**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**_________________**





**FORM
        10-Q/A**


(Amendment
        No.1)


**_________________**





**(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, 2005**





**OR**





**[
      ]**  **Transition
      report pursuant to Section 13 of 15(d) of the Securities Exchange Act of
      1934**





**Commission
      File Number: 333-119385**





**_________________**





**SMART
      ONLINE, INC.**


**(Exact
      name of registrant as specified in its charter)**





**_________________**








**Delaware**
            **95-4439334****(State
                of other jurisdiction of**
            **(IRS
                Employer****incorporation
                or organization)**
            **Identification
                No.)**








**2530
      Meridian Parkway, 2nd Floor**


**Durham,
      North Carolina 27713**


**(Address
      of principal executive offices)**





**(919)
      765-5000**


**(Registrant’s
      telephone number, including area code)**


**_________________**





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





Indicate
      by check mark whether the Registrant is an accelerated filer (as described
      in
      Rule 12b-2 of the Securities Exchange Act of 1934). Yes [ ] No [X]





As
      of
      June 30, 2005, there were approximately 12,498,435 million shares of the
      Registrant’s Common Stock outstanding.






















**Smart
      Online, Inc.**





**INDEX**








**PART
      I. FINANCIAL INFORMATION**





**Page
                No.****Item
                1.**
            **Financial
                Statements:**
            3Balance
                Sheets as of June 30, 2005 (unaudited) and December 31,
                2004
            3Statements
                of Operations (unaudited) for the three months and six months ended
                June
                30, 2005 and 2004
            4Statements
                of Cash Flows (unaudited) for the three months and six months ended
                June
                30, 2005 and 2004
            5Notes
                to Financial Statements (unaudited)
            6**Item
                2.**
            **Management’s
                Discussion and Analysis of Financial Condition and Results of Operations
                (including Risk Factors)**
            16**Item
                3.**
            **Quantitative
                and Qualitative Disclosures About Market Risk**
            50**Item
                4.**
            **Controls
                and Procedures**
            50**PART
                II. OTHER INFORMATION****Item
                1.**
            **Legal
                Proceedings**
            50**Item
                2.**
            **Unregistered
                Sales of Equity Securities and Use of Proceeds**
            51**Item
                3.**
            **Defaults
                Upon Senior Executives**
            51**Item
                4.**
            **Submission
                of Matters to a Vote of Securities Holders**
            51**Item
                5.**
            **Other
                Information**
            51**Item
                6.**
            **Exhibits**
            51**Signatures**
            52









**EXPLANATORY
            NOTE**
 
 The
            purpose of this Amendment No. 1 to Quarterly Report on Form 10-Q/A is
            to restate
            the unaudited financial statements of Smart Online, Inc. (the “Company”) for the
            quarter ended June 30, 2005, filed with the Securities and Exchange Commission
            (“SEC”) on August 15, 2005 to correct the accounting treatment of certain
            warrants. As originally filed in its Form 10-Q, Smart Online incorrectly
            reported $506,000 of expense associated with certain warrants issued
            during
            2003. Since these warrants were part of permanent equity, Smart Online
            should
            not have applied the mark to market provisions of Emerging Issues Task
            Force
            (EITF) 00-19, *Accounting for Derivative Financial Instruments Indexed to,
            and Potentially Settled In, a Company's Own Stock.*  The Items which
            are amended and restated herein are:
 
 1. 
              Part I, Item 1 - Financial Statements (including applicable
            footnotes);
 2.    Part
            I, Item 2 - Management's Discussion and Analysis of Financial Condition
            and
            Results of Operations (including Risk Factors); and
 3.    Part
            II, Item 6 - Exhibits
 
 Except
            as
            otherwise expressly noted herein, this Amendment No. 1 to Quarterly Report
            on
            Form 10-Q/A does not reflect events occurring after the August 15, 2005
            filing
            of our Quarterly Report on Form 10-Q in any way, except as those required
            to
            reflect the effects of this restatement of our financial statements for
            the
            periods presented, as deemed necessary in connection with the completion
            of
            restated financial statements.
 
 The
            remaining Items contained within this Amendment No. 1 to our Quarterly
            Report on
            Form 10-Q/A consist of all other Items originally contained in our Quarterly
            Report on Form 10-Q for the quarterly period ended June 30, 2005 in the
            form
            filed with the SEC on August 15, 2005.  These remaining Items are not
            amended hereby, but are included for the convenience of the reader. In
            order to
            preserve the nature and character of the disclosures set forth in such
            Items as
            originally filed, except as expressly noted herein, this report continues
            to
            speak as of the date of the original filing, and we have not updated
            the
            disclosures in this report to speak as of a later date.  While this report
            primarily relates to the historical periods covered, events may have
            taken place
            since the original filing that might have been reflected in this report
            if they
            had taken place prior to the original filing.








**PART
      I. FINANCIALINFORMATION**





**Item
      1. FINANCIALSTATEMENTS**





**Smart
      Online, Inc.**


**BalanceSheets**








**Assets**
            
            
            **June
                30,**
              **2005**
              **(Unaudited)**
              **(Restated)**
            
            
            **December
                31**,
              **2004**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            552,407
            
            $
            173,339Marketable
                securities
            
            
            -
            
            
            395,000Accounts
                receivable, net
            
            
            30,706
            
            
            30,904Other
                accounts receivable
            
            
            -
            
            
            43,455Prepaid
                expenses
            
            
            259,739
            
            
            24,850Total
                current assets
            
            
            842,852
            
            
            667,548PROPERTY
                AND EQUIPMENT, net
            
            
            141,600
            
            
            75,636INTANGIBLE
                ASSETS, net
            
            
            15,394
            
            
            16,623OTHER
                ASSETS
            
            
            13,540
            
            
            13,894TOTAL
                ASSETS
            
            $
            1,013,386
            
            $
            773,701CURRENT
                LIABILITIES:Accounts
                payable
            
            $
            190,283
            
            $
            186,382Accrued
                payroll
            
            
            160,088
            
            
            110,079Accrued
                payroll taxes, penalties and interest
            
            
            11,528
            
            
            574,827Deferred
                revenue
            
            
            531,479
            
            
            721,689Total
                current liabilities
            
            
            893,378
            
            
            1,592,977LONG-TERM
                LIABILITIES:Deferred
                compensation, notes payable and interest
            
            
            -
            
            
            1,091,814Total
                long-term liabilities
            
            
            -
            
            
            1,091,814Total
                liabilities
            
            
            893,378
            
            
            2,684,791COMMITMENTS
                AND CONTINGENCIES
            
            
            -
            
            
            -STOCKHOLDERS'
                EQUITY (DEFICIT):Common
                stock, $.001 par value, 45,000,000 shares authorized, shares issued
                and
                outstanding:
              June
                30, 2005 - 12,498,435; December 31, 2004 —11,631,832
            
            
            12,498
            
            
            11,632Additional
                paid-in capital
            
            
            38,000,363
            
            
            34,809,832Accumulated
                deficit
            
            
            (37,892,853
            )
            
            (36,732,554
            )Total
                stockholders' equity (deficit)
            
            
            120,008
            
            
            (1,911,090
            )TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
            
            $
            1,013,386
            
            $
            773,701








See
      Notes
      to Financial Statements


3





**SMART
      ONLINE, INC.**


**STATEMENTS
      OF OPERATIONS**


**(unaudited)**


**Three
                Months Ended**
            
            
            **Six
                Months Ended****June
                30, 2005**
            
            **June
                30, 2004**
            
            
            **June
                30, 2005**
            
            
            **June
                30, 2004****(Restated)**
            
            
            
            
            **(Restated)**REVENUES:Integration
                fees
            
            $
            252,198
            
            $
            89,931
            
            
            $
            381,720
            
            $
            193,750Syndication
                fees
            
            
            103,602
            
            
            30,621
            
            
            
            195,642
            
            
            61,242OEM
                revenue
            
            
            12,000
            
            
            13,750
            
            
            
            24,000
            
            
            28,436Web
                services
            
            
            25,731
            
            
            18,276
            
            
            
            40,890
            
            
            34,990Other
                revenues
            
            
            12,585
            
            
            755
            
            
            
            17,102
            
            
            2,130Related
                party revenues
            
            
            -
            
            
            82,512
            
            
            
            -
            
            
            165,025Total
                revenues
            
            
            406,116
            
            
            235,845
            
            
            
            659,354
            
            
            485,573COST
                OF REVENUES
            
            
            21,911
            
            
            43,408
            
            
            
            53,638
            
            
            100,427GROSS
                PROFIT
            
            
            384,205
            
            
            192,437
            
            
            
            605,716
            
            
            385,146OPERATING
                EXPENSES:General
                and administrative
            
            
            724,162
            
            
            593,250
            
            
            
            1,243,198
            
            
            1,042,507Sales
                and marketing
            
            
            287,946
            
            
            179,232
            
            
            
            582,678
            
            
            277,631Development
            
            
            246,403
            
            
            127,643
            
            
            
            501,630
            
            
            292,021Total
                operating expenses
            
            
            1,258,511
            
            
            900,125
            
            
            
            2,327,506
            
            
            1,612,159LOSS
                FROM OPERATIONS
            
            
            (874,306
            )
            
            (707,688
            )
            
            
            (1,721,790
            )
            
            (1,227,013
            )OTHER
                INCOME (EXPENSE):Interest
                income (expense), net
            
            
            4,197
            
            
            (6,945
            )
            
            
            10,195
            
            
            (114,597
            )Gain
                on debt forgiveness
            
            
            9,293
            
            
            21,847
            
            
            
            556,634
            
            
            49,395Total
                other income (expense)
            
            
            13,490
            
            
            14,902
            
            
            
            566,829
            
            
            (65,202
            )NET
                LOSS
            
            
            (860,816
            )
            
            (692,786
            )
            
            
            (1,154,961
            )
            
            (1,292,215
            )Preferred
                stock dividends and accretion of discount on preferred
                stock
            
            
            -
            
            
            -
            
            
            
            -
            
            
            (2,215,625
            )Accretive
                dividend issued in connection with registration rights
                agreement
            
            
            (3
            )
            
            -
            
            
            
            (3
            )
            
            -Converted
                preferred stock inducement cost
            
            
            -
            
            
            -
            
            
            
            -
            
            
            (3,225,410
            )Net
                loss attributed to common stockholders
            
            $
            (860,819
            )
            $
            (692,786
            )
            
            $
            (1,154,964
            )
            $
            (6,733,250
            )NET
                LOSS PER SHARE:Net
                loss attributed to
              common
                stockholders -
              Basic
                and Diluted
            
            $
            (0.07
            )
            $
            (0.06
            )
            
            $
            (0.10
            )
            $
            (0.75
            )SHARES
                USED IN COMPUTING NET LOSS PER SHARE
              Basic
                and Diluted
            
            
            12,387,333
            
            
            10,722,507
            
            
            
            12,110,013
            
            
            9,022,107





See
      notes
      to financial statements.


4





**SMART
      ONLINE, INC.**


**STATEMENTS
      OF CASHFLOWS**


**(unaudited)**




**Three
                Months Ended**
            
            **Six
                Months Ended****June
                30, 2005**
            ****
            **June
                30, 2004**
            ****
            **June
                30, 2005**
            ****
            **June
                30, 2004****(Restated)**
            
            
            
            **(Restated)**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (860,819
            )
            $
            (692,786
            )
            $
            (1,154,964
            )
            $
            (1,292,215
            )Adjustments
                to reconcile net loss to net cashused
                in operating activities:Depreciation
            
            
            13,155
            
            
            11,975
            
            
            24,248
            
            
            22,079Common
                shares, warrants, or options issued in lieu of
                compensation
            
            
            79,279
            
            
            -
            
            
            79,279
            
            
            161,000Common
                shares issued for extension of loan
            
            
            -
            
            
            -
            
            
            -
            
            
            75,000Issuance
                of warrants
            
            
            -
            
            
            
            
            
            19,231Gain
                on debt forgiveness
            
            
            (9,293
            )
            
            (21,847
            )
            
            (556,634
            )
            
            (49,395
            )Changes
                in assets and liabilities:Accounts
                receivable
            
            
            (18,517
            )
            
            (28,506
            )
            
            198
            
            
            29,720Related
                party receivable
            
            
            
            
            
            5,625
            
            
            
            
            
            38,682Other
                accounts receivable
            
            
            (4,999
            )
            
            4,583
            
            
            33,769
            
            
            (13,750
            )Prepaid
                expenses
            
            
            (185,422
            )
            
            8,559
            
            
            (225,203
            )
            
            (17,116
            )Legal
                settlement obligation
            
            
            -
            
            
            (181,563
            )
            
            -
            
            
            (181,563
            )Other
                assets
            
            
            3,653
            
            
            -
            
            
            1,433
            
            
            -Deferred
                revenue
            
            
            (142,382
            )
            
            (117,261
            )
            
            (190,210
            )
            
            (300,981
            )Accounts
                payable
            
            
            (26,477
            )
            
            214,003
            
            
            31,332
            
            
            (128,691
            )Accrued
                payroll
            
            
            43,741
            
            
            28,345
            
            
            55,961
            
            
            29,717Accrued
                payroll taxes payable
            
            
            (49,341
            )
            
            25,352
            
            
            (49,341
            )
            
            (965,506
            )Accrued
                interest payable
            
            
            -
            
            
            3,166
            
            
            -
            
            
            (134,998
            )Deferred
                compensation, notes payable, and interest
            
            
            -
            
            
            (35,649
            )
            
            (1,091,814
            )
            
            (76,343
            )Net
                cash used in operating activities
            
            
            (1,157,422
            )
            
            (776,004
            )
            
            (3,022,715
            )
            
            (2,651,674
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of furniture and equipment
            
            
            (34,841
            )
            
            (24,264
            )
            
            (86,104
            )
            
            (24,908
            )Redemption
                of marketable securities
            
            
            -
            
            
            -
            
            
            395,000
            
            
            -Net
                cash provided by (used in) investing activities
            
            
            (34,841
            )
            
            (24,264
            )
            
            308,896
            
            
            (24,908
            )CASH
                FLOWS FROM FINANCING ACTIVITIES:Repayments
                on notes payable
            
            
            -
            
            
            -
            
            
            -
            
            
            (350,000
            )Repayments
                from stockholder
            
            
            -
            
            
            -
            
            
            -
            
            
            (86,480
            )Issuance
                of common stock
            
            
            357,887
            
            
            1,045,142
            
            
            3,092,887
            
            
            3,333,641Net
                cash provided by financing activities
            
            
            357,887
            
            
            1,045,142
            
            
            3,092,887
            
            
            2,897,161NET
                (DECREASE) INCREASE IN CASH
              AND
                CASH EQUIVALENTS
            
            
            (834,376
            )
            
            244,874
            
            
            379,068
            
            
            220,579CASH
                AND CASH EQUIVALENTS,
              BEGINNING
                OF PERIOD
            
            
            1,386,783
            
            
            77,191
            
            
            173,339
            
            
            101,486CASH
                AND CASH EQUIVALENTS,
              END
                OF PERIOD
            
            $
            552,407
            
            $
            322,065
            
            $
            552,407
            
            $
            322,065Supplemental
                disclosures:Cash
                payment during the period for interest:
            
            $
            -
            
            $
            -
            
            $
            154,288
            
            $
            164,055Non-cash
                financing activities:Non-cash
                accretion of preferred stock redemption value
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            2,215,625Conversion
                of preferred stock into common stock
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            19,724,839





See
      notes
      to financial statements.


5





**Smart
      Online, Inc.**





**Notes
      to Financial Statements - Unaudited**





**1.**  **Summary
      of Business and Significant Accounting Policies**





***Basis
      of Presentation*** -The
      accompanying balance sheet as of June 30, 2005 and the statements of operations
      and cash flows for the three months and six months ended June 30, 2005 and
      2004
      are unaudited. These statements should be read in conjunction with the audited
      financial statements and related notes, together with management’s discussion
      and analysis of financial position and results of operations, contained in
      the
      Company’s Form 10-K for the year ended December 31, 2004.





The
      financial statements have been prepared in accordance with accounting principles
      generally accepted in the United States, or U.S. GAAP. In the opinion of the
      Company’s management, the unaudited statements in the Form 10-Q include all
      adjustments necessary for the fair presentation of the Company’s statement of
      financial position as of June 30, 2005, its results of operations and its cash
      flows for the three months and six months ended June 30, 2005 and 2004. The
      results for the three months and six months ended June 30, 2005 are not
      necessarily indicative of the results to be expected for the fiscal year ending
      December 31, 2005.





The
      accompanying financial statements have been prepared assuming that the Company
      will continue as a going concern. As such, they do not include adjustments
      relating to the recoverability of recorded asset amounts and classification
      of
      recorded assets and liabilities. The Company had accumulated losses of
      approximately $38 million at June 30, 2005 and will be required to make
      significant expenditures in connection with continuing development and marketing
      efforts along with general and administrative expenses. The Company's ability
      to
      continue its operations is dependant upon its raising of capital through equity
      financing in order to meet its working needs.





These
      conditions raise substantial doubt about the Company's ability to continue
      as a
      going concern, and, if substantial additional funding is not acquired or
      alternative sources developed, management will be required to curtail its
      operations.





The
      Company needs to raise additional capital by the sale of its equity securities
      or other financing avenues. Management believes that actions presently being
      taken to obtain additional funding provides the additional opportunity for
      the
      Company to continue as a going concern.





***Description
      of Business -*** Smart
      Online, Inc. (the "Company" or "Smart Online") was incorporated in the State
      of
      Delaware in 1993. Smart Online develops and markets Internet-delivered
      Software-as-Service (SaS) software applications and data resources to start,
      run, protect and grow small businesses (one to fifty employees). Smart Online's
      subscribers access Smart Online's products through the portal at www.SmartOnline.com directly
      and through the web sites of private label syndication partners that include
      major companies and financial institutions.





***Fiscal
      Year -*** The
      fiscal year ends December 31. References to fiscal 2005, for example, refer
      to
      the fiscal year ending December 31, 2005.





***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 from those estimates.





***Segments
      -*** The
      Company operates in one segment.





***Revenue
      Recognition*** -
      The
      Company recognizes revenue in accordance with accounting standards for software
      and service companies including United States Securities and Exchange Commission
      (“SEC”), Staff Accounting Bulletin No. 104 “Revenue Recognition” (“SAB 104”),
      the Emerging Issues Task Force Issue No. 00-21 “Revenue Arrangements with
      Multiple Deliverables” (“EITF 00-21”) *,* and
      related interpretations including American Institute of Certified Public
      Accountants (“AICPA”) Technical Practice Aids. We also utilize interpretative
      guidance from regulatory and accounting bodies, which include, but are not
      limited to, the SEC, the AICPA, the Financial Accounting Standards Board
      (“FASB”), and various professional organizations.





We
      recognize revenue when all of the following conditions are satisfied: (1) there
      is persuasive evidence of an arrangement; (2) the service has been provided
      to
      the customer; (3) the collection of our fees is probable; and (4) the amount
      of
      fees to be paid by the customer is fixed or determinable. EITF 00-21 states
      that
      revenue arrangements with multiple deliverables should be divided into separate
      units of accounting if the deliverables in the arrangement meet the following
      criteria: (1) the delivered item has value to the


6


customer
      on a standalone basis; (2) there is objective and reliable evidence of the
      fair
      value of the undelivered item; and (3) if the arrangement includes a general
      right of return relative to the delivered item, deliver or performance of the
      undelivered item is considered probable and substantially in control of the
      vendor. Smart Online’s syndication and integration agreements typically include
      multiple deliverables including the grant of a non-exclusive license to
      distribute, use and access the Smart Online platform, fees for the integration
      of content into the Smart Online platform, maintenance and hosting fees,
      documentation and training, and technical support and customer support fees.
      Smart Online cannot establish fair value of the individual revenue deliverables
      based on objective and reliable evidence because the Company does not have
      a
      long, consistent history of standard syndication and integration contractual
      arrangements, there have only been a few contracts that have continued past
      the
      initial contractual term, the Company does not have any contracts in which
      these
      elements have been sold as stand-alone items, and there is no third-party
      evidence of fair value for products or services that are interchangeable and
      comparable to Smart Online’s products and services. As such, Smart Online can
      not allocate revenue to the individual deliverables and must record all revenues
      received as a single unit of accounting as further described below.
      Additionally, Smart Online has evaluated the timing and substantive nature
      of
      the performance obligations associated with the multiple deliverables noted
      above, including the determination that the remaining obligations are essential
      to the on-going usability and functionality of the delivered products, and
      determined that revenue should be recognized over the life of the contracts
      due
      to such factors as the length of time over which the remaining obligations
      will
      be performed, the complex nature of integrating and maintaining customer content
      with Smart Online’s platform, which services are unavailable from other vendors,
      and the timing of payment of a portion of the contract price such as monthly
      hosting payments.





Syndication
      fees consist primarily of fees charged to syndication partners to create and
      maintain a customized private-label site and ongoing support, maintenance and
      customer service. The syndication agreements typically include an advance fee
      and monthly hosting fees. We generally invoice our customers in annual or
      monthly installments and typical payment terms provide that our customers pay
      us
      within 30 days of invoice. Amounts that have been invoiced are recorded in
      accounts receivable and in deferred revenue and the revenue is recognized
      ratably over the specified lives of the contracts, commencing on the date the
      site goes on-line. In general, we collect our billings in advance of the service
      period. The hosting fees are typically billed on a monthly basis. Our contracts
      and support contracts are non-cancelable, though they typically provide for
      early termination upon a material breach by either party that is not cured
      in a
      timely manner. We continue to evaluate and adjust the length of these
      amortization periods as we gain more experience with implementation schedules
      and contract cancellations. Should the contract terminate earlier than its
      term
      then we recognize the remaining deferred revenue upon termination. At present,
      Smart Online has insufficient historical data to determine if the relationship
      with its existing customers will extend beyond the initial term with the
      customer continuing to benefit from the advance fee. If Smart Online determines
      that existing and/or future contracts are expected to extend beyond the initial
      term whereby the customer continuing to benefit from the advance fee, Smart
      Online would extend the revenue recognition period accordingly to include the
      extended term. Based on that experience, it is possible that, in the future,
      the
      estimates of customer lives may change and, in such event, the period over
      which
      such syndication revenues are amortized would be adjusted. Any such change
      in
      specified contract lives would affect our future results of operations.
      Additionally, the syndication contracts typically include revenue sharing
      arrangements whereby syndication partners typically charge their customers
      a
      monthly fee to access the private-label site. In most cases, the syndication
      agreement provides for Smart Online to receive a percentage of these fees.
      Fees
      derived from such revenue sharing arrangements are recorded when earned. To
      date
      such revenue sharing fees have been negligible.





Integration
      fees consist primarily of fees charged to integration partners to integrate
      their products into the Smart Online syndication platform. Integrating
      third-party content and products has been a key component of Smart Online’s
      strategy to continuously expand and enhance the platform offered to its
      syndication partners and its own customer base. We generally invoice our
      customers in advance of the service period in annual or monthly installments
      and
      typical payment terms provide that our customers pay us within 30 days of
      invoice. Amounts that have been invoiced are recorded in accounts receivable
      and
      in deferred revenue and the revenue is recognized ratably over the specified
      lives of the contracts, commencing on the date the site goes on-line. We
      continue to evaluate and adjust the length of these amortization periods as
      we
      gain more experience with implementation schedules and contract cancellations.
      At present, Smart Online has insufficient historical data to determine if the
      relationship with its existing customers will extend beyond the initial term
      with the customer continuing to benefit from the advance fee. If Smart Online
      determines that existing and/or future contracts are expected to extend beyond
      the initial term whereby the customer continues to benefit from the advance
      fee,
      Smart Online would extend the revenue recognition period accordingly to include
      the extended term. Our contracts and support contracts are non-cancelable,
      though they provide for early termination upon a material breach by either
      party
      that is not cured in a timely manner. Should the contract terminate earlier
      than
      its term then we recognize the remaining deferred revenue upon termination.
      Based on that experience, it is possible that, in the future, the estimates
      of
      customer lives may change and, in such event, the period over which such
      syndication revenues are amortized would be adjusted. Any such change in
      specified contract lives would affect our future results of operations.
      Additionally, integration agreements typically include an upfront fee and a
      revenue sharing component. Fees derived from such revenue sharing arrangements
      are recorded when earned. To date such revenue sharing fees have been
      negligible.





7


Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      is
      received upfront. Our contracts and support contracts are non-cancelable, though
      customers typically have the right to terminate their contracts for cause if
      we
      fail to perform. We generally invoice our customers in annual or monthly
      installments and typical payment terms provide that our customers pay us within
      30 days of invoice. Amounts that have been invoiced are recorded in accounts
      receivable and in deferred revenue or revenue depending on whether the revenue
      recognition criteria have been met. In general, we collect our billings in
      advance of the service period. Online marketing, which consists of marketing
      services provided to our integration and syndication partners have in the past
      generated additional revenue. In addition, certain users have requested that
      Smart Online implement online marketing initiatives for them, such as promoting
      their products through Google or Overture Services. Online marketing has not
      been a material source of past income. We intend to seek an increase in the
      level of online marketing services in the future.





Web
      Services revenues are comprised of e-commerce sales directly to end-users,
      hosting and maintenance fees, e-commerce website design fees and online loan
      origination fees. E-commerce sales are made either on a subscription or a la
      carte basis. Subscription, which is access to most Smart Online offerings,
      is
      payable in advance on a monthly basis and is targeted at small companies or
      divisions of large companies. We will seek to grow our monthly subscription
      volume over the next 24 months as new versions of Smart Online’s platforms
      (OneBiz Conductor SM )
      are
      released.





Additionally,
      Smart Online receives a portion of third-party sales of products and services
      through revenue sharing arrangements, which involves a split of realized
      revenues. Hosting and maintenance fees are charged for supporting and
      maintaining the private-label portal and providing customer and technical
      support directly to our syndication partner’s users and are recognized on a
      monthly basis. E-commerce website design fees which are charged for building
      and
      maintaining corporate websites or to add the capability for e-commerce
      transactions are recognized over the life of the project. We have discontinued
      our third-party arrangement for online web design. We expect to resume this
      service after a new partner is under contract. Online loan origination fees
      are
      charged to provide users online financing options by which Smart Online receives
      payments for loan or credit provided. We intend to become more aggressive about
      promoting this line item in the future.





Subscription
      revenue is recognized ratably over the subscription period (usually one year).
      Third-party premium products are shared with integration partners.





OEM
      revenues are recorded based on the greater of actual sales or contractual
      minimum guaranteed royalty payments. Smart Online records the minimum guaranteed
      royalties monthly and receives payment of the royalties on a quarterly basis,
      30
      days in arrears. To the extent actual royalties exceed the minimum guaranteed
      royalties, the excess is recorded in the quarter Smart Online receives
      notification of such additional royalties.





*Barter
      Transactions* -
      Barter
      revenue relates to syndication and integration services provided by Smart Online
      to business customers in exchange for advertising in the customers’ trade
      magazines and on their Web sites. Barter expenses reflect the expense offset
      to
      barter revenue. The amount of barter revenue and expense is recorded at the
      estimated fair value of the services received or the services provided,
      whichever is more objectively determinable, in the month the services and
      advertising are exchanged. Smart Online applies APB 29, Accounting for
      Non-Monetary Transactions, the provisions of EITF 93-11, “Accounting for Barter
      Transactions Involving Barter Credits” and EITF 99-13 “Accounting for
      Advertising Barter Transactions” and, accordingly, recognizes barter revenues
      only to the extent that Smart Online has similar cash transactions within a
      period not to exceed six months prior to the date of the barter transaction.
      To
      date, the amount of barter revenue to be recognized has been more objectively
      determinable based on integration and syndication services provided rather
      than
      based upon the value of advertising received. For revenue from integration
      and
      syndication services provided for cash to be considered similar to the
      integration and syndication services provided in barter transactions, the
      services rendered must have been in the same media and similar term as the
      barter transaction. Further, the quantity or volume of integration or
      syndication revenue received in a qualifying past cash transaction can only
      evidence the fair value of an equivalent quantity or volume of integration
      or
      syndication revenue received in subsequent barter transactions. In other words,
      a past cash transaction can only support the recognition of revenue on
      integration and syndication contracts transactions up to the dollar amount
      of
      the cash transactions. When the cash transaction has been used to support an
      equivalent quantity and dollar amount of barter revenue, that transaction cannot
      serve as evidence of fair value for any other barter transaction. Once the
      value
      of the barter revenue has been determined, Smart Online follows the same revenue
      recognition principals as it applies to cash transactions with unearned revenues
      being deferred as described more fully above. At the time the barter revenue
      is
      recorded, an offsetting pre-paid barter advertising asset is recorded on Smart
      Online’s balance sheet. This pre-paid barter advertising asset is amortized to
      expense as advertising services are received such as when an advertisement
      runs
      in a magazine. Where more than one deliverable exists, such as when the barter
      partner is to provide advertising in four issues of a magazine, the expense
      is
      recognized pro-rata as the advertising deliverable is provided. Barter revenues
      totaled $160,477 and $5,000 for the three months ended June 30, 2005 and 2004,
      respectively. Barter revenues totaled $268,142 and $8,333 for the six months
      ended June 30, 2005 and 2004, respectively.








8


***Cash
      and Cash Equivalents*** -
      All
      highly liquid investments with an original maturity of three months or less
      are
      considered to be cash equivalents.





***Marketable
      Securities*** -
      Management determines the appropriate classification of investments in
      marketable securities at the time of purchase in accordance with Statement
      of
      Financial Accounting Standards No. 115. *Accounting
      for Certain Investments in Debt and Equity Securities* and
      reevaluates such determination at each balance sheet date. Securities, which
      are
      classified as available for sale at December 31, 2004, are carried at fair
      value, with the unrealized gains and losses, net of tax, reported as a separate
      component of stockholders’ equity. Fair value is determined based on quoted
      market rates. There were no unrealized gains or losses at December 31, 2004.
      Realized gains and losses and declines in value judged to be
      other-than-temporary on securities available for sale are included as a
      component of interest income. The cost of securities sold is based on the
      specific-identification method. Interest on securities classified as available
      for sale is also included as a component of interest income.





***Software
      Development Costs*** -
      Smart
      Online has not capitalized any direct or allocated overhead associated with
      the
      development of software products prior to general release. SFAS No. 86, *Accounting
      for the Costs of Software to be Sold, Leased or Otherwise
      Marketed* ,
      requires capitalization of certain software development costs subsequent to
      the
      establishment of technological feasibility. Based on the Company’s product
      development process, technological feasibility is established upon completion
      of
      a working model. Costs related to software development incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant.





***Impairment
      of Long Lived Assets*** -
      Long-lived assets and certain identifiable intangibles are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future net cash flows expected to be generated by the asset. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds the fair value
      of
      the assets. Assets to be disposed of are reported at the lower of the carrying
      amount or fair value less costs to sell.





***Property
      and Equipment*** -
      Property and equipment are stated at cost and are depreciated over their
      estimated useful lives, using the straight-line method as follows:





Office
                equipment
            5
                yearsFurniture
                and fixtures
            7
                yearsComputer
                software
            3
                yearsComputer
                equipment
            3
                yearsAutomobiles
            5
                years





***Intangible
      Assets*** -
      Intangible assets consists primarily of trademarks and are being amortized
      over
      their estimated useful lives.





***Fair
      Values*** -
      The
      fair values of cash equivalents, accounts receivable, accounts payable, accrued
      liabilities, and notes payable approximate the carrying values due to the short
      period of time to maturity.





***Accretion
      of Redemption Value of Redeemable Preferred Stock*** -
      The
      Company accreted the redemption value of redeemable preferred stock ratably
      over
      the minimum period such stock was outstanding. In addition, accrued but unpaid
      dividends were recorded to increase the carrying value of the redeemable
      preferred stock to the redemption value at maturity.





***Advertising
      Costs*** -
      Smart
      Online expenses all advertising costs as they are incurred. The amount charged
      to expense during the three months ended June 30, 2005 and 2004 were $53,518
      and
      $65,007, respectively. The amount charged to expense during the six months
      ended
      June 30, 2005 and 2004 were $189,852 and $54,482, respectively. The 2004 period
      reflects a credit related to prior advertising activities. These advertising
      costs included $46,250 and $41,250 of barter advertising expense for the three
      months ended June 30, 2005 and 2004, respectively, and $181,250 and $41,250
      for
      the six-months ended June 30, 2005 and 2004, respectively.





***Net
      Loss per Share-*** Basic
      loss per share is computed using the weighted-average number of common shares
      outstanding during the periods. Diluted 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 redeemable
      preferred stock, stock options and warrants that are computed using the treasury
      stock method. The Company excluded shares issueable upon the exercise of
      redeemable preferred stock, stock options and warrants from the calculation
      of
      common equivalent shares as the impact was anti-dilutive.





***Stock-Based
      Compensation*** -
      Smart
      Online accounts for its stock-based compensation plans in accordance with the
      intrinsic value provisions of Accounting Principles Board Opinion (“APB”) No.
      25, “Accounting for Stock Issued to Employees.” Stock Options are


9


generally
      granted at prices equal to the fair value of Smart Online’s common stock on the
      grant dates. Accordingly, Smart Online did not record any compensation expense
      in the accompanying financial statements for its stock-based compensation plans.
      Had compensation expense been recognized consistent with the fair value
      provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” Smart
      Online’s net loss attributed to common stockholders and net loss attributed to
      common stockholders per share for the quarters ended June 30, 2005 and 2004
      would have been changed to the pro forma amounts indicated below:




Three
                  Months Ended
              
              Six Months
                  Ended**June
                  30, 2005**
                (Restated)
              ****
              **June
                  30, 2004**
              ****
              **June
                  30, 2005**
                (Restated)
              ****
              **June
                  30, 2004**Net
                  loss attributed tocommon
                  stockholders:As
                  reported
              
              $
              (860,819
              )
              $
              (692,786
              )
              $
              (1,154,961
              )
              $
              (6,733,250
              )Add:
                  Compensation costrecorded
                  at intrinsic value
              
              
              -
              
              
              -
              
              
              -
              
              
              161,000Less:
                  Compensation cost usingthe
                  fair value method
              
              
              (62,352
              )
              
              (113,658
              )
              
              (96,404
              )
              
              (382,483
              )Pro
                  forma
              
              $
              (923,171
              )
              $
              (806,444
              )
              $
              (1,251,365
              )
              $
              (6,954,733
              )








**Three
                months ended**
            
            
            **Six
                months ended****June
                30, 2005**
            
            **June
                30, 2004**
            
            
            
            **June
                30, 2005**
            
            **June
                30, 2004**Reported
                net loss attributed tocommon
                stockholders:Basic
                and diluted
            
            $
            (0.07
            )
            $
            (0.06
            )
            
            $
            (0.10
            )
            $
            (0.75
            )Pro
                forma net loss per share:Basic
                and diluted
            
            $
            (0.07
            )
            $
            (0.08
            )
            
            $
            (0.10
            )
            $
            (0.77
            )





The
      fair
      value of option grants under Smart Online’s plan and other stock option
      issuances during the quarter and six months ended June 30, 2005 and 2004 were
      estimated using the Black-Scholes option-pricing model with the following
      weighted-average assumptions:





**Three
                Months Ended**
            
            **Six
                Months Ended****June
                30,**
              **2005**
            
            
            **June
                30,**
              **2004**
            
            **June
                30,**
              **2005**
            
            **June
                30,**
              **2004**Dividend
                yield
            
            0.
                00
            %
            
            
            0.
                00
            %
            
            0.
                00
            %
            
            0.
                00
            %Expected
                volatility
            
            33.06
            %
            
            
            0.00
            %
            
            0.00
                - 33.06
            %
            
            0.00
            %Risk
                free interest rate
            
            4.24
            %
            
            
            4.23
            %
            
            4..23
            %
            
            4.23
            %Expected
                lives (years)
            
            9.2
            
            
            
            5.0
            
            
            9.1
            
            
            5.0





***New
      Accounting Standards***





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
      Payment” (“SFAS 123(R)”). SFAS 123(R), a revision of SFAS 123, “Accounting for
      Stock-Based Compensation”, supersedes APB Opinion No. 25, “Accounting for Stock
      Issued to Employees”, and amends SFAS No. 95, “Statement of Cash Flows.” SFAS
      123(R) requires all share-based payments to employees, including grants of
      employee stock options, to be recognized in the financial statements based
      on
      their fair values. SFAS 123(R) is effective for the beginning of the annual
      period beginning after June 15, 2005. Therefore the Company plans to adopt
      SFAS
      123(R) on January 1, 2006. The Company is currently assessing the impact of
      this
      prospective change in accounting and believes that it will not have a material
      and adverse impact on the Company’s reported results of operations.





**2.
      Balance Sheets Accounts**





***Marketable
      Securities***





At
      December 31, 2004, marketable securities consisted of the
      following:





**Amortized**
              **Cost**
            
            
            **Fair
                Value**Municipal
                bonds - redeemed February 2005
            
            $
            395,000
            
            $
            395,000





10





Smart
      Online did not hold any marketable securities on June 30, 2005.





***Receivables***





Smart
      Online evaluates the need for an allowance for doubtful accounts based on
      specifically identified amounts that management believes to be uncollectible.
      Management also records an additional allowance based on certain percentages
      of
      its receivables over 90 days old, which are determined based on historical
      experience and management’s assessment of the general financial conditions
      affecting its customer base. If actual collections experience changes, revisions
      to the allowance may be required. Based upon the aforementioned criteria,
      management has determined that no provision for uncollectible accounts is
      required as of June 30, 2005 and December 31, 2004.





***Property
      and Equipment***





Property
      and equipment consists of the following at:





**June
                30,**
              **2005**
            
            
            **December
                31,**
              **2004**Office
                equipment
            
            $
            30,897
            
            $
            16,187Furniture
                and fixtures
            
            
            7,125
            
            
            7,125Computer
                software
            
            
            420,656
            
            
            393,629Computer
                equipment
            
            
            710,041
            
            
            663,723Automobiles
            
            
            29,504
            
            
            29,5041,198,223
            
            
            1,110,168Less
                accumulated depreciation
            
            
            (1,056,623
            )
            
            (1,034,532
            )Property
                and equipment, net
            
            $
            141,600
            
            $
            75,636





Depreciation
      expense for the three months ended June 30, 2005 and 2004 was $13,155 and
      $10,104, respectively. Depreciation expense for the six months ended June 30,
      2005 and 2004 was $11,093 and $10,104, respectively.





***Deferred
      Compensation***





Certain
      officers of Smart Online deferred a portion of their compensation, including
      commissions and interest charges on previously earned but unpaid compensation,
      from the second quarter of 2001 until September, 2003. In October 2003, these
      salary deferrals plus interest were converted to promissory notes (the “2003
      Notes”) in the aggregate amount of $1,049,765. These notes were payable on or
      before May 31, 2004 and bore interest at a rate of 15% per annum. During the
      fourth quarter of 2003 and the first quarter of 2004, these officers deferred
      an
      additional $141,771. Additionally, during this period $50,135 of the original
      notes payable were repaid. In April 2004, the holders of the 2003 Notes agreed
      to exchange the existing notes for new promissory notes payable on or before
      December 31, 2005. The principal amount of the new notes, $1,141,401, included
      the unpaid principal from the original notes plus the subsequent deferrals.
      Subsequently during 2004, $160,904 was repaid against the successor notes and
      an
      additional $2,302 of compensation was deferred. The successor notes bore
      interest at a rate of 15% per annum through June 1, 2004 at which time the
      holders voluntarily reduced the rate to 8% per annum. On April 30, 2004, the
      2004 Notes were extended until May 31, 2005, but later during 2004 the officers
      entered into standstill agreements not to demand payment until June 30, 2006.
      The standstill agreement was again amended on December 22, 2004, to provide
      that
      demand for payment could be made upon the earlier of June 30, 2006 or the
      closing after January 1, 2005 of a financing with gross proceeds to Smart Online
      of $2,000,000 or more. After Smart Online raised $2,500,000 from a sale of
      securities to a foreign investor in February 2005, Smart Online paid in full
      the
      $949,777 of deferred compensation, plus all accrued interest of $154,288, and
      cancelled the related promissory notes to these officers.





**3.
      Stockholders’ Equity (Deficit)**





***Common
      Stock***





During
      February and March 2005, Smart Online sold 580,000 shares of common stock
      resulting in gross proceeds of $2.9 million to foreign investors in sales exempt
      under Regulation S. A portion of those funds were used to repay deferred
      compensation, including interest thereon, as more fully discussed in Note 2.
      In
      connection with this financing, Smart Online incurred stock issuance costs
      of
      $290,000. In connection with this financing, Smart Online issued to one of
      the
      investors a warrant to purchase 50,000 shares of common stock in consideration
      for the investor agreeing to certain restrictions on its ability to sell the
      shares. These warrants have an exercise price of $5 per share and terminate
      on
      January 1, 2007. During March 2005, Smart Online raised an additional $125,000
      in gross proceeds from the sale of 25,000 shares of common stock at $5.00 per
      share in a private placement.


11








In
      connection with the aforementioned private placement conducted during March
      2005, Smart Online and the investors executed registration rights agreements.
      One of these registration rights agreements requires Smart Online to pay
      investors 0.5% of their investment for each thirty-day period after April 30,
      2005 in which Smart Online failed to file a registration statement registering
      shares sold in the private placement, which amount is prorated for partial
      30-day periods. During the second quarter of 2005, the Company accrued $5,338
      as
      a dividend to the investor.





***Warrants***





During
      February 2005, a consulting firm that was issued 350,000 warrants in November
      2003 acquired 50,000 shares of Smart Online’s Common Stock as a result of the
      cashless exercise of warrants. Warrants to purchase 67,568 shares of Common
      Stock were cancelled in this cashless exercise. The fair market value of Smart
      Online’s Common Stock at the time of exercise was $5.00. During May 2005, this
      same consulting firm acquired 48,617 shares of Smart Online’s Common Stock as a
      result of the cashless exercise of warrants. Warrants to purchase 62,432 shares
      of Common Stock were cancelled in this cashless exercise. The fair market value
      of Smart Online’s Common Stock at the time of exercise was $5.875. At June 30,
      2005, 220,000 of the warrants issued in November 2003 were still
      outstanding .




***Stock
      Option Plans***





Smart
      Online maintains three equity compensation plans.





The
      following is a summary of the status of the plan and stock option
      activity:





**Shares**
            
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                December 31, 2004
            
            
            1,768,900
            
            $
            2.78Granted
            
            
            307,500
            
            
            5.31Exercised
            
            
            (16,500
            )
            
            3.50Forfeited
            
            
            (350,500
            )
            $
            1.82BALANCE,
                June 30, 2005
            
            
            1,709,400
            
            $
            4.69





The
      following table summarizes information about stock options outstanding at June
      30, 2005:





**Currently
                Exercisable****Exercise**
              **Price**
            **Number
                of**
              **Shares**
              **Outstanding**
            **Average**
              **Remaining**
              **Contractual
                Life**
              **(Years)**
            **Weighted**
              **Average
                Exercise**
              **Price**
            **Number
                of**
              **Shares**
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
                1.30 - $ 1.43
            670,000
            3.5
            $
                1.40
            670,000
            $
                1.40$
                3.50
            497,500
            8.8
            $
                3.50
            186,730
            $
                3.50$
                5.00
            493,900
            5.5
            $
                5.00
            234,400
            $
                5.00$
                7.00
            48,000
            9.9
            $
                7.00
            -
            $
                7.00$
                1.30 - $ 7.00
            1,709,400
            5.8
            $
                3.21
            1,091,130
            $
                2.53





***Dividends***





Smart
      Online has not paid any cash dividends through June 30, 2005.


12





**4.
      Major Customers and Concentration of Credit Risk**





Smart
      Online derives a significant portion of its revenues from certain customer
      relationships. The following is a summary of customers that represent greater
      than ten percent of total revenues:





3
                Months Ended June 30, 2005Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Integration/Barter
            
            $
            82,500
            
            
            20.3
            %Customer
                B
            
            
            Integration
            
            
            50,000
            
            
            12.3
            %Customer
                C
            
            
            Integration
            
            
            51,183
            
            
            12.6
            %Customer
                D
            
            
            Syndication/Barter
            
            
            46,250
            
            
            11.4
            %Others
            
            
            Various
            
            
            176,183
            
            
            43.4
            %Total
            
            
            
            
            $
            406,116
            
            
            100.0
            %





3
                Months Ended June 30, 2004Revenues
            
            %
                of Total
              RevenuesCustomer
                E
            
            
            Integration
            
            $
            82,513
            
            
            35.0
            %Customer
                F
            
            
            Integration
            
            
            25,000
            
            
            10.1
            %Customer
                G
            
            
            Integration
            
            
            25,000
            
            
            10.1
            %Others
            
            
            Various
            
            
            103,332
            
            
            43.8
            %Total
            
            
            
            
            $
            235,845
            
            
            100.0
            %





6
                Months Ended June 30, 2005Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Integration/Barter
            
            $
            123,750
            
            
            18.8
            %Customer
                B
            
            
            Integration
            
            
            75,000
            
            
            11.4
            %Customer
                D
            
            
            Syndication/Barter
            
            
            80,938
            
            
            12.3
            %Others
            
            
            Various
            
            
            379,666
            
            
            57.5
            %Total
            
            
            
            
            $
            659,354
            
            
            100.0
            %





6
                Months Ended June 30, 2004Revenues
            
            %
                of Total
              RevenuesCustomer
                E
            
            
            Integration
            
            $
            165,025
            
            
            34.0
            %Customer
                F
            
            
            Integration
            
            
            50,000
            
            
            10.3
            %Customer
                G
            
            
            Integration
            
            
            50,000
            
            
            10.3
            %Others
            
            
            Various
            
            
            220,548
            
            
            45.4
            %Total
            
            
            
            
            $
            485,573
            
            
            100.0
            %





At
      June
      30, 2005, Smart Online had one customer that accounted for 36% of accounts
      receivable and a second customer that accounted for the remaining 64% of
      accounts receivable. One of these customers accounted for substantially all
      of
      the accounts receivable at December 31, 2004.





**5.**  **Related
      Party Transactions**





American
      Investment Holding Group, Inc., which is wholly-owned by two officers of Smart
      Online, owns approximately 23% of the outstanding Common Stock of Smart Online
      as of June 30, 2005. The same officers also own a controlling interest in other
      companies, some of which companies own Smart Online Common
      Stock.


13








An
      officer of Smart Online and a trust established by this officer for the benefit
      of his children have from time to time provided loans to Smart Online. As of
      January 1, 2004, Smart Online owed these parties $47,798 related to outstanding
      loans. During the first six months of 2004, the Company borrowed an additional
      $186,335 and repaid the entire remaining outstanding balance of $186,335. As
      of
      September 30, 2004 all borrowings from and loans to the officer and the trust
      were repaid in full. Until October 2003, the Company did not pay any interest
      on
      these loans, thereafter the loans accrued interest at a rate of
      15.0%.





During
      2004 and 2005, Smart Online contracted with a consulting firm owned by an
      individual who was an officer of the Company at the time to provide strategic
      international sales and marketing services. Smart Online paid consulting fees
      of
      $17,500 during both the first quarter of 2005 and 2004 related to these
      services. Additionally, Smart Online paid the same consulting firm $2,500
      related to the sale of certain shares of Common Stock during the first quarter
      of 2004. This consulting agreement was terminated in March, 2005.





On
      August
      13, 2002, Smart Online entered into an integration agreement with SIL, a company
      owned by a shareholder of Smart Online, to incorporate its products into Smart
      Online’s platform. As part of this agreement, SIL paid Smart Online $300,000 for
      such integration, and the parties agreed to share future revenues generated
      from
      the sales of the products. On August 30, 2002, the parties signed an amendment
      to the original agreement, in order for Smart Online to provide SIL certain
      co-development services, which includes instant messenger and video
      conferencing. In exchange, SIL paid Smart Online an additional sum of $300,000.
      The parties further agreed that the products developed as a result of both
      companies’ efforts will be owned by both parties. On April 30, 2003, Smart
      Online and SIL signed a new amendment and restated the integration program
      agreement. According to this new amendment and restated agreement, Smart Online
      agreed to fund the future development of the products. In exchange, SIL agreed
      to limit future amounts payable by Smart Online under the original shared
      revenue agreement to $1.7 million.





In
      addition to the above agreements, on August 30, 2002, Smart Online and SIL
      also
      entered into a reseller agreement whereby SIL paid the sum of $200,000 for
      the
      right to distribute Smart Online’s products in the territories of Israel, the
      United Kingdom, France, Italy, Netherlands, and Spain, in exchange for Smart
      Online’s marketing support and a twenty percent commission from the gross sales
      generated by SIL. On March 17 and 27, 2003, the parties subsequently modified
      the original re-seller agreement to restrict the territory to only Israel and
      Netherlands. Additionally, on December 22, 2003, Smart Online signed a private
      label syndication agreement with SIL to provide website development for SIL’s
      website.





Smart
      Online also paid SIL $90,000 pursuant to their contract dated December 20,
      2003
      for technical co-development work on a monthly payment of $15,000 starting
      in
      December of 2003 and ending in May of 2004.





In
      March
      2004, SIL ceased further development of its technology and laid-off its
      employees. SIL is currently seeking opportunities to license or sell its
      technology. The Company continues to support this technology on behalf of SIL.
      The revenues derived from this agreement with SIL were recognized as income
      on a
      straight line basis over the life of the agreement. Smart Online recognized
      $330,050 of revenue related to the aforementioned integration, co-development
      and reseller agreements during 2004.





During
      the first half of 2004, Smart Online paid $158,384 to the Small Business Lending
      Institute (SBLI), of which an officer of Smart Online is also an officer and
      in
      which another officer of Smart Online is a minority shareholder, because SBLI
      paid Smart Online’s employees during the first quarter of 2004 while Smart
      Online was dealing with a tax matter with the Internal Revenue
      Service.





The
      following is a summary of related party revenues for the three months and six
      months ended June 30, 2005 and 2004:








Three
                Months Ended
            
            
            Six Months
                EndedJune 30,
                2005
            
            
            June
                30, 2004
            
            
            June
                30, 2005
            
            
            June
                30, 2004Smart
                II, Ltd. ("SIL"), formerly
              known
                as Smart Revenue Europe Ltd.- Integration fees
            
            $
            -
            
            $
            82,512
            
            $
            -
            
            $
            165,025Total
                Related Party Revenues
            
            $
            -
            
            $
            82,512
            
            $
            -
            
            $
            165,025








14





The
      following is a summary of related party expenses for the three months and six
      months ended June 30, 2005 and 2004:





Three
                Months Ended
            
            Six
                Months EndedJune
                30, 2005
            
            June
                30, 2004
            
            June
                30, 2005
            
            June
                30, 2004Nen,
                Inc. - consulting fees included
              in
                sales and marketing expense
              related
                to strategic international sales and marketing services
            
            $
            -
            
            $
            17,500
            
            $
            17,500
            
            $
            35,000Nen,
                Inc. - consulting fees included
              in
                general and administrative
              expense
                related to assisting Smart
              Online
                with obtaining additional
              equity
                financing
            
            
            -
            
            
            28,500
            
            
            -
            
            
            31,000Small
                Business Loan Institute -
              consulting
                fees included in general
              and
                administrative expense
            
            
            -
            
            
            -
            
            
            -
            
            
            30,000Smart
                II, Ltd. - Moving expenses,
              reseller
                payment, and technical co-
              development
                work
            
            
            -
            
            
            30,000
            
            
            -
            
            
            75,000Interest
                expense incurred on
              loans
                from officer
            
            
            
            
            
            1,526
            
            
            
            
            
            4,649Total
                Related Party Revenues
            
            $
            -
            
            $
            77,526
            
            $
            17,500
            
            $
            175,649





**6.
      Commitments and Contingencies**





Smart
      Online is subject to claims and suits that arise from time to time in the
      ordinary course of business. During
      the second quarter of 2005, Smart Online settled claims with two former
      commercial business partners. The first claim asserted that Smart Online owed
      $92,204 for advertising which Smart Online asserted was faulty. Smart Online
      settled this claim in April 2005, paid the other party $50,000, and the case
      was
      dismissed with prejudice. As a result of this settlement, Smart Online recorded
      a gain on legal settlements of $42,293. In the second claim, Smart Online was
      being sued for breach of contract, unfair and deceptive trade practices, and
      punitive damages, alleging that Smart Online improperly refused to refund a
      $32,500 integration fee. Smart Online settled this claim in May 2005 by paying
      $30,000 and the case was dismissed with prejudice.





Smart
      Online did not pay its payroll taxes for the period of the fourth quarter of
      2000 through the fourth quarter of 2003. In March 2004, Smart Online notified
      the Internal Revenue Service of its delinquent payroll tax filings and
      voluntarily paid the outstanding balance of its payroll taxes in the amount
      of
      $1,003,830 plus accrued interest of $122,655 to the Internal Revenue Service.
      The Internal Revenue Service notified Smart Online that it owed penalties plus
      accrued interest related to the above matter. At December 31, 2004, Smart Online
      had recorded a liability for accrued penalties and interest of $573,022. On
      February 18, 2005, the Internal Revenue Service agreed to accept Smart Online’s
      offer in compromise (Form 656) in settlement of all of Smart Online’s
      outstanding federal tax liabilities. Pursuant to the terms of the agreement,
      Smart Online, Inc. agreed to pay $26,100, surrender all credits and refunds
      for
      2005 or earlier tax periods, and remain in compliance with all federal tax
      obligations for a term of five years. Smart Online paid $26,100 to the Internal
      Revenue Service on February 25, 2005, as required under the settlement terms.
      As
      a result of the settlement, Smart Online recorded a gain on legal settlement
      of
      approximately $547,000 during the first quarter of 2005.




**7. 
Restatement**
  Smart
          Online, in consultation with BDO, has determined that it incorrectly
          applied certain provisions of EITF 00-19, *Accounting for Derivative
          Financial Instruments Indexed to, and Potentially Settled in, a Company's
          Own
          Stock.*  Specifically, Smart Online incorrectly recorded $506,000 of
          general and administrative expense during the second quarter of 2005 related
          to
          a mark to market adjustment of certain warrants. Since these warrants were
          part
          of permanent equity, Smart Online should not have applied the mark to market
          provisions of EITF 00-19. Accordingly, the net loss for the quarter ended
          June 30, 2005 has been reduced by $506,000.


15
  The
            restatements for the quarter and six months ended June 30, 2005 are summarized
            as follows:
  **Balance
              sheets:**
  June
                        30, 2005Previously
                    
                    Asreported
                    
                    restatedAdditional
                        paid-in capital
                    
                    
                    38,506,363
                    
                    
                    38,000,363Accumulated
                        deficit
                    
                    
                    (38,398,853
                    )
                    
                    (37,892,853
                    )
 **Statements
            of operations:**
  Three
                      months ended
                  
                  Six
                      months endedJune
                      30, 2005
                  
                  June
                      30, 2004Previously
                  
                  As
                  
                  Previously
                  
                  Asreported
                  
                  restated
                  
                  reported
                  
                  restatedGeneral
                      and administrative expense
                  
                  $
                  1,230,162
                  
                  $
                  724,162
                  
                  $
                  1,749,198
                  
                  $
                  1,243,198Total
                      operating expenses
                  
                  
                  1,764,511
                  
                  
                  1,258,511
                  
                  
                  2,833,506
                  
                  
                  2,327,506Loss
                      from operations
                  
                  
                  (1,380,306
                  )
                  
                  (874,306
                  )
                  
                  (2,833,506
                  )
                  
                  (1,721,790
                  )Net
                      loss
                  
                  
                  (1,366,816
                  )
                  
                  (860,816
                  )
                  
                  (1,660,961
                  )
                  
                  (1,154,961
                  )Net
                      loss attributed to common stockholders
                  
                  
                  (1,366,819
                  )
                  
                  (860,819
                  )
                  
                  (1,660,964
                  )
                  
                  (1,154,964
                  )Net
                      loss attributed to common stockholders - basic and diluted
                  
                  $
                  (0.11
                  )
                  $
                  (0.07
                  )
                  $
                  (0.14
                  )
                  $
                  (0.10
                  )
  **8.
            Subsequent Events**
 
 ***Sales
            of Common Stock***
 
 During
            July 2005, Smart Online sold 90,909 shares of its common stock to an
            existing
            investor for a price of $5.50 per share resulting in gross proceeds of
            $500,000.
            Also during July 2005, Smart Online sold an additional 36,363 shares
            to a new
            investor resulting in gross proceeds of $199,997. Smart Online incurred
            issuance
            costs totaling $70,000 related to these stock sales. Additionally, in
            connection
            with these offerings, Smart Online entered into Registration Rights Agreements
            with these shareholders under which Smart Online is required to file
            a
            registration statement with the SEC to register the shares sold in the
            offering
            no later than September 30, 2005.




16








***Stock
      Option Activity***





During
      July 2005, Smart Online granted options to purchase 721,250 shares of common
      stock to employees and officers and an additional 20,000 options to members
      of
      the Board of Directors. These options contain an exercise price of $8.61 per
      share. Also during July 2005, options to purchase 150,000 shares at a weighted
      average exercise price of $5.00 per share expired unexercised.





***Pending
      Acquisitions***





During
      July 2005, Smart Online signed a non-binding letter of intent to acquire a
      privately held developer and distributor of customer relationship management
      software based in the mid-western United States. Under the terms of the letter
      of intent, Smart Online will issue the seller 500,000 shares of Smart Online
      common stock and assume certain liabilities of the seller. Smart Online is
      currently performing due diligence on this potential acquisition and anticipates
      that the acquisition will not close until September or October 2005 pending
      the
      outcome of its due diligence procedures and execution of definitive documents.
      Because due diligence and negotiations have not been completed, there is no
      assurance this transaction will be completed.





Also
      during July 2005, Smart Online signed a non-binding letter of intent to acquire
      a privately held developer and distributor of multi-channel commerce systems
      based in the Great Lakes region of the United States. Under the terms of the
      letter of intent, Smart Online will pay the seller $5.1 million, payable 66%
      in
      cash and 34% in shares of Smart Online common stock. The cash portion of the
      purchase price is payable in two halves, the first half of which is payable
      in
      four equal installments on the first business day of each quarter for four
      calendar quarters with the first payment due on the first day of the fiscal
      quarter following closing, and the second half of which is payable in cash
      on
      January 5, 2007. In addition, Smart Online is to pay $780,000 for noncompetition
      agreements to key personnel of the acquired company in eight equal quarterly
      installments during the two years after the closing. Smart Online is currently
      performing due diligence on this potential acquisition and anticipates that
      the
      acquisition will not close until September or October 2005 pending the outcome
      of its due diligence procedures and execution of definitive documents. Because
      due diligence and negotiations have not been completed, there is no assurance
      this transaction will be completed.








**Item
      2. MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS (including Risk Factors)**





*The
      following discussion in Management’s Discussion and Analysis of Financial
      Condition as Results of Operations (“MD&A”) and elsewhere in this report
      contains forward-looking statements within the meaning of Section 27A of the
      Securities Act of 1933 and Section 12E of the Securities Exchange Act of 1934.
      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 foreign currency exchange rate and 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
“expects,““anticipates,”“projects,”“intends,”“plans,”“estimates,” variations of
      such words, and similar expressions are also 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 below, under “Risk Factors” and elsewhere in this report, for factors
      that may cause actual results to be different than those expressed in these
      forward-looking statements. Except as required by law, we undertake no
      obligation to revise or update publicly any forward-looking statements for
      any
      reason.*





**Overview**




The
        results of operations presented below reflect certain restatements to our
        previously reported results of operations for the three and six months ended
        June 30, 2005.  See Note 7 of the Notes to Financial
        Statements.






Smart
      Online develops and markets Internet-delivered or Software-as-Services (SaS)
      software applications and data resources to start, run, and grow small
      businesses. Many of our users are provided free use of our products. We reach
      small businesses through our own website www.smartonline.com and through
      private-label syndication arrangements with large corporations that
      private-label the Smart Online offering through their corporate web sites.
      Our
      syndication relationships provide a cost- and time-efficient way to market
      to
      the extremely large and diverse small business sector.





Smart
      Online has developed numerous sources of revenue as its business plan has
      changed to adapt to changing business circumstances. These sources of revenue
      include syndication partners, integration partners, OEMs, subscriptions from
      small businesses, one-time purchases by small businesses and barter transactions
      with media companies. Currently, each of these revenue streams is not
      substantial. Our business plan is designed to utilize existing and future
      relationships in each revenue source to increase the amount of revenue we derive
      from all sources. We have described below the key elements of how we plan to
      achieve this.


17





Incorporated
      in Delaware in 1993, Smart Online pioneered the market for small business
      software applications. Our initial offerings were sold as shrink-wrapped
      products through major retail chains such as Staples, Office Depot and Egghead
      Software. Since 2000, our products have been primarily offered through an
      Internet-based platform. Smart Online also pioneered the syndication or
      private-label distribution model to more efficiently and effectively reach
      the
      large and diverse small business sector. Market analyst firm Summit Strategies
      says, “Smart Online’s proprietary distribution platform enables the vendor to
      quickly customize for and integrate with its partners’ services, making their
      joint services accessible to customers via a single sign-on.”





Smart
      Online is currently developing the next generation of its services portal,
      called OneBiz Conductor SM ,
      which
      will include significant enhancements to the technology platform and add
      additional applications to our product offerings. We plan to accomplish this
      through a combination of internal development, joint development, licensing
      from
      other companies, and acquisitions. OneBiz Conductor SM will
      be
      released in three versions. The first version was released during the first
      quarter of 2005. The second and third versions are expected to be released
      at
      the end of the third quarter of 2005 and the end of the fourth quarter of 2005,
      respectively.





Our
      objective is to be a leading provider of on-demand business software application
      services for small businesses. We also believe that, when we complete
      development of OneBiz Conductor SM later
      this year, our products may be more attractive to middle size companies with
      up
      to 500 employees. At that time, we intend to begin marketing to such middle
      size
      companies. To address the significant market opportunity, our management team
      is
      focused on a number of short and long-term challenges, including strengthening
      and extending our service offerings, converting our registered users to paying
      customers, and expanding our sales efforts. Conversion of registered users
      to
      paying customers will begin when we release the second version of OneBiz
      Conductor SM which
      we
      expect will occur before the end of the third quarter of 2005.





Since
      2000, Smart Online’s major focus has been on developing and validating our
      online content, applications, services, delivery platform and user interface.
      To
      validate the platform, services, and products, many customers received access
      to
      the Smart Online products and portal free-of-charge in exchange for their
      evaluation and feedback. We have also used a number of different marketing
      approaches to test and validate the best techniques to acquire and retain small
      business customers.





With
      this
      validation and analysis nearly complete, we intend to increase our focus on
      revenue generation. Smart Online has recently begun to develop targeted programs
      to market and sell the Smart Online offerings. These efforts are targeted to
      direct customer acquisition and retention, recovery of former customers and
      closing on new syndication partnerships.





During
      fiscal 2004, Smart Online entered into several new syndication and integration
      agreements totaling approximately $1.2 million, including $640,000 of barter
      transactions. During the first half of 2005, Smart Online continued its efforts
      to expand its syndication and integration partnership reach. These efforts
      resulted in the Company signing an agreement with Capital One during April
      2005.
      We are planning to substantially increase our advertising and marketing in
      future years. We have started to enter into new syndication partnerships that
      target strategic partners for bartering arrangements for advertising and joint
      marketing programs to take advantage of discounted advertising rates and to
      provide an opportunity for us to share in the revenue generated by our
      syndication partners from use of our platform. We began targeting small business
      media companies during the first quarter of 2004, such as Inc. Magazine,
      FastCompany Magazine, and BusinessWeek, which have small-business customer
      bases. Smart Online anticipates the revenue share arrangements with the media
      companies will enable it to increase web services revenue for both Smart Online
      and its private label syndication partners as we begin to share in the revenue
      our partners generate from their websites. We expect to create these
      arrangements in the future with media companies which offer the ability to
      reach
      small-business customers and assist in off-setting Smart Online’s cash
      expenditures for print and online advertising and marketing. While we intend
      to
      derive a majority of our syndication revenue from traditional non-barter
      transactions, we will evaluate barter transactions on a case-by-case basis
      when
      we believe such transactions make economic or strategic sense. Pursuant to
      the
      requirements of Emerging Issues Task Force (EITF) No. 93-11, “Accounting for
      Barter Transactions Involving Barter Credits,” and EITF 99-13, “Accounting for
      Advertising Barter Transactions,” Smart Online recognized approximately $268,142
      and $8,333 of barter revenue in the first half of 2005 and 2004,
      respectively.





To
      increase our revenues and take advantage of our market opportunity, we will
      need
      to add substantial numbers of paying subscribers. We define paying subscriptions
      as unique user accounts. We plan to re-invest earnings for the foreseeable
      future in the following ways: hiring additional personnel, particularly in
      marketing and sales; expanding marketing and sales activities; increasing our
      research and development activities to upgrade and extend our service offerings
      and to develop new services and technologies; adding to our infrastructure
      to
      support our growth; and formalizing our operational and financial systems to
      manage a growing business.





We
      expect
      sales and marketing costs to increase substantially in dollars and as a percent
      of total expenses commencing with the second half of 2005 as we prepare for
      the
      launch of the second and third versions of OneBiz Conductor SM later
      this year and as we seek to add and manage more paying subscribers, build brand
      awareness and increase the number of marketing and sales programs implemented.
      We expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenues from sales of subscriptions.  We expect
      the second version of OneBiz ConductorSM will be released on or
      before September 30, 2005, except that all or part of the accounting application
      software may not be released until during the fourth quarter.  The third
      version of OneBiz Conductor SM  including enhanced accounting
      software, is expected to be released before the end of 2005.


18





**Fiscal
      Year**





Our
      fiscal year ends on December 31. References to fiscal 2005, for example, refer
      to the calendar year ending December 31, 2005.





**Sources
      of Revenue**





Smart
      Online currently derives revenues from the following sources:





·
            Syndication
                Fees - fees consisting of:





o
            Fees
                charged to syndication partners to create a customized private-label
                site.





o
            Barter
                revenue derived from syndication agreements with media
                companies.





·
            Integration
                Fees - fees charged to partners to integrate their products into
                the Smart
                Online syndication platform. Integrating third-party content and
                products
                has been a key component of Smart Online’s strategy to continuously expand
                and enhance its platform offered to syndication partners and its
                own
                customer base.





·
            Web
                Services fees - comprised of the
                following:





o
            E-commerce
                sales directly to end-users:





·
            Subscription





·
            Multiuser
                subscription paid by enterprises for their business
                customers





·
            A
                la carte





·
            E-commerce
                revenue sharing with integration
                partners





o
            Hosting
                and maintenance fees





o
            E-commerce
                Website Design and Build





o
            Loan
                origination fees





o
            Online
                marketing to our syndication/integration
                partners





o
            Marketing
                fee for loan request through the integrated
                platform





·
            OEM
                agreements with third-party computer manufacturers for various individual
                Smart Online applications.





·
            Other
                Revenues - Includes revenues generated from consulting fees and the
                sale
                of legacy shrink-wrapped products.





Smart
      Online also plans to seek new sources of revenue, including the following
      sources:





·
            Technology
                Platform Licensing Revenue - We plan to seek to generate revenue
                from
                licensing our technology platform.





·
            Advertising
                Revenue - We plan to add direct advertising revenue in the
                future.





During
      2004, we entered into several new syndication and integration partnerships
      with
      targeted strategic partners, whereby we will receive a percentage of the revenue
      generated by our partners from their websites. The Company also signed an
      agreement with Capital One during April 2005. Certain of these agreements also
      included bartering arrangements for advertising and joint marketing


19


programs
      to take advantage of discounted advertising rates and to provide an opportunity
      for revenue sharing. With these new partnerships more than 4 million small
      businesses utilize the websites of our syndication partners for various
      purposes. We intend to focus our future marketing and sales efforts on selling
      our products to the users of the websites of our syndication partners. Smart
      Online embarked on this program after other companies, including Google,
      Overture, and Career Builder, successfully implemented revenue share strategies
      where media companies provide these services to their customers to increase
      revenue for both companies. Smart Online began targeting small business media
      companies during the first quarter of 2004. We estimate our revenue share
      arrangements with the media companies will enable us to increase web services
      revenue for both Smart Online and our private label syndication partners. Smart
      Online expects to create arrangements in the future with media companies to
      assist in reducing Smart Online’s outlay of cash for more costly print and
      online advertising and marketing. While we intend to derive a majority of our
      syndication revenue from traditional non-barter transactions, we will evaluate
      barter transactions on a case-by-case basis when we believe such transactions
      make economic or strategic sense. During 2004, Smart Online signed syndication
      contracts with Inc. Magazine, FastCompany Magazine, and BusinessWeek. In
      addition we have embarked on a telesales effort to upsell current users to
      additional Smart Online services and to bring former users back to Smart
      Online.





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      is
      received upfront. Our contract and support contracts are non-cancelable, though
      customers typically have the right to terminate their contracts for cause if
      we
      fail to perform. We generally invoice our paying customers in annual or monthly
      installments and typical payment terms provide that our customers pay us within
      30 days of invoice. Amounts that have been invoiced are recorded in accounts
      receivable and in deferred revenue or revenue depending on whether the revenue
      recognition criteria have been met. In general, we collect our billings in
      advance of the service period. Online marketing, which consists of marketing
      services provided to our integration and syndication partners have in the past
      generated additional revenue. In addition, certain users have requested that
      Smart Online implement online marketing initiatives for them, such as promoting
      their products through Google or Overture Services. Online marketing has not
      been a material source of past income. We intend to seek an increase in the
      level of online marketing services in the future.





Web
      Services revenues are comprised of e-commerce sales directly to end-users,
      hosting and maintenance fees, e-commerce website design fees and online loan
      origination fees. E-commerce sales are made either on a subscription or a la
      carte basis. Subscription, which is access to most Smart Online software and
      content services, is payable in advance on a monthly basis and is targeted
      at
      small companies or divisions of large companies. We will seek to grow our
      revenue, including monthly subscription volume, substantially over the next
      24
      months as new versions of Smart Online’s platform (OneBiz Conductor SM )
      are
      released. To date, most of our users have been given free use of our products.
      We plan to change that policy when we release the second version of OneBiz
      Conductor SM ,
      which
      is planned to occur at the end of the third quarter of 2005. We expect that
      the
      monthly subscription fees will typically be $29.95 to $49.95 for new subscribers
      direct through www.smartonline.com and that
      there may be an introductory free trial period. We expect lower fees from
      subscribers at the private label syndication websites of our partners.
      Currently, we pay most of our syndication partners a percentage of the revenue
      we derive from their private label syndication websites, which amounts we report
      as a component of our sales and marketing expense. A la carte pricing, which
      allows customers to purchase one-time use of a specific software or content
      services, ranges from $10 to $300, which can include third-party charges when
      applicable, such as state and federal fees associated with incorporating a
      business or additional fees associated with having a press release written
      and
      revised.  We are currently evaluating inclusion in the second and
      third versions of OneBiz ConductorSMthe accounting software
      applications developed by another company.  This may delay the release
      of the accounting software of the second version of OneBiz
      ConductorSM until the fourth quarter of 2005.  Such delay
      may cause a delay in our ability to sell subscriptions on the accounting
      software is an important part of the second version of OneBiz
      ConductorSM.





Additionally,
      Smart Online receives a portion of third-party sales of products and services
      through revenue sharing arrangements, which involves a split of realized
      revenues. We charge hosting and maintenance fees for supporting and maintaining
      the private-label portal of our syndication partners and for providing customer
      and technical support directly to our syndication partners’ users. We recognize
      this revenue on a monthly basis. E-commerce website design fees, which are
      charged for building and maintaining corporate websites or to add the capability
      for e-commerce transactions, are recognized over the life of the project. We
      have discontinued our third-party arrangement for online web design. We expect
      to resume this service after a new partner is under contract. Online loan
      origination fees are charged to provide users online financing option by which
      Smart Online receives payments for loans or credit provided by our partners.
      We
      intend to become more aggressive about promoting this line item in the
      future.





Technology
      Platform License Revenue: Smart Online is in the process of determining whether
      its technology platform can become a licensable product for applications and
      content providers interested in creating their own syndication and online
      delivery business model. It is too early in our evaluation process to determine
      whether this will develop into another source of revenue.





Revenues
      from OEM arrangements are reported and paid to Smart Online on a quarterly
      basis
      based on actual sales, subject to certain contractual minimum
      volumes.





Other
      revenues consist primarily of traditional shrink-wrap sales, which are not
      a
      core revenue source for Smart Online. We expect that consulting fees, which
      in
      the past have generated significant revenues, will not be a material revenue
      source in the future.


20





**Revenue
      From Related Parties**





Approximately
      33.0% of total revenues for the quarter ended June 30, 2004 were from a single
      customer, Smart IL Ltd. (“SIL”), formerly known as Smart Revenue Europe Ltd., an
      Israeli based software company that specialized in secured instant messaging
      products. During March 2004 SIL ceased further development of its technology
      and
      laid-off all employees after SIL completed development of, and delivered to
      us,
      its instant messenger product. SIL is currently seeking to license or sell
      its
      technology; however, we do not expect to receive substantial revenue from SIL
      in
      the future. SIL is owned by Doron Roethler, a shareholder of Smart Online.
      Smart
      Online did not derive any revenue from related parties during the first half
      of
      2005.





The
      following is a summary of related party revenues:





Three
                Months Ended
            
            Six
                Months EndedJune
                30, 2005
            
            June
                30, 2004
            
            June
                30, 2005
            
            June
                30, 2004Smart
                IL, Ltd. ("SIL"), formerly
              known
                as Smart Revenue Europe Ltd.- Integration fees
            
            $
            -
            
            $
            82,512
            
            $
            -
            
            $
            165,025Total
                Related Party Revenues
            
            $
            -
            
            $
            82,512
            
            $
            -
            
            $
            165,025





Smart
      Online does not expect revenue from related parties to be a significant part
      of
      Smart Online’s future revenues. If Smart Online fails to replace revenue from
      related parties with revenue from unrelated parties, Smart Online’s revenue will
      decrease.





**Cost
      of Revenues**





*Cost
      of Revenues* .
      To date
      Smart Online has not capitalized any costs associated with the development
      of
      its products and platform. Smart Online has not capitalized any direct or
      allocated overhead associated with the development of software products prior
      to
      general release. SFAS No. 86, “Accounting for the Costs of Software to be Sold,
      Leased or Otherwise Marketed”, requires capitalization of certain software
      development costs subsequent to the establishment of technological feasibility.
      Based on Smart Online’s product development process, technological feasibility
      is established upon completion of a working model. Costs related to software
      development incurred between completion of the working model and the point
      at
      which the product is ready for general release have been insignificant. Cost
      of
      revenues is comprised primarily of salaries and related employee expenses
      associated with employees who provide maintenance and support
      services.





**Operating
      Expenses**





During
      the first half of 2005 and fiscal 2004 our efforts were primarily focused on
      product development and integration. During 2004 and the first half of 2005,
      Smart Online added eight additional members to its development team and had
      26 full-time employees as of June 30, 2005. Smart Online had 16 employees at
      June 30, 2004. Most employees performed multiple functions. As noted below,
      during the first quarter of 2004, Smart Online’s employees were transferred to
      another entity and leased back.





*Research
      and Development* .
      We have
      historically focused our research and development activities on increasing
      the
      functionality and enhancing the ease of use of our on-demand application
      service. Because of our proprietary, 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 enables us to have relatively low research and
      development expenses as compared to traditional enterprise software business
      models. We expect that in the future, research and development expenses will
      increase substantially in absolute dollars as we upgrade and extend our service
      offerings and develop new technologies. We expect this to be particularly true
      during 2005 as we incur expenses to develop our next generation services portal,
      OneBiz Conductor SM .
      OneBiz
      Conductor SM will
      include significant enhancements to the technology platform and add additional
      applications to our product offerings. We plan to accomplish this through a
      combination of internal development, joint development, licensing from other
      companies, and acquisitions. OneBiz Conductor SM will
      be
      released in three versions. The first version was released during the first
      quarter of 2005. We
      expect
      the second version of OneBiz ConductorSMwill be
      released on or before September 30, 2005, except that all or part of the
      accounting application may not be released until during the fourth quarter.
      The
      third version of OneBiz ConductorSM,
      including enhanced accounting software, is expected to be released before the
      end of 2005. We
      had 8
      development team members at June 30, 2004 and 13 development team members at
      June 30, 2005. We expect to add 2 to 5 additional development team members
      during the second half of 2005.


21





*Marketing
      and Sales* .
      During
      2004 and the first half of 2005, Smart Online has spent limited funds on
      marketing, advertising, and public relations. We expect these expenditures
      to
      increase significantly starting in mid-2005 and expect this trend to continue
      as
      we strive to grow our revenue. Smart Online has also embarked on an effort
      to
      develop programs similar to marketing efforts by Google, Overture, and Career
      Builder where media companies provide Smart Online’s Private Label Syndication
      services to their small business end users. Smart Online began targeting small
      business media companies in the first quarter of 2004, such as Inc. Magazine
      and
      FastCompany Magazine, who have small business customer bases. The strategy
      has
      been to implement Private Label Syndication platforms in exchange for
      advertising and joint marketing programs with these companies. Smart Online
      estimates the revenue capabilities from its back-end revenue-sharing
      arrangements with these contracts will enable it to increase web services
      revenue for both Smart Online and its partners beginning after we release the
      second version of OneBiz Conductor SM ,
      which
      is planned to occur before the end of the third quarter of 2005. Smart Online
      expects to create certain types of these arrangements in the future with media
      companies who offer the ability to reach small business customers and will
      assist in off-setting Smart Online’s outlay of cash for print and online
      advertising and marketing while providing reduced advertising prices. Media
      companies are requesting such services to assist in driving additional
      revenue.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We plan to
      continue to invest heavily in marketing and sales by increasing the number
      of
      direct sales personnel and increase penetration within our existing customer
      base, expanding our domestic and international selling and marketing activities,
      building brand awareness and participating in additional marketing programs.
      We
      expect to hire 5 to 10 additional sales people during the second half of 2005.
      As a result, we expect that in the future, marketing and sales expenses will
      increase in absolute dollars and will be a significant cost.





*General
      and Administrative* .
      General
      and administrative expenses consist of salaries and related expenses for
      executive, finance and accounting, human resources, and management information
      systems personnel, professional fees, and other corporate expenses, including
      facilities costs. We expect that in the future, general and administrative
      expenses will increase as we add administrative and finance personnel and incur
      additional professional fees and insurance costs related to the growth of our
      business and to our operations as a public company.





*Stock-Based
      Expenses* .
      Our
      operating expenses include stock-based expenses related to options and warrants
      issued to employees and non-employees. These charges have been significant
      and
      are reflected in our historical financial results.





**Critical
      Accounting Policies and Estimates**





Our
      discussion and analysis of financial condition and results of operations are
      based upon our financial statements, which have been 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 re-evaluate our critical accounting policies
      and estimates, including those related to revenue recognition, provision for
      doubtful accounts and sales returns, 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 presently believe the following
      critical accounting policies involve the most significant judgments and
      estimates used in the preparation of our consolidated financial
      statements.





*Revenue
      Recognition* -
      We
      recognize revenue in accordance with accounting standards for software and
      service companies including the United States Securities and Exchange Commission
      (“SEC”) Staff Accounting Bulletin 104 “Revenue Recognition” (“SAB 104”),
      Emerging Issues Task Force Issue No. 00-21 “Revenue Arrangements with Multiple
      Deliverables” (“EITF 00-21”) *,* and
      related interpretations including American Institute of Certified Public
      Accountants (“AICPA”) Technical Practice Aids. We also utilize interpretative
      guidance from regulatory and accounting bodies, which include, but are not
      limited to, the SEC, the AICPA, the Financial Accounting Standards Board
      (“FASB”), and various professional organizations.





We
      recognize revenue when all of the following conditions are satisfied: (1) there
      is persuasive evidence of an arrangement; (2) the service has been provided
      to
      the customer; (3) the collection of our fees is probable; and (4) the amount
      of
      fees to be paid by the customer is fixed or determinable. EITF 00-21 states
      that
      revenue arrangements with multiple deliverables should be divided into separate
      units of accounting if the deliverables in the arrangement meet the following
      criteria: 1) the delivered item has value to the customer on a standalone basis;
      2) there is objective and reliable evidence of the fair value of the undelivered
      item; and 3) if the arrangement includes a general right of return relative
      to
      the delivered item, delivery or performance of the undelivered item is
      considered probable and substantially in control of the vendor. Smart Online’s
      syndication and integration agreements typically include multiple deliverables
      including the grant of a non-exclusive license to distribute, use and access
      the
      Smart Online platform, fees for the integration of content into the Smart Online
      platform, maintenance and hosting fees, documentation and training, and
      technical support and customer support fees. Smart Online cannot establish
      fair
      value of the individual revenue deliverables based on


22


objective
      and reliable evidence, because Smart Online does not have a long, consistent
      history of standard syndication and integration contractual arrangements, as
      there have only been a few contracts that have continued past the initial
      contractual term, Smart Online does not have any contracts in which these
      elements have been sold as stand-alone items, and there is no third-party
      evidence of fair value for products or services that are interchangeable and
      comparable to the Smart Online’s products and services. As such, Smart Online
      cannot allocate revenue to the individual deliverables and must record all
      revenues received as a single unit of accounting as further described below.
      Additionally, Smart Online has evaluated the timing and substantive nature
      of
      the performance obligations associated with the multiple deliverables noted
      above, including the determination that the remaining obligations are essential
      to the on-going usability and functionality of the delivered products, and
      determined that revenue should be recognized over the life of the contracts,
      commencing on the date the site goes on-line, due to such factors as the length
      of time over which the remaining obligations will be performed, the complex
      nature of integrating and maintaining customer content with Smart Online’s
      platform which services are unavailable from other vendors, and the timing
      of
      payment of a portion of the contract price such as monthly hosting
      payments.





Syndication
      fees consist primarily of fees charged to syndication partners to create and
      maintain a customized private-label site and ongoing support, maintenance and
      customer service. Our syndication agreements typically include an advance fee
      and monthly hosting fees. We generally invoice our customers in annual or
      monthly installments and typical payment terms provide that our customers pay
      us
      within 30 days of invoice. Amounts that have been invoiced are recorded in
      accounts receivable and in deferred revenue and the revenue is recognized
      ratably over the specified lives of the contracts, commencing on the date the
      site goes on-line. In general, we collect our billings in advance of the service
      period. Our hosting fees are typically billed on a monthly basis. We continue
      to
      evaluate and adjust the length of these amortization periods as we gain more
      experience with implementation schedules and contract cancellations. At present,
      Smart Online has insufficient historical data to determine if the relationship
      with its existing customers would extend beyond the initial term with the
      customer continuing to benefit from the advance fee. If Smart Online determines
      that existing and/or future contracts are expected to extend beyond the initial
      term whereby the customer continues to benefit from the advance fee, Smart
      Online would extend the revenue recognition period accordingly to include the
      extended term. Our syndication contracts and support contracts typically provide
      for early termination only upon a material breach by either party that is not
      cured in a timely manner. If a contract terminates earlier than its term, we
      recognize the remaining deferred revenue upon termination. Based on that
      experience, it is possible that, in the future, the estimates of expected
      duration of customer contract lives may change and, in such event, the period
      over which such syndication revenues are amortized would be adjusted. Any such
      change in specified contract lives would affect our future results of
      operations. Additionally, the syndication contracts typically include revenue
      sharing arrangements whereby syndication partners typically charge their
      customers a monthly fee to access the private-label site. In most cases, the
      syndication agreements provides for Smart Online to receive a percentage of
      these fees. Fees derived from such revenue sharing arrangements are recorded
      when earned. To date, such revenue sharing fees have been
      negligible.





Integration
      fees consist primarily of fees charged to integration partners to integrate
      their products into the Smart Online syndication platform. Integrating
      third-party content and products has been a key component of Smart Online’s
      strategy to continuously expand and enhance its platform offered to syndication
      partners and its own customer’s base. We generally invoice our customers in
      advance of the service period in annual or monthly installments and typical
      payment terms provide that our customers must pay us within 30 days of invoice.
      Amounts that have been invoiced are recorded in accounts receivable and in
      deferred revenue and the revenue is recognized ratably over the specified lives
      of the contracts, commencing on the date the site goes on-line. We continue
      to
      evaluate and adjust the length of these amortization periods as we gain more
      experience with implementation schedules and contract cancellations. At present,
      Smart Online has insufficient historical data to determine if the relationship
      with its existing customers would extend beyond the initial term with the
      customer continuing to benefit from the advance fee. If Smart Online determines
      that existing and/or future contracts are expected to extend beyond the initial
      term whereby the customer continues to benefit from the advance fee, Smart
      Online would extend the revenue recognition period accordingly to include the
      extended term. Our integration contracts and support contracts typically provide
      for early termination only upon a material breach by either party that is not
      cured in a timely manner. If a contract terminates earlier than its term, we
      recognize the remaining deferred revenue upon termination. Based on that
      experience, it is possible that, in the future, the estimates of expected
      implementation periods and customer lives may change. In such event, the period
      over which such syndication revenues are amortized will be adjusted. Any such
      change in specified contract lives would affect our future results of
      operations. Additionally, integration agreements typically include an upfront
      fee and a revenue sharing component. Fees derived from such revenue sharing
      arrangements are recorded when earned. To date, such revenue sharing fees have
      been negligible.





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      agreements is received upfront. Our syndication and integration contracts and
      support contracts typically provide that customers have the right to terminate
      their contracts during the initial term only for cause if we fail to perform.
      We
      generally invoice our customers in annual or monthly installments and typical
      payment terms provide that our customers are required to pay us within 30 days
      of invoice. Amounts that have been invoiced are recorded in accounts receivable
      and in deferred revenue or revenue depending on whether the revenue recognition
      criteria have been met. In general, we collect our billings in advance of the
      service period. Online marketing, which consists of marketing services provided
      to our integration and syndication partners have in the past generated
      additional revenue. In addition, certain users have requested that Smart Online
      implement online marketing initiatives for them, such as promoting their
      products through Google or Overture Services. Online marketing has not been
      a
      material source of revenue in the past. We expect to increase our online
      marketing services revenue in the future.


23





Web
      Services revenues are comprised of e-commerce sales directly to end-users,
      hosting and maintenance fees, e-commerce website design fees and online loan
      origination fees. E-commerce sales are made either on a subscription or a la
      carte basis. Subscription, which provides users with access to most of our
      products is payable in advance on a monthly basis and is targeted at small
      companies or small divisions of large companies. At present, we provide free
      access to our subscribers. We will seek to grow our monthly subscription volume
      substantially over the 24 months after new versions of Smart Online’s platforms
      (OneBiz Conductor SM )
      are
      released and we have time to market and invest more in marketing and sales.
      We
      expect monthly subscription fees will typically be $29.95 to $49.95, for new
      subscribers at www.smartonline.com , and that
      there may be an introductory trial period .
      To date
      we have given free access to our web services to most users. We expect lower
      fees from subscribers at the private label syndication websites of our partners.
      Currently, we pay most of our syndication partners a percentage of the revenue
      we derive from their private label syndication websites, which amounts we report
      as a component of our sales and marketing expense. A la carte pricing, which
      allows customers to purchase one-time use of a specific software or content
      service, ranges from $10 to $300, which includes third-party charges when
      applicable, such as state and federal fees associated with incorporating a
      business or additional fees associated with having a press release written
      and
      revised.





Additionally,
      Smart Online receives a portion of revenue from third-party sales of products
      and services through our website and websites of our syndication partners from
      revenue sharing arrangements, which involves a split of realized revenues.
      We
      charge hosting and maintenance fees for supporting and maintaining the
      private-label portal of our partners and for providing customer and technical
      support directly to our syndication partner’s users and are recognized on a
      monthly basis. E-commerce website design fees, which are charged for building
      and maintaining corporate websites or to add the capability for e-commerce
      transactions, are recognized over the life of the project. We have discontinued
      our third-party arrangement for online web design. We expect to resume this
      service after a new partner is under contract. Online loan origination fees
      are
      charged to provide users online financing options. Smart Online receives
      payments for loans or credit provided. We intend to become more aggressive
      about
      promoting this service in the future.





Subscription
      revenue is recognized ratably over the subscription period (usually one year).
      Third-party premium products are shared with integration partners.





OEM
      revenues are recorded based on the greater of actual sales or contractual
      minimum guaranteed royalty payments. Smart Online records the minimum guaranteed
      royalties monthly and receives payment of the royalties on a quarterly basis,
      thirty days in arrears. To the extent actual royalties exceed the minimum
      guaranteed royalties, the excess is recorded in the quarter Smart Online
      receives notification of such additional royalties.





*Barter
      Transactions* -
      Barter
      revenue relates to syndication and integration services provided by Smart Online
      to business customers in exchange for advertising in the customers’ trade
      magazines and on their Web sites. Barter expenses reflect the expense offset
      to
      barter revenue. The amount of barter revenue and expense is recorded at the
      estimated fair value of the services received or the services provided,
      whichever is more objectively determinable, in the month the services and
      advertising are exchanged. Smart Online applies APB 29, Accounting for
      Non-Monetary Transactions, the provisions of EITF 93-11, “Accounting for
      Advertising Barter Transactions Involving Barter Credits” and EITF 99-13,
“Accounting for Advertising and Barter Transactions” and, accordingly,
      recognizes barter revenues only to the extent that Smart Online has similar
      cash
      transactions within a period not to exceed six months prior to the date of
      the
      barter transaction. To date the amount of barter revenue to be recognized has
      been more objectively determinable based on integration and syndication services
      provided. For revenue from integration and syndication services provided for
      cash to be considered similar to the integration and syndication services
      provided in barter transactions, the services rendered must have been in the
      same media and similar term as the barter transaction. Further, the quantity
      or
      volume of integration or syndication revenue recorded in a qualifying past
      cash
      transaction can only evidence the fair value of an equivalent quantity or volume
      of integration or syndication revenue recorded in subsequent barter
      transactions. In other words, a past cash transaction can only support the
      recognition of revenue on integration and syndication contracts barter
      transactions up to the dollar amount of the cash transactions. When the cash
      transaction has been used to support an equivalent quantity and dollar amount
      of
      barter revenue, that transaction cannot serve as evidence of fair value for
      any
      other barter transaction. Once the value of the barter revenue has been
      determined, Smart Online follows the same revenue recognition principals as
      it
      applies to cash transactions with unearned revenues being deferred as described
      more fully under the caption “ *Revenue
      Recognition* ”
above.
      At the time the barter revenue is recorded, an offsetting pre-paid barter
      advertising asset is recorded on Smart Online’s balance sheet. This pre-paid
      barter advertising asset is amortized to expense as advertising services are
      received such as when an advertisement runs in a magazine. Where more than
      one
      deliverable exists, such as when the barter partner is to provide advertising
      in
      four issues of a magazine, the expense is recognized pro-rata as the advertising
      deliverable is provided. Barter revenues totaled $8,333 and $268,142 in the
      first half of 2004 and 2005, respectively.





*Marketable
      Securities* -
      Management determines the appropriate classification of investments in
      marketable securities at the time of purchase in accordance with Statement
      of
      Financial Accounting Standards No. 115.


24








*Accounting
      for Certain Investments in Debt and Equity Securities* and
      reevaluates such determination at each balance sheet date. Securities, which
      are
      classified as available for sale are carried at fair value, with the unrealized
      gains and losses, net of tax, reported as a separate component of stockholders’
equity. Fair value is determined based on quoted market rates. Realized gains
      and losses and declines in value judged to be other-than-temporary on securities
      available for sale are included as a component of interest income. The cost
      of
      securities sold is based on the specific-identification method. Interest on
      securities classified as available for sale is also included as a component
      of
      interest income.





*Impairment
      of Long Lived Assets* -
      Long-lived assets and certain identifiable intangibles are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future net cash flows expected to be generated by the asset. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds the fair value
      of
      the assets. Assets to be disposed of are reported at the lower of the carrying
      amount or fair value less costs to sell.





*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, an adjustment
      would be made in the period such determination is made. We recorded no income
      tax expense in any of the periods presented, as we have experienced significant
      operating losses to date. If utilized, the benefit of our total net operating
      loss carryforwards may be applied to reduce future tax expense. Since our
      utilization of these deferred tax assets is dependent on future profits, which
      are not assured, we have recorded a valuation allowance equal to the net
      deferred tax assets. These carryforwards would also be subject to limitations,
      as prescribed by applicable tax laws. As a result of prior equity financings
      and
      the equity issued in conjunction with certain acquisitions, we have incurred
      ownership changes, as defined by applicable tax laws. Accordingly, our use
      of
      the acquired net operating loss carryforwards may be limited. Further, to the
      extent that any single year loss is not utilized to the full amount of the
      limitation, such unused loss is carried over to subsequent years until the
      earlier of its utilization or the expiration of the relevant carryforward
      period.





**Overview
      of Results of Operations for the Quarters Ended June 30, 2005 and
      2004**





Revenue
      totaled $406,116 for the second quarter of 2005 as compared to $235,845 for
      the
      second quarter of 2004. These revenues reflect a 180 percent increase in
      integration revenues and a 238 percent increase in syndication revenues. During
      the second quarter of 2005, no revenues were derived from related parties as
      compared to $82,512 for the comparable 2004 period. Gross margin improved from
      $192,437, or 81.6 percent of revenues, during the 2004 period to $384,205,
      or
      94.6 percent of revenues, for the 2005 period primarily as a result of a
      decrease in the number of staff assigned to the customer support
      function.





Operating
          expenses increased from $900,125 during the second quarter of 2004 to $1,258,511
          for the second quarter of 2005. As discussed below, the principal factors
          resulting in the increase in operating expense were (1) an increase of
          approximately $113,000 in consulting expenses, an increase of approximately
          $53,000 in travel related expenses, and an increase in expenses associated
          with
          the Sarbanes-Oxley Act, (2) the hiring of three additional sales staff,
          the use
          of consultants to assist in the development and implemenation of our sales
          strategy, and referral fees paid to our integration and syndication partners,
          and (3) additional programming, database management, quality assurance,
          and
          project management resources in the development function to support the
          on-going
          development of the OneBiz Conductor SM product.
 
 Net
          loss
          increased from $692,786 in the second quarter of 2004 to $860,816 in the
          second
          quarter of 2005. The
          above
          net losses equated to a loss per share of $0.07 during the second quarter
          of
          2005 and a loss per share of $0.06 during the second quarter of 2004 based
          on
          12,387,333 and 10,722,507 weighted average shares outstanding,
          respectively.


**Overview
      of Results of Operations for the Six Months Ended June 30, 2005 and
      2004**





Revenue
      totaled $659,354 for the first half of 2005 as compared to $485,573 for the
      first half of 2004. These revenues reflect a 97.0 percent increase in
      integration revenues and a 219 percent increase in syndication revenues. During
      the first half of 2005, no revenues were derived from related parties as
      compared to $165,025 for the comparable 2004 period. Gross margin improved
      from
      $385,146, or 79.3 percent of revenues, during the 2004 period to $605,717,
      or
      91.9 percent of revenues, for the 2005 primarily as a result of a decrease
      in
      stock based consulting expenses and a reduction in the number of staff assigned
      to the customer support function. During
      the second quarter of 2005, two integration agreements were cancelled resulting
      in the recognition of $41,250 of revenue that would otherwise have been
      recognized during the third quarter of 2005.


25








Operating
          expenses increased from $1,612,159 during the first half of 2004 to $2,327,506
          for the first half of 2005. As discussed below, the principal factors resulting
          in the increase in operating expense were (1) ) an increase of approximately
          $70,000 in consulting expenses, an increase of approximately $53,000 in
          travel
          related expenses, and
          an
          increase of approximately $153,000 in accounting and consulting fees associated
          with complying with public company reporting requirements and the Sarbanes-Oxley
          Act , (2
          )increased barter advertising, consulting fees, and additional sales staff
          in
          sales and marketing, and (3) additional programming, database management,
          quality assurance, and project management resources in the development
          function
          to support the on-going development of the OneBiz Conductor SM product.
 
 Net
          loss
          decreased from $6,733,250 in the first half of 2004 to $1,154,964 in the
          first
          half of 2005. In addition to the revenue and expense factors noted above,
          the
          decrease in net loss was also attributable to a $507,238 increase in one-time
          gains resulting from debt forgiveness. Additionally, the first half 2004
          net
          loss included $2,215,625 of expense related to preferred stock dividends
          and
          accretion of discount on the preferred stock prior to its conversion to
          Common
          Stock later during the same quarter and $3,225,410 of expense related to
          an
          accretive dividend issued in connection with a registration rights
          agreement.
 
 The
          above
          net losses equated to a loss per share of $0.10 during the first half of
          2005
          and a loss per share of $0.75 during the first half of 2004 based on 12,110,013
          and 9,022,107 weighted average shares outstanding,
          respectively.


The
      following tables set forth selected statements of operations data for each
      of
      the periods indicated.





**Revenues**





**Three
                Months Ended**
            
            
            **Six
                Months Ended****June
                30, 2005**
            
            **June
                30, 2004**
            
            
            **June
                30, 2005**
            
            
            **June
                30, 2004**REVENUES:Integration
                fees
            
            $
            252,198
            
            $
            89,931
            
            
            $
            381,720
            
            $
            193,750Syndication
                fees
            
            
            103,602
            
            
            30,621
            
            
            
            195,642
            
            
            61,242OEM
                revenue
            
            
            12,000
            
            
            13,750
            
            
            
            24,000
            
            
            28,436Web
                services
            
            
            25,731
            
            
            18,276
            
            
            
            40,890
            
            
            34,990Other
                revenues
            
            
            12,585
            
            
            755
            
            
            
            17,102
            
            
            2,130Related
                party revenues
            
            
            -
            
            
            82,512
            
            
            
            -
            
            
            165,025Total
                revenues
            
            $
            406,116
            
            $
            235,845
            
            
            $
            659,354
            
            $
            485,573





Three
      Months Ended June 30, 2005 and 2004





Total
      revenues were $406,116 for the second quarter of 2005 compared to $235,845
      for
      the second quarter 2004 representing an increase of $170,271 or 72.2
      percent.





During
      fiscal 2004 the Company focused on entering into integration and syndication
      agreements with third parties who have significant small-business customer
      bases
      as it prepares for the launch of its OneBiz Conductor SM product.
      This focus resulted in Smart Online entering into agreements with two new
      syndication partners during the second quarter of 2004. The Company also signed
      an agreement with Capital One during April 2005. As more fully described under
      “Significant Accounting Policies”, Smart Online recognizes revenue from
      syndication and integration agreements over the expected service period of
      the
      related agreement.





At
      June
      30, 2005, Smart Online had nine
      active integration
      agreements and six active syndication agreements. At June 30, 2004, Smart Online
      had nine active integration agreements and four active syndication agreements.
      During the second quarter of 2005, two integration agreements were cancelled
      resulting in the recognition of $41,250 of revenue that would otherwise have
      been recognized during the third quarter of 2005.





Substantially
      all of the integration and syndication revenue for the quarter ended June 30,
      2005, was derived from six integration partners and three syndication
      partners.





Substantially
      all the integration and syndication revenue for the quarter ended June 30,
      2004,
      was derived from eight integration partners and three syndication
      partners.





Integration
      revenues for the second quarter of 2005 totaled $252,198 as compared to $89,931
      for the same period in 2004 representing an increase of $162,267 or 180%.
      Approximately 72.8% of the 2005 integration revenues were from three integration
      agreements each of which accounted for greater than 10% of total second quarter
      revenues. Included in the second quarter 2005 integration revenues is $41,250
      of
      revenue recognized as a result of the company terminating a barter integration
      agreement. In total, the 2005 and 2004 periods included $87,500 and $5,000
      of
      revenue derived from barter transactions, respectively.


26








Syndication
      revenues for the second quarter of 2005 totaled $103,602 as compared to $30,621
      for the same period in 2004 representing an increase of $72,981 or 238%. The
      2005 revenues were derived from three syndication agreements one of which
      accounted for greater than 10% of total second quarter revenues. The 2005 and
      2004 periods included $72,977 and
      $ 0 of
      revenue derived from barter transactions, respectively.





Web
      services and other revenues increased by $7,455 in the second quarter 2005
      as
      compared to the same period in 2004.





Smart
      Online did not derive any revenue from related parties during the second quarter
      of 2005. During the second quarter of 2004, revenues from related parties
      accounted for $82,513,
      or 35.0%, of total
      revenue. Management does not expect related party revenues to be a significant
      source of income going forward.





Six
      Months Ended June 30, 2005 and 2004





Total
      revenues were $659,354 for the six months ended 2005 compared to $485,573 for
      the six months ended 2004 representing an increase of $173,781 or 35.8
      percent.





Integration
      revenues for the six months ended 2005 totaled $381,720 as compared to $193,750
      for the same period in 2004 representing an increase of $187,970 or 97.0%.
      Approximately 52% of the 2005 integration revenues were from two integration
      agreements each of which accounted for greater than 10% of total first half
      2005
      revenues. The 2005 and 2004 periods included $133,750 and $ 8,333 of
      revenue derived from barter transactions, respectively.





Syndication
      revenues for the six months ended 2005 totaled $195,642 as compared to $61,242
      for the same period in 2004 representing an increase of $134,400 or 219%. All
      of
      the 2005 revenues were from three syndication agreements each of which accounted
      for greater than 10% of total first half revenues. The 2005 and 2004 periods
      included $134,392
      and $0 of
      revenue derived from barter transactions, respectively.





Web
      services revenue and other revenues increased by $5,900 and $14,972,
      respectively, for the six months ended June 30, 2005 as compared to the same
      2004 period.





Smart
      Online did not derive any revenue from related parties during the first half
      of
      2005. During the first half of 2004, revenues from related parties accounted
      for $165,025,
      or 34.0%, of total
      revenue. Management does not expect related party revenues to be a significant
      source of income going forward.





**Cost
      of Revenues**





**Three
                Months Ended**
            
            **Six
                Months Ended****June
                30, 2005**
            
            **June
                30, 2004**
            
            **June
                30, 2005**
            
            **June
                30, 2004**Cost
                of Revenues
            
            $
            21,911
            
            $
            43,408
            
            $
            53,638
            
            $
            100,427





Three
      months ended June 30, 2005 and 2004





Cost
      of
      revenues is comprised primarily of salaries and the cost of an external hosting
      facility associated with maintaining and supporting integration and syndication
      partners. Cost of revenues decreased 50% from $43,408 in the second quarter
      2004
      to $21,911 in the second quarter of 2005 primarily due to lower compensation
      expense. Compensation expense for the fist and second quarters of 2005 was
      approximately 50% lower than the comparable 2004 periods as internal resources
      were reallocated to better match developments, sales, and customer support
      needs. Cost of revenues is expected to increase in future periods commensurate
      with growth in integration and syndication partners and as users are added
      following the 2005 release of OneBiz Conductor SM .
      Additionally, Smart Online incurred approximately $9,000 of external hosting
      expense during the second quarter of 2005 as compared to $0 for the same period
      in 2004. During the third quarter of 2004, Smart Online migrated certain of
      its
      hosting services from its in-house operations to a third party that has a global
      reach and provides superior data hosting, data access, security, and back-up
      capabilities.


27





Six
      Months Ended June 30, 2005 and 2004





Cost
      of
      revenues decreased 53% from $100,427 in the six months ended 2004 to $53,638
      in
      the six months ended 2005 primarily due to lower compensation expense. As noted
      above in the discussion of second quarter results, compensation expense included
      in cost of revenues decreased by approximately 50% as internal resources were
      reallocated to better match development, sales, and customer support
      needs.





**Operating
      Expenses**





**Three
                  Months Ended**
              
              **Six
                  Months Ended****June
                  30, 2005**
                **(Restated)**
              
              **June
                  30, 2004**
              
              **June
                  30, 2005**
                **(Restated)**
              
              **June
                  30, 2004**OPERATING
                  EXPENSES:General
                  and administrative
              
              $
              724,162
              
              $
              593,250
              
              $
              1,243,198
              
              $
              1,042,507Sales
                  and marketing
              
              
              287,946
              
              
              179,232
              
              
              582,678
              
              
              277,631Development
              
              
              246,403
              
              
              127,643
              
              
              501,630
              
              
              292,021Total
                  operating expenses
              
              $
              1,258,511
              
              $
              900,125
              
              $
              2,327,506
              
              $
              1,612,159





Three
      months ended June 30, 2005 and 2004





*General
        and Administrative* -
        General
        and administrative expenses increased by $130,912 from $593,250 in the second
        quarter of 2004 to $724,162 in the same period of 2005 primarily as a result
        of
        an increase of approximately $113,000 in consulting expenses, an increase
        of
        approximately $53,000 in travel related expenses, and an increase in expenses
        associated with the Sarbanes-Oxley Act. These increases were offset in part
        by a
        decrease of approximately $71,000 in legal and professional fees. The increase
        in consulting fees is attributable to approximately $68,000 of expense
        associated with the issuance of stock options to a strategic consultant and
        fees
        to various consultants engaged by the company to assist with public relations,
        investor relations, financing, and strategic planning. The increase in travel
        related expenses is primarily related to an increase in travel associated
        with
        investor relations and presentations to investor prospects.





Management
      expects that certain costs such as compliance with the Sarbanes-Oxley Act and
      other public company-related expenses including investor relations, public
      relations, shareholder related expenses and insurance will increase general
      and
      administrative expenses during the remaining fiscal 2005 as compared to the
      2004
      period. Smart Online is also shifting from dependence on outside consultants
      to
      Smart Online employees. In June 2005, Smart Online hired a General Counsel.
      Additionally, in the third quarter of 2005, Smart Online engaged a search firm
      to assist the company in a search for a Chief Financial Officer with public
      company experience.





*Sales
      and Marketing* -
      Sales
      and marketing increased from $179,232 the second quarter of 2004 to $287,946
      in
      the second quarter of 2005, an increase of approximately $108,714 .
      This
      increase in sales and marketing expense was primarily attributable to the hiring
      of additional sales personnel and higher recruiting and travel expenses
      associated with these new hires, the engagement of consultants, and fees due
      to
      integration and syndication partners for driving subscribers to our site. During
      the second quarter of 2005, Smart Online added three new sales people, including
      regional managers in California and New York, to assist with the roll out of
      the
      OneBiz Conductor SM product.
      Additionally, during the quarter Smart Online engaged the services of
      consultants to assist with the development and implementation of its sales
      and
      marketing strategy and to assist the company with syndication and integration
      prospects. One of these consultants was subsequently appointed Vice President
      of
      Sales during the third quarter of 2005. These sales hires will increase the
      salary related expenses in the last two quarters of 2005. The 2005 period also
      includes approximately $8,000 of fees paid to integration and syndication
      partners, which fees are based on percentages of the subscription and ala carte
      revenue we generated from customers referred by our integration and syndication
      partners.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We plan to
      invest heavily in marketing and sales by increasing the number of direct sales
      personnel and increase penetration within our existing customer base, expanding
      our domestic and international selling and marketing activities, building brand
      awareness and participating in additional marketing programs **.** During
      the second half of 2005 we expect to hire 5 to 10 additional sales people.
      This
      increase is being timed to coincide with the planned release of the second
      version our Next Generation Platform, OneBiz Conductor SM .


28





*Development* -
      Development expense increased from $127,643 in the second quarter of 2004 to
      $246,403 in the second quarter of 2005. The increase in development expenses
      was
      primarily attributable to the hiring of additional programming, database
      management, quality assurance, and project management resources to support
      the
      on-going development of the OneBiz Conductor SM product.





Smart
      Online expects development expenses to increase significantly during the last
      two quarters of 2005 as a result of anticipated hiring of additional
      development, database management, and project management resources.








Six
      Months Ended June 30, 2005 and 2004





*General
        and Administrative* -
        General
        and administrative expenses increased by $200,691 from $1,042,507 in the
        six
        months ended 2004 to $1,243,198 in the same period of 2005. As noted in the
        discussion of second quarter results, this increase was primarily as a result
        of
        an increase of approximately $70,000 in consulting expenses, an increase
        of
        approximately $53,000 in travel related expenses, and an increase of
        approximately $153,000 in accounting and consulting fees associated with
        complying with public company reporting requirements and the Sarbanes-Oxley
        Act.
        The increase in consulting fees is attributable to approximately $68,000
        of
        expense associated with the issuance of stock options to a strategic consultant
        and fees to various consultants engaged by the company to assist with public
        relations, investor relations, financing, and strategic planning. The increase
        in travel related expenses is primarily related to an increase in travel
        associated with investor relations and presentations to investor prospects.
        These increases were offset in part by a $45,000 decrease in legal and
        professional fees .
        Additionally, general and administrative expense for the first six months
        of
        2004 included $66,287 of expense related to stock options for which there
        was $0
        in the 2005 period.





*Sales
      and Marketing* -
      Sales
      and marketing increased from $277,631 in the six months ended 2004 to $582,678
      in the six months ended 2005, an increase of approximately $305, 047.
      The
      first half 2005 increase was primarily attributable to increased advertising,
      consulting fees, and additional sales staff. The increase in advertising expense
      is primarily attributable to barter advertising expense, which increased by
      approximately $140,000 during the first half of 2005, as compared to the first
      half of 2004. Consulting fees increased by approximately $36,000 due to the
      engagement of consultants to assist the company with its development and
      implementation of its sales and marketing strategy and to assist the company
      with syndication and integration prospects. Staff related expenses, including
      new hires, compensation adjustments, and recruiting expenses, increased
      approximately $64,000 for the six months ended June 30, 2005 as compared to
      the
      comparable 2004 period. These sales hires will increase the salary related
      expenses in the last two quarters of 2005.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We plan to
      invest heavily in marketing and sales by increasing the number of direct sales
      personnel and increase penetration within our existing customer base, expanding
      our domestic and international selling and marketing activities, building brand
      awareness and participating in additional marketing programs .
      As
      previously noted, during the second half of 2005 we expect to hire 5 to 10
      additional sales people. This increase is being timed to coincide with the
      planned release of the second version our Next Generation Platform, OneBiz
      Conductor SM .





*Development* -
      Development expense increased from $292,021 in the six months ended June 30,
      2004 to $501,630 in the six months ended 2005. This increase is primarily the
      result of Smart Online adding additional programming, database management,
      quality assurance, and project management resources to support the on-going
      development of the OneBiz Conductor SM product.





Smart
      Online expects development expenses to increase significantly during the last
      two quarters of 2005 as compared to the same period in 2004 as a result of
      anticipated hiring of additional development, database management, and project
      management resources.





**Other
      Income (Expense)**





**Three
                Months Ended**
            
            **Six
                Months Ended****June
                30, 2005**
            
            **June
                30, 2004**
            
            **June
                30, 2005**
            
            **June
                30, 2004**OTHER
                INCOME (EXPENSE):Interest
                income (expense), net
            
            $
            4,197
            
            $
            (6,945
            )
            $
            10,195
            
            $
            (114,597
            )Gain
                on debt forgiveness
            
            
            9,293
            
            
            21,847
            
            
            556,633
            
            
            49,395Total
                other income (expense)
            
            $
            13,490
            
            $
            14,902
            
            $
            566,829
            
            $
            (65,202
            )





29





Three
      months end June 30, 2005 vs. 2004





Smart
      Online incurred net interest income of $4,197 for the second quarter of 2005
      and
      net interest expense of $6,945 for the second quarter of 2004. During the second
      quarter of 2005, Smart Online realized gains from debt forgiveness of $9,293
      compared to $21,847 during the second quarter of 2004. These gains resulted
      from
      negotiated and contractual releases of outstanding liabilities.











Six
      Months Ended June 30, 2005 and 2004





Smart
      Online had net interest income of $10,195 for the first six months of 2005
      as
      compared to net interest expense of $114,597 for the comparable 2004 period.
      The
      2004 interest expense amounts included $75,000 of interest related to the
      issuance of 150,000 shares of common stock to a relative of one of Smart
      Online’s officers in consideration for extending the term of a loan and loaning
      additional funds to the corporation. The remainder of the 2004 interest expense
      is primarily attributable to interest due on deferred compensation owed to
      officers of Smart Online and interest related to unpaid payroll tax obligations.
      Both the deferred compensation and income tax obligations were relieved during
      the first quarter of 2005. Therefore, management expects that interest expense
      will be significantly lower in 2005.





During
      the first half of 2005, Smart Online realized gains of $556,633 as compared
      to
      $49,395 during the first half of 2004, from negotiated and contractual releases
      of outstanding liabilities. The gains from debt forgiveness resulted from
      unrelated third parties. The first half 2005 gain resulted primarily from a
      settlement of Internal Revenue Service claims for penalty and interest. During
      the first half of 2004, the gain resulted primarily from trade creditors who
      had
      performed services for Smart Online, agreeing to accept as payment in full
      a
      lesser amount than the stated liability in consideration for timely payment
      of
      the negotiated settlement. Smart Online does not expect gains from debt
      forgiveness to be material in future periods.





**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 half of 2005 or fiscal 2004 primarily due to continued substantial
      uncertainty regarding our ability to realize our deferred tax assets. Based
      upon
      available objective evidence, there has been sufficient uncertainty regarding
      the ability to realize our deferred tax assets, which warrants a full valuation
      allowance in our financial statements. Smart Online has approximately
      $29,000,000 in net operating loss carryforwards, which may utilized to offset
      future taxable income.





**Liquidity
      and Capital Resources**





At
      June
      30, 2005, our principal sources of liquidity were cash and cash equivalents
      totaling $552,407 and accounts receivable of $30,706. We do not have a bank
      line
      of credit.





At
      June
      30, 2005, we had approximately a $51,000 deficit in working capital. Our working
      capital is not sufficient to fund our operations beyond the end of September
      2005, unless we substantially increase our revenue, limit expenses or raise
      substantial additional capital.





Our
      primary source of liquidity during 2004 and the first half of 2005 was from
      sales of our securities. When restrictions on resale of over nine million shares
      of our Common Stock terminate on October 1, 2005, the volume of resales may
      adversely affect the market value of our Common Stock and may make it more
      difficult to raise capital.  See "Risk Factor (52)" for information about
      lock-up agreements and other restrictions on resale.  During 2004, Smart
      Online generated net cash from financing activities, including the sales of
      common stock, of approximately $4.2 million. During the same period Smart Online
      consumed approximately $3.7 million of cash in operations, including payment
      of
      $1,126,485 paid related to outstanding payroll tax liabilities. During the
      first
      half of 2005, Smart Online raised an additional $3,092,887 of proceeds, net
      of
      stock issuance costs of $290,000, through the sale of additional shares of
      Common Stock and a warrant to purchase 50,000 shares of Common Stock.
      Approximately $1.1 million of the proceeds were used in the first quarter of
      2005 to pay deferred compensation to our officers and related accrued interest
      amounts. Additionally, during February 2005, Smart Online reached a settlement
      with the Internal Revenue Service, paid $26,100, surrendered all credits and
      refunds for 2005 or earlier tax periods, and agreed to remain in compliance
      with
      all federal tax obligations for a term of five years to resolve all outstanding
      federal tax issues.





As
      a
      result of the 2005 cash infusion from stock sales, payment of the deferred
      compensation and accrued interest, settlement of various claims and lawsuits,
      and based upon current cash-on-hand and contracts signed to date, management
      of
      Smart Online believes the Company has funds sufficient working capital to fund
      operations through September 2005. Management is actively evaluating additional
      financing options through existing and new shareholders for 2005, signing
      additional syndication partners, signing additional integration partners, and
      growing its base of subscription customers.


30





**Deferred
      Revenue.** At
      June
      30, 2005 Smart Online had deferred revenue totaling $531,479, net of offsetting
      amounts receivable. Deferred revenue represents amounts collected in advance
      of
      the revenue being recognized. Based upon current conditions, Smart Online
      expects that approximately 60% of this amount will be recognized in 2005 with
      the remainder expected to be recognized during 2006.





**Going
      Concern.** Our
      auditors have issued an explanatory paragraph in their report included in our
      Form 10-K for the year ended December 31, 2004 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 Smart Online be unable to continue as a going concern.
      Smart Online’s continuation as a going concern is dependent upon its ability to
      generate sufficient cash flows to meets its obligations on a timely basis,
      to
      obtain additional financing as may be required and ultimately to attain
      profitable operations and positive cash flows. As is discussed below, management
      has plans which it believes will enable Smart Online to raise capital and
      generate greater cash flows from operations. However, there can be no assurance
      that these efforts will be successful. If our efforts are unsuccessful, we
      may
      have to cease operations and liquidate our business.





**Recent
      Developments.** During
      July 2005, Smart Online sold 90,909 shares of its common stock to an existing
      investor for a price of $5.50 per share resulting in gross proceeds of $500,000.
      Also during July 2005, Smart Online sold an additional 36,363 shares to a new
      investor resulting in gross proceeds of $199,997. Smart Online incurred issuance
      costs totaling $70,000 related to these stock sales. Additionally, in connection
      with these offerings, Smart Online entered into Registration Rights Agreements
      with these shareholders under which Smart Online is required to file a
      registration statement with the SEC to register the shares sold in the offering
      no later than September 30, 2005.





During
      July 2005, Smart Online signed a non-binding letter of intent to acquire a
      privately held developer and distributor of customer relationship management
      software based in the mid-western United States. Under the terms of the letter
      of intent, Smart Online will issue the seller 500,000 shares of Smart Online
      common stock and assume certain liabilities of the seller. Smart Online is
      currently performing due diligence on this potential acquisition and anticipates
      that the acquisition will not close until September or October 2005 pending
      the
      outcome of its due diligence procedures and execution of definitive documents.
      Because due diligence and negotiations have not been completed, there is no
      assurance this transaction will be completed.





Also
      during July 2005, Smart Online signed a non-binding letter of intent to acquire
      a privately held developer and distributor of multi-channel commerce systems
      based in the Great Lakes region of the United States. Under the terms of the
      letter of intent, Smart Online will pay the seller $5.1 million, payable 66%
      in
      cash and 34% in shares of Smart Online common stock. The cash portion of the
      purchase price is payable in two halves, the first half of which is payable
      in
      four equal installments on the first business day of each quarter for four
      calendar quarters with the first payment due on the first day of the fiscal
      quarter following closing, and the second half of which is payable in cash
      on
      January 5, 2007. In addition, Smart Online is to pay $780,000 for noncompetition
      agreements to key personnel of the acquired company in eight equal quarterly
      installments during the two years after the closing. Smart Online is currently
      performing due diligence on this potential acquisition and anticipates that
      the
      acquisition will not close until September or October 2005 pending the outcome
      of its due diligence procedures and execution of definitive documents. Because
      due diligence and negotiations have not been completed, there is no assurance
      this transaction will be completed.





**Future
      Capital Raising and Acquisitions.** The
      effect of these potential acquisitions on the cash resources and needs of Smart
      Online are not known at this time and will not be known until Smart Online
      complete due diligence. However, it is anticipated that substantial expenses
      will be incurred in professional fees in connection with these transactions,
      as
      well as in integrating the acquired companies into Smart Online. Management
      believes that the contemplated acquisitions will instantly result in greater
      working capital needs as we expect Smart Online will not acquire substantial
      accounts receivables. Further, one of the target companies has factored
      approximately 65% of its current contracts and owes approximately $2.0 million
      to factors at June 30, 2005 which obligation Smart Online will assume. As a
      result of the factor arrangements, Smart Online will be required to provide
      services to the customers but will only receive approximately 35% of the
      corresponding customer payments. Management believes these acquisitions will
      eventually result in positive cash flow to Smart Online, but the initial effect
      on Smart Online’s working capital will be negative. In addition, the proposed
      terms of one of the acquisitions requires Smart Online
      to
      pay the seller $5.1 million, payable 66% in cash and 34% in shares of Smart
      Online common stock. The cash portion of the purchase price is payable in two
      halves, the first half of which is payable in four equal installments of the
      first business day of each quarter for four calendar quarters with the first
      payment due on the first day of the fiscal quarter following closing, and the
      second half of which is payable in cash on January 5, 2007. There can be no
      assurance that any potential acquisition for which there is a letter but not
      a
      definitive purchase agreement will close. Smart Online does not currently have
      sufficient cash to fund the purchase obligations and there can be no assurance
      that Smart Online will be able to fund the commitments it is making in this
      acquisition.





**Anticipated
      Increases in Expenses to Fund Growth In Revenue.** With
      the
      release of our OneBiz Conductor SM next
      generation platform and the expenses associated with becoming a public company,
      we believe our capital requirements in 2005 and beyond will be greater than
      in
      past years. As such, our historical cash flows may not be indicative of future
      cash flows. The following is a discussion of factors that we consider important
      to our future capital requirements and which will affect the amount of
      additional capital we need to raise.


31





Our
      future capital requirements will depend on many factors, including our rate
      of
      revenue growth, the expansion of our marketing and sales activities, the timing
      and extent of spending to support product development efforts and expansion
      into
      new territories, the timing of introductions of new services and enhancements
      to
      existing services, the effect of the contemplated acquisitions as described
      above, and the market acceptance of our services.





Primary
      drivers for future operating cash flows include the commercial success of our
      existing services and products and the timing and success of any new services
      and products. Smart Online will continue to seek additional integration and
      syndication customers who typically pay an upfront fee and to increase revenues
      generated from small business end users.





**Integration,
      Syndication and Other Contracts.** Upfront
      payments totaling approximately $330,000, primarily related to new integration
      and syndication contracts, positively impacted operating cash flows for the
      year-ended December 31, 2004. We are devoting greater efforts to enter into
      syndication and integration agreements as we release our Next Generation
      Platform, OneBiz Conductor SM .





**Receivables.** If
      we are
      successful in signing new contracts, we anticipate our receivables and
      collections from integration, syndication, and end-user licensing opportunities
      to increase significantly starting during the first quarter of 2006. Smart
      Online’s receivables are primarily from major companies or banking institutes,
      and not end users. Management has evaluated the need for an allowance for
      doubtful accounts and determined that no provision for uncollectible accounts
      is
      required as of June 30, 2005 and December 31, 2004.





**Facilities.** Smart
      Online’s principal administrative, sales, marketing, and research and
      development facility is located in Durham, North Carolina and consists of over
      5,000 square feet of office space. The facility, which is fully furnished,
      is
      subject to a lease agreement that expires on October 31, 2005. Smart Online
      is
      currently evaluating its options with regard to extending its current lease
      and
      relocating to new facilities. Should management determine that it is in Smart
      Online’s best interest to relocate, Smart Online will likely incur significant
      additional costs associated with relocating its operations and furnishing the
      new space. In addition, if the acquisitions that are currently planned actually
      occur, Smart Online will operate from multiple locations.




**Media
      and Barter Transactions.** Smart
      Online expects to create arrangements in the future with media
      companies who
      offer the ability to reach small business customers and will assist in
      off-setting Smart Online’s outlay of cash for more costly print and online
      advertising and marketing. While we intend to derive a majority of our
      syndication revenue from traditional non-barter transactions, we will evaluate
      barter transactions on a case-by-case basis when we believe such transactions
      make economic or strategic sense.





**End
      User Customer Revenue.** We
      currently allow many users of our web-based products to access our products
      without charge. Our primary marketing strategy to date has been price-based
      promotions, which gains us users, but limits our revenue. For example, CD-ROM
      products are provided to OEMs for a nominal charge. In addition, Smart Online
      has permitted many customers to use its web-based products for free, either
      by
      offering free initial service or by allowing users that fail to pay our monthly
      subscription fees to continue to access our web-based products. We plan to
      continue to offer free or discounted pricing on our products until we introduce
      the second version of our Next Generation Platform, OneBiz Conductor SM ,
      which
      is expected to occur at the end of the third quarter of 2005. We will seek
      to
      grow our monthly subscription volume substantially over the 24 months following
      the release of later versions of OneBiz Conductor SM ,
      although we expect substantial increases only after we have sufficient time
      to
      sell our new product and after we invest substantially greater amounts in
      marketing and sales. We expect monthly subscription fees will typically be
      $29.95 to $49.95 for new subscribers at www.SmartOnline.com after an
      initial free use period although to date we have given free access to our web
      services to most users. We expect lower fees from subscribers at the private
      label syndication websites of our syndication partners. Currently, we pay most
      of our syndication partners a percentage of the revenue we receive from their
      private label syndication websites, which amounts we report as a component
      of
      our sales and marketing expense. A la carte pricing, which allows customers
      to
      purchase one-time use of a specific software or content service, ranges from
      $10
      to $300, which includes third-party charges when applicable, such as state
      and
      federal fees associated with incorporating a business or additional fees
      associated with having a press release written and revised. However, there
      can
      be no assurance that we will be successful in attracting new customers or that
      customers will pay for our products after we introduce the second version of
      our
      Next Generation Platform. We are currently
      evaluating for inclusion in the second and third versions of OneBiz
      ConductorSMthe accounting software application developed by another
      company.  This may delay the release of the accounting software of the
      second version of OneBiz ConductorSM until the fourth quarter of
      2005.  Such delay may cause a delay in our ability to sell subscriptions on
      the accounting software is an important part of the second version of OneBiz
      ConductorSM.




**Marketing
      and Sales Expense Increases** .
      At the
      end of the third quarter of 2005, we plan to invest heavily in marketing and
      sales by increasing the number of direct sales personnel and increasing
      penetration within our existing customer base, expanding our domestic and
      international selling and marketing activities, building brand awareness and
      participating in additional marketing programs. This increase is being timed
      to
      coincide with the planned release of the second version of our Next Generation
      Platform, OneBiz Conductor SM which
      we
      anticipate will occur at the end of the third quarter of 2005.





**Gains
      From Debt Foregiveness.** During
      the first half of 2005 and 2004 Smart Online realized gains totaling $547,241
      and $27,548, respectively, resulting from negotiated and contractual releases
      of
      outstanding liabilities. The 2005 gain was primarily from the settlement with
      the Internal Revenue Service. The 2004 gains were primarily related to unrelated
      third parties, primarily trade


32


creditors
      who had performed services for Smart Online, agreeing to accept as payment
      in
      full a lesser amount than the stated liability in consideration for timely
      payment of the negotiated settlement. Had Smart Online not been able to reach
      agreement with the Internal Revenue Service and these creditors, Smart Online’s
      liabilities and future cash flow requirements would have been higher by the
      amount of the debt foregiven.





**Public
      Company Expenses.** As
      a
      public company, we will incur significant legal, accounting and other expenses
      that we did not incur as a private company. We will incur costs associated
      with
      our public company reporting requirements. We also anticipate that we will
      incur
      costs associated with recently adopted corporate governance requirements,
      including requirements under the Sarbanes-Oxley Act of 2002, as well as new
      rules implemented by the Securities and Exchange Commission, the NASD, and
      national securities exchanges. We expect these rules and regulations to increase
      our legal and financial compliance costs and to make some activities more
      time-consuming and costly. Any unanticipated difficulties in preparing for
      and
      implementing these reforms could result in material delays in complying with
      these new laws and regulations or significantly increase our costs. Our ability
      to fully comply with these new laws and regulations is also uncertain. Our
      failure to timely prepare for and implement the reforms required by these new
      laws and regulations could significantly harm our business, operating results,
      and financial condition. We are currently evaluating and monitoring developments
      with respect to these new rules, and we cannot predict or estimate the amount
      of
      additional costs we may incur or the timing of such costs. We estimate this
      will
      add approximately $500,000 to our expenses during 2005, our first year as a
      public company.





**Legal
      Claims.** Smart
      Online is subject to other claims and suits that arise from time to time in
      the
      ordinary course of business. While management currently believes that resolving
      these matters, individually or in aggregate, will not have a material adverse
      impact on Smart Online’s financial position or results of operations, the
      litigation and other claims noted above are subject to inherent uncertainties
      and management’s view of these matters may change in the future. In the event an
      unfavorable final outcome were to occur, there exists the possibility of a
      material adverse impact on Smart Online’s financial position and the results of
      operations for the period in which the effect becomes reasonably estimable.
      See
“Part II - Item 1. Legal Proceedings” for a description of current
      litigation.





**Risk
      Factors**





An
      investment in Smart Online involves significant risks. You should read the
      risks
      described below very carefully before deciding whether to invest in Smart
      Online. The following is a description of what we consider our key challenges
      and risks.








We
      operate in a dynamic and rapidly changing business environment that involves
      substantial risk and uncertainty and these risks may change over time. The
      following discussion addresses some of the risks and uncertainties that could
      cause, or contribute to causing, actual results to differ materially from
      expectations. In evaluating our business, readers should pay particular
      attention to the descriptions of risks and uncertainties described below and
      in
      other sections of this document and our other filings with the Securities and
      Exchange Commission.





**We
      have organized these factors into the following categories
      below:**





·
            Our
                Financial Condition


·
            Our
                Products and Operations


·
            Our
                Market, Customers and Partners


·
            Our
                Officers, Directors, Employees and
                Shareholders


·
            Regulatory
                Matters that Affect Our Business


·
            Matters
                Related to The Market for Our
                Securities





**RISKS
      ASSOCIATED WITH OUR FINANCIAL CONDITION**





**(1)
      We Have Had Recurring Losses From Operations Since Inception, and Have
      Deficiencies in Working Capital and Equity Capital. If We Do Not Rectify These
      Deficiencies, We May Have to Cease Operations and Liquidate Our Business.
      Because We Have Only Nominal Tangible Assets, You May Lose Your Entire
      Investment.**





Through
        June 30, 2005, we have lost an aggregate of approximately $38.0 million since
        inception on August 10, 1993. During the six months ended June 30, 2005 and
        the
        year ended December 31, 2004, we suffered a net loss of approximately $1.2
        million and $8.3 million, respectively. At June 30, 2005, we had approximately
        a
        $51,000 deficit in working capital. Our working capital is not sufficient
        to
        fund our


33


operations
      for the next year, unless we substantially increase our revenue, limit expenses
      or raise substantial additional capital. At June 30, 2005, we had cash and
      cash
      equivalents totaling $552,407 and we had only nominal tangible assets. If we
      do
      not rectify these deficiencies, we may have to cease operations and liquidate
      our business. Because we have only nominal tangible assets, you may lose your
      entire investment.





**(2)
      Our Independent Registered Public Accountants Have Indicated That They Have
      Substantial Doubts That Smart Online Can Continue as a Going Concern. Our
      Independent Registered Public Accountants’ Opinion May Negatively Affect Our
      Ability to Raise Additional Funds, Among Other Things. If We Fail to Raise
      Sufficient Capital, We Will Not Be Able to Implement Our Business Plan, We
      May
      Have To Liquidate Our Business and You May Lose Your
      Investment.**





BDO
      Seidman, LLP, our independent registered public accountants, has expressed
      substantial doubt, in their report included in our Form 10-K for the year ended
      December 31, 2004, about our ability to continue as a going concern given our
      recurring losses from operations and deficiencies in working capital and equity,
      which are described in the first risk factor above. This opinion could
      materially limit our ability to raise additional funds by issuing new debt
      or
      equity securities or otherwise. If we fail to raise sufficient capital, we
      will
      not be able to implement our business plan, we may have to liquidate our
      business and you may lose your investment. You should consider our auditor’s
      comments when determining if an investment in Smart Online is
      suitable.





**(3)
      We Will Require Additional Financing To Fund Our Operations Or Growth. If
      Financing Is Not Available, We May Have To Liquidate Our Business and You May
      Lose Your Investment.**





In
      the
      future, we will be required to seek additional financing to fund our operations
      or growth. Factors such as the commercial success of our existing services
      and
      products, the timing and success of any new services and products, the progress
      of our research and development efforts, our results of operations, the status
      of competitive services and products, and the timing and success of potential
      strategic alliances or potential opportunities to acquire technologies or assets
      may require us to seek additional funding sooner than we expect. We cannot
      assure you that such funding will be available. If sufficient capital is not
      raised, our ability to achieve or sustain positive cash flows, maintain current
      operations, fund any potential growth, take advantage of unanticipated
      opportunities, develop or enhance services or products, or otherwise respond
      to
      competitive pressures would be significantly limited. If we fail to raise
      sufficient capital, we will not be able to implement our business plan, we
      may
      have to liquidate our business and you may lose your investment **.** When restrictions on resale of over nine million
      shares of our Common Stock terminate on October 1, 2005, the volume of resales
      may adversely affect the market value of our Common Stock and may make it more
      difficult to raise capital.  See Risk Factor (52) for information about
      lock-up agreements and other restrictions on resale.





**(4)
      If We Are Able To Raise Capital, But Are Not Able To Obtain Terms That are
      Favorable To Us, Existing Shareholders and New Investors May Suffer Dilution
      Of
      Their Ownership Interests in Our Company Or Otherwise Lose Value In Our
      Securities.**





If
      we
      raise additional funds through the issuance of equity securities or debt
      convertible into equity securities, the percentage of stock ownership by our
      existing stockholders would be reduced. In addition, such securities could
      have
      rights preferences and privileges senior to those of our current stockholders
      and new investors in this offering, which could substantially decrease the
      value
      of our securities owned by them.





**(5)
      We Will Rely Heavily On Successful Development and Market Acceptance of Our
      Next
      Generation Platform, OneBiz Conductor** SM **.**





Since
      2000, we have generated substantially all of our revenues from our current
      Internet-based services, content and software applications. Internet-based
      products are growing in sophistication and customer expectations are rising
      as
      new products are introduced. In March 2005 we released the first version of
      OneBiz Conductor SM ,
      our
      Next Generation Product, but we do not expect to see substantial revenue
      increases until after we release and have time to sell the third installment
      of
      OneBiz Conductor SM ,
      which
      is scheduled to occur at the end of 2005. Our future financial performance
      and
      revenue growth will depend upon the successful development, introduction, and
      customer acceptance of OneBiz Conductor SM .
      We plan
      to introduce OneBiz Conductor SM directly
      to our existing customer base through our online business solution site at www.SmartOnline.com .
      If
      OneBiz Conductor SM has
      been
      accepted and modified based on customer feedback on www.SmartOnline.com ,
      it will
      then be integrated into our private label syndication partners sites so Smart
      Online can leverage both channels to generate revenue while minimizing our
      direct marketing expenses.





**(6)
      We May Not Successfully Develop or Introduce the Next Two Installments of Our
      Next Generation Product, OneBiz Conductor** **SM** **,
      and Other New Products or Enhancements to Existing Products, Which Could Harm
      Our Business.**





Our
      future financial performance and revenue growth will depend, in part, upon
      the
      successful development, introduction, and customer acceptance of our next
      generation product, OneBiz Conductor SM .
      Thereafter other new products and enhanced versions of


34


our
      web-native business applications will be critically important to our business.
      Our business could be harmed if we fail to deliver enhancements that customers
      desire to our current and future solutions. From time to time, we have
      experienced delays in the planned release dates of our software (including
      OneBiz Conductor SM )
      and
      upgrades, and we have discovered software defects in new releases both before
      and after their introduction. New product versions or upgrades may not be
      released according to schedule, or may contain certain defects when released.
      Either situation could result in adverse publicity, loss of sales, delay in
      market acceptance of our services and products, or customer claims against
      us,
      any of which could harm our business. If we do not deliver new product versions,
      upgrades, or other enhancements to existing services and products on a timely
      and cost-effective basis, our business will be harmed. We are also continually
      seeking to develop new offerings. However, we remain subject to all of the
      risks
      inherent in product development, including unanticipated technical or other
      development problems, which could result in material delays in product
      introduction and acceptance or significantly increased costs. There can be
      no
      assurance that we will be able to successfully develop new services or products,
      or to introduce in a timely manner and gain acceptance of such new services
      or
      products in the marketplace. We
      expect
      the second version of OneBiz Conductor SM will be
      released on or before September 30, 2005, except that all or part of the
      accounting application may not be released until during the fourth quarter.
      The
      third version of OneBiz Conductor SM ,
      including enhanced accounting software, is expected to be released before the
      end of 2005.





**(7)
      We Have Experienced Delays in Developing Our Next Generation Platform, OneBiz
      Conductor** **SM** **.
      Existing Factors May Result in Further Delays Which Could Harm Our
      Business.**





We
      had
      planned to release the first version of our Next Generation Platform during
      the
      fourth quarter of 2004. Testing by some customers of the first version began
      at
      the end of 2004, but commercial release was delayed until March 2005. In
      addition to the factors that may delay or prevent completion of any new product
      development project, some existing factors may further delay or prevent
      development of our next generation product, OneBiz Conductor SM .
      These
      factors include the following. OneBiz Conductor SM requires
      both enhancing our existing technology platform and adding many new software
      applications. Integrating so many new applications at the same time is
      difficult. Another factor that might delay or prevent development of OneBiz
      Conductor SM is
      that
      we have to hire, train and manage new development personnel to complete internal
      development on time. In addition, for many of the most important new
      applications of OneBiz Conductor SM ,
      such as
      sales automation, we intend to rely on third party sources, whether through
      licensing, joint development or purchase. The willingness of third parties
      to
      enter into agreements with us and the ability of third parties to perform
      agreements are totally outside our control. We
      expect
      the second version of OneBiz Conductor SM will be
      released on or before September 30, 2005, except that all or part of the
      accounting application may not be released until during the fourth quarter.
      The
      third version of OneBiz Conductor SM ,
      including enhanced accounting software, is expected to be released before the
      end of 2005. Our
      business could be harmed, if we fail to deliver the improved performance that
      customers want with respect to our current and future offerings. There can
      be no
      assurance that our next generation platform will achieve widespread market
      penetration or that we will derive significant revenues from sales of OneBiz
      Conductor SM .





**(8)
      Our Products Might Not Keep Pace with Technological Change, Which Could Harm
      Our
      Business.**





We
      must
      continually modify and enhance our services and products to keep pace with
      changes in hardware and software platforms, database technology, and electronic
      commerce technical standards. As a result, uncertainties related to the timing
      and nature of new product announcements or introductions, or modifications
      by
      vendors of operating systems, back-office applications, and browsers and other
      Internet-related applications, could harm our business.





**(9)
      Our Business Is Difficult To Evaluate Because Our Business Models and Operating
      Plans Have Changed As A Result of Forces Beyond Our Control. Consequently,
      We
      Have Not Yet Demonstrated That We Have a Successful Business Model or Operating
      Plan.**





We
      incorporated in 1993 with a CD-ROM based business model. In 1999, we
      commercially introduced our Internet-based Software-as-Service (SaS) business
      model, when it became clear that the developing Internet world offered a better
      delivery platform. We began to enter into syndication partnering arrangements
      during the year 2000 primarily as a result of the need to leverage the marketing
      and sales resources of others. Our business models and operating plans have
      evolved as a result of changes in our market, the expectations of customers
      and
      the behavior of competitors. Today, we anticipate that our future financial
      performance and revenue growth will depend, in large part, upon our
      Internet-based SaS business model and syndication partnering arrangements,
      but
      these business models may again become ineffective due to forces beyond our
      control that we do not currently anticipate. Consequently, we have not yet
      demonstrated that we have a successful business model or operating plan. Our
      evolving business model makes our business operations and prospects difficult
      to
      evaluate. Investors in our securities should consider all the risks and
      uncertainties that are commonly encountered by companies in this stage of
      business operations, particularly companies, such as ours, that are in emerging
      and rapidly evolving markets.





**(10)
      It Is Important For Us To Continue To Manage Changing Business Conditions.
      Failure To Do So Could Harm Our Business.**





Our
      future operating results will depend, in part, on our ability to manage changing
      business conditions, including such conditions as the general economic slowdown,
      reduced investment in information technology by customers and prospective
      customers, and reduced business travel and entertainment budgets. If we are
      unable to manage changing business conditions effectively, our
      business,


35


financial
      condition, and results of operations could be materially and adversely affected.
      Failure to manage our operations with reduced staffing levels may strain our
      management, financial, legal, and other resources, and could have a material
      adverse effect on our business, financial condition, and results of
      operations.





**(11)
      The Success of Our Business Depends on The Continued Growth and Acceptance
      of
      the Internet as a Business Tool. If These Positive Trends Do Not Continue To
      Develop, Our Business Could Be Harmed.**





Expansion
      in the sales of our service depends on the continued growth and acceptance
      of
      the Internet as a communications and commerce platform for enterprises. The
      Internet could lose its viability as a business tool due to delays in the
      development or adoption of new standards and protocols to handle increased
      demands of Internet activity, security, reliability, cost, ease-of-use,
      accessibility and quality-of-service. The performance of the Internet and its
      acceptance as a business tool has been harmed by “viruses,”“worms” and similar
      malicious programs, and the Internet has experienced a variety of outages and
      other delays as a result of damage to portions of its infrastructure. If for
      any
      reason the Internet does not remain a widespread communications medium and
      commercial platform, the demand for our service would be significantly reduced,
      which would harm our business.





**(12)
      We Sell Third-Party Software and Web Services That May be Difficult to Replace.
      If We Are Not Able to Replace Third Party Software And Web Services, Our
      Business May Be Harmed.**





We
      rely
      on software licensed from third parties to offer some of our services and
      software offerings, including merchant services, incorporation services, on-line
      direct mail services and loan referrals. During 2004, approximately 6% of our
      revenue was derived from such third party software and services. During 2003
      and
      2002 approximately 16% and 17%, respectively, of our revenue was derived from
      such sources. These software and services may not continue to be available
      on
      commercially reasonable terms, if at all. We plan to increase our reliance
      on
      third party software when we introduce OneBiz Conductor SM by
      licensing sales automation software from third parties. The loss or inability
      to
      maintain any of these arrangements could result in delays in the sale of our
      services or software offerings until equivalent technology or services are
      either developed by us, or, if available, are identified, licensed, and
      integrated. Any such delay could harm our business.





**(13)
      If We Acquire Companies, Products, or Technologies, We May Face Risks Associated
      with Those Acquisitions. These Risks Include, But Are Not Limited to, Difficulty
      of Integrating, Dilution of Stockholder Value and Disruption of Our Business,
      Which Could Adversely Affect Our Operating Results.**





In
      the
      future, we plan to acquire products or technologies. We may not realize the
      anticipated benefits of our future acquisitions or investments to the extent
      that we anticipate, or at all. We have had discussions with several companies,
      but have not yet entered into any purchase agreements. We may have to issue
      debt
      or issue equity securities to pay for future acquisitions or investments, the
      issuance of which could be dilutive to our existing stockholders and investors
      in this offering. If any acquisition or investment is not perceived as improving
      our earnings per share, our stock price may decline. In addition, we may incur
      non-cash amortization charges from acquisitions, which could harm our operating
      results. Any completed acquisitions would also require significant integration
      efforts, diverting our attention from our business operations and strategy.
      We
      have made limited acquisitions to date, and therefore our ability as an
      organization to make acquisitions or investments is unproven. Acquisitions
      and
      investments involve numerous risks, including:





·
            difficulties
                in integrating operations, technologies, services and
                personnel;


·
            diversion
                of financial and managerial resources from existing
                operations;


·
            risk
                of entering new markets;


·
            potential
                write-offs of acquired assets;


·
            potential
                loss of key employees;


·
            inability
                to generate sufficient revenue to offset acquisition or investment
                costs;
                and


·
            delays
                in customer purchases due to
                uncertainty.





In
      addition, if we finance acquisitions by issuing convertible debt or equity
      securities, our existing stockholders and investors in this offering may be
      diluted which could affect the market price of our stock. As a result, if we
      fail to properly evaluate and execute acquisitions or investments, our business
      and prospects may be seriously harmed.





During
      July 2005, Smart Online signed a non-binding letter of intent to acquire a
      privately held developer and distributor of customer relationship management
      software based in the mid-western United States. Also during July 2005, Smart
      Online signed a non-binding letter of intent to acquire a privately held
      developer and distributor of multi-channel commerce systems based in the Great
      Lakes


36


region
      of
      the United States. In addition to the general risks associated with acquisitions
      outlined above, there are additional risks associated with these two proposed
      acquisitions including:





·
            risk
                of operating and integrating geographically remote
                offices;


·
            risk
                of integrating technologies and offerings with the OneBiz
                ConductorSMproduct;


·
            risk
                of converting customer data from stand alone product offerings of
                the
                acquisition targets to formats utilized by the OneBiz
                ConductorSMproduct;


·
            risk
                of losing customers of the acquired companies due to actual or perceived
                changes in operations and customer
                interfaces;


·
            risk
                of integrating management, administrative, operational and financial
                infrastructures; and


·
            risks
                of implementing and monitoring compliance with corporate governance
                andpublic
                company reporting requirements and the ability of management to manage
                and
                timely and accurately consolidate the results of
                operations.





**(14)
      We Rely on Third-Party Hardware and Software That May Be Difficult To Replace
      or
      Which Could Cause Errors or Failures of Our Service. Such Events May Harm Our
      Business.**





We
      rely
      on hardware purchased or leased and software licensed from third parties in
      order to offer our service. We use commercially available hardware and software
      from vendors like Oracle, Sun Microsystems, IBM, Microsoft, Verisign, Dell,
      Apple, HP, Cisco, Nokia, Adobe, Macromedia, Checkpoint, Symantec, Appligent
      and
      Quest. We have purchased or licensed all the equipment and software and we
      have
      not leased or borrowed to acquire any of them. These software and hardware
      systems will need periodic upgrades in the future as part of normal operation
      of
      business, which will be an added expense.





We
      also
      use certain software from leading opensource communities like Sun Microsystems,
      Apache Group, GNU, Suse (Novell) that are free and available in the public
      domain. The OneBiz Conductor SM product
      will use additional public domain software, if needed for successful
      implementation and deployment. In addition, we are currently evaluating the
      accounting application software developed by another company.  If the
      evaluation is favorable, we may include all or part of that third party
      accounting software in OneBiz ConductorSM. 
      Using such software does not guarantee us support and upgrades of the software,
      and therefore could cause disruption in our service, if certain critical defects
      are discovered in the software at a future date.





The
      hardware and software we use may not continue to be available on commercially
      reasonable terms, or at all, or upgrades may not be available when we need
      them.
      We are not currently aware of any problems, but any loss of the right to use
      any
      of this hardware or software could result in delays in the provisioning of
      our
      services until equivalent technology is either developed by us, or, if
      available, is identified, obtained and integrated, which could harm our
      business. Any errors or defects in, or unavailability of, third-party hardware
      or software could result in errors or a failure of our service, which could
      harm
      our business.





**(15)
      Interruption Of Our Operations Could Significantly Harm Our
      Business.**





Significant
      portions of our operations depend on our ability to protect our computer
      equipment and the information stored in such equipment, our offices, and our
      hosting facilities against damage from fire, power loss, telecommunications
      failures, unauthorized intrusion, and other events. We back up software and
      related data files regularly and store the backup files at an off-site location.
      However, there can be no assurance that our disaster preparedness will eliminate
      the risk of extended interruption of our operations. In connection with our
      subscription and hosting services, we have engaged third-party hosting facility
      providers to provide the hosting facilities and certain related infrastructure
      for such services. We also retain third-party telecommunications providers
      to
      provide Internet and direct telecommunications connections for our services.
      These providers may fail to perform their obligations adequately. Any damage
      or
      failure that interrupts our operations or destroys some or all of our data
      or
      the data of our customers, whether due to natural disaster or otherwise, could
      expose us to litigation, loss of customers, or other harm to our business.





**(16)
      Defects in Our Service Could Diminish Demand for Our Service and Subject Us
      to
      Substantial Liability, Damage Our Reputation, Or Otherwise Harm Our
      Business.**





Because
      our service is complex, it may have errors or defects that users identify after
      they begin using it, which could harm our reputation and our business.
      Internet-based services frequently contain undetected errors when first
      introduced or when new versions or enhancements are released. We have from
      time
      to time found defects in our service and new errors in our existing service
      may
      be detected in the future. Since our customers use our service for important
      aspects of their business, any errors, defects or other performance problems
      with our service could hurt our reputation and may damage our customers’
businesses. If that occurs, customers could elect not to renew, or delay or
      withhold payment to us, we could lose future sales or customers may make
      warranty claims against us, which could result in an increase in our provision
      for doubtful accounts, an increase in collection cycles for accounts receivable
      or the expense and risk of litigation.


37





**(17)
      Security and Other Concerns may Discourage Use of Our Internet Based
      Software-as-Service (SaS) Model, Which Could Harm Our
      Business.**





Our
      service involves the storage and transmission of customers’ proprietary
      information, and security breaches could expose us to a risk of loss of this
      information, litigation and possible liability. If our security measures are
      breached as a result of third-party action, employee error, malfeasance or
      otherwise, and, as a result, someone obtains unauthorized access to one of
      our
      customers’ data, our reputation will be damaged, our business may suffer and we
      could incur significant liability. Because techniques used to obtain
      unauthorized access or to sabotage systems change frequently and generally
      are
      not recognized until launched against a target, we may be unable to anticipate
      these techniques or to implement adequate preventative measures. If an actual
      or
      perceived breach of our security occurs, the market perception of the
      effectiveness of our security measures could be harmed and we could lose sales
      and customers. If customers determine that our services offerings do not provide
      adequate security for the dissemination of information over the Internet or
      corporate extranets, or are otherwise inadequate for Internet or extranet use
      or
      if, for any other reason, customers fail to accept our products for use, our
      business will be harmed.





As
      part
      of our operations, we receive credit card, employee, purchasing, supplier,
      and
      other financial and accounting data, through the Internet or extranets. Although
      we have security systems in place, there can be no assurance that this
      information will not be subject to computer break-ins, theft, and other improper
      activity that could jeopardize the security of information for which we are
      responsible. Any such lapse in security could expose us to litigation, loss
      of
      customers, or other harm to our business. In addition, any person who is able
      to
      circumvent our security measures could misappropriate proprietary or
      confidential customer information or cause interruptions in our operations.
      We
      may be required to incur significant costs to protect against security breaches
      or to alleviate problems caused by breaches. Any general concern regarding
      security in the marketplace could deter customers or prospects from using the
      Internet to conduct transactions that involve transmitting confidential
      information. Our failure to prevent security breaches, or well-publicized
      security breaches affecting the Internet in general, could significantly harm
      our business, operating results, and financial condition.





**(18)
      If We Experience Significant Fluctuations In Our Operating Results And Rate
      Of
      Growth And Fail To Balance Our Expenses With Our Revenue and Earnings
      Expectations, Our Results Would Be Harmed And Our Stock Price May Fall Rapidly
      And Without Advance Notice.** ******




Due
      to
      our limited operating history, our evolving business model and the
      unpredictability of our emerging industry, we may not be able to accurately
      forecast our rate of growth. We base our current and future expense levels
      and
      our investment plans on estimates of future revenue and future rate of growth.
      Our expenses and investments are, to a large extent, fixed and we expect that
      these expenses will increase in the future. We may not be able to adjust our
      spending quickly enough if our revenue falls short of our expectations.




As
      a
      result, we expect that our operating results may fluctuate significantly on
      a
      quarterly basis. Revenue growth may not be sustainable and may decrease in
      the
      future. We believe that period-to-period comparisons of our operating results
      may not be meaningful, and you should not rely upon them as an indication of
      future performance.





**(19)
      Because We Recognize Revenue From Our Partners Over The Term Of The Agreement,
      Downturns or Upturns In Sales May Not Be Immediately Reflected in Our Operating
      Results.** ******




We
      generally recognize revenue from partners ratably over the terms of their
      agreements. As a result, much of the revenue we report in each quarter is
      deferred revenue from partner agreements entered into during previous quarters.
      Consequently, a decline in new or renewed partners in any one quarter will
      not
      necessarily be fully reflected in the revenue in that quarter and will
      negatively affect our revenue in future quarters. In addition, we may be unable
      to adjust our cost structure to reflect these reduced revenues. Accordingly,
      the
      effect of significant downturns in transactions with our partners may not be
      fully reflected in our results of operations until future periods. Our reliance
      on revenue from our partners makes it difficult for us to rapidly increase
      our
      partner revenue through additional sales in any period, as revenue from new
      partners must be recognized over the applicable agreement term.





**Risks
      Associated With Our Market Customers and Partners**





**(20)
      If Our On-Demand Application Service is Not Widely Accepted, Our Operating
      Results Will Be Harmed.**





Historically,
      we have derived a small percentage of our revenue from subscriptions to our
      on-demand application service, but our business plan requires us to
      substantially increase this source of revenue in the future. As a result,
      widespread acceptance of our service is critical to our future success. Factors
      that may affect market acceptance of our service include:





·
            potential
                reluctance by businesses to migrate to an on-demand application
                service;





38





·
            the
                price and performance of our
                service;





·
            the
                level of customization we can
                offer;





·
            the
                availability, performance and price of competing products and services;
                and





·
            potential
                reluctance by businesses to trust third parties to store and manage
                their
                internal data.





Many
      of
      these factors are beyond our control. The inability of our service to achieve
      widespread market acceptance would harm our business.





**(21)
      The Market for Our Technology Delivery Model and On-Demand Application Services
      Is Immature And Volatile, and if It Does Not Develop or Develops More Slowly
      Than We Expect, Our Business Will Be Harmed.**





The
      market for on-demand application services is new and unproven, and it is
      uncertain whether these services will achieve and sustain high levels of demand
      and market acceptance. Our success will depend to a substantial extent on the
      willingness of businesses to increase their use of on-demand application
      services. Many businesses have invested substantial personnel and financial
      resources to integrate traditional business software into their businesses,
      and
      therefore may be reluctant or unwilling to migrate to on-demand application
      services. Furthermore, some businesses may be reluctant or unwilling to use
      on-demand application services because they have concerns regarding the risks
      associated with security capabilities, among other things, of the technology
      delivery model associated with these services. If businesses do not perceive
      the
      benefits of on-demand application services, then the market for these services
      may not develop at all, or it may develop more slowly than we expect, either
      of
      which would significantly adversely affect our operating results. In addition,
      because this is an unproven market, we have limited insight into trends that
      may
      develop and affect our business. We may make errors in predicting and reacting
      to relevant business trends, which could harm our business.





**(22)
      We Do Not Have an Adequate History With Our Subscription Model To Predict the
      Rate of Customer Subscription Renewals and the Impact These Renewals Will Have
      on Our Revenue or Operating Results.**





Our
      small
      business customers do not sign long-term contracts. Our customers have no
      obligation to renew their subscriptions for our service after the expiration
      of
      their initial subscription period and in fact, customers have often elected
      not
      to do so. In addition, our customers may renew for a lower priced edition of
      our
      service or for fewer users. Many of our customers utilize our services without
      charge. We have limited historical data with respect to rates of customer
      subscription renewals for paying customers, so we cannot accurately predict
      customer renewal rates. Our customers’ renewal rates may decline or fluctuate as
      a result of a number of factors, including when we begin charging for our
      services, their dissatisfaction with our service and their ability to continue
      their operations and spending levels. If our customers do not renew their
      subscriptions for our service, our revenue may decline and our business will
      suffer.





**(23)
      We Depend on Small Businesses for Our Revenue. Small Businesses are Often
      Financially Unstable, Have High Rates of Attrition and can be Expensive
      Customers to Which to Market Products.**





Substantially
      all our revenue is from small business customers with fifty or fewer employees,
      whether directly or indirectly from our partners who do business with small
      businesses. Although this is a large market, it can be very expensive to
      penetrate this market. Each customer results in only a small amount of revenue.
      In addition, small businesses are often financially unstable, which can cause
      them to go out of business. Our small business customers, typically have short
      initial subscription periods and, based on our experience to date, have had
      a
      high rate of attrition and non-renewal. If we cannot replace our small business
      customers that do not renew their subscriptions for our service with new paying
      customers quickly enough, our revenue could decline. This adversely affects
      our
      ability to develop long-term customer relationships. We must continually attract
      new customers to maintain the same level of revenue.





**(24)
      If We Fail to Develop Our Brand Cost-Effectively, Our Business May
      Suffer.**





We
      believe that developing and maintaining awareness of the Smart Online brand
      in a
      cost-effective manner is critical to achieving widespread acceptance of our
      existing and future services and is an important element in attracting new
      customers. Furthermore, we believe that the importance of brand recognition
      will
      increase as competition in our market develops. Successful promotion of our
      brand will depend largely on the effectiveness of our marketing efforts and
      on
      our ability to provide reliable and useful services at competitive prices.
      In
      the past, our efforts to build our brand have involved significant expense.
      Brand promotion activities may not yield increased revenue, and even if they
      do,
      any increased revenue may not offset the expenses we incurred in building our
      brand. If


39


we
      fail
      to successfully promote and maintain our brand, or incur substantial expenses
      in
      an unsuccessful attempt to promote and maintain our brand, we may fail to
      attract enough new customers or retain our existing customers to the extent
      necessary to realize a sufficient return on our brand-building efforts, and
      our
      business could suffer.





**(25)
      We Depend on Corporate Partners to Market Our Products Through Their Web Sites
      and OEM or Integration Relationships Under Relatively Short Term Agreements.
      Termination of These Agreements Could Cause A Substantial Decline in Our Revenue
      and a Substantial Increase in Customer Acquisition Costs.**





Approximately
      91% of total revenue during the first half of 2005, 93% of total revenue during
      year 2004, and approximately 83% of total revenue during year 2003 was derived
      from syndication, integration and OEM agreements with large companies whereby
      our content, software applications and technology platform are integrated into
      the web sites of our syndication partners and the software and services of
      our
      integration partners is sold on our website, and our CD-Rom products are bundled
      with the products of others through our OEM relationships. Under these
      agreements we both derive revenue and we utilize the resources of our partners
      to reduce our customer acquisition costs. As of August 1, 2005, we have six
      syndication agreements, where we currently or will have our content and software
      on the website of large corporate partners. As of August 1, 2005, we have nine
      integration partnership agreements where we integrate the content or services
      of
      our partners into our technology platform. As of August 1, 2005, we have one
      OEM
      relationship through our distributor, PC Treasures. Not all these agreements
      generate revenue for us at this time. These agreements typically have initial
      terms of from one to three years. In the event these agreements were to
      terminate or not be renewed, or their terms substantially renegotiated, we
      expect that our revenues would decline and our customer acquisition costs would
      increase. Although our partners are important to our business on a collective
      basis, no single partner is material to our business. The syndication,
      integration, and OEM agreement revenue described above includes revenue from
      an
      integration agreement between Smart Online and Smart IL, a related party owned
      by a shareholder of Smart Online. Smart IL accounted for approximately 0% of
      our
      total revenues in the first half of 2005, 27.2% of our total revenue in 2003,
      and approximately 32.9% of total revenue during 2004. We do not expect to
      receive revenue from Smart IL after 2004. Our dealings with Smart IL are
      described under “Management Discussion and Analysis of Financial Condition and
      Results of Operations - Revenue From Related Parties.”





**(26)
      It is Important for Us to Continue to Develop and Maintain Strategic
      Relationships. Failure to Do So Could Harm Our Business.**





We
      depend
      on syndication and integration partners, OEM relationships and referral
      relationships to offer products and services to a larger customer base than
      we
      can reach through direct sales, and other marketing efforts. Approximately
      81%
      of our total revenue during 2002 and approximately 83% of our total revenue
      during 2003 and approximately 93% of our total revenue during 2004 was derived
      through such relationships. If we were unable to maintain our existing strategic
      relationships or enter into additional strategic relationships, we would have
      to
      devote substantially more resources to the distribution, sales, and marketing
      of
      our products and services. Our success depends in part on the ultimate success
      of our syndication and integration partners, OEM relationships and referral
      partners and their ability to market our products and services successfully.
      Our
      partners are not obligated to provide potential customers to us. In addition,
      some of these third parties have entered, and may continue to enter, into
      strategic relationships with our competitors. Further, many of our strategic
      partners have multiple strategic relationships, and they may not regard us
      as
      significant for their businesses. Our strategic partners may terminate their
      respective relationships with us, pursue other partnerships or relationships,
      or
      attempt to develop or acquire products or services that compete with our
      products or services. Our strategic partners also may interfere with our ability
      to enter into other desirable strategic relationships. One of our syndication
      partnership agreements with Gruner + Jahr USA Publishing, pursuant to which
      we
      syndicate our platform and applications to the websites www.Inc.com and www.FastCompany.com ,
      contains a prohibition against our syndicating our platform and applications
      to
      two competitors of Gruner + Jahr. All of our integration partnership agreements
      limit our ability to integrate products or services onto our website that
      compete with the products or services being provided through our website by
      our
      integration partners.





**(27)
      Our Lengthy Sales Cycle with Syndication, Integration Partners and OEM
      Relationships Could Adversely Affect Our Financial
      Results.**





Our
      syndication and integration partners and OEM relationships typically commit
      significant resources to an evaluation of available solutions and require us
      to
      expend substantial time, effort, and money educating them about the value of
      our
      services and software. Our sales cycle, which is the time between initial
      contact with a potential partner and ultimately signing a contract, is often
      lengthy and unpredictable. As a result, we have limited ability to forecast
      the
      timing and size of new specific partnering and OEM relationships. In addition,
      revenue may not begin to flow from such contracts until long after they are
      signed due to delays in implementing the contracts or the failure of our
      partners to devote the resources required to promote our products to small
      businesses. Any delay in signing or implementing syndication, integration and
      OEM contracts or other strategic agreements could cause our operating results
      to
      vary significantly.


40





**(28)
      We Face Significant Competition, Which Could Adversely Affect Our
      Business.**





The
      market for our solutions is intensely competitive and rapidly changing. The
      direct competition we face depends on the market segment focus and delivery
      model capabilities of our competitors. We also, at times have to overcome
      customer reluctance to move away from existing paper-based systems. We have
      two
      primary categories of competitors: companies that offer a broad range of
      software applications for small businesses and companies that offer one or
      two
      applications that compete with our broad range of applications. Our principal
      direct competition primarily comes from large companies, such as Microsoft,
      Oracle, Intuit, SAP and Yahoo!, who provide multiple software products used
      by
      many small businesses. In addition, we face competition from other competitors
      who sell single applications. Salesforce.com is an example of one of the many
      companies that fall within this second category of competitors. Many of our
      competitors have longer operating histories, greater financial, technical,
      marketing, and other resources, greater name recognition, and a larger total
      number of customers for their products and services than we do. Some of our
      competitors sell many products to our current and potential customers, as well
      as to systems integrators and other vendors and service providers. These
      competitors may also be able to respond more quickly to new or emerging
      technologies and changes in customer requirements, or to devote greater
      resources to the development, promotion, and sale of their products, than we
      may
      be able to do. In addition, we anticipate new competitors will enter the market
      in the future. Increased competition may result in price reductions, reduced
      gross margins, and change in market share and could have a material adverse
      effect on our business, financial condition, and results of operations. New
      product announcements by competitors may make it difficult to sell our products
      even before the competitor releases the product. For example, in May 2005
      Microsoft announced that it intends to introduce a new small business accounting
      application in September 2005, which is before Smart Online's planned release
      of
      its own accounting application at the end of 2005.





**(29)
      We Depend on Nonrecurring Revenue, Which May Cause Our Revenue to Fluctuate
      Substantially From One Quarter to Another or to Decline Permanently as Market
      Conditions Change.**





We
      depend
      on nonrecurring revenue. Nonrecurring revenue is primarily derived from
      integration fees and other up-front payments received upon signing syndication
      and integration agreements with corporate partners for which we charge a
      one-time fee. This revenue is recognized on a monthly basis over the initial
      term of the integration and syndication contracts and may fluctuate
      substantially from one quarter to another. All of our integration revenues
      were
      from nonrecurring sources during the years ended December 31, 2003 and December
      31, 2004. Approximately 68% of our syndication revenues for 2004 and 48.1%
      of
      our syndication revenues for 2003 were from nonrecurring sources. In addition,
      such revenue may substantially decrease on a permanent basis due to market
      conditions over which we have little or no control, including competitors
      introducing new products to the market or reducing the price of competing
      products.





**(30)
      We Depend on Web Services Revenues; Our Future Growth is Substantially Dependent
      on Customer Demand for Our Subscription Services Delivery Models. Failure to
      Increase This Revenue Could Harm Our Business.**





Revenues
      from small businesses for our Web Services, which include subscriptions, revenue
      share, e-commerce fees, hosting fees, loan origination fees and marketing fees,
      represented approximately 6.3% of our total revenue for the first half of 2005,
      6.2% of our total revenue for 2004, and approximately 16.5% of total revenue
      for
      fiscal 2003. We anticipate that Web Services revenues will continue to represent
      a significant percentage of our total revenues and that our future financial
      performance and revenue growth will depend, in large part, upon the growth
      in
      customer demand for our outsourced services delivery models. As such, we have
      invested significantly in infrastructure, operations, and strategic
      relationships to support these models, which represent a significant departure
      from the delivery strategies that other software vendors and we have
      traditionally employed. To maintain positive margins for our small business
      services, our revenues will need to continue to grow more rapidly than the
      cost
      of such revenues. There can be no assurance that we will be able to maintain
      positive gross margins in our subscription services delivery models in future
      periods. If our subscription services business does not grow sufficiently,
      we
      could fail to meet expectations for our results of operations, which could
      harm
      our business.





Any
      delays in implementation may prevent us from recognizing subscription revenue
      for periods of time; even when we have already incurred costs relating to the
      implementation of our subscription services. Additionally, customers can cancel
      our subscription services contracts at any time and, as a result, we may
      recognize substantially less revenue than we expect. If large numbers of
      customers cancel or otherwise seeks to terminate subscription agreements quicker
      than we expect, our operating results could be substantially harmed. To become
      successful, we must cause subscribers who do not pay fees to begin paying fees
      and increase the length of time subscribers pay subscription fees.





**(31)
      There are Risks Associated with International Operations, Which We Expect Will
      Become a Bigger Part of Our Business in the Future.**





We
      currently do not generate substantial revenue from international operations,
      but
      we plan to conduct greater international operations in the future. Our
      international operations will be subject to risks associated with operating
      abroad. We expect international operations


41


will
      become an important component of our business. These international operations
      are subject to a number of difficulties and special costs,
      including:





·
            costs
                of customizing products for foreign
                countries;


·
            laws
                and business practices favoring local
                competitors;


·
            uncertain
                regulation of electronic commerce;


·
            compliance
                with multiple, conflicting, and changing governmental laws and
                regulations;


·
            longer
                sales cycles; greater difficulty in collecting accounts
                receivable;


·
            import
                and export restrictions and
                tariffs;


·
            potentially
                weaker protection for our intellectual property than in the United
                States,
                and practical difficulties in enforcing such rights
                abroad;


·
            difficulties
                staffing and managing foreign
                operations;


·
            multiple
                conflicting tax laws and regulations;
                and


·
            political
                and economic instability.





Our
      international operations will also face foreign currency-related risks. To
      date,
      most of our revenues have been denominated in United States Dollars, but we
      believe that an increasing portion of our revenues will be denominated in
      foreign currencies. We currently do not engage in foreign exchange hedging
      activities, and therefore our international revenues and expenses are currently
      subject to the risks of foreign currency fluctuations.





We
      must
      also customize our services and products for international markets. This process
      is much more complex than merely translating languages. For example, our ability
      to expand into international markets will depend on our ability to develop
      and
      support services and products that incorporate the tax laws, accounting
      practices, and currencies of applicable countries. Since a large part of our
      value proposition to customers is that our products have been developed with
      the
      peculiar needs of small businesses in mind, any variation in business practice
      from one country to another may substantially decrease the value of our products
      in that country, unless we identify the important differences and customize
      our
      product to address the differences.





Our
      international operations also increase our exposure to international laws and
      regulations. If we cannot comply with foreign laws and regulations, which are
      often complex and subject to variation and unexpected changes, we could incur
      unexpected costs and potential litigation. For example, the governments of
      foreign countries might attempt to regulate our services and products or levy
      sales or other taxes relating to our activities. In addition, foreign countries
      may impose tariffs, duties, price controls or other restrictions on foreign
      currencies or trade barriers, any of which could make it more difficult for
      us
      to conduct our business in international markets.





We
      intend
      to continue to expand our international sales and marketing activities and
      enter
      into relationships with additional international distribution partners. We
      are
      in the early stages of developing our indirect distribution channels in markets
      outside the United States. We may not be able to attract and retain distribution
      partners that will be able to market our products effectively.





**(32)
      Historically Substantial Amounts of Our Revenue Were Derived From Transactions
      with Related Parties, Which Means That Our Revenue May Not Reflect the True
      Commercial Viability of Our Business and That Our Revenue May Decline If We
      Cannot Replace this Revenue With Revenue From Unrelated Third
      Parties.**





During
      2004, approximately $330,000 of our total revenue, constituting approximately
      32.9% of total 2004 revenue, was derived from related party transactions. During
      2003, approximately $513,057 of our total revenue, constituting approximately
      40.7% of 2003 total revenue, was derived from transactions with parties in
      which
      our officers, directors and stockholders have a direct or indirect interest.
      For
      year 2002, related party transactions provided approximately $140,149 of our
      revenue, constituting approximately 10.1% of 2002 total revenue. None of our
      revenues during the first half of 2005 were derived from related
      parties.





Because
      our officers, directors and stockholders derive a benefit from promoting the
      success of our business, these transactions may have been entered into by these
      related parties to promote our business. Consequently, revenue derived from
      these transactions may not be as indicative of the true commercial viability
      of
      our business as revenue derived from transactions with unrelated
      parties.


42








Our
      officers, directors and stockholders have limited resources and will not be
      able
      to enter into the same dollar volumes of transactions in the future as in the
      past. Having high amounts of revenue from related party transactions, therefore,
      means our revenue will decrease, if we are not able to replace this revenue
      with
      revenue from transactions with unrelated parties. Specifically, one related
      party, Smart IL, which accounted for approximately 32.9% of our total revenue
      during 2004 and approximately 27.2% of our total revenue during 2003, is not
      expected to contribute to our revenue in the future. See “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations -
      Revenue from Related Parties,” for a description of our dealings with Smart
      IL.





**Risks
      Associated With Our Officers, Directors, Employees and
      Stockholders**





**(33)
      Any Failure to Adequately Expand Our Direct Sales Force Will Impede Our Growth,
      Which Could Harm Our Business.**





We
      expect
      to be substantially dependent on our direct sales force to obtain new customers.
      We believe that there is significant competition for direct sales personnel
      with
      the advanced sales skills and technical knowledge we need. Our ability to
      achieve significant growth in revenue in the future will depend, in large part,
      on our success in recruiting, training and retaining sufficient direct sales
      personnel. New hires require significant training and may, in some cases, take
      more than a year before they achieve full productivity. Our recent hires and
      planned hires may not become as productive as we would like, and we may be
      unable to hire sufficient numbers of qualified individuals in the future in
      the
      markets where we do business. If we are unable to hire and develop sufficient
      numbers of productive sales personnel, sales of our services will
      suffer.





**(34)
      Because Competition for Our Target Employees Is Intense, We May Not Be Able
      to
      Attract and Retain the Highly Skilled Employees We Need to Support Our Planned
      Growth, Which Could Harm Our Business.**





To
      execute our growth plan, we must attract and retain highly qualified personnel.
      Competition for these personnel is intense, especially for engineers with high
      levels of experience in designing and developing software and Internet-related
      services and senior sales executives. We may not be successful in attracting
      and
      retaining qualified personnel. We have from time to time in the past
      experienced, and we expect to continue to experience in the future, difficulty
      in hiring and retaining highly skilled employees with appropriate
      qualifications. Many of the companies with which we compete for experienced
      personnel have greater resources than we have. In addition, in making employment
      decisions, particularly in the Internet and high-technology industries, job
      candidates often consider the value of the stock options they are to receive
      in
      connection with their employment. Significant volatility in the price of our
      stock may, therefore, adversely affect our ability to attract or retain key
      employees. Furthermore, the
      new
      requirement to expense stock options may discourage
      us from granting the size or type of stock options awards that job candidates
      require to join our company. If we fail to attract new personnel or fail to
      retain and motivate our current personnel, our business and future growth
      prospects could be severely harmed.





**(35)
      Our Growth Could Strain Our Personnel and Infrastructure Resources, and if
      We
      Are Unable to Implement Appropriate Controls and Procedures To Manage Our
      Growth, We May Not Be Able to Successfully Implement Our Business
      Plan.**





We
      plan
      to have a period of rapid growth in our headcount and operations, which has
      placed, and will continue to place, a significant strain on our management,
      administrative, operational and financial infrastructure. We anticipate that
      further growth will be required to address increases in our customer base,
      as
      well as our expansion into new geographic areas .
      During
      the second quarter of 2005, we added sales personnel in California and New
      York.





Our
      success will depend in part upon the ability of our senior management to manage
      this growth effectively. To do so, we must continue to hire, train and manage
      new employees as needed. If our new hires perform poorly, or if we are
      unsuccessful in hiring, training, managing and integrating these new employees,
      or if we are not successful in retaining our existing employees, our business
      may be harmed. To manage the expected growth of our operations and personnel,
      we
      will need to continue to improve our operational, financial and management
      controls and our reporting systems and procedures. The additional headcount
      and
      capital investments we are adding will increase our cost base, which will make
      it more difficult for us to offset any future revenue shortfalls by offsetting
      expense reductions in the short term. If we fail to successfully manage our
      growth, we will be unable to execute our business plan.








**(36)
      Our Executive Management Team is Critical to the Execution of Our Business
      Plan
      and the Loss of Their Services Could Severely Impact Negatively on Our
      Business.**





Our
      success depends significantly on the continued services of our management
      personnel, including Michael Nouri, who is our chairman of the board, president
      and chief executive officer, and Henry Nouri, our Executive Vice President,
      Research and Development. Losing any one of our officers could seriously harm
      our business. Competition for executives is intense. If we had to


43


replace
      any of our officers, we would not be able to replace the significant amount
      of
      knowledge that they have about our operations. We do not maintain key man
      insurance policies on anyone.





**(37)
      Officers, Directors and Principal Stockholders Control Us. This Might Lead
      Them
      to Make Decisions that do not Benefit the Stockholder
      Interests.**





At
      August
      1, 2005, our officers and directors beneficially owned approximately 5,402,995
      (approximately 36%) of our outstanding stock, which includes approximately
      739,750 shares which can be acquired upon exercise of options within sixty
      (60)
      days after August 1, 2005. These shares included approximately 4,092,658 shares
      beneficially owned by Michael Nouri and Henry Nouri, who are brothers and Ronna
      Loprete, who is Michael Nouri’s wife. In addition, 584,250 shares are subject to
      issuance upon exercise of options owned by the officers and directors, which
      options cannot be exercised within sixty days after August 1 2005, and therefore
      are not counted as being beneficially owned at that date. As a result, these
      persons, acting together, will have the ability to control substantially all
      matters submitted to our stockholders for approval (including the election
      and
      removal of directors and any merger, consolidation or sale of all or
      substantially all of our assets) and to control our management and affairs.
      Accordingly, this concentration of ownership may have the effect of delaying,
      deferring or preventing a change in control of us, impeding a merger,
      consolidation, takeover or other business combination involving us or
      discouraging a potential acquirer from making a tender offer or otherwise
      attempting to obtain control of us, which in turn could materially and adversely
      affect the market price of the common stock.





**(38)
      Sales by Officers and Directors Could Adversely Affect of Our Stock
      Price.**





Sales
      of
      significant amounts of shares held by our directors and executive officers
      after
      their contractual lock-up provisions expire, or the prospect of these sales,
      could adversely affect our common stock price, both because significant sales
      could depress prices, and because sales by management could provide a negative
      signal to the market about our prospects.





**(39)
      All of the Shares of Common Stock Owned by Our Officers, Directors and
      Consultants Will be Registered Later in a Registration on Form S-8 and May
      be
      Resold by Them, Which May Have a Negative Impact on Their Interest in Smart
      Online’s Future.**





We
      intend
      to register all of the shares of our outstanding common stock, including all
      of
      the shares held by our officers, directors and consultants. This will allow
      our
      officers, directors and consultants to more easily sell all of their Smart
      Online stock after their contractual lock-up restrictions expire, which may
      have
      a negative impact on their interest in the future success of Smart Online.
      Shares owned by officers and directors are deemed to be “control” securities
      and, until Smart Online meets certain criteria, resales by officers and
      directors pursuant to a Form S-8 registration statement are subject to the
      volume limitations of Rule 144(e), which means that an officer or director
      would
      be entitled to sell within any three-month period a number of shares that does
      not exceed (i) 1% of the number of shares of common stock then outstanding,
      or
      (ii) the average weekly trading volume of the common stock during the four
      calendar weeks preceding the filing of a Form 144 with respect to such
      sale.





**Regulatory
      Risks**





**(40)
      Our Revenue Recognition Policy May Change And Affect Our Earnings, Which Could
      Adversely Affect Our Stock Price.**





We
      believe our current revenue recognition policies and practices are consistent
      with applicable accounting standards. However, revenue recognition rules for
      software and service companies are complex and require significant
      interpretations by management. Changes in circumstances, interpretations, or
      accounting guidance may require us to modify our revenue recognition policies.
      Such modifications could impact the timing of revenue recognition and our
      operating results. See “Management’s Discussion And Analysis Of Financial
      Condition And Results Of Operations” regarding our current revenue recognition
      policies.





**(41)
      Compliance With New Regulations Governing Public Company Corporate Governance
      and Reporting is Uncertain and Expensive. Our Difficulties in Complying with
      Public Company Reporting Obligations Are Greater, Because Our Chief Financial
      Officer Does Not Have Prior Experience with a Public
      Company.**





As
      a
      public company, we have incurred and will incur significant legal, accounting
      and other expenses that we did not incur as a private company. We will incur
      costs associated with our public company reporting requirements. We also
      anticipate that we will incur costs associated with recently adopted corporate
      governance requirements, including requirements under the Sarbanes-Oxley Act
      of
      2002, as well as new rules implemented by the Securities and Exchange Commission
      and the NASD. We expect these rules and regulations to increase our legal and
      financial compliance costs and to make some activities more time-consuming
      and
      costly. Any unanticipated difficulties in preparing for and implementing these
      reforms could result in material delays in complying with these
      new


44


laws
      and
      regulations or significantly increase our costs. Our ability to fully comply
      with these new laws and regulations is also uncertain. Our failure to timely
      prepare for and implement the reforms required by these new laws and regulations
      could significantly harm our business, operating results, and financial
      condition. Our current chief financial officer does not have public company
      experience. Consequently, we will have greater difficulty complying with public
      company reporting requirements than most public companies. We also expect these
      new rules and regulations may make it more difficult and more expensive for
      us
      to obtain director and officer liability insurance and we may be required to
      accept reduced policy limits and coverage or incur substantially higher costs
      to
      obtain the same or similar coverage. As a result, it may be more difficult
      for
      us to attract and retain qualified individuals to serve on our board of
      directors or as executive officers. We are currently evaluating and monitoring
      developments with respect to these new rules. We estimate this will add
      approximately $500,000 to our expenses during our first year as a public
      company, but there can be no assurance that costs will not be
      higher.





**(42)
      We Believe Our Financial Results Will Be Adversely Affected By Changes in
      Accounting Principles Generally Accepted in the United
      States.**





Accounting
      principles generally accepted in the United States are subject to interpretation
      by the Financial Accounting Standards Board, or FASB, the American Institute
      of
      Certified Public Accountants, the Securities and Exchange Commission, or SEC,
      and various bodies formed to promulgate and interpret appropriate accounting
      principles. A change in these principles or interpretations could have a
      significant effect on our reported financial results, and could affect the
      reporting of transactions completed before the announcement of a
      change.





For
      example, in December 2004, the FASB announced its decision to require companies
      to expense employee stock options. We will adopt this new accounting
      pronouncement, Statement of Financial Accounting Standards No. 123 (revised
      2004), *Share-Based
      Payment* ,
      beginning on January 1, 2006, which is the start of fiscal 2006. We believe
      this
      change in accounting will materially and adversely affect our reported results
      of operations.





**(43)** **Privacy
      concerns and laws or other domestic or foreign regulations may reduce the
      effectiveness of our solution and adversely affect our business.**




Our
      customers can use our service to store contact and other personal or identifying
      information regarding their customers and contacts. Federal, state and foreign
      government bodies and agencies, however, have adopted or are considering
      adopting laws and regulations regarding the collection, use and disclosure
      of
      personal information obtained from consumers and individuals. The costs of
      compliance with, and other burdens imposed by, such laws and regulations that
      are applicable to the businesses of our customers may limit the use and adoption
      of our service and reduce overall demand for it. Furthermore, privacy concerns
      may cause our customers’ customers to resist providing the personal data
      necessary to allow our customers to use our service effectively. Even the
      perception of privacy concerns, whether or not valid, may inhibit market
      adoption of our service in certain industries. For example, regulations such
      as
      the Gramm-Leach-Bliley Act, which protects and restricts the use of consumer
      credit and financial information, and the Health Insurance Portability and
      Accountability Act of 1996, which regulates the use and disclosure of personal
      health information, impose significant requirements and obligations on
      businesses that may affect the use and adoption of our service.




The
      European Union has also adopted a data privacy directive that requires member
      states to impose restrictions on the collection and use of personal data that,
      in some respects, are far more stringent, and impose more significant burdens
      on
      subject businesses, than current privacy standards in the United States. All
      of
      these domestic and international legislative and regulatory initiatives may
      adversely affect our customers’ ability to collect and/or use demographic and
      personal information from their customers, which could reduce demand for our
      service.




In
      addition to government activity, privacy advocacy groups and the technology
      and
      other industries are considering various new, additional or different
      self-regulatory standards that may place additional burdens on us. If the
      gathering of personal information were to be curtailed in this manner, certain
      of our solutions would be less effective, which may reduce demand for our
      service and harm our business.





**(44)
      Our business is subject to changing regulations regarding corporate governance
      and public disclosure that has increased both our costs and the risk of
      noncompliance.**




We
      are
      subject to rules and regulations by various governing bodies, including the
      U.S.
      Securities and Exchange Commission, New York Stock Exchange and Public Company
      Accounting Oversight Board, that are charged with the protection of investors
      and the oversight of companies whose securities are publicly traded. Our efforts
      to comply with these new regulations, most notably the Sarbanes-Oxley Act,
      or
      SOX, have resulted in, and are likely to continue to result in, increased
      general and administrative expenses and a diversion of management time and
      attention to compliance activities.


45




By
      the
      end of fiscal 2006, we are required to comply with the SOX requirements
      involving the assessment of our internal controls over financial reporting
      and
      our external auditors’ audit of that assessment. Although we believe our
      on-going review and testing of our internal controls will enable us to be
      compliant with the SOX requirements, we may identify deficiencies that we may
      not be able to remediate by the end of fiscal 2006. If we cannot assess our
      internal controls over financial reporting as effective, or our external
      auditors are unable to provide an unqualified attestation report on such
      assessment, our stock price could decline.




Moreover,
      because these laws, regulations and standards are subject to varying
      interpretations, their application in practice may evolve over time as new
      guidance becomes available. This evolution may result in continuing uncertainty
      regarding compliance matters and additional costs necessitated by ongoing
      revisions to our disclosure and governance practices. If we fail to address
      and
      comply with these regulations and any subsequent changes, our business may
      be
      harmed.





**(45)
      Evolving Regulation of the Internet May Harm Our Business.**





As
      Internet commerce continues to evolve, increasing regulation by federal, state
      or foreign agencies becomes more likely. For example, we believe increased
      regulation is likely in the area of data privacy, and laws and regulations
      applying to the solicitation, collection, processing or use of personal or
      consumer information could affect our customers’ ability to use and share data,
      potentially reducing demand for our services and restricting our ability to
      store, process and share data with our customers. In addition, taxation of
      services provided over the Internet or other charges imposed by government
      agencies or by private organizations for accessing the Internet may also be
      imposed. Any regulation imposing greater fees for Internet use or restricting
      information exchange over the Internet could result in a decline in the use
      of
      the Internet and the viability of Internet-based services, which could harm
      our
      business.





**(46)
      Our Ability to Protect Our Intellectual Property is Limited and Our Products
      may
      be Subject to Infringement Claims by Third Parties.**





Our
      success depends, in part, upon our proprietary technology, processes, trade
      secrets, and other proprietary information, and our ability to protect this
      information from unauthorized disclosure and use. We rely on a combination
      of
      copyright, trade secret, and trademark laws, confidentiality procedures,
      contractual provisions, and other similar measures to protect our proprietary
      information.





We
      do not
      own any issued patents or have any patent applications pending. Despite our
      efforts to protect our proprietary rights, unauthorized parties may attempt
      to
      copy aspects of our products or to obtain and use information that we regard
      as
      proprietary, and third parties may attempt to develop similar technology
      independently. Policing unauthorized use of our products is difficult,
      particularly because the global nature of the Internet makes it difficult to
      control the ultimate destination or security of software or other data
      transmitted. While we are unable to determine the extent to which piracy of
      our
      software products exists, software piracy can be expected to be a persistent
      problem.





In
      addition, the laws of some foreign countries do not protect our proprietary
      rights to as great an extent as do the laws of the United States, and we expect
      that it will become more difficult to monitor use of our products as we increase
      our international presence. Over the past several years, we have made numerous
      changes in our product names. Although we own registered trademarks in the
      United States and have filed trademark applications in the United States and
      in
      certain other countries, we do not have assurance that our strategy with respect
      to our trademark portfolio will be adequate to secure or protect all necessary
      intellectual property. There can be no assurance that our means of protecting
      these proprietary rights will be adequate, or that our competitors will not
      independently develop similar technology.





The
      software and Internet industries are characterized by the existence of a large
      number of patents, trademarks and copyrights and by frequent litigation based
      on
      allegations of infringement or other violations of intellectual property rights.
      As the number of entrants into our market increases, the possibility of an
      intellectual property claim against us grows. Our technologies may not be able
      to withstand any third-party claims or rights against their use. Any
      intellectual property claims, with or without merit, could be time-consuming
      and
      expensive to litigate or settle, and could divert management attention from
      executing our business plan. In addition, our agreements often require us to
      indemnify our syndication partners for third-party intellectual property
      infringement claims, which would increase the cost to us of an adverse ruling
      in
      such a claim. An adverse determination could also prevent us from offering
      our
      service to others. No third party has asserted any intellectual property claims
      against us.





**(47)
      Anti-Takeover Effects of Charter Documents and Delaware Law Could Discourage
      or
      Prevent a Change in Control, Even If a Change of Control Would Be Beneficial
      to
      Shareholders and Investors.**





Provisions
      in our certificate of incorporation and bylaws, as amended and restated, as
      well
      as provisions of Delaware law may have the effect of delaying or preventing
      a
      change of control or changes in our management even if a change of control
      would
      be beneficial to our shareholders and investors. These provisions include the
      following:


46





·
            Our
                board of directors is divided into three classes whenever the number
                of
                Directors is six or more, in which case, approximately one-third
                of our
                board of directors will be elected each year. This delays the ability
                of
                shareholders, including any acquiror, to change our board of
                directors.





·
            Our
                board of directors has the right to elect directors to fill a vacancy
                created by the expansion of the board of directors or the resignation,
                death or removal of a director, which prevents stockholders from
                being
                able to fill vacancies on our board of
                directors.





·
            Cumulative
                voting in the election of directors is not authorized by our certificate
                of incorporation. This limits the ability of minority stockholders
                to
                elect director candidates.





·
            Stockholders
                must provide advance notice to nominate individuals for election
                to the
                board of directors or to propose matters that can be acted upon at
                a
                stockholders’ meeting. This requirement may discourage or deter a
                potential acquiror from conducting a solicitation of proxies to elect
                the
                acquiror’s own slate of directors or otherwise attempting to obtain
                control of our company.





·
            Our
                board of directors may issue, without stockholder approval, shares
                of
                undesignated preferred stock. The ability to authorize undesignated
                preferred stock makes it possible for our board of directors to issue
                preferred stock with voting or other rights or preferences that could
                impede the success of any attempt to acquire
                us.





As
      a
      Delaware corporation, we are also subject to certain Delaware anti-takeover
      provisions. Under Delaware law, a corporation may not engage in a business
      combination with any holder of 15% or more of its capital stock, unless the
      holder has held the stock for three years or, among other things, the board
      of
      directors has approved the transaction. Our board of directors could rely on
      Delaware law to prevent or delay an acquisition of us even if a change of
      control would be beneficial to stockholders and investors. For a description
      of
      our capital stock, see “Description of Capital Stock.”





**Risks
      Associated With The Market For Our Securities**





**(48)
      Our Common Stock Began Being Quoted for Trading on the Over-the-Counter
      Electronic Bulletin Board in April 2005, but There Is No Assurance Volume
      Trading Will Develop. Therefore You may be Unable to Sell Your
      Shares.**





Our
      common stock began trading on the Over-the-Counter Electronic Bulletin Board
      (“OTCBB” or “Bulletin Board”) during April 2005. There is no assurance that
      volume trading will develop. Other public markets, such as NASDAQ or a national
      securities exchange, have qualitative and quantitative listing criteria that
      we
      do not currently meet. These criteria include operating results, net assets,
      corporate governance, minimum trading price and minimums for public float,
      which
      is the amount of stock not held by affiliates of the issuer.





To
      remain
      eligible to have our securities quoted on OTCBB, we must file reports with
      the
      Securities and Exchange Commission pursuant to Section 13 or Section 15(d)
      of
      the Securities Act of 1933 and we must remain current in our periodical
      reporting obligations. A broker/dealer must also file a Form 211 with the
      National Association of Securities Dealers (“NASD”) to allow our common stock to
      be quoted on the OTCBB. For more information on the OTCBB see its web site
      at www.otcbb.com .





There
      can
      be no assurance our market maker will continue to quote our stock. If for any
      reason, our securities are not eligible for continued quotation on the Bulletin
      Board or a public trading market does not develop, purchasers of the shares
      may
      have difficulty selling their securities should they desire to do so. If we
      are
      unable to satisfy the requirements for quotation on the Bulletin Board, any
      trading in our common stock would be conducted in the over-the-counter market
      in
      what are commonly referred to as the “pink sheets.” The “pink sheets” are
      operated by a private company and are not affiliated with the NASD. However,
      a
      broker-dealer must file a Form 211 and undergo NASD review before it can quote
      securities on the “pink sheets.” Companies quoted on the “pink sheets” need not
      file periodic reports with the Securities and Exchange Commission. Trading
      volume for securities traded only on the “pink sheets” is generally lower than
      for securities traded on the OTCBB. If our securities quoted for trading only
      on
      the “pink sheets,” an investor may find it more difficult to dispose of, or to
      obtain accurate quotations as to the price of, the securities offered
      hereby.





The
      above-described rules may materially adversely affect the liquidity of the
      market for our securities. There can be no assurance that an active trading
      market will ever develop or, if it develops, will be maintained. Failure to
      develop or maintain an active trading market could negatively affect the price
      of our securities, and you will be unable to sell your shares. If so, your
      investment will be a complete loss.


47





**(49)
      If Securities Analysts Do Not Publish Research or Reports About Our Business
      or
      If They Downgrade Our Stock, the Price of Our Stock Could
      Decline.**





The
      trading market for our common stock will rely in part on the research and
      reports that industry or financial analysts publish about us or our business.
      If
      we do not succeed in attracting analysts to report about our company, most
      investors will not know about our company even if we are successful in
      implementing our business plan. We do not control these analysts. There are
      many
      large, well established publicly traded companies active in our industry and
      market, which may mean it will be less likely that we receive widespread analyst
      coverage. Furthermore, if one or more of the analysts who do cover us downgrade
      our stock, our stock price would likely decline rapidly. If one or more of
      these
      analysts cease coverage of our company, we could lose visibility in the market,
      which in turn could cause our stock price to decline. Lower trading volume
      may
      also mean that you could not resell your shares.





**(50)
      Our Quarterly Revenues and Operating Results may Fluctuate in Future Periods
      and
      We may Fail to Meet Expectations of Investors and Public Market Analysts, Which
      Could Cause the Price of Our Common Stock to Decline.**





Our
      quarterly revenues and operating results may fluctuate significantly from
      quarter to quarter. If quarterly revenues or operating results fall below the
      expectations of investors or public market analysts, the price of our common
      stock could decline substantially. Factors that might cause quarterly
      fluctuations in our operating results include:





·
            the
                evolving demand for our services and
                software;


·
            spending
                decisions by our customers and prospective
                customers;


·
            our
                ability to manage expenses;


·
            the
                timing of new product releases;


·
            changes
                in our pricing policies or those of our
                competitors;


·
            the
                timing of execution of large
                contracts;


·
            changes
                in the mix of our services and software
                offerings;


·
            the
                mix of sales channels through which our services and software are
                sold;


·
            costs
                of developing new products and
                enhancements;


·
            global
                economic and political conditions;


·
            our
                ability to retain and increase sales to existing customers, attract
                new
                customers and satisfy our customers’
                requirements;


·
            the
                renewal rates for our service;


·
            the
                rate of expansion and effectiveness of our sales force;


·
            the
                length of the sales cycle for our
                service;


·
            new
                product and service introductions by our
                competitors;


·
            technical
                difficulties or interruptions in our
                service;


·
            regulatory
                compliance costs;payment defaults by customers;
                and


·
            extraordinary
                expenses such as litigation or other dispute-related settlement
                payments.





In
      addition, due to a slowdown in the general economy and general uncertainty
      of
      the current geopolitical environment, a existing and potential customer may
      reassess or reduce their planned technology and Internet-related investments
      and
      defer purchasing decisions. Further delays or reductions in business spending
      for technology could have a material adverse effect on our revenues and
      operating results.





**(51)
      Our Stock Price is Likely to be Highly Volatile and May
      Decline.**





The
      trading prices of the securities of technology companies have been highly
      volatile. Accordingly, the trading price of our common stock has been and is
      likely to continue to be subject to wide fluctuations. Further, our common
      stock
      has a limited trading history. Factors affecting the trading price of our common
      stock include:





·
            variations
                in our actual and anticipated operating
                results;


·
            changes
                in our earnings estimates by
                analysts;


·
            the
                volatility inherent in stock prices within the emerging sector within
                which we conduct business;


·
            announcements
                of technological innovations, new services or service enhancements,
                strategic alliances or significant agreements by us or by our
                competitors;


48





·
            recruitment
                or departure of key personnel;


·
            changes
                in the estimates of our operating results or changes in recommendations
                by
                any securities analysts that elect to follow our common
                stock;


·
            market
                conditions in our industry, the industries of our customers and the
                economy as a whole;


·
            and
                the volume of trading in our common stock, including sales of substantial
                amounts of common stock issued upon the exercise of outstanding options
                and warrants.





In
      addition, Over-the-Counter Bulletin Board, administered by the NASD, on which
      our stock is quoted has experienced extreme price and volume fluctuations that
      have affected the trading prices of many technology and computer software
      companies, particularly Internet-related companies. Such fluctuations have
      often
      been unrelated or disproportionate to the operating performance of these
      companies. These broad trading fluctuations could adversely affect the trading
      price of our common stock.





Further,
      securities class action litigation has often been brought against companies
      that
      experience periods of volatility in the market prices of their securities.
      Securities class action litigation could result in substantial costs and a
      diversion of our management’s attention and resources. If such a suit is brought
      against us, we may determine, like many defendants in such lawsuits, that it
      is
      in our best interests to settle such a lawsuit even if we believe that the
      plaintiffs’ claims have no merit, to avoid the cost and distraction of continued
      litigation. Any liability we incur in connection with this potential lawsuit
      could materially harm our business and financial position and, even if we defend
      ourselves successfully, there is a risk that management’s distraction in dealing
      with this type of lawsuit could harm our results.





**(52)
      Shares Eligible for Public Sale Could Adversely Affect Our Stock Price.** **Holders
      of Shares of Our Common Stock Signed Agreements That Prohibit Resales of
      Approximately 9,954,624 shares of our Common Stock. The Lock-up Period Will
      Expire on October 1, 2005. If Substantial Numbers of Shares Are Resold At or
      After October 1, 2005, the Market Price of Our Common Stock Is likely to
      Decrease Substantially.**





At
      August
      1, 2005, 12,625,707 shares of our common stock were issued and outstanding
      and
      2,720,628 shares may be issued pursuant to the exercise of warrants and options.





Of
      these
      shares, 1,550,972 shares registered on Form S-1 are freely tradable under
      Federal securities law. The remaining shares are restricted and may be sold
      in
      the public market only if they qualify for an exemption from registration
      described below under Rules 144, 144(k) or 701 promulgated under the Securities
      Act.





**Rule
      144**





In
      general, under Rule 144 as currently in effect, but subject to the Lock-Up
      Agreements described below, if applicable, a person (or persons whose shares
      are
      aggregated) who has purchased our common stock from us or any “affiliate” of
      ours at least one year before the date of resale would be entitled to sell
      within any three-month period a number of shares that does not exceed the
      greater of: (i) 1% of the number of shares of our common stock then outstanding;
      or (ii) the average weekly trading volume of the volume of our common stock
      during the four calendar weeks preceding the filing of a Form 144 with respect
      to such sale. Sales under Rule 144 are also subject to manner of sale provisions
      and notice requirements, and to the availability of current public information
      about us.





In
      addition, a person who is not deemed to have been our “affiliate” at any time
      during the 90 days preceding a sale and who has beneficially owned for at least
      two years the shares proposed to be sold is entitled to sell such shares under
      Rule 144(k) without regard to the volume limitations and other requirements
      described above. Therefore, unless otherwise restricted, Rule 144(k) shares
      may
      be sold at any time. See the table below entitled “Rule 144 and Lock-Up Shares,”
setting forth the number of shares not sellable under Rule 144, the number
      sellable under Rule 144 with volume restrictions, and the number sellable under
      Rule 144(k) with no volume restrictions.





**Rule
      701**





Our
      employees, directors, officers and consultants who acquired Common Stock prior
      to February 15, 2005, (the date we became subject to the reporting requirements
      of the Exchange Act) under written compensatory benefit plans or written
      contracts relating to the compensation of those persons may rely on Rule 701
      with respect to the resale of that stock. In general, Rule 701 permits resales
      of shares issued under compensatory benefit plans and contracts in reliance
      upon
      Rule 144, but without compliance with certain restrictions, including the
      holding period requirements described in Rule 144. Accordingly, subject to
      the
      lock-up agreements described below, if applicable, commencing May 16, 2005,
      under Rule 701 persons who received compensation shares and who are not our
      “affiliates” may resell those shares subject only to the manner of sale
      provisions of Rule 144, and persons who received compensation shares and who
      are
      our “affiliates” may resell those shares without compliance with Rule 144’s
      minimum holding period requirements.


49








**Equity
      Compensation Plans**





On
      May 3,
      2005, we filed a registration statement on Form S-8 under the Securities Act
      with respect to the 5,000,000 shares of the Common Stock reserved for issuance
      under our 2004 Equity Compensation Plan, which is now effective.  We also
      anticipate, as described below, filing additional registration statements on
      Form S-8 under the Securities Act with respect to certain shares of the Common
      Stock.





Shares
      registered on Form S-8, other than shares held by officers and directors, may
      be
      sold in the public markets. Shares registered on Form S-8 and held by our
      officers and directors may only be resold in compliance with the volume
      limitations of Rule 144(e), which means that an officer or director would be
      entitled to sell within any three-month period a number of shares that does
      not
      exceed the greater of: (i) 1% of the number of shares of Common Stock then
      outstanding; or (ii) the average weekly trading volume of the Common Stock
      during the four calendar weeks preceding the filing of a Form 144 with respect
      to such sale. Shares registered on Form S-8 held by persons other than officers
      and directors are not subject to any value limitations.





**Lock-Up
      Agreements**





Most
      of
      our security holders have signed lock-up agreements (the “Lock-up Agreements”)
      restricting the sale of our securities and/or agreements that limit the number
      of shares sellable during specific time periods (“Dribble Out Agreements”). The
      Dribble Out Agreements apply to all the shares sold by us in private placements
      and Regulation S offerings during 2004 and 2005, which shares have been
      registered for resale or which we are under an obligation to register for
      resale.





The
      number of outstanding shares subject to each Lock-Up Agreements and Dribble
      Out
      Agreements between Smart Online and its security holders is set forth below
      in
      the footnotes to the table entitled “Rule 144 and Lock-Up Shares.”





The
      lock-up period will expire on September 30, 2005. Thereafter, shareholders
      who
      were prohibited from reselling shares may for one year sell up to 8.5% of the
      formerly locked up shares in any rolling 30-day period.





**Market
      Price Decline and Low Trading Volume**





Our
      stock
      is very thinly traded. The
      average trading volume for our Common Stock during July 2005 was approximately
      ten thousand shares per day. The number of shares that could be sold during
      this
      period was restrained by the lock-up agreements, while there was no similar
      contractual restraint on the number of buyers of our Common Stock. This means
      that market supply may increase more than market demand for our shares when
      the
      lock-up period expires. Many companies experience a decrease in the market
      price
      of their shares when a lock-up period terminates. If substantial numbers of
      shares are resold at or after October 1, 2005, the market price of our Common
      Stock is likely to decrease substantially.





We
      cannot
      predict if future sales of our common stock, or the availability of our common
      stock held for sale, will materially and adversely affect the market price
      for
      our common stock or our ability to raise capital by offering equity securities.
      Our stock price may decline, if the resale of shares under Rule 144, in addition
      to the resale of registered shares, at certain time in the future, exceeds
      the
      market demand for our stock.





Unless
      a
      trading market for our shares develops, you will not be able to resell your
      stock, and, market makers may influence the stock price. Market conditions
      and
      market makers may cause your investment in our common stock to significantly
      diminish and may become very illiquid.





We
      can
      offer no assurance that the volume of trading of our shares in the public
      markets will be sufficient to allow all sellers to sell at the times or prices
      sellers desire. Future sales of substantial amounts of our shares in the public
      market could adversely affect market prices prevailing from time to time and
      could impair our ability to raise capital through the sale of our equity
      securities.





**Summary
      Table**


The
      following table summarizes 12,625,707 shares outstanding as of August 1, 2005
      by
      both (i) their resale status under Rule 144 and registration statements and
      (ii)
      restrictions or limits on resale under contracts between shareholders and Smart
      Online.


50





**Rule
      144 and Lock-Up Shares** **(1)**





**COLUMN
                A**
            **COLUMN
                B**
            **COLUMN
                C**
            **COLUMN
                D**
            **COLUMN
                E**Lock-up
                Shares(7)
            33
                1/3% Per Month
              Dribble-Out
                Shares(8)
            25%
                Per Month
              Dribble-Out
                Shares(9)
            Shares
                With No Contractual
              Restrictions
                on Resale(10)
            Totals
                Each RowShares
                Not Sellable under Rule 144(2)
            None
            None
            732,272
            31,886
            764,158Shares
                Sellable under Rule 144withRule
                144 Volume Restrictions(3)(4)
            7,131,902
            None
            None
            177,874
            7,309,776Shares
                Sellable under Rule 144(k)withoutRule 144 Volume Restrictions(5)
            2,722,722
            None
            None
            178,079
            2,900,801Shares
                Registered for Resale(6)
            100,000
            1,307,647
            None
            243,325
            1,650,972Totals
                Each Column
            9,954,624
            1,307,647
            732,272
            631,164
            12,625,707





(1)
      Table
      includes only shares issued and outstanding as of August 1, 2005. Table does
      not
      include options or warrants.





(2)
      Represents shares purchased from Smart Online, or from an “affiliate” of Smart
      Online, as that term is defined in Rule 144, less than one year prior to August
      1, 2005, including 732,272 shares Smart Online has an obligation to register
      for
      resale, but which have not been registered as of August 1, 2005. Does not
      include shares held for less than one year, but registered as described in
      Footnote (6). Includes no shares held by “affiliates” of Smart Online, as that
      term is defined in Rule 144.





(3)
      Represents shares purchased from Smart Online, or from an “affiliate” of Smart
      Online, as that term is defined in Rule 144, more than one year but less than
      two years prior to August 1, 2005 and shares acquired pursuant to Rule 701.
      Also
      includes 5,430,431 shares held for a year or more by “affiliates” of Smart
      Online, as that term is defined in Rule 144.





(4)
      Does
      not include 956,284 shares held for more than one year, but less than two years,
      and registered for resale as described in Footnote (6).





(5)
      Represents shares purchased from Smart Online, or purchased from an “affiliate”
of Smart Online, as that term is defined in Rule 144, more than two years prior
      to August 1, 2005, other than such shares held by “affiliates” of Smart Online,
      as that term is defined in Rule 144 and shares held by affiliates acquired
      pursuant to Rule 701.





(6)
      Represents outstanding shares registered for resale pursuant to the registration
      statement No. 333-119385 declared effective by the SEC on February 15, 2005,
      none of which are owned by affiliates of Smart Online as that term is defined
      in
      Rule 144. May 3, 2005 Smart Online filed a registration statement on Form S-8
      to
      cover shares of its 2004 Equity Compensation Plan and may thereafter file
      additional registration statements on Form S-8 to cover its other option plans
      and Smart Online has also signed registration rights agreements to register
      additional shares purchased by investors during 2005, which shares will also
      be
      registered during 2005.





(7)
      Represents shares held by stockholders with whom Smart Online has entered into
      Lock-Up Agreements which provide, in general, for a lock-up that expires on
      September 30, 2006. Under these agreements, no resales of shares covered by
      the
      Lock-up Agreements are prohibited until October 1, 2005, and commencing October
      1, 2005 each such stockholder may sell or transfer up to 8.5% of the shares
      of
      Common Stock of that stockholder that are subject to the Lock-Up Agreement
      during each calendar month until September 30, 2006.


51





(8)
      Represents shares held by investors who purchased shares during 2004 with whom
      Smart Online has entered into Dribble Out Agreements which provide, in general,
      for a volume limitation that expires 18 months after effective date of the
      first
      registration statement that registers the shares for resale. These 1,309,647
      shares are covered by Registration Statement No. 333-119385 which became
      effective February 15, 2005. Consequently, the 18-month volume limitation
      continues until August 15, 2006. Under these agreements, each such stockholder
      may sell or transfer up to 33 1/3% of such holder’s shares of Common Stock
      covered by the Dribble Out Agreements during any rolling 30-day period prior
      to
      August 15, 2006.





(9)
      Represents shares held by investors who purchased shares during 2005 with whom
      Smart Online has entered into Dribble Out Agreements which provide, in general,
      for a volume limitation that expires six months after the effective date of
      the
      first registration statement that registers such shares for resale. Under these
      agreements, commencing with the effective date of such registration statement,
      each such stockholder may sell or transfer up to 25% of such holder’s shares of
      Common Stock covered by the Dribble Out Agreements during any rolling 30-day
      period prior to the termination of the agreement. A registration statement
      to
      register these shares has not become effective as of August 1, 2005.





(10)
      Represents shares held by stockholders with whom Smart Online has not entered
      into any Lock-Up Agreements or Dribble Out Agreements.





52





**Option
      and Warrant Table** **(1)**





The
      following table summarizes the number of shares issuable pursuant to currently
      exercisable options and warrants outstanding at August 1, 2005 by both (i)
      their
      resale status under Rules 701 and 144 and registration statements and (ii)
      restrictions or limits on resale under contracts between Smart Online and option
      holders and warrant holders.





**COLUMN
                A**
            **COLUMN
                B**
            **COLUMN
                C**
            **COLUMN
                D**
            **COLUMN
                E**Lock-up
                Shares(8)
            33
                1/3% Per Month
              Dribble-Out
                Shares(9)
            25%
                Per Month
              Dribble-Out
                Shares(10)
            Shares
                With No Contractual Restrictions on Resale(11)
            Totals
                Each RowWarrant
                Shares not Sellable
              under
                Rule 701 or Rule 144(2)
            None
            None
            50,000
            92,000
            142,000Option
                Shares Owned by
              Affiliates
                Sellable under Rule
              701withRule 144 Volume
              Resale
                Limitations(3)
            650,000
            None
            None
            None
            650,000Option
                Shares Owned by Non-Affiliates Sellable under Rule 701 or Rule 144withoutRule 144 Volume Resale Limitations(4)
            60,000
            None
            None
            38,400
            98,400Shares
                Owned by Non-Affiliates Registered in May 2005 SellablewithoutRule 144 Volume Resale Limitations(5)
            281,000
            None
            None
            447,250
            728,250Option
                Shares Owned by Affiliates Registered in May 2005withRule 144 Volume Limitations(6)
            570,000
            None
            None
            254,000
            824,000Warrant
                Shares Registered(7)
            None
            276,978
            None
            None
            276,978Totals
                Each Column
            1,561,000
            276,978
            50,000
            831,650
            2,719,628





53





(1)
      Table
      includes only shares currently issuable upon exercise of warrants and options
      issued and outstanding as of August 1, 2005. Additional outstanding options,
      which are not currently exercisable, are not included in this Table.





(2)
      Represents options issued after February 15, 2005 and warrants where the shares
      issuable upon exercise of the options and warrants have not been registered
      for
      resale and which will not be included in the Registration Statement on Form
      S-8
      that Smart Online filed on May 3, 2005, but which may be included in a later
      registration statement on Form S-8





(3)
      Represents options issued before February 15, 2005 to affiliates of Smart
      Online, as that term is defined in Rule 144, pursuant to Rule 701, which options
      are not included in the Registration Statement on Form S-8 that Smart Online
      filed on May 3, 2005, but which may be included in a later registration
      statement on Form S-8.





(4)
      Represents options issued before February 15, 2005 to “non-affiliates” of Smart
      Online, as that term is defined in Rule 144, pursuant to Rule 701, which options
      are not included in the Registration Statement on Form S-8 Smart Online filed
      on
      May 3, 2005, but which may be included in a later registration statement on
      Form
      S-8.





(5)
      Represents option shares registered for resale pursuant to a registration
      statement on Form S-8 that Smart Online filed on May 3, 2005, which are not
      owned by affiliates of Smart Online as that term is defined in Rule 144.





(6)
      Represents option shares registered for resale pursuant to a registration
      statement Form S-8 that Smart Online filed on May 3, 2005, all of which are
      owned by affiliates of Smart Online as that term is defined in Rule 144.





(7)
      Represents shares registered for resale pursuant to the registration statement
      No. 333-119385 declared effective by the SEC on February 15, 2005. The shares
      are issuable upon exercise of currently exercisable warrants.





(8)
      Represents shares held by stockholders with whom Smart Online has entered into
      Lock-Up Agreements which provide, in general, for a lock-up that expires on
      September 30, 2006. Under these agreements, resale of shares covered by the
      Lock-Up Agreements are prohibited until October 1, 2005, and commencing October
      1, 2005 each such stockholder may sell or transfer up to 8.5% of the shares
      of
      Common Stock of that stockholder that are subject to the Lock-Up Agreement
      during each calendar month until September 30, 2006.





(9)
      Represents warrants held by investors who purchased warrants during 2004 with
      whom Smart Online has entered into Dribble Out Agreements which provide, in
      general, for a volume limitation that expires 18 months after effective date
      of
      the first registration statement that registers the shares for resale. These
      warrant shares are covered by Registration Statement No. 333-119385 which became
      effective February 15, 2005. Consequently, the 18-month volume limitation
      continues until August 15, 2006. Under these agreements, each such stockholder
      may sell or transfer up to 33 1/3% of such holder’s shares of Common Stock
      covered by the Dribble Out Agreements during any rolling 30-day period prior
      to
      August 15, 2006.





(10)
      Represents warrants held by investors who purchased warrants during 2005 with
      whom Smart Online has entered into Dribble Out Agreements which provide, in
      general, for a volume limitation that expire six months after the effective
      date
      of the first registration statement that registers such shares for resale.
      Under
      these agreements, commencing with the effective date of such registration
      statement, each such stockholder may sell or transfer up to 25% of such holder’s
      shares of Common Stock covered by the Dribble Out Agreements during any rolling
      30-day period prior to the termination of the agreement. A registration
      statement to register these shares has not become effective as of August 1,
      2005. Consequently, the date of termination of the 6-month post-effective
      restriction period is not known at this time.





(11)
      Represents shares issuable pursuant to currently exercisable outstanding
      warrants and options held by persons with whom Smart Online has not entered
      into
      any Lock-Up Agreements or Dribble Out Agreements.





**(53)
      Our Securities May Be Subject to "Penny Stock" Rules, Which Could Adversely
      Affect Our Stock Price and Make It More Difficult for You to Resell Our
      Stock.**





The
      Securities and Exchange Commission has adopted rules that regulate broker-dealer
      practices in connection with transactions in penny stocks. Penny stocks are
      generally equity securities with a price of less than $5.00 (other than
      securities registered on certain national securities exchanges or quoted on
      NASDAQ, provided that reports with respect to transactions in such securities
      are provided by the exchange or quotation system pursuant to an effective
      transaction reporting plan approved by the Commission.)





The
      penny
      stock rules require a broker-dealer, prior to a transaction in a penny stock
      not
      otherwise exempt from those rules, to deliver a standardized risk disclosure
      document prepared by the Commission, which:


54





·
            Contains
                a description of the nature and level of risk in the market for penny
                stocks in both public offerings and secondary
                trading;


·
            Contains
                a description of the broker’s or dealer’s duties to the customer and of
                the rights and remedies available to the customer with respect to
                a
                violation to such duties or other
                requirements;


·
            Contains
                a brief, clear, narrative description of a dealer market, including
“bid”
                and “ask” prices for penny stocks and the significance of the spread
                between the bid and ask price;


·
            Contains
                a toll-free telephone number for inquiries on disciplinary
                actions;


·
            defines
                significant terms in the disclosure document or in the conduct of
                trading
                penny stocks; and


·
            Contains
                such other information and is in such form (including language, type,
                size, and format) as the Commission shall
                require.


·
            The
                broker-dealer also must provide, prior to effecting any transaction
                in a
                penny stock, the customer:


·
            with
                bid and offer quotations for the penny
                stock;


·
            the
                compensation of the broker-dealer and its salesperson in the
                transaction;


·
            the
                number of shares to which such bid and ask prices apply, or other
                comparable information relating to the depth and liquidity of the
                market
                for such stock; and


·
            Monthly
                account statements showing the market value of each penny stock held
                in
                the customer’s account.





In
      addition, the penny stock rules require that prior to a transaction in a penny
      stock not otherwise exempt from those rules; the broker-dealer must make a
      special written determination that the penny stock is a suitable investment
      for
      the purchaser and receive the purchaser’s written acknowledgment of the receipt
      of a risk disclosure statement, a written agreement to transactions involving
      penny stocks, and a signed and dated copy of a written suitability statement.
      These disclosure requirements will have the effect of reducing the trading
      activity in the secondary market for our stock because it will be subject to
      these penny stock rules. Therefore, stockholders may have difficulty selling
      those securities.





**Item
      3. Quantitativeand Qualitative Disclosures about Market
      Risk**





***Foreign
      currency exchange risk***





During
      2004, 2003, and 2002, all of our contracts and transactions were U.S. dollar
      denominated. As a result our results of operations and cash flows are not
      subject to fluctuations due to changes in foreign currency exchange
      rates.





***Interest
      rate sensitivity***





We
      had
      unrestricted cash and cash equivalents totaling $173,339, $101,486, and $26,940
      at December 31, 2004, 2003, and 2002, respectively. These amounts were invested
      primarily in demand deposit accounts and money market funds. The unrestricted
      cash and cash equivalents are held for working capital purposes. We do not
      enter
      into investments for trading or speculative purposes. Due to the short-term
      nature of these investments, we believe that we do not have any material
      exposure to changes in the fair value of our investment portfolio as a result
      of
      changes in interest rates. Declines in interest rates, however, will reduce
      future investment income.





**Item
      4. Controlsand Procedures**





Attached
      as exhibits to this Form 10-Q are certifications of our Chief Executive Officer
      (CEO) and Chief Financial Officer (CFO), which are required in accordance with
      Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the "Exchange
      Act"). This “Controls and Procedures” section includes information concerning
      the disclosure controls and procedures evaluation referred to in the
      certifications. This section should be read in conjunction with the
      certifications for a more complete understanding of the topics
      presented.





**Evaluation
      of Disclosure Controls and Procedures**





Our
      Board
      of Directors approved disclosure controls and procedures (“Disclosure Controls”)
      based on the evaluation and recommendations of our Chief Executive Officer
      and
      Chief Financial Officer in connection with preparation of financial statements
      for the period covered by this Form 10-Q. Disclosure Controls are controls
      and
      procedures designed to reasonably assure that information required to be
      disclosed in our reports filed under the Exchange Act, such as this Form 10-Q,
      is recorded, processed, summarized and reported within the time periods
      specified in the U.S. Securities and Exchange Commission’s (SEC’s) rules and


55


forms.
      Disclosure Controls are also designed to reasonably assure that such information
      is accumulated and communicated to our management, including the CEO and CFO,
      as
      appropriate to allow timely decisions regarding required
      disclosure.





The
      evaluation of our Disclosure Controls included a review of the controls’
objectives and design, our implementation of the controls and the effect of
      the
      controls on the information generated for use in this Form 10-Q. This type
      of
      evaluation will be performed on a quarterly basis so that the conclusions of
      management, including the CEO and CFO, concerning the effectiveness of the
      Disclosure Controls can be reported in our periodic reports on Form 10-Q and
      Form 10-K. The overall goals of our evaluation activities are to monitor our
      Disclosure Controls, and to modify them as necessary.





Based
      upon the Disclosure Controls evaluation, our CEO and CFO have concluded that,
      as
      of the end of the period covered by this Form 10-Q, our Disclosure Controls
      were
      effective to provide reasonable assurance that information required to be
      disclosed in our Exchange Act reports is recorded, processed, summarized and
      reported within the time periods specified by the SEC, and that material
      information relating to Smart Online is accumulated and communicated to
      management, including the CEO and CFO as appropriate to allow timely decisions
      regarding required disclosure.





**Internal
      Controls**





There
      have been no changes in our internal control over financial reporting that
      occurred during our last fiscal quarter that have materially affected, or are
      reasonably likely to materially affect, our internal control over financial
      reporting.





**Inherent
      Limitations on Effectiveness of Controls**





Our
      management, including the CEO and CFO, does not expect that our Disclosure
      Controls or our internal control over financial reporting will prevent or detect
      all error and all fraud. A control system, no matter how well designed and
      operated, can provide only reasonable, not absolute, assurance that the control
      system’s objectives will be met. The design of a control system must reflect the
      fact that there are resource constraints, and the benefits of controls must
      be
      considered relative to their costs. Further, because of the inherent limitations
      in all control systems, no evaluation of controls can provide absolute assurance
      that misstatements due to error or fraud will not occur or that all control
      issues and instances of fraud, if any, within the company have been detected.
      These inherent limitations include the realities that judgments in
      decision-making can be faulty and that breakdowns can occur because of simple
      error or mistake. Controls can also be circumvented by the individual acts
      of
      some persons, by collusion of two or more people, or by management override
      of
      the controls. The design of any system of controls is based in part on certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions. Projections of any evaluation of controls effectiveness
      to
      future periods are subject to risks. Over time, controls may become inadequate
      because of changes in conditions or deterioration in the degree of compliance
      with policies or procedures.




Smart
        Online has determined, in consultation with
        BDO, that its expenses for the quarter ended June 30, 2005 were overstated
        by $506,000.  See Note 7 of Notes to Financial Statements regarding the
        cause of the restatement of our financial statements for the quarter ended
        June
        30, 2005.





**PART
      II. OTHERINFORMATION**





**Item
      1.  LegalProceedings**





U.S.
      News & World Report v. Smart Online, Inc. -
      U.S.
      News instituted this action against Smart Online in January 2003 in New York
      (Case No. 102959/03) for breach of contract, due to Smart Online’s refusal to
      pay the sum of $92,204.17 for an advertising insert, which Smart Online asserts
      was faulty. On October 27, 2003, the New York action was dismissed by the
      Supreme Court of the State of New York, because the State of New York had no
      jurisdiction over this suit. On February 6, 2004, U.S. News filed a similar
      claim in the District Court of Durham County, North Carolina (Case No.
      04-CVD-00575). On April 7, 2005, the parties entered into a settlement agreement
      in consideration for Smart Online paying $50,000.00 and dismissing its
      counterclaims. The suit has been voluntarily dismissed with
      prejudice.





Infopia,
      Inc. v. Smart Online, Inc. -
      Infopia
      instituted this action against Smart Online on August 6, 2003 in District Court,
      Wake County, North Carolina (Case No. 03-CVD-10567) for breach of contract,
      unfair and deceptive trade practices, and punitive damages, alleging that Smart
      Online improperly refused to refund the $32,500 integration fee paid by Infopia
      to Smart Online for Smart Online’s integration of Infopia’s products into Smart
      Online’s platform. On May 10, 2005, the parties entered into a settlement
      agreement in consideration for Smart Online paying $30,000 and dismissing its
      counterclaims. The suit has been voluntarily dismissed with
      prejudice.





Smart
      Online, Inc. v. Genuity, Inc. -
      Smart
      Online instituted this action against Genuity on May 22, 2001, in the Superior
      Court of Wake County, North Carolina, Civil Action No. 01-CVS-06277. Smart
      Online brought claims against Genuity for breach of contract, breach of express
      warranty, breach of implied warranty of merchantability, breach of warranty
      of
      fitness for a particular purpose, conversion, unfair and deceptive trade
      practices, negligent misrepresentation and fraud arising from Genuity’s failure
      to perform


56


properly
      under contracts between the parties, from Genuity’s failure to return certain
      property belonging to Smart Online, and from certain representations made by
      Genuity with regard to the services needed by Smart Online under the contracts.
      On or about July 23, 2001, Genuity filed its answer to the complaint along
      with
      counterclaims against Smart Online. In its counterclaims, Genuity brought claims
      for breach of contract alleging that Smart Online failed to pay for the services
      rendered by Genuity. On October 22, 2002, the court denied Genuity’s request to
      dismiss Smart Online’s breach of contract claim, allowed Smart Online to amend
      its complaint to restate its claim for breach of contract, and dismissed Smart
      Online’s claims for breach of implied warranties. The parties were completing
      discovery and preparing for trial when the case was automatically stayed as
      a
      result of Genuity’s filing for bankruptcy. This case is still subject to the
      automatic stay.





**Item
      2. UnregisteredSales of Equity Securities and
      Use of
      Proceeds**





(1)
            In
                May 2005, Smart Online engaged a firm to act as a non-exclusive placement
                agent for the sale of the company’s common stock. Upon signing the
                placement agency agreement, Smart Online issued the firm 2,500 shares
                of
                its common stock that vested immediately. A legend was placed on
                the stock
                certificates stating that the securities have not been registered
                under
                the Securities Act and cannot be sold or otherwise transferred without
                an
                effective registration or exemption from
                registration.





(2)
            In
                June 2005, Smart Online engaged a firm to prepare an equity research
                report on the company. In full consideration for such services, Smart
                Online issued the firm a total of 14,286 shares of its common stock.
                A
                legend was placed on the stock certificates stating that the securities
                have not been registered under the Securities Act and cannot be sold
                or
                otherwise transferred without an effective registration or exemption
                from
                registration.





(3)
            During
                July 2005, Smart Online sold 90,909 shares of its common stock to
                an
                existing investor for a price of $5.50 per share resulting in gross
                proceeds of $500,000. Also during July 2005, Smart Online sold an
                additional 36,363 shares to a new investor resulting in gross proceeds
                of
                $199,997. In connection with these sales, Smart Online incurred issuance
                costs totaling $70,000.





This
      offering was conducted pursuant to Rule 506 under Regulation D. All the
      investors are accredited investors. All the investors have prior experience
      investing in start-up technology companies. All the investors were provided
      access to all the information they deemed relevant to their investment
      decisions. All the investors had prior business dealings with one another or
      with Smart Online. Neither Smart Online nor any person acting on its behalf
      offered or sold the securities by any general solicitation or general
      advertising. A legend was placed on the stock certificates stating that the
      securities have not been registered under the Securities Act and cannot be
      sold
      or otherwise transferred without an effective registration or exemption from
      registration.





The
      proceeds from this offering will be used to fund Smart Online’s working capital
      requirements.





**Item
      3. DefaultsUpon Senior Securities**





Not
      applicable.





**Item
      4. Submissionof Matters to a Vote of Security
      Holders**





None.





**Item
      5. OtherInformation**





(1)
            During
                July 2005, Smart Online’s Board of Directors approved charters for three
                new Board committees: Audit, Compensation and Nominating and adopted
                an
                Insider Trading Policy. Copies of these charters and policies are
                available on the company’s website at
                www.smartonline.com.




**Item
      6. Exhibits**





**Exhibits**





The
      Exhibits listed in the Exhibit Index are incorporated herein by
      reference.


57


**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.





Dated:
        November 22, 2005








**Smart
                Online, Inc.**/s/
                Michael Nouri**Michael
                Nouri**
              **Principal
                Executive Officer****Smart
                Online, Inc.**/s/
                Scott Whitaker**Scott
                Whitaker**
              **Principal
                Financial Officer and****Principal
                Accounting Officer**











58








**SMART
      ONLINE, INC.**


**EXHIBIT
      INDEX**








**Exhibit**
              **Number**
            **Exhibit
                Description**
            **Form**
            **File**
              **Number**
            **Exhibit**
            **Filing**
              **Date**
            **Filed**
              **Herewith**3.1
            Amended
                and Restated
              Certification
                of Incorporation
            SB-2
            333-119385
            3.1
            9/30/043.2
            Amended
                and Restated By-Laws
            SB-2
            333-119385
            3.1
            9/30/0410.1
            2004
                Equity Compensation Plan
            SB-2
            333-119385
            10.1
            9/30/0410.2
            2001
                Equity Compensation Plan
            SB-2
            333-119385
            10.2
            9/30/0410.3
            1998
                Stock Option Plan
            SB-2
            333-119385
            10.3
            9/30/0410.4
            Form
                of Reorganization Lock-up Proxy and Release Agreement dated 1/01/04
                between Online and stockholders of Smart Online
            SB-2
            333-119385
            10.4
            9/30/0410.5
            Form
                of Lock-up Agreement dated 01/01/04, between Smart Online and stockholders
                of Smart Online
            SB-2
            333-119385
            10.5
            9/30/0410.6
            Form
                of Subscription Agreement with lock-up provisions between Smart Online
                and
                investors
            SB-2
            333-119385
            10.6
            9/30/0410.7
            Form
                of Registration Rights Agreement dated as of 02/01/04 between Smart
                Online
                and investors
            SB-2
            333-119385
            10.7
            9/30/0410.8
            Employment
                Agreement dated 04/01/04 with Michael Nouri
            SB-2
              Amendment
                1
            333-119385
            10.8
            11/24/0410.9
            Employment
                Agreement dated 04/01/04 with
              Henry
                Nouri
            SB-2
              Amendment
                1
            333-119385
            10.9
            11/24/0410.10
            Employment
                Agreement dated 04/01/04 with Ronna Loprete
            SB-2
              Amendment
                1
            333-119385
            10.10
            11/24/0410.11
            Employment
                Agreement dated 05/01/04 with Jose Collazo
            SB-2
              Amendment
                1
            333-119385
            10.11
            11/24/0410.12
            Employment
                Agreement dated 05/01/04 with Anil Kamath
            SB-2
              Amendment
                1
            333-119385
            10.12
            11/24/0410.13
            Security
                Agreement dated 10/13/03 with Smart Online as the Debtor and Michael
                Nouri, Henry Nouri, Thomas Furr, Ronna Loprete and Eric Nouri as
                the
                Secured Parties
            SB-2
              Amendment
                1
            333-119385
            10.13
            11/24/0410.14
            $418,749.93
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Michael
                Nouri
            SB-2
              Amendment
                1
            333-119385
            10.14
            11/24/0410.15
            $64,602.90
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Michael
                Nouri
            SB-2
              Amendment
                1
            333-119385
            10.15
            11/24/0410.16
            $398,383.27
                Promissory Note dated 04/01/04 from Smart Online as the Debtor to
                Henry
                Nouri
            SB-2
              Amendment
                1
            333-119385
            10.16
            11/24/0410.17
            $116,507.60
                Promissory Note dated 04/30/04 from Smart Online as the Debtor Thomas
                Furr
            SB-2
              Amendment
                1
            333-119385
            10.17
            11/24/0410.18
            $92,500
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Ronna
                Loprete
            SB-2
              Amendment
                1
            333-119385
            10.18
            11/24/0410.19
            $47,740.18
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Eric
                Nouri
            SB-2
              Amendment
                1
            333-119385
            10.19
            11/24/0410.20
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Michael
                Nouri
            SB-2
              Amendment
                2
            333-119385
            10.20
            12/23/0410.21
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Henry
                Nouri
            SB-2
              Amendment
                2
            333-119385
            10.21
            12/23/0410.22
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Thomas
                Furr
            SB-2
              Amendment
                2
            333-119385
            10.22
            12/23/0410.23
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Ronna
                Loprete
            SB-2
              Amendment
                2
            333-119385
            10.23
            12/23/0410.24
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Eric
                Nouri
            SB-2
              Amendment
                2
            333-119385
            10.24
            12/23/04













59

















10.25
                Amended
                    and Restated Integration Program Agreement for Vmail and Internet
                    Messenger Engine dated 04/30/03 with Smart IL, Ltd.
                SB-2
                  Amendment
                    1
                333-119385
                10.25
                11/24/0410.26
                Amendment
                    to Amended and Restated Integration Program Agreement dated 10/29/03
                    with
                    Smart IL, Ltd.
                SB-2
                  Amendment
                    1
                333-119385
                10.26
                11/24/0410.27
                Form
                    of Lock-up Proxy and Release Agreement dated January 1, 2004Between
                    Smart Online and stockholders of Smart
                  Online
                10-Q
                333-119385
                10.27
                08/15/0510.28
                Form
                    of Subscription Agreement with lock-up provisions between Smart
                    Online and
                    investors
                10-Q
                333-119385
                10.28
                08/15/0510.29
                Form
                    of Registration Rights Agreement between Smart Online and
                    investors
                10-Q
                333-119385
                10.29
                08/15/0531.1
                Certification
                    of Principal Executive Officer of Periodic Report Pursuant to
                    Rule
                    13a-14(a) or Rule 15d-14(a)
                
                
                
                
                X31.2
                Certification
                    of Principal Financial Officer of Periodic Report Pursuant to
                    Rule
                    13a-14(a) or Rule 15d-14(a)
                
                
                
                
                X32.1
                Certification
                    of Principal Executive Officer of Periodic Report Pursuant to
                    Rule
                    13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350
                
                
                
                
                X32.2
                Certification
                    of Principal Financial Officer of Periodic Report Pursuant to
                    Rule
                    13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350
                
                
                
                
                X