000 for
the gain on legal settlements with our insurance carrier as described in Note 4,
“Commitments and Contingencies,” to the consolidated financial statements in
this report.
 
 During
the first nine months of 2009, we recognized $10,267 net gain on the sale of
assets. We had no sales of assets during the nine months ended September 30,
2010.
 
 Provision
for Income Taxes
 
 We have
not recorded a provision for income tax expense because we have been generating
net losses. Furthermore, we have not recorded an income tax benefit for the
third quarter of 2010 primarily due to continued substantial uncertainty based
on objective evidence regarding our ability to realize our deferred tax assets,
thereby warranting a full valuation allowance in our financial statements. We
have approximately $52,000,000 in net operating loss carryforwards, which may be
utilized to offset future taxable income.
 
 Liquidity
and Capital Resources
 
 At
September 30, 2010, our principal sources of liquidity were cash and cash
equivalents totaling $56,686 and current accounts receivable of -0-. As of
November 10, 2010, our principal sources of liquidity were cash and cash
equivalents totaling approximately $229,000 and accounts receivable of
$-0-.  As of September 30, 2010, we had drawn approximately $2.1
million on our $2.47 million line of credit with Paragon, leaving approximately
$370,000 available under the line of credit for our operations. As of November
10, 2010, we had drawn approximately $2.4 million on the Paragon line of credit.
We expect to draw from the credit facility currently being negotiated with a New
York City bank, described below, replacing the Paragon line of credit, as needed
for working capital purposes. During the third quarter of 2008, management
established automated sweeps among its accounts at Paragon whereby all available
cash at the end of each day is used to pay down the line of credit with Paragon,
the purpose of which is to reduce our interest expense. This line of credit
expired in October 2010 and we are currently finalizing a new credit
facility with a New York City based bank that we anticipate will provide
approximately $6 million of term loans, that will be due eighteen-month from the
date of the definitive agreements.  The loans would be collateralized
by letters of credit provided by UBS and HSBC to the bank on behalf of Atlas
Capital.  A representative of the bank has informed us that the bank has
completed its approval process for the proposed credit facility. Paragon Bank
continues to provide our banking facility, which is supported by the underlying
irrevocable standby letter of credit remains in force. This letter of credit is
currently scheduled to expire in December 2010. As of November 10, 2010, we also
have the ability to call up to approximately $2.6 million of additional funding
from our convertible noteholders.  On November 9, 2010, the Company
sold a note in the principal amount of $300,000 to a current noteholder with
substantially the same terms and conditions as the previously outstanding
notes.
  Page
29 of 38
  During
the quarter ended September 30, 2010, our working capital deficit decreased by
approximately $479,045 to approximately $6,096,000 compared to a working capital
deficit of $6,575,351 at December 31, 2009. As described more fully below, the
working capital deficit at September 30, 2010 is primarily attributable to
negative cash flows from operations, including a $377,348 increase in accounts
receivable, a $54,888 increase in notes receivable, and a $148,204 decrease
in prepaid expenses during the first nine months of 2010.
 
 Cash Flow from Operations.
Cash used in operations for the nine months ended September 30, 2010 totaled
$2,801,610, up from $2,703,117 for the same period in 2009. This increase is
primarily due to the increase in accounts payable and accrued expenses offset by
the net increase in notes receivable and the related bad debt expense
experienced in 2009.
 
 Cash Flow from Investing
Activities. Cash used in investing activities for the nine months ended
September 30, 2010 totaled $7,009, down from $176,038 for the same period in
2009. This decrease is primarily due to the fact that the Company acquired less
computer equipment and capitalized less software development in the first nine
months of 2010 compared to the same period in 2009.
 
 Cash Flow from Financing
Activities. Cash provided by financing activities for the nine months
ended September 30, 2010 totaled $2,745,509, down from $2,879,302 for the same
period in 2009. This decrease is primarily due to cash raised in 2010 from debt
borrowings to help fund operations.
 
 Debt Financing.
 On
February 20, 2008, the Company entered into a $2.47 million revolving credit
arrangement with Paragon that was renewable on an annual basis subject to mutual
approval to be used for general working capital. Any advances made on the line
of credit were to be paid off no later than February 19, 2009, subject to
extension due to renewal, with monthly payments being applied first to accrued
interest and then to principal. Interest accrued on the unpaid principal balance
at the Wall Street Journal’s published Prime Rate minus one-half percent. The
line of credit was secured by an irrevocable standby letter of credit in the
amount of $2.5 million issued by HSBC with Atlas as account party with an
original expiration date of February 18, 2010. The Company also agreed with
Atlas that in the event of a default by the Company in the repayment of the line
of credit that results in the letter of credit being drawn, the Company shall
reimburse Atlas any sums that Atlas is required to pay under such letter of
credit.  At the sole discretion of Atlas, these payments may be made
in cash or by issuing shares of the Company’s common stock at a set per-share
price of $2.50.
 
 On
February 19, 2009, the Company renewed its revolving credit arrangement with
Paragon. Any advances made on the line of credit were required to be paid off no
later than February 19, 2010 with interest shall accruing on the unpaid
principal balance at the Wall Street Journal's published Prime Rate, with a
floor at 5.5%.
  On
February 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to the
Paragon Note, delivered by the Company to Paragon in the maximum principal
amount of $2,500,000.  The Modification Agreement (i) extended
the maturity date of the Paragon Note from February 11, 2010 to August 11,
2010, and (ii) changed the interest rate from a variable annual rate equal
to The Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual
rate of 6.50%.   On August 19, 2010, the Paragon Note was further
extended to October 10, 2010. Effective January 28, 2010, the expiration
date of the standby letter of credit in the amount of $2,500,000 issued by HSBC
securing the Paragon Note was extended from February 18, 2010 to
October 17, 2010 and the expiration date of the letter of credit was
subsequently extended through December 17, 2010.  We are currently
finalizing a new credit facility with a New York City based bank that we
anticipate will provide approximately $6 million of term loans that will be due
eighteen months from the date of the definitive agreements.  The loans
would be collateralized by letters of credit provided by UBS and HSBC to
the bank on behalf of Atlas. A representative of the bank has informed us that
the bank has completed its approval process for the proposed credit
facility. The credit facility will be available subject to execution of
definitive agreements.
  As of
September 30, 2010, the Company had $12.2 million aggregate principal amount of
convertible secured subordinated notes due November 14, 2013 (the “notes”)
outstanding, after the $200,000 reduction of such current outstanding debt on
account of the sale-leaseback described in Item 1, Note 4, Commitments and
Contingencies. The convertible notes have been sold as
follows:
  Page
30 of 38
  Through the Quarter ending September
                                  30, 2010Note Buyer
                                
                                Date of Purchase
                                
                                Amount of
                                  Convertible
                                  Note
                                
                                
                                Interest
                                  Rate
                                
                                Original
                                  Due Date
                                
                                Restated
                                  due DateAtlas
      Capital
                                
                                November
      14, 2007
                                
                                $
                                2,050,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Crystal
      Management
                                
                                November
      14, 2007
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013William
      Furr
                                
                                November
      14, 2007
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Blueline
      Fund
                                
                                November
      14, 2007
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                August
      12, 2008
                                
                                $
                                1,250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Crystal
      Management
                                
                                August
      12, 2008
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013UBP,
      Union Bancaire Privee
                                
                                November
      21, 2008
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013HSBC
      Private Bank (Suisse), SA
                                
                                November
      21, 2008
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                January
      6, 2009
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                February
      24, 2009
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                April
      3, 2009
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                June
      2, 2009
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                July
      16, 2009
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                August
      26, 2009
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                September
      8, 2009
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                October
      5, 2009
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013UBP,
      Union Bancaire Privee
                                
                                October
      9, 2009
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                November
      6, 2009
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                December
      23, 2009
                                
                                $
                                750,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                February
      11, 2010
                                
                                $
                                500,000
                                
                                
                                
                                8
                                %
                                11/14/2010
                                
                                11/14/2013Atlas
      Capital
                                
                                April
      1, 2010
                                
                                $
                                350,000
                                
                                
                                
                                8
                                %
                                11/14/2013Atlas
      Capital
                                
                                June
      2, 2010
                                
                                $
                                600,000
                                
                                
                                
                                8
                                %
                                11/14/2013Atlas
      Capital
                                
                                July
      1, 2010
                                
                                $
                                250,000
                                
                                
                                
                                8
                                %
                                11/14/2013Atlas
      Capital
                                
                                August
      13, 2010
                                
                                $
                                100,000
                                
                                
                                
                                8
                                %
                                11/14/2013Atlas
      Capital
                                
                                August
      30, 2010
                                
                                $
                                200,000
                                
                                
                                
                                8
                                %
                                11/14/2013Atlas
      Capital
                                
                                September
      14, 2010
                                
                                $
                                300,000
                                
                                
                                
                                8
                                %
                                11/14/2013Atlas
      Capital
                                
                                September
      30, 2010
                                
                                $
                                300,000
                                
                                
                                
                                8
                                %
                                11/14/2013
 
 On August
12, 2008, the Company exercised its option to sell $1.5 million aggregate
principal amount of Additional Notes with substantially the same terms and
conditions as the Initial Notes sold in November 2007. In connection with the
sale of the Additional Notes, the noteholders holding a majority of the
aggregate principal amount of the notes then outstanding agreed to increase the
aggregate principal amount of notes that they are committed to purchase from
$8.5 million to $15.3 million.
 
 On
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that the Company may sell up to $6
million aggregate principal amount of notes to new investors or existing
noteholders at any time on or before December 31, 2009 with a maturity date of
November 14, 2010 or later. In addition, the maturity date definition for each
of the notes was changed from November 14, 2010 to the date upon which the note
is due and payable, which is the earlier of (1) November 14, 2010, (2) a change
of control, or (3) if an event of default occurs, the date upon which
noteholders accelerate the indebtedness evidenced by the notes.
 
 The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and set at the lowest “applicable conversion
price,” as described below.
 
 The
Company is obligated to pay interest on the notes at an annualized rate of 8%
payable in quarterly installments commencing three months after the purchase
date of the notes. The Company is not permitted to prepay the notes without
approval of the holders of at least a majority of the principal amount of the
notes then outstanding.
 
 On March
5, 2010, the Company entered into the Fourth Amendment with the holders of a
majority of the aggregate outstanding principal amount of the notes issued by
the Company under the Note Purchase Agreement.  The Fourth Amendment
extends the original maturity date of the notes from November 14, 2010 to
November 14, 2013, and amends the Note Purchase Agreement, the notes and the
Registration Rights Agreement, dated November 14, 2007, to reflect this
extension
 
 On the
earlier of November 14, 2013 or a merger or acquisition or other transaction
pursuant to which existing stockholders of the Company hold less than 50% of the
surviving entity, or the sale of all or substantially all of the Company’s
assets, or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:
 
 ·
              convert the principal then
      outstanding on its notes into shares of the Company’s common stock,
      or
 
 ·
              receive immediate repayment in
      cash of the notes, including any accrued and unpaid
      interest.
 
 If a
noteholder elects to convert its notes under these circumstances, the conversion
price for each note will be the lowest “applicable conversion price” determined
for all of the notes. The “applicable conversion price” for each note shall be
calculated by multiplying 120% by the lowest of:
 
 ·
              the average of the high and low
      prices of the Company's common stock on the OTC Bulletin Board averaged
      over the five trading days prior to the closing date of the issuance of
      such note,
 
 ·
              if the Company's common stock is
      not traded on the Over-The-Counter market, the closing price of the common
      stock reported on the Nasdaq National Market or the principal exchange on
      which the common stock is listed, averaged over the five trading days
      prior to the closing date of the issuance of such note,
      or
  Page
31 of 38
  ·
              the closing price of the
      Company's common stock on the OTC Bulletin Board, the Nasdaq National
      Market or the principal exchange on which the common stock is listed, as
      applicable, on the trading day immediately preceding the date such note is
      converted,
 
 in each
case as adjusted for stock splits, dividends or combinations, recapitalizations
or similar events.
 
 Payment
of the notes will be automatically accelerated if the Company enters voluntary
or involuntary bankruptcy or insolvency proceedings.
 
 The notes
and the common stock into which they may be converted have not been registered
under the Securities Act, or the securities laws of any other jurisdiction. As a
result, offers and sales of the notes were made pursuant to Regulation D of the
Securities Act and only made to accredited investors. The investors in the
Initial Notes include (i) The Blueline Fund, which originally recommended
Philippe Pouponnot, a former director of the Company, for appointment to the
Company’s Board of Directors; (ii) Atlas, an affiliate of the Company that
originally recommended Shlomo Elia, one of the Company’s current directors, for
appointment to the Board of Directors; (iii) Crystal, which is owned by Doron
Roethler, the former Chairman of the Company’s Board of
Directors,  who serves as the noteholders’ bond representative; and
(iv) William Furr, who is the father of Thomas Furr, who, at the time, was one
of the Company’s directors and executive officers. The noteholders in the
additional notes are Atlas and Crystal.
  If the
Company proposes to file a registration statement to register any of its common
stock under the Securities Act in connection with the public offering of such
securities solely for cash, subject to certain limitations, the Company shall
give each noteholder who has converted its notes into common stock the
opportunity to include such shares of converted common stock in the
registration. The Company has agreed to bear the expenses for any of these
registrations, exclusive of any stock transfer taxes, underwriting discounts,
and commissions.
 
 No fees
to third parties are payable in connection with the sale of
notes.
  Page
32 of 38
  We have
not yet achieved positive cash flows from operations, and our main sources of
funds for our operations are the sale of securities in private placements, the
sale of additional convertible notes, and bank lines of credit. We must continue
to rely on these sources until we are able to generate sufficient revenue to
fund our operations. We believe that anticipated cash flows from operations,
funds available from our existing line of credit, and additional issuances of
notes, together with cash on hand, and the anticipated extension of the due date
for the existing notes will provide sufficient funds to finance our operations
at least for the next 12 to 18 months, depending on our ability to achieve
strategic goals outlined in our annual operating budget approved by our Board of
Directors. Changes in our operating plans, lower than anticipated sales,
increased expenses, or other events may cause us to seek additional equity or
debt financing in future periods. There can be no guarantee that financing will
be available on acceptable terms or at all. Additional equity financing could be
dilutive to the holders of our common stock, and additional debt financing, if
available, could impose greater cash payment obligations and more covenants and
operating restrictions.
 Going
Concern
 
 Our
independent registered public accountants for fiscal 2009 have issued an
explanatory paragraph in their report included in our Annual Report on Form 10-K
for the year ended December 31, 2009 in which they express substantial doubt as
tour ability to continue as an ongoing concern. The financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or classification of liabilities that might be necessary
should we be unable to continue as a going concern. Our continuation as a going
concern depends on our ability to generate sufficient cash flows to meet our
obligations on a timely basis, to obtain additional financing that is currently
required, an ultimately to attain profitable operations and positive cash flows.
There can be no assurance that our efforts to raise capital or increase revenue
will be successful. If our efforts are unsuccessful, we may have to cease
operations and liquidate our business.
  Page
33 of 38
  Recent
Developments
 
 For more
information on recent developments, see Item 1, Note 7 – “Subsequent
Events”.
 
 Item 3.      
  Quantitative and
Qualitative Disclosures About Market Risk
 
 Not
applicable.
 
 Item 4.      
  Controls and
Procedures
 
 Our
management, with the participation of our  interim Chief Executive
Officer has evaluated the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this Quarterly Report on Form
10-Q. The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and
other procedures of a company that are designed to ensure that information
required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported, within
the time periods specified in the SEC’s rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the company’s management, including its principal executive and principal
financial officers, as appropriate to allow timely decisions regarding required
disclosure. Management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, as ours are designed to do, and
management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based on such evaluation, our
Interim Chief Executive Officer and Interim Chief Financial Officer concluded
that, as of the end of the period covered by this Quarterly Report on Form 10-Q,
our disclosure controls and procedures were effective at the reasonable
assurance level.
 
 We
routinely review our internal control over financial reporting and from time to
time make changes intended to enhance the effectiveness of our internal control
over financial reporting.
  Review of our revenue
recognition procedures during the fourth quarter of 2009 caused the restatement
of financial statements for the first three quarters of 2009 and three quarters
of 2008.  The restatement included the presentation of net
subscription revenue as compared to the gross subscription
revenue.  In the past, we recognized all subscription revenue on a
gross basis and in accordance with our policy to periodically review our
accounting procedures we identified the fact that certain contracts require
the reporting of subscription revenue on a gross basis and others on a net basis
according to US GAAP.  As a result of our review, we continue to
report subscription revenue from certain contracts on a gross basis and others
on a net basis.  The net effect of this reclassification of expenses
only impacts gross revenue and certain gross expenses; it does not change the
net income.
 
 In order
to address the material weakness we have implemented a system whereby each new
contract entered into by the company must be reviewed and approved by the Chief
Financial Officer.
 
 We will
continue to evaluate the effectiveness of our disclosure controls and procedures
and internal control over financial reporting on an ongoing basis and will take
action as appropriate. There have been no changes to our internal control over
financial reporting, as such, term is defined in Rules 13a-15(f) and 15d-15(f)
under the Exchange Act, during the three months ended September 30, 2010 that we
believe materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.
 Changes
in Internal Control Over Financial Reporting
  There
were no changes in our internal control over financial reporting that occurred
during the third quarter of fiscal year 2010 that have materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.
  PART
II – OTHER INFORMATION
 
 Item 1.      
  Legal
Proceedings
 
 Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2009 and Part II, Item 1 of our Quarterly Reports on
Form 10-Q for the quarterly periods ended March 31, 2010 and June 30, 2010 for a
description of material legal proceedings, including the proceedings discussed
below.
 
 The
Company is subject to claims and suits that arise from time to time in the
ordinary course of business.
  Page
34 of 38
  On
October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in the
United States District Court for the Middle District of North Carolina naming
the Company, certain of its current and former officers and directors, Maxim
Group, LLC, Jesup & Lamont Securities Corp. and Sherb & Co. (our former
independent registered  accounting firm) as defendants. The lawsuit
was filed on behalf of all persons other than the defendants who purchased the
Company’s securities from May 2, 2005 through September 28, 2007 and were
damaged. The complaint asserted violations of federal securities laws, including
violations of Section 10(b) of the Securities Exchange Act of 1934, as
amended, and Rule 10b-5. The complaint asserted that the defendants made
material and misleading statements with the intent to mislead the investing
public and conspired in a fraudulent scheme to manipulate trading in the
Company’s stock, allegedly causing plaintiffs to purchase the stock at an
inflated price. The complaint requested certification of the plaintiff as class
representative and seeks, among other relief, unspecified compensatory damages
including interest, plus reasonable costs and expenses including counsel fees
and expert fees. On June 24, 2008, the court entered an order appointing a lead
plaintiff for the class action. On September 8, 2008, the plaintiff filed an
amended complaint that added additional defendants who had served as directors
or officers of the Company during the class period as well as the Company’s
independent auditor.
 
 On June
18, 2010, the Company entered into a Stipulation and Agreement of Settlement
(the "Stipulation") with the lead plaintiff in the pending securities class
action. Also included in the settlement are all the current and former officers,
directors, shareholders and employees of the Company who had also been named as
defendants in the securities class action, as well as Maxim Group. The
Stipulation provides for the settlement of the securities class action on the
terms described below. The settlement is subject to preliminary and final
approval of the United States District Court for the Middle District of North
Carolina, which the Company anticipates will occur in the fourth quarter of this
year.
  The
Stipulation provides for the certification of a class consisting of all persons
who purchased the Company's publicly-traded securities between May 2, 2005 and
September 28, 2007, inclusive. The settlement class will receive total
consideration of a cash payment of $350,000 to be made by the Company, a cash
payment of $112,500 to be made by Maxim Group, the transfer from Henry Nouri to
the class of 25,000 shares of Company common stock and the issuance by the
Company to the class of 1,475,000 shares of Company common stock. Under the
terms of the Stipulation, counsel for the settlement class may sell some or all
of the common stock received in the settlement before distribution to the class,
subject to the limitation that it cannot sell more than 10,000 shares on one day
or 50,000 shares in 30 calendar days. Subject to the terms of the Stipulation,
we paid the lead plaintiff $75,000 on July 14, 2010 and $100,000 on September
15, 2010. In addition, the terms of the stipulation call for the payment of
$100,000 on December 14, 2010 and $75,000 on March 14, 2011.
 
 All
claims against the settling defendants will be dismissed with
prejudice. The claims of the lead plaintiff against Jesup & Lamont
Securities Corp. and the Company’s former independent registered public
accounting firm, Sherb & Co., are not being dismissed and will continue. The
Stipulation contains no admission of fault or wrongdoing by the Company or the
other settling defendants.
 
 On July
2, 2009, Dennis Michael Nouri, a former officer of the Company, and Reza
Eric Nouri, a former employee of the Company (together, the “Nouris”), were
convicted of nine counts of criminal activity in a federal criminal action
brought against them in the United States District Court for the Southern
District of New York involving a fraudulent scheme to manipulate the
Company’s stock price. On May 19, 2010, Dennis Michael Nouri was sentenced
to eight years incarceration and two years supervised release; he filed a notice
of appeal on June 1, 2010. On May 10, 2010, Reza Eric Nouri was sentenced to 18
months incarceration and 24 months supervised release; he filed a notice of
appeal on May 27, 2010 and was allowed to remain out on bail pending
appeal.
 
 On
September 24, 2009, the Nouris filed a motion in the Court of Chancery of
the State of Delaware against the Company seeking the appointment of a
receiver for the Company for the purpose of collecting a judgment in the
amount of $826,798 entered against it by order of the Court of Chancery on
August 6, 2009 (the “Order”) for the advancement of legal expenses incurred by
the Nouris in their defense of criminal proceedings brought against them by the
United States, and in their defense of civil proceedings brought against them by
the Securities and Exchange Commission and the Company’s stockholders. Such
legal expenses were in addition to legal fees and costs totaling $3 million
that were paid out by the Company’s insurance carrier under the Company’s
insurance policy, which exhausted the insurance coverage. The terms of the Order
were previously reported in the Form 10-Q filed by the Company for the quarterly
period ended June 30, 2009. The Company has recorded a total of unpaid legal
expense obligations of $1,798,595 for this matter based on invoices received
from the Nouris’ law firms through March 31, 2010, which figure does not include
invoices generated but not yet received.
 
 On June
18, 2010, the Company entered into a Settlement Agreement (the "Settlement
Agreement") with Dennis Michael Nouri, Reza Eric Nouri, Henry Nouri
and Ronna Loprete Nouri (collectively, the “Nouri Parties”). The Settlement
Agreement provides for the payment by the Company of up to $1,400,000. Of that
amount, $500,000 is payable within ten days after the date (the “Effective
Date”) of preliminary judicial approval of the class action settlement described
above (“Class Action Preliminary Judicial Approval”), and $900,000 is payable in
twelve fixed monthly installments of $75,000 commencing 60 days after the
Effective Date, with the last four scheduled installments totaling $300,000
subject to reduction to the extent that fees and disbursements for the
Nouris’ appeal are below certain levels or if the appeal is not taken to final
adjudication. The Settlement Agreement provides for the exchange of mutual
releases by the parties.
 
 The
Settlement Agreement is contingent upon Class Action Preliminary Judicial
Approval.
  Page
35 of 38
  Item 1A.      
  Risk
Factors
 
 Other
than, with respect to the risk factors described below, there have been no
changes in our risk factors for our quarter ended September 30, 2010 from those
previously reported in our Quarterly Report on Form 10-Q filed on August 12,
2010.
  We
previously noted that the Paragon line of credit was set to
expire on August 11, 2010.  On August 10, 2010, Paragon Bank
extended the maturity date of the Paragon note from August 11, 2010 to
October 17, 2010 with the provision that the standby letter of credit in the
amount of $2,500,000 securing the Paragon note is also extended to November 17,
2010. We are currently finalizing a new credit facility with a New York
City-based bank that we anticipate will provide approximately $6 million of term
loans that will be due eighteen months from the date of definitive
agreements.  If we are unable to establish this credit facility, we may
have difficulty dealing with cash flow activities of daily business operations
that will be disruptive to the future success of the
business.
  Failure
to comply with the provisions of our debt financing arrangements could have a
material adverse effect on us.
 
 Our
revolving line of credit from Paragon is secured by an irrevocable standby
letter of credit issued by HSBC with Atlas as account party. Our convertible
secured subordinated notes are secured by a first priority lien on all of our
unencumbered assets.
 
 We are
currently finalizing a new credit facility with a New York City based bank that
we anticipate will provide approximately $6 million of term loans, that will be
due eighteen-month from the date of the definitive agreements.  The loans
would be collateralized by letters of credit provided by UBS and HSBC to
the bank on behalf of Atlas Capital.  A representative of the bank has
informed us that the bank has completed its approval process for the proposed
credit facility.
 
 If an
event of default occurs under our debt financing arrangements and remains
uncured, then the lender could foreclose on the assets securing the debt. If
that were to occur, it would have a substantial adverse effect on our business.
In addition, making the principal and interest payments on these debt
arrangements may drain our financial resources or cause other material harm to
our business.
  Page
36 of 38
  Item 2.      
Unregistered Sales of Equity
Securities and Use of Proceeds
 
 During
the first, second and third quarter of fiscal 2010, we did not sell any equity
securities that were not registered under the Securities Act, other than the
Convertible Notes as described in our Current Reports on Form 8-K filed in
connection with such transactions.
 
 There
were no repurchases during the third quarter of fiscal 2010 of any of our
securities registered under Section 12 of the Exchange Act by or on behalf
of us or any affiliated purchaser.
 
 Item 6.     Exhibits
 
 The
following exhibits are being filed herewith and are numbered in accordance with
Item 601 of Regulation S-K:
 
 Exhibit No.
              
              Description31.1
              
              Certification
      of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200231.2
              
              Certification
      of Principal Financial Officer Pursuant to Rule 13a-14(a) as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200232.1
              
              Certification
      of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.32.2
              
              Certification
      of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.
  Page
37 of 38
  SIGNATURES
 
 Pursuant
to the requirements 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.
 
 Smart
      Online, Inc./s/ Dror ZoreffDror
      ZoreffDate:
      November 15, 2010
              Interim
      Chief Executive Officer, President and Principal
                Executive
      Officer/s/ Thaddeus J. ShalekThaddeus
      J. ShalekChief  Financial
      Officer andDate:
      November 15, 2010
              Principal
      Accounting Officer
  Page
38 of 38