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 June 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 has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files). 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
August 6, 2010, there were approximately 18,342,543 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 June 30, 2010





TABLE
OF CONTENTS





Page No.PART
      I – FINANCIAL INFORMATIONItem
      1.
                          Financial
      StatementsBalance
      Sheets as of June 30, 2010 (unaudited) and December 31,
    2009
                          
                          3Statements
      of Operations (unaudited) for the three and six months ended June 30, 2010
      and 2009
                          
                          4Statements
      of Cash Flows (unaudited) for the six months ended June30, 2010 and
      2009
                          
                          5Notes
      to Financial Statements (unaudited)
                          
                          6Item
      2.
                          Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                          
                          19Item
      3.
                          Quantitative
      and Qualitative Disclosures About Market Risk
                          
                          38Item
      4.
                          Controls
      and Procedures
                          
                          38Item
      4T.
                          Controls
      and Procedures
                          
                          38PART
      II – OTHER INFORMATIONItem
      1.
                          Legal
      Proceedings
                          
                          39Item
      1A.
                          Risk
      Factors
                          
                          39Item
      2.
                          Unregistered
      Sales of Equity Securities and Use of Proceeds
                          
                          40Item
      6.
                          Exhibits
                          
                          40Signatures
                          
                          42


2


PART I – FINANCIAL
INFORMATION





Item
1.       Financial Statements





SMART ONLINE, INC.


BALANCE
SHEETS





June 30,
                  
                  
                  December 31,2010
                  
                  
                  2009(unaudited)ASSETSCurrent
      Assets:Cash
      and cash equivalents
                  
                  $
                  22,316
                  
                  
                  $
                  119,796Accounts
      receivable, net
                  
                  
                  -
                  
                  
                  
                  13,056Prepaid
      expenses
                  
                  
                  203,939
                  
                  
                  
                  240,840Total
      current assets
                  
                  
                  226,255
                  
                  
                  
                  373,692Property
      and equipment, net
                  
                  
                  228,322
                  
                  
                  
                  258,450Capitalized
      software, net
                  
                  
                  416,235
                  
                  
                  
                  450,782Note
      Receivable, non-current
                  
                  
                  -
                  
                  
                  
                  -Prepaid
      expenses, non-current
                  
                  
                  36,900
                  
                  
                  
                  110,700Intangible
      assets, net
                  
                  
                  150,000
                  
                  
                  
                  150,000Other
      assets
                  
                  
                  -
                  
                  
                  
                  2,496TOTAL
      ASSETS
                  
                  $
                  1,057,712
                  
                  
                  $
                  1,346,120LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesAccounts
      payable
                  
                  $
                  334,739
                  
                  
                  $
                  518,309Notes
      payable (See Note 3)
                  
                  
                  2,154,328
                  
                  
                  
                  1,964,281Deferred
      revenue (See Note 2)
                  
                  
                  34,803
                  
                  
                  
                  40,115Accrued
      liabilities - Nouri
                  
                  
                  1,400,000
                  
                  
                  
                  1,802,379Accrued
      liabilities (See Note 2)
                  
                  
                  2,693,953
                  
                  
                  
                  2,623,959Total
      current liabilities
                  
                  
                  6,617,823
                  
                  
                  
                  6,949,043Long-term
      liabilities:Long-term
      portion of notes payable (See Note 3)
                  
                  
                  11,224,189
                  
                  
                  
                  9,785,255Deferred
      revenue (See Note 2)
                  
                  
                  2,750
                  
                  
                  
                  5,601Total
      long-term liabilities
                  
                  
                  11,226,939
                  
                  
                  
                  9,790,856Total
      liabilities
                  
                  
                  17,844,762
                  
                  
                  
                  16,739,899Commitments
      and contingencies (See Note 7)Stockholders'
      equity (deficit):Preferred
      stock, 0.001 par value, 5,000,000 shares authorized, no shares issued and
      outstanding at June 30, 2010 and December 31, 2009Common
      Stock, $.001 par value, 45,000,000 shares authorized, 18,342,543 and
      18,332,542 shares Issued and Outstanding at June 30, 2010 and December 31,
      2009 respectively.
                  
                  
                  18,343
                  
                  
                  
                  18,333Additional
      paid-in capital
                  
                  
                  67,048,479
                  
                  
                  
                  67,036,836Accumulated
      deficit
                  
                  
                  (83,853,872
                  )
                  
                  
                  (82,448,948
                  )Total
      Stockholders’ Equity (Deficit)
                  
                  
                  (16,787,050
                  )
                  
                  
                  (15,163,779
                  )TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                  
                  $
                  1,057,712
                  
                  
                  $
                  1,346,120





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


3


SMART ONLINE, INC.


STATEMENTS
OF OPERATIONS (unaudited)





Three Months Ended
                      
                      
                      Six Months EndedJune30,2010
                      
                      
                      June30,2009
                      
                      
                      June30,2010
                      
                      
                      June30,2009REVENUES:Subscription
      fees
                      
                      $
                      123,146
                      
                      
                      $
                      209,820
                      
                      
                      $
                      259,404
                      
                      
                      $
                      451,602Professional
      service fees
                      
                      
                      7,050
                      
                      
                      
                      79,726
                      
                      
                      
                      69,825
                      
                      
                      
                      198,499License
      fees
                      
                      
                      70,850
                      
                      
                      
                      11,250
                      
                      
                      
                      158,650
                      
                      
                      
                      22,500Hosting
      fees
                      
                      
                      37,722
                      
                      
                      
                      33,045
                      
                      
                      
                      81,994
                      
                      
                      
                      105,255Other
      revenue
                      
                      
                      20,950
                      
                      
                      
                      36,806
                      
                      
                      
                      53,745
                      
                      
                      
                      74,478Total
      revenues
                      
                      
                      259,718
                      
                      
                      
                      370,647
                      
                      
                      
                      623,618
                      
                      
                      
                      852,334COST
      OF REVENUES
                      
                      
                      336,310
                      
                      
                      
                      202,333
                      
                      
                      
                      702,244
                      
                      
                      
                      694,934GROSS
      PROFIT (LOSS)
                      
                      
                      (76,592
                      )
                      
                      
                      168,314
                      
                      
                      
                      (78,626
                      )
                      
                      
                      157,400OPERATING
      EXPENSES:General
      and administrative
                      
                      
                      389,469
                      
                      
                      
                      862,050
                      
                      
                      
                      1,061,888
                      
                      
                      
                      1,757,643Sales
      and marketing
                      
                      
                      179,640
                      
                      
                      
                      216,780
                      
                      
                      
                      332,275
                      
                      
                      
                      516,318Research
      and development
                      
                      
                      10,380
                      
                      
                      
                      226,950
                      
                      
                      
                      42,385
                      
                      
                      
                      503,826Loss
      on impairment of assets
                      
                      
                      -
                      
                      
                      
                      438,228
                      
                      
                      
                      -
                      
                      
                      
                      438,228Total
      operating expenses
                      
                      
                      579,489
                      
                      
                      
                      1,744,008
                      
                      
                      
                      1,436,548
                      
                      
                      
                      3,216,015LOSS
      FROM OPERATIONS
                      
                      
                      (656,081
                      )
                      
                      
                      (1,575,694
                      )
                      
                      
                      (1,515,174
                      )
                      
                      
                      (3,058,615
                      )OTHER
      INCOME (EXPENSE):Interest
      expense, net
                      
                      
                      (233,025
                      )
                      
                      
                      (158,343
                      )
                      
                      
                      (443,720
                      )
                      
                      
                      (286,342
                      )Gain
      on legal settlements, net
                      
                      
                      401,107
                      
                      
                      
                      -
                      
                      
                      
                      553,970
                      
                      
                      
                      6,000Gain
      on disposal of assets
                      
                      
                      -
                      
                      
                      
                      
                      
                      
                      
                      -
                      
                      
                      
                      10,267Total
      other expense
                      
                      
                      168,082
                      
                      
                      
                      (158,343
                      )
                      
                      
                      110,250
                      
                      
                      
                      (270,075
                      )NET
      LOSS
                      
                      $
                      (487,999
                      )
                      
                      $
                      (1,734,037
                      )
                      
                      $
                      (1,404,924
                      )
                      
                      $
                      (3,328,690
                      )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                      
                      $
                      (0.03
                      )
                      
                      $
                      (0.09
                      )
                      
                      $
                      (0.08
                      )
                      
                      $
                      (0.18
                      )WEIGHTED-AVERAGE
      NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
    SHAREBasic
      and fully diluted
                      
                      
                      18,342,543
                      
                      
                      
                      18,333,122
                      
                      
                      
                      18,342,543
                      
                      
                      
                      18,333,122





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


4


SMART ONLINE, INC.


STATEMENTS
OF CASH FLOWS


(unaudited)





Six
      Months
                  
                  
                  Six
      MonthsEnded
                  
                  
                  EndedJune 30, 2010
                  
                  
                  June 30, 2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      Loss
                  
                  $
                  (1,404,924
                  )
                  
                  $
                  (3,328,690
                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                  
                  
                  69,046
                  
                  
                  
                  328,525Bad
      debt expense
                  
                  
                  249,760
                  
                  
                  
                  421,922Stock-based
      compensation expense
                  
                  
                  11,642
                  
                  
                  
                  82,483Loss
      on impairment of intangible assets
                  
                  
                  -
                  
                  
                  
                  438,228Gain
      on disposal of assets
                  
                  
                  -
                  
                  
                  
                  (10,267
                  )Changes
      in assets and liabilities:Accounts
      receivable
                  
                  
                  (185,426
                  )
                  
                  
                  173,983Notes
      receivable
                  
                  
                  (51,278
                  )
                  
                  
                  (1,420,581
                  )Prepaid
      expenses
                  
                  
                  110,701
                  
                  
                  
                  132,796Other
      assets
                  
                  
                  2,496
                  
                  
                  
                  (350
                  )Deferred
      revenue
                  
                  
                  (8,163
                  )
                  
                  
                  (88,522
                  )Accounts
      payable
                  
                  
                  (183,570
                  )
                  
                  
                  1,884,427Accrued
      and other expenses
                  
                  
                  (332,385
                  )
                  
                  
                  15,672Net
      cash used in operating activities
                  
                  
                  (1,722,101
                  )
                  
                  
                  (1,370,374
                  )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of furniture and equipment
                  
                  
                  (4,372
                  )
                  
                  
                  (14,565
                  )Capitalized
      software
                  
                  
                  -
                  
                  
                  
                  (212,824
                  )Proceeds
      from sale of furniture and equipment
                  
                  
                  -
                  
                  
                  
                  45,361Net
      Cash used in Investing Activities
                  
                  
                  (4,372
                  )
                  
                  
                  (182,028
                  )CASH
      FLOWS FROM FINANCING ACTIVITIES:Repayments
      on notes payable
                  
                  
                  (2,991,573
                  )
                  
                  
                  (3,734,867
                  )Debt
      borrowings
                  
                  
                  4,620,566
                  
                  
                  
                  5,301,379Net
      cash provided by (used in) financing activities
                  
                  
                  1,628,993
                  
                  
                  
                  1,566,512NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                  
                  
                  (97,480
                  )
                  
                  
                  14,110CASH
      AND CASH EQUIVALENTS,BEGINNING
      OF PERIOD
                  
                  
                  119,796
                  
                  
                  
                  18,602CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                  
                  $
                  22,316
                  
                  
                  $
                  32,712Supplemental
      disclosures of cash flow information:Cash
      paid during the period for:Interest
                  
                  $
                  467,489
                  
                  
                  $
                  173,818Taxes
                  
                  $
                  
                  
                  
                  $
                  10Supplemental
      schedule of non-cash financing activities:Conversion
      of debt to equity
                  
                  $
                  -
                  
                  
                  $
                  -





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


5


SMART
ONLINE, INC.


NOTES
TO 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 (One Biz®) 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 six
months ended June 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 accounting principles
generally accepted in the United States (“U.S. 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 June 30,
2010, and its results of operations for the three and six months ended June 30,
2010 and 2009. The results for the three and six months ended June 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 six months ended
June 30, 2010 and 2009, the Company incurred net losses as well as negative cash
flows, was involved in a class action lawsuit (See Note 7, “Commitments and
Contingencies,” in the 2009 Annual Report), and had deficiencies in working
capital. 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. As of August 10, 2010, the Company has a
commitment from its convertible secured subordinated noteholders to purchase up
to an additional $3.8 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 $3.8 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 future plans include the continued development and
marketing of the Loyalty Clicks platform for not-for profit organizations, 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 six months ended June
30, 2010 are consistent with those used for the year ended December 31, 2009.
Accordingly, please refer to the 2009 Annual Report for the Company’s
significant accounting policies.





Use of Estimates
- The preparation of financial statements in conformity with U.S. 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.


6


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 practicable 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 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.





Additionally,
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. During the second quarter of 2008, the Company entered into a web
services agreement with a direct-selling organization customer that provided for
extended payment terms related to both professional services and the grant of a
software license. During the third quarter of 2008, this customer began
experiencing cash flow difficulties and has since significantly slowed its
payments to the Company. In addition, the Company entered into a web services
agreement with a real estate services customer in the third quarter of 2007 that
called for contractual payments against a note receivable upon delivery and
acceptance of a custom application. The customer has not made payments as per
the revised agreements reached in December 2009.





Based on
these criteria, management determined that at June 30, 2010, an allowance for
doubtful accounts of $1,072,071 was required, comprising the full outstanding
balance of the direct-selling organization customer’s account and contract
receivable and the entire real estate services customer’s note
receivable.





Intangible
Assets - Intangible assets consist primarily of assets obtained
through the acquisitions of Computility, Inc. (“Computility”) and iMart
Incorporated (“iMart”) in 2005 and include customer bases, acquired technology,
non-compete agreements, trademarks, and trade names. The Company also owns
several copyrights and trademarks related to products, names, and logos used
throughout its non-acquired product lines. All assets are amortized on a
straight-line basis over their estimated useful lives with the exception of the
iMart trade name, which is deemed by management to have an indefinite life and
is not amortized.  These assets are re-evaluated on a quarterly basis
and the values are revised based upon current US GAAP
pronouncements.


7


Revenue
Recognition -  The Company derives revenue primarily from
subscription fees charged to customers accessing its 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 the Company licenses, sells,
leases, or otherwise markets computer software, it uses the residual method
pursuant to US GAAP.  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.





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.
            collection
      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 and custom software development 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 in 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.


8


Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. The Company typically has a revenue-share arrangement
with these marketing partners in order to encourage them to market the Company’s
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. The Company
recognizes certain revenue on a gross basis in accordance with US GAAP, when
services are provided directly by the Company to end users and revenue-share
arrangements exist with its marketing partners.





Because
its customers generally do not have the contractual right to take possession of
the software it licenses or markets at any time, the Company recognizes revenue
on hosting and maintenance fees as the services are provided in accordance with
US GAAP.





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.





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.





Stock-Based
Compensation -  Total stock-based compensation expense recognized
under US GAAP provisions during the three and six months ended June 30, 2010 was
$8,095 and $11,656 respectively of which $2,850 and $2,850 related to the
issuance of restricted stock and $5,245 and $8,806 was expense associated with
stock options for the respective three and six month period. Total stock-based
compensation expense during the three and six months ended June 30, 2009 was
$29,339 and $82,483 respectively, of which $20,937 and $47,499 related to
the issuance of restricted stock and $8,402 and $34,984 was expense associated
with stock options for the respective periods. No stock-based compensation was
capitalized in the financial statements.





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, expected remaining lives of the awards, and forfeiture rate. The
forfeiture rate is the estimated percentage of equity grants that are expected
to be forfeited or cancelled on an annual basis before becoming fully vested.
The Company estimates pre-vesting forfeiture rates at the time of grant based on
historical data and revises those estimates in subsequent periods if actual
forfeitures differ from those estimates, with the cumulative effect on current
and prior periods of such changes recognized in compensation cost in the period
of the change. The Company records stock-based compensation expense only for
those awards that are expected to vest, amortized on a straight-line basis over
the requisite service periods of the awards, which are generally the vesting
periods. The assumptions used in calculating the fair value of share-based
payment awards, including if the Company’s actual forfeiture rate is materially
different from what the Company has recorded in the current period, 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.





The fair
value of option grants under the Company’s equity compensation plan during the
three and six months ended June 30, 2010 and 2009 were estimated using the
following weighted average assumptions:


9





Three Months Ended
                  June 30,
                
                
                Six Months Ended
                  June 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Dividend
      yield
                
                
                0.0
                %
                
                
                0.0
                %
                
                
                0.0
                %
                
                
                0.0
                %Expected
      volatility
                
                
                98.3
                %
                
                
                102.1
                %
                
                
                98.5
                %
                
                
                101.28
                %Risk
      free interest rate
                
                
                1.40
                %
                
                
                2.54
                %
                
                
                1.79
                %
                
                
                2.29
                %Expected
      lives (years)
                
                
                3
                
                
                
                3
                
                
                
                3
                
                
                
                3





Dividend yield – The Company
has never declared or paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.





Expected volatility –
Volatility is a measure of the amount by which a financial variable such as
share price has fluctuated (historical volatility) or is expected to fluctuate
(expected volatility) during a period. The Company used the Company’s monthly
historical volatility since April 2005 to calculate the expected
volatility.





Risk-free interest rate – The
risk-free interest rate is based on the published yield available on U.S.
Treasury issues with a remaining term similar to the expected life of the
option.





Expected lives – 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.





Net Loss
Per Share -
Basic net loss per share is computed by dividing net loss by the weighted
average number of common shares outstanding during the periods. Diluted net loss
per share is computed using the weighted average number of common and dilutive
common equivalent shares outstanding during the periods. Common equivalent
shares consist of convertible notes, stock options, and warrants that are
computed using the treasury stock method. Shares issuable upon the exercise of
stock options and warrants, totaling 1,794,035 and 1,796,535 on June 30, 2010
and 2009, respectively, were excluded from the calculation of common equivalent
shares, as the impact was anti-dilutive.





Recently Issued
Accounting Pronouncements - 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.      BALANCE
SHEET ACCOUNTS





Prepaid
Expenses





In July
2008, the Company entered into a 36-month sublease agreement, subsequently
restructured as a lease with the primary landlord, for approximately 9,837
square feet of office space in Durham, North Carolina located near Research
Triangle Park 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 12 months
classified as non-current, and is being amortized to rent expense over the term
of the lease.





Intangible
Assets





The
following table summarizes information about intangible assets at June 30,
2010:


10





Asset Category
                
                Value
                  Assigned
                
                
                Residual
                  Value
                
                
                Weighted
                  Average
                  Amortization
                  Period
                  (in Years)
                
                
                Accumulated
                  Amortization
                  and
                  Impairments
                
                
                Carrying
                  ValueCustomer base
                
                $
                539,872
                
                
                $
                -
                
                
                
                6.2
                
                
                $
                539,872
                
                
                $
                -Acquired
      technology
                
                
                501,264
                
                
                
                -
                
                
                
                3.0
                
                
                
                501,264
                
                
                
                -Non-compete
      agreements
                
                
                801,785
                
                
                
                -
                
                
                
                4.0
                
                
                
                801,785
                
                
                
                -Trade
      name
                
                
                432,372
                
                
                
                N/A
                
                
                
                N/A
                
                
                
                282,372
                
                
                
                150,000Totals
                
                $
                2,275,293
                
                
                $
                -
                
                
                
                
                
                
                $
                2,125,293
                
                
                $
                150,000





Intangible
assets acquired were valued using the US GAAP standards concerning BusinessCombinations , 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.” Copyrights and trademarks were
capitalized using the costs of all legal and application fees
incurred.





Accrued
Liabilities





At June
30, 2010, the Company had accrued liabilities totaling $4,093,953. 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; $75,436 of liability related to the
development of the Company’s custom accounting application; $2,149,500 for legal
costs, settlement fees and estimated value of stock to be issued in accordance
with the Class Action settlement agreement; $47,574 for accrued payroll;
$119,552 of convertible note interest payable; $247,506 of unearned cash due to
customers and $54,385 of other liabilities.





At
December 31, 2009, the Company had accrued liabilities totaling $4,426,338. This
amount consisted primarily of $99,453 of liability related to the development of
the Company’s custom accounting application; $1,802,379 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; $152,657 for accrued
legal fees related to the defense;  $71,159 for accrued payroll and
related costs; and $102,647 of convertible note interest payable and $2,149,500
for the estimated settlement costs for the class action lawsuit. (See Note 4
“Commitments and Contingencies”).





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 e-mail
      accounts.





·
            License fees –
      Licensing revenue where customers did not meet all the criteria of US
      GAAP. Such deferred revenue is recognized when delivery has occurred or
      collectability becomes probable.





·
            Professional service fees
      – A customer that purchased a license and paid professional service
      fees during 2008 and 2007 to develop a customized application decided in
      the latter part of 2008 to move the application to the Company’s new
      technology platform. In connection with this new arrangement, the customer
      desires customization beyond the original scope of the project and will
      also be responsible for a monthly fee to maintain the application starting
      in October 2009. This deferred revenue represents the difference between
      earned fees and unearned license and professional service fees to be
      recognized as professional service fees revenue in
  2009.




The
components of deferred revenue for the periods indicated were as
follows:


11





June 30,
                    2010
                  
                  
                  December 31,
                    2009Subscription
      fees
                  
                  $
                  37,553
                  
                  
                  $
                  40,115License
      fees
                  
                  
                  -
                  
                  
                  
                  5,601Totals
                  
                  $
                  37,553
                  
                  
                  $
                  45,716Current
      portion
                  
                  $
                  34,803
                  
                  
                  $
                  40,115Non-current
      portion
                  
                  
                  2,750
                  
                  
                  
                  5,601Totals
                  
                  $
                  37,553
                  
                  
                  $
                  45,716





3.    
  NOTES PAYABLE





Convertible
Notes





As of
June 30, 2010, the Company had $11.05 million aggregate principal amount of
convertible secured subordinated notes due November 14, 2013 (the “notes”)
outstanding, net of a $200,000 reduction in connection with the Company’s
sale/leaseback of equipment in September 2009. On November 14, 2007, in an
initial closing, the Company sold $3.3 million aggregate principal amount of
initial notes due November 14, 2010. In addition, the noteholders committed to
purchase on a pro rata basis up to $5.2 million aggregate principal of
convertible secured subordinated notes in future closings upon approval and call
by our Board of Directors. On August 12, 2008, we exercised our option to sell
$1.5 million aggregate principal of additional notes due November 14, 2010 to
existing noteholders, with substantially the same terms and conditions as the
initial notes. In connection with the sale of the additional notes, the
noteholders holding a majority of the aggregate principal amount of the
convertible secured subordinated notes then outstanding agreed to increase the
aggregate principal amount of convertible secured subordinated notes that they
are committed to purchase from $8.5 million to $15.3 million. On November 21,
2008, we sold $500,000 aggregate principal amount of new notes due November 14,
2010 to two new convertible noteholders, with substantially the same terms and
conditions as the Initial notes and the additional notes. At December 31, 2008,
$5.3 million aggregate principal amount of notes were outstanding.




On
January 6, 2009, the Company sold $500,000 aggregate principal amount of notes
to Atlas, on substantially the same terms and conditions as the previously
issued notes.




On February 24, 2009, the Company sold
$500,000 aggregate principal amount of notes to Atlas on substantially the same
terms and conditions as the previously issued notes. On the same date, 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 additional notes to new convertible noteholders 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.




On each
of April 3, 2009 and June 2, 2009, the Company sold a Note in the principal
amount of $500,000 to Atlas on substantially the same terms and conditions as
the previously issued notes.  On each of July 16, 2009, August 26,
2009, September 8, 2009, and October 5, 2009, the Company sold a Note in the
principal amount of $250,000 to Atlas on substantially the same terms and
conditions as the previously issued notes.  On October 9, 2009, the
Company sold a Note in the principal amount of $250,000 to UBP, Union Bancaire
Privee, an existing noteholder, on substantially the same terms and conditions
as the previously issued notes.  On November 6, 2009, the Company sold
a note to Atlas in the principal amount of $500,000, on December 23, 2009 the
Company sold a note to Atlas in the principal amount of $750,000, and on
February 11, 2010, the Company sold a note to Atlas in the principal amount of
$500,000, all upon substantially the same terms and conditions as the previously
issued notes.




On March
5, 2010, the Company and the Requisite Percentage Holder, among other
noteholders, entered into the Fourth Amendment. 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 and the Registration
Rights Agreement, dated November 14, 2007, to reflect this extension, as
reported on the Form 8-K filed by the Company on March 10, 2010.




On April
1, 2010, the Company sold a note to Atlas in the principal amount of $350,000,
on Jun2 2010, the Company sold a note to Atlas in the principal amount of
$600,000, on July 1, 2010, the Company sold a note to Atlas in the principal
amount of $250,000.  Each note is due November 14, 2013, upon
substantially the same terms and conditions as the previously issued
notes.


12


On the
earlier of the maturity date of November 14, 2013 or a merger or acquisition or
other transaction pursuant to which our existing stockholders hold less than 50%
of the surviving entity, or the sale of all or substantially all of our 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 will be the lowest “applicable conversion price” determined for each note.
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




·
            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.




We are
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. We are 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.





Payment
of the notes will be automatically accelerated if we enter 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 noteholders
of the initial notes include (i) The Blueline Fund, or Blueline, which
originally recommended Philippe Pouponnot, one of our former directors, for
appointment to the Board of Directors; (ii) Atlas, an affiliate that originally
recommended Shlomo Elia, one of our current directors, for appointment to the
Board of Directors; (iii) Crystal Management Ltd., which is owned by Doron
Roethler, the former Chairman of our Board of Directors and former Interim Chief
Executive Officer and who currently serves as the noteholders’ bond
representative; and (iv) William Furr, who is the father of Thomas Furr, who, at
the time, was one of our directors and executive officers. The noteholders of
the additional notes are Atlas and Crystal Management Ltd.  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.





Lines
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. The
interest accrued on the unpaid principal balance at the Wall Street Journal’s
published Prime Rate minus one-half percent. The line of credit is 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 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to the
Paragon Note. 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%.
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 September 17, 2010.  On August 10,
2010, Paragon Bank further extended the maturity date of the Paragon note to
October 11, 2010 with the provision that the standby letter of credit in the
amount of $2,500,000 issued by HSBC that is securing the Paragon Note be
extended to November 17, 2010.


13


As of
August 10, 2010, the Company had an outstanding balance of $2.435 million under
the line of credit.





As of
June 30, 2010, the Company had notes payable totaling $13,378,517. The detail of
these notes is as follows:





Note Description
                                  
                                  Short-
                                    Term
                                    Portion
                                  
                                  
                                  Long-
                                    Term
                                    Portion
                                  
                                  
                                  Total
                                  
                                  Maturity
                                  
                                  RateParagon
      Commercial Bank credit line
                                  
                                  $
                                  2,127,174
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  2,127,174
                                  
                                  Aug
      2010
                                  
                                  Prime, not less
                                    than 6.5
                                  %Insurance
      premium note
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  Jul
      2010
                                  
                                  
                                  5.4
                                  %Various
      capital leases
                                  
                                  
                                  27,153
                                  
                                  
                                  
                                  174,190
                                  
                                  
                                  
                                  201,343
                                  
                                  Various
                                  
                                  
                                  10.7-18.9
                                  %Convertible
      notes
                                  
                                  
                                  -
                                  
                                  
                                  
                                  11,050,000
                                  
                                  
                                  
                                  11,050,000
                                  
                                  Nov
      2013
                                  
                                  
                                  8.0
                                  %Totals
                                  
                                  $
                                  2,154,327
                                  
                                  
                                  $
                                  11,224,190
                                  
                                  
                                  $
                                  13,378,517





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 $201,342 and $222,794 at June 30, 2010 and December 31, 2009, respectively,
net of accumulated amortization of $70,821 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 June
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 North Carolina headquarters to another facility near Research
Triangle Park. As described in Note 2, “Balance Sheet Accounts,” 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 non-cancelable lease through October 2009 for an apartment near its
headquarters that is utilized by its out of town executives and members of its
Board of Directors. As of June 30, 2010, future annual minimum operating lease
payments for 2010 are $53,744.





Rent
expense for the six months ended June 30, 2010 and 2009 was $107,509 and
$87,727, respectively.


14


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 June 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.





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 second half 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.





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.


15


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 seeks 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 have indicated that Advantis has defaulted on the terms of
the lease and Nottingham Hall is now pursuing 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 the 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 ($4,900.00) 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 ended December 31, 2009 for a further description of material legal
proceedings.





5.      STOCKHOLDERS’
EQUITY





Preferred
Stock





The Board
of Directors is authorized, without further stockholder approval, 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 June 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 June 30, 2010, it had 18,342,543 shares of common stock
outstanding. Holders of common stock are entitled to one vote for each share
held.





Warrants





As
incentive to modify a letter of credit relating to the Wachovia line of credit
(see Note 3, “Notes Payable”), 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.





Under a
Securities Purchase Agreement with two investors entered in connection with a
2007 private placement of the Company’s common stock, the investors were issued
warrants for the purchase of an aggregate of 1,176,471 shares of common stock at
an exercise price of $3.00 per share. These warrants contain a provision for
cashless exercise and must be exercised by February 21, 2010.  These
warrants were not exercised.


16


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
June 30, 2010, warrants to purchase up to 1,655,915 shares were
outstanding.





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 shares of restricted stock to Shlomo
Elia, as compensation for his service as a member of the Board of Directors. A
total of 479 shares of restricted stock were canceled during the first two
quarters of 2009 due to terminations and payment of employee tax obligations
resulting from share vesting. At June 30, 2010, there remains $8,550 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
June 30, 2010:





Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      PriceBALANCE, December
      31, 2009
                    
                    
                    132,500
                    
                    
                    $
                    4.43Granted
                    
                    
                    125,000
                    
                    
                    
                    1.14ExercisedCanceled
                    
                    
                    (2,500
                    )BALANCE,
      June 30, 2010
                    
                    
                    255,000
                    
                    
                    $
                    2.77





The
following table summarizes information about stock options outstanding at June
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
                          
                          
                          $
                          1.14
                          
                          
                          
                          -
                          
                          
                          $
                          -From
      $2.50 to $3.50
                          
                          
                          85,000
                          
                          
                          
                          5.8
                          
                          
                          $
                          3.15
                          
                          
                          
                          85,000
                          
                          
                          $
                          3.15$5.00
                          
                          
                          25,000
                          
                          
                          
                          4.3
                          
                          
                          $
                          5.00
                          
                          
                          
                          25,000
                          
                          
                          $
                          5.00$8.61
                          
                          
                          20,000
                          
                          
                          
                          3.5
                          
                          
                          $
                          8.61
                          
                          
                          
                          20,000
                          
                          
                          $
                          8.61Totals
                          
                          
                          255,000
                          
                          
                          
                          3.6
                          
                          
                          $
                          2.77
                          
                          
                          
                          130,000
                          
                          
                          $
                          4.35


17




At June
30, 2010, there remains $77,697 of unvested expense yet to be recorded related
to all options outstanding.





Dividends - The Company has
not paid any cash dividends through June 30, 2010.





6.      MAJOR
CUSTOMERS AND CONCENTRATION OF CREDIT RISK





Financial
instruments that potentially subject the Company to credit risk principally
consist of trade receivables. 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 the credit 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:





Three Months Ended
                    June 30, 2010Revenue Type
                  
                  Revenues
                  
                  % of Total
                    RevenuesCustomer A
                  Subscription fees
                  
                  $
                  -
                  
                  -
                  %Customer
      B
                  Professional
      service and other fees
                  
                  
                  95,573
                  
                  36.8
                  %Customer
      C
                  Subscription
      fees
                  
                  
                  44,919
                  
                  17.3
                  %Others
                  Various
                  
                  
                  119,226
                  
                  45.9
                  %Total
                  
                  
                  $
                  259,718
                  
                  100
                  %





Three Months Ended
                      June 30, 2009Revenue Type
                    
                    Revenues
                    
                    
                    % of Total
                      RevenuesCustomer A
                    Subscription
      fees
                    
                    $
                    73,049
                    
                    
                    
                    19.7
                    %Customer
      B
                    Professional
      service and other fees
                    
                    
                    109,521
                    
                    
                    
                    29.5
                    %Customer
      C
                    Subscription
      fees
                    
                    
                    92,216
                    
                    
                    
                    24.9
                    %Others
                    Various
                    
                    
                    95,861
                    
                    
                    
                    25.9
                    %Total
                    
                    
                    $
                    370,647
                    
                    
                    
                    100
                    %





Six Months Ended
                        June 30, 2010Revenue Type
                      
                      Revenues
                      
                      
                      % of Total
                        RevenuesCustomer A
                      Subscription
      fees
                      
                      $
                      -
                      
                      
                      
                      -
                      %Customer
      B
                      Professional
      service and other fees
                      
                      
                      207,454
                      
                      
                      
                      33.3
                      %Customer
      C
                      Subscription
      fees
                      
                      
                      97,359
                      
                      
                      
                      15.6
                      %Others
                      Various
                      
                      
                      318,805
                      
                      
                      
                      51.1
                      %Total
                      
                      
                      $
                      623,618
                      
                      
                      
                      100
                      %





Six Months Ended
                      June 30, 2009Revenue Type
                    
                    Revenues
                    
                    
                    % of Total
                      RevenuesCustomer A
                    Subscription
      fees
                    
                    $
                    229,749
                    
                    
                    
                    27.0
                    %Customer
      B
                    Professional
      service and other fees
                    
                    
                    215,816
                    
                    
                    
                    25.3
                    %Customer
      C
                    Subscription
      fees
                    
                    
                    217,719
                    
                    
                    
                    25.5
                    %Others
                    Various
                    
                    
                    189,050
                    
                    
                    
                    22.2
                    %Total
                    
                    
                    $
                    852,334
                    
                    
                    
                    100
                    %





As of
June 30, 2010, two customers accounted for 100% of accounts receivable, which
are both fully reserved. As of December 31, 2009, one customer accounted for 91%
of accounts receivable.





7.      SUBSEQUENT
EVENTS





On July
1, 2010, the Company sold $250,000 aggregate principal amount of convertible
secured subordinated notes due November 14, 2013 to Atlas with substantially the
same terms and conditions as the previously outstanding notes, as described in
Note 3, “Notes Payable.”




On July
2, 2010, the Company paid $75,000 as the first payment in accordance with the
settlement terms of the class action law suit.




Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal y
ear ended December 31, 2009 for a further description of material legal
proceedings.


18


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,” 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 One Biz®  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 Clicks 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.


19


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.


20


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 Clicks TMand iMart products, through both channel partners and
direct sales efforts. Additionally, we have placed renewed emphasis on
marketing our consulting and software development capabilities (i Mart ®) 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 don’t 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.


21


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.


22


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.





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
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. We
accrue any payments received in advance of the subscription period as deferred
revenue and amortize them over the subscription period. We recognize revenue on
a gross basis in accordance with US GAAP concerning Reporting Revenue Gross as a
Principal versus Net as an Agent, when we provide services directly to end users
and revenue-share arrangements exist with our marketing partners.





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.


23


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 or second 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.





Results
of Operations for the Three Months Ended June 30, 2010 and June 30,
2009





The
following table sets forth certain statements of operations data for the periods
indicated:




Three Months Ended
                  June 30, 2010
                
                
                Three Months Ended
                  June 30, 2009Dollars
                
                
                % of
                  Revenue
                
                
                Dollars
                
                
                % of
                  RevenueTotal
      revenues
                
                $
                259,718
                
                
                
                100.0
                %
                
                $
                370,647
                
                
                
                100.0
                %Cost
      of revenues
                
                
                336,310
                
                
                
                129.5
                %
                
                
                202,333
                
                
                
                54.6
                %Gross
      profit
                
                $
                (76,592
                )
                
                
                -29.5
                %
                
                $
                168,314
                
                
                
                45.4
                %Operating
      expenses
                
                
                579,489
                
                
                
                223.1
                %
                
                
                1,744,008
                
                
                
                470.5
                %Loss
      from operations
                
                $
                (656,081
                )
                
                
                -252.6
                %
                
                $
                (1,575,694
                )
                
                
                -425.1
                %Other
      income (expense), net
                
                
                168,082
                
                
                
                64.7
                %
                
                
                (158,343
                )
                
                
                -42.7
                %Net
      loss
                
                $
                (487,999
                )
                
                
                -187.9
                %
                
                $
                (1,734,037
                )
                
                
                -467.8
                %Net
      loss per common share
                
                $
                (0.03
                )
                
                
                
                
                
                $
                (0.09
                )


24


Revenues





Revenues
for the three months ended June 30, 2010 and 2009 comprise the
following:





Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentSubscription
      fees
                
                $
                123,146
                
                
                $
                209,820
                
                
                $
                (86,674
                )
                
                
                -41.31
                %Professional
      service fees
                
                
                7,050
                
                
                
                79,726
                
                
                
                (72,676
                )
                
                
                -91.16
                %License
      fees
                
                
                70,850
                
                
                
                11,250
                
                
                
                59,600
                
                
                
                529.78
                %Hosting
      fees
                
                
                37,722
                
                
                
                33,045
                
                
                
                4,677
                
                
                
                14.15
                %Other
      revenue
                
                
                20,950
                
                
                
                36,806
                
                
                
                (15,856
                )
                
                
                -43.08
                %Total
      revenues
                
                $
                259,718
                
                
                $
                370,647
                
                
                $
                (110,929
                )
                
                
                -29.93
                %





Revenues
decreased 30% to $259,719 for the three months ended June 30, 2010 from $370,647
for the same period in 2009. Our overall decrease in revenues was driven by
substantial declines in subscription fees and professional service fees and
offset by an increase in license fees. Select items are discussed in detail
below.





Subscription
Fees





Revenues
from subscription fees for the three months ended June 30, 2010 and 2009 are as
follows:





Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentSubscription fees
                
                $
                123,146
                
                
                $
                209,820
                
                
                $
                (86,674
                )
                
                -41.3
                %Percent
      of total revenues
                
                
                47.4
                %
                
                
                56.6
                %





Revenues
from subscription fees decreased 41.3% to $123,146 for the three months ended
June 30, 2010 from $209,820 for the same period in 2009. This decline is
primarily attributable to the ongoing migration of one direct-selling
organization customer to its own technology solution that has resulted in a
continuous decline in subscription fees.





Professional
Service Fees





Revenues
from professional service fees for the three months ended June 30, 2010 and 2009
are as follows:




Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentProfessional service
      fees
                
                $
                7,050
                
                
                $
                79,726
                
                
                $
                (72,676
                )
                
                
                -91.2
                %Percent
      of total revenues
                
                
                2.71
                %
                
                
                21.51
                %





Revenues
from professional service fees decreased 91.2% to $7,050 for the three months
ended June 30, 2010 from $79,726 for the same period in 2009. This decrease is
primarily due to a significant decline in web consulting services provided to
customers during the second quarter of 2010.


25


License
Fees





Revenues
from license fees for the three months ended June 30, 2010 and 2009 are as
follows:




Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentLicense fees
                
                $
                70,850
                
                
                $
                11,250
                
                
                $
                59,600
                
                
                
                529.8
                %Percent
      of total revenues
                
                
                27.28
                %
                
                
                3.04
                %





Revenues
from license fees increased 530% to $70,850 for the three months ended June 30,
2010 from $11,250 for the same period in 2009. License fee revenue recognized in
the second quarter of 2010 comprised the ratable recognition of a term license
that commenced in December 2009.





Hosting
Fees





Revenues
from hosting fees for the three months ended June 30, 2010 and 2009 are as
follows:




Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentHosting
      fees
                
                $
                37,722
                
                
                $
                33,045
                
                
                $
                4,677
                
                
                
                14.2
                %Percent
      of total revenues
                
                
                14.52
                %
                
                
                8.92
                %





Revenues
from hosting fees increased 14.2% to $37,772 for the three months ended June 30,
2010 from $33,045 for the same period in 2009. This increase is due to the
growth of services provided to clients.





Other
Revenue





Revenues
from other sources for the three months ended June 30, 2010 and 2009 are as
follows:




Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentOther
      revenue
                
                $
                20,950
                
                
                $
                36,806
                
                
                $
                (15,856
                )
                
                
                -43.1
                %Percent
      of total revenues
                
                
                8.07
                %
                
                
                9.93
                %





Revenues
from non-core activities decreased 43.1% to $20,950 for the three months ended
June 30, 2010 from $36,806 for the same period in 2009. We expect these revenue
streams to continue to be insignificant in the future as we focus on the growth
of our subscription fees revenue.





Cost
of Revenues





Cost of
revenues for the three months ended June 30, 2010 and 2009 are as
follows:


26





Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentCost
      of revenues
                
                $
                336,310
                
                
                $
                202,333
                
                
                $
                133,977
                
                
                
                66.2
                %Percent
      of total revenues
                
                
                129.49
                %
                
                
                54.59
                %




Cost of
revenues increased 66.2% to $336,310 for the three months ended June 30, 2010
from $202,333 for the same period in 2009. This increase is the result of
additional professional service costs associated with subscription revenue.





Operating
Expenses





Operating
expenses for the three months ended June 30, 2010 and 2009 comprise the
following:





Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentSales
      and marketing
                
                $
                179,640
                
                
                $
                216,780
                
                
                $
                (37,140
                )
                
                
                -17.1
                %Research
      and development
                
                
                10,380
                
                
                
                226,950
                
                
                
                (216,570
                )
                
                
                -95.4
                %General
      and administrative
                
                
                389,469
                
                
                
                862,050
                
                
                
                (472,581
                )
                
                
                -54.8
                %(Loss)
      on impairment of assets
                
                
                -
                
                
                
                438,228
                
                
                
                (438,228
                )
                
                
                -100.0
                %Total
      operating expenses
                
                $
                579,489
                
                
                $
                1,744,008
                
                
                $
                -1,164,520
                )
                
                
                -66.8
                %





Operating
expenses decreased 66.8% to $579,489 for the three months ended June 30, 2010
from $1,744,008 for the same period in 2009. This decrease is the direct result
of our concerted efforts during the latter part of 2009 and into 2010 to reduce
operating expenses by improving efficiencies and eliminating unnecessary costs
offset by the recognition of loss on the reevaluation of an intangible asset.
Select items are discussed in detail below.





Sales
and Marketing





Sales and
marketing expenses for the three months ended June 30, 2010 and 2009 are as
follows:





Three Months Ended
                              June 30,
                            
                            Change2010
                            
                            
                            2009
                            
                            Dollars
                            
                            
                            PercentSales
      and marketing
                            
                            $
                            179,640
                            
                            
                            $
                            216,780
                            
                            $
                            (37,140
                            )
                            
                            
                            -17.1
                            %Percent
      of total revenues
                            
                            
                            69.17
                            %
                            
                            
                            58.49
                            %





Sales and
marketing expenses decreased 17% to $179,640 for the three months ended June 30,
2010 from $216,780 for the same period in 2009. This variance is primarily
attributable to reductions associated with revenue-sharing arrangements
with our multi-level marketing partners.





Research
and Development





Research
and development expenses for the three months ended June 30, 2010 and 2009 are
as follows:


27





Three Months Ended
                                    June 30,
                                  
                                  
                                  Change2010
                                  
                                  
                                  2009
                                  
                                  
                                  Dollars
                                  
                                  
                                  PercentResearch
      and development
                                  
                                  $
                                  10,380
                                  
                                  
                                  $
                                  226,950
                                  
                                  
                                  $
                                  (216,570
                                  )
                                  
                                  
                                  -95.4
                                  %Percent
      of total revenues
                                  
                                  
                                  4.00
                                  %
                                  
                                  
                                  61.23
                                  %





Research
and development expenses decreased 95% to $10,380 for the three months ended
June 30, 2010 from $226,950 for the same period in 2009. This decrease is
primarily attributable to a reduction in employee head count and outside
contractor fees incurred and allocation of internal resources to current
production requirements during the second quarter of 2010.





General
and Administrative





General
and administrative expenses for the three months ended June 30, 2010 and 2009
are as follows:





Three Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentGeneral
      and administrative
                        
                        $
                        389,469
                        
                        
                        $
                        862,050
                        
                        
                        $
                        (472,581
                        )
                        
                        
                        -54.8
                        %Percent
      of total revenues
                        
                        
                        149.96
                        %
                        
                        
                        232.58
                        %





General
and administrative expenses decreased 55% to $389,469 for the three months ended
June 30, 2010 from $862,050 for the same period in 2009. This decrease is
primarily attributable to reductions in bad debt expense $128,000; and $15,000
stock-based compensation expense resulting from employee turnover and a decrease
in new equity grants; and $167,000 reduction in legal expenses; $135,000
reduction in the amount of amortization of intangible costs; and $10,300 in
management consulting fees. Bad debt expense is reduced because management is
being more cautious of new customer acceptance and sales volume is down for the
three months ended June 30, 2010.  Legal expense reduced because we
have been able to settle the outstanding litigation that the Company was
involved with since 2007.





(Loss)
on impairment of assets, net





(Loss) on
impairment of assets, net for the three months ended June 30, 2010 and 2009 are
as follows:





Three Months Ended
                                June 30,
                              
                              Change2010
                              
                              
                              2009
                              
                              Dollars
                              
                              
                              Percent(Loss) on
      impairment of assets, net
                              
                              $
                              -
                              
                              
                              $
                              (438,228
                              )
                              
                              $
                              (438,228
                              )
                              
                              
                              -100.0
                              %Percent
      of total revenues
                              
                              
                              -
                              %
                              
                              
                              118.23
                              %





(Loss) on
impairment of assets, net decreased by 100% since the reevaluation of
intangibles assets as of June 30, 2010 did not require any adjustment and there
were no sales of assets.




Other
Income (Expense)





Other
income (expense) for the three months ended June 30, 2010 and 2009 comprise the
following:





Three Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentInterest
      (expense) net
                
                $
                (233,025
                )
                
                $
                (158,343
                )
                
                $
                (74,682
                )
                
                
                -47.2
                %Gain
      on legal settlements, net
                
                
                401,107
                
                
                
                -
                
                
                
                401,107
                
                
                
                100.0
                %Other
      income (expense)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                %Total
      other income (expense)
                
                $
                168,082
                
                
                $
                (158,343
                )
                
                $
                326,425
                
                
                
                206.2
                %





Net other
income increased 206% to $168,082 for the three months ended June 30, 2010
from an expense of $158,343 for the same period in 2009. This net increase was
primarily attributable to the settlement of the Nouri litigation.





Interest
Expense, Net





Interest
expense, net of interest income, for the three months ended June 30, 2010 and
2009 is as follows:


28





Three Months Ended
                            June 30,
                          
                          Change2010
                          
                          2009
                          
                          Dollars
                          
                          PercentInterest
      expense, net
                          
                          $
                          233,025
                          
                          $
                          158,343
                          
                          $
                          (74,682
                          )
                          47.2
                          %Percent
      of total revenues
                          
                          
                          -89.72
                          %
                          
                          -42.72
                          %





Net
interest expense decreased 47% to $233,025 for the three months ended June 30,
2010 from $158,343 for the same period in 2009. This increase is primarily the
$74,682 of interest expense recognized in the second quarter of 2009 relating to
additional borrowings in 2010.





Gain
on legal settlements, Net





Three Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentGain
      on legal settlements, Net
                        
                        $
                        401,107
                        
                        
                        $
                        -
                        
                        $
                        401,107
                        
                        
                        
                        100.0
                        %Percent
      of total revenues
                        
                        
                        154.4
                        %
                        
                        
                        -
                        %





Net gain
on legal settlements increased 100% to $401,107 for the three months ended
June 30, 2010 from an expense of $-0- for the same period in 2009. This net
increase was primarily attributable to the results of the negotiations to settle
the Nouri litigation.





Results
of Operations for the Six Months Ended June 30, 2010 and June 30,
2009





The
following table sets forth certain statements of operations data for the periods
indicated:




Six Months Ended
                  June 30, 2010
                
                
                Six Months Ended
                  June 30, 2009Dollars
                
                
                % of
                  Revenue
                
                
                Dollars
                
                
                % of
                  RevenueTotal
      revenues
                
                $
                623,618
                
                
                
                100.00
                %
                
                $
                852,334
                
                
                
                100.00
                %Cost
      of revenues
                
                
                702,244
                
                
                
                112.61
                %
                
                
                694,934
                
                
                
                81.53
                %Gross
      profit
                
                $
                (78,626
                )
                
                
                -12.61
                %
                
                $
                157,400
                
                
                
                18.47
                %Operating
      expenses
                
                
                1,436,548
                
                
                
                230.36
                %
                
                
                3,216,015
                
                
                
                377.32
                %Loss
      from operations
                
                $
                (1,515,174
                )
                
                
                -242.97
                %
                
                $
                (3,058,615
                )
                
                
                -358.85
                %Other
      income (expense), net
                
                
                110,250
                
                
                
                17.68
                %
                
                
                (270,075
                )
                
                
                -31.699
                %Net
      loss
                
                $
                (1,404,924
                )
                
                
                -225.29
                %
                
                $
                (3,328,690
                )
                
                
                -390.54
                %Net
      loss per common share
                
                $
                (0.08
                )
                
                
                
                
                
                $
                (0.18
                )


29


Revenues





Revenues
for the six months ended June 30, 2010 and 2009 comprise the
following:





Six Months Ended
                        June 30,
                      
                      
                      Change2010
                      
                      
                      2009
                      
                      
                      Dollars
                      
                      PercentSubscription
      fees
                      
                      $
                      259,404
                      
                      
                      $
                      451,602
                      
                      
                      $
                      (192,198
                      )
                      -42.6
                      %Professional
      service fees
                      
                      
                      69,825
                      
                      
                      
                      198,499
                      
                      
                      
                      (128,674
                      )
                      -64.8
                      %License
      fees
                      
                      
                      158,650
                      
                      
                      
                      22,500
                      
                      
                      
                      136150
                      
                      605.1
                      %Hosting
      fees
                      
                      
                      81,994
                      
                      
                      
                      105,255
                      
                      
                      
                      (23,261
                      )
                      -22.1
                      %Other
      revenue
                      
                      
                      53,745
                      
                      
                      
                      74,478
                      
                      
                      
                      (20,733
                      )
                      -27.8
                      %Total
      revenues
                      
                      $
                      623,618
                      
                      
                      $
                      852,334
                      
                      
                      $
                      (228,716
                      )
                      -26.8
                      %





Revenues
decreased 26.8% to $623,618 for the six months ended June 30, 2010 from $852,334
for the same period in 2009. Our overall decrease in revenues was driven by
substantial declines in subscription fees and professional service fees. Select
items are discussed in detail below.





Subscription
Fees





Revenues
from subscription fees for the six months ended June 30, 2010 and 2009 are as
follows:




Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentSubscription fees
                
                $
                259,404
                
                
                $
                451,602
                
                
                $
                (192,198
                )
                
                
                -42.6
                %Percent
      of total revenues
                
                
                41.60
                %
                
                
                52.98
                %




Revenues
from subscription fees decreased 42.6% to $259,404 for the six months ended June
30, 2010 from $451,602 for the same period in 2009. This decline is primarily
attributable to the ongoing migration of one direct-selling organization
customer to its own technology solution that has resulted in a continuous
decline in subscription fees.





Professional
Service Fees





Revenues
from professional service fees for the six months ended June 30, 2010 and 2009
are as follows:




Six Months Ended
                  June 30,
                
                Change2010
                
                
                2009
                
                Dollars
                
                
                PercentProfessional service
      fees
                
                $
                69,825
                
                
                $
                198,499
                
                
                $
                (128,674
                )
                
                
                -64.8
                %Percent
      of total revenues
                
                
                11.20
                %
                
                
                12.9
                %




Revenues
from professional service fees decreased 64.8% to $128,674 for the six months
ended June 30, 2010 from $198,499 for the same period in 2009. This decrease is
primarily due to a significant decline in web consulting services provided to
customers during the second quarter of 2010.


30


License
Fees





Revenues
from license fees for the six months ended June 30, 2010 and 2009 are as
follows:





Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentLicense fees
                
                $
                158,650
                
                
                $
                22,500
                
                
                $
                136,150
                
                
                
                605.1
                %Percent
      of total revenues
                
                
                25.44
                %
                
                
                2.64
                %





Revenues
from license fees increased 605% to $158,650 for the six months ended June 30,
2010 from $22,500 for the same period in 2009. License fee revenue recognized in
the first and second quarter of 2010 includes fees from customers that began in
June 2009 and January 2010.





Hosting
Fees





Revenues
from hosting fees for the six months ended June 30, 2010 and 2009 are as
follows:




Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentHosting
      fees
                
                $
                81,994
                
                
                $
                105,255
                
                
                $
                (23,261
                )
                
                
                -22.1
                %Percent
      of total revenues
                
                
                13.15
                %
                
                
                12.35
                %




Revenues
from hosting fees decreased 22% to $81,994 for the six months ended June 30,
2010 from $105,255 for the same period in 2009. This decrease is due to the
reduced customer traffic for clients.





Other
Revenue





Revenues
from other sources for the six months ended June 30, 2010 and 2009 are as
follows:





Six Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentOther
      revenue
                        
                        $
                        53,745
                        
                        
                        $
                        74,478
                        
                        
                        $
                        (20,733
                        )
                        
                        
                        -27.8
                        %Percent
      of total revenues
                        
                        
                        8.62
                        %
                        
                        
                        8.74
                        %





Revenues
from non-core activities decreased 28% to $53,745 for the six months ended June
30, 2010 from $74,478 for the same period in 2009. We expect these revenue
streams to continue to be insignificant in the future as we focus on the growth
of our subscription fees revenue.





Cost
of Revenues





Cost of
revenues for the six months ended June 30, 2010 and 2009 are as
follows:


31





Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentCost
      of revenues
                
                $
                702,244
                
                
                $
                694,934
                
                
                $
                7,310
                
                
                
                1.05
                %Percent
      of total revenues
                
                
                112.61
                %
                
                
                81.53
                %





Cost of
revenues increased 1% to $702,244 for the six months ended June 30, 2010 from
$694,434 for the same period in 2009. This increase is the result of increased
professional services costs associated with subscription fees
revenue.





Operating
Expenses





Operating
expenses for the six months ended June 30, 2010 and 2009 comprise the
following:





Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentSales
      and marketing
                
                $
                332,275
                
                
                $
                516,318
                
                
                $
                (184,043
                )
                
                
                -35.7
                %Research
      and development
                
                
                42,385
                
                
                
                503,826
                
                
                
                (461,441
                )
                
                
                -91.6
                %General
      and administrative
                
                
                1,061,888
                
                
                
                1,757,643
                
                
                
                (695,755
                )
                
                
                -39.6
                %(Gain)
      loss on impairment of assets, net
                
                
                -
                
                
                
                438,228
                
                
                
                (438,228
                )
                
                
                -100.0Total
      operating expenses
                
                $
                1,436,548
                
                
                $
                3,216,015
                
                
                $
                (1,779,468
                )
                
                
                -55.2
                %





Operating
expenses decreased 55% to $1,436,548 for the six months ended June 30, 2010 from
$3,216,015 for the same period in 2009. This decrease is the direct result of
our concerted efforts during the latter part of 2009 and into 2010 to reduce
operating expenses by improving efficiencies and eliminating unnecessary costs
offset by the recognition of loss on the reevaluation of an intangible asset.
Select items are discussed in detail below.





Sales
and Marketing





Sales and
marketing expenses for the six months ended June 30, 2010 and 2009 are as
follows:





Six Months Ended
                            June 30,
                          
                          Change2010
                          
                          
                          2009
                          
                          Dollars
                          
                          
                          PercentSales
      and marketing
                          
                          $
                          332,275
                          
                          
                          $
                          516,318
                          
                          $
                          (184,043
                          )
                          
                          
                          -35.65
                          %Percent
      of total revenues
                          
                          
                          53.28
                          %
                          
                          
                          60.58
                          %





Sales and
marketing expenses decreased 36% to $332,275 for the six months ended June 30,
2010 from $516,318 for the same period in 2009. This variance is primarily
attributable to reductions associated with revenue-sharing arrangements with our
channel partners.


32


Research and Development





Research
and development expenses for the six months ended June 30, 2010 and 2009 are as
follows:




Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentResearch
      and development
                
                $
                42,385
                
                
                $
                503,826
                
                
                $
                (461,441
                )
                
                
                -91.6
                %Percent
      of total revenues
                
                
                6.8
                %
                
                
                59.11
                %





Research
and development expenses decreased 92% to $42,385 for the six months ended June
30, 2010 from $503,826 for the same period in 2009. This decrease is primarily
attributable to a reduction in employee head count and outside contractor fees
incurred during the first and second quarter of 2010.





General
and Administrative





General
and administrative expenses for the six months ended June 30, 2010 and 2009 are
as follows:





Six Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentGeneral
      and administrative
                        
                        $
                        1,061,888
                        
                        
                        $
                        1,757,643
                        
                        
                        $
                        (695,755
                        )
                        
                        
                        -39.6
                        %Percent
      of total revenues
                        
                        
                        170.28
                        %
                        
                        
                        206.22
                        %





General
and administrative expenses decreased 40% to $1,061,888 for the six months ended
June 30, 2010 from $1,757,643 for the same period in 2009. This decrease is
primarily attributable to reductions in personnel costs of $60,000; and $43,000
stock-based compensation expense resulting from employee turnover and a decrease
in new equity grants; and $9,000 in management consulting expenses; and $116,000
reduction in outside legal fees; $271,000 reduction in the amount of
amortization of intangible costs; and $172,000 reduction in bad debt
expense.





(Loss)
on impairment of assets





(Loss) on
impairment of assets for the six months ended June 30, 2010 and 2009 are as
follows:





Six Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        Percent(Loss) on
      impairment of assets
                        
                        $
                        -
                        
                        
                        $
                        (438,228
                        )
                        
                        $
                        (438,228
                        )
                        
                        
                        100.0
                        %Percent
      of total revenues
                        
                        
                        -
                        %
                        
                        
                        -51.42
                        %





(Loss) on impairment of assets,
net decreased by 100% since the reevaluation of intangibles assets as of
June 30, 2010 did not require any adjustment and there were no sales of
assets.





Other
Income (Expense)





Other
income (expense) for the six months ended June 30, 2010 and 2009 comprise the
following:





Six Months Ended
                  June 30,
                
                
                Change2010
                
                
                2009
                
                
                Dollars
                
                
                PercentInterest
      expense, net
                
                $
                (443,720
                )
                
                $
                (286,342
                )
                
                $
                (157,378
                )
                
                
                54.9
                %Gain
      on legal settlements, net
                
                
                553,970
                
                
                
                6,000
                
                
                
                547,970
                
                
                
                9,132.8
                %Gain
      on disposal of asset
                
                
                -
                
                
                
                10,267
                
                
                
                10,267
                
                
                
                100.0
                %Total
      other (expense) income
                
                $
                110,250
                
                
                $
                (270,075
                )
                
                $
                380,325
                
                
                
                -140.8
                %





Net other
(expense) income decreased 139% to $110,250 for the six months ended June
30, 2010 from ($270,075) for the same period in 2009. This net decrease was
primarily attributable to the net increase in interest expense offset by
significant gain on legal settlements for the six months ending June 30,
2010.





Interest
Expense, Net





Interest
expense, net of interest income, for the six months ended June 30, 2010 and 2009
is as follows:


33





Six Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentInterest
      (expense), net
                        
                        $
                        (443,720
                        )
                        
                        $
                        (286,342
                        )
                        
                        $
                        (157,378
                        )
                        
                        
                        54.9
                        %Percent
      of total revenues
                        
                        
                        -71.15
                        %
                        
                        
                        -33.60
                        %





Net
interest expense increased 55% to $443,720 for the six months ended June 30,
2010 from $286,342 for the same period in 2009. This increase is primarily the
result of additional borrowings during 2010.





Gain
on legal settlements, Net





Six Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentGain
      on legal settlements, Net
                        
                        $
                        553,970
                        
                        
                        $
                        6,000
                        
                        
                        $
                        547,970
                        
                        
                        
                        9,132.8
                        %Percent
      of total revenues
                        
                        
                        88.8
                        %
                        
                        
                        -
                        %





Net gain
on legal settlements increased 9,133% to $553,970 for the six months ended
June 30, 2010 from $6,000 for the same period in 2009. This net increase was
primarily attributable to the results of the negotiations to settle the Nouri
litigation.





Gain
on disposal of assets





Six Months Ended
                          June 30,
                        
                        Change2010
                        
                        
                        2009
                        
                        Dollars
                        
                        
                        PercentGain
      on disposal of assets
                        
                        $
                        0
                        
                        
                        $
                        10,267
                        
                        
                        $
                        (10,267
                        )
                        
                        
                        -100.0
                        %Percent
      of total revenues
                        
                        
                        -
                        %
                        
                        
                        1.20
                        %





Gain on
disposal of assets decreased 100% to $-0- for the six months ended June 30,
2010 from $10,267 for the same period in 2009. This net decrease was due to the
fact there were no assets disposed of during the period.





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
first or second 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 $49.6 million in net operating loss
carryforwards, which may be utilized to offset future taxable
income.





Utilization
of our net operating loss carryforwards may be subject to substantial annual
limitation due to the ownership change limitations provided by the Internal
Revenue Code of 1986, as amended and similar state provisions. Such an annual
limitation could result in the expiration of the net operating loss
carryforwards before utilization.





Liquidity
and Capital Resources





Overview





As of
June 30, 2010, our principal sources of liquidity were cash and cash equivalents
totaling $22,000 and current accounts receivable of $ -0-, net of allowance for
doubtful accounts, as compared to $120,000 of cash and cash equivalents and
$13,000 in accounts receivable as of December 31, 2009. We maintain a low cash
balance because of automated sweeps among our accounts at Paragon whereby all
available cash at the end of each day is used to pay down our line of credit
with Paragon, the purpose of which is to reduce our interest expense. As of June
30, 2010, we had drawn approximately $2,154,000 on the $2,470,000 line of
credit, leaving approximately $316,000 available under the line of credit for
our operations. Deferred revenue at June 30, 2010 was $37,500 as compared to
$46,000 at December 31, 2009.





As of
August 6, 2010, our principal sources of liquidity were cash and cash
equivalents totaling approximately $22,000 and accounts receivable of
approximately $-0-. In addition, we had drawn approximately $2,152,000 on the
Paragon line of credit, leaving approximately $318,000 available under the line
of credit for operations. As of August 6, 2010, we also have a commitment from
our convertible secured subordinated noteholders to purchase up to an additional
$3.8 million in convertible notes upon approval and call by our Board of
Directors.





Cash
Flows





During
the six months ended June 30, 2010, our working capital deficit decreased by
approximately $184,000 to $6,392,000 from a working capital deficit of
$6,575,000 at December 31, 2009. As described more fully below, the working
capital deficit at June 30, 2010 is primarily attributable to negative cash
flows from operations, offset in part by net debt borrowings.


34


Cash
Flows from Operating Activities





Six Months Ended
                          June 30,
                        
                        
                        Change2010
                        
                        
                        2009
                        
                        
                        Dollars
                        
                        
                        PercentNet
      cash used in operating activities
                        
                        $
                        1,722,101
                        
                        
                        $
                        1,370,374
                        
                        
                        $
                        351,727
                        
                        
                        
                        -25.7
                        %





Net cash
used in operating activities increased 26% to $1,722,101 for the six months
ended June 30, 2010 from $1,370,374 for the same period in 2009. This decrease
is primarily attributable a decrease in accounts payable and accrued
liabilities, decrease in accounts receivable and bad debt expense.





Cash
Flows from Investing Activities





Six Months Ended
                          June 30,
                        
                        
                        Change2010
                        
                        
                        2009
                        
                        
                        Dollars
                        
                        
                        PercentNet
      cash provided by (used in) investing activities
                        
                        $
                        (4,372
                        )
                        
                        $
                        (182,028
      )
                        
                        
                        $
                        177,656
                        
                        
                        
                        97.6
                        %





Net cash
used in investing activities decreased 97.6% to $4,372 for the six months ended
June 30, 2010 from $182,028 for the same period in 2009. This net decrease in
use of cash is attributable to the fact that we are no longer capitalizing
software costs related to our new industry-standard platform that we release in
July 2009.  The current use relates to the purchase of office
equipment in 2010.





Cash
Flows from Financing Activities





Six Months Ended
                          June 30,
                        
                        
                        Change2010
                        
                        
                        2009
                        
                        
                        Dollars
                        
                        
                        PercentNet
      cash provided by (used in) financing activities
                        
                        $
                        1,628,993
                        
                        
                        $
                        1,566,512
                        
                        
                        $
                        (62,481
                        )
                        
                        
                        -3.8
                        %





Net cash
provided by financing activities increased 4% to $1,628,993 for the six months
ended June 30, 2010 from net cash used in financing activities of $1,566,512 for
the same period in 2009. This net source of cash is primarily due to net debt
borrowings in the first and second quarters of 2010, as described
below.





The net
cash for the second quarter of 2010 from our financing activities was generated
through debt financing, as described below.





Debt Financing.  In
November 2006, we established a $1.3 million revolving credit arrangement with
Wachovia Bank, NA (“Wachovia”) to be used for general working capital purposes,
which we increased to $2.5 million in January 2007. The line of credit
was secured by our deposit account at Wachovia and an irrevocable standby
letter of credit issued by HSBC Private Bank (Suisse) SA, or HSBC, with
Atlas Capital, SA (“Atlas”), a current stockholder and affiliate, as account
party. Any advances made on the line of credit were to be paid off no later than
August 1, 2008. On February 15, 2008, we repaid the full outstanding
principal balance of $2,052,000 and accrued interest of $2,890 outstanding under
the line of credit, and our deposit account and the irrevocable standby letter
of credit were both released by Wachovia.





On
February 20, 2008, we entered into a revolving credit arrangement with Paragon
that was renewable on an annual basis subject to mutual approval. The line of
credit advanced by Paragon was $2.47 million, 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.





The
interest accrued on the unpaid principal balance at the Wall Street Journal has
published Prime Rate minus one-half percent. On February 19, 2009, we renewed
our revolving credit arrangement with Paragon. Any advances made on the line of
credit were to be paid off no later than February 11, 2010, with interest to
accrue on the unpaid principal balance at the Wall Street Journal's published
Prime Rate, but at no time at a rate less than 5.5%.  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, expiring February 18,
2010. We also have agreed with Atlas that in the event of our default in the
repayment of the line of credit that results in the letter of credit being
drawn, we would reimburse Atlas any sums that Atlas is required to pay under
such letter of credit. At our sole discretion, these payments may be made in
cash or by issuing shares of our common stock at a set per-share price of
$2.50.





On
February 25, 2010, the Company and Paragon extended the maturity date of the
Paragon line of credit from February 11, 2010 to August 11, 2010, and changed
the interest rate on the line of credit from the variable Prime Rate published
by the Wall Street Journal, with a floor of 5.50%, to a fixed annual rate of
6.50%.  The Company has been advised that, effective January 28, 2010,
the expiration date of the standby letter of credit in the amount of $2,500,000
issued by HSBC has been extended from February 18, 2010 to September 17,
2010.  As of August 10, 2010, the Company had an outstanding balance
of $2.435 million under the line of credit. On August 10, 2010, Paragon Bank
extended the maturity date of the Paragon note to October 11, 2010 with the
provision that the standby letter of credit in the amount of $2,500,000 issued
by HSBC that is securing the Paragon Note is also extended to November 17,
2010.


35


The
Paragon line of credit replaced our line of credit with Wachovia. As an
incentive for the letter of credit from Atlas to secure the Wachovia line of
credit, we had entered into a stock purchase warrant and agreement with Atlas.
Under the terms of the agreement, Atlas received a warrant to purchase up to
444,444 shares of our common stock at $2.70 per share within 30 business days of
the termination of the Wachovia line of credit or if we are in default under the
terms of the line of credit with Wachovia. In consideration for Atlas providing
the letter of credit to secure the Paragon line of credit, we agreed to amend
the agreement to provide that the warrant is exercisable within 30 business days
of the termination of the Paragon line of credit or if we are in default under
the terms of the line of credit with Paragon.





As of
June 30, 2010, we had $11.05 million aggregate principal amount of convertible
secured subordinated notes due November 14, 2010, or the notes, outstanding, net
of a $200,000 reduction in connection with the Company’s sale/leaseback of
equipment in September 2009.  On November 14, 2007, in an initial closing,
we sold $3.3 million aggregate principal amount of notes, or the initial notes.
In addition, the noteholders committed to purchase on a pro rata basis up to
$5.2 million aggregate principal amount of notes in future closings upon
approval and call by our Board of Directors. On August 12, 2008, we exercised
our option to sell $1.5 million aggregate principal amount of notes with
substantially the same terms and conditions as the initial notes, or the
additional 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 November
21, 2008, we sold $500,000 aggregate principal amount of notes, or the new
notes, to two new investors with substantially the same terms and conditions as
the previously outstanding notes. On each of January 6, 2009 and February 24,
2009, we sold $500,000 aggregate principal amount of notes to a current
noteholder with substantially the same terms and conditions as the previously
outstanding notes.





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 Additional notes to new convertible
noteholders 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.





On each
of April 3, 2009 and June 2, 2009, the Company sold a note in the principal
amount of $500,000 to Atlas on substantially the same terms and conditions as
the previously issued notes.  On each of July 16, 2009, August 26,
2009, September 8, 2009, and October 5, 2009, the Company sold a Note in the
principal amount of $250,000 to Atlas on substantially the same terms and
conditions as the previously issued notes.  On October 9, 2009, the
Company sold a Note in the principal amount of $250,000 to UBP, Union Bancaire
Privee, an existing noteholder, on substantially the same terms and conditions
as the previously issued notes.  On November 6, 2009, the Company sold
a Note to Atlas in the principal amount of $500,000, on December 23, 2009 the
Company sold a Note to Atlas in the principal amount of $750,000, and on
February 11, 2010, the Company sold a Note to Atlas in the principal amount of
$500,000, all upon substantially the same terms and conditions as the previously
issued notes.


On March
5, 2010, the Company and the Requisite Percentage Holder, among other
noteholders, entered into the Fourth Amendment. 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 and the Registration
Rights Agreement, dated November 14, 2007, to reflect this extension, as
reported on the Form 8-K filed by the Company on March 10, 2010.




On April
1, 2010, the Company sold a Note to Atlas in the principal amount of $350,000,
on June 2 2010, the Company sold a Note to Atlas in the principal amount of
$600,000, on July 1, 2010, the Company sold a Note to Atlas in the principal
amount of $250,000.  Each Note is due November 14, 2013, upon
substantially the same terms and conditions as the previously issued
notes.





We are
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. We are 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 the
earlier of November 14, 2013 or a merger or acquisition or other transaction
pursuant to which our existing stockholders hold less than 50% of the surviving
entity, or the sale of all or substantially all of our 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 our common
      stock, or






            receive
      immediate repayment in cash of the notes, including any accrued and unpaid
      interest.




36





If a
noteholder elects to convert its notes under these circumstances, the conversion
price will be the lowest “applicable conversion price” determined for each note.
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 our 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
      our 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






            the
      closing price of our 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 we enter 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, one of our former directors, for appointment to the Board of
Directors; (ii) Atlas, an affiliate that originally recommended Shlomo Elia, one
of our current directors, for appointment to the Board of Directors; (iii)
Crystal Management Ltd., which is owned by Doron Roethler, who subsequently
became Chairman of our Board of Directors and Interim President and Chief
Executive Officer until May 19, 2009 and serves as the noteholders’ bond
representative; and (iv) William Furr, who is the father of Thomas Furr, who, at
the time, was one of our directors and executive officers. The investors in the
additional notes are Atlas and Crystal Management Ltd. The investors in the new
notes are not affiliated with the Company.





If we
propose 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, we must give each
noteholder who has converted its notes into common stock the opportunity to
include such shares of converted common stock in the registration. We have
agreed to bear the expenses for any of these registrations, exclusive of any
stock transfer taxes, underwriting discounts, and commissions.





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 secured subordinated notes, and bank lines of
credit. We must continue to rely on these sources until we are able to generate
sufficient cash from revenues 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, 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 that is 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 could require additional covenants
and operating restrictions. In addition, legal settlement payments arising
out of indemnification obligations in favor of certain former officer and
employees will put further strain on the cash flow of the Company (see item 4
Legal Proceedings).


37


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
to our ability 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 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, and 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.





Recent
Developments





On July
1, 2010, the Company sold $250,000 aggregate principal amount of convertible
secured subordinated notes due November 14, 2013 to Atlas with substantially the
same terms and conditions as the previously outstanding notes, as described in
Note 3, “Notes Payable.”





Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2009 for a further description of material legal
proceedings.





Item
      3.
            Quantitative
      and Qualitative Disclosures About Market
Risk




Not
applicable.





Item
      4.
            Controls
      and Procedures





Not
applicable.





Item
      4T.
            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 June 30, 2010 that we
believe materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.


38


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 for a description of material legal
proceedings.





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 second half 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.





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.





As
previously reported in the Company’s Form 8-K filed on June 4, 2009, Dennis
Michael Nouri and Reza Eric Nouri (together, the “Nouris”), a former officer and
employee of the Company, respectively, filed a complaint (the “Nouri Complaint”)
to bring a summary proceeding against the Company in the Court of Chancery of
the State of Delaware. The Nouri Complaint sought to compel the Company to
advance legal fees and costs in the amount of $826,798 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, together with future
verified expenses that will be incurred by the Nouris in defending the actions
against them and the expenses incurred by the Nouris in prosecuting the
advancement action against the Company.




On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris. By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 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. A current note receivable is recorded for the same amount due
from the individuals.




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.




Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2009 for a further description of material legal
proceedings.





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 June 30, 2010 from those
previously reported in our Quarterly Report on Form 10-Q filed on May 14,
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 11, 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. If we are unable to establish a new line of credit, we may have difficulty
dealing with cash flow activities of daily business operations that will be
disruptive to the future success of the business.


39


Item
2.      Unregistered Sales of Equity Securities and Use
of Proceeds





During
the second quarter of fiscal 2010, there were no sales of unregistered
securities other than the sales of convertible notes, as described in our
Current Reports on Form 8-K filed in connection with such
transactions.





There
were no repurchases during the second 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 4.     SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS




As
reported in a Form 8-K filed by the Company on June 22, 2010, the Annual Meeting
of Stockholders of the Company was convened as scheduled on June
22,  The annual meeting was held for the purposes of electing
directors to serve until the next annual meeting of stockholders or until their
successors are appointed and qualified. Mr. C. James Meese, Jr. resigned as
directors prior to the Annual Meeting, and was not a candidate for
re-election.




Amir
Elbaz, Dror Zoreff and Shlomo Elia were each elected as directors of the
Company, with the number of votes for and withheld, respectively, for such
persons as follows:




For
                
                
                WithheldAmir
      Elbaz.
                
                
                14,713,433
                
                
                
                22,077Dror
      Zoreff
                
                
                14,713,433
                
                
                
                22,077Shlomo
      Elia
                
                
                14,713,433
                
                
                
                22,077




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/Principal Accounting Officer Pursuant to
      Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002


40





32.1
              
              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/Principal Accounting 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.


41


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.By:
              /s/ Dror ZoreffAugust
      12, 2010
              
              Dror
      ZoreffPrincipal
      Executive Officer, Interim CEO and PresidentSMART
      ONLINE, INC.By:
              /s/ Thaddeus J. ShalekAugust
      12, 2010
              
              Thaddeus
      J. ShalekPrincipal
      Accounting Officer and Interim Chief Financial
  Officer


42


EXHIBIT
INDEX





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/Principal Accounting 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/Principal Accounting 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.





43