**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q**





**(Mark
      One)**


**x** **Quarterly
      report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934**





**For
      the quarterly period ended September 30, 2007**





**OR**





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





**Commission
      File Number: 001-32634**




**SMART
      ONLINE, INC.**


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







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





**2530
                Meridian Parkway, 2nd Floor**
              **Durham,
                North Carolina**
            
            **27713****(Address
                of principal executive offices)**
            
            **(Zip
                Code)**





**(919)
      765-5000**


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










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





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):





Large
                Accelerated Filero
            Accelerated
                Filero
            Non-accelerated
                Filerx





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





As
      of
      November 12, 2007, there were approximately 18,010,000 shares of the
      registrant's common stock outstanding.










**Smart
      Online, Inc.**


**Page
                  No.****PART
                  I. FINANCIAL INFORMATION****Item
                  1.**
              **Financial
                  Statements:**Consolidated
                  Balance Sheets as of September 30, 2007 (unaudited) and December
                  31,
                  2006
              3Consolidated
                  Statements of Operations (unaudited) for the three and nine months
                  ended
                  September 30, 2007 and 2006
              4Consolidated
                  Statements of Cash Flows (unaudited) for the nine months ended
                  September
                  30, 2007 and 2006
              5Notes
                  to Consolidated Financial Statements (unaudited)
              6**Item
                  2.**
              **Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations**
              16**Item
                  3.**
              **Quantitative
                  and Qualitative Disclosures About Market Risk**
              29**Item
                  4.**
              **Controls
                  and Procedures**
              30**Item
                  4T.**
              **Controls
                  and Procedures**
              30**PART
                  II. OTHER INFORMATION****Item
                  1.**
              **Legal
                  Proceedings**
              30**Item
                  1A.**
              **Risk
                  Factors**
              31**Item
                  5.**
              **Other
                  Information**
              42**Item
                  6.**
              **Exhibits**
              44**Signatures**
              46





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          |
          2




**PART
      I.** **FINANCIAL INFORMATION**


**1.
      Financial Statements**





**SMART
      ONLINE, INC.**


**CONSOLIDATED
      BALANCE SHEETS**




**September 30,**
              **2007**
              **(unaudited)**
            
            **December 31,**
              **2006****Assets**CURRENT
                ASSETS:Cash
                and Cash Equivalents
            
            $
            2,228,027
            
            $
            326,905Restricted
                Cash (See Note 5)
            
            
            250,000
            
            
            250,000Accounts
                Receivable, Net
            
            
            964,264
            
            
            247,618Current
                Portion of Note Receivable
            
            
            50,000
            
            
            -Prepaid
                Expenses
            
            
            119,109
            
            
            100,967Deferred
                Financing Costs (See Note 5)
            
            
            414,220
            
            
            -Total
                Current Assets
            
            $
            4,025,620
            
            $
            925,490PROPERTY
                AND EQUIPMENT, Net
            
            $
            187,195
            
            $
            180,360LONG
                TERM PORTION OF NOTE RECEIVABLE
            
            
            230,000
            
            
            -INTANGIBLE
                ASSETS, Net
            
            
            3,036,419
            
            
            3,617,477GOODWILL
            
            
            2,696,642
            
            
            2,696,642OTHER
                ASSETS
            
            
            75,311
            
            
            13,040TOTAL
                ASSETS
            
            $
            10,251,187
            
            $
            7,433,009**Liabilities
                and Stockholders' Equity**CURRENT
                LIABILITIES:Accounts
                Payable
            
            $
            720,845
            
            $
            850,730Accrued
                Registration Rights Penalty
            
            
            -
            
            
            465,358Current
                Portion of Notes Payable (See Note 6)
            
            
            3,187,346
            
            
            2,839,631Deferred
                Revenue (See Note 5)
            
            
            475,099
            
            
            313,774Accrued
                Liabilities (See Note 5)
            
            
            629,997
            
            
            301,266Total
                Current Liabilities
            
            $
            5,013,287
            
            $
            4,770,759LONG-TERM
                LIABILITIES:Long-Term
                Portion of Notes Payable (See Note 6)
            
            $
            165,863
            
            $
            825,000Deferred
                Revenue
            
            
            259,534
            
            
            11,252Total
                Long-Term Liabilities
            
            
            425,397
            
            
            836,252Total
                Liabilities
            
            $
            5,438,684
            
            $
            5,607,011COMMITMENTS
                AND CONTINGENCIESSTOCKHOLDERS'
                EQUITY:Common
              Stock, $.001 Par Value, 45,000,000 Shares Authorized, Shares Issued
              and
              Outstanding:September
                30, 2007 - 18,009,564; December 31, 2006 - 15,379,030
            
            
            18,009
            
            
            15,379Additional
                Paid-in Capital
            
            
            66,231,024
            
            
            59,159,919Accumulated
                Deficit
            
            
            (61,436,530
            )
            
            (57,349,300
            )Total
                Stockholders' Equity
            
            
            4,812,503
            
            
            1,825,998TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY
            
            $
            10,251,187
            
            $
            7,433,009





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




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          |
          3




**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS (unaudited)**




**Three Months Ended**
                
                **Nine Months Ended****September**
                
                **September**
                
                **September**
                
                **September****30, 2007**
                
                **30, 2006**
                
                **30, 2007**
                
                **30, 2006**REVENUES:Integration
                    Fees
                
                $
                -
                
                $
                6,250
                
                $
                5,000
                
                $
                182,660Syndication
                    Fees
                
                
                15,000
                
                
                57,352
                
                
                45,000
                
                
                183,619Subscription
                    Fees (See Note 3)
                
                
                830,660
                
                
                429,426
                
                
                2,040,243
                
                
                1,476,194Professional
                    Services Fees
                
                
                378,068
                
                
                242,177
                
                
                984,548
                
                
                601,200License
                    Fees
                
                
                200,000
                
                
                -
                
                
                480,000
                
                
                450,000Other
                    Revenues
                
                
                5,467
                
                
                14,001
                
                
                20,720
                
                
                54,312Total
                    Revenues
                
                $
                1,429,195
                
                $
                749,206
                
                $
                3,575,511
                
                $
                2,947,985COST
                    OF REVENUES
                
                $
                168,035
                
                $
                31,311
                
                $
                355,942
                
                $
                212,515GROSS
                    PROFIT
                
                $
                1,261,160
                
                $
                717,895
                
                $
                3,219,569
                
                $
                2,735,470OPERATING
                    EXPENSES:General
                    and Administrative
                
                
                1,398,170
                
                
                1,208,044
                
                
                3,567,385
                
                
                4,844,464Sales
                    and Marketing
                
                
                635,201
                
                
                135,027
                
                
                1,563,653
                
                
                666,940Research
                    and Development
                
                
                636,780
                
                
                455,997
                
                
                1,908,644
                
                
                1,279,198Total
                    Operating Expenses
                
                $
                2,670,151
                
                $
                1,799,068
                
                $
                7,039,682
                
                $
                6,790,602LOSS
                    FROM CONTINUING OPERATIONS
                
                
                (1,408,991
                )
                
                (1,081,173
                )
                
                (3,820,113
                )
                
                (4,055,132
                )OTHER
                    INCOME (EXPENSE):Interest
                    Expense, Net
                
                
                (139,124
                )
                
                (51,746
                )
                
                (400,910
                )
                
                (190,802
                )Takeback
                    of Investor Relations Shares
                
                
                -
                
                
                1,562,500
                
                
                -
                
                
                3,125,000Legal
                    Reserve and Debt Forgiveness, Net
                
                
                (39,477
                )
                
                -
                
                
                (34,877
                )
                
                144,351Writeoff
                    of Investment
                
                
                -
                
                
                -
                
                
                -
                
                
                (25,000
                )Other
                    Income
                
                
                24,866
                
                
                -
                
                
                168,672
                
                
                -Total
                    Other Income (Expense)
                
                $
                (153,735
                )
                $
                1,510,754
                
                
                (267,115
                )
                
                3,053,549NET
                    INCOME (LOSS) FROM CONTINUING OPERATIONS
                
                
                (1,562,726
                )
                
                429,581
                
                
                (4,087,228
                )
                
                (1,001,583
                )DISCONTINUED
                    OPERATIONSLoss
                    of Operations of Smart CRM, net of tax
                
                
                -
                
                
                (2,329,429
                )
                
                -
                
                
                (2,525,563
                )NET
                    LOSS attributed to common stockholders
                
                $
                (1,562,726
                )
                
                (1,899,848
                )
                $
                (4,087,228
                )
                $
                (3,527,146
                )NET
                    LOSS PER SHARE:Continuing
                    OperationsBasic
                    and Fully Diluted
                
                $
                (0.09
                )
                $
                0.03
                
                $
                (0.24
                )
                $
                (0.07
                )Discontinued
                    OperationsBasic
                    and Fully Diluted
                
                $
                -
                
                $
                (0.15
                )
                $
                -
                
                $
                (0.17
                )Net
                    Loss Attributed to Common StockholdersBasic
                
                $
                (0.09
                )
                
                (0.13
                )
                
                (0.24
                )
                
                (0.23
                )Fully
                    Diluted
                
                
                (0.09
                )
                
                (0.12
                )
                
                (0.24
                )
                
                (0.23
                )SHARES
                    USED IN COMPUTING NET LOSS PER SHAREBasic
                
                
                17,292,639
                
                
                15,127,510
                
                
                17,002,827
                
                
                15,077,583Fully
                    Diluted
                
                
                17,292,639
                
                
                15,387,110
                
                
                17,002,827
                
                
                15,077,583





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




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          |
          4




**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (unaudited)**





**Nine Months**
              **Ended**
              **September 30, 2007**
            
            **Nine Months**
              **Ended**
              **September 30, 2006**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                Loss
            
            $
            (4,087,228
            )
            $
            (1,001,583
            )Adjustments
                to reconcile Net Loss to Net Cashused
                in Operating Activities:Depreciation
                and Amortization
            
            
            631,267
            
            
            530,969Amortization
                of Deferred Financing Costs
            
            
            320,083
            
            
            -Takeback
                of Investor Relation Shares
            
            
            -
            
            
            (3,125,000
            )Stock
                Option Related Compensation Expense
            
            
            574,343
            
            
            622,442Writeoff
                of Investment
            
            
            -
            
            
            25,000Registration
                Rights Penalty
            
            
            (320,632
            )
            
            345,870Gain
                on Debt Forgiveness
            
            
            (215,123
            )
            
            (144,351
            )Changes
                in Assets and Liabilities:Accounts
                Receivable
            
            
            (716,154
            )
            
            215,569Prepaid
                Expenses
            
            
            (18,634
            )
            
            97,074Other
                Assets
            
            
            (32,271
            )
            
            129Deferred
                Revenue
            
            
            410,179
            
            
            (309,460
            )Accounts
                Payable
            
            
            85,290
            
            
            379,431Accrued
                and Other Expenses
            
            
            329,643
            
            
            102,402Net
                cash from operations of discontinued operations
            
            
            -
            
            
            212,199Net
                Cash used in Operating Activities
            
            $
            (3,039,237
            )
            $
            (2,049,309
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of Furniture and Equipment
            
            
            (86,549
            )
            
            (7,362
            )Purchase
                of Tradename
            
            
            (2,033
            )
            
            -Net
                cash from investing activities of discontinued operations
            
            
            -
            
            
            431,076Net
                Cash provided by (used in) Investing Activities
            
            $
            (88,582
            )
            $
            423,714CASH
                FLOWS FROM FINANCING ACTIVITIES:Repayments
                on Notes Payable
            
            
            (1,784,272
            )
            
            (1,460,333
            )Debt
                Borrowings
            
            
            1,472,850
            
            
            -Notes
                Receivable
            
            
            (280,000
            )
            
            -Advances
                to Smart CRM
            
            
            -
            
            
            (744,918
            )Advances
                from Smart CRM
            
            
            -
            
            
            1,308,340Restricted
                Cash
            
            
            -
            
            
            (102,409
            )Issuance
                of Common Stock
            
            
            5,748,607
            
            
            2,522,100Expenses
                Related to Form S-1 Filing
            
            
            (128,244
            )
            
            -Net
                cash from financing activities of discontinued operations
            
            
            -
            
            
            (651,364
            )Net
                Cash provided by Financing Activities
            
            $
            5,028,941
            
            $
            871,416NET
                INCREASE (DECREASE) IN CASHAND
                CASH EQUIVALENTS
            
            $
            1,901,122
            
            $
            (754,179
            )CASH
                AND CASH EQUIVALENTS,BEGINNING
                OF PERIOD
            
            $
            326,905
            
            $
            1,427,489CASH
                AND CASH EQUIVALENTS OF DISCONTINUED OPERATIONS, BEGINNING OF
                PERIOD
            
            
            -
            
            
            7,477CASH
                AND CASH EQUIVALENTS,END
                OF PERIOD
            
            $
            2,228,027
            
            $
            680,787Supplemental
                Disclosures:Cash
                Paid During the Period for Interest:
            
            $
            247,400
            
            $
            `
                154,288Cash
                Payment for Interest by Discontinued Operations
            
            
            -
            
            
            41,875Cash
                Paid for Taxes
            
            
            -
            
            
            -Shares
                Issued in Settlement of Registration RightsPenalties
            
            
            144,351
            
            
            -





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




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          |
          5




**Smart
      Online, Inc.**


**Consolidated
      Financial Statements - Unaudited**





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




***Description
      of Business -*** Smart
      Online, Inc. (the “Company”) was incorporated in the State of Delaware in 1993.
      The Company develops and markets Internet-delivered Software-as-a-Service
      (“SaaS”) software applications and data resources to help start and run small
      businesses. Subscribers access the Company’s products through the websites of
      its private label syndication partners, and its portal at www.onebiz.com.
      Corporate information on the Company can be found at
      www.smartonline.com.





***Basis
      of Presentation*** -
      The
      accompanying balance sheet as of September 30, 2007 and the statements of
      operations for the three months and nine months ended September 30, 2007 and
      2006 and the statements of cash flows for the nine months ended September 30,
      2007 and 2006 are unaudited. The balance sheet as of December 31, 2006 is
      obtained from the audited financial statements as of that date. The accompanying
      statements should be read in conjunction with the audited financial statements
      and related notes, together with management's discussion and analysis of
      financial position and results of operations, contained in the Company's Annual
      Report on Form 10-K for the year ended December 31, 2006 filed with the
      Securities and Exchange Commission (the “SEC”) on March 30, 2007 (the “2006
      Annual Report”).





The
      financial statements have been prepared in accordance with accounting principles
      generally accepted in the United States (“U.S. GAAP”). In the opinion of the
      Company's management, the unaudited statements in this Quarterly Report on
      Form
      10-Q include all normal and recurring adjustments necessary for the fair
      presentation of the Company's statement of financial position as of September
      30, 2007, and its results of operations for the three months and nine months
      ended September 30, 2007 and September 30, 2006 and the statements of cash
      flows
      for the nine months ended September 30, 2007 and 2006. The results for the
      three
      months and nine months ended September 30, 2007 are not necessarily indicative
      of the results to be expected for the fiscal year ending December 31,
      2007.




The
      Company continues to incur development expenses to enhance and expand its
      products by focusing on establishing its Internet-delivered SaaS applications
      and data resources. All allocable expenses to establish the technical
      feasibility of the software have been recorded as research and development
      expense. The ability of the Company to successfully develop and market its
      products is dependent upon certain factors, including the timing and success
      of
      any new services and products, the progress of research and development efforts,
      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.




***Significant
      Accounting Policies -*** In the
      opinion of the Company's management, the significant accounting policies used
      for the three months and nine months ended September 30, 2007 are consistent
      with those used for the years ended December 31, 2006, 2005 and 2004.
      Accordingly, please refer to the 2006 Annual Report for our significant
      accounting policies.





***Reclassifications
      -*** Certain
      prior year amounts have been reclassified to conform to current year
      presentation. These reclassifications had no effect on previously reported
      net
      income or shareholders’ equity.





***Revenue
      Recognition -*** The
      Company derives revenue from the license of software platforms along with the
      sale of associated maintenance, consulting, and application development
      services. The arrangement may include delivery in multiple-element arrangements
      if the customer purchases a combination of products and/or services. The Company
      uses the residual method pursuant to American Institute of Certified Public
      Accountants (“AICPA”) Statement of Position 97-2, *Software
      Revenue Recognition* (“SOP
      97-2”), as amended. This method allows the Company to recognize revenue for a
      delivered element when such element has vendor specific objective evidence
      (“VSOE”) of the fair value of the delivered element. If VSOE cannot be
      determined or maintained for an element, it could impact revenues as all or
      a
      portion of the revenue from the multiple-element arrangement may need to be
      deferred.





If
      multiple-element arrangements involve significant development, modification
      or
      customization or if it is determined that certain elements are essential to
      the
      functionality of other elements within the arrangement, revenue is deferred
      until all elements necessary to the functionality are provided by the Company
      to
      a customer. The determination of whether the arrangement involves significant
      development, modification or customization could be complex and require the
      use
      of judgment by management.





The
      amount of revenue to be recognized from development and consulting services
      is
      typically based on the amount of work performed within a given period. Revenue
      recognition is typically based on estimates involving total costs to complete
      and the stage of completion. The assumptions and estimates made to determine
      the
      total costs and stage of completion may affect the timing of revenue
      recognition. Changes in estimates of progress to completion and costs to
      complete are accounted for as cumulative catch-up adjustments.




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          |
          6




Under
      SOP
      97-2, provided the arrangement does not require significant development,
      modification or customization, revenue is recognized when all of the following
      criteria have been met:





1.
            persuasive
                evidence of an arrangement exists


2.
            delivery
                has occurred


3.
            the
                fee is fixed or determinable


4.
            collectability
                is probable





If
      at the
      inception of an arrangement, the fee is not fixed or determinable, revenue
      is
      deferred until the arrangement fee becomes due and payable. If collectability
      is
      deemed not probable, revenue is deferred until payment is received or collection
      becomes probable, whichever is earlier. The determination of whether fees are
      collectible requires judgment of management, and the amount and timing of
      revenue recognition may change if different assessments are made.




***Fiscal
      Year -*** The
      Company's fiscal year ends December 31. References to fiscal 2006, for example,
      refer to the fiscal year ending December 31, 2006.




***Use
      of Estimates -*** The
      preparation of financial statements in conformity with U.S. GAAP requires
      management to make estimates and assumptions in the Company's financial
      statements and notes thereto. Significant estimates and assumptions made by
      management include the determination of the provision for income taxes, the
      fair
      market value of stock awards issued and the period over which revenue is
      generated. Actual results could differ materially from those
      estimates.





***Software
      Development Costs*** - The
      Company has not capitalized any direct or allocated overhead associated with
      the
      development of software products prior to general release. Statement of
      Financial Accounting Standard (“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 historically 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.





***Advertising
      Costs*** -
      The
      Company expenses all advertising costs as they are incurred. The amounts charged
      to sales and marketing expense during the third quarter of 2007 and 2006 were
      $11,133 and $104, respectively. The amounts charged to sales and marketing
      expense during the first nine months of 2007 and 2006 were $26,802 and $42,419,
      respectively. There were no barter advertising expenses for the three months
      ending September 30, 2007 and September 30, 2006, respectively, and $0 and
      $37,915 for the nine months ended September 30, 2007 and September 30, 2006,
      respectively.





***Net
      Loss per Share -*** Basic
      loss per share is computed using the weighted-average number of common shares
      outstanding during the relevant periods. Diluted loss per share is computed
      using the weighted-average number of common and dilutive common equivalent
      shares outstanding during the relevant ****** periods.
      Common equivalent shares consist of redeemable preferred stock, stock options
      and warrants that are computed using the treasury stock method.





***Stock-Based
      Compensation -*** In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS
      No. 123 (revised 2004), *Share-Based Payment* (“SFAS
      No. 123R”), which replaces SFAS No. 123, *Accounting for Stock-Based Compensation* (“SFAS
      No. 123”), and supersedes Accounting Principles Board (“APB”) Opinion No.
      25, *Accounting for Stock Issued to Employees* (“APB
      No. 25”). SFAS No. 123R requires all share-based payments, including grants of
      employee stock options and restricted stock, to be recognized in the financial
      statements based on their fair values. Under SFAS No. 123R, public companies
      are
      required to measure the costs of services received in exchange for stock
      options, restricted stock and similar awards based on the grant date fair value
      of the awards and recognize this cost in the income statement over the period
      during which an award recipient is permitted to provide service in exchange
      for
      the award. The pro forma disclosures previously permitted under SFAS No. 123
      are
      no longer an alternative to financial statement recognition.




Page
          |
          7




The
      Company maintains stock-based compensation arrangements under which employees,
      consultants and directors may be awarded grants of unrestricted and restricted
      stock. Effective January 1, 2006, the Company adopted SFAS No. 123R using
      the Modified Prospective Approach. Under the Modified Prospective Approach,
      the
      amount of compensation cost recognized includes: (i) compensation cost for
      all share-based payments granted prior to, but not yet vested as of,
      January 1, 2006, based on the grant date fair value estimated in accordance
      with the provisions of SFAS No. 123 and (ii) compensation cost for all
      share-based payments that will be granted subsequent to January 1, 2006,
      based on the grant date fair value estimated in accordance with the provisions
      of SFAS No. 123R. Upon adoption, the Company recognizes the stock-based
      compensation of previously granted share-based awards and new share-based awards
      under the straight-line method over the requisite service period. Total
      stock-based compensation expense recognized under SFAS No. 123R was
      approximately $194,325 and $574,344 for the three months and nine months ended
      September 30, 2007, respectively. Total stock-based compensation expense
      recognized under SFAS No. 123R was approximately $173,428 and $622,442 for
      the
      three months and nine months ended September 30, 2006, respectively.
      No stock-based compensation was capitalized in the consolidated financial
      statements.





The
      fair
      value of option grants under the Company's 2004 Equity Compensation Plan (the
      “2004 Plan”) and other stock options outstanding during the three months and
      nine months ended September 30, 2007 and September 30, 2006 was estimated using
      the Black-Scholes option-pricing model with the following weighted-average
      assumptions:





**Three Months Ended**
            
            **Nine Months Ended****September 30,**
              **2007**
            
            **September 30,**
              **2006**
            
            **September 30,**
              **2007**
            
            **September 30,**
              **2006**Dividend
                yield
            
            
            0.0
            %
            
            0.
                00
            %
            
            0.0
            %
            
            0.
                00
            %Expected
                volatility
            
            
            150
            %
            
            48.6
            %
            
            150
            %
            
            150
            %Risk
                free interest rate
            
            
            4.59
            %
            
            4.64
            %
            
            4.59
            %
            
            4.64
            %Expected
                lives (years)
            
            
            5
            
            
            5
            
            
            5
            
            
            5





The
      expected lives of the options represents the estimated period of time until
      exercise or forfeiture and is based on historical experience of similar awards.
      Expected volatility is based on the historical volatility of the Company’s
      common stock over a period of time. The risk free interest rate is based on
      the
      published yield available on U.S. treasury issues with an equivalent term
      remaining equal to the expected life of the option.





Compensation
      expense is recognized only for option grants expected to vest. The Company
      estimates forfeitures at the date of grant based on historical experience and
      future expectation.





The
      following is a summary of the stock option activity for the nine months ended
      September 30, 2007:




**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                December 31, 2006
            
            
            2,360,100
            
            $
            5.33Granted
            
            
            20,000
            
            $
            2.80Forfeited
            
            
            160,800
            
            $
            4.49Exercised
            
            
            20,000
            
            $
            1.30BALANCE,
                September 30, 2007
            
            
            2,199,300
            
            $
            5.40





**Recently
      Issued Accounting Pronouncements**





In
      September 2006, the FASB issued SFAS No. 157, *Fair
      Value Measurements* (“SFAS
      No. 157”). SFAS No. 157 defines fair value, establishes a framework for
      measuring fair value in U.S. GAAP, and expands disclosures about fair value
      measurements. SFAS No. 157 applies under other accounting pronouncements that
      require or permit fair value measurements, the FASB having previously concluded
      in those accounting pronouncements that fair value is a relevant measurement
      attribute. Accordingly, SFAS No. 157 does not require any new fair value
      measurements. However, for some entities, the application of SFAS No. 157 will
      change current practices. SFAS No. 157 is effective for financial statements
      for
      fiscal years beginning after November 15, 2007. Earlier application is permitted
      provided that the reporting entity has not yet issued financial statements
      for
      that fiscal year. Management does not believe that the adoption of SFAS No.
      157
      will have a material impact on the Company's results of operations or financial
      condition once adopted.





In
      February 2007, the FASB issued SFAS No. 159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB Statement No. 115* (“SFAS
      No. 159”). SFAS No. 159 provides companies with an option to measure, at
      specified election dates, many financial instruments and certain other items
      at
      fair value that are not currently measured at fair value. A company that adopts
      SFAS No. 159 will report unrealized gains and losses on items for which the
      fair
      value option has been elected in earnings at each subsequent reporting date.
      SFAS No. 159 also establishes presentation and disclosure requirements designed
      to facilitate comparisons between entities that choose different measurement
      attributes for similar types of assets and liabilities. SFAS No. 159 is
      effective for fiscal years beginning after November 15, 2007. Management does
      not believe that the adoption of SFAS No. 159 will have a material impact on
      the
      Company's results of operations or financial condition once
      adopted.




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          |
          8




**2.
      PRESENTATION OF SUBSIDIARIES**





As
      more
      fully detailed in the 2006 Annual Report, the Company completed two acquisitions
      in October 2005. On October 4, 2005, the Company purchased substantially all
      of
      the assets of Computility, Inc. (“Computility”). In consideration for the
      purchased assets, the Company issued the seller 484,213 shares of the Company's
      common stock and assumed certain liabilities of Computility totaling
      approximately $1.9 million.  The shares were valued at $7.30 per share,
      which was the median trading price on the acquisition date. The total purchase
      price, including liabilities assumed, was approximately $5.8 million including
      approximately $228,000 of acquisition fees. The
      Company operated this business under the name Smart CRM, Inc. (d/b/a
      Computility) (“Smart CRM”).





On
      October 18, 2005, the Company completed its purchase of all of the capital
      stock
      of iMart Incorporated (“iMart”), a Michigan based company providing
      multi-channel electronic commerce systems. The Company issued 205,767 shares
      of
      its common stock to iMart's stockholders and agreed to pay iMart's stockholders
      approximately $3,462,000 in cash installments. This cash amount was payable
      in
      four equal payments of $432,866 on the first business day of each of January
      2006, April 2006, July 2006 and October 2006. The final installment payment
      of
      approximately $1.7 million was payable in January 2007. As of January 2007,
      the
      entire purchase price was paid in full. The shares were valued at $8.825 per
      share, which was the median trading price on the acquisition date. The total
      purchase price for all of the outstanding iMart shares was approximately $5.3
      million including approximately $339,000 of acquisition fees. The
      Company operates this subsidiary as Smart
      Commerce, Inc. (d/b/a iMart) (“Smart Commerce”) .





Upon
      the
      Company's successful integration of the sales force automation and customer
      relationship management (“SFA/CRM”) application into its OneBiz SM platform, management deemed the remaining operations of Smart CRM, specifically
      consulting and network management, to be non-strategic to ongoing operations.
      On
      September 29, 2006, the Company, Smart CRM and Alliance Technologies, Inc.
      ("Alliance") executed and delivered an Asset Purchase Agreement pursuant to
      which Alliance acquired substantially all of the assets of Smart CRM. In
      accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets* ,
      the
      Company has reported the operating results for Smart CRM as discontinued
      operations. For the three months and nine months ended September 30, 2006,
      the
      revenues associated with the discontinued operations were $462,468 and
      $1,497,002, respectively. For the three months and nine months ended September
      30, 2006, the net losses associated with the discontinued operations were
      $(2,329,429) and $(2,525,563), respectively. Because the sale had been completed
      in 2006, the 2007 periods contain no results of discontinued
      operations.





**3.
      SUBSCRIPTION REVENUE**





Effective
      January 1, 2007, a major customer executed a letter of clarification which
      more
      clearly defined the roles and responsibilities of each party. Individual
      Business Owners (“IBOs”) associated with this customer are provided e-commerce,
      domain name and email services. In exchange for marketing these services to
      its
      IBOs, the customer is paid a marketing fee. At the inception of the business
      relationship, it was agreed that the customer would collect the gross service
      fee from the IBOs, and the customer would retain its marketing fee and remit
      the
      net remaining cash to the Company. Because the roles and responsibilities of
      each party were vaguely defined in the past, revenue was recorded only on the
      net cash received. Following the execution of the letter of clarification and
      in
      accordance with Emerging Issues Task Force (“EITF”) 99-19, *Reporting
      Revenue Gross as a Principal versus Net as an Agent,* this
      revenue is now recorded as the gross amount paid by the IBO and a sales and
      marketing expense is recorded for the marketing services rendered by the
      customer. Ultimately, the effect on net income is nil; however, subscription
      revenue and sales and marketing expense are effectively and appropriately
      grossed up. Because the new accounting method was triggered by a clarification
      to the existing agreement and not by a change from one accepted accounting
      method to another, the 2006 subscription revenue was not retroactively adjusted
      as would be required by SFAS No. 154, *Accounting Changes and Error Corrections - a replacement of APB Opinion No.
      20
      and FASB Statement No. 3* .
      For the
      three months and nine months ended September 30, 2007, this accounting method
      resulted in approximately $203,000 and $691,000, respectively, of additional
      subscription revenue and a corresponding charge to sales and marketing
      expense.





**4.  
      INDUSTRY SEGMENT INFORMATION**





SFAS
      No.
      131, *Disclosures about Segments of an Enterprise and Related
      Information* (“SFAS
      No. 131”), establishes standards for the way in which public companies disclose
      certain information about operating segments in their financial reports.
      Consistent with SFAS No. 131, the Company has defined two reportable segments,
      described below, based on factors such as geography, how the Company manages
      its
      operations and how its chief operating decision maker views results.





Smart
      Commerce revenue is generally composed of subscription fees, professional
      services fees and licensing fees related to domain name subscriptions,
      e-commerce or networking consulting or networking maintenance
      agreements.





The
      Smart
      Online segment generates revenue from the development and distribution of
      internet-delivered SaaS small business applications through a variety of
      subscription, licensing, integration and syndication channels.




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          |
          9




The
      Company includes costs such as corporate general and administrative expenses
      and
      share-based compensation expenses that are not allocated to specific segments
      in
      the Smart Online segment, which includes the parent or corporate
      segment.





The
      following table shows the Company's financial results by reportable segment
      for
      the three months ended September 30, 2007:





Smart
              Online,
              Inc.
            
            Smart
              Commerce,
              Inc.
            
            ConsolidatedREVENUES:Syndication
                Fees
            
            
            15,000
            
            
            -
            
            
            15,000Subscription
                Fees
            
            
            13,892
            
            
            816,768
            
            
            830,660Professional
                Services Fees
            
            
            -
            
            
            378,068
            
            
            378,068License
                Fees
            
            
            -
            
            
            200,000
            
            
            200,000Other
                Revenues
            
            
            1,117
            
            
            4,350
            
            
            5,467Total
                Revenues
            
            $
            30,009
            
            $
            1,399,186
            
            $
            1,429,195COST
                OF REVENUES
            
            $
            60,748
            
            $
            107,287
            
            $
            168,035OPERATING
                EXPENSES
            
            $
            1,756,889
            
            $
            913,262
            
            $
            2,670,151OPERATING
                INCOME (LOSS)
            
            $
            (1,787,628
            )
            $
            378,637
            
            $
            (1,408,991
            )OTHER
                INCOME (EXPENSE)
            
            $
            (126,424
            )
            $
            (27,311
            )
            $
            (153,735
            )NET
                INCOME/(LOSS) BEFORE INCOME TAXES
            
            $
            (1,914,052
            )
            $
            351,326
            
            $
            (1,562,726
            )TOTAL
                ASSETS
            
            $
            6,564,696
            
            $
            3,686,492
            
            $
            10,251,187





The
      following table shows the Company's financial results by reportable segment
      for
      the nine months ended September 30, 2007:





Smart
              Online,
              Inc.
            
            Smart
              Commerce,
              Inc.
            
            ConsolidatedREVENUES:Integration
                Fees
            
            $
            5,000
            
            $
            -
            
            $
            5,000Syndication
                Fees
            
            
            45,000
            
            
            -
            
            
            45,000Subscription
                Fees
            
            
            41,426
            
            
            1,998,817
            
            
            2,040,243Professional
                Services Fees
            
            
            -
            
            
            984,548
            
            
            984,548License
                Fees
            
            
            280,000
            
            
            200,000
            
            
            480,000Other
                Revenues
            
            
            6,802
            
            
            13,918
            
            
            20,720Total
                Revenues
            
            $
            378,228
            
            $
            3,197,283
            
            $
            3,575,511COST
                OF REVENUES
            
            $
            109,522
            
            $
            246,420
            
            $
            355,942OPERATING
                EXPENSES
            
            $
            4,743,036
            
            $
            2,296,646
            
            $
            7,039,682OPERATING
                INCOME (LOSS)
            
            $
            (4,474,330
            )
            $
            654,217
            
            $
            (3,820,113
            )OTHER
                INCOME (EXPENSE)
            
            $
            (168,106
            )
            $
            (99,009
            )
            $
            (267,115
            )NET
                INCOME/(LOSS) BEFORE INCOME TAXES
            
            $
            (4,642,436
            )
            $
            555,208
            
            $
            (4,087,228
            )TOTAL
                ASSETS
            
            $
            6,564,696
            
            $
            3,686,492
            
            $
            10,251,187




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          |
          10




**5.  
      ASSETS & LIABILITIES**





***Accounts
      Receivable, Net***





The
      Company 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 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 on these criteria, management has recorded an allowance for doubtful
      accounts of approximately $65,000 and $65,000 as of September 30, 2007 and
      December 31, 2006, respectively.





***Restricted
      Cash***





Under
      the
      terms of a promissory note between Smart Commerce and Fifth Third Bank, $250,000
      on deposit at Fifth Third Bank serves as loan collateral and is restricted.
      Such
      restricted cash is scheduled to be released from the restrictions in three
      equal
      installments of approximately $83,000, on June 30, 2007, December 31, 2007
      and
      June 30, 2008, if the Company meets certain debt covenants regarding operating
      metrics for Smart Commerce. Those
      operating metrics relate to Smart Commerce’s actual results of operations as
      compared to certain projections provided to Fifth Third Bank at the inception
      of
      the loan. The metrics for the June 30, 2007 release were not met, and therefore,
      no cash has yet been released.





***Deferred
      Financing Costs***





In
      order
      to secure a modification to a line of credit with Wachovia Bank, NA (“Wachovia”)
      (see Note 6 - Notes Payable), Atlas Capital, S.A. (“Atlas”) provided the Company
      with a modified letter of credit. In exchange for the modified letter of credit,
      the Company issued Atlas a warrant to purchase 444,444 shares of common stock
      at
      $2.70 per share (see Note 7 - Stockholders' Equity). The fair value of that
      warrant was $734,303 as measured using the Black-Scholes option-pricing model
      at
      the time the warrant was issued. Such amount was recorded as deferred financing
      costs and is being amortized to interest expense in the amount of $37,657 per
      month over the remaining period of the modified line of credit, which is
      scheduled to expire in August 2008. As of September 30, 2007, the deferred
      financing costs that will be amortized to interest expense over the next twelve
      months, or $414,220, were classified as current assets.





***Accrued
      Liabilities***





At
      December 31, 2006, the Company had accrued liabilities totaling $301,266. This
      amount consisted primarily of $107,333 of liability accrued related to the
      development of the Company’s custom accounting application, $56,997 related to
      its internal investigation conducted during 2006 and $25,000 accrued liability
      related to a lawsuit against the Company for legal fees incurred by an
      independent director in connection with the suspension of trading of the
      Company’s securities. At September 30, 2007, total accrued liabilities increased
      to $629,997. This amount reflects the addition of $300,000 of additional accrued
      liability as a reserve for the current litigation involving the
      Company.





***Deferred
      Revenue***





At
      December 31, 2006, deferred revenue consisted of the short-term and long-term
      portion of cash received related to one or two year subscriptions for domain
      names and/or email accounts. At September 30, 2007, deferred revenue consisted
      of the same domain name and e-mail types of deferred revenue in the amount
      of
      $254,633. In addition, at September 30, 2007, the Company had deferred $480,000
      of perpetual licensing revenue related to two customers that did not meet all
      the criteria of SOP 97-2. Such deferred revenue will be recognized as cash
      is
      received or collectability becomes probable.





**6.
      NOTES PAYABLE**





As
      of
      September 30, 2007, the Company had notes payable totaling $3,353,209. The
      detail of these notes is as follows:





Note Description
            
            Short-Term
              Portion
            
            Long-Term
              Portion
            
            TOTAL
            
            Maturity
            
            RateWachovia
                Credit Line
            
            $
            2,052,000
            
            
            -
            
            $
            2,052,000
            
            
            Aug
                `08
            
            
            Libor
                + 0.9%Fifth
                Third Loan
            
            $
            900,000
            
            
            150,000
            
            
            1,050,000
            
            
            Nov
                `08
            
            
            Prime
                + 1.5%Ailco
                Financial
            
            
            6,987
            
            
            15,863
            
            
            22,850
            
            
            June
                ‘10
            
            
            18%Acquisition
                Fee (iMart)
            
            
            209,177
            
            
            -
            
            
            209,177
            
            
            Oct
                ‘07
            
            
            8%Acquisition
                Fee (Computility)
            
            
            19,182
            
            
            -
            
            
            19,182
            
            
            Mar
                ‘07
            
            
            8%TOTAL
            
            $
            3,187,346
            
            $
            165,863
            
            $
            3,353,209





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          |
          11




On
      January 24, 2007, the Company entered into an amendment to its line of credit
      with Wachovia. The amendment resulted in an increase in the line of credit
      from
      $1.3 million to $2.5 million. The pay-off date for the line of credit was also
      extended from August 1, 2007 to August 1, 2008. Interest accrues on the unpaid
      principal balance at the LIBOR Market Index Rate plus 0.9%. The line of credit
      is secured by the Company's deposit account at Wachovia and an irrevocable
      standby letter of credit in the amount of $2,500,000 issued by HSBC Private
      Bank
      (Suisse) S.A. with Atlas as account party. As of September 30, 2007, the Company
      has drawn down approximately $2.1 million on the line of credit.





**7.
      STOCKHOLDERS' EQUITY**




***Common
      Stock and Warrants***




During
      the nine months ended September 30, 2007, a total of 159,500 shares of
      restricted stock were issued. A total of 55,000 shares of restricted stock
      were
      issued to the Company’s independent directors in accordance with the Company’s
      board compensation policy. The restrictions on such shares lapse with respect
      to
      the number of shares equal to 25% of the total securities issued over the
      subsequent four quarters provided that the director remains on the Board of
      Directors at the time each quarter commences. A total of 25,000 shares of
      restricted stock were issued to the newly appointed Chief Operating Officer,
      with the restrictions on such shares lapsing with respect to the number of
      shares equal to 12.5% of the total securities issued over the subsequent eight
      quarters, provided that at the time each quarter commences, the officer is
      still
      employed as an officer of Company. Finally, a total of 79,500 shares of
      restricted stock were issued to various employees, one of whom is an officer.
      Restrictions lapse as to one-third of these shares upon grant, with restrictions
      lapsing on the remaining shares over the next two years provided the respective
      employee remains employed by the Company.





In
      a
      transaction that closed on February 21, 2007, the Company sold an aggregate
      of
      2,352,941 shares of its common stock to two new investors (the “Investors”). The
      private placement shares were sold at $2.55 per share pursuant to a Securities
      Purchase Agreement (the “SPA”) between the Company and each of the Investors.
      The aggregate gross proceeds to the Company were $6 million, and the Company
      has
      incurred issuance costs of approximately $637,000 as of September 30, 2007.
      Under the SPA, the Company issued the Investors warrants for the purchase of
      an
      aggregate of 1,176,471 shares of common stock at an exercise price of $3.00
      per
      share. These warrants contain a provision for cashless exercise and must be
      exercised, if at all, by February 21, 2010.




The
      Company and each of the Investors also entered into a Registration Rights
      Agreement (the “Investor RRA”) whereby the Company had an obligation to register
      the shares for resale by the Investors by filing a registration statement within
      30 days of the closing of the private placement, and to have the registration
      statement declared effective 60 days after actual filing, or 90 days after
      actual filing if the SEC reviewed the registration statement. If a registration
      statement was not timely filed or declared effective by the date set forth
      in
      the Investor RRA, the Company would have been obligated to pay a cash penalty
      of
      1% of the purchase price on the day after the filing or declaration of
      effectiveness was due, and 0.5% of the purchase price per every 30-day period
      thereafter, to be prorated for partial periods, until the Company fulfilled
      these obligations. Under no circumstances could the aggregate penalty for late
      registration or effectiveness exceed 10% of the aggregate purchase price. Under
      the terms of the Investor RRA, the Company could not offer for sale or sell
      any
      securities until May 22, 2007, subject to certain limited exceptions, unless,
      in
      the opinion of the Company's counsel, such offer or sale did not jeopardize
      the
      availability of exemptions from the registration and qualification requirements
      under applicable securities laws with respect to this placement. On March 28,
      2007, the Company entered into an amendment to the Investor RRA with each
      Investor to extend the registration filing obligation date by an additional
      eleven calendar days. On April 3, 2007, the Company filed the registration
      statement within the extended filing obligation period, thereby avoiding the
      first potential penalty. Effective July 2, 2007, the Company entered into
      another amendment to the Investor RRA to extend the registration effectiveness
      obligation date to July 31, 2007. On July 31, 2007, the SEC declared the
      registration statement effective. Accordingly, the Company met all of its
      requirements under the amended Investor RRA and no penalties were
      incurred.





As
      part
      of the commission paid to Canaccord Adams Inc. (“CA”), the Company's placement
      agent in the transaction described above, CA was issued a warrant to purchase
      35,000 shares of the Company's common stock at an exercise price of $2.55 per
      share. This warrant contains a provision for cashless exercise and must be
      exercised by February 21, 2012. CA and the Company also entered into a
      Registration Rights Agreement (the “CA RRA”). Under the CA RRA, the shares
      issuable upon exercise of the warrant were required to be included on the same
      registration statement the Company was obligated to file under the Investor
      RRA
      described above, but CA was not entitled to any penalties for late registration
      or effectiveness.





As
      incentive to modify a letter of credit relating to the Wachovia line of
      credit (see Note 6 - Notes Payable), the Company entered into a Stock
      Purchase Warrant and Agreement (the “Warrant Agreement”) with Atlas on January
      15, 2007. Under the terms of the Warrant Agreement, Atlas received a warrant
      to
      purchase up to 444,444 shares of the Company's common stock at $2.70 per share
      at the termination of the line of credit or if the Company is in default under
      the terms of the line of credit with Wachovia. If the warrant is exercised
      in
      full, it will result in gross proceeds to the Company of approximately
      $1,200,000.





On
      March
      29, 2007, the Company issued 55,666 shares of its common stock to certain
      investors as registration penalties for its failure to timely file a
      registration statement covering shares owned by those investors as required
      pursuant to amendments to registration rights agreements between such investors
      and the Company. On
      July
      20, 2007, the Company issued 27,427 additional shares as registration penalties
      to certain investors who did not enter into amendments to certain registration
      rights agreements.




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          |
          12


On
        July
        30, 2007, certain of the Company’s affiliates entered into lock-up agreements
        covering a portion of their shares (the “Lock-Up Agreements”). These agreements
        restrict the sale of 1,296,623 shares of the Company’s common stock. Under the
        terms of these Lock-Up Agreements, these affiliates cannot sell, pledge,
        grant
        or otherwise transfer the shares subject to the agreement for one year following
        July 31, 2007. After one year, 2.5% of these shares per quarter are released
        from these restrictions on a pro rata basis among these affiliates. All
        remaining shares will be released from the Lock-Up Agreements on July 31,
        2009.
        These Lock-Up Agreements will otherwise terminate at the following times:
        (A) if
        the Registration Statement on Form S-1 filed by the Company and declared
        effective on July 31, 2007 (the “Registration Statement”) is terminated, the
        earlier of (i) the date of termination if no shares were sold, or (ii) the
        date
        any proceeds received from public investors are placed in the mail for return;
        (B) the date the Company’s common stock is listed on a national securities
        exchange, or (C) 30 days following the date the persons signing these Lock-Up
        Agreements are no longer affiliates.
 
 ***Equity
        Compensation Plans***
  On
        April
        11, 2007, the Company entered into a stock option agreement for the purchase
        of
        up to 20,000 shares of the Company’s common stock at an exercise price of $2.80
        per share with an independent director. Under the terms of the option agreement,
        this option vests in equal quarterly increments on February 16, 2007, May
        16,
        2007, August 16, 2007, and November 16, 2007 if this director is serving
        as a
        member of the Company’s Board of Directors on such dates. These dates were
        selected so that all shares will have vested by the first anniversary of
        this
        director’s appointment to the Board. In the event of a change of control or
        reorganization of the Company (both as defined in the option agreement),
        the
        option vests as to all shares on the date of such event.
  In
        June
        2007, the Company limited the issuance of shares of its common stock reserved
        under the 2004 Plan to awards of restricted or unrestricted stock. Also in
        June
        2007, the non-interested members of the Company’s Board of Directors approved an
        offer for certain holders of outstanding options with an exercise price of
        $2.50
        per share or greater, including such options held by the Company’s named
        executive officers and directors, to exchange the outstanding options for
        a
        certain number of shares of restricted stock. In this offer, the Company
        intends
        to divide the outstanding options into classes based on the exercise price
        and
        the remaining expected life of the option and to use the Black-Scholes
        option-pricing model in its determination of the exchange ratios for the
        several
        classes of eligible options. The Company targets using exchange ratios such
        that
        the eligible options surrendered for cancellation would exceed the number
        of
        shares of restricted stock that would be received in exchange for such options.
        The exchange offer has not commenced and will not commence until certain
        actions
        are taken by the Company, including the filing of a tender offer statement
        and
        offer to exchange on Schedule TO with the SEC.
 
 The
        following table summarizes information about stock options outstanding at
        September 30, 2007:
 
 **Currently
                  Exercisable****Exercise**
                **Price**
              
              **Number of**
                **Shares**
                **Outstanding**
              
              **Average**
                **Remaining**
                **Contractual Life**
                **(Years)**
              
              **Weighted**
                **Average Exercise**
                **Price**
              
              **Number of**
                **Shares**
              
              **Weighted**
                **Average**
                **Exercise**
                **Price**From
                  $1.30 to $1.43
              
              
              575,000
              
              
              1.3
              
              $
              1.41
              
              
              575,000
              
              $
              1.41From
                  $2.50 to $3.50
              
              
              432,500
              
              
              7.0
              
              $
              3.34
              
              
              284,708
              
              $
              3.44$5.00
              
              
              211,600
              
              
              8
              
              $
              5.00
              
              
              196,600
              
              $
              5.00$7.00
              
              
              150,000
              
              
              8.3
              
              $
              7.00
              
              
              50,000
              
              $
              7.00From
                  $8.61 to $9.00
              
              
              570,000
              
              
              7.9
              
              $
              8.71
              
              
              200,700
              
              $
              8.68From
                  $9.60 to $9.82
              
              
              260,200
              
              
              0.7
              
              $
              9.82
              
              
              210,080
              
              $
              9.82
 
 ***Dividends***
 
 The
        Company has not paid any cash dividends through September 30, 2007.
 
 Page
            |
            13
  **8.
        MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK**
 
 The
        Company 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 for their respective time
        periods:
  Three
                  Months Ended
                September
                  30, 2007Revenues
              
              % of TotalRevenuesCustomer
                  A
              
              
              License
                  Fees
              
              $
              218,330
              
              
              15
              %Customer
                  B
              
              
              Subscriptions
              
              $
              425,778
              
              
              30
              %Customer
                  C
              
              
              Professional Service
                  Fees
              
              $
              327,937
              
              
              23
              %Others
              
              
              Various
              
              $
              457,150
              
              
              32
              %Total
              
              
              
              
              $
              1,429,19529
              
              
              100
              %
 
 Three
                  Months Ended
                September
                  30, 2006Revenues
              
              % of TotalRevenuesCustomer
                  C
              
              
              Professional Service
                  Fees
              
              $
              185,935
              
              
              25
              %Customer
                  B
              
              
              Subscription
              
              $
              352,553
              
              
              47
              %Others
              
              
              Various
              
              $
              210,718
              
              
              28
              %Total
              
              
              
              
              $
              749,206
              
              
              100
              %
  Nine
                  Months Ended
                September
                  30, 2007Revenues
              
              %
                  of Total RevenuesCustomer
                  C
              
              
              Professional Service
                  Fees
              
              $
              754,493
              
              
              21
              %Customer
                  B
              
              
              Subscription
              
              $
              1,562,319
              
              
              44
              %Others
              
              
              Various
              
              $
              1,258,699
              
              
              35
              %Total
              
              
              
              
              $
              3,575,511
              
              
              100
              %
  Nine
                  Months Ended
                September
                  30, 2006Revenues
              
              %
                  of Total RevenuesCustomer
                  B
              
              
              Professional
                  Services
              
              $
              848,217
              
              
              29
              %Customer
                  C
              
              
              Subscription
              
              $
              1,365,826
              
              
              46
              %Others
              
              
              Various
              
              $
              733,942
              
              
              25
              %Total
              
              
              
              
              $
              2,947,985
              
              
              100
              %
 
 As
        of
        September 30, 2007, the Company had three customers that accounted for 18%,
        19%
        and 34% of net receivables, respectively. As of September 30, 2006, the Company
        had three customers that accounted for 11%, 29% and 50% of net receivables,
        respectively.
 
 **9.
        COMMITMENTS AND CONTINGENCIES**
 
 Please
        refer to Part I, Item 3 of the Company’s Annual Report on Form 10-K for the
        fiscal year ended December 31, 2006 for a description of material legal
        proceedings, including the proceedings discussed below.
 
 Securities
        and Exchange Commission Litigation .
        As
        previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal
        year ended December 31, 2006, the SEC temporarily suspended the trading of
        the
        Company’s securities on January 17, 2006 and advised the Company that it
        was ****** conducting
        a non-public investigation. On September 11, 2007, the Company was informed
        that
        Dennis Michael Nouri, its then serving President, Chief Executive Officer,
        and a
        director, had been charged in a criminal complaint that alleges federal
        securities fraud and conspiracy to commit fraud. The Company is not named
        in the
        criminal complaint. The U.S. government filed the complaint under seal on
        August
        1, 2007 in the U.S. District Court for the Southern District of New York.
        Also
        named as defendants in the criminal complaint are Reeza Eric Nouri, a former
        manager of the Company, and Ruben Serrano, Anthony Martin, James Doolan,
        and
        Alain Lustig, brokers alleged to have participated with the Nouris in the
        alleged fraud. The criminal complaint alleges that the defendants, directly
        and
        indirectly, used manipulative and deceptive devices in violation of Sections
        2
        and 371 of Title 18 of the U.S. Code, Sections 10(b) and 32 of the Securities
        Exchange Act of 1934, as amended (“the Exchange Act”), and Rule 10b-5
        promulgated under the Exchange Act (“Rule 10b-5”). On November 8, 2007, as part
        of this on-going action, the U.S. government filed a grand jury indictment
        against Dennis Michael Nouri, Reeza Nouri, Reuben Serrano and Alain Lustig
        in
        the U.S. District Court for the Southern District of New York. The grand
        jury
        indictment charges these defendants with conspiracy to commit securities
        fraud
        in violation of Sections 78j(b) and 78 ff of Title 17 of the U.S. Code and
        Rule
        10b-5, wire fraud in violation of Sections 1343 and 1346 of Title 18 of the
        U.S.
        Code and commercial bribery in violation of Section 1952(a)(3) of Title 18
        of
        the U.S. Code and Sections 180.00 and 180.03 of the New York State Penal
        Law.
        Under the grand jury indictment, the U.S. government is seeking forfeiture
        from
        these defendants of all property, real and personal, that constitutes or
        is
        derived from proceeds traceable to the commission of the alleged securities
        fraud offenses.
 
 Page
            |
            14
  On
        September 11, 2007, the SEC filed a civil action against the Company and
        the
        defendants named in the criminal complaint in the U.S. District Court for
        the
        Southern District of New York. The SEC complaint alleged that the defendants
        in
        this civil action, either directly or indirectly, engaged in transactions,
        acts,
        practices, and courses of business which constitute violations of Section
        17(a)
        of the Securities Act of 1933, as amended (“the Securities Act”), Section 10(b)
        of the Exchange Act, and Rule 10b-5. The SEC complaint sought to permanently
        enjoin each of the civil defendants from committing future violations of
        the
        foregoing federal securities laws. The SEC complaint also requested that
        each of
        the defendants, excluding the Company, be required to disgorge his ill-gotten
        gains and pay civil penalties. The SEC complaint further sought an order
        permanently barring Michael Nouri from serving as an officer or director
        of a
        public company. The SEC complaint did not seek any fines or other monetary
        penalties against the Company. On September 28, 2007, the Company agreed,
        without admission of any liability, to the entry of a consent judgment against
        it which permanently enjoins it from further violations of the antifraud
        provisions of the federal securities laws, specifically Section 17(a) of
        the
        Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. No fines
        or
        other monetary sanctions were levied against the Company. The consent judgment
        settles the SEC complaint against the Company and was entered by the court
        on
        October 2, 2007. The litigation is continuing against the other
        defendants.
 
 Gooden
        v. Smart Online, Inc. On
        October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit
        in the
        United States District Court for the Middle District of North Carolina naming
        the Company, certain of its current and former officers and directors, Maxim
        Group, LLC, and Jesup & Lamont Securities Corp. as defendants. The lawsuit
        was filed on behalf of all persons other than the defendants who purchased
        the
        Company’s securities from May 2, 2005 through September 28, 2007 and were
        damaged. The complaint asserts violations of federal securities laws, including
        violations of Section 10(b) of the Exchange Act and Rule 10b-5. The
        complaint is based on the matters alleged in the SEC complaint described
        above
        and asserts that the defendants participated in a fraudulent scheme to
        manipulate trading in the Company’s stock, allegedly causing plaintiffs to
        purchase the stock at an inflated price. The complaint requests certification
        of
        the plaintiff as class representative and seeks, among other relief, unspecified
        compensatory damages, including interest, plus reasonable costs and expenses,
        including counsel fees and expert fees.
 
 Nouri
        v. Smart Online, Inc. On
        October 17, 2007, Henry Nouri, the Company’s former Executive Vice President,
        filed a civil action against the Company in the General Court of Justice,
        Superior Court Division, in Orange County, North Carolina. The complaint
        alleges
        that the Company had no “cause” to terminate Mr. Nouri’s employment and that it
        breached Mr. Nouri’s employment agreement by notifying him that his employment
        was terminated for cause, by failing to itemize the cause for the termination,
        and by failing to pay him benefits to which he would have been entitled had
        his
        employment been terminated without “cause.” The complaint seeks unspecified
        compensatory damages, including interest, a declaratory judgment that no
        cause
        existed for the termination of Mr. Nouri’s employment and that Mr. Nouri is
        entitled to the benefits provided under his employment agreement for a
        termination without “cause,” and costs and expenses.
 
 At
        this
        time, the Company is not able to determine the likely outcome of the legal
        matters described above, nor can it estimate its potential financial exposure.
        The Company’s management has made an initial estimate based upon its knowledge,
        experience and input from legal counsel, and the Company has accrued
        approximately $300,000 of additional legal reserves. Such reserves will be
        adjusted in future periods as more information becomes available.
 
 **10.
        SUBSEQUENT EVENTS**
  On
        November 14, 2007, in an initial closing, the Company sold $3.3 million
        aggregate principal amount of secured subordinated convertible notes due
        November 14, 2010. In addition, the noteholders have committed to purchase
        on a
        pro rata basis up to $5.2 million aggregate principal of secured subordinated
        notes upon approval and call by the Company’s Board of Directors in future
        closings. The Company is obligated to pay interest on the notes at an annualized
        rate of 8% payable in quarterly installments commencing on February 14, 2008.
        The Company does not have the ability to prepay the notes without approval
        of at
        least a majority of the principal amount of the notes then outstanding.
 
 On
        the
        earlier of the maturity date of November 14, 2010 or a merger, acquisition,
        sale
        of all or substantially all of the Company’s assets or capital stock or similar
        transaction, each noteholder in its sole discretion shall have the option
        to:
 
 ·
              convert
                  the principal then outstanding on its note into shares of the Company’s
                  common stock, or
 ·
              demand
                  immediate repayment in cash of the note, including any accrued
                  and unpaid
                  interest.
  Page
            |
            15
  If
        a
        noteholder elects to convert its note under these circumstances, the conversion
        price for notes:
  ·
              issued
                  in the initial closing on November 14, 2007 shall be a 20% premium
                  above
                  the average of the closing bid and asked prices of shares of the
                  Company’s
                  common stock quoted in the Over-The-Counter Market Summary averaged
                  over
                  five trading days prior to November 14, 2007;
                  and
 ·
              issued
                  in any additional closings shall be the lesser of a 20% premium
                  above the
                  average of the closing bid and asked prices of shares of the Company’s
                  common stock quoted in the Over-The-Counter Market Summary (or,
                  if the
                  Company’s shares are traded on the Nasdaq Stock******Market
                  or another exchange, the closing price of shares of the Company’s common
                  stock quoted on such exchange) averaged over five trading days
                  prior to
                  the respective additional closing
                  date.
 
 Payment
        of the notes will be automatically accelerated if the Company enters voluntary
        or involuntary bankruptcy or insolvency proceedings.
 
 The
        notes
        and the common stock into which they may be converted have not been registered
        under the Securities Act or the securities laws of any other jurisdiction.
        As a
        result, offers and sales of the notes were made pursuant to Regulation D
        of the
        Securities Act and only made to accredited investors that were the Company’s
        existing stockholders. The investors include, among others, (i) The Blueline
        Fund, who originally recommended Philippe Pouponnot, one of the Company’s
        directors, for appointment to the Company’s Board of Directors, (ii) Atlas
        Capital, S.A., who originally recommended Shlomo Elia, another one of the
        Company’s directors, for appointment to the Board of Directors, and (iii)
        William Furr, who is the father of Thomas Furr, one of the Company’s directors
        and executive officers.
 
 In
        addition, if the Company proposes to file a registration statement to register
        any of its
        common stock under
        the Securities Act in connection with the public offering of such securities
        solely for cash, subject to certain limitations, the Company shall give each
        noteholder who has converted its notes into common stock the opportunity
        to
        include such shares of converted common stock in the registration. The Company
        has agreed to bear the expenses for any of these registrations, exclusive
        of any
        stock transfer taxes, underwriting discounts and commissions.
 
 On
        November 6, 2007, Canaccord Adams Inc. agreed to waive any rights it held
        under
        its January 2007 engagement letter with the Company that it may have with
        respect to the convertible note offering, including the right to receive
        any
        fees in connection with the offering.
 
 **2. MANAGEMENT'S
        DISCUSSION AND ANALYSIS OF**
 **FINANCIAL
        CONDITION AND RESULTS OF OPERATIONS**
 
 *Information
        set forth in this Quarterly Report on Form 10-Q contains various forward-looking
        statements within the meaning of Section 27A of the Securities Act of 1933,
        or
        the Securities Act, and Section 21E of the Securities Exchange Act of 1934,
        or
        the Exchange Act. Forward-looking statements consist of, among other things,
        trend analyses, statements regarding future events, future financial
        performance, our plan to build our business and the related expenses, our
        anticipated growth, trends in our business, the effect of 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 “expect,” “anticipate,” “project,” “intend,” “plan,”
“estimate,” variations of such words, and similar expressions also are intended
        to identify such forward-looking statements. These forward-looking statements
        are subject to risks, uncertainties and assumptions that are difficult to
        predict. Therefore, actual results may differ materially and adversely from
        those expressed in any forward-looking statements. Readers are directed to
        risks
        and uncertainties identified 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**
 
 We
        develop and market Internet-delivered Software-as-a-Service, or SaaS, software
        applications and data resources for small businesses. We reach small businesses
        through (1) syndication arrangements with other companies that private label
        our
        software applications through their corporate web sites and (2) our own website
        at www.onebiz.com. Our syndication relationships provide a cost and time
        effective way to market our products and services to the small business sector.
        We also provide solutions to companies developing customized IT applications
        through the licensing of one of our platforms.
  Page
            |
            16
  We
        currently operate our company in two segments. Those segments are our core
        operations, or the Smart Online segment, and the operations of our wholly-owned
        subsidiary Smart Commerce, Inc., or the Smart Commerce segment. The Smart
        Online
        segment generates revenues from the development and distribution of
        Internet-delivered SaaS small business applications through a variety of
        subscription, licensing, integration and syndication channels. The Smart
        Commerce segment generally generates revenue from subscription fees,
        professional services fees, and licensing fees related to domain name
        subscriptions, e-commerce or networking consulting or networking maintenance
        agreements. We include costs such as corporate general and administrative
        expenses and share-based compensation expenses that are not allocated to
        specific segments in the Smart Online segment.
 
 **Sources
        of Revenue**
 
 We
        derive
        revenues from the following sources:
 
 ·
              Subscription
                  fees - monthly fees charged to end-users for access to our SaaS
                  applications.
  ·
              License
                  fees –
                  fees charged for licensing of platforms or applications. Licenses
                  may be
                  perpetual or for a specific term.
  ·
              Integration
                  fees - fees charged to partners to integrate their products into
                  our
                  syndication platform.
  ·
              Syndication
                  fees
  o
              fees
                  charged to syndication partners to create a customized private-label
                  site.
  o
              barter
                  revenue derived from syndication agreements with media
                  companies.
  ·
              Professional
                  services fees - fees related to consulting services which complement
                  our
                  other products and applications.
  ·
              Other
                  revenues - revenues generated from non-core activities such as
                  sales of
                  shrink-wrapped products, original equipment manufacturer, or OEM,
                  contracts and miscellaneous other
                  revenues.
  Our
        current primary focus is to target established companies that have both a
        substantial base of small business customers as well as a recognizable and
        trusted brand name. We are also seeking to establish partnerships with smaller
        companies with a specific vertical expertise catering to the small business
        customer base that we view as more ready to adopt new technologies. Our goal
        is
        to enter into partnerships with these companies whereby they private label
        our
        products and offer them to their base of small business customers. We believe
        the combination of the magnitude of their customer bases and their trusted
        brand
        names and recognition will help drive our subscription volume. In addition,
        we
        are targeting larger or developing enterprises that are developing a customized
        application delivery system or IT solution that might utilize our platforms
        as a
        solution. Such enterprises might wish to use our platform(s) as the framework
        into which they will integrate their own or other third-party applications,
        or
        they might wish to use all or some of our existing applications. Such solutions
        generally would generate licensing revenue and potentially subscription revenue
        for us if the customer desires that our applications be made a part of their
        solution.
 
 Subscription
        revenues consist of sales of subscriptions directly to end-users, or to others
        for distribution to end-users, hosting and maintenance fees, and e-commerce
        website design fees. Subscription sales are made either on a subscription
        or on
        a “for fee” basis. Subscriptions, which include access to most of our offerings,
        are payable in advance on a monthly basis and are typically paid via credit
        card
        of the individual end-user or the aggregating entity. We offer new subscribers
        a
        limited free use period and notify such free users that we will terminate
        access
        it they fail to become paid subscribers within a certain period of time.
        We
        expect lower net subscription fees from subscribers at the private label
        syndication websites of our partners than from our main portal since our
        syndication agreements require us to share revenue generated from syndication
        sites with each respective partner. In the first nine months of 2007, 98%
        of our
        subscription revenue was generated by our Smart Commerce segment, and the
        remaining 2% by our Smart Online segment. As of September 30, 2007, we had
        an
        aggregate of approximately 13,500 subscribers: approximately 13,100 through
        our
        Smart Commerce segment and 400 through our Smart Online segment.
 
 Licensing
        revenue consists of perpetual or term license agreements for the use of the
        Smart Online platform, the Smart Commerce platform or any of our applications.
        Perpetual license revenue is typically recorded in the period the license
        is
        sold and meets the requirements of American Institute of Certified Public
        Accountants Statement of Position 97-2, *Software
        Revenue Recognition* ,
        or SOP
        97-2; specifically, that there is evidence of an arrangement, the product
        has
        been delivered, the fee is fixed and determinable, and collection is reasonably
        assured. The revenue associated with term licenses is typically recorded
        over
        the period of the license. In the first nine months of 2007, 58% of our
        licensing revenue was generated by our Smart Online segment and 42% by our
        Smart
        Commerce segment.
 
 When
        appropriate, we charge our partners a fee for private-labeling our website
        in
        their own customized interface (i.e., in the “look and feel” of our partners'
        sites). This fee is based on the extent of the modifications required as
        well as
        the revenue sharing ratio that has been negotiated between us and our partner.
        If a fee is charged for the production of the website and the modifications, it
        is recorded as syndication revenue.
 
 In
        certain instances, we have integrated products offered by other companies
        into
        our products or websites. This integration approach is a means for the
        integration partner to generate additional traffic to its own website or
        revenue
        for its own product while expanding the range of our products and services.
        Such
        revenue is recorded as integration revenue. Our integration contracts also
        provide for us to receive a percentage of revenue generated by our partner.
        Such
        revenues have been immaterial during the nine months ended September 30,
        2007.
  Page
            |
            17
  Both
        syndication and integration fees are recognized on a monthly basis over the
        life
        of the contract, although a significant portion of integration fees is received
        upfront. Our contracts and support contracts are generally non-cancelable,
        though customers typically have the right to terminate their contracts for
        cause
        if we fail to perform. We generally invoice our paying syndication or
        integration partners in annual or monthly installments, and typical payment
        terms provide that they pay us within 30 days of invoice. Invoiced amounts
        are
        recorded as accounts receivable and in deferred revenue or revenue
        depending on whether the appropriate revenue recognition criteria have been
        met.
        In general, we collect our billings in advance of the service period. As
        we
        shift our focus to increasing subscription revenue, which we deem to have
        the
        greatest potential for future revenue growth, we have seen a decrease in
        syndication and integration revenue through the first nine months of 2007,
        and
        we expect this decrease to continue through the remainder of the fiscal year.
        In
        the first nine months of 2007, 100% of our syndication and integration revenue
        was generated by our Smart Online segment.
 
 Professional
        services fees are fees generated from consulting services. For example, a
        partner may request that we re-design its website to better accommodate our
        products or to improve its own website traffic. Such fees are typically billed
        on a time and material basis and are recognized as revenue when these services
        are performed and the customer is invoiced. In the nine months of 2007, 100%
        of
        our professional services revenue was generated by our Smart Commerce
        segment.
 
 Other
        revenues consist primarily of non-core revenue sources such as traditional
        shrink-wrap software sales and miscellaneous web services. It also includes
        OEM
        revenue generated through sales of our applications bundled with products
        offered by manufacturers such as Dell, Gateway and CompUSA. Revenues from
        OEM
        arrangements are reported and paid to us on a quarterly basis. In the first
        nine
        months of 2007, 33% of our other revenues were generated by our Smart Online
        segment and the remaining 67% were generated by our Smart Commerce
        segment.
 
 **Cost
        of Revenues**
 
 Cost
        of
        revenues is primarily composed of salaries associated with maintaining and
        supporting integration and syndication partners and the cost of external
        hosting
        facilities associated with maintaining and supporting integration and
        syndication partners. Historically, we have not capitalized any costs associated
        with the development of our products and platforms. Statement of Financial
        Accounting Standards, or SFAS, No. 86, *Accounting
        for the Costs of Computer Software to Be Sold, Leased, or Otherwise
        Marketed* ,
        or SFAS
        No. 86, requires capitalization of certain software development costs subsequent
        to the establishment of technological feasibility. Based on our 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.
 
 **Operating
        Expenses**
 
 In
        previous years, our efforts primarily focused on basic product development
        and
        integration. In the fourth quarter of 2006, we shifted our focus to increasing
        subscription revenue while concentrating our development efforts on enhancements
        and customization of our proprietary platforms and applications. In the early
        part of 2007, we also began to focus on licensing our platform products and
        applications. As of September 30, 2007, we had 56 employees. Most employees
        perform multiple functions.
 
 *Research
        and Development* .
        Historically, we have not capitalized any costs associated with the development
        of our products and platforms. SFAS No. 86 requires capitalization of certain
        software development costs subsequent to the establishment of technological
        feasibility. Because any such costs that would be capitalized following the
        establishment of technological feasibility would immediately be written off
        due
        to uncertain realizability, all such costs have been recorded as research
        and
        development costs and expensed as incurred. 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, but decrease as a percentage
        of
        total revenue, as we hire additional personnel in both segments to enhance
        and
        customize our platforms and applications.
 
 *Sales
        and Marketing* .
        Historically, we spent limited funds on marketing, advertising, and public
        relations. Our business model of partnering with established companies with
        extensive small business customer bases allows us to leverage the marketing
        dollars spent by our partners rather than requiring us to incur such costs.
        We
        do not conduct any significant direct marketing or advertising programs.
        Our
        sales and marketing costs have increased significantly in 2007 due to the
        addition of several sales personnel. As we begin to grow the number of
        subscribers to our products, we expect sales and marketing expense to increase
        due to the percentages of revenue we may be required to pay to partners as
        marketing fees.
  Page
            |
            18
  *General
        and Administrative* .
        General
        and administrative expenses consist of salaries and related expenses for
        executive, finance and accounting, legal, human resources, and information
        technology personnel, professional fees, and other corporate expenses, including
        facilities costs. We anticipate general and administrative expenses will
        increase as we add personnel and incur additional professional fees and
        insurance costs related to the growth of our business and to our operations
        as a
        public company. Non-recurring general and administrative expenses increased
        significantly in 2006 as a result of the suspension of trading of our securities
        by the Securities and Exchange Commission, or the SEC, the related SEC
        investigation, and the internal investigation of matters relating to that
        suspension. Our expenses related to these matters decreased to an immaterial
        amount in the fourth quarter of 2006 and first half of 2007. Due to legal
        matters in which we are involved, as more fully described in Part II, Item
        1,
“Legal Proceedings” of this report, legal fees increased significantly in the
        third quarter of 2007, and we expect those increased costs to continue through
        the first half of 2008. We also expect to incur additional material costs
        in
        2007 and 2008 as we take the necessary steps to comply with Section 404 of
        the
        Sarbanes-Oxley Act of 2002.
 
 *Stock-Based
        Expenses* .
        Our
        operating expenses include stock-based expenses related to stock awards,
        options
        and warrants issued to employees and non-employees. These charges have been
        significant and are reflected in our historical financial results. Effective
        January 1, 2006, we adopted SFAS No. 123 (revised 2004), *Share-Based Payment* ,
        or SFAS
        No. 123R, which resulted and will continue to result in material costs on
        a
        prospective basis as long as a significant number of options are outstanding.
        In
        addition, in June 2007, we limited the issuance of awards under our 2004
        Equity
        Compensation Plan, or the 2004 Plan, to awards of restricted or unrestricted
        stock and do not anticipate any further stock option awards to be granted
        under
        the 2004 Plan.
 
 **Critical
        Accounting Policies and Estimates**
 
 Our
        discussion and analysis of financial condition and results of operations
        is
        based upon our consolidated financial statements, which we prepared in
        accordance with accounting principles generally accepted in the United States.
        The preparation of these financial statements requires us to make estimates
        and
        judgments that affect the reported amounts of assets, liabilities, revenues
        and
        expenses, and related disclosures of contingent assets and liabilities.
“Critical accounting policies and estimates” are defined as those most important
        to the financial statement presentation and that require the most difficult,
        subjective, or complex judgments. We base our estimates on historical experience
        and on various other factors that we believe to be reasonable under the
        circumstances, the results of which form the basis for making judgments about
        the carrying value of assets and liabilities that are not readily apparent
        from
        other sources. Under different assumptions and/or conditions, actual results
        of
        operations may materially differ. We periodically 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. Management has
        consistently applied the same critical accounting policies and estimates
        which
        are fully described in our Annual Report on Form 10-K for the year ended
        December 31, 2006.
 
 Effective
        January 1, 2007, a major customer executed a letter of clarification which
        more
        clearly defined the roles and responsibilities of each party. Individual
        Business Owners, or IBOs, associated with this customer are provided e-commerce,
        domain name and email services. In exchange for marketing these services
        to its
        IBOs, the customer is paid a marketing fee. At the inception of the business
        relationship, it was agreed that the customer would collect the gross service
        fee from the IBOs, and the customer would retain its marketing fee and remit
        the
        net remaining cash to us. Because the roles and responsibilities of each
        party
        were vaguely defined in the past, revenue was recorded only on the net cash
        received. Following the execution of the letter of clarification and in
        accordance with Emerging Issues Task Force, or EITF, 99-19, *Reporting
        Revenue Gross as a Principal versus Net as an Agent* ,
        this
        revenue is now recorded as the gross amount paid by the IBO and a sales and
        marketing expense for the marketing services rendered by the customer.
        Ultimately, the effect on net income is nil; however, subscription revenue
        and
        sales and marketing expense are effectively and appropriately recognized
        on a
        gross basis. Because the new accounting method was triggered by a clarification
        to the existing agreement and not by a change from one accepted accounting
        method to another, the 2006 subscription revenue was not retroactively adjusted
        as would be required by SFAS No. 154, *Accounting Changes and Error Corrections - a replacement of APB Opinion No.
        20
        and FASB Statement No. 3* ,
        or SFAS
        No. 154. For the three months and nine months ended September 30, 2007, this
        accounting method resulted in approximately $203,000 and $691,000, respectively,
        of additional subscription revenue and a corresponding charge to sales and
        marketing expense.
 
 We
        derive
        revenue from the licensing of software platforms along with the sale of
        associated maintenance, consulting, and application development services.
        The
        arrangement may include delivery in multiple-element arrangements if the
        customer purchases a combination of products and/or services. We use the
        residual method pursuant to SOP 97-2. This method allows us to recognize
        revenue
        for a delivered element when such element has vendor specific objective
        evidence, or VSOE, of the fair value of the delivered element. If VSOE cannot
        be
        determined or maintained for an element, it could impact revenues as all
        or a
        portion of the revenue from the multiple-element arrangement may need to
        be
        deferred.
 
 If
        multiple-element arrangements involve significant development, modification
        or
        customization or if it is determined that certain elements are essential
        to the
        functionality of other elements within the arrangement, revenue is deferred
        until all elements necessary to the functionality are provided by us to a
        customer. The determination of whether the arrangement involves significant
        development, modification or customization could be complex and require the
        use
        of judgment by management.
 
 The
        amount of revenue to be recognized from development and consulting services
        is
        typically based on estimates involving total costs to complete, the stage
        of
        completion and the amount of work performed in a given period. The assumptions
        and estimates made to determine total costs and stage of completion may affect
        the timing of revenue recognition. Changes in estimates of progress to
        completion and costs to complete are accounted for as cumulative catch-up
        adjustments.
  Page
            |
            19
  Under
        SOP
        97-2, provided the arrangement does not require significant development,
        modification or customization, revenue is recognized when all of the following
        criteria have been met:
 
 1.
              persuasive
                  evidence of an arrangement exists
 2.
              delivery
                  has occurred
 3.
              the
                  fee is fixed or determinable
 4.
              collectability
                  is probable
 
 If
        at the
        inception of an arrangement, the fee is not fixed or determinable, revenue
        is
        deferred until the arrangement fee becomes due and payable. If collectability
        is
        deemed not probable, revenue is deferred until payment is received or collection
        becomes probable, whichever is earlier. The determination of whether fees
        are
        collectible requires judgment of management, and the amount and timing of
        revenue recognition could change if different assessments are made.
 
 We
        are
        currently facing legal actions from stockholders as well as a former employee,
        some of which relate to the charges filed against our former Chief Executive
        Officer described in Part II, Item 1, “Legal Proceedings” in this report. At
        this time, we are not able to determine the likely outcome of these legal
        matters, nor can we estimate our potential financial exposure. Management
        has
        made an initial estimate based upon its knowledge, experience and input from
        legal counsel, and we have accrued approximately $300,000 of additional legal
        reserves. Such reserves will be adjusted in future periods as more information
        becomes available.
 
 **Overview
        of Results of Operations for the Three Months Ended September 30, 2007 and
        September 30, 2006**
 
 **Three MonthsEndedSeptember30, 2007**
              
              **Three
                  MonthsEndedSeptember 30,2006**REVENUES:Integration
                  Fees
              
              $
              -
              
              $
              6,250Syndication
                  Fees
              
              
              15,000
              
              
              57,352Subscription
                  Fees
              
              
              830,660
              
              
              429,426Professional
                  Services Fees
              
              
              378,068
              
              
              242,177License
                  Fees
              
              
              200,000
              
              
              -Other
                  Revenues
              
              
              5,467
              
              
              14,001Total
                  Revenues
              
              
              1,429,195
              
              
              749,206COST
                  OF REVENUES
              
              
              168,035
              
              
              31,311GROSS
                  PROFIT
              
              
              1,261,160
              
              
              717,895OPERATING
                  EXPENSES:General
                  and Administrative
              
              
              1,398,170
              
              
              1,208,044Sales
                  and Marketing
              
              
              635,201
              
              
              135,027Research
                  and Development
              
              
              636,780
              
              
              455,997Total
                  Operating Expenses
              
              
              2,670,151
              
              
              1,799,068LOSS
                  FROM CONTINUING OPERATIONS
              
              
              (1,408,991
              )
              
              (1,081,173
              )OTHER
                  INCOME (EXPENSE):Interest
                  Expense, Net
              
              
              (139,124
              )
              
              (51,746
              )Takeback
                  of Investor Relations Shares
              
              
              -
              
              
              1,562,500Legal
                  Reserve and Debt Forgiveness, Net
              
              
              (39,477
              )
              
              -Other
                  Income
              
              
              24,866
              
              
              -Total
                  Other Income (Expense)
              
              
              (153,735
              )
              
              1,510,754NET
                  INCOME (LOSS) FROM CONTINUING OPERATIONS
              
              
              (1,562,726
              )
              
              429,581DISCONTINUED
                  OPERATIONSLoss
                  of Operations of Smart CRM, net of tax
              
              
              -
              
              
              (2,329,429
              )NET
                  LOSSNet
                  loss attributed to common stockholders
              
              $
              (1,562,726
              )
              $
              (1,899,848
              )NET
                  LOSS PER SHARE:Continuing
                  OperationsBasic
                  and Fully Diluted
              
              $
              (0.09
              )
              
              0.03Discontinued
                  OperationsBasic
                  and Fully Diluted
              
              $
              -
              
              
              (0.15
              )Net
                  Loss Attributed to Common StockholdersBasic
              
              $
              (0.09
              )
              
              (0.13
              )Fully
                  Diluted
              
              
              (0.09
              )
              
              (0.12
              )SHARES
                  USED IN COMPUTING NET LOSS PER SHAREBasic
              
              
              17,292,639
              
              
              15,127,510Fully
                  Diluted
              
              
              17,292,639
              
              
              15,387,110
 
 Page
            |
            20
 
 The
        following table shows our consolidated statements of operations data expressed
        as a percentage of revenue for the periods indicated:
  **Three
                  MonthsEndedSeptember 30,2007**
              
              **Three
                  MonthsEndedSeptember 30,**
                **2006**REVENUES:Integration
                  Fees
              
              
              0
              %
              
              1
              %Syndication
                  Fees
              
              
              1
              %
              
              8
              %Subscription
                  Fees
              
              
              58
              %
              
              57
              %Professional
                  Services Fees
              
              
              26
              %
              
              32
              %License
                  Fees
              
              
              14
              %
              
              0
              %Other
                  Revenues
              
              
              1
              %
              
              2
              %Total
                  revenues
              
              
              100
              %
              
              100
              %COST
                  OF REVENUES
              
              
              12
              %
              
              4
              %GROSS
                  PROFIT
              
              
              88
              %
              
              96
              %OPERATING
                  EXPENSES:General
                  and Administrative
              
              
              98
              %
              
              161
              %Sales
                  and Marketing
              
              
              44
              %
              
              18
              %Research
                  and Development
              
              
              45
              %
              
              61
              %Total
                  Operating Expenses
              
              
              187
              %
              
              240
              %LOSS
                  FROM OPERATIONS
              
              
              (99
              )%
              
              (144
              )%OTHER
                  INCOME (EXPENSE):Interest
                  Income (Expense), net
              
              
              (10
              )%
              
              (7
              )%Other
                  Income
              
              
              2
              %
              
              0
              %Takeback
                  of Investor Relations Shares
              
              
              0
              %
              
              209
              %Legal
                  Reserve and Debt Forgiveness, Net
              
              
              (3
              )%
              
              0
              %DISCONTINUED
                  OPERATIONSLoss
                  of Operations of Smart CRM, net of tax
              
              
              0
              %
              
              (311
              )%NET
                  INCOME(LOSS)
              
              
              (109
              )%
              
              (254
              )%
 
 Page
            |
            21
 
 **Overview
        of Results of Operations of the Three Months Ended September 30,
        2007**
 
 Total
        revenues were $1,429,000 for the third quarter of 2007 compared to $749,000
        for
        the third quarter of 2006, representing an increase of $680,000, or 91%.
        Gross
        profit increased $543,000, or 76%, to $1,261,000 from $718,000. Operating
        expenses increased $871,000, or 48%, to $2,670,000 from $1,799,000. Loss
        from
        continuing operations grew to $1,409,000 from $1,081,000, an increase of
        $328,000, or 30%, while net loss from continuing operations grew to $1,563,000
        from a gain of $430,000, an increase in loss of $1,993,000. Net loss attributed
        to common stockholders for the three months ended September 30, 2007 decreased
        $337,000, or 18%, to $1,563,000 from $1,900,000. The net loss for the third
        quarter of 2006 included other non-cash income of $1,562,500 related to the
        takeback of certain investor relations shares. Net loss attributed to common
        stockholders for the third quarter of 2007 decreased $337,000, or 18%, to
        $1,563,000 from $1,900,000.
 
 **Comparison
        of the Results of Operations for the Three Months Ended September 30, 2007
        and
        September 30, 2006**
 
 **Revenues**
 
 Total
        revenues were $1,429,000 for the third quarter of 2007 compared to $749,000
        for
        the third quarter of 2006 representing an increase of $680,000, or 91%. This
        increase is primarily attributable to increases in revenue from license fees
        of
        $200,000, subscription fees of $402,000 and professional services fees of
        $136,000, which were offset by decreases in integration revenue of $6,000,
        syndication fees of $42,000 and other revenues of $9,000.
 
 Revenues
        from license fees increased to $200,000 for the third quarter of 2007 from
        $0
        for the third quarter of 2006 and represented 14% of our consolidated revenue
        for the third quarter of 2007. This increase is attributable to a $400,000
        platform license sale in our Smart Commerce segment in the second quarter
        of
        2007. Such revenue was deferred based on collectability issues. In the third
        quarter of 2007, we received a payment of $200,000 related to that platform
        license and the cash received was recognized as revenue in the third quarter
        of
        2007 in accordance with SOP 97-2.
 
 Subscription
        revenues increased $402,000, or 94%, to $831,000 for the third quarter of
        2007
        from $429,000 for the third quarter of 2006. This increase was due to
        approximately $203,000 of additional revenue recorded in the third quarter
        of
        2007 due to our adoption of gross revenue reporting. As discussed above,
        certain
        subscription revenues that were recorded net for the third quarter of 2006
        were
        recorded as gross for the third quarter of 2007. Because the new accounting
        method was triggered by a clarification to an existing agreement and not
        by a
        change from one accepted accounting method to another, the 2006 subscription
        revenues were not retroactively adjusted as would be required by SFAS No.
        154.
        Therefore, subscription revenues for the third quarter of 2007 are not recorded
        in the same manner as subscription revenues for the third quarter of
        2006. ****** If
        revenue from this customer had been recognized on a net basis (making it
        comparable to the third quarter of 2006), subscription revenues for the third
        quarter of 2007 would have been approximately $628,000, as compared to
        approximately $429,000 in the same period of 2006, an increase of approximately
        $199,000, or 46%. The remaining increase was the result of two new customers
        in
        our Smart Commerce segment, one of which launched in June 2007 and the other
        in
        July 2007.
 
 Revenues
        from professional services fees, all of which are derived from our Smart
        Commerce segment, increased $136,000, or 56%, to $378,000 for the third quarter
        of 2007 from $242,000 for the third quarter of 2006. This increase was
        attributable to the addition of one new customer as well as additional services
        being provided to one existing customer.
 
 Integration
        revenues decreased $6,250, or 100%, to $0 for the third quarter of 2007 as
        compared to $6,250 for the same period in 2006. The third quarters of 2007
        and
        2006 also included $0 and $5,000, respectively, of revenue derived from barter
        transactions. Almost all integration contract revenue was recognized by the
        end
        of 2006 and we have entered into no new integration agreements. As we shift
        our
        focus to growing subscription and license revenue, we have not sought any
        new or
        additional integration partners.
 
 Syndication
        revenues decreased $42,000, or 74%, to $15,000 for the third quarter of 2007
        from $57,000 for the third quarter of 2006. This decrease primarily is due
        to a
        change in our strategy regarding syndication fees. In the past, we sought
        and
        received syndication fees as part of our contracts with partners to set up
        private label websites. Currently, as part of our efforts to increase the
        number
        of subscribers to our services through these partnerships, we are no longer
        seeking contracts which include such syndication fees and are focusing on
        increasing subscription revenues from end subscribers. The $15,000 of recognized
        syndication revenues in the third quarter of 2007 relates to a monthly hosting
        fee in the amount of $5,000 from one syndication partner.
 
 Other
        revenues decreased $9,000, or 64%, to $5,000 for the third quarter of 2007
        as
        compared to $14,000 for the same period in 2006. This revenue is generated
        from
        non-core activities such as sales of shrink-wrapped products, OEM contracts
        and
        miscellaneous other revenues.
 
 **Cost
        of Revenues**
 
 Cost
        of
        revenues increased $137,000, or 442%, to $168,000 in the third quarter of
        2007
        from $31,000 in the third quarter of 2006, primarily as a result of increased
        hosting costs at our Smart Commerce segment related to hosting for additional
        customers, which resulted in an increase in cost of revenues of approximately
        $70,000. There was approximately $65,000 of additional expense incurred in
        the
        third quarter of 2007 at the Smart Online segment as compared to the third
        quarter of 2006 related to the addition of several employees in our call
        center
        providing customer service which are categorized as cost of
        revenues.
  Page
            |
            22
  **Operating
        Expenses**
 
 Operating
        expenses increased $871,000, or 48%, to $2,670,000 for the third quarter
        of 2007
        from $1,799,000 during the third quarter of 2006. This increase is primarily
        due
        to an increase in general and administrative expenses of approximately $190,000,
        an increase in research and development expenses of approximately $181,000,
        and
        an increase in sales and marketing expense of approximately $500,000.
  *General
        and Administrative* -
        General and administrative expenses increased by $190,000, or 16%,
        to $1,398,000 for the third quarter of 2007 from $1,208,000 for the third
        quarter of 2006. This increase was primarily due to certain increases in
        expenses at the Smart Online segment. There was an increase in wages and
        associated taxes of approximately $73,000 related to the hiring of a new
        Chief
        Operating Officer as well as the appointment of an interim Chief Executive
        Officer. Compensation expense required by SFAS No. 123R increased by $21,000
        from the prior period as there have been several grants of restricted stock
        which had portions vest in the third quarter of 2007. Legal and professional
        fees increased by approximately $150,000 over the corresponding period in
        2006
        due to the legal fees incurred in connection with the legal proceedings brought
        during the third quarter of 2007 against us, our former executive officer
        and a
        former employee. Rent for the period increased approximately $16,000 over
        the
        preceding period as a result of a rent increase at the North Carolina corporate
        office and the addition of a sales office in Iowa, which was subsequently
        closed
        in September 2007. Board compensation increased by approximately $14,000
        due to
        the addition of independent directors between September 30, 2006 and 2007.
        Investor relations expense increased approximately $15,000 as we retained
        consultants to assist with our analysis of returning to a national market
        and
        address blue sky issues related to the registration statement we filed in
        April
        2007. These additions were offset by a reduction of approximately $116,000
        of
        registration rights penalties as we successfully filed a registration statement
        in 2007 terminating such penalties. In the third quarter of 2006, we paid
        a
        commission of $55,000 to a related party in connection with the sale of our
        Smart CRM segment. There was no corresponding charge in 2007. At the Smart
        Commerce segment, credit card transaction fees increased by approximately
        $23,000 in the third quarter of 2007 compared to the third quarter of 2006
        as we
        launched several new customer websites which generated revenue along with
        associated credit card processing fees.
 
 We
        are
        currently disputing our insurance carrier's refusal to cover certain legal
        expenses related to our securities litigation matters. We contend that these
        legal expenses should be reimbursed by our insurance carrier. Because the
        outcome of this dispute is unclear, we have expensed all legal costs incurred
        with respect to the SEC matters and our internal investigation, and we will
        account for any insurance reimbursement, should there be any, in the period
        such
        amounts are reimbursed.
 
 *Sales
        and Marketing* - Sales
        and marketing expense increased to $635,000 in the third quarter of 2007
        from
        $135,000 in the third quarter of 2006, an increase of $500,000, or
        370%. ****** As
        detailed in the Revenues section above, in the Smart Commerce segment, there
        was
        approximately $203,000 of additional revenue recorded in the third quarter
        of
        2007 due to our adoption of gross revenue reporting. A corresponding increase
        in
        sales and marketing expense of $203,000 was recorded in association with
        the new
        gross accounting method. In addition, the two new customers created revenue
        share expense in the amount of approximately $215,000 for the third quarter
        of
        2007, for which there was no corresponding expense in the third quarter of
        2006.
        At the Smart Online segment, there was an increase in sales and marketing
        wages
        of approximately $38,000 as we had expanded our sales force in both our North
        Carolina and Iowa offices earlier in 2007. The Iowa office was subsequently
        closed in September of 2007 as part of our internal restructuring. During
        the
        second quarter of 2007, a former employee became a sales consultant, which
        generated consulting expense of approximately $23,000 in the third quarter
        of
        2007 for which there was no corresponding expense in the third quarter of
        2006.
        That consulting contract was terminated in November of 2007.
 
 *Research
        and Development* -
        Research and development expense increased to $637,000 in the third quarter
        of
        2007 from $456,000 in the third quarter of 2006, an increase of approximately
        $181,000, or 40%. This increase is due primarily to increased wages, payroll
        taxes and commission expenses from the Smart Online segment of approximately
        $178,000 as we added research and development personnel. We expect research
        and
        development expenses to increase during the last quarter of 2007 as a result
        of
        anticipated hiring of additional research and development personnel for both
        the
        Smart Online and Smart Commerce segments to enhance and customize our platforms
        and applications and launch additional private label sites.
 
 **Other
        Income (Expense)**
 
 We
        incurred net interest expense of $139,000 during the third quarter of 2007
        compared to $52,000 during the third quarter of 2006, an increase of
        approximately $87,000, or 169%. Interest expense increased as a direct result
        of
        the notes payable to Fifth Third Bank related to the refinance of the debt
        to
        the sellers of iMart Incorporated, or iMart. The Fifth Third Bank note was
        originated in the fourth quarter of 2006, so there was no corresponding interest
        expense in the third quarter of 2006. The monthly interest on that note has
        been
        approximately $11,000 per month but decreases each month as our outstanding
        principal balance is reduced. Additionally, interest expense of approximately
        $33,000 was incurred during the third quarter of 2007 on our revolving line
        of
        credit with Wachovia Bank, NA, or Wachovia. We earned interest income of
        $35,000
        during the third quarter of 2007 on money market account deposits compared
        to
        $3,000 earned for the same period in 2006. The third quarter 2007 interest
        income increase was attributable to the interest earned on the cash proceeds
        of
        the February 2007 private placement described in Note 7, “Stockholders’ Equity,”
to the consolidated financial statements in this report.
  Page
            |
            23
  We
        realized a gain of $211,000 during the third quarter of 2007 from negotiated
        and
        contractual releases of outstanding liabilities compared to $0 gain from
        debt
        forgiveness in the third quarter of 2006. During the third quarter of 2007,
        we
        recorded reserves of approximately $300,000 for legal expenses and losses
        we
        might incur as a result of the litigation we are facing.
  **Overview
        of Results of Operation for the Nine Months Ended September 30, 2007 and
        2006**
 
 **Nine
                  MonthsEndedSeptember 30,2007**
              
              **Nine
                  Months**
                **EndedSeptember 30,2006**REVENUES:Integration
                  Fees
              
              $
              5,000
              
              $
              182,660Syndication
                  Fees
              
              
              45,000
              
              
              183,619Subscription
                  Fees
              
              
              2,040,243
              
              
              1,476,194Professional
                  Services Fees
              
              
              984,548
              
              
              601,200License
                  Fees
              
              
              480,000
              
              
              450,000Other
                  Revenues
              
              
              20,720
              
              
              54,312Total
                  Revenues
              
              
              3,575,511
              
              
              2,947,985COST
                  OF REVENUES
              
              
              355,942
              
              
              212,515GROSS
                  PROFIT
              
              
              3,219,569
              
              
              2,735,470OPERATING
                  EXPENSES:General
                  and Administrative
              
              
              3,567,385
              
              
              4,844,464Sales
                  and Marketing
              
              
              1,563,653
              
              
              666,940Research
                  and Development
              
              
              1,908,644
              
              
              1,279,198Total
                  Operating Expenses
              
              
              7,039,682
              
              
              6,790,602LOSS
                  FROM CONTINUING OPERATIONS
              
              
              (3,820,113
              )
              
              (4,055,132
              )OTHER
                  INCOME (EXPENSE):Interest
                  Expense, Net
              
              
              (400,910
              )
              
              (190,802
              )Gain
                  on Debt Forgiveness
              
              
              -
              
              
              144,351Takeback
                  of Investor Relations Shares
              
              
              -
              
              
              3,125,000Gain
                  (Loss) from Legal Settlements
              
              
              (34,877
              )
              
              -Writeoff
                  of Investment
              
              
              -
              
              
              (25,000
              )Other
                  Income
              
              
              168,672
              
              
              -Total
                  Other Income (Expense)
              
              
              (267,115
              )
              
              3,053,549NET
                  LOSS FROM CONTINUING OPERATIONS
              
              
              (4,087,228
              )
              
              (1,001,583
              )DISCONTINUED
                  OPERATIONSLoss
                  of Operations of Smart CRM, net of tax
              
              
              -
              
              
              (2,525,563
              )NET
                  LOSSNet
                  loss attributed to common stockholders
              
              $
              (4,087,228
              )
              $
              (3,527,146
              )NET
                  LOSS PER SHARE:Continuing
                  OperationsBasic
                  and Fully Diluted
              
              $
              (0.24
              )
              
              (0.07
              )Discontinued
                  OperationsBasic
                  and Fully Diluted
              
              $
              -
              
              
              (0.17
              )Net
                  Loss Attributed to Common StockholdersBasic
              
              $
              (0.24
              )
              
              (0.23
              )Fully
                  Diluted
              
              
              (0.24
              )
              
              (0.23
              )SHARES
                  USED IN COMPUTING NET LOSS PER SHAREBasic
                  and Fully Diluted
              
              
              17,002,827
              
              
              15,077,583
 
 Page
            |
            24
 
 The
        following table shows our consolidated statements of operations data expressed
        as a percentage of revenue for the periods indicated:
  **Nine
                  MonthsEndedSeptember 30,2007**
              
              **Nine
                  MonthsEndedSeptember 30,2006**REVENUES:Integration
                  fees
              
              
              0
              %
              
              6
              %Syndication
                  fees
              
              
              1
              %
              
              6
              %Subscription
                  fees
              
              
              57
              %
              
              50
              %Professional
                  services fees
              
              
              28
              %
              
              21
              %License
                  fees
              
              
              1
              %
              
              15
              %Other
                  revenues
              
              
              13
              %
              
              2
              %Total
                  revenues
              
              
              100
              %
              
              100
              %COST
                  OF REVENUES
              
              
              10
              %
              
              7
              %GROSS
                  PROFIT
              
              
              90
              %
              
              93
              %OPERATING
                  EXPENSES:General
                  and administrative
              
              
              100
              %
              
              164
              %Sales
                  and marketing
              
              
              44
              %
              
              23
              %Research
                  and development
              
              
              53
              %
              
              43
              %Total
                  operating expenses
              
              
              197
              %
              
              230
              %LOSS
                  FROM OPERATIONS
              
              
              (107
              )%
              
              (137
              )%OTHER
                  INCOME (EXPENSE):Interest
                  expense, net
              
              
              (11
              )%
              
              (7
              )%Other
                  income
              
              
              5
              %
              
              0
              %Writeoff
                  of investment
              
              
              0
              %
              
              (1
              )%Takeback
                  of investor relations shares
              
              
              0
              %
              
              106
              %Loss
                  on legal settlements
              
              
              (1
              )%
              
              0
              %Gain
                  on debt forgiveness
              
              
              0
              %
              
              5
              %Total
                  Other Income (Expense)
              
              
              (7
              )%
              
              103
              %DISCONTINUED
                  OPERATIONSLoss
                  of Operations of Smart CRM, net of tax
              
              
              0
              %
              
              (86
              )%NET
                  INCOME (LOSS)
              
              
              (114
              )%
              
              (120
              )%
 
 Page
            |
            25
  **Overview
        of Results of Operations for the Nine Months Ended September 30,
        2007**
 
 Total
        revenues were $3,576,000 for the nine months ended September 30, 2007 compared
        to $2,948,000 for the nine months ended September 30, 2006, representing
        an
        increase of $628,000, or 21%. Gross profit increased $485,000, or 18%, to
        $3,220,000 from $2,735,000. Operating expenses increased $249,000, or 4%,
        to
        $7,040,000 from $6,791,000. Loss from continuing operations decreased by
        $235,000, or 6%, to $3,820,000 from $4,055,000, while net loss from continuing
        operations grew by $3,085,000, or 303%, to $4,087,000 from $1,002,000. The
        net
        loss for the nine months ended September 30, 2006 included other non-cash
        income
        of $3,125,000 related to the takeback of certain investor relations shares.
        Net
        loss attributable to common stockholders for the nine months ended September
        30,
        2007 increased $560,000, or 16%, to $4,087,000 from $3,527,000.
 
 **Comparison
        of the Results of Operations for the Nine Months Ended September 30, 2007
        and
        September 30, 2006**
 
 **Revenues.**
 
 Total
        revenues were $3,576,000 for the nine months ended September 30, 2007 compared
        to $2,948,000 for the same period of 2006, representing an increase of $628,000,
        or 21%. This increase is primarily attributable to increases in subscription
        fees of $564,000, professional services fees of $384,000 and license fees
        of
        approximately $30,000, offset by decreases in integration and syndication
        fees
        of approximately $316,000 and other revenues of approximately
        $34,000.
 
 Revenues
        from license fees increased by $30,000, or 7%, to $480,000 for the nine months
        ended September 30, 2007 from $450,000 for the same period of 2006, representing
        13% of our consolidated revenue for the first three quarters of 2007. This
        increase is attributable to there being one $280,000 platform license sale
        from
        the Smart Online segment in the first nine months of 2007 and one $200,000
        sale
        in the Smart Commerce segment, as compared to one $450,000 license sale in
        the
        Smart Commerce segment for the same period in 2006. ******
 
 Subscription
        revenues increased approximately $564,000, or 16%, to $2,040,000 for the
        nine
        months ended September 30, 2007 from $1,476,000 for the nine months ended
        September 30, 2006. This increase was due to approximately $691,000 of
        additional revenue recorded in the nine months ended September 30, 2007 due
        to
        our adoption of gross revenue reporting. As discussed above, certain
        subscription revenues recorded on a net basis for the nine months ended
        September 30, 2006 were recorded on a gross basis for the nine months ended
        September 30, 2007. Because the new accounting method was triggered by a
        clarification to an existing agreement and not by a change from one accepted
        accounting method to another, the 2006 subscription revenues were not
        retroactively adjusted as would be required by SFAS No. 154 *.* Therefore, subscription revenues for the nine months ended September 30,
        2007
        are not recorded in the same manner as subscription revenues for the nine
        months
        ended September 30, 2006. If revenue from this customer had been recognized
        on a
        net basis (making it comparable to the nine months ended September 30, 2006),
        subscription revenues for the nine months ended September 30, 2007 would
        have
        been approximately $1,350,000 as compared to approximately $1,476,000 in
        the
        same period of 2006. This net decrease of approximately $126,000 primarily
        resulted from a decrease in the number of subscribers resulting from the
        2006
        restructuring of a major customer of the Smart Commerce segment, which lowered
        gross revenue by approximately $493,000. This decrease was partially offset
        by
        the addition of two new customers in the Smart Commerce segment that generated
        an additional $367,000 of gross revenue.
 
 Revenues
        from professional services fees, all of which are derived from our Smart
        Commerce segment, increased to $985,000 for the nine months ended September
        30,
        2007 from $601,000 for the nine months ended September 30, 2006. This increase
        of $384,000, or 64%, was attributable to the addition of one new customer
        as
        well as additional services being provided to one existing
        customer.
 
 Integration
        revenues decreased $178,000, or 97%, to $5,000 for the nine months ended
        September 30, 2007 as compared to $183,000 for the same period in 2006. The
        2007
        and 2006 periods also included $0 and $5,000 of revenue derived from barter
        transactions, respectively. Almost all integration contract revenue was
        recognized by the end of 2006 and we have entered into no new integration
        agreements. As we shift our focus to growing subscription revenue, we have
        not
        sought any new or additional integration partners.
 
 Syndication
        revenues decreased $139,000, or 76%, to $45,000 for the nine months ended
        September 30, 2007 as compared to $184,000 for the same period in 2006. This
        decrease primarily is due to a change in our strategy regarding syndication
        fees. In the past, we sought and received syndication fees as part of our
        contracts with partners to set up private label websites. Currently, as part
        of
        our efforts to increase the number of subscribers to our services through
        these
        partnerships, we are no longer seeking contracts which include such revenues
        and
        are focusing on increasing subscription revenues. The $45,000 of recognized
        syndication revenues in the nine months ended September 30, 2007 relates
        to a
        monthly hosting fee in the amount of $5,000 from one syndication
        partner.
 
 Other
        revenues totaled approximately $21,000 for the nine months ended September
        30,
        2007 as compared to $54,000 for the comparable period in 2006. Other revenues
        relate primarily to smaller OEM contracts and other miscellaneous revenues.
        These are non-core and non-recurring sources of revenue. The decrease is
        primarily related to decreased sales of remnant shrink wrap
        products.
 
 Page
            |
            26
  **Cost
        of Revenues**
 
 Cost
        of
        revenues increased $143,000, or 67%, to $356,000 in the nine months ended
        September 30, 2007, from $213,000 in the comparable period in 2006, primarily
        as
        a result of increased hosting costs at our Smart Commerce segment related
        to
        hosting for additional customers, which resulted in an increase in cost of
        revenues of approximately $75,000. There was approximately $66,000 of additional
        expense incurred in the nine months ended September 30, 2007 at the Smart
        Online
        segment as compared to the same period of 2006 related to the addition of
        several employees in our call center providing customer service which are
        categorized as cost of revenues.
 
 **Operating
        Expenses**
 
 Operating
        expenses increased $249,000, or 4%, to $7,040,000 for the nine months ended
        September 30, 2007 from $6,791,000 for the nine months ended September 30,
        2006.
        This increase is primarily due to an increase in sales and marketing expenses
        of
        approximately $897,000 and an increase in research and development expenses
        of
        approximately $630,000, offset by a decrease in general and administrative
        expenses of approximately $1,277,000.
  *General
        and Administrative* -
        General and administrative expenses decreased by $1,277,000, or 26%,
        to $3,567,000 for the nine months ended September 30, 2007 from $4,844,000
        in the same period of 2006. This decrease is primarily due to a reduction
        of
        $719,000 in legal fees as the nine months ended September 30, 2006 included
        legal expense related to the SEC’s suspension of trading of our securities and
        our own internal investigation. Those 2006 legal fees of approximately $900,000
        were partially offset by an increase in legal fees of approximately $200,000
        incurred in the third quarter of 2007 related to legal actions against us
        and a
        former executive officer and a former employee. Compensation expense required
        by
        SFAS No. 123R decreased $48,000 from the prior period. This decrease was
        primarily due to minimal option grants from the nine months ended September
        30,
        2006 through the end of the nine months ended September 30, 2007, and because
        the number of expirations exceeded the grants. This decrease was offset by
        an
        increase in such expense as a result of the lapse of a portion of the
        restrictions for several grants of restricted shares in 2007. Registration
        rights penalties decreased $323,000 as certain stockholders settled claims
        for
        registration penalties in the nine months ended September 30, 2007, and no
        additional penalties were accrued for those individuals. In addition, our
        filing
        of a resale registration statement enabled us to avoid similar registration
        rights penalties in 2007 as compared to those incurred during prior years.
        Accounting expense was reduced by approximately $151,000 in the first nine
        months of 2007 as compared to the same period in 2006 primarily through the
        hiring of a full-time Chief Financial Officer and the elimination of using
        outside firms to provide those services. In addition, the 2006 period contains
        additional audit fees incurred as we engaged new independent accountants
        following the resignation of our previous independent accountants.
 
 We
        are
        currently disputing our insurance carrier's refusal to cover certain legal
        expenses related to our securities litigation matters. We contend that these
        legal expenses should be reimbursed by our insurance carrier. Because the
        outcome of this dispute is unclear, we have expensed all legal costs incurred
        with respect to the SEC matters and our own internal investigation, and we
        will
        account for any insurance reimbursement, should there be any, in the period
        such
        amounts are reimbursed.
 
 *Sales
        and Marketing* - Sales
        and marketing expense was $1,564,000 for the nine months ended September
        30,
        2007, up from $667,000 in the nine months ended September 30, 2006, an increase
        of $897,000, or 134%. ****** As
        detailed in the Revenues section above, due to our adoption of gross revenue
        reporting for the nine months ended September 30, 2007, we recorded
        approximately $691,000 of additional revenue and an equivalent increase in
        sales
        and marketing expense. In addition, two new customers at the Smart Commerce
        segment resulted in revenue share expense of approximately $227,000, for
        which
        there was no corresponding charge for the nine months ended September 2006.
        The
        expansion of the Smart Online segment’s sales and marketing offices in North
        Carolina and Iowa resulted in additional wages for the nine months ended
        September 30, 2007 of approximately $89,000 as compared to the corresponding
        period of 2006. Our Iowa office was closed in September 2007 as part of our
        internal restructuring. These increases were offset by several decreases
        in
        sales and marketing expense in the Smart Online segment, including a $38,000
        reduction in barter advertising expense and a $75,000 decrease in revenue
        share
        expense, as we paid our partners a fee in the nine months ended September
        30,
        2006 for a syndication contract and had no similar expense in the nine months
        ended September 30, 2007.
 
 Generally,
        we expect we will need to increase sales and marketing expenses before we
        can
        substantially increase our revenue from sales of subscriptions. We increased
        investment in sales and marketing by increasing the number of direct sales
        personnel and increasing penetration within our existing customer base,
        expanding our domestic selling and marketing activities, attempting to build
        brand awareness and participating in additional marketing programs, and we
        are
        planning to continue to increase these investments.
 
 *Research
        and Development* -
        Research and development expense increased to $1,909,000 in the nine months
        ended September 30, 2007 from $1,279,000 in the nine months ended September
        30,
        2006, an increase of approximately $630,000, or 49%. This increase is due
        to
        several factors in the Smart Online segment, including increases of $227,000
        in
        consulting expense for our accounting application and an increase of $275,000
        for wages for additional staffing. In addition, at our Smart Commerce segment,
        our research and development wages increased by approximately $80,000 and
        our
        consulting expense increased by approximately $47,000 related to additional
        staff and support required to accommodate our new customers.
 
 Page
            |
            27
  **Other
        Income (Expense)**
 
 We
        incurred net interest expense of $401,000 during the nine months ended September
        30, 2007 compared to $191,000 during the nine months ended September 30,
        2006.
        Interest expense increased as a direct result of approximately $320,000 of
        interest expense related to the amortization of deferred financing costs
        of the
        warrants issued to Atlas Capital, S.A., or Atlas. Additionally, interest
        expense
        of approximately $92,000 was incurred on our revolving line of credit with
        Wachovia and $150,000 of interest expense was incurred related to the Smart
        Commerce loan with Fifth Third Bank during the nine months ended September
        30,
        2007. Interest income for our Smart Online segment totaling $115,000 was
        earned
        on money market account deposits compared to $5,000 earned for the same period
        in 2006. The first nine months of 2007 interest income increase was attributable
        to the interest earned on the cash proceeds of the February 2007 private
        placement described in Note 7, “Stockholders’ Equity,” to the consolidated
        financial statements in this report.
 
 We
        realized a gain of $215,000 ****** during
        the nine months ended September 30, 2007 from negotiated and contractual
        releases of outstanding liabilities as compared to $144,000 in the nine months
        ended September 30, 2006. During 2007, we recorded reserves of approximately
        $300,000 for legal expenses and losses we might incur as a result of litigation
        we are facing.
 
 One
        of
        the assets purchased as part of our acquisition of iMart was a $25,000
        investment in a privately held company that was a customer of iMart's.
        Management determined that it is likely that such investment is currently
        worthless, so the entire $25,000 investment along with approximately $65,000
        of
        the accounts receivable due from that customer was written off in the nine
        months ended September 30, 2006. We did not have similar expenses in the
        nine
        months ended September 30, 2007. This accounts for $90,000 decrease in other
        expenses.
 
 **Provision
        for Income Taxes**
 
 We
        have
        not recorded a provision for income tax expense because we have been generating
        net losses. Furthermore, we have not recorded an income tax benefit for the
        third quarter of 2007 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. We have approximately $35,000,000 in net operating
        loss carryforwards, which may be utilized to offset future taxable
        income.
 
 **Liquidity
        and Capital Resources**
 
 At
        September 30, 2007, our principal sources of liquidity were unrestricted
        cash
        and cash equivalents totaling $2,228,000 and accounts receivable of $964,000.
        As
        of November 12, 2007, our principal sources of liquidity were cash and cash
        equivalents totaling approximately $1,300,000 and accounts receivable of
        approximately $821,000. ****** However,
        $250,000 of our cash is restricted under the loan agreement with Fifth Third
        Bank as described below. As of September 30, 2007, we have drawn approximately
        $2.1 million of our $2.5 million line of credit with Wachovia, leaving
        approximately $400,000 available for our operations.
 
 At
        September 30, 2007, we had a working capital deficit of approximately $1.0
        million, however the proceeds raised through the secured
        subordinated convertible notes sold on November 14, 2007 results in
        approximately $1.7 million of working capital as of November 12, 2007. In
        addition, we may call up to approximately $5.2 million of additional funding
        from our convertible noteholders as well as an additional $0.4 million under
        our
        Line of Credit with Wachovia.
 
 **Cash
        Flow from Operations** .
        Cash
        flows used in operations for the nine months ended September 30, 2007 totaled
        $3,039,000, up from $2,049,000 for the nine months ended September 30, 2006.
        This increase is primarily due to increased accounts receivable as well as
        the
        loss of cash flow from discontinued operations.
 
 **Cash
        Flow from Financing Activity** .
        For the
        nine months ended September 30, 2007, we generated a total of $5,029,000
        net
        cash from our financing activities, up from $871,000 for the nine months
        ended
        September 30, 2006. This net cash was generated through both equity and debt
        financing, as described below.
 
 *Equity
        Financing* .
        In a
        transaction that closed on February 21, 2007, we sold an aggregate of 2,352,941
        shares of our common stock to two new investors, or the Investors. The private
        placement shares were sold at $2.55 per share pursuant to a Securities Purchase
        Agreement, or the SPA, between us and each of the Investors. The aggregate
        gross
        proceeds to us were $6 million, and we incurred issuance costs of approximately
        $637,000 as of September 30, 2007. These costs were higher than the $585,000
        originally anticipated due to state securities law filing requirements along
        with the associated legal fees. Under the SPA, the Investors were issued
        warrants for the purchase of an aggregate of 1,176,471 shares of common stock
        at
        an exercise price of $3.00 per share. These warrants contain a provision
        for
        cashless exercise and must be exercised, if at all, by February 21,
        2010.
  Page
            |
            28
  *Debt
        Financing.* On
        November 9, 2006, Smart Commerce entered into a loan agreement with Fifth
        Third
        Bank. Under the terms of this agreement, Smart Commerce borrowed $1.8 million
        to
        be repaid in 24 monthly installments of $75,000 plus interest beginning in
        December 2006. The interest rate is prime plus 1.5% as periodically determined
        by Fifth Third Bank. The loan is secured by all of the assets of Smart Commerce,
        including a cash security account of $250,000 and all of Smart Commerce's
        intellectual property. Such restricted cash is scheduled to be released from
        the
        restrictions in three equal installments of approximately $83,000, on June
        30,
        2007, December 31, 2007 and June 30, 2008, if certain debt covenants regarding
        operating metrics for Smart Commerce are met. Those operating metrics relate
        to
        Smart Commerce’s actual results of operations as compared to certain projections
        provided to Fifth Third Bank at the inception of the loan. Failure to meet
        these
        metrics could, after receipt of notice of an event of default from Fifth
        Third
        Bank and the expiration of a ten-day cure period, result in an acceleration
        of
        the debt. The
        metrics for the June 30, 2007 release were not met, and therefore, no cash
        has
        yet been released. ****** Fifth
        Third Bank has not notified us that any default exists. As of November 12,
        2007,
        our outstanding principal balance on this debt was approximately
        $900,000.
 
 On
        November 14, 2006, we entered into a revolving credit arrangement with Wachovia,
        or the Line of Credit, for $1.3 million which can be used for general working
        capital. Any advances made on the Line of Credit were to be paid off no later
        than August 1, 2007, with monthly payments of accrued interest on any
        outstanding balance commencing on December 1, 2006. Interest accrues on the
        unpaid principal balance at the LIBOR Market Index Rate plus 0.9%. On January
        24, 2007, we entered into an amendment to the Line of Credit. The amendment
        resulted in an increase in the line of credit from $1.3 million to $2.5 million.
        The pay-off date was also extended from August 1, 2007 to August 1, 2008.
        The
        Line of Credit is secured by our deposit account at Wachovia and an irrevocable
        standby letter of credit in the amount of $2,500,000 issued by HSBC Private
        Bank
        (Suisse) S.A. with Atlas as account party. We have separately agreed with
        Atlas
        that in the event of a default by us in the repayment of the Line of Credit
        that
        results in the letter of credit being drawn, we shall reimburse Atlas any
        sums
        that Atlas is required to pay. At our sole discretion, these payments may
        be
        made in cash or by issuing shares of our common stock at a set per share
        price
        of $2.50. As of November 12, 2007, we have drawn down approximately $2.1
        million
        on the Line of Credit.
 
 We
        have
        not yet achieved positive cash flows from operations, and our main sources
        of
        funds for our operations are the sale of securities in private placements,
        the
        sale of additional convertible notes and the Wachovia Line of Credit. We
        must
        continue to rely on these sources until we are able to generate sufficient
        revenue to fund our operations. We believe that anticipated cash flows from
        operations, funds available from our existing Line of Credit and additional
        issuances of notes (as described below), together with cash on hand, will
        provide sufficient funds to finance our operations at least for the next
        22 to
        28 months, depending on the annual operating budget approved by the Board
        of
        Directors. Changes in our operating plans, lower than anticipated sales,
        increased expenses, or other events may cause us to seek additional equity
        or
        debt financing in future periods. There can be no guarantee that financing
        will
        be available on acceptable terms or at all. Additional equity financing could
        be
        dilutive to the holders of our common stock, and additional debt financing,
        if
        available, could impose greater cash payment obligations and more covenants
        and
        operating restrictions.
 
 **Recent
        Developments**
 
 As
        more
        fully described elsewhere in this report, a stockholder class action lawsuit
        was
        filed against us and other defendants on October 18, 2007. This lawsuit may
        require the re-allocation of significant financial resources from working
        capital to the payment of legal fees and expenses related to the lawsuit.
        In
        addition, certain of the other named defendants may be entitled to
        indemnification and advancement of legal fees and expenses under our Bylaws.
        We
        have referred the complaint to our insurance carrier. Although our carrier
        has
        accepted our tender of coverage, it has reserved its right to seek reimbursement
        of the amounts it pays, and may not pay us all of the expenses we incur,
        either
        of which may have a material adverse effect on our results of operations
        and
        financial condition.
 
 As
        more
        fully described elsewhere in this report, on November 14, 2007 in an initial
        closing, we sold $3.3 million aggregate principal amount of secured subordinated
        convertible notes due November 14, 2010. In addition, the noteholders have
        committed to purchase on a pro rata basis up to $5.2 million aggregate principal
        of secured subordinated notes upon approval and call by our Board of Directors
        in future closings. We are obligated to pay interest on the notes at an
        annualized rate of 8% payable in quarterly installments commencing on February
        14, 2008. We do not have the ability to prepay the notes without approval
        of at
        least a majority of the principal amount of the notes then outstanding.
 
 **3.****QUANTITATIVE
        AND QUALITATIVE**
 **DISCLOSURES
        ABOUT MARKET RISK**
  ***Interest
        rate sensitivity***
 
 We
        had
        unrestricted cash and cash equivalents totaling $327,000, $1,435,000, and
        $173,000 at December 31, 2006, 2005, and 2004, respectively. At September
        30, 2007, our unrestricted cash was $2,228,000. These amounts were invested
        primarily in demand deposit accounts and money market funds. The 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.
 
 Two
        debt
        instruments have variable interest rates: one is prime + 1.5% and the other
        is
        LIBOR + .9% (See Note 6, “Notes Payable,” to the consolidated financial
        statements). As of September 30, 2007, the outstanding principal balance
        on
        these loans was $1,050,000 and $2,052,000, respectively. Due to the relatively
        short term of these debt instruments combined with the relative stability
        of
        interest rates, we do not expect interest rate or market volatility will
        have a
        material effect on our cash flows.
  Page
            |
            29
  **4.
        CONTROLS AND PROCEDURES**
 
 Not
        applicable.
 **4T. CONTROLS
        AND PROCEDURES**
 
 As
        required by paragraph (b) of Rule 13a-15 under the Exchange Act, an evaluation
        was carried out under the supervision and with the participation of our
        management, including our Chief Executive Officer and Chief Financial Officer,
        of the effectiveness of our disclosure controls and procedures (as defined
        in
        Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the
        period
        covered by this Quarterly Report. As defined in Rule 13a-15(e) and 15d-15(e)
        under the Exchange Act, the term disclosure controls and procedures means
        controls and other procedures of an issuer that are designed to ensure that
        information required to be disclosed by the issuer in the reports that it
        files
        or submits under the Exchange Act is recorded, processed, summarized and
        reported within the time periods specified in the SEC's rules and forms.
        Disclosure controls and procedures include, without limitation, controls
        and
        procedures designed to ensure that information required to be disclosed by
        an
        issuer in the reports that it files or submits under the Exchange Act is
        accumulated and communicated to the issuer's management, including its principal
        executive and principal financial officers, or persons performing similar
        functions, as appropriate to allow timely decisions regarding required
        disclosure.
  Based
        on
        their evaluation, our Chief Executive Officer and Chief Financial Officer
        concluded that, as of the end of the period covered by this Quarterly Report,
        our disclosure controls and procedures were not effective because we have
        not
        completed the testing of certain changes in our internal control over financial
        reporting that were implemented in July 2006. Management first reported on
        these
        changes to our internal controls under Item 9A of Part II of our Annual Report
        on Form 10-K for the fiscal year ended December 31, 2005, or the 2005 Annual
        Report, and most recently provided an update regarding the implementation
        of the
        internal controls in our Quarterly
        Report on Form 10-Q for the quarterly period ended June 30, 2007 .
        See
“Changes to Internal Control Over Financial Reporting” below for a more detailed
        description of the status of these internal control changes.
  **Changes
        to Internal Control Over Financial Reporting**
 
 There
        have been no changes in our internal control over financial reporting that
        occurred during the third quarter of fiscal 2007 that have materially affected,
        or are reasonably likely to materially affect, our internal control over
        financial reporting.
  As
        described in our 2005 Annual Report, and as updated in our Quarterly
        Report on Form 10-Q for the quarterly period ended June 30, 2007, we
        have
        continued to test certain internal controls added in response to the final
        findings of our Audit Committee’s investigation related to the SEC’s suspension
        of trading of our common stock in January 2006. The internal controls that
        are
        still being tested for effectiveness as of the end of the period covered
        by this
        Quarterly Report include the following:
  1.
              Our
                  outside counsel has provided periodic educational training for
                  management
                  and directors by outside legal counsel and other appropriate professional
                  advisors.
  2.
              We
                  have adopted a revised Securities Trading
                  Policy.
  3.
              We
                  have instituted a program requiring written confirmation of compliance
                  with our Code of Ethics and Conflicts of Interest Policy on a quarterly
                  basis from all members of management and the Board of
                  Directors.
  We
        cannot
        assure you that we will not in the future identify deficiencies in our controls.
        However, we plan to continue to review and make any necessary changes to
        the
        overall design of our control environment in order to enhance our corporate
        governance and reporting practices.
  **II. 
        OTHER INFORMATION**
 **1.  LEGAL
        PROCEEDINGS**
 
 Please
        refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
        year ended December 31, 2006 for a description of material legal proceedings,
        including the proceedings discussed below.
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            30
  Securities
        and Exchange Commission Litigation .
        As
        previously disclosed in our Annual Report on Form 10-K for the fiscal year
        ended
        December 31, 2006, the SEC temporarily suspended the trading of our securities
        on January 17, 2006 and advised us that it was ****** conducting
        a non-public investigation. On September 11, 2007, we were informed that
        Dennis
        Michael Nouri, our then serving President, Chief Executive Officer, and a
        director, had been charged in a criminal complaint that alleges federal
        securities fraud and conspiracy to commit fraud. We are not named in the
        criminal complaint. The U.S. government filed the complaint under seal on
        August
        1, 2007 in the U.S. District Court for the Southern District of New York.
        Also
        named as defendants in the criminal complaint are Reeza Eric Nouri, a former
        manager of our company, and Ruben Serrano, Anthony Martin, James Doolan,
        and
        Alain Lustig, brokers alleged to have participated with the Nouris in the
        alleged fraud. The criminal complaint alleges that the defendants, directly
        and
        indirectly, used manipulative and deceptive devices in violation of Sections
        2
        and 371 of Title 18 of the U.S. Code, Sections 10(b) and 32 of the Exchange
        Act,
        and Rule 10b-5 promulgated under the Exchange Act, or Rule 10b-5. On November
        8,
        2007, as part of this on-going action, the U.S. government filed a grand
        jury
        indictment against Dennis Michael Nouri, Reeza Nouri, Reuben Serrano and
        Alain
        Lustig in the U.S. District Court for the Southern District of New York.
        The
        grand jury indictment charges these defendants with conspiracy to commit
        securities fraud in violation of Sections 78j(b) and 78 ff of Title 17 of
        the
        U.S. Code and Rule 10b-5, wire fraud in violation of Sections 1343 and 1346
        of
        Title 18 of the U.S. Code and commercial bribery in violation of Section
        1952(a)(3) of Title 18 of the U.S. Code and Sections 180.00 and 180.03 of
        the
        New York State Penal Law. Under the grand jury indictment, the U.S. government
        is seeking forfeiture from these defendants of all property, real and personal,
        that constitutes or is derived from proceeds traceable to the commission
        of the
        alleged securities fraud offenses.
 
 On
        September 11, 2007, the SEC filed a civil action against us and the defendants
        named in the criminal complaint in the U.S. District Court for the Southern
        District of New York. The SEC complaint alleged that the defendants in this
        civil action, either directly or indirectly, have engaged in transactions,
        acts,
        practices, and courses of business which constitute violations of Section
        17(a)
        of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5.
        The
        SEC complaint sought to permanently enjoin each of the civil defendants from
        committing future violations of the foregoing federal securities laws. The
        SEC
        complaint also requested that each of the defendants, excluding us, be required
        to disgorge his ill-gotten gains and pay civil penalties. The SEC complaint
        further sought an order permanently barring Michael Nouri from serving as
        an
        officer or director of a public company. The SEC complaint did not seek any
        fines or other monetary penalties against us. On September 28, 2007, we agreed,
        without admission of any liability, to the entry of a consent judgment against
        us which permanently enjoins us from further violations of the antifraud
        provisions of the federal securities laws, specifically Section 17(a) of
        the
        Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. No fines
        or
        other monetary sanctions were levied against us. The consent judgment settles
        the SEC complaint against us and was entered by the court on October 2, 2007.
        The litigation is continuing against the other defendants.
 
 Gooden
        v. Smart Online, Inc. On
        October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit
        in the
        United States District Court for the Middle District of North Carolina naming
        us, certain of our current and former officers and directors, Maxim Group,
        LLC,
        and Jesup & Lamont Securities Corp. as defendants. The lawsuit was filed on
        behalf of all persons other than the defendants who purchased our securities
        from May 2, 2005 through September 28, 2007 and were damaged. The complaint
        asserts violations of federal securities laws, including violations of
        Section 10(b) of the Exchange Act and Rule 10b-5. The complaint is based on
        the matters alleged in the SEC complaint described above and asserts that
        the
        defendants participated in a fraudulent scheme to manipulate trading in our
        stock, allegedly causing plaintiffs to purchase the stock at an inflated
        price.
        The complaint requests certification of the plaintiff as class representative
        and seeks, among other relief, unspecified compensatory damages, including
        interest, plus reasonable costs and expenses, including counsel fees and
        expert
        fees.
 
 Nouri
        v. Smart Online, Inc. On
        October 17, 2007, Henry Nouri, our former Executive Vice President, filed
        a
        civil action against us in the General Court of Justice, Superior Court
        Division, in Orange County, North Carolina. The complaint alleges that we
        had no
“cause” to terminate Mr. Nouri’s employment and that we breached Mr. Nouri’s
        employment agreement by notifying him that his employment was terminated
        for
        cause, by failing to itemize the cause for the termination, and by failing
        to
        pay him benefits to which he would have been entitled had his employment
        been
        terminated without “cause.” The complaint seeks unspecified compensatory
        damages, including interest, a declaratory judgment that no cause existed
        for
        the termination of Mr. Nouri’s employment and that Mr. Nouri is entitled to the
        benefits provided under his employment agreement for a termination without
        “cause,” and costs and expenses.
 
 At
        this
        time, we are not able to determine the likely outcome of the legal matters
        described above, nor can we estimate our potential financial exposure. Our
        management has made an initial estimate based upon its knowledge, experience
        and
        input from legal counsel, and we have accrued approximately $300,000 of
        additional legal reserves. Such reserves will be adjusted in future periods
        as
        more information becomes available. If an unfavorable resolution of any of
        these
        matters occurs, our business, results of operations and financial condition
        could be materially adversely affected.
  **1A.
        RISK FACTORS**
 
 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, you should pay particular attention
        to
        the descriptions of risks and uncertainties described below and in other
        sections of this document and our other filings. These risks and uncertainties
        are not the only ones we face. Additional risks and uncertainties not presently
        known to us, which we currently deem immaterial, or that are similar to those
        faced by other companies in our industry or business in general may also
        affect
        our business. If any of the risks described below actually occurs, our business,
        financial condition, or results of operations could be materially and adversely
        affected.
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            31
  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
                  Stockholders
  ·
              Regulatory
                  and Litigation Risks
 
 ·
              Market
                  for Our Securities
 
 **Risks
        Associated with Our Financial Condition**
 
 **(1)**  **We
        have had recurring losses from operations since inception and continue to
        have
        negative cash flows. If we do not rectify these deficiencies through additional
        financing or growth, we may have to cease operations and liquidate our
        business.**
 
 Through
        September 30, 2007, we have lost an aggregate of approximately $61.4 million
        since inception on August 10, 1993. During the quarters ended September 30,
        2007
        and 2006, we incurred a net loss of approximately $1,600,000 and $1,900,000,
        respectively. At September 30, 2007, we had a working capital deficit of
        approximately $1.0 million. Due to the secured
        subordinated convertible note
        financing that closed on November 14, 2007, we now have approximately $1.7
        million of working capital not including additional amounts available to
        us from
        future capital calls on the convertible noteholders. Our working capital,
        including our line of credit, February 2007 financing transaction and
        convertible note financing, should fund our operations for the next 22-28
        months, depending on the annual operating budget approved by our Board of
        Directors. 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, the timing and success of potential
        strategic alliances or potential opportunities to acquire technologies or
        assets, the charges filed against a former officer and a former employee
        filed
        by the SEC and the United States Attorney General and the resulting drop
        in
        share price, the shareholder class action lawsuit, trading volume and liquidity,
        may require us to seek additional funding sooner than we expect. If we fail
        to
        raise sufficient financing, we will not be able to implement our business
        plan;
        we may have to liquidate our business.
 
 **(2)**  **Any
        issuance of shares of our common stock in the future could have a dilutive
        effect on your investment.**
 
 We
        may
        issue shares of our common stock in the future for a variety of reasons.
        For
        example, under the terms of the stock purchase warrant and agreement we entered
        into with Atlas in January 2007, it may elect to purchase up to 444,444 shares
        of our common stock at $2.70 per share upon termination of, or if we are
        in
        breach under the terms of, our line of credit with Wachovia. In connection
        with
        our private financing in February 2007, we issued warrants to the investors
        to
        purchase an additional 1,176,471 shares of our common stock at $3.00 per
        share
        and a warrant to our placement agent in that transaction to purchase 35,000
        shares of our common stock at $2.55 per share. Upon maturity of their
        convertible notes, our noteholders may elect to convert all, a part or none
        of
        their notes into shares of our common stock at variable conversion prices.
        In
        addition, we may raise funds in the future by issuing additional shares of
        common stock or other 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,
        which could substantially decrease the value of our securities owned by them.
        Depending on the share price we are able to obtain, we may have to sell a
        significant number of shares in order to raise the necessary amount of capital.
        You may experience dilution in the value of your shares as a
        result.
 
 **(3)**  **In
        the future, we may enter into certain debt financing transactions with third
        parties that could adversely affect our financial health.**
 
 We
        currently have a secured loan arrangement from Fifth Third Bank. Under the
        terms
        of this agreement, Smart Commerce borrowed $1.8 million to be repaid in 24
        monthly installments of $75,000 plus interest beginning in December 2006.
        The
        interest rate is prime plus 1.5% as periodically determined by Fifth Third
        Bank.
        The loan is secured by all of the assets of Smart Commerce and all of Smart
        Commerce's intellectual property. The loan is guaranteed by us and such guaranty
        is secured by all the common stock of Smart Commerce.
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            |
            32
  We
        also
        have a revolving line of credit from Wachovia. This line of credit is $2.5
        million, and as of November 12, 2007, we have drawn down approximately $2.1
        million. Any advances made on the line of credit must be repaid no later
        than
        August 1, 2008, with monthly payments of accrued interest only commencing
        on
        December 1, 2006 on any outstanding balance. The interest shall accrue on
        the
        unpaid principal balance at the LIBOR Market Index Rate plus 0.9%. The line
        of
        credit is secured by our deposit account at Wachovia and an irrevocable standby
        letter of credit in the amount of $2.5 million issued by HSBC Private Bank
        (Suisse) S.A. with Atlas as account party.
 
 On
        November 14, 2007, in an initial closing, we sold $3.3 million aggregate
        principal amount of secured subordinated convertible notes due November 14,
        2010. In addition, the noteholders have committed to purchase on a pro rata
        basis up to $5.2 million aggregate principal of secured subordinated notes
        upon
        approval and call by our Board of Directors in future closings. We are obligated
        to pay interest on the notes at an annualized rate of 8% payable in quarterly
        installments commencing on February 14, 2008.
 
 In
        the
        future, we may need to evaluate additional equity and debt financing options
        and
        may incur indebtedness that could adversely affect our financial health.
        For
        example, indebtedness could:
  ·
              increase
                  our vulnerability to general adverse economic and industry
                  conditions;
 
 ·
              require
                  us to dedicate a substantial portion of our cash flow from operations
                  to
                  payments on our debt, thereby reducing the availability of our
                  cash flow
                  to fund working capital, capital expenditures and other general
                  corporate
                  purposes;
 
 ·
              limit
                  our flexibility in planning for, or reacting to, changes in our
                  business
                  and the industry in which we
                  operate;
 
 ·
              result
                  in the loss of a significant amount of our assets or the assets
                  of our
                  subsidiary if we are unable to meet the obligations of these
                  arrangements;
 
 ·
              place
                  us at a competitive disadvantage compared to our competitors that
                  have
                  less indebtedness or better access to capital by, for example,
                  limiting
                  our ability to enter into new markets;
                  and
 
 ·
              limit
                  our ability to borrow additional funds in the
                  future.
  **(4)**  **Failure to comply with the provisions of our debt financing arrangements
        could
        have a material adverse effect on us.**
 
 Our
        loan
        from Fifth Third Bank is secured by all of the assets of Smart Commerce,
        including a security account of $250,000 and all of Smart Commerce's
        intellectual property. The loan is guaranteed by us, and such guaranty is
        secured by all the common stock of Smart Commerce. Our revolving line of
        credit
        from Wachovia is secured by our deposit account at Wachovia and an irrevocable
        standby line of credit issued by HSBC Private Bank (Suisse) S.A. with Atlas
        as
        account party. Our secured subordinated convertible notes are
        secured by a first-priority lien on all of our unencumbered assets, and a
        primary subordinated security interest in our encumbered assets, as permitted
        by
        our agreements with Wachovia and Fifth Third Bank.
 
 If
        an
        event of default occurs under any of these debt financing arrangements and
        remains uncured, then the lenders could foreclose on the assets securing
        the
        debt. If that were to occur, it would have a substantial adverse effect on
        our
        business. In addition, making the principal and interest payments on these
        debt
        arrangements may drain our financial resources or cause other material harm
        to
        our business if any of the lenders foreclose on the secured assets.
 
 **Risks
        Associated with Our Products and Operations**
 
 **(5)**  **Our
        business is dependent upon the development and market acceptance of our
        applications, including the acceptance of using some of our applications
        to
        conduct business. 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
        continually revise our business models and operating plans 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 SaaS business
        model and the results of our sales efforts to reach agreements with syndication
        partners with small business customer bases, but this business model may
        become
        ineffective due to forces beyond our control that we do not currently
        anticipate. In 2007, we have entered into agreements with ten new partners
        and
        customers. However, 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. There can be no assurance
        that
        our revised business model will allow us to capture significant future market
        potential. Investors in our securities should consider all the risks and
        uncertainties that are commonly encountered by companies in this stage of
        operations under our current business model, particularly companies, such
        as
        ours, that are in emerging and rapidly evolving markets.
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            |
            33
  Our
        future financial performance and revenue growth will depend, in part, upon
        the
        successful development, integration, introduction, and customer acceptance
        of
        our software applications. Thereafter, other new products, either developed
        or
        acquired, and enhanced versions of our existing applications will be critically
        important to our business. Our business could be harmed if we fail to deliver
        timely enhancements to our current and future solutions that our customers
        desire. We also must continually modify and enhance our services and products
        to
        keep pace with market demands regarding hardware and software platforms,
        database technology, information security, and electronic commerce technical
        standards. 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 our new services or products in the marketplace.
 
 Our
        business could be harmed if we fail to achieve the improved performance that
        customers want with respect to our current and future product offerings.
        There
        can be no assurance that our products will achieve widespread market penetration
        or that we will derive significant revenues from the sale or licensing of
        our
        platforms or applications.
  Certain
        of our services involve the storage and transmission of customers' personal
        and
        proprietary information (such as credit card, employee, purchasing, supplier,
        and other financial and accounting data). If customers determine that our
        services 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. 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.
 
 **(6)**  **We
        may consider strategic divestiture, acquisition or investment opportunities
        in
        the future. We face risks associated with any such
        opportunity.**
 
 From
        time
        to time we evaluate strategic opportunities available to us for product,
        technology or business acquisitions, investments and divestitures. In the
        future, we may divest ourselves of products or technologies that are not
        within
        our continually evolving business strategy or acquire other products or
        technologies. We may not realize the anticipated benefits of any such current
        or
        future opportunity to the extent that we anticipate, or at all. We may have
        to
        issue debt or equity securities to pay for future acquisitions or investments,
        the issuance of which could be dilutive to our existing stockholders. If
        any
        opportunity 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
        or divestitures would also require significant integration or separation
        efforts, diverting our attention from our business operations and strategy.
        We
        have limited acquisition experience, and therefore our ability as an
        organization to integrate any acquired companies into our business 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
 
 ·
              reduction
                  of available cash
 
 ·
              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
 
 ·
              delays
                  in customer purchases due to
                  uncertainty
  If
        we
        fail to properly evaluate and execute acquisitions, divestitures or investments,
        our business and prospects may be seriously harmed.
 
 **(7)**  **We
        rely on third-party software that may be difficult to repair should errors
        or
        failures occur. Such an error or failure, or the process undertaken by us
        to
        correct such an error or failure, could disrupt our services and harm our
        business.**
 
 We
        rely
        on software licensed from third parties in order to offer our services. We
        use
        key systems software from commercial vendors. The 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 currently do not have
        support contracts or upgrade subscriptions with some of our key vendors.
        We are
        not currently aware of any immediate issues, but any loss of the right to
        use
        any of this software could result in delays in providing 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 software could result in
        errors
        or a failure of our services, which could harm our business.
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            |
            34
  We
        also
        use key systems software from leading open source communities that are free
        and
        available in the public domain. Our products will use additional public domain
        software, if needed for successful implementation and deployment. We currently
        do not have support contracts for the open source software that we use. We
        rely
        on our own research and development personnel and the open source community
        to
        discover and fix any errors and bugs that may exist in the software we use.
        As a
        result, if there are errors in such software of which we are unaware or are
        unable to repair in a timely manner, there could be a disruption in our services
        if certain critical defects are discovered in the software at a future
        date.
 
 **Risks
        Associated with Our Markets, Customers and Partners**
 
 **(8)**  **The
        structure of our subscription model makes it difficult to predict the rate
        of
        customer subscription renewals or the impact non-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 services 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
        services or for fewer users. Many of our customers utilize our services without
        charge. These factors make it difficult to 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 services and their capability to continue their
        operations and spending levels. Most of our subscribers are in our Smart
        Commerce segment. Since the first quarter of 2006, the number of subscribers
        to
        our software products in our Smart Online segment has declined. We are not
        certain what caused this decline. Some customers indicated that they had
        difficulty accessing our software applications on our website. Consequently,
        we
        redesigned our website and product bundling to address this problem. As of
        November 2007, the decline in the number of subscribers has continued, but
        has
        been offset by an increase in the number of subscribers to our Smart Commerce
        segment. However, if our customers do not renew their subscriptions for our
        services or we are not able to increase the number of subscribers, our revenue
        may decline and our business will suffer.
 
 **(9)**  **We
        depend on corporate partners to market our products through their web sites
        under relatively short-term agreements in order to increase subscription
        fees
        and grow revenue. Failure of our partners' marketing efforts or termination
        of
        these agreements could harm our business.**
 
 Subscription
        fees represented approximately 58% of total revenues in the third quarter
        of
        2007 compared to 57% of total revenues in the third quarter of 2006. With
        the
        launch of our new applications and the acquisition of iMart, subscription
        fees
        represent a significant percentage of our total revenues and our future
        financial performance and revenue growth depends, in large part, upon the
        growth
        in customer demand for our outsourced services delivery models. We depend
        on our
        syndication partners and referral relationships to offer our products and
        services to a larger customer base than we can reach through direct sales
        or
        other marketing efforts. Although we entered into agreements with ten new
        partners and customers during 2007, and a marketing referral agreement, our
        success depends in part on the ultimate success of our syndication partners
        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. If
        we
        are unable to maintain our existing strategic relationships or enter into
        additional strategic relationships, we will have to devote substantially
        more
        resources to the distribution, sales, and marketing of our products and
        services.
 
 **(10)**  **Our
        future growth is substantially dependent on customer demand for our subscription
        services delivery models. Failure to increase this revenue could harm our
        business.**
 
 We
        have
        invested significantly in infrastructure, operations, and strategic
        relationships to support our SaaS delivery model, which represents 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 revenue for periods
        of
        time, even when we have already incurred costs relating to the implementation
        of
        our subscription services. Additionally, subscribers can cancel their
        subscriptions to our services at any time and, as a result, we may recognize
        substantially less revenue than we expect. If large numbers of customers
        cancel
        or otherwise seek to terminate subscription agreements more quickly 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,
        increase the length of time subscribers pay subscription fees and continue
        to
        increase the number of subscribers.
  Page
            |
            35
 
 **(11)**  **There
        are risks associated with international operations, which may become a bigger
        part of our business in the future.**
 
 We
        currently do not generate revenue from international operations. Although
        we
        signed an agreement with a company in January 2007 to market our products
        and
        services in a foreign country, this agreement has not yet generated any revenue
        for us. We are currently evaluating whether and how to expand into additional
        international markets. If we continue to develop our international operations,
        these operations will be subject to risks associated with selling abroad.
        These
        international operations are subject to a number of difficulties and special
        costs, including:
  ·
              costs
                  of customization and localization of 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
  ·
              political
                  and economic instability
  Our
        international operations may also face foreign currency-related risks. To
        date,
        all of our revenues have been denominated in United States Dollars, but an
        increasing portion of our revenues may be denominated in foreign currencies.
        We
        do not engage in foreign exchange hedging activities, and therefore our
        international revenues and expenses may be 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 particular countries. Since a large part of
        our
        value proposition to customers is tied to developing products 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 may also increase our exposure to international
        laws
        and regulations. If we cannot comply with domestic or 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.
 
 **Risks
        Associated with Our Officers, Directors, Employees and
        Stockholders**
 
 **(12)**  **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
        executive management team recently has undergone significant changes. On
        August
        15, 2007, we hired a new chief operating officer. On September 11, 2007,
        our
        President and Chief Executive Officer resigned from those positions and also
        resigned as a member of our Board of Directors. We terminated the employment
        of
        our Executive Vice President in September 2007, and we did not renew the
        employment contract of the c hief
        operating officer and vice president of our Smart Commerce segment, which
        expired on October 17, 2007. We
        were
        able to appoint a person serving on our Board of Directors as an independent
        director to serve as Interim President and Chief Executive Officer and are
        currently in the process of determining who will serve as a permanent
        replacement. Although we have resolved the SEC charges filed against us,
        we may
        not be able to attract highly qualified candidates to serve as our President
        and
        Chief Executive Officer. If we cannot attract and retain a qualified replacement
        and to integrate new members of our executive management team effectively
        into
        our business, then our business and financial results may suffer.
 
 Page
            |
            36




Our
      success depends significantly on the continued services of our remaining
      executive management personnel. Losing any of our remaining officers could
      seriously harm our business. Competition for executives is intense. If we had
      to
      replace any of our other officers, we would not be able to replace the
      significant amount of knowledge that they may have about our operations. All
      of
      our executive team work at the same location, which could make us vulnerable
      to
      loss of our entire management team in the event of a natural or other disaster.
      We do not maintain key man insurance policies on any of our
      employees.





**(13)**  **Officers,
      directors and principal stockholders control us. This might lead them to make
      decisions that do not benefit the interests of minority
      stockholders.**





Our
      officers, directors and principal stockholders beneficially own or control
      approximately 50% of our outstanding common stock. Certain of these principal
      stockholders hold warrants and convertible notes, which may be exercised or
      converted into additional shares of our common stock under certain conditions. The
      convertible noteholders have designated a bond representative to act as their
      agent. We have agreed that the bond representative shall be granted access
      to
      our facilities and personal during normal business hours, shall have the right
      to attend all meetings of our Board of Directors and its committees and to
      receive all materials provided to our Board of Directors or any committee of
      our
      Board. In addition, so long as the notes are outstanding, we have agreed that
      we
      will not take certain material corporate actions without approval of the bond
      representative.





As
      a
      result, these persons, acting together, would 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 our common stock.





**Regulatory
      and Litigation Risks**





**(14)**  **Compliance
      with regulations governing public company corporate governance and reporting
      is
      uncertain and expensive.**





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 corporate governance and
      disclosure requirements, including requirements under the Sarbanes-Oxley Act
      of
      2002, or Sarbanes-Oxley, as well as new rules implemented by the SEC 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 laws and regulations or
      significantly increase our costs. Our ability to fully comply with these laws
      and regulations is also uncertain. Our failure to prepare timely for and
      implement the reforms required by these laws and regulations could significantly
      harm our business, operating results, and financial condition. We also expect
      that these 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.





**(15)**  **Remediation
      of deficiencies in our internal control over financial reporting is uncertain
      and may be expensive.**





By
      the
      end of fiscal 2007, we are required to comply with Sarbanes-Oxley requirements
      involving management's assessment of our internal control over financial
      reporting, and our independent accountant's audit of our internal control over
      financial reporting is required for fiscal 2008. In March 2006, we retained
      a
      new Chief Financial Officer, whose review of our internal control over financial
      reporting to date and the final findings of our 2006 Audit Committee
      investigation have identified several deficiencies in our internal control
      over
      financial reporting. In July 2006, the Audit Committee concluded that: (i)
      our
      then Chief Executive Officer should have disclosed and sought approval from
      the
      Board of Directors before entering into certain transactions and arrangements,
      including personal loans; (ii) there was inadequate diligence by management
      and
      the Board of Directors regarding third parties with which we contracted,
      including outside investor relations vendors, some of which were registered
      brokers; (iii) management and our directors lacked sufficient knowledge
      regarding rules and regulations with respect to dealings between registered
      brokers and public companies, (iv) we lack clear policies regarding the limits
      on the Chief Executive Officer's authority to enter into business transactions
      and agreements without Board approval; (v) there has been inadequate legal
      and
      accounting review of material contracts; (vi) there has been inadequate training
      and understanding of SEC disclosure requirements; (vii) there was an
      unintentional violation of our Securities Trading Policy by one of our directors
      as previously reported in our public filings; (viii) we have inadequate
      processes for determination of independence of Board members; and (ix) there
      has
      been a failure to communicate and stress the importance of controls and
      procedures throughout our organization. The Audit Committee investigation
      concluded that these deficiencies primarily resulted from our transition from
      a
      private company to a publicly reporting company and insufficient preparation
      for, focus on, and experience with compliance requirements for a publicly
      reporting company. We reported the changes to our internal controls related
      to
      the Audit Committee's findings in our Annual Report on Form 10-K for the fiscal
      year ended December 31, 2005, filed with the SEC on July 11, 2006, as updated
      in
      our Annual Report on Form 10-K for the fiscal year ended December 31, 2006,
      filed with the SEC on March 30, 2007.





Page
          | 37




While
      we
      have made some progress on this remediation effort, we continue to work on
      addressing all the issues raised in these findings. We have identified some
      deficiencies and may identify others that we may not be able to remediate and
      test by the end of fiscal 2007.





If
      we
      cannot assess our internal controls over financial reporting as effective,
      it
      may affect our management's assessment of our internal control environment
      as it
      will be disclosed in our Annual Report on Form 10-K for fiscal 2007 and our
      stock price could decline.





**(16)**  **The
      SEC action against us, the SEC and criminal actions brought against certain
      former employees, and related stockholder and other lawsuits have damaged our
      business, and they could damage our business in the
      future.**





The
      lawsuit filed against us by the SEC, the SEC and criminal actions filed against
      a former officer and a former employee, the class action lawsuit filed against
      us and certain current and former officers, directors and employees and the
      lawsuit filed by a former executive officer against us has harmed our business
      in many ways, and may cause further harm in the future. Since the initiation
      of
      these actions, our ability to raise financing from new investors on favorable
      terms has suffered due to the lack of liquidity of our stock, the questions
      raised by these actions, and the resulting drop in the price of our common
      stock. As a result, we may have to rely solely on existing investors for such
      financing, and may not raise sufficient financing, if necessary, in the
      future. ******





Legal
      and
      other fees related to these actions have also reduced our cash flow. We
      completed a private placement financing for $6 million in February 2007 and
      a
      convertible note financing for an initial $3.3 million in November 2007;
      however, we make no assurance that we will not continue to experience additional
      harm as a result of these matters. The time spent by our management team and
      directors dealing with issues related to these actions detracts from the time
      they spend on our operations, including strategy development and implementation.
      These actions also have harmed our reputation in the business community and
      jeopardized our relationships with vendors and customers, especially given
      the
      media coverage of these events. An important part of our business plan is to
      enter into private label syndication agreements with large companies. These
      actions and related matters have caused us to be a less attractive partner
      for
      large companies and to lose important opportunities. These actions and related
      matters may cause other problems in our operations.





**(17)
      We face uncertainty regarding amounts that we may have to pay as indemnification
      to certain current and former officers, directors and employees under our Bylaws
      and Delaware law. We may not recover all of these amounts from our directors
      and
      officers liability insurance policy carrier. These expenses may substantially
      harm our business and operations.**





Our
      Bylaws and Delaware law generally require us to indemnify, and in certain
      circumstances advance legal expenses to, current and former officers, directors,
      employees and agents against claims arising out of such person’s status or
      activities as our officer, director, employee or agent, unless such person
      (i)
      did not act in good faith and in a manner the person reasonably believed to
      be
      in or not opposed to our best interests or (ii) had reasonable cause to believe
      his conduct was unlawful. As of November 12, 2007, there are SEC and criminal
      actions pending against a former executive officer and a former employee who
      have requested that we indemnify them and advance expenses incurred by them
      in
      the defense of those actions. Also, a stockholder class action lawsuit has
      been
      filed against us and certain of our current and former officers, directors
      and
      employees. The SEC, criminal, and stockholder actions are more fully described
      in Part II, Item 1, “Legal Proceedings” in this report.





Generally,
      we are required to advance defense expenses prior to any final adjudication
      of
      an individual’s culpability. The expense of indemnifying our current and former
      directors, officers and employees for their defense or related expenses in
      connection with the current actions may be significant. Our Bylaws require
      that
      any director, officer, employee or agent requesting advancement of expenses
      enter into an undertaking with us to repay any amounts advanced unless it is
      ultimately determined that such person is entitled to be indemnified for the
      expenses incurred. This provides us with an opportunity, depending upon the
      final outcome of the matters and the Board’s subsequent determination of such
      person’s right to indemnity, to seek to recover amounts advanced by us. However,
      we may not be able to recover any amounts advanced if the person to whom the
      advancement was made lacks the financial resources to repay the amounts that
      have been advanced. If we are unable to recover the amounts advanced, or can
      do
      so only at great expense, our operations may be substantially harmed as a result
      of loss of capital.





Although
      we have purchased insurance that may cover these obligations, we can offer
      no
      assurances that all of the amounts that may be expended by us will be recovered
      under our insurance policy. It is possible that we may have an obligation to
      indemnify our current and former officers, directors and employees under the
      terms of our Bylaws and Delaware law, but that there may be insufficient
      coverage for these payments under the terms of our insurance policy. The
      available coverage under our directors and officers liability insurance policy
      for the SEC, criminal and stockholder actions is limited to $3 million.
      Approximately $1 million of this coverage, including a $150,000 retention,
      already has been paid in connection with the SEC investigation that commenced
      in
      January 2006, leaving approximately $2 million in available coverage for the
      current actions. Therefore, we face the risk of making substantial payments
      related to the defense of these actions, which could significantly reduce
      amounts available to fund working capital, capital expenditures and other
      general corporate objectives.





Page
          | 38




In
      addition, our insurance policy provides that, under certain conditions, our
      insurer may have the right to seek recovery of any amounts it paid to the
      individual insureds or us. As of November 12, 2007, we do not know and can
      offer
      no assurances about whether these conditions will apply or whether the insurance
      carrier will change its position regarding coverage related to the current
      actions.  Therefore, we can offer no assurances that our insurer will not
      seek to recover any amounts paid under its policy from the individual insureds
      or us.  If such recovery is sought, then we may have to expend considerable
      financial resources in defending and potentially settling or otherwise resolving
      such a claim, which could substantially reduce the amount of capital available
      to fund our operations.





Finally,
      if our directors and officers liability insurance premiums increase as a result
      of the current actions, our financial results may be materially harmed in future
      periods. If we are unable to obtain coverage due to prohibitively expensive
      premiums, we would have more difficulty in retaining and attracting officers
      and
      directors and would be required to self-fund any potential future liabilities
      ordinarily mitigated by directors and officers liability insurance.





**Risks
      Associated with the Market for Our Securities**





**(18)**  **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 relies in part on the research and reports
      that industry or financial analysts publish about us or our business. Because
      our stock is currently quoted on the Over-the-Counter Bulletin Board rather
      than
      traded on a national exchange, analysts may not be interested in conducting
      research or publishing reports on us. If we do not succeed in attracting
      analysts to report about our company, most investors will not know about us
      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.





**(19)**  **Our
      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
      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 product releases




·
            changes
                in our pricing policies or those of our
                competitors





·
            the
                timing of execution of 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 product enhancements





·
            global
                economic and political conditions




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





·
            subscription
                renewal rates for our service




·
            the
                rate of expansion and effectiveness of our sales
                force




Page
          | 39




·
            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





·
            integration
                of acquisitions




·
            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, an existing or potential customer may
      reassess or reduce its 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.





**(20)**  **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





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




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





·
            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




·
            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, the stock market from time to time has experienced extreme price
      and
      volume fluctuations that have affected the trading prices of many emerging
      growth 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.
      Such
      an action was filed against us in October 2007 as more fully described elsewhere
      in this report. This securities class action litigation could result in
      substantial costs and a diversion of our management's attention and resources.
      We may determine, like many defendants in such lawsuits, that it is in our
      best
      interests to settle the 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 or any other 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.





**(21)**  **Shares
      eligible for public sale could adversely affect our stock
      price.**





Certain
      holders of shares of our common stock signed agreements that prohibit resales
      of
      our common stock. If substantial numbers of shares are resold as lock-up periods
      expire, the market price of our common stock is likely to decrease
      substantially.





Page
          | 40




At
      November 12, 2007, 18,009,564 shares of our common stock were issued and
      outstanding and 3,855,215 shares may be issued pursuant to the exercise of
      warrants and options. In addition, on November 14, 2007, we sold $3.3 million
      aggregate principal amount of secured subordinate convertible notes due November
      14, 2010, which principal amount may be converted into the number of shares
      of
      our common stock calculated by using a conversion price equal to a 20% premium
      above the average of the closing bid and asked prices of shares of our common
      stock quoted in the Over-the-Counter Market Summary averaged over five trading
      days prior to November 14, 2007. During May 2005, we registered on Form S-8
      5,000,000 shares of our common stock for issuance to our officers, directors
      and
      consultants under the 2004 Plan, of which at November 12, 2007, 156,000
      unrestricted shares were outstanding, 174,500 restricted shares were outstanding
      and 1,373,700 shares are subject to outstanding stock options of the 5,000,000
      shares reserved for issuance under the 2004 Plan. In June 2007, we limited
      the
      issuance of shares of our common stock reserved under the 2004 Plan to awards
      of
      shares of restricted and unrestricted common stock. Also in June 2007, our
      Board
      of Directors approved an offer for certain holders of outstanding options with
      an exercise price of $2.50 per share or greater to exchange the outstanding
      options for a certain number of shares of restricted stock. We target that
      the
      restriction on these shares of stock would lapse in four equal, quarterly
      increments over the year following the acceptance of the exchange offer. The
      exchange offer has not commenced and will not commence until certain actions
      are
      taken by us, including a filing of a tender offer statement and offer to
      exchange on Scheduled TO with the SEC. This Quarterly Report on Form 10-Q is
      not
      an offer or solicitation of an offer to sell or exchange any outstanding
      options.





We
      entered into agreements that limit the number of shares that may be sold during
      specific time periods, or Dribble Out Agreements, with all of the investors
      who
      purchased shares of our stock from us in private placements during 2005 and
      2006, a total of approximately 2,497,000 shares. Under these Dribble Out
      Agreements, sales of shares are limited to 25% during a rolling 30-day period.
      Such limitations terminate six months after the effective date of the
      registration statement registering these shares. Almost all of these shares
      are
      registered on our Registration Statement on Form S-1 (Registration No.
      333-141853), or the Registration Statement, which was declared effective by
      the
      SEC as of July 31, 2007.





Certain
      of our affiliates have also entered into other Lock-Up Agreements covering
      a
      portion of their shares. These agreements restrict the sale of 1,296,623 shares
      of our common stock. Under the terms of these Lock-Up Agreements, these
      affiliates cannot sell, pledge, grant or otherwise transfer the shares subject
      to the agreement for one year following July 31, 2007. After one year, 2.5%
      of
      these shares per quarter are released from these restrictions on a pro rata
      basis among these affiliates. All remaining shares will be released from the
      Lock-Up Agreements on July 31, 2009. These Lock-Up Agreements will otherwise
      terminate at the following times: (A) if the Registration Statement is
      terminated, the earlier of (i) the date of termination if no shares were sold,
      or (ii) the date any proceeds received from public investors are placed in
      the
      mail for return; (B) the date our common stock is listed on a national
      securities exchange, or (C) 30 days following the date the persons signing
      these
      Lock-Up Agreements are no longer affiliates.





Our
      stock
      is very thinly traded. The average daily trading volume for our common stock
      between January 2007 and November 2007 was approximately 16,200 shares per
      day.
      The number of shares that could be sold during this period was restrained by
      Dribble Out Agreements, Lock-Up Agreements, and other contractual limitations
      imposed on some of our shares, 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 lock-up and dribble-out
      periods expire. Many companies experience a decrease in the market price of
      their shares when such events occur.





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 or other
      securities. Our stock price may decline if the resale of shares under Rule
      144,
      in addition to the resale of registered shares, at any time in the future
      exceeds the market demand for our stock.





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 securities.





**(22)**  **Our
      securities may be subject to “penny stock” rules, which could adversely affect
      our stock price and make it more difficult for our stockholders to resell their
      stock.**





The
      SEC
      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 per share (other than securities registered on
      certain national securities exchanges or quotation systems, 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 SEC).





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 prescribed by the SEC, which:





·
            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 of such duties or other
                requirements




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          | 41




·
            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





·
            contains
                such other information and is in such form (including language, type,
                size, and format) as the SEC
                requires




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




·
            bid
                and ask 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





·
            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 related to transactions
      involving penny stocks, and a signed and dated copy of a written suitability
      statement. These disclosure requirements could 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.





**5.
      OTHER INFORMATION**





Effective
      October 16, 2007, we amended our Third Amended and Restated Bylaws. The
      amendment permits us to issue shares of our stock in book entry form in addition
      to preparing stock certificates.





Effective
      October 17, 2007, the employment contract between Smart Commerce and Gary Mahieu
      expired according to the terms of that agreement, and as of that date Mr. Mahieu
      no longer serves as an employee of ours or Smart Commerce. Mr. Mahieu had served
      as the Chief Operating Officer and Vice President at Smart
      Commerce.





On
      November 14, 2007, in an initial closing, we sold $3.3 million aggregate
      principal amount of secured subordinated convertible notes due November 14,
      2010. In addition, the noteholders have committed to purchase on a pro rata
      basis up to $5.2 million aggregate principal of secured subordinated notes
      upon
      approval and call by our Board of Directors in future closings. We are obligated
      to pay interest on the notes at an annualized rate of 8% payable in quarterly
      installments commencing on February 14, 2008. We do not have the ability to
      prepay the notes without approval of at least a majority of the principal amount
      of the notes then outstanding.





On
      the
      earlier of the maturity date of November 14, 2010 or a merger, acquisition,
      sale
      of all or substantially all of our assets or capital stock or similar
      transaction, each noteholder in its sole discretion shall have the option
      to:





·
            convert
                the principal then outstanding on its note into shares of our common
                stock, or


·
            demand
                immediate repayment in cash of the note, including any accrued and
                unpaid
                interest.





If
      a
      noteholder elects to convert its note under these circumstances, the conversion
      price for notes:




·
            issued
                in the initial closing on November 14, 2007 shall be a 20% premium
                above
                the average of the closing bid and asked prices of shares of our
                common
                stock quoted in the Over-The-Counter Market Summary averaged over
                five
                trading days prior to November 14, 2007;
                and


·
            issued
                in any additional closings shall be the lesser of a 20% premium above
                the
                average of the closing bid and asked prices of shares of our common
                stock
                quoted in the Over-The-Counter Market Summary (or, if our shares
                are
                traded on the Nasdaq Stock Market or another exchange, the closing
                price
                of shares of our common stock quoted on such exchange) averaged over
                five
                trading days prior to :






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          | 42




o
            November
                14, 2007; or


o
            the
                respective additional closing date.





Upon
      the
      following events of default and at any time during the continuance of such
      an
      event of default, the noteholders have the right, with the consent of the agent
      appointed for such noteholders, to accelerate payment on their
      notes:





·
            failure
                to pay any amounts when due;


·
            non-performance
                of any material covenant that remains uncured for 15
                days;


·
            any
                of our representations and warranties prove to have been false or
                misleading in any material respect when
                made;


·
            one
                or more judgments, decrees, or orders (excluding settlement orders)
                for
                the payment of money in the aggregate of $1,000,000 or more is entered
                against us or a subsidiary and is not discharged or stayed for a
                period of
                60 days; or


·
            default
                by us or a subsidiary under any agreement related to indebtedness
                resulting in the acceleration of more than $500,000 of
                indebtedness.





In
      addition, payment of the notes will be automatically accelerated if we enter
      voluntary or involuntary bankruptcy or insolvency proceedings.





The
      notes
      are secured by a first-priority lien on all our unencumbered assets, and a
      primary subordinated security interest in our encumbered assets, as permitted
      by
      our agreements with Wachovia and Fifth Third Bank.





The
      notes
      and the common stock into which they may be converted have not been registered
      under the Securities Act of 1933, as amended, or the Securities Act, or the
      securities laws of any other jurisdiction. As a result, offers and sales of
      the
      notes were made pursuant to Regulation D of the Securities Act and only made
      to
      accredited investors that were our existing stockholders. The investors include,
      among others, (i) The Blueline Fund, who originally recommended Philippe
      Pouponnot, one of the Company’s directors, for appointment to the Company’s
      Board of Directors, (ii) Atlas Capital, S.A., who originally recommended Shlomo
      Elia, another one of the Company’s directors, for appointment to the Board of
      Directors, and (iii) William Furr, who is the father of Thomas Furr, one of
      the
      Company’s directors and executive officers. Unless and until they are
      registered, the notes and the common stock into which they may be converted
      may
      not be offered or sold except pursuant to an exemption from, or in a transaction
      not subject to, the registration requirements of the Securities Act or
      applicable securities laws of other jurisdictions.





If
      notes
      are converted into our common stock and a demand for registration of the shares
      of common stock is made by a holder of a majority of the converted common stock,
      we have agreed, subject to certain limitations, to use our best efforts to
      file
      a registration statement with the SEC:





·
            within
                180 days of such demand if:


o
            we
                are eligible to use Form S-1,and


o
            the
                demand is made with respect to at least 40% of the converted common
                stock
                then outstanding (or a lesser percentage if the anticipated aggregate
                offering price, net of selling expenses, would exceed $5
                million);
                and


·
            within
                90 days of such demand if:


o
            we
                are eligible to use Form S-3, and


o
            the
                demand is made with respect to at least 30% of the converted common
                stock
                then outstanding (or a lesser percentage if the anticipated aggregate
                offering price, net of selling expenses, would exceed $2
                million).





In
      addition, if we propose to file a registration statement to register any of
      our
      common stock under the Securities Act in connection with the public offering
      of
      such securities solely for cash, subject to certain limitations, we shall give
      each noteholder who has converted its notes into common stock the opportunity
      to
      include such shares of converted common stock in the registration. We have
      agreed to bear the expenses for any of these registrations, exclusive of any
      stock transfer taxes, underwriting discounts and commissions.





The
      noteholders have designated a bond representative to act as their agent. We
      have
      agreed that the bond representative shall be granted access to our facilities
      and personal during normal business hours, shall have the right to attend all
      meetings of our Board of Directors and its committees and to receive all
      materials provided to our Board of Directors or any committee of our Board.
      We
      have agreed to pay all reasonable travel and lodging expenses of the bond
      representative related to his access to our facilities. In addition, so long
      as
      the notes are outstanding, we have agreed that we will not take any of the
      following actions without approval of the bond representative:




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          | 43




·
            make
                any loan or advance to, or own any stock or other securities of,
                any
                subsidiary or other corporation, partnership, or other entity unless
                it is
                wholly owned by us except that we may own securities of 1-800-Pharmacy,
                Inc. pursuant to an agreement we have with them without obtaining
                the bond
                representative’s consent;





·
            make
                any loan or advance to any person, except advances and similar
                expenditures in the ordinary course of business or under the terms
                of an
                employee stock or option plan approved by our Board of Directors;





·
            guarantee
                any indebtedness except for our trade accounts or those of a subsidiary
                arising in the ordinary course of business;





·
            make
                any investment other than investments in prime commercial paper,
                money
                market funds, certificates of deposit in any United States bank having
                a
                net worth in excess of $100,000,000 or obligations issued or guaranteed
                by
                the United States of America, in each case having a maturity not
                in excess
                of two years;





·
            incur
                any aggregate indebtedness in excess of $25,000, other than trade
                credit
                incurred in the ordinary course of business;





·
            increase
                or approve the compensation of our named executive officers, including
                benefits, bonuses and issuances of equity compensation;





·
            change
                our principal business, enter new lines of business, or exit the
                current
                line of business;





·
            sell,
                transfer, exclusively license, pledge or encumber technology or
                intellectual property;





·
            create
                or authorize the creation of or issue any other security convertible
                into
                or exercisable for any equity security, other than issuances to employees
                pursuant to equity compensation plans approved by our Board of Directors;





·
            purchase
                or redeem or pay any dividend on any capital stock, other than stock
                repurchased from former employees or consultants in connection with
                the
                cessation of their employment/services, at the lower of fair market
                value
                or cost; or





·
            increase
                the number of shares authorized for issuance to officers, directors,
                employees, consultants and advisors pursuant to equity incentive
                plans or
                arrangements.




On
      November 6, 2007, Canaccord Adams Inc. agreed to waive any rights it held under
      its January 2007 engagement letter with the Company that it may have with
      respect to the convertible note offering, including the right to receive any
      fees in connection with the offering.





Proceeds
      from the sale of notes in the initial closing will be used to meet ongoing
      working capital and capital spending requirements.





**6.  EXHIBITS**





The
      following exhibits have been or are being filed herewith and are numbered in
      accordance with Item 601 of Regulation S-K:




Exhibit
                No.
            
            Description3.1
            
            Fourth
                Amended and Restated Bylaws4.1
            
            Convertible
                Secured Subordinated Note Purchase Agreement, dated November 14,
                2007, by
                and among Smart Online, Inc. and certain investors4.2
            
            Form
                of Convertible Secured Subordinated Promissory Note10.1
            
            Form
                of Amendment to Registration Rights Agreement, dated July 3, 2007,
                by and
                between Smart Online, Inc. and each of Magnetar Capital Master Fund,
                Ltd.
                and Herald Investment Management Limited on behalf of Herald Investment
                Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
                No. 3 to our Registration Statement on Form S-1 (Registration No.
                333-141853), as filed with the SEC on July 31, 2007)10.2
            
            Form
                of Lock-In Agreement, dated July 30, 2007, by and between Smart Online,
                Inc. and certain of its affiliates (incorporated herein by reference
                to
                Exhibit 10.56 to Amendment No. 3 to our Registration Statement on
                Form S-1
                (Registration No. 333-141853), as filed with the SEC on July 31,
                2007)




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          | 44




10.3
            
            Form
                of Restricted Stock Award Agreement (for employees) under Smart Online,
                Inc.’s 2004 Equity Compensation Plan (incorporated herein by reference
                to
                Exhibit 10.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                August 21, 2007)10.4
            
            Employment
                Agreement, dated August 15, 2007, withJoseph
                Francis Trepanier III10.5
            
            Amendment,
                dated August 15, 2007, to Employment Agreement, dated April 1, 2004,
                with
                Thomas P. Furr10.6
            
            Registration
                Rights Agreement, dated November 14, 2007, by and among Smart Online,
                Inc.
                and certain investors10.7
            
            Security
                Agreement, dated November 14, 2007, among Smart Online, Inc. and
                Doron
                Roethler, as agent for certain investors10.8
            
            Promissory
                Note, Modification Number One to Loan Agreement, and Security Agreement,
                dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
                Bank, NA31.1
            
            Certification
                of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200231.2
            
            Certification
                of Principal Financial Officer Pursuant to Rule 13a-14(a) as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200232.1
            
            Certification
                of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350,
                as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
                This
                exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002 and shall not, except to the extent required by that
                Act, be
                deemed to be incorporated by reference into any document or filed
                herewith
                for the purposes of liability under the Securities Exchange Act of
                1934,
                as amended, or the Securities Act of 1933, as amended, as the case
                may
                be.32.2
            
            Certification
                of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350,
                as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
                This
                exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002 and shall not, except to the extent required by that
                Act, be
                deemed to be incorporated by reference into any document or filed
                herewith
                for the purposes of liability under the Securities Exchange Act of
                1934,
                as amended, or the Securities Act of 1933, as amended, as the case
                may
                be.





Page
          | 45


**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 14, 2007




**Smart
                Online, Inc.**/s/ David E. Colburn**David E. Colburn****Principal Executive Officer****Smart
                Online, Inc.**/s/ Nicholas Sinigaglia******Nicholas Sinigaglia****Principal Financial Officer and****Principal Accounting
                Officer**




Page
          | 46


**EXHIBIT
      INDEX**




Exhibit
                No.
            
            Description3.1
            
            Fourth
                Amended and Restated Bylaws4.1
            
            Convertible
                Secured Subordinated Note Purchase Agreement, dated November 14,
                2007, by
                and among Smart Online, Inc. and certain investors4.2
            
            Form
                of Convertible Secured Subordinated Promissory Note10.1
            
            Form
                of Amendment to Registration Rights Agreement, dated July 3, 2007,
                by and
                between Smart Online, Inc. and each of Magnetar Capital Master Fund,
                Ltd.
                and Herald Investment Management Limited on behalf of Herald Investment
                Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
                No. 3 to our Registration Statement on Form S-1 (Registration No.
                333-141853), as filed with the SEC on July 31, 2007)10.2
            
            Form
                of Lock-In Agreement, dated July 30, 2007, by and between Smart Online,
                Inc. and certain of its affiliates (incorporated herein by reference
                to
                Exhibit 10.56 to Amendment No. 3 to our Registration Statement on
                Form S-1
                (Registration No. 333-141853), as filed with the SEC on July 31,
                2007)10.3
            
            Form
                of Restricted Stock Award Agreement (for employees) under Smart Online,
                Inc.’s 2004 Equity Compensation Plan (incorporated herein by reference
                to
                Exhibit 10.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                August 21, 2007)10.4
            
            Employment
                Agreement, dated August 15, 2007, withJoseph
                Francis Trepanier III10.5
            
            Amendment,
                dated August 15, 2007, to Employment Agreement, dated April 1, 2004,
                with
                Thomas P. Furr10.6
            
            Registration
                Rights Agreement, dated November 14, 2007, by and among Smart Online,
                Inc.
                and certain investors10.7
            
            Security
                Agreement, dated November 14, 2007, among Smart Online, Inc. and
                Doron
                Roethler, as agent for certain investors10.8
            
            Promissory
                Note, Modification Number One to Loan Agreement, and Security Agreement,
                dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
                Bank, NA31.1
            
            Certification
                of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200231.2
            
            Certification
                of Principal Financial Officer Pursuant to Rule 13a-14(a) as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200232.1
            
            Certification
                of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350,
                as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
                This
                exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002 and shall not, except to the extent required by that
                Act, be
                deemed to be incorporated by reference into any document or filed
                herewith
                for the purposes of liability under the Securities Exchange Act of
                1934,
                as amended, or the Securities Act of 1933, as amended, as the case
                may
                be.32.2
            
            Certification
                of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350,
                as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
                This
                exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002 and shall not, except to the extent required by that
                Act, be
                deemed to be incorporated by reference into any document or filed
                herewith
                for the purposes of liability under the Securities Exchange Act of
                1934,
                as amended, or the Securities Act of 1933, as amended, as the case
                may
                be.




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