UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
  
 
 FORM
10-Q
  (Mark
One)
 x    Quarterly
report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
 
 For
the quarterly period ended June 30, 2009
 
 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. Employerincorporation or organization)
                    Identification No.)
 
 4505 Emperor Blvd., Ste. 320
                        Durham, North Carolina
                      27703(Address of principal executive offices)
                      (Zip Code)
  (919) 765-5000
 (Registrant’s
telephone number, including area code)
  
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days: Yes x  No o
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).  Yes xNo  ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
 
 Large
      accelerated filer
                 ̈
                
                Accelerated
      filer  ̈Non-accelerated
      filer
                 ̈
                (Do
      not check if a smaller reporting company)
                Smaller
      reporting company x
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes o No x
 
 As of
August 10, 2009, there were approximately 18,332,542 shares of the registrant’s
common stock, par value $0.001 per share, outstanding.
  
 
 SMART
ONLINE, INC.
 
 FORM
10-Q
 For the
Quarterly Period Ended June 30, 2009
 
 TABLE
OF CONTENTS
 
 Page No.PART
      I – FINANCIAL INFORMATIONItem
      1.
                      Financial
      StatementsBalance
      Sheets as of June 30, 2009 (unaudited) and December 31,
    2008
                      
                      
                      3Statements of Operations
      (unaudited) for the three and six months ended June 30,2009 and
    2008
                      
                      
                      4Statements of Cash Flows
      (unaudited) for the three and six months ended June30,2009 and
    2008
                      
                      
                      5Notes
      to Financial Statements (unaudited)
                      
                      
                      8Item
      2.
                      Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                      
                      
                      21Item
      3.
                      Quantitative
      and Qualitative Disclosures About Market Risk
                      
                      
                      40Item
      4.
                      Controls
      and Procedures
                      
                      
                      40Item
      4T.
                      Controls
      and Procedures
                      
                      
                      40PART
      II – OTHER INFORMATIONItem
      1.
                      Legal
      Proceedings
                      
                      
                      41Item
      1A.
                      Risk
      Factors
                      
                      
                      41Item
      2.
                      Unregistered
      Sales of Equity Securities and Use of Proceeds
                      
                      
                      47Item
      6.
                      Exhibits
                      
                      
                      47Signatures
                      
                      
                      49
  2
  PART
I – FINANCIAL INFORMATION
 
 Item
1.              Financial
Statements
 
 SMART
ONLINE, INC.
 BALANCE
SHEETS
 
 June 30,
                      
                      
                      December 31,2009
                      
                      
                      2008(unaudited)ASSETSCurrent
      Assets:Cash
      and Cash Equivalents
                      
                      $
                      32,712
                      
                      
                      $
                      18,602Accounts
      Receivable, Net
                      
                      
                      27,842
                      
                      
                      
                      184,930Note
      Receivable
                      
                      
                      -
                      
                      
                      
                      60,000Prepaid
      Expenses
                      
                      
                      230,377
                      
                      
                      
                      289,372Total
      current assets
                      
                      
                      290,931
                      
                      
                      
                      552,904Property
      and equipment, net
                      
                      
                      287,703
                      
                      
                      
                      365,993Capitalized
      software, net
                      
                      
                      474,044
                      
                      
                      
                      261,221Note
      Receivable, non-current
                      
                      
                      -
                      
                      
                      
                      372,317Prepaid
      expenses, non-current
                      
                      
                      184,500
                      
                      
                      
                      258,301Intangible
      assets, net
                      
                      
                      701,252
                      
                      
                      
                      1,410,245Other
      assets
                      
                      
                      2,086
                      
                      
                      
                      1,736TOTAL
      ASSETS
                      
                      $
                      1,940,518
                      
                      
                      $
                      3,222,717LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesAccounts
      payable
                      
                      $
                      868,582
                      
                      
                      $
                      398,237Notes
      payable (See Note 3)
                      
                      
                      1,922,291
                      
                      
                      
                      2,341,177Deferred
      revenue (See Note 2)
                      
                      
                      252,816
                      
                      
                      
                      323,976Accrued
      liabilities (See Note 2)
                      
                      
                      495,683
                      
                      
                      
                      478,917Total
      current liabilities
                      
                      
                      3,539,372
                      
                      
                      
                      3,542,307Long-term
      liabilities:Long-term
      portion of notes payable (See Note 3)
                      
                      
                      7,312,609
                      
                      
                      
                      5,327,211Deferred
      revenue (See Note 2)
                      
                      
                      49,992
                      
                      
                      
                      67,353Total
      long-term liabilities
                      
                      
                      7,362,601
                      
                      
                      
                      5,394,564Total
      liabilities
                      
                      
                      10,901,973
                      
                      
                      
                      8,936,871Commitments
      and contingencies (See Note 7)Stockholders'
      equity (deficit):Preferred stock, 0.001 par value,
      5,000,000 shares authorozed,no shares issued and outstanding at June
      30, 2009 and December 31, 2008Common Stock, $.001 par value,
      45,000,000 shares authorized, 18,332,543 and 18,333,601 shares
      Issued and Outstanding atJune 30, 2009 and December 31,
      2008 respectively.
                      
                      
                      18,333
                      
                      
                      
                      18,334Additional
      paid-in capital
                      
                      
                      67,026,977
                      
                      
                      
                      66,945,588Accumulated
      deficit
                      
                      
                      (76,006,765
                      )
                      
                      
                      (72,678,076
                      )Total
      Stockholders’ Equity (Deficit)
                      
                      
                      (8,961,455
                      )
                      
                      
                      (5,714,154
                      )TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                      
                      $
                      1,940,518
                      
                      
                      $
                      3,222,717
 
 The
accompanying notes are an integral part of these financial
statements.
  
 
 SMART ONLINE, INC.
 STATEMENTS
OF OPERATIONS (unaudited)
 
 Three Months Ended
                    
                    
                    Six Months EndedJune30,2009
                    
                    
                    June30,2008
                    
                    
                    June30,2009
                    
                    
                    June30,2008REVENUES:Subscription
      fees
                    
                    $
                    668,344
                    
                    
                    $
                    747,068
                    
                    
                    $
                    1,141,923
                    
                    
                    $
                    1,489,907Professional
      service fees
                    
                    
                    79,726
                    
                    
                    
                    932,444
                    
                    
                    
                    198,499
                    
                    
                    
                    1,436,527License
      fees
                    
                    
                    11,250
                    
                    
                    
                    3,750
                    
                    
                    
                    22,500
                    
                    
                    
                    103,750Hosting
      fees
                    
                    
                    33,045
                    
                    
                    
                    36,196
                    
                    
                    
                    105,255
                    
                    
                    
                    95,678Other
      revenue
                    
                    
                    36,806
                    
                    
                    
                    36,173
                    
                    
                    
                    74,477
                    
                    
                    
                    76,932Total
      revenues
                    
                    
                    829,171
                    
                    
                    
                    1,755,631
                    
                    
                    
                    1,542,654
                    
                    
                    
                    3,202,794COST
      OF REVENUES
                    
                    
                    202,333
                    
                    
                    
                    647,528
                    
                    
                    
                    694,934
                    
                    
                    
                    1,359,195GROSS
      PROFIT
                    
                    
                    626,838
                    
                    
                    
                    1,108,103
                    
                    
                    
                    847,720
                    
                    
                    
                    1,843,599OPERATING
      EXPENSES:General
      and administrative
                    
                    
                    862,050
                    
                    
                    
                    1,002,080
                    
                    
                    
                    1,757,640
                    
                    
                    
                    2,245,353Sales
      and marketing
                    
                    
                    675,304
                    
                    
                    
                    772,263
                    
                    
                    
                    1,206,640
                    
                    
                    
                    1,467,488Research
      and development
                    
                    
                    226,950
                    
                    
                    
                    458,409
                    
                    
                    
                    503,826
                    
                    
                    
                    910,533Gain
      (loss) on impairment of assets, net
                    
                    
                    438,228
                    
                    
                    
                    -
                    
                    
                    
                    427,961
                    
                    
                    
                    -Total
      operating expenses
                    
                    
                    2,202,532
                    
                    
                    
                    2,232,752
                    
                    
                    
                    3,896,067
                    
                    
                    
                    4,623,374LOSS
      FROM OPERATIONS
                    
                    
                    (1,575,694
                    )
                    
                    
                    (1,124,649
                    )
                    
                    
                    (3,048,347
                    )
                    
                    
                    (2,779,775
                    )OTHER
      INCOME (EXPENSE):Interest
      expense, net
                    
                    
                    (158,343
                    )
                    
                    
                    (190,922
                    )
                    
                    
                    (286,342
                    )
                    
                    
                    (369,236
                    )Gain
      on legal settlements, net
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    6,000
                    
                    
                    
                    -Other
      Income
                    
                    
                    -
                    
                    
                    
                    13,512
                    
                    
                    
                    -
                    
                    
                    
                    16,069Total
      other expense
                    
                    
                    (158,343
                    )
                    
                    
                    (177,410
                    )
                    
                    
                    (280,342
                    )
                    
                    
                    (353,167
                    )NET
      LOSS
                    
                    $
                    (1,734,037
                    )
                    
                    $
                    (1,302,059
                    )
                    
                    $
                    (3,328,689
                    )
                    
                    $
                    (3,132,942
                    )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                    
                    $
                    (0.09
                    )
                    
                    $
                    (0.08
                    )
                    
                    $
                    (0.18
                    )
                    
                    $
                    (0.19
                    )WEIGHTED-AVERAGE
      NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
    SHAREBasic
      and fully diluted
                    
                    
                    18,332,765
                    
                    
                    
                    17,252,639
                    
                    
                    
                    18,333,140
                    
                    
                    
                    16,728,010
 
 The
accompanying  notes are an integral part of these financial
statements.
  
 
 SMART ONLINE, INC.
 STATEMENTS
OF CASH FLOWS
 (unaudited)
 
 Three
      Months
                                                                              
                                                                              
                                                                              Three
      Months
                                                                              
                                                                              
                                                                              Six
      Months
                                                                              
                                                                              
                                                                              Six
      MonthsEnded
                                                                              
                                                                              
                                                                              Ended
                                                                              
                                                                              
                                                                              Ended
                                                                              
                                                                              
                                                                              EndedJune
      30, 2009
                                                                              
                                                                              
                                                                              June
      30, 2008
                                                                              
                                                                              
                                                                              June
      30, 2009
                                                                              
                                                                              
                                                                              June
      30, 2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      Loss
                                                                              
                                                                              $
                                                                              (1,734,037
                                                                              )
                                                                              
                                                                              $
                                                                              (1,302,059
                                                                              )
                                                                              
                                                                              $
                                                                              (3,328,689
                                                                              )
                                                                              
                                                                              $
                                                                              (3,132,942
                                                                              )Adjustments
      to reconcile let loss to net cash used in operating
      activities:Depreciation
      and amortization
                                                                              
                                                                              
                                                                              164,237
                                                                              
                                                                              
                                                                              
                                                                              207,893
                                                                              
                                                                              
                                                                              
                                                                              328,525
                                                                              
                                                                              
                                                                              
                                                                              415,523Amortization
      of deferred financing costs
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              112,971
                                                                              
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              225,942Bad
      debt expense
                                                                              
                                                                              
                                                                              197,929
                                                                              
                                                                              
                                                                              
                                                                              9,532
                                                                              
                                                                              
                                                                              
                                                                              421,922
                                                                              
                                                                              
                                                                              
                                                                              45,000Stock-based
      compensation expense
                                                                              
                                                                              
                                                                              29,339
                                                                              
                                                                              
                                                                              
                                                                              89,645
                                                                              
                                                                              
                                                                              
                                                                              82,483
                                                                              
                                                                              
                                                                              
                                                                              260,144Loss
      on impairment of intangible assets
                                                                              
                                                                              
                                                                              438,228
                                                                              
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              438,228
                                                                              
                                                                              
                                                                              
                                                                              -Gain
      on disposal of assets
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              (10,267
                                                                              )
                                                                              
                                                                              
                                                                              (2,665
                                                                              )Changes
      in assets and liabilities:Accounts
      receivable
                                                                              
                                                                              
                                                                              129,548
                                                                              
                                                                              
                                                                              
                                                                              (474,056
                                                                              )
                                                                              
                                                                              
                                                                              173,983
                                                                              
                                                                              
                                                                              
                                                                              (452,207
                                                                              )Notes
      receivable
                                                                              
                                                                              
                                                                              (1,417,331
                                                                              )
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              (1,420,581
                                                                              )
                                                                              
                                                                              
                                                                              -Costs
      in excess of billings
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              (60,437
                                                                              )
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              (60,437
                                                                              )Prepaid
      expenses
                                                                              
                                                                              
                                                                              53,240
                                                                              
                                                                              
                                                                              
                                                                              2,645
                                                                              
                                                                              
                                                                              
                                                                              132,796
                                                                              
                                                                              
                                                                              
                                                                              (38,113
                                                                              )Other
      assets
                                                                              
                                                                              
                                                                              900
                                                                              
                                                                              
                                                                              
                                                                              10,560
                                                                              
                                                                              
                                                                              
                                                                              (351
                                                                              )
                                                                              
                                                                              
                                                                              25,560Deferred
      revenue
                                                                              
                                                                              
                                                                              (40,571
                                                                              )
                                                                              
                                                                              
                                                                              85,014
                                                                              
                                                                              
                                                                              
                                                                              (88,522
                                                                              )
                                                                              
                                                                              
                                                                              (4,262
                                                                              )Accounts
      payable
                                                                              
                                                                              
                                                                              1,874,010
                                                                              
                                                                              
                                                                              
                                                                              (65,938
                                                                              )
                                                                              
                                                                              
                                                                              1,884,427
                                                                              
                                                                              
                                                                              
                                                                              (150,363
                                                                              )Accrued
      and other expenses
                                                                              
                                                                              
                                                                              (180,976
                                                                              )
                                                                              
                                                                              
                                                                              (112,874
                                                                              )
                                                                              
                                                                              
                                                                              15,672
                                                                              
                                                                              
                                                                              
                                                                              28,517Net
      cash used in operating activities
                                                                              
                                                                              
                                                                              (485,484
                                                                              )
                                                                              
                                                                              
                                                                              (1,497,104
                                                                              )
                                                                              
                                                                              
                                                                              (1,370,374
                                                                              )
                                                                              
                                                                              
                                                                              (2,840,303
                                                                              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of furniture and equipment
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              (52,363
                                                                              )
                                                                              
                                                                              
                                                                              (14,565
                                                                              )
                                                                              
                                                                              
                                                                              (61,800
                                                                              )Capitalized
      software
                                                                              
                                                                              
                                                                              (98,745
                                                                              )
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              (212,824
                                                                              )
                                                                              
                                                                              
                                                                              -Proceeds
      from sale of furniture and equipment
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              45,361
                                                                              
                                                                              
                                                                              
                                                                              12,500Net
      Cash used in Investing Activities
                                                                              
                                                                              
                                                                              (98,745
                                                                              )
                                                                              
                                                                              
                                                                              (52,363
                                                                              )
                                                                              
                                                                              
                                                                              (182,028
                                                                              )
                                                                              
                                                                              
                                                                              (49,300
                                                                              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Repayments
      on notes payable
                                                                              
                                                                              
                                                                              (1,797,216
                                                                              )
                                                                              
                                                                              
                                                                              (2,461
                                                                              )
                                                                              
                                                                              
                                                                              (3,734,867
                                                                              )
                                                                              
                                                                              
                                                                              (2,284,526
                                                                              )Debt
      borrowings
                                                                              
                                                                              
                                                                              2,375,868
                                                                              
                                                                              
                                                                              
                                                                              1,383,215
                                                                              
                                                                              
                                                                              
                                                                              5,301,379
                                                                              
                                                                              
                                                                              
                                                                              1,883,215Net
      cash provided by (used in) financing activities
                                                                              
                                                                              
                                                                              578,652
                                                                              
                                                                              
                                                                              
                                                                              1,380,754
                                                                              
                                                                              
                                                                              
                                                                              1,566,512
                                                                              
                                                                              
                                                                              
                                                                              (401,311
                                                                              )NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                                                                              
                                                                              
                                                                              (5,577
                                                                              )
                                                                              
                                                                              
                                                                              (168,713
                                                                              )
                                                                              
                                                                              
                                                                              14,110
                                                                              
                                                                              
                                                                              
                                                                              (3,290,914
                                                                              )CASH
      AND CASH EQUIVALENTS,BEGINNING
      OF PERIOD
                                                                              
                                                                              
                                                                              38,289
                                                                              
                                                                              
                                                                              
                                                                              351,758
                                                                              
                                                                              
                                                                              
                                                                              18,602
                                                                              
                                                                              
                                                                              
                                                                              3,473,959CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                                                                              
                                                                              $
                                                                              32,712
                                                                              
                                                                              
                                                                              $
                                                                              183,045
                                                                              
                                                                              
                                                                              $
                                                                              32,712
                                                                              
                                                                              
                                                                              $
                                                                              183,045Supplemental
      disclosures of cash flow information:Cash
      paid during the period for:Interest
                                                                              
                                                                              $
                                                                              46,068
                                                                              
                                                                              
                                                                              $
                                                                              190,215
                                                                              
                                                                              
                                                                              $
                                                                              173,818
                                                                              
                                                                              
                                                                              $
                                                                              383,064Taxes
                                                                              
                                                                              $
                                                                              -
                                                                              
                                                                              
                                                                              $
                                                                              17,350
                                                                              
                                                                              
                                                                              $
                                                                              10
                                                                              
                                                                              
                                                                              $
                                                                              35,370Supplemental
      schedule of non-cash financing activities:Conversion
      of debt to dquity
                                                                              
                                                                              $
                                                                              -
                                                                              
                                                                              
                                                                              $
                                                                              -
                                                                              
                                                                              
                                                                              $
                                                                              -
                                                                              
                                                                              
                                                                              $
                                                                              228,546
 
 The
accompanying notes are an integral part of these financial
statements.
  SMART
ONLINE, INC.
 NOTES
TO FINANCIAL STATEMENTS
 (unaudited)
 
 1.            SUMMARY
OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
 
 Description of
Business - Smart Online, Inc. (the “Company”) was incorporated in the
State of Delaware in 1993. The Company develops and markets software products
and services (One BizTM) targeted to small businesses that are delivered via a
Software-as-a-Service (“SaaS”) model. The Company sells its SaaS products and
services primarily through private-label marketing partners. In addition, the
Company provides sophisticated and complex website consulting and development
services, primarily in the e-commerce retail and direct-selling organization
industries. The Company maintains a website that offers additional information
about these capabilities as well as certain corporate information at
www.smartonline.com.
 
 Basis of
Presentation- The financial statements as of and for the three and six
months ended June 30, 2009 and 2008 included in this Quarterly Report on
Form 10-Q are unaudited. The balance sheet as of December 31, 2008 is obtained
from the audited financial statements as of that date. The accompanying
statements should be read in conjunction with the audited financial statements
and related notes, together with management’s discussion and analysis of
financial condition and results of operations, contained in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2008 filed with the
Securities and Exchange Commission (the “SEC”) on March 30, 2009 (the “2008
Annual Report”).
 
 The
financial statements have been prepared in accordance with accounting principles
generally accepted in the United States (“U.S. GAAP”). In the opinion of the
Company’s management, the unaudited statements in this Quarterly Report on Form
10-Q include all normal and recurring adjustments necessary for the fair
presentation of the Company’s statement of financial position as of June 30,
2009, and its results of operations and cash flows for the three and six months
ended June 30, 2009 and 2008. The results for the three and six months ended
June 30, 2009 are not necessarily indicative of the results to be expected for
the fiscal year ending December 31, 2009.
 
 The
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. During the three and six  months
ended June 30, 2009 and 2008, the Company incurred net losses as well as
negative cash flows, is involved in a class action lawsuit (See Note 7,
“Commitments and Contingencies,” in the 2008 Annual Report), and had
deficiencies in working capital. These factors indicate that the Company may be
unable to continue as a going concern.
 
 The
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts or
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. At August 10, 2009, the Company does have
a commitment from its convertible secured subordinated noteholders to purchase
up to an additional $8.5 million in convertible notes upon approval and call by
the Company’s Board of Directors. There can be no assurance that, if the
noteholders do not purchase the $8.5 million in convertible notes, the Company
will be able to obtain alternative funding. There can be no assurance that the
Company’s efforts to raise capital or increase revenue will be successful. If
these efforts are unsuccessful, the Company may have to cease operations and
liquidate the business. The Company’s future plans include the introduction of
its new One BizTM platform, the development of additional new products and
applications, and further enhancement of its existing small-business
applications and tools. The Company’s continuation as a going concern
depends upon its capability to generate sufficient cash flows to meet its
obligations on a timely basis, to obtain additional financing as may be
required, and ultimately to attain profitable operations and positive cash
flows.
 
 Significant
Accounting Policies- In the opinion of the Company’s management,
the significant accounting policies used for the three and six months ended June
30, 2009 are consistent with those used for the year ended December 31, 2008.
Accordingly, please refer to the 2008 Annual Report for the Company’s
significant accounting policies.
 
 Use of Estimates
- The preparation of financial statements in conformity with U.S. GAAP
requires management to make estimates and assumptions in the Company’s financial
statements and notes thereto. Significant estimates and assumptions made by
management include the determination of the provision for income taxes, the fair
market value of stock awards issued, and the period over which revenue is
generated. Actual results could differ materially from those
estimates.
  9
  Fair Value of
Financial Instruments -Statement of Financial Accounting Standards
(“SFAS”) No. 107, Disclosures
about Fair Value of Financial Instruments, requires disclosures of
fair value information about financial instruments, whether or not recognized in
the balance sheet, for which it is practicable to estimate that value. Due to
the short period of time to maturity, the carrying amounts of cash equivalents,
accounts receivable, accounts payable, accrued liabilities, and notes payable
reported in the financial statements approximate the fair value.
 
 Reclassifications
- Certain prior year and comparative period amounts have been
reclassified to conform to current year presentation. These reclassifications
had no effect on previously reported net income or stockholders’
equity.
 
 Principles of
Consolidation - The accompanying financial statements for the three and
six months ended June 30, 2008 include the accounts of the Company and its
former wholly owned subsidiaries, Smart CRM, Inc. (“Smart CRM”) and Smart
Commerce, Inc. (“Smart Commerce”). All significant intercompany accounts and
transactions have been eliminated. Subsidiary accounts are included only from
the date of acquisition forward. On December 31, 2008, each of Smart CRM and
Smart Commerce were merged into the Company.
 
 Segments
- Segmentation is based on an entity’s internal organization and
reporting of revenue and operating income based upon internal accounting methods
commonly referred to as the “management approach.” Operating segments are
defined as components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief operating
decision maker in deciding how to allocate resources and in assessing
performance. The Company’s chief operating decision maker is its Chief Executive
Officer, who reviews financial information presented on a consolidated basis.
Accordingly, the Company has determined that it has a single reporting segment
and operating unit structure.
 
 Concentration of
Credit Risk - Financial instruments that potentially subject the Company
to concentrations of credit risk consist primarily of cash and accounts
receivable. At times, cash balances may exceed the Federal Deposit Insurance
Corporation (“FDIC”) insurable limits. See Note 6, “Major Customers and
Concentration of Credit Risk,” for further discussion of risk within accounts
receivable.
 
 Allowance for
Doubtful Accounts - The Company maintains an allowance for doubtful
accounts for estimated losses resulting from the inability, failure, or refusal
of its customers to make required payments. The need for an allowance for
doubtful accounts is evaluated based on specifically identified amounts that
management believes to be potentially uncollectible. If actual collections
experience changes, revisions to the allowance may be required.
 
 Additionally,
from time to time the Company, as part of its negotiated contracts, has granted
extended payment terms to its strategic partners. As payments become due under
the terms of the contract, they are invoiced and reclassified as accounts
receivable. During the second quarter of 2008, the Company entered into a web
services agreement with a direct-selling organization customer that provided for
extended payment terms related to both professional services and the grant of a
software license. During the third quarter of 2008, this customer began
experiencing cash flow difficulties and has since significantly slowed its
payments to the Company. In addition, the Company entered into a web services
agreement with a real estate services customer in the third quarter of 2007 that
called for contractual payments against a note receivable upon delivery and
acceptance of a custom application. The Company and the customer are currently
in discussions with respect to whether the application was delivered as per the
specifications, and the customer has not commenced payment subject to the
outcome of these discussions.
 
 Based on
these criteria, management determined that at June 30, 2009, an allowance for
doubtful accounts of $850,080 was required, comprising the full outstanding
balance of the direct-selling organization customer’s account and contract
receivable and one half of the real estate services customer’s note
receivable.
 
 Intangible
Assets - Intangible assets consist primarily of assets obtained
through the acquisitions of Computility, Inc. (“Computility”) and iMart
Incorporated (“iMart”) in 2005 and include customer bases, acquired technology,
non-compete agreements, trademarks, and trade names. The Company also owns
several copyrights and trademarks related to products, names, and logos used
throughout its non-acquired product lines. All assets are amortized on a
straight-line basis over their estimated useful lives with the exception of the
iMart trade name, which is deemed by management to have an indefinite life and
is not amortized. During
the three month period ending June 30, 2009, we impaired the value of a portion
of the customer base intangible asset due to the fact that the Company is no
longer doing business with the customer.
  10
  Revenue
Recognition - The Company derives revenue primarily from
subscription fees charged to customers accessing its SaaS applications;
professional service fees, consisting primarily of consulting and custom
software development; the perpetual or term licensing of software platforms or
applications; and hosting and maintenance services. These arrangements may
include delivery in multiple-element arrangements if the customer purchases a
combination of products and/or services. Because the Company licenses, sells,
leases, or otherwise markets computer software, it uses the residual method
pursuant to 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.
 
 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.
                collection
      is probable
 
 If at the
inception of an arrangement the fee is not fixed or determinable, revenue is
deferred until the arrangement fee becomes due and payable. If collectability is
deemed not probable, revenue is deferred until payment is received or collection
becomes probable, whichever is earlier. The determination of whether fees are
collectible requires judgment of management, and the amount and timing of
revenue recognition may change if different assessments are made.
 
 Under the
provisions of Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables, consulting, website design fees, and application
development services are accounted for separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, revenues are recognized as the services are rendered
for time and material contracts, and when milestones are achieved and accepted
by the customer for fixed-price or long-term contracts. The majority of the
Company’s consulting service and custom software development contracts are on a
time and material basis and are typically billed monthly based upon standard
professional service rates.
 
 Application
development services are typically fixed in price and of a longer term. As such,
they are accounted for as long-term construction contracts that require revenue
recognition to be based on estimates involving total costs to complete and the
stage of completion. The assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, the associated costs of such
projects are capitalized and included in costs in excess of billings on the
balance sheet until such time that revenue recognition is
permitted.
  11
  Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. The Company typically has a revenue-share arrangement
with these marketing partners in order to encourage them to market the Company’s
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user. Any payments received in advance of the subscription period are accrued as
deferred revenue and amortized over the subscription period. The Company
recognizes revenue on a gross basis in accordance with Emerging Issues Task
Force Issue No. 99-19, Reporting Revenue Gross as a
Principal versus Net as an Agent, when services are provided directly by
the Company to end users and revenue-share arrangements exist with its marketing
partners.
 
 Because
its customers generally do not have the contractual right to take possession of
the software it licenses or markets at any time, the Company recognizes revenue
on hosting and maintenance fees as the services are provided in accordance with
Emerging Issues Task Force Issue No. 00-3, Application of AICPA Statement of
Position 97-2 to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.
 
 Deferred
Revenue -Deferred revenue consists of billings or payments
received in advance of revenue recognition, and it is recognized as the revenue
recognition criteria are met. Deferred revenue also includes certain
professional service fees and license fees where all the criteria of SOP 97-2
were not met. Deferred revenue that will be recognized over the succeeding
12-month period is recorded as current and the remaining portion is recorded as
non-current.
  Cost of
Revenues -Cost of revenues primarily is composed of costs related
to third-party hosting services, salaries and associated costs of customer
support and professional services personnel, credit card processing,
depreciation of computer hardware and software used in revenue-producing
activities, domain name and e-mail registrations, and allocated development
expenses and general and administrative overhead.
 
 The
Company allocates development expenses to cost of revenues based on time spent
by development personnel on revenue-producing customer projects and support
activities. The Company allocates general and administrative overhead such as
rent and occupancy expenses, depreciation, general office expenses, and
insurance to all departments based on headcount. As such, general and
administrative overhead expenses are reflected in cost of revenues and each
operating expense category.
 
 Stock-Based
Compensation - Effective January 1, 2006, the Company adopted
SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS
No. 123R”). Total stock-based compensation expense recognized under SFAS
No. 123R during the three and six months ended June 30, 2009 was
approximately $29,339 and $82,483 respectively of which $20,937 and $47,499
related to the issuance of restricted stock and $8,402 and $34,984 was expense
associated with stock options for the respective three and six month period.
Total stock-based compensation expense during the three and six months ended
June 30, 2008 was approximately $89,645 and $260,144 respectively, of which
$62,703 and $184,940 related to the issuance of restricted stock and $26,942 and
$75,204 was expense associated with stock options for the respective periods. No
stock-based compensation was capitalized in the financial
statements.
 
 In
computing the impact of stock-based compensation expense, the fair value of each
award is estimated on the date of grant based on the Black-Scholes option
pricing model utilizing certain assumptions for a risk-free interest rate,
volatility, expected remaining lives of the awards, and forfeiture rate. The
forfeiture rate is the estimated percentage of equity grants that are expected
to be forfeited or cancelled on an annual basis before becoming fully vested.
The Company estimates pre-vesting forfeiture rates at the time of grant based on
historical data and revises those estimates in subsequent periods if actual
forfeitures differ from those estimates, with the cumulative effect on current
and prior periods of such changes recognized in compensation cost in the period
of the change. The Company records stock-based compensation expense only for
those awards that are expected to vest, amortized on a straight-line basis over
the requisite service periods of the awards, which are generally the vesting
periods. The assumptions used in calculating the fair value of share-based
payment awards, including if the Company’s actual forfeiture rate is materially
different from what the Company has recorded in the current period, represent
management’s best estimates, but these estimates involve inherent uncertainties
and the application of management’s judgment. As a result, if factors change and
the Company uses different assumptions, the Company’s stock-based compensation
expense could be materially different in the future.
 
 The fair
value of option grants under the Company’s equity compensation plan during the
three and six months ended June 30, 2009 and 2008 were estimated using the
following weighted average assumptions:
  12
 
 ThreeMonthsEndedJune30,
                  
                  
                  SixMonthsEndedJune30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Dividend
      yield
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %Expected
      volatility
                  
                  
                  102.1
                  %
                  
                  
                  40.0
                  %
                  
                  
                  101.28
                  %
                  
                  
                  50.0
                  %Risk
      free interest rate
                  
                  
                  2.54
                  %
                  
                  
                  4.45
                  %
                  
                  
                  2.29
                  %
                  
                  
                  4.55
                  %Expected
      lives (years)
                  
                  
                  3
                  
                  
                  
                  4
                  
                  
                  
                  3
                  
                  
                  
                  5
 
 Dividend yield – The Company
has never declared or paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.
 
 Expected volatility –
Volatility is a measure of the amount by which a financial variable such as
share price has fluctuated (historical volatility) or is expected to fluctuate
(expected volatility) during a period. The Company used the Company’s monthly
historical volatility since April 2005 to calculate the expected
volatility.
 
 Risk-free interest rate – The
risk-free interest rate is based on the published yield available on U.S.
Treasury issues with a remaining term similar to the expected life of the
option.
 
 Expected lives – The expected
lives of the options represent the estimated period of time until exercise or
forfeiture and are based on historical experience of similar
awards.
 
 Net Loss
PerShare -Basic net loss per share is computed by dividing net loss by the weighted
average number of common shares outstanding during the periods. Diluted net loss
per share is computed using the weighted average number of common and dilutive
common equivalent shares outstanding during the periods. Common equivalent
shares consist of convertible notes, stock options, and warrants that are
computed using the treasury stock method. Shares issuable upon the exercise of
stock options and warrants, totaling 1,796,535 and 1,704,500 on June 30, 2009
and 2008, respectively, were excluded from the calculation of common equivalent
shares as the impact was anti-dilutive.
 
 Recently Issued
Accounting Pronouncements -In April 2008, the Financial Accounting
Standards Board (“FASB”) issued FASB Staff Position No. 142-3, Determination of the Useful Life of
Intangible Assets (“FSP 142-3”). The standard requires entities to
consider their own historical experience in renewing or extending similar
arrangements when developing assumptions regarding the useful lives of
intangible assets and also mandates certain related disclosure requirements. FSP
142-3 is effective for fiscal years beginning after December 15, 2008, with
early adoption prohibited. The Company has determined that adoption of FSP
142-3 will not have a material impact on its financial statements.
 
 All other
new and recently issued, but not yet effective, accounting pronouncements have
been deemed to be not relevant to the Company and therefore are not expected to
have any impact once adopted.
 
 2.            BALANCE
SHEET ACCOUNTS
 
 Prepaid
Expenses
 
 In July
2008, the Company entered into a 36-month sublease agreement for approximately
9,837 square feet of office space in Durham, North Carolina located near
Research Triangle Park North Carolina, into which the Company relocated its
headquarters in September 2008. The agreement included the conveyance of certain
furniture to the Company without a stated value and required a lump-sum, upfront
payment of $500,000 that was made in September 2008. Management has assessed the
fair market value of the furniture to be approximately $50,000, and this amount
was capitalized and is subject to depreciation in accordance with the Company’s
fixed asset policies. The remainder of the payment was recorded as prepaid
expense, with the portion relating to rent for periods beyond the next 12 months
classified as non-current, and is being amortized to rent expense over the term
of the lease.
 
 Intangible
Assets
 
 The
following table summarizes information about intangible assets at June 30,
2009:
  13
 
 Asset Category
                          
                          Value
                            Assigned
                          
                          
                          Residual
                            Value
                          
                          
                          Weighted
                            Average
                            Amortization
                            Period
                            (in Years)
                          
                          
                          Accumulated
                            Amortization
                          
                          
                          Carrying
                            ValueCustomer base
                          
                          $
                          1,012,421
                          
                          
                          $
                          -
                          
                          
                          
                          6.2
                          
                          
                          $
                          750,845
                          
                          
                          $
                          261,576Acquired
      technology
                          
                          
                          501,264
                          
                          
                          
                          -
                          
                          
                          
                          3.0
                          
                          
                          
                          501,264
                          
                          
                          
                          -Non-compete
      agreements
                          
                          
                          801,785
                          
                          
                          
                          -
                          
                          
                          
                          4.0
                          
                          
                          
                          743,322
                          
                          
                          
                          58,463Trademarks
      and copyrights
                          
                          
                          52,372
                          
                          
                          
                          -
                          
                          
                          
                          9.7
                          
                          
                          
                          51,159
                          
                          
                          
                          1,213Trade
      name
                          
                          
                          380,000
                          
                          
                          
                          N/A
                          
                          
                          
                          N/A
                          
                          
                          
                          N/A
                          
                          
                          
                          380,000Totals
                          
                          $
                          2,747,842
                          
                          
                          $
                          -
                          
                          
                          
                          
                          
                          
                          $
                          2,046,590
                          
                          
                          $
                          701,252
 
 Intangible
assets acquired were valued using the standard of “fair value” defined in SFAS
No. 141, Business
Combinations, as “the amount at which an asset (or liability) could be
bought (or incurred) or sold (or settled) in a current transaction between
willing parties, that is, other than in a forced or liquidation sale.”
Copyrights and trademarks were capitalized using the costs of all legal and
application fees incurred.
 
 Accrued
Liabilities
 
 At June
30, 2009, the Company had accrued liabilities totaling $495,683. This amount
consisted primarily of $117,102 of liability related to the development of the
Company’s custom accounting application; $24,561 for tax-related liabilities
associated with the vesting of restricted stock; $79,590 of estimated loss on a
customer contract; $58,351 for accrued payroll; $189,662 of convertible note
interest payable and $26,417 of other liabilities.
 
 At
December 31, 2008, the Company had accrued liabilities totaling $478,917. This
amount consisted primarily of $117,102 of liability related to the development
of the Company’s custom accounting application; $137,500 related to legal
reserves; $30,198 for tax-related liabilities associated with the vesting of
restricted stock; $30,903 of estimated loss on a long-term customer contract;
$79,300 of cash collected through the Company's merchant account on behalf of a
customer; and $54,467 of convertible note interest payable and other liabilities
of $29,447.
 
 Deferred
Revenue
 
 Deferred
revenue comprises the following items:
  ·
                Subscription
      fees –Short-term and long-term
      portions of cash received related to one- or two-year subscriptions for
      domain names and/or e-mail
accounts.
 
 ·
                License fees
      –Licensing revenue
      where customers did not meet all the criteria of SOP 97-2. Such deferred
      revenue is recognized when delivery has occurred or collectability becomes
      probable.
 
 ·
                Professional
      service fees –A
      customer that purchased a license and paid professional service fees
      during 2008 and 2007 to develop a customized application decided in the
      latter part of 2008 to move the application to the Company’s new
      technology platform. In connection with this new arrangement, the customer
      desires customization beyond the original scope of the project and will
      also be responsible for a monthly fee to maintain the application starting
      inOctober2009. This deferred revenue
      represents the difference between earned fees and unearned license and
      professional service fees to be recognized as professional service fees
      revenue in 2009.
  The
components of deferred revenue for the periods indicated were as
follows:
  14
 
 June 30,
                        2009
                      
                      
                      December 31,
                        2008Subscription
      fees
                      
                      $
                      69,258
                      
                      
                      $
                      89,852License
      fees
                      
                      
                      86,250
                      
                      
                      
                      108,750Professional
      service fees
                      
                      
                      147,300
                      
                      
                      
                      192,727Totals
                      
                      $
                      302,808
                      
                      
                      $
                      391,329Current
      portion
                      
                      $
                      252,816
                      
                      
                      $
                      323,976Non-current
      portion
                      
                      
                      49,992
                      
                      
                      
                      67,353Totals
                      
                      $
                      302,808
                      
                      
                      $
                      391,329
 
 3.       
    NOTES PAYABLE
 
 Convertible
Notes
 
 As of
June 30, 2009, the Company had $7.3 million aggregate principal amount of
convertible secured subordinated notes due November 14, 2010 (the “notes”)
outstanding. On November 14, 2007, in an initial closing, the Company sold $3.3
million aggregate principal amount of notes (the “Initial Notes”). In addition,
the noteholders committed to purchase on a pro rata basis up to $5.2 million
aggregate principal amount of notes in future closings upon approval and call by
the Company’s Board of Directors. On August 12, 2008, the Company exercised its
option to sell $1.5 million aggregate principal amount of notes with
substantially the same terms and conditions as the Initial Notes (the
“Additional Notes”). In connection with the sale of the Additional Notes, the
noteholders holding a majority of the aggregate principal amount of the notes
then outstanding agreed to increase the aggregate principal amount of notes that
they are committed to purchase from $8.5 million to $15.3 million.
 
 On
November 21, 2008, the Company sold $500,000 aggregate principal amount of notes
(the “New Notes”) to two new investors with substantially the same terms and
conditions as the previously outstanding notes.
 
 On each
of January 6, 2009, February 24, 2009, April 3, 2009, and June 2, 2009 the
Company sold $500,000  aggregate principal amount of notes (total
$2,000,000) to a current noteholder with substantially the same terms and
conditions as the previously outstanding notes.
 
 On July
16, 2009, the Company sold a $250,000 principal amount note to a current
noteholder with substantially the same terms and conditions as the previously
outstanding notes.
 
 Also on
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that the Company may sell up to $6
million aggregate principal amount of notes to new investors or existing
noteholders at any time on or before December 31, 2009 with a maturity date of
November 14, 2010 or later. In addition, the maturity date definition for each
of the notes was changed from November 14, 2010 to the date upon which the note
is due and payable, which is the earlier of (1) November 14, 2010, (2) a change
of control, or (3) if an event of default occurs, the date upon which
noteholders accelerate the indebtedness evidenced by the notes.
 
 The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and set at the lowest “applicable conversion
price,” as described below.
 
 The
Company is obligated to pay interest on the notes at an annualized rate of 8%
payable in quarterly installments commencing three months after the purchase
date of the notes. The Company is not permitted to prepay the notes without
approval of the holders of at least a majority of the principal amount of the
notes then outstanding.
 
 On the
earlier of November 14, 2010 or a merger or acquisition or other transaction
pursuant to which existing stockholders of the Company hold less than 50% of the
surviving entity, or the sale of all or substantially all of the Company’s
assets, or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:
  15
 
 ·
              convert the principal then
      outstanding on its notes into shares of the Company’s common stock,
      or
 
 ·
              receive immediate repayment in
      cash of the notes, including any accrued and unpaid
      interest.
 
 If a
noteholder elects to convert its notes under these circumstances, the conversion
price will be the lowest “applicable conversion price” determined for each note.
The “applicable conversion price” for each note shall be calculated by
multiplying 120% by the lowest of:
 
 ·
              the average of the high and low
      prices of the Company's common stock on the OTC Bulletin Board averaged
      over the five trading days prior to the closing date of the issuance of
      such note,
 
 ·
              if the Company's common stock is
      not traded on the Over-The-Counter market, the closing price of the common
      stock reported on the Nasdaq National Market or the principal exchange on
      which the common stock is listed, averaged over the five trading days
      prior to the closing date of the issuance of such note,
      or
 
 ·
              the closing price of the
      Company's common stock on the OTC Bulletin Board, the Nasdaq National
      Market or the principal exchange on which the common stock is listed, as
      applicable, on the trading day immediately preceding the date such note is
      converted,
 
 in each
case as adjusted for stock splits, dividends or combinations, recapitalizations
or similar events.
 
 Payment
of the notes will be automatically accelerated if the Company enters voluntary
or involuntary bankruptcy or insolvency proceedings.
 
 The notes
and the common stock into which they may be converted have not been registered
under the Securities Act of 1933, as amended (the “Securities Act”), or the
securities laws of any other jurisdiction. As a result, offers and sales of the
notes were made pursuant to Regulation D of the Securities Act and only made to
accredited investors. The investors in the Initial Notes include (i) The
Blueline Fund, which originally recommended Philippe Pouponnot, a former
director of the Company, for appointment to the Company’s Board of Directors;
(ii) Atlas Capital SA (“Atlas”), an affiliate of the Company that originally
recommended Shlomo Elia, one of the Company’s current directors, for appointment
to the Board of Directors; (iii) Crystal Management Ltd. (“Crystal”), which is
owned by Doron Roethler, who subsequently served as Chairman of the Company’s
Board of Directors and Interim President and Chief Executive Officer from
December 9, 2008 until  May 19, 2009,  and serves as the
noteholders’ bond representative; and (iv) William Furr, who is the father of
Thomas Furr, who, at the time, was one of the Company’s directors and executive
officers. The investors in the Additional Notes are Atlas and Crystal. The
investors in the New Notes are not affiliated with the Company. Atlas purchased
the notes issued in 2009.
 
 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.
 
 Lines
of Credit
 
 On
November 14, 2006, the Company entered into a revolving credit arrangement with
Wachovia Bank, NA (“Wachovia”) for $1.3 million to 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. The interest accrued on the
unpaid principal balance at the LIBOR Market Index Rate plus 0.9%. The line of
credit was secured by the Company’s deposit account at Wachovia and an
irrevocable standby letter of credit in the amount of $1.3 million issued by
HSBC Private Bank (Suisse) SA (“HSBC”) with Atlas, a current stockholder, as
account party.
 
 On
January 24, 2007, the Company entered into an amendment to its line of credit
with Wachovia to increase the available principal from $1.3 million to $2.5
million and to extend the maturity date from August 1, 2007 to August 1, 2008.
The amended line of credit was secured by the Company’s deposit account at
Wachovia and a modified irrevocable standby letter of credit in the amount of
$2.5 million issued by HSBC with Atlas as account party. On February 15, 2008,
the Company repaid the full outstanding principal balance of $2,052,000 and
accrued interest of $2,890.
  16





On
February 20, 2008, the Company entered into a revolving credit arrangement with
Paragon Commercial Bank (“Paragon”) that is renewable on an annual basis subject
to mutual approval. The line of credit advanced by Paragon is $2.47 million and
can be used for general working capital. Any advances made on the line of credit
were to be paid off no later than February 19, 2009, subject to extension due to
renewal, with monthly payments being applied first to accrued interest and then
to principal. The interest accrued on the unpaid principal balance at the Wall
Street Journal’s published Prime Rate minus one half percent. The line of
credit is secured by an irrevocable standby letter of credit in the amount of
$2.5 million issued by HSBC with Atlas as account party that expires on February
18, 2010. The Company also has agreed with Atlas that in the event of a default
by the Company in the repayment of the line of credit that results in the letter
of credit being drawn, the Company shall reimburse Atlas any sums that Atlas is
required to pay under such letter of credit. At the sole discretion of the
Company, these payments may be made in cash or by issuing shares of the
Company’s common stock at a set per-share price of $2.50.





On
February 19, 2009, the Company renewed its revolving credit arrangement with
Paragon. Any advances made on the line of credit must be paid off no later than
February 11, 2010. Interest shall accrue on the unpaid principal balance at the
Wall Street Journal's published Prime Rate, but at no time shall the interest
rate be less than 5.5%. As of August 10, 2009, the Company had an outstanding
balance of $2.16 million under the line of credit.





As of
June 30, 2009, the Company had notes payable totaling $9,234,900. The detail of
these notes is as follows:





Note Description
                            
                            Short-
                              Term
                              Portion
                            
                            
                            Long-
                              Term
                              Portion
                            
                            
                            Total
                            
                            Maturity
                            
                            RateParagon
      Commercial Bank credit line
                            
                            $
                            1,894,076
                            
                            
                            $
                            0
                            
                            
                            $
                            1,894,076
                            
                            Feb
      2010
                            
                            Prime, not less
                              than 5.5
                            %Insurance
      premium note
                            
                            
                            0
                            
                            
                            
                            0
                            
                            
                            
                            0
                            
                            Jul
      2009
                            
                            
                            6.1
                            %Various
      capital leases
                            
                            
                            28,215
                            
                            
                            
                            12,609
                            
                            
                            
                            40,824
                            
                            Various
                            
                            
                            10.7-18.9
                            %Convertible
      notes
                            
                            
                            -
                            
                            
                            
                            7,300,000
                            
                            
                            
                            7,300,000
                            
                            Nov
      2010
                            
                            
                            8.0
                            %Totals
                            
                            $
                            1,922,291
                            
                            
                            $
                            7,312,609
                            
                            
                            $
                            9,234,900





4.           COMMITMENTS
AND CONTINGENCIES





Lease
Commitments





The
Company leases computer and office equipment under capital lease agreements that
expire through July 2011. Total amounts financed under these capital leases were
$40,824 and $53,517 at June 30, 2009 and December 31, 2008, respectively, net of
accumulated amortization of $27,806 and $18,647, respectively. The current and
non-current portions of the capital leases have been recorded in current and
long-term portions of notes payable on the balance sheets as of June 30, 2009
and December 31, 2008. See also Note 3, “Notes Payable.”





In 2008,
the Company entered into a non-cancelable sublease with a remaining term of 36
months to relocate its headquarters to another facility near Research Triangle
Park, North Carolina. As described in Note 2, “Balance Sheet Accounts,” the
Company prepaid the lease and purchased existing furniture and fixtures for a
lump-sum payment of $500,000, of which $450,080 was allocated to rent and is
being amortized monthly over the remaining term of the lease. The Company also
has a non-cancelable lease through October 2009 for an apartment near its
headquarters that is utilized by its out of town executives and members of its
Board of Directors. As of June 30, 2009, future annual minimum operating lease
payments for 2009 are $7,980.





Rent
expense for the six months ended June 30, 2009 and 2008 was $87,727 and $76,947
respectively.





17





Development
Agreement





In August
2005, the Company entered into a software assignment and development agreement
with the developer of a customized accounting software application. In
connection with this agreement, the developer would be paid up to $512,500 and
issued up to 32,395 shares of the Company’s common stock based upon the
developer attaining certain milestones. This agreement was modified on
March 26, 2008 to adjust the total number of shares issuable under the agreement
to 29,014. As of June 30, 2009, the Company had paid $470,834 and issued 3,473
shares of common stock related to this obligation.





Legal
Proceedings





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




On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris.  By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009.   The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $1.9 million. Though the
Nouris have entered into an undertaking that requires them to repay to the
Company any amounts advanced by it in the event the Nouris are ultimately
determined not to be entitled to indemnification for the expenses incurred, it
is uncertain at this time that the Company will be able to recover such amounts
advanced without considerable expense to the Company, or whether the Company
will be able to recover any of the amounts advanced at all.




Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2008 for a further description of material legal
proceedings.





5.           STOCKHOLDERS’
EQUITY





Preferred
Stock





The Board
of Directors is authorized, without further stockholder approval, to issue up to
5,000,000 shares of $0.001 par value preferred stock in one or more series and
to fix the rights, preferences, privileges, and restrictions applicable to such
shares, including dividend rights, conversion rights, terms of redemption, and
liquidation preferences, and to fix the number of shares constituting any series
and the designations of such series. There were no shares of preferred stock
outstanding at June 30, 2009.





Common
Stock





The
Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
value per share. As of June 30, 2009, it had 18,332,543 shares of common stock
outstanding. Holders of common stock are entitled to one vote for each share
held.





In
January 2008, the Company issued 28,230 shares of common stock to a consulting
firm as full payment of the outstanding obligation related to fees accrued for
services rendered in conjunction with the 2005 acquisitions of iMart and
Computility.





Warrants





As
incentive to modify a letter of credit relating to the Wachovia line of credit
(see Note 3, “Notes Payable”), the Company entered into a Stock Purchase Warrant
and Agreement (the “Warrant Agreement”) with Atlas on January 15, 2007. Under
the terms of the Warrant Agreement, Atlas received a warrant containing a
provision for cashless exercise to purchase up to 444,444 shares of the
Company’s common stock at $2.70 per share at the termination of the line of
credit or if the Company is in default under the terms of the line of credit
with Wachovia. The fair value of the warrant was $734,303 as measured using the
Black-Scholes option pricing model at the time the warrant was issued. This
amount was recorded as deferred financing costs and was amortized to interest
expense in the amount of $37,657 per month over the remaining period of the
modified line of credit, which expired on August 2008. As of December 31,
2007, the deferred financing costs to be amortized to interest expense over the
remaining eight months, or $301,249, were classified as current assets. In
consideration for Atlas providing the Paragon line of credit (see Note 3, “Notes
Payable”), the Company agreed to amend the Warrant Agreement to provide that the
warrant is exercisable within 30 business days of the termination of the Paragon
line of credit or if the Company is in default under the terms of the line of
credit. If the warrant is exercised in full for cash, it will result in gross
proceeds to the Company of approximately $1.2 million.





Under a
Securities Purchase Agreement with two investors entered in connection with a
2007 private placement of the Company’s common stock, the investors were issued
warrants for the purchase of an aggregate of 1,176,471 shares of common stock at
an exercise price of $3.00 per share. These warrants contain a provision for
cashless exercise and must be exercised by February 21, 2010.





18





As part
of the commission paid to Canaccord Adams, Inc. (“CA”), the Company’s placement
agent in the 2007 private placement transaction, CA was issued a warrant to
purchase 35,000 shares of the Company’s common stock at an exercise price of
$2.55 per share. This warrant contains a provision for cashless exercise and
must be exercised by February 21, 2012.





As of
June 30, 2009, warrants to purchase up to 1,655,915 shares were
outstanding.





Equity
Compensation Plans





The
Company adopted its 2004 Equity Compensation Plan (the “2004 Plan”) as of March
31, 2004. The 2004 Plan provides for the grant of incentive stock options,
non-statutory stock options, restricted stock, and other direct stock awards to
employees (including officers) and directors of the Company as well as to
certain consultants and advisors. In June 2007, the Company temporarily limited
the issuance of shares of its common stock reserved under the 2004 Plan to
awards of restricted or unrestricted stock and in June 2008 again made options
available for grant under the 2004 Plan. The total number of shares of common
stock reserved for issuance under the 2004 plan is 5,000,000 shares, subject to
adjustment in the event of a stock split, stock dividend, recapitalization, or
similar capital change.





Restricted Stock – During the
first and second quarters of 2009, no shares of restricted stock were issued. A
total of 479 shares of restricted stock were canceled during the first two
quarters of 2009 due to terminations and payment of employee tax obligations
resulting from share vesting. At June 30, 2009, there remains $35,207 of
unvested expense yet to be recorded related to all restricted stock
outstanding.





Stock Options– The exercise
price for incentive stock options granted under the 2004 Plan is required to be
no less than the fair market value of the common stock on the date the option is
granted, except for options granted to 10% stockholders, which are required to
have an exercise price of not less than 110% of the fair market value of the
common stock on the date the option is granted. Incentive stock options
typically have a maximum term of ten years, except for option grants to 10%
stockholders, which are subject to a maximum term of five years. Non-statutory
stock options have a term determined by either the Board of Directors or the
Compensation Committee. Options granted under the 2004 Plan are not
transferable, except by will and the laws of descent and
distribution.





The
following is a summary of the stock option activity for the six months ended
June 30, 2009:





Shares
                      
                      
                      Weighted
                        Average
                        Exercise
                        PriceBALANCE, December
      31, 2008
                      
                      
                      271,250
                      
                      
                      $
                      5.89Granted
                      
                      
                      40,000
                      
                      
                      
                      1.10Exercised
                      
                      
                      -
                      
                      
                      
                      -Canceled
                      
                      
                      (53,550
                      )
                      
                      
                      5.75BALANCE,
      June 30, 2009
                      
                      
                      257,700
                      
                      
                      $
                      4.84





The
following table summarizes information about stock options outstanding at June
30, 2009:





Currently ExercisableExercise Price
                                  
                                  Number of
                                    Options
                                    Outstanding
                                  
                                  
                                  Average
                                    Remaining
                                    Contractual
                                    Life (Years)
                                  
                                  
                                  Weighted
                                    Average
                                    Exercise
                                    Price
                                  
                                  
                                  Number of
                                    Shares
                                  
                                  
                                  Weighted
                                    Average
                                    Exercise
                                    Price$1.10
                                  
                                  
                                  40,000
                                  
                                  
                                  
                                  1.0
                                  
                                  
                                  $
                                  1.10
                                  
                                  
                                  
                                  -
                                  
                                  
                                  $
                                  -From
      $2.50 to $3.50
                                  
                                  
                                  85,000
                                  
                                  
                                  
                                  6.3
                                  
                                  
                                  $
                                  3.15
                                  
                                  
                                  
                                  75,000
                                  
                                  
                                  $
                                  3.14$5.00
                                  
                                  
                                  25,000
                                  
                                  
                                  
                                  6.0
                                  
                                  
                                  $
                                  5.00
                                  
                                  
                                  
                                  15,000
                                  
                                  
                                  $
                                  5.00$7.00
                                  
                                  
                                  75,000
                                  
                                  
                                  
                                  0.0
                                  
                                  
                                  $
                                  7.00
                                  
                                  
                                  
                                  75,000
                                  
                                  
                                  $
                                  7.00From
      $8.61 to $9.00
                                  
                                  
                                  32,500
                                  
                                  
                                  
                                  6.5
                                  
                                  
                                  $
                                  8.73
                                  
                                  
                                  
                                  19,500
                                  
                                  
                                  $
                                  8.73$9.60
                                  
                                  
                                  200
                                  
                                  
                                  
                                  6.5
                                  
                                  
                                  $
                                  9.60
                                  
                                  
                                  
                                  120
                                  
                                  
                                  $
                                  9.60Totals
                                  
                                  
                                  257,700
                                  
                                  
                                  
                                  3.6
                                  
                                  
                                  $
                                  4.84
                                  
                                  
                                  
                                  184,620
                                  
                                  
                                  $
                                  5.46





19





At June
30, 2009, there remains $35,767 of unvested expense yet to be recorded related
to all options outstanding.





Dividends - The Company has
not paid any cash dividends through June 30, 2009.





6.           MAJOR
CUSTOMERS AND CONCENTRATION OF CREDIT RISK





Financial
instruments that potentially subject the Company to credit risk principally
consist of trade receivables. The Company believes the concentration of credit
risk in its trade receivables is substantially mitigated by ongoing credit
evaluation processes, relatively short collection terms, and the nature of the
Company’s customer base, primarily mid- and large-size corporations with
significant financial histories. Collateral is not generally required from
customers. The need for an allowance for doubtful accounts is determined based
upon factors surrounding the credit risk of specific customers, historical
trends, and other information.





A
significant portion of revenues is derived from certain customer relationships.
The following is a summary of customers that represent greater than 10% of total
revenues:





Three Months Ended
                                  June 30, 2009Revenue Type
                                
                                Revenues
                                
                                % of Total
                                  RevenuesCustomer A
                                Subscription fees
                                
                                $
                                558,698
                                
                                67
                                %Customer
      B
                                Professional
      service fees
                                
                                
                                73,049
                                
                                9
                                %Customer
      C
                                Subscription
      fees
                                
                                
                                92,916
                                
                                11
                                %Others
                                Various
                                
                                
                                104,508
                                
                                13
                                %Total
                                
                                
                                $
                                829,171
                                
                                100
                                %





Three Months Ended
                                    June 30, 2008Revenue Type
                                  
                                  Revenues
                                  
                                  % of Total
                                    RevenuesCustomer A
                                  Subscription
      fees
                                  
                                  $
                                  358,607
                                  
                                  21
                                  %Customer
      B
                                  Professional
      service fees
                                  
                                  
                                  307,913
                                  
                                  18
                                  %Customer
      C
                                  Subscription
      fees
                                  
                                  
                                  182,068
                                  
                                  11
                                  %Customer
      D
                                  Professional
      service fees
                                  
                                  
                                  401,805
                                  
                                  23
                                  %Others
                                  Various
                                  
                                  
                                  475,238
                                  
                                  27
                                  %Total
                                  
                                  
                                  $
                                  1,755,631
                                  
                                  100
                                  %





Six Months Ended
                                  June 30, 2009Revenue Type
                                
                                Revenues
                                
                                % of Total
                                  RevenuesCustomer A
                                Subscription
      fees
                                
                                $
                                848,096
                                
                                55
                                %Customer
      B
                                Professional
      service fees
                                
                                
                                222,314
                                
                                14
                                %Customer
      C
                                Subscription
      fees
                                
                                
                                217,354
                                
                                14
                                %Customer
      D
                                Professional
      service fees
                                
                                
                                39,178
                                
                                3
                                %Others
                                Various
                                
                                
                                215,712
                                
                                14
                                %Total
                                
                                
                                $
                                1,542,654
                                
                                100
                                %





Six Months Ended
                                  June 30, 2008Revenue Type
                                
                                Revenues
                                
                                % of Total
                                  RevenuesCustomer A
                                Subscription
      fees
                                
                                $
                                659,941
                                
                                21
                                %Customer
      B
                                Professional
      service fees
                                
                                
                                669,003
                                
                                21
                                %Customer
      C
                                Subscription
      fees
                                
                                
                                398,351
                                
                                13
                                %Customer
      D
                                Professional
      service fees
                                
                                
                                784,996
                                
                                25
                                %Others
                                Various
                                
                                
                                690,503
                                
                                20
                                %Total
                                
                                
                                $
                                3,202,794
                                
                                100
                                %





As of
June 30, 2009, one customer accounted for 80% of accounts receivable. As of
December 31, 2008, one customer accounted for 93% of accounts
receivable.





7.           SUBSEQUENT
EVENTS





On July
16, 2009, the Company sold $250,000 aggregate principal amount of convertible
secured subordinated notes due November 14, 2010 to Atlas with substantially the
same terms and conditions as the previously outstanding notes, as described in
Note 3, “Notes Payable.”





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




On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris.  By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009.   The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $1.9 million. Though the
Nouris have entered into an undertaking that requires them to repay to the
Company any amounts advanced by it in the event the Nouris are ultimately
determined not to be entitled to indemnification for the expenses incurred, it
is uncertain at this time that the Company will be able to recover such amounts
advanced without considerable expense to the Company, or whether the Company
will be able to recover any of the amounts advanced at all.




Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
yearended
December 31, 2008 for a further description of material legal
proceedings.




The
Company is in the process of terminating its Services Agreement relationship
with Vera Bradley.  The fees for services and licensing paid by Vera
Bradley under the Services Agreement were $1,358,892 in 2008
and  $275,111 for the six month period ending June 30,
2009.




20





Item
2.           Management’s
Discussion and Analysis of Financial Condition and Results of
Operations





Information
set forth in this Quarterly Report on Form 10-Q contains various forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, or
the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or
the Exchange Act. Forward-looking statements consist of, among other things,
trend analyses, statements regarding future events, future financial
performance, our plan to build our business and the related expenses, our
anticipated growth, trends in our business, the effect of interest rate
fluctuations on our business, the potential impact of current litigation or any
future litigation, the potential availability of tax assets in the future and
related matters, and the sufficiency of our capital resources, all of which are
based on current expectations, estimates, and forecasts, and the beliefs and
assumptions of our management. Words such as “expect,” “anticipate,” “project,”
“intend,” “plan,” “estimate,” variations of such words, and similar expressions
also are intended to identify such forward-looking statements. These
forward-looking statements are subject to risks, uncertainties, and assumptions
that are difficult to predict. Therefore, actual results may differ materially
and adversely from those expressed in any forward-looking statements. Readers
are directed to risks and uncertainties identified under Part II, Item 1A, “Risk
Factors,” for factors that may cause actual results to be different than
those expressed in these forward-looking statements. Except as required by law,
we undertake no obligation to revise or update publicly any forward-looking
statements for any reason.





The
following discussion is designed to provide a better understanding of our
unaudited financial statements, including a brief discussion of our business and
products, key factors that impacted our performance, and a summary of our
operating results. The following discussion should be read in conjunction with
the unaudited financial statements and the notes thereto included in Part I,
Item 1 of this Quarterly Report on Form 10-Q, and the consolidated financial
statements and notes thereto and Management’s Discussion and Analysis of
Financial Condition and Results of Operations contained in our Annual Report on
Form 10-K for the year ended December 31, 2008. Historical results and
percentage relationships among any amounts in the financial statements are not
necessarily indicative of trends in operating results for any future
periods.





Overview





Through
our OneBizTM platform, we develop and market software products and services
targeted to small businesses that are delivered via a Software-as-a-Service, or
SaaS, model. We also provide website consulting and custom software development
services, primarily in the e-commerce retail and direct-selling organization
industries. We reach small businesses primarily through arrangements with
channel partners that private label our software applications and market them to
their customer bases through their corporate websites. We believe these
relationships provide a cost- and time-efficient way to market to a diverse and
fragmented yet very sizeable small-business sector. We also offer our products
directly to end-user small businesses through our OneBizTM branded
website.





In the
second half of 2007, we commenced an overall evaluation of our business model as
well as our current technologies, the outcome of which was our decision to
develop a core industry-standard platform for small business with an
architecture designed to integrate with a virtually unlimited number of other
applications, services, and existing infrastructures. These applications would
include not only our own small-business applications, which we are currently
optimizing, but also other applications we expect to arise from collaborative
partnerships with third-party developers and service providers. In addition, we
identified emerging-market opportunities in the small-business segment to
leverage social networking and community building. We are currently refining and
integrating these capabilities into the core platform in an effort to meet any
anticipated customer need. We believe that , but cannot assure, this platform
and associated applications will provide opportunities for new sources of
revenue, including an increase in our subscription fees. As we near completion
of the development of our industry-standard platform, as evidenced by the
release of OneBizTM 1.1, we have begun increasing our focus on the sales and
marketing of the new platform.





21





In light
of our new operating strategy involving the industry-standard platform, the
consolidation of all operations into our North Carolina headquarters, and other
factors including certain income tax advantages, we concluded in the latter part
of 2008 that it was no longer necessary to operate with the Smart Commerce, Inc.
and Smart CRM, Inc. subsidiaries. As a result, an upstream merger was completed
as of December 31, 2008 that merged the subsidiaries with the parent
corporation.





Sources
of Revenue





We derive
revenues from the following sources:





·
            Subscription
      fees – monthly fees charged to customers for access to our SaaS
      applications




·
            Professional
      service fees – fees related to consulting services, some of which
      complement our other products and
applications




·
            License
      fees – fees charged for perpetual or term licensing of platforms or
      applications





·
            Hosting
      fees – fees charged to customers for the hosting of platforms or
      applications




·
            Other
      revenue – revenues generated from non-core activities such as maintenance
      fees; original equipment manufacturer, or OEM, contracts; and
      miscellaneous other revenues





Our
current primary focus is to target those established companies that have both a
substantial base of small-business customers as well as a recognizable and
trusted brand name in specific market segments. Our goal is to enter into
partnerships with these established companies whereby they private label our
products and offer them to their small-business customers. We believe, but
cannot assure,  the combination of the magnitude of their customer
bases and their trusted brand names and recognition will help drive our
subscription volume.





Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. Applications for which subscriptions
are available vary from our own internal development to applications provided to
us by  our partners. Subscriptions are generally payable on a monthly
basis and are typically paid via credit card of the individual end user. We are
focusing our efforts on enlisting new channel partners as well as diversifying
with vertical intermediaries in various industries.





We
generate professional service fees from our consulting and custom software
development services. For example, a customer may request that we re-design its
website to better accommodate our products or to improve its own website
traffic. We typically bill professional service fees on a time and material
basis.





License
fees consist of perpetual or term license agreements for the use of the Smart
Online platform or any of our applications.





Because
we retain ownership to our platform and applications, we provide hosting
services to our customers and typically charge a monthly fee based on the number
of users accessing the programs and the bandwidth consumed.





Other
revenue primarily consists of non-core revenue sources such as maintenance fees,
miscellaneous web services, and OEM revenue generated through sales of our
applications bundled with products offered by other manufacturers.





22





Cost
of Revenues





Cost of
revenues primarily is composed of costs related to third-party hosting services,
salaries and associated costs of customer support and professional services
personnel, credit card processing, depreciation of computer hardware and
software used in revenue-producing activities, domain name and e-mail
registrations, and allocated development expenses and general and administrative
overhead.





We
allocate development expenses to cost of revenues based on time spent by
development personnel on revenue-producing customer projects and support
activities. We allocate general and administrative overhead such as rent and
occupancy expenses, depreciation, general office expenses, and insurance to all
departments based on headcount. As such, general and administrative overhead
expenses are reflected in cost of revenues and each operating expense
category.





Operating
Expenses





On July
14, 2009 we launched our new industry-standard platform (OneBizTM 1.1) that
contains relevant applications targeted to small businesses, and we are devoting
resources to the sale and marketing of these SaaS based applications through
both channel partners and direct sales efforts.  Additionally, we have
placed renewed emphasis on marketing our consulting and software development
capabilities (i Mart)to support companies who require sophisticated and complex
e-commerce websites.





Sales and Marketing – Sales
and marketing expenses are composed primarily of costs associated with our sales
and marketing activities and consist of salaries and related compensation costs
of our sales and marketing personnel, travel and other costs, and marketing,
public relations and advertising expenses. Historically, we spent limited funds
on marketing, advertising, and public relations, particularly due to our
business model of partnering with established companies with extensive
small-business customer bases. In June 2008, we engaged a public relations firm
and, as a result, our public relations expenses increased during the latter part
of 2008. As we continue to execute our sales and marketing strategy, we expect
associated costs to increase throughout 2009 due to targeting new partnerships,
development of channel partner enablement programs, advertising campaigns,
additional sales and marketing personnel, and the various percentages of
revenues we may be required to pay to future partners as marketing fees or
pursuant to revenue share arrangements.





Research and Development –
Research and development expenses include costs associated with the development
of new products, enhancements of existing products, and general technology
research. These costs are composed primarily of salaries and related
compensation costs of our research and development personnel as well as outside
consultant costs.





Statement
of Financial Accounting Standard, 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, with costs incurred prior to this
time expensed as research and development. Technological feasibility is
established when all planning, designing, coding, and testing activities that
are necessary to establish that the product can be produced to meet its design
specifications have been completed. Historically, we had not developed detailed
design plans for our SaaS applications, and the costs incurred between the
completion of a working model of these applications and the point at which the
products were ready for general release had been insignificant. As a result of
these factors, combined with the historically low revenue generated by the sale
of the applications that do not support the net realizable value of any
capitalized costs, we continued the expensing of underlying costs as
research and development.





Beginning
in May 2008, we determined that it was strategically desirable to develop an
industry-standard platform and to enhance our current SaaS applications. A
detailed design plan indicated that the product was technologically feasible. In
July 2008, we commenced development, and from that point in time, we have
capitalized all related costs in accordance with SFAS No. 86. Because of
our scalable and secure multi-user architecture, we are able to provide all
customers with a service based on a single version of our application. As a
result, we do not have to maintain multiple versions, which means we don’t have
to incur certain development costs as do those companies who
develop  traditional enterprise software business models. As we
further the development of our new applications throughout 2009, we expect that
future research and development expenses will decrease in both absolute and
relative dollars.





23





General and Administrative
– General and administrative expenses are composed primarily of
costs associated with our executive, finance and accounting, legal, human
resources, and information technology personnel and consist of salaries and
related compensation costs; professional services (such as outside legal counsel
fees, audit, and other compliance costs); depreciation and amortization;
facilities and insurance costs; and travel and other costs. We anticipate
general and administrative expenses will decrease slightly in 2009 as part of
the objectives identified by current management.  However, we may be
obligated to pay a material amount of indemnification costs in 2009 related to
the previously reported Securities and Exchange Commission, or SEC, litigation
against certain former officers and directors described in detail in Part I,
Item 3, “Legal Proceedings,” in our Annual Report on Form 10-K for the year
ended December 31, 2008 and in item 4. Legal Proceedings, above, which would
significantly increase our general and administrative expenses.





Stock-Based Expenses – Our
operating expenses include stock-based expenses related to options, restricted
stock awards, and warrants issued to employees and non-employees. 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
June 2007, we limited the issuance of awards under our 2004 Equity Compensation
Plan, or the 2004 Plan, to awards of restricted or unrestricted stock. In June
2008, we made options available for grant under the 2004 Plan once again,
primarily due to the adversetax
consequences to recipients of restricted stock upon the lapsing of
restrictions.





Critical
Accounting Policies and Estimates





Our
discussion and analysis of financial condition and results of operations are
based upon our financial statements, which we prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues, and expenses and
related disclosures of contingent assets and liabilities. “Critical accounting
policies and estimates” are defined as those most important to the financial
statement presentation and that require the most difficult, subjective, or
complex judgments. We base our estimates on historical experience and on various
other factors that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying value of
assets and liabilities that are not readily apparent from other sources. Under
different assumptions and/or conditions, actual results of operations may
materially differ. We periodically reevaluate our critical accounting policies
and estimates, including those related to revenue recognition, provision for
doubtful accounts, expected lives of customer relationships, useful lives of
intangible assets and property and equipment, provision for income taxes,
valuation of deferred tax assets and liabilities, and contingencies and
litigation reserves. We believe the following critical accounting policies
involve the most significant judgments and estimates used in the preparation of
our financial statements.





Revenue Recognition– We
derive revenue primarily from subscription fees charged to customers accessing
our SaaS applications; professional service fees, consisting primarily of
consulting and custom software development; the perpetual or term licensing of
software platforms or applications; and hosting and maintenance services. These
arrangements may include delivery in multiple-element arrangements if the
customer purchases a combination of products and/or services. Because we
license, sell, lease, or otherwise market computer software, we use the residual
method pursuant to American Institute of Certified Public Accountants Statement
of Position 97-2,Software
Revenue Recognition, or SOP 97-2, as amended. This method allows us to
recognize revenue for a delivered element when such element has vendor specific
objective evidence, or VSOE, of the fair value of the delivered element. If we
cannot determine or maintain VSOE for an element, it could impact revenues, as
we may need to defer all or a portion of the revenue from the multiple-element
arrangement.





24





If
multiple-element arrangements involve significant development, modification, or
customization, or if we determine that certain elements are essential to the
functionality of other elements within the arrangement, we defer revenue until
we provide to the customer all elements necessary to the functionality. The
determination of whether the arrangement involves significant development,
modification, or customization could be complex and require the use of judgment
by our management.





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





1.     persuasive
evidence of an arrangement exists





2.     delivery
has occurred





3.     the
fee is fixed or determinable





4.     collection
is probable





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





Under the
provisions of Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables, we account for consulting, website design fees, and
application development services separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, we recognize revenue as the services are rendered for
time and material contracts, and when milestones are achieved and accepted by
the customer for fixed-price or long-term contracts. The majority of our
consulting service contracts are on a time and material basis, and we typically
bill our customers monthly based upon standard professional service
rates.





Application
development services are typically fixed in price and of a longer term. As such,
we account for them as long-term construction contracts that require us to
recognize revenue based on estimates involving total costs to complete and the
stage of completion. Our assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, we capitalize the associated costs
of such projects and include them in costs in excess of billings on the balance
sheet until such time that we are permitted to recognize revenue.





Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
marketing partners in order to encourage them to market our products and
services to their customers. Subscriptions are generally payable on a monthly
basis and are typically paid via credit card of the individual end user. We
accrue any payments received in advance of the subscription period as deferred
revenue and amortize them over the subscription period. We recognize revenue on
a gross basis in accordance with Emerging Issues Task Force Issue No. 99-19,
Reporting Revenue Gross as a
Principal versus Net as an Agent, when we provide services directly to
end users and revenue-share arrangements exist with our marketing
partners.





Because
our customers generally do not have the contractual right to take possession of
the software we license or market at any time, we recognize revenue on hosting
and maintenance fees as we provide the services in accordance with Emerging
Issues Task Force Issue No. 00-3, Application of AICPA Statement of
Position 97-2 to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.





25





Provision for Doubtful Accounts
– We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability, failure, or refusal of our customers to make
required payments. We evaluate the need for an allowance for doubtful accounts
based on specifically identified amounts that we believe to be potentially
uncollectible. Although we believe that our allowances are adequate, if the
financial conditions of our customers deteriorate, resulting in an impairment of
their ability to make payments, or if we underestimate the allowances required,
additional allowances may be necessary, which will result in increased expense
in the period in which we make such determination.





Impairment of Long-Lived Assets– We record our long-lived assets, such as property and equipment, at
cost. We review the carrying value of our long-lived assets for possible
impairment at the earlier of annually in the fourth quarter or whenever events
or changes in circumstances indicate that the carrying amount of assets may not
be recoverable in accordance with the provisions of SFAS No. 144,
Accounting for the Impairment
or Disposal of Long-Lived Assets. We measure the recoverability of assets
to be held and used by comparing the carrying amount of the asset to future net
undiscounted cash flows expected to be generated by the asset. If we consider
such assets to be impaired, we measure the impairment as the amount by which the
carrying amount exceeds the fair value, and we recognize it as an operating
expense in the period in which the determination is made.





We report
assets to be disposed of at the lower of the carrying amount or fair value less
costs to sell. Although we believe that the carrying values of our long-lived
assets are appropriately stated, changes in strategy or market conditions or
significant technological developments could significantly impact these
judgments and require adjustments to recorded asset balances.





In
addition to the recoverability assessment, we also routinely review the
remaining estimated useful lives of our long-lived assets. Any reduction in the
useful-life assumption will result in increased depreciation and amortization
expense in the period when such determinations are made, as well as in
subsequent periods.





Income Taxes– We are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This involves estimating our current tax liabilities in each
jurisdiction, including the impact, if any, of additional taxes resulting from
tax examinations, as well as making judgments regarding our ability to realize
our deferred tax assets. Such judgments can involve complex issues and may
require an extended period to resolve. In the event we determine that we will
not be able to realize all or part of our net deferred tax assets, we would make
an adjustment in the period we make such determination. We recorded no income
tax expense in the first or second quarter of 2009, or in 2008 and 2007, as we
have experienced significant operating losses to date. If utilized, we may apply
the benefit of our total net operating loss carryforwards to reduce future tax
expense. Since our utilization of these deferred tax assets is dependent on
future profits, which are not assured, we have recorded a valuation allowance
equal to the net deferred tax assets. These carryforwards would also be subject
to limitations, as prescribed by applicable tax laws.





As a
result of prior equity financings and the equity issued in conjunction with
certain acquisitions, we have incurred ownership changes, as defined by
applicable tax laws. Accordingly, our use of the acquired net operating loss
carryforwards may be limited. Further, to the extent that any single-year loss
is not utilized to the full amount of the limitation, such unused loss is
carried over to subsequent years until the earlier of its utilization or the
expiration of the relevant carryforward period.





Results
of Operations for the Three Months Ended June 30, 2009 and June 30,
2008





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




Three Months Ended
                              June 30, 2009
                            
                            
                            Three Months Ended
                              June 30, 2008Dollars
                            
                            
                            % of
                              Revenue
                            
                            
                            Dollars
                            
                            
                            % of
                              RevenueTotal
      revenues
                            
                            $
                            829,171
                            
                            
                            
                            100.0
                            %
                            
                            $
                            1,755,631
                            
                            
                            
                            100.0
                            %Cost
      of revenues
                            
                            
                            202,333
                            
                            
                            
                            69.0
                            %
                            
                            
                            647,528
                            
                            
                            
                            13.1
                            %Gross
      profit
                            
                            $
                            626,838
                            
                            
                            
                            31.0
                            %
                            
                            $
                            1,108,103
                            
                            
                            
                            86.9
                            %Operating
      expenses
                            
                            
                            2,202,532
                            
                            
                            
                            265.6
                            %
                            
                            
                            2,232,752
                            
                            
                            
                            152.1
                            %Loss
      from operations
                            
                            $
                            (1,575,694
                            )
                            
                            
                            -190.0
                            %
                            
                            $
                            (1,124,649
                            )
                            
                            
                            -64.1
                            %Other
      income (expense), net
                            
                            
                            (158,343
                            )
                            
                            
                            -15.7
                            %
                            
                            
                            (177,410
                            )
                            
                            
                            -10.3
                            %Net
      loss
                            
                            $
                            (1,734,037
                            )
                            
                            
                            -209.1
                            %
                            
                            $
                            (1,302,059
                            )
                            
                            
                            -74.2
                            %Net
      loss per common share
                            
                            $
                            (0.07
                            )
                            
                            
                            
                            
                            
                            $
                            (0.07
                            )





26





Revenues





Revenues
for the three months ended June 30, 2009 and 2008 comprise the
following:





Three Months Ended
                        June 30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentSubscription
      fees
                      
                      $
                      668,344
                      
                      
                      $
                      747,068
                      
                      
                      $
                      (78,724
                      )
                      
                      
                      -10.5
                      %Professional
      service fees
                      
                      
                      79,726
                      
                      
                      
                      932,444
                      
                      
                      
                      (852,718
                      )
                      
                      
                      -91.4
                      %License
      fees
                      
                      
                      11,250
                      
                      
                      
                      3,750
                      
                      
                      
                      7,500
                      
                      
                      
                      200.0
                      %Hosting
      fees
                      
                      
                      33,045
                      
                      
                      
                      36,196
                      
                      
                      
                      (3,151
                      )
                      
                      
                      -8.7
                      %Other
      revenue
                      
                      
                      36,806
                      
                      
                      
                      36,173
                      
                      
                      
                      633
                      
                      
                      
                      1.7
                      %Total
      revenues
                      
                      $
                      829,171
                      
                      
                      $
                      1,755,631
                      
                      
                      $
                      (926,460
                      )
                      
                      
                      -52.8
                      %





Revenues
decreased 52.8% to $829,171 for the three months ended June 30, 2009 from
$1,755,631 for the same period in 2008. Our overall decrease in revenues was
driven by substantial declines in subscription fees, professional service fees,
and license fees. Select items are discussed in detail below.





Subscription
Fees





Revenues
from subscription fees for the three months ended June 30, 2009 and 2008 are as
follows:





Three Months Ended
                                                                              June
      30,
                                                                            
                                                                            
                                                                            Change2009
                                                                            
                                                                            
                                                                            2008
                                                                            
                                                                            
                                                                            Dollars
                                                                            
                                                                            
                                                                            PercentSubscription fees
                                                                            
                                                                            $
                                                                            668,344
                                                                            
                                                                            
                                                                            $
                                                                            747,068
                                                                            
                                                                            
                                                                            $
                                                                            (78,724
                                                                            )
                                                                            
                                                                            -10.5
                                                                            %Percent
      of total revenues
                                                                            
                                                                            
                                                                            80.6
                                                                            %
                                                                            
                                                                            
                                                                            42.6
                                                                            %





Revenues
from subscription fees decreased 10.5% to $668,344 for the three months ended
June 30, 2009 from $747,068 for the same period in 2008. This decline is
primarily attributable to the ongoing migration of one direct-selling
organization customer to its own technology solution that has resulted in a
continuous decline in subscription fees.





Professional
Service Fees





Revenues
from professional service fees for the three months ended June 30, 2009 and 2008
are as follows:




Three Months Ended
                        June 30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentProfessional service
      fees
                      
                      $
                      79,726
                      
                      
                      $
                      932,444
                      
                      
                      $
                      (852,718
                      )
                      
                      
                      -91.4
                      %Percent
      of total revenues
                      
                      
                      9.6
                      %
                      
                      
                      53.1
                      %





Revenues
from professional service fees decreased 91% to $79,726 for the three months
ended June 30, 2009 from $932,444 for the same period in 2008. This decrease is
primarily due to a significant decline in web consulting services provided to
customers during the second quarter of 2009.





27




License
Fees





Revenues
from license fees for the three months ended June 30, 2009 and 2008 are as
follows:




Three Months Ended
                        June 30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentLicense fees
                      
                      $
                      11,250
                      
                      
                      $
                      3,750
                      
                      
                      $
                      7,500
                      
                      
                      
                      200.0
                      %Percent
      of total revenues
                      
                      
                      1.4
                      %
                      
                      
                      .2
                      %





Revenues
from license fees increased 200% to $11,250 for the three months ended June 30,
2009 from $3,750 for the same period in 2008. License fee revenue recognized in
the second quarter of 2009 comprised the ratable recognition of a term license
that commenced in June 2008. We expect that license fees will continue to
represent a small percentage of our revenues in the future as we focus on
increasing our subscription fees revenue derived from our SaaS
applications.





Hosting
Fees





Revenues
from hosting fees for the three months ended June 30, 2009 and 2008 are as
follows:




Three
      Months Ended
                        June
      30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentHosting
      fees
                      
                      $
                      33,045
                      
                      
                      $
                      36,196
                      
                      
                      $
                      -3,151
                      
                      
                      
                      -8.7
                      %Percent
      of total revenues
                      
                      
                      4.0
                      %
                      
                      
                      2.1
                      %





Revenues
from hosting fees decreased 8.7% to $33,045 for the three months ended June 30,
2009 from $36,196 for the same period in 2008. This decrease is due to the
reduction of services provided to clients.





Other
Revenue





Revenues
from other sources for the three months ended June 30, 2009 and 2008 are as
follows:




Three Months Ended
                        June 30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentOther
      revenue
                      
                      $
                      36,806
                      
                      
                      $
                      36,173
                      
                      
                      $
                      633
                      
                      
                      
                      1.7
                      %Percent
      of total revenues
                      
                      
                      4.4
                      %
                      
                      
                      2.1
                      %





Revenues
from non-core activities increased 1.7% to $36,806 for the three months ended
June 30, 2009 from $36,173 for the same period in 2008. We expect these revenue
streams to continue to be insignificant in the future as we focus on the growth
of our subscription fees revenue.





Cost
of Revenues





Cost of
revenues for the three months ended June 30, 2009 and 2008 are as
follows:





28


Three Months Ended June 30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentCost
      of revenues
                      
                      $
                      202,333
                      
                      
                      $
                      647,528
                      
                      
                      $
                      (445,195
                      )
                      
                      
                      -68.8
                      %Percent
      of total revenues
                      
                      
                      24.4
                      %
                      
                      
                      36.9
                      %




Cost of
revenues decreased 68.8% to $202,333 for the three months ended June 30, 2009
from $647,528 for the same period in 2008. This decrease is the result of lower
professional services costs associated with professional service fees revenue,
which is generally billed on a time and material basis. In addition, we have
allocated lower amounts of development and general and administrative expenses
as a result of an overall reduction in those areas.





Operating
Expenses





Operating
expenses for the three months ended June 30, 2009 and 2008 comprise the
following:





Three Months Ended
                      June 30,
                    
                    
                    Change2009
                    
                    
                    2008
                    
                    
                    Dollars
                    
                    
                    PercentSales
      and marketing
                    
                    $
                    675,304
                    
                    
                    $
                    772,263
                    
                    
                    $
                    (96,959
                    )
                    
                    
                    -13
                    %Research
      and development
                    
                    
                    226,950
                    
                    
                    
                    458,409
                    
                    
                    
                    (231,459
                    )
                    
                    
                    -51
                    %General
      and administrative
                    
                    
                    862,050
                    
                    
                    
                    1,002,080
                    
                    
                    
                    (140,030
                    )
                    
                    
                    -14
                    %Gain
      (loss) on impairment of assets, net
                    
                    
                    438,228
                    
                    
                    
                    -
                    
                    
                    
                    (438,228
                    )
                    
                    
                    100
                    %Total
      operating expenses
                    
                    $
                    2,202,532
                    
                    
                    $
                    2,232,752
                    
                    
                    $
                    (30,220
                    )
                    
                    
                    -1
                    %





Operating
expenses decreased 1% to $2,202,532 for the three months ended June 30, 2009
from $2,232,752 for the same period in 2008. This decrease is the direct result
of our concerted efforts during the latter part of 2008 and into 2009 to reduce
operating expenses by improving efficiencies and eliminating unnecessary costs
offset by the recognition of loss on the reevaluation of an intangible asset.
Select items are discussed in detail below.





Sales
and Marketing





Sales and
marketing expenses for the three months ended June 30, 2009 and 2008 are as
follows:





Three Months Ended
                  June 30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentSales
      and marketing
                
                $
                675,304
                
                
                $
                772,263
                
                
                $
                (96,959
                )
                
                
                -13
                %Percent
      of total revenues
                
                
                81.4
                %
                
                
                44.0
                %





Sales and
marketing expenses decreased 13% to $675,304 for the three months ended June 30,
2009 from $772,263 for the same period in 2008. This variance is primarily
attributable to reductions  associated with revenue-sharing
arrangements with our channel partners.





Research
and Development





Research
and development expenses for the three months ended June 30, 2009 and 2008 are
as follows:


29




Three Months Ended
                                June 30,
                              
                              
                              Change2009
                              
                              
                              2008
                              
                              
                              Dollars
                              
                              
                              PercentResearch
      and development
                              
                              $
                              226,950
                              
                              
                              $
                              458,409
                              
                              
                              $
                              (231,459
                              )
                              
                              
                              -51
                              %Percent
      of total revenues
                              
                              
                              27.4
                              %
                              
                              
                              26.1
                              %





Research
and development expenses decreased 51% to $226,950 for the three months ended
June 30, 2009 from $458,409 for the same period in 2008. This decrease is
primarily attributable to a reduction in outside contractor fees incurred during
the first quarter of 2008 as we worked on enhancing our business tools and
applications that were not incurred in the first quarter of 2009.





General
and Administrative





General
and administrative expenses for the three months ended June 30, 2009 and 2008
are as follows:





Three Months Ended
                  June 30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentGeneral
      and administrative
                
                $
                862,050
                
                
                $
                1,002,080
                
                
                $
                (140,030
                )
                
                
                -14
                %Percent
      of total revenues
                
                
                104
                %
                
                
                57.1
                %





General
and administrative expenses decreased 14% to $862,050 for the three months ended
June 30, 2009 from $1,002,080 for the same period in 2008. This decrease is
primarily attributable to reductions in personnel costs of $97,000 ;and $67,000
stock-based compensation expense resulting from employee turnover and a decrease
in new equity grants; and $35,000 in rent due to closing of Michigan operations;
and $30,000 in management consulting expenses; and $29,000 reduction in outside
accounting and audit fees; $49,000 reduction in the amount of amortization of
intangible costs. These decreases were offset in part by a net increase of
$189,000 in bad debt expense on trade accounts and notes
receivable.





Gain
(loss) on disposal of assets, net





Gain
(loss) on disposal of assets, net for the three months ended June 30, 2009 and
2008 are as follows:





ThreeMonthsEnded
                  June30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentGain
      (loss)  on impairment of assets, net
                
                $
                (438,228
                )
                
                $
                -
                
                
                $
                (438,226
                )
                
                
                -100
                %Percent
      of total revenues
                
                
                -52.9
                %
                
                
                -
                %





(Loss)
on disposal of assets, net  increased by 100% due to the reevaluation
of certain intangibles assets as of June 30, 2009 and the determination that the
intangible asset no longer had any remaining value.




Other
Income (Expense)





Other
income (expense) for the three months ended June 30, 2009 and 2008 comprise the
following:





ThreeMonthsEnded
                        June30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentInterest
      expense, net
                      
                      $
                      (158,343
                      )
                      
                      $
                      (190,922
                      )
                      
                      $
                      (32,579
                      )
                      
                      
                      -17
                      %Other
      income (expense)
                      
                      
                      -
                      
                      
                      
                      13,512
                      
                      
                      
                      (13,512
                      )
                      
                      
                      -100
                      %Total
      other expense
                      
                      $
                      (158,343
                      )
                      
                      $
                      (177,410
                      )
                      
                      $
                      (19,067
                      )
                      
                      
                      -26
                      %





Net other
expense decreased 26% to $158,343 for the three months ended June 30, 2009
from $177,410 for the same period in 2008. This net decrease was primarily
attributable to the net reduction of interest expense at June 30,
2009.





Interest
Expense, Net





Interest
expense, net of interest income, for the three months ended June 30, 2009 and
2008 is as follows:


30




ThreeMonthsEnded
                  June30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentInterest
      expense, net
                
                $
                158,343
                
                
                $
                190,922
                
                
                $
                (32,579
                )
                
                
                -17
                %Percent
      of total revenues
                
                
                19.1
                %
                
                
                10.9
                %





Net
interest expense decreased 17% to $158,343 for the three months ended June 30,
2009 from $190,922 for the same period in 2008. This decrease is primarily
associated with the $113,000 of interest expense recognized in the second
quarter of 2008 relating to the warrants issued to Atlas Capital SA, or Atlas,
in connection with the extension of our line of credit with Wachovia Bank, NA,
or Wachovia, that was fully amortized by the end of 2008, offset in part by an
increase in convertible bond interest due to additional borrowings of
$81,000.





Results
of Operations for the Six Months Ended June 30, 2009 and June 30,
2008





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




Six Months Ended
                  June 30, 2009
                
                
                Six Months Ended
                  June 30, 2008Dollars
                
                
                % of
                  Revenue
                
                
                Dollars
                
                
                % of
                  RevenueTotal
      revenues
                
                $
                1,542,654
                
                
                
                100.0
                %
                
                $
                3,202,794
                
                
                
                100.0
                %Cost
      of revenues
                
                
                694,934
                
                
                
                45.0
                %
                
                
                1,359,195
                
                
                
                42.4
                %Gross
      profit
                
                $
                847,720
                
                
                
                55.0
                %
                
                $
                1,843,599
                
                
                
                57.6
                %Operating
      expenses
                
                
                3,896,067
                
                
                
                252.6
                %
                
                
                4,623,374
                
                
                
                144.4
                %Loss
      from operations
                
                $
                (3,048,347
                )
                
                
                -197.69
                %
                
                $
                (2,779,775
                )
                
                
                -86.8
                %Other
      income (expense), net
                
                
                (280,342
                )
                
                
                -18.2
                %
                
                
                (353,167
                )
                
                
                -11.0
                %Net
      loss
                
                $
                (3,328,689
                )
                
                
                -215.8
                %
                
                $
                (3,132,942
                )
                
                
                -97.8
                %Net
      loss per common share
                
                $
                (0.17
                )
                
                
                
                
                
                $
                (0.15
                )




31





Revenues





Revenues
for the six months ended June 30, 2009 and 2008 comprise the
following:





Six Months Ended
                                                June 30,
                                              
                                              
                                              Change2009
                                              
                                              
                                              2008
                                              
                                              
                                              
                                              Dollars
                                              
                                              
                                              PercentSubscription
      fees
                                              
                                              $
                                              1,141,923
                                              
                                              
                                              $
                                              1,489,907
                                              
                                              
                                              $
                                              (347,984
                                              )
                                              
                                              -23.4
                                              %Professional
      service fees
                                              
                                              
                                              198,499
                                              
                                              
                                              
                                              1,436,527
                                              
                                              
                                              
                                              (1,238,028
                                              )
                                              
                                              -86.2
                                              %License
      fees
                                              
                                              
                                              22,500
                                              
                                              
                                              
                                              103,750
                                              
                                              
                                              
                                              (81,250
                                              )
                                              
                                              -78.3
                                              %Hosting
      fees
                                              
                                              
                                              105,255
                                              
                                              
                                              
                                              95,678
                                              
                                              
                                              
                                              9,577
                                              
                                              
                                              10.0
                                              %Other
      revenue
                                              
                                              
                                              74,477
                                              
                                              
                                              
                                              76,932
                                              
                                              
                                              
                                              (2,455
                                              )
                                              
                                              -3.2
                                              %Total
      revenues
                                              
                                              $
                                              1,542,654
                                              
                                              
                                              $
                                              3,202,794
                                              
                                              
                                              $
                                              (1.660,140
                                              )
                                              
                                              -51.8
                                              %





Revenues
decreased 51.8% to $1,542,654 for the six months ended June 30, 2009 from
$3,202,794 for the same period in 2008. Our overall decrease in revenues was
driven by substantial declines in subscription fees, professional service fees,
and license fees. Select items are discussed in detail below.





Subscription
Fees





Revenues
from subscription fees for the six months ended June 30, 2009 and 2008 are as
follows:




Six Months Ended
                        June30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentSubscription fees
                      
                      $
                      1,141,923
                      
                      
                      $
                      1,489,907
                      
                      
                      $
                      (347,984
                      )
                      
                      
                      -23.4
                      %Percent
      of total revenues
                      
                      
                      74.0
                      %
                      
                      
                      46.5
                      %




Revenues
from subscription fees decreased 23.4% to $1,141,923 for the six months ended
June 30, 2009 from $1,489,907 for the same period in 2008. This decline is
primarily attributable to the ongoing migration of one direct-selling
organization customer to its own technology solution that has resulted in a
continuous decline in subscription fees.





Professional
Service Fees





Revenues
from professional service fees for the six months ended June 30, 2009 and 2008
are as follows:




Six Months Ended
                    June 30,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentProfessional service
      fees
                  
                  $
                  198,499
                  
                  
                  $
                  1,436,527
                  
                  
                  $
                  (1,238,028
                  )
                  
                  
                  -86.2
                  %Percent
      of total revenues
                  
                  
                  12.9
                  %
                  
                  
                  44.9
                  %


Revenues
from professional service fees decreased 86.2% to $198,499 for the six months
ended June 30, 2009 from $1,436,527 for the same period in 2008. This decrease
is primarily due to a significant decline in web consulting services provided to
customers during the second quarter of 2009.


32




License
Fees





Revenues
from license fees for the six months ended June 30, 2009 and 2008 are as
follows:





Six Months Ended
                              June 30,
                            
                            
                            Change2009
                            
                            
                            2008
                            
                            
                            Dollars
                            
                            
                            PercentLicense fees
                            
                            $
                            22,500
                            
                            
                            $
                            103,750
                            
                            
                            $
                            (81,250
                            )
                            
                            
                            -78.3
                            %Percent
      of total revenues
                            
                            
                            12.9
                            %
                            
                            
                            44.9
                            %





Revenues
from license fees decreased 78.3% to $22,500 for the six months ended June 30,
2009 from $103,750 for the same period in 2008. License fee revenue recognized
in the first and second quarter of 2009 comprised the ratable recognition of a
term license that commenced in June 2008. We expect that license fees will
continue to represent a small percentage of our revenues in the future as we
focus on increasing our subscription fees revenue derived from our SaaS
applications.





Hosting
Fees





Revenues
from hosting fees for the six months ended June 30, 2009 and 2008 are as
follows:




Six Months
      Ended
                        June
      30,
                      
                      
                      Change2009
                      
                      
                      2008
                      
                      
                      Dollars
                      
                      
                      PercentHosting
      fees
                      
                      $
                      105,225
                      
                      
                      $
                      95,678
                      
                      
                      $
                      9,547
                      
                      
                      
                      10.0
                      %Percent
      of total revenues
                      
                      
                      6.8
                      %
                      
                      
                      3.0
                      %




Revenues
from hosting fees increased 10% to $105,255 for the six months ended June 30,
2009 from $95,678 for the same period in 2008. This increase is due to the
additional customer traffic for clients.





Other
Revenue





Revenues
from other sources for the six months ended June 30, 2009 and 2008 are as
follows:





Six Months Ended
                  June 30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentOther
      revenue
                
                $
                74,477
                
                
                $
                76,932
                
                
                $
                (2,455
                )
                
                
                -3.2
                %Percent
      of total revenues
                
                
                4.8
                %
                
                
                2.4
                %





Revenues
from non-core activities decreased 3.2% to $74,477 for the six months ended June
30, 2009 from $76,932 for the same period in 2008. We expect these revenue
streams to continue to be insignificant in the future as we focus on the growth
of our subscription fees revenue.





Cost
of Revenues





Cost of
revenues for the six months ended June 30, 2009 and 2008 are as
follows:


33




Six Months Ended
                          June 30,
                        
                        
                        Change2009
                        
                        
                        2008
                        
                        
                        Dollars
                        
                        
                        PercentCost
      of revenues
                        
                        $
                        694,934
                        
                        
                        $
                        1,359,195
                        
                        
                        $
                        (664,261
                        )
                        
                        
                        -48.9
                        %Percent
      of total revenues
                        
                        
                        45.0
                        %
                        
                        
                        42.4
                        %





Cost of
revenues decreased 48.9% to $694,934 for the six months ended June 30, 2009 from
$1,359,195 for the same period in 2008. This decrease is the result of lower
professional services costs associated with professional service fees revenue,
which is generally billed on a time and material basis. In addition, we have
allocated lower amounts of development and general and administrative expenses
as a result of an overall reduction in those areas.





Operating
Expenses





Operating
expenses for the six months ended June 30, 2009 and 2008 comprise the
following:





Six Months Ended
                      June 30,
                    
                    
                    Change2009
                    
                    
                    2008
                    
                    
                    Dollars
                    
                    
                    PercentSales
      and marketing
                    
                    $
                    1,206,640
                    
                    
                    $
                    1,467,488
                    
                    
                    $
                    (260,848
                    )
                    
                    
                    -18
                    %Research
      and development
                    
                    
                    503,826
                    
                    
                    
                    910,533
                    
                    
                    
                    (406,707
                    )
                    
                    
                    -45
                    %General
      and administrative
                    
                    
                    1,757,640
                    
                    
                    
                    2,245,353
                    
                    
                    
                    (487,713
                    )
                    
                    
                    -22
                    %Gain
      (loss) on impairment of assets, net
                    
                    
                    427,961
                    
                    
                    
                    -
                    
                    
                    
                    427,961
                    
                    
                    
                    -100Total
      operating expenses
                    
                    $
                    3,896,067
                    
                    
                    $
                    4,623,374
                    
                    
                    $
                    (727,307
                    )
                    
                    
                    -16
                    %





Operating
expenses decreased 16% to $3,896,067 for the six months ended June 30, 2009 from
$4,623,374 for the same period in 2008. This decrease is the direct result of
our concerted efforts during the latter part of 2008 and into 2009 to reduce
operating expenses by improving efficiencies and eliminating unnecessary costs
offset by the recognition of loss on the reevaluation of an intangible asset.
Select items are discussed in detail below.





Sales
and Marketing





Sales and
marketing expenses for the six months ended June 30, 2009 and 2008 are as
follows:





Six Months Ended
                  June 30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentSales
      and marketing
                
                $
                1,206,640
                
                
                $
                1,467,488
                
                
                $
                (260,848
                )
                
                
                -18
                %Percent
      of total revenues
                
                
                78.2
                %
                
                
                45.8
                %





Sales and
marketing expenses decreased 18% to $1,206,640 for the six months ended June 30,
2009 from $1,467,488 for the same period in 2008. This variance is primarily
attributable to reductions associated with revenue-sharing arrangements with our
channel partners.





Research
and Development





Research
and development expenses for the six months ended June 30, 2009 and 2008 are as
follows:


34




SixMonthsEnded
                      June30,
                    
                    
                    Change2009
                    
                    
                    2008
                    
                    
                    Dollars
                    
                    
                    PercentResearch
      and development
                    
                    $
                    503,826
                    
                    
                    $
                    910,533
                    
                    
                    $
                    (406,707
                    )
                    
                    
                    -45
                    %Percent
      of total revenues
                    
                    
                    32.7
                    %
                    
                    
                    28.4
                    %





Research
and development expenses decreased 45% to $503,829 for the six months ended June
30, 2009 from $910,533 for the same period in 2008. This decrease is primarily
attributable to a reduction in outside contractor fees incurred during the first
and second quarter of 2008 as we worked on enhancing our business tools and
applications that were not incurred in the first and second quarter of
2009.





General
and Administrative





General
and administrative expenses for the six months ended June 30, 2009 and 2008 are
as follows:





SixMonthsEnded
                  June30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentGeneral
      and administrative
                
                $
                1,757,640
                
                
                $
                2,245,353
                
                
                $
                (487,713
                )
                
                
                -22
                %Percent
      of total revenues
                
                
                113.9
                %
                
                
                70.11
                %





General
and administrative expenses decreased 22% to $1,757,640 for the six months ended
June 30, 2009 from $2,245,353 for the same period in 2008. This decrease is
primarily attributable to reductions in personnel costs of $498,000;and $35,000
stock-based compensation expense resulting from employee turnover and a decrease
in new equity grants; and $69,000 in rent due to closing of Michigan operations;
and $30,000 in management consulting expenses; and $101,000 reduction in outside
accounting and audit fees; $98,000 reduction in the amount of amortization of
intangible costs. These decreases were offset in part by a net increase of
$377,000 in bad debt expense on trade accounts and notes
receivable.





Gain
(loss) on disposal of assets, net





Gain
(loss) on impairment of assets, net for the six months ended June 30, 2009 and
2008 are as follows:





SixMonthsEnded
                  June30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentGain
      (loss)  on impairment of assets, net
                
                $
                (427,961
                )
                
                $
                -
                
                
                $
                (438,226
                )
                
                
                -100
                %Percent
      of total revenues
                
                
                -27.7
                %
                
                
                -
                %





(Loss)
on disposal of assets, net  increased by 100% due to the reevaluation
of certain intangibles assets as of June 30, 2009 and the determination that the
intangible asset no longer had any remaining value.





Other
Income (Expense)





Other
income (expense) for the six months ended June 30, 2009 and 2008 comprise the
following:





SixMonthsEnded
                    June30,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentInterest
      expense, net
                  
                  $
                  (286,342
                  )
                  
                  $
                  (369,236
                  )
                  
                  $
                  82,894
                  
                  
                  
                  -23
                  %Gain
      on legal settlements, net
                  
                  
                  6,0000
                  
                  
                  
                  -
                  
                  
                  
                  (6,000
                  ))
                  
                  
                  100
                  %Other
      income (expense)
                  
                  
                  -
                  
                  
                  
                  16,069
                  
                  
                  
                  16,069
                  
                  
                  
                  -100
                  %Total
      other expense
                  
                  $
                  (280,342
                  )
                  
                  $
                  (353,167
                  )
                  
                  $
                  (72,825
                  )
                  
                  
                  -21
                  %





Net other
expense decreased 21% to $280,342 for the six months ended June 30, 2009
from $353,167 for the same period in 2008. This net decrease was primarily
attributable to the net reduction in interest expense for the six months ending
June 30, 2009.





Interest
Expense, Net





Interest
expense, net of interest income, for the six months ended June 30, 2009 and 2008
is as follows:


35




SixMonthsEnded
                  June30,
                
                Change2009
                
                
                2008
                
                Dollars
                
                
                PercentInterest
      expense, net
                
                $
                286,342
                
                
                $
                369,236
                
                
                $
                (82,894
                )
                
                
                -23
                %Percent
      of total revenues
                
                
                18.6
                %
                
                
                11.5
                %





Net
interest expense decreased 23% to $286,342 for the six months ended June 30,
2009 from $369,236 for the same period in 2008. This decrease is primarily
associated with the $226,000 of interest expense recognized in the first and
second quarter of 2008 relating to the warrants issued to Atlas Capital SA, or
Atlas, in connection with the extension of our line of credit with Wachovia
Bank, NA, or Wachovia, that was fully amortized by the end of 2008, offset in
part by an increase in convertible bond interest due to additional borrowings of
$125,000 and additional interest expense of $25,000 paid to Paragon National
Bank on the funds borrowed on the line of credit.





Provision
for Income Taxes





We have
not recorded a provision for income tax expense because we have been generating
net losses. Furthermore, we have not recorded an income tax benefit for the
first or second quarter of 2009 primarily due to continued substantial
uncertainty based on objective evidence regarding our ability to realize our
deferred tax assets, thereby warranting a full valuation allowance in our
financial statements. We have approximately $49.0 million in net operating loss
carryforwards, which may be utilized to offset future taxable
income.





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





Liquidity
and Capital Resources





Overview





As of
June 30, 2009, our principal sources of liquidity were cash and cash equivalents
totaling $33,000 and current accounts receivable of $28,000, as compared to
$19,000 of cash and cash equivalents and $185,000 in accounts receivable as of
December 31, 2008. We maintain a low cash balance because of automated sweeps
among our accounts at Paragon whereby all available cash at the end of each day
is used to pay down our line of credit with Paragon, the purpose of which is to
reduce our interest expense. As of June 30, 2009, we had drawn approximately
$1,894,000 on the $2,470,000 line of credit, leaving approximately $576,000
available under the line of credit for our operations. Deferred revenue at June
30, 2009 was $303,000 as compared to $391,000 at December 31, 2008.





As of
August 10, 2009, our principal sources of liquidity were cash and cash
equivalents totaling approximately $48,000 and accounts receivable of
approximately $18,000. In addition, we had drawn approximately $2,160,000 on the
Paragon line of credit, leaving approximately $310,000 available under the line
of credit for operations. As of August 10 , 2009, we also have a commitment from
our convertible secured subordinated noteholders to purchase up to an additional
$7.75 million in convertible notes upon approval and call by our Board of
Directors.





Cash
Flows





During
the six months ended June 30, 2009, our working capital deficit increased by
approximately $259,000 to $3,248,000 from a working capital deficit of
$2,989,000 at December 31, 2008. As described more fully below, the working
capital deficit at June 30, 2009 is primarily attributable to negative cash
flows from operations, offset in part by net debt borrowings.


36




Cash
Flows from Operating Activities





SixMonthsEnded
                  June30,
                
                
                Change2009
                
                
                2008
                
                
                Dollars
                
                
                PercentNet
      cash used in operating activities
                
                $
                1,370,374
                
                
                $
                2,840,303
                
                
                $
                (1,469,929
                )
                
                
                -59
                %





Net cash
used in operating activities decreased 59% to $1,370,375 for the six months
ended June 30, 2009 from $2,840,303 for the same period in 2008. This decrease
is primarily attributable an increase in bad debt expense, recognition of the
impairment of intangible assets, increase in accounts payable. These items are
offset in part by an increase in short term notes receivable and decrease in
deferred revenue.





Cash
Flows from Investing Activities





SixMonthsEnded
                  June30,
                
                
                Change2009
                
                
                2008
                
                
                Dollars
                
                
                PercentNet
      cash provided by (used in) investing activities
                
                $
                (182,028
                )
                
                $
                (49,300
                )
                
                $
                (132,728
                )
                
                
                269.6
                %





Net cash
used in investing activities increased 269.6% to $182,027 for the six months
ended June 30, 2009 from $49,300 for the same period in 2008. This net use of
cash is attributable to the capitalization of software costs related to our new
industry-standard platform that we commenced in the latter part of 2008, offset
in part by proceeds from the sale of equipment to a customer.





Cash
Flows from Financing Activities





SixMonthsEnded
                  June30,
                
                
                Change2009
                
                
                2008
                
                
                Dollars
                
                
                PercentNet
      cash provided by (used in) financing activities
                
                $
                1,566,511
                
                
                $
                (401,311
                )
                
                $
                1,967,822
                
                
                
                490
                %





Net cash
provided by financing activities increased 490% to $1,566,511 for the six months
ended June 30, 2009 from net cash used in financing activities of $401,311 for
the same period in 2008. This net source of cash is primarily due to net debt
borrowings in the first and second quarters of 2009 versus the repayment of the
Wachovia line of credit in the first quarter of 2008, as described
below.





The net
cash for the second quarter of 2009 from our financing activities was generated
through debt financing, as described below.





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





On
February 20, 2008, we entered into a revolving credit arrangement with Paragon
that is renewable on an annual basis subject to mutual approval. The line of
credit advanced by Paragon is $2.47 million and can be used for general working
capital. Any advances made on the line of credit were to be paid off no later
than February 19, 2009, subject to extension due to renewal, with monthly
payments being applied first to accrued interest and then to principal. The
interest accrued on the unpaid principal balance at the Wall Street Journal’s
published Prime Rate minus one half percent. The line of credit is secured by an
irrevocable standby letter of credit in the amount of $2.5 million issued by
HSBC with Atlas as account party, expiring February 18, 2010. We also have
agreed with Atlas that in the event of our default in the repayment of the line
of credit that results in the letter of credit being drawn, we will reimburse
Atlas any sums that Atlas is required to pay under such letter of credit. At our
sole discretion, these payments may be made in cash or by issuing shares of our
common stock at a set per-share price of $2.50.


37




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





On
February 19, 2009, we renewed our revolving credit arrangement with Paragon. Any
advances made on the line of credit must be paid off no later than February 11,
2010. Interest shall accrue on the unpaid principal balance at the Wall Street
Journal's published Prime Rate, but at no time shall the interest rate be less
than 5.5%.





As of
June 30, 2009, we had $7.3 million aggregate principal amount of convertible
secured subordinated notes due November 14, 2010, or the notes, outstanding.
 On November 14, 2007, in an initial closing, we sold $3.3 million
aggregate principal amount of notes, or the initial notes. In addition, the
noteholders committed to purchase on a pro rata basis up to $5.2 million
aggregate principal amount of notes in future closings upon approval and call by
our Board of Directors. On August 12, 2008, we exercised our option to sell $1.5
million aggregate principal amount of notes with substantially the same terms
and conditions as the initial notes, or the additional notes. In connection with
the sale of the additional notes, the noteholders holding a majority of the
aggregate principal amount of the notes then outstanding agreed to increase the
aggregate principal amount of notes that they are committed to purchase from
$8.5 million to $15.3 million. On November 21, 2008, we sold $500,000 aggregate
principal amount of notes, or the new notes, to two new investors with
substantially the same terms and conditions as the previously outstanding notes.
On each of January 6, 2009 and February 24, 2009, we sold $500,000 aggregate
principal amount of notes to a current noteholder with substantially the same
terms and conditions as the previously outstanding notes.  Additional
notes with similar terms of $500,000 each were sold on April 3, 2009 and June 2,
2009.





On July
16, 2009 the Company sold a $250,000 principal amount note to a current
shareholder with substantially the same terms and conditions as the previously
outstanding notes.





Also on
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that we may sell up to $6 million
aggregate principal amount of notes to new investors or existing noteholders at
any time on or before December 31, 2009 with a maturity date of November 14,
2010 or later. In addition, the maturity date definition for each of the notes
was changed from November 14, 2010 to the date upon which the note is due and
payable, which is the earlier of (1) November 14, 2010, (2) a change of control,
or (3) if an event of default occurs, the date upon which noteholders accelerate
the indebtedness evidenced by the notes.





The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and set at the lowest “applicable conversion
price,” as described below.





We are
obligated to pay interest on the notes at an annualized rate of 8% payable in
quarterly installments commencing three months after the purchase date of the
notes. We are not permitted to prepay the notes without approval of the holders
of at least a majority of the principal amount of the notes then
outstanding.





On the
earlier of November 14, 2010 or a merger or acquisition or other transaction
pursuant to which our existing stockholders hold less than 50% of the surviving
entity, or the sale of all or substantially all of our assets, or similar
transaction, or event of default, each noteholder in its sole discretion shall
have the option to:





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





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





38




If a
noteholder elects to convert its notes under these circumstances, the conversion
price will be the lowest “applicable conversion price” determined for each note.
The “applicable conversion price” for each note shall be calculated by
multiplying 120% by the lowest of:





·
            the average of the high and low
      prices of our common stock on the OTC Bulletin Board averaged over the
      five trading days prior to the closing date of the issuance of such
      note,





·
            if our common stock is not traded
      on the Over-The-Counter market, the closing price of the common stock
      reported on the Nasdaq National Market or the principal exchange on which
      the common stock is listed, averaged over the five trading days prior to
      the closing date of the issuance of such note,
  or





·
            the closing price of our common
      stock on the OTC Bulletin Board, the Nasdaq National Market or the
      principal exchange on which the common stock is listed, as applicable, on
      the trading day immediately preceding the date such note is
      converted,





in each
case as adjusted for stock splits, dividends or combinations, recapitalizations
or similar events.





Payment
of the notes will be automatically accelerated if we enter voluntary or
involuntary bankruptcy or insolvency proceedings.





The notes
and the common stock into which they may be converted have not been registered
under the Securities Act or the securities laws of any other jurisdiction. As a
result, offers and sales of the notes were made pursuant to Regulation D of the
Securities Act and only made to accredited investors. The investors in the
initial notes include (i) The Blueline Fund, which originally recommended
Philippe Pouponnot, one of our former directors, for appointment to the Board of
Directors; (ii) Atlas, an affiliate that originally recommended Shlomo Elia, one
of our current directors, for appointment to the Board of Directors; (iii)
Crystal Management Ltd., which is owned by Doron Roethler, who subsequently
became Chairman of our Board of Directors and Interim President and Chief
Executive Officer until May 19, 2009 and serves as the noteholders’ bond
representative; and (iv) William Furr, who is the father of Thomas Furr, who, at
the time, was one of our directors and executive officers. The investors in the
additional notes are Atlas and Crystal Management Ltd. The investors in the new
notes are not affiliated with the Company. Atlas purchased the notes issued in
2009.





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





We have
not yet achieved positive cash flows from operations, and our main sources of
funds for our operations are the sale of securities in private placements, the
sale of additional convertible secured subordinated notes, and bank lines of
credit. We must continue to rely on these sources until we are able to generate
sufficient cash from revenues to fund our operations. We believe that
anticipated cash flows from operations, funds available from our existing line
of credit, and additional issuances of notes, together with cash on hand, will
provide sufficient funds to finance our operations at least for the next 12 to
18 months, depending on our ability to achieve strategic goals outlined in our
annual operating budget that is approved by our Board of Directors. Changes in
our operating plans, lower than anticipated sales, increased expenses, or other
events may cause us to seek additional equity or debt financing in future
periods. There can be no guarantee that financing will be available on
acceptable terms or at all. Additional equity financing could be dilutive to the
holders of our common stock, and additional debt financing, if available, could
impose greater cash payment obligations and could require additional covenants
and operating restrictions.  In addition existing indemnification
obligations in favor of certain former officer and employees will put further
strain on the cash flow of the Company (see item 4 Legal
Proceedings.)




39




Going
Concern





Our
independent registered public accountants for fiscal 2008 have issued an
explanatory paragraph in their report included in our Annual Report on Form 10-K
for the year ended December 31, 2008 in which they express substantial doubt as
to our ability to continue as a going concern. The financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or the amounts or classification of liabilities that
might be necessary should we be unable to continue as a going concern. Our
continuation as a going concern depends on our ability to generate sufficient
cash flows to meet our obligations on a timely basis, to obtain additional
financing that is currently required, and ultimately to attain profitable
operations and positive cash flows. There can be no assurance that our efforts
to raise capital or increase revenue will be successful. If our efforts are
unsuccessful, we may have to cease operations and liquidate our
business.





Recent
Developments





On July
16, 2009, the Company sold $250,000 aggregate principal amount of convertible
secured subordinated notes due November 14, 2010 to Atlas with substantially the
same terms and conditions as the previously outstanding notes, as described in
Note 3, “Notes Payable.”





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




On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris.  By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009.   The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $1.9 million. Though the
Nouris have entered into an undertaking that requires them to repay to the
Company any amounts advanced by it in the event the Nouris are ultimately
determined not to be entitled to indemnification for the expenses incurred, it
is uncertain at this time that the Company will be able to recover such amounts
advanced without considerable expense to the Company, or whether the Company
will be able to recover any of the amounts advanced at all.




Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2008 for a further description of material legal
proceedings. .





Item 3.
            Quantitative and Qualitative
      Disclosures About Market
Risk




Not
applicable.





Item
      4.
            Controls
      and Procedures





Not
applicable.





Item
      4T.
            Controls
      and Procedures





Our
management, with the participation of our  interim Chief Executive
Officer has evaluated the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this Quarterly Report on Form
10-Q. The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and
other procedures of a company that are designed to ensure that information
required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported, within
the time periods specified in the SEC’s rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the company’s management, including its principal executive and principal
financial officers, as appropriate to allow timely decisions regarding required
disclosure. Management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, as ours are designed to do, and
management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based on such evaluation, our
Interim Chief Executive Officer and Interim Chief Financial Officer concluded
that, as of the end of the period covered by this Quarterly Report on Form 10-Q,
our disclosure controls and procedures were effective at the reasonable
assurance level.





We
routinely review our internal control over financial reporting and from time to
time make changes intended to enhance the effectiveness of our internal control
over financial reporting. We will continue to evaluate the effectiveness of our
disclosure controls and procedures and internal control over financial reporting
on an ongoing basis and will take action as appropriate. There have been no
changes to our internal control over financial reporting, as such term is
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, during the
three months ended June 30, 2009 that we believe materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.


40


PART
II – OTHER INFORMATION





Item
1.           Legal
Proceedings





Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2008 for a description of material legal
proceedings.





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




On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris.  By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009.   The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $1.9 million, which amount
has been included in the accounts payable of the Company as of June 30,
2009.  A current note receivable is recorded for the same amount due
from the individuals. Though the Nouris have entered into an undertaking that
requires them to repay to the Company any amounts advanced by it in the event
the Nouris are ultimately determined not to be entitled to indemnification for
the expenses incurred, it is uncertain at this time that the Company will be
able to recover such amounts advanced without considerable expense to the
Company, or whether the Company will be able to recover any of the amounts
advanced at all.




Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2008 for a further description of material legal
proceedings.





Item
1A.        Risk Factors




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. If any of these
risks actually occur, our business, financial condition, or results of
operations could be materially and adversely affected.





Historically,
we have operated at a loss, and we continue to do so.





We have
had recurring losses from operations and continue to have negative cash flows.
If we do not become cash flow positive through additional financing or growth,
we may have to cease operations and liquidate our business. Our working capital,
including our revolving line of credit with Paragon and convertible note
financing should fund our operations for the next 12 to 18 months. As of August
10, 2009, we have approximately $310,000 available on our line of credit and
$7.75 million available through our convertible note financing. 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 by the SEC and the United States
Attorney General, and the pending shareholder class action lawsuit 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 and may
not be able to sustain our business.





In
addition, our current primary credit facilities consisting of the Paragon line
of credit and the convertible note financing both have maturity dates in 2010.
Should we be unable to repay the principal then due from operations or from new
or renegotiated capital funding sources, we may not be able to sustain our
business. As of August 10, 2009, we have approximately $2.16 million outstanding
on our line of credit and $7.55 million aggregate principal amount of
convertible notes outstanding.





Our
independent registered public accountants for fiscal 2008 indicated that they
have substantial doubts that we can continue as a going concern. Their opinion
may negatively affect our ability to raise additional funds, among other things.
If we fail to raise sufficient capital, we will not be able to implement our
business plan, we may have to liquidate our business, and you may lose your
investment.





Sherb
& Co., LLP, our independent registered public accountants for fiscal 2008,
has expressed substantial doubt in their report included with our Annual Report
on Form 10-K for the year ended December 31, 2008 about our ability to continue
as a going concern given our recurring losses from operations and deficiencies
in working capital and equity, which are described in the first risk factor
above. This opinion could materially limit our ability to raise additional funds
by issuing new debt or equity securities or otherwise. If we fail to raise
sufficient capital, we will not be able to implement our business plan, we may
have to liquidate our business, and you may lose your investment. You should
consider our independent registered public accountants’ comments when
determining if an investment in us is suitable.


41





Current
economic uncertainties in the global economy could adversely impact our growth,
results of operations, and our ability to forecast future business.




Since
2008, there has been a downturn in the global economy, slower economic activity,
decreased consumer confidence, reduced corporate profits and capital spending,
adverse business conditions, and liquidity concerns. These conditions make it
difficult for our customers and us to accurately forecast and plan future
business activities, and they could cause our customers to slow or defer
spending on our products and services, which would delay and lengthen sales
cycles, or change their willingness to enter into longer-term licensing and
support arrangements with us. Furthermore, during challenging economic times our
customers may face issues gaining timely access to sufficient credit, which
could result in an impairment of their ability to make timely payments to us. If
that were to occur, we may be required to increase our allowance for doubtful
accounts and our results would be negatively impacted.




We may
also face difficulties in obtaining additional credit or renewing existing
credit at favorable terms, or at all, which could impact our ability to fund our
operations or to meet debt repayment requirements as they come due.




We cannot
predict the timing, strength, or duration of any economic slowdown or subsequent
economic recovery. If the downturn in the general economy or markets in which we
operate persists or worsens from present levels, our business, financial
condition, and results of operations could be materially and adversely
affected.





Our
business is dependent upon the development and market acceptance of our
applications.




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, whether 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. 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.





We
have not yet demonstrated that we have a successful business model.





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 we and other software vendors 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. 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 marketing
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. Although we currently have various agreements and continue to
solicit new agreements, our success depends in part on the ultimate success of
our marketingpartners
and referral partners and their ability to market our products and services
successfully. Our partners are not obligated to provide potential customers to
us and may have difficulty retaining customers within certain markets that we
serve. 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.


42


In
addition, our end users currently do not sign long-term contracts. They have no
obligation to renew their subscriptions for our services after the expiration of
their initial subscription period and, in fact, they have often elected not to
do so. Our end users also may renew for a lower-priced edition of our services
or for fewer users. 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 their dissatisfaction with our
services, and their capability to continue their operations and sustain their
spending levels. 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.





Failure
to comply with the provisions of our debt financing arrangements could have a
material adverse effect on us.





Our
revolving line of credit from Paragon is secured by an irrevocable standby
letter of credit issued by HSBC with Atlas as account party. Our convertible
secured subordinated notes are secured by a first priority lien on all of our
unencumbered assets.





If an
event of default occurs under our debt financing arrangements and remains
uncured, then the lender could foreclose on the assets securing the debt. If
that were to occur, it would have a substantial adverse effect on our business.
In addition, making the principal and interest payments on these debt
arrangements may drain our financial resources or cause other material harm to
our business.





If
our security measures are breached and unauthorized access is obtained to our
customers’ data or our data, our service may be perceived as not being secure,
customers may curtail or stop using our service, and we may incur significant
legal and financial exposure and liabilities.





Our
service involves the storage and transmission of customers’ proprietary
information. If our security measures are breached as a result of third-party
action, employee error, malfeasance or otherwise and, as a result, unauthorized
access is obtained to our customers’ data or our data, our reputation could be
damaged, our business may suffer, and we could incur significant liability. In
addition, third parties may attempt fraudulently to induce employees or
customers to disclose sensitive information such as user names, passwords, or
other information in order to gain access to our customers’ data or our data,
which could result in significant legal and financial exposure and a loss of
confidence in the security of our service that would harm our future business
prospects. Because the techniques used to obtain unauthorized access, or to
sabotage systems, change frequently and generally are not recognized until
launched against a target, we may be unable to anticipate these techniques or to
implement adequate preventive  measures. If an actual or perceived
breach of our security occurs, the market perception of the effectiveness of our
security measures could be harmed and we could lose sales and customers. In
addition, our new industry-standard platform may allow access by third-party
technology providers to access customer data. Because we do not control the
transmissions between our customers and third-party technology providers, or the
processing of such data by third-party technology providers, we cannot ensure
the complete integrity or security of such transmissions or
processing.





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, and criminal actions filed against a former
officer and a former employee, and the class action lawsuit filed against us and
certain current and former officers, directors, and employees have 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 not raise sufficient financing, if necessary,
in the future.





Legal and
other fees related to these actions have also reduced our available cash for
operations. 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, jeopardized our relationships with vendors and customers, and
decreased our ability to attract qualified personnel, especially given the media
coverage of these events.


43


In
addition, 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 with respect to these actions, and we may not
recover all of these amounts from our directors’ and officers’ liability
insurance policy carrier. Our Bylaws and Delaware law generally require us
to advance legal expenses to current and former officers, directors, and
employees against claims arising out of such person’s status or activities as
our officer, director, or employee, and indemnify an officer, director or
employee from such claims unless any such indemnitee  (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. Also, there is a stockholder class action lawsuit pending
against us and certain of our currentand
former officers, directors, and employees, as described in Part I, Item 3,
“Legal Proceedings,” of our Annual Report on Form 10-K for the year ended
December 31, 2008.




Generally,
we are required to advance defense expenses prior to any final adjudication of
an employee’s, officer’s or director’s  culpability. The expense of
indemnifying our current and former directors, officers, and employees for their
defenses 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 us. 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.





As
reported on the Form 8-K filed by the Company on June 4, 2009, our insurance
coverage for advancement claims has been exhausted. As noted herein in Item 4,
“Commitments and Contingencies – Legal Proceedings”, by order dated August 6,
2009, the Company is obligated to pay to Dennis Michael Nouri and Reza Eric
Nouri $826,798 in advanced expenses for legal services performed by counsel to
the Nouris through April 2009.   The total amount of the legal
fees the Company will ultimately be required to advance to the Nouris is
expected to be in excess of $1.9 million. In
addition, a number of our current and former employees  were asked to
appear as witnesses in the criminal action and may seek advancement of legal
expenses from us. Payment of these amounts would adversely impact our financial
condition and results of operations, which could result in a significant
reduction in the amounts available to fund working capital, capital
expenditures, and other general corporate objectives and could ultimately
require us to file for bankruptcy.





Finally,
our insurance policies provide that, under certain conditions, our insurance
carriers may have the right to seek recovery of any amounts they paid to us or
the individual insureds. As of August 10, 2009, we do not know and can offer no
assurances about whether these conditions will apply or whether the insurance
carriers will change their position regarding coverage related to the current
actions. Therefore, we can offer no assurances that our insurance carriers will
not seek to recover any amounts paid under their policies from us or the
individual insureds. 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 and could ultimately require us to file
for bankruptcy.





Compliance
with regulations governing public company corporate governance and reporting is
uncertain and expensive.





As a
public company, we have incurred and will continue to incur significant legal,
accounting, and other expenses that we did not incur as a private company. We
incur costs associated with our public company reporting requirements and with
corporate governance and disclosure requirements, including requirements under
the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and new rules implemented by
the SEC and the Financial Industry Regulatory Authority, or FINRA. We expect
these rules and regulations to increase our legal and financial compliance costs
and to make some activities more time consuming and costly.


44





We
currently are required to comply with the requirements of Section 404 of
Sarbanes-Oxley 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 2009. To comply with
these requirements, we are evaluating and testing our internal controls, and
where necessary, taking remedial actions, to allow management to report on,
and our independent auditors to attest to, our internal control over financial
reporting. As a result, we have incurred and will continue to incur expenses and
diversion of management’s time and attention from the daily operations of
the business, which may increase our operating expenses and impair our
ability to achieve profitability.





Directors,
and principal stockholders control us. This might lead them to make decisions
that do not align with interests of minority stockholders.





Directors,
and principal stockholders beneficially own or control a large percentage 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. The bond
representative is Mr. Doron Roethler, our former Chairman of the Board and
Interim Chief executive Officer.  We have agreed that the bond
representative shall be granted access to our facilities and personnel during
normal business hours, shall have the right to attend all meetings of our Board
of Directors and its committees, and shall 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.





Directors,
and principal stockholders, acting together, would have the
voting  power 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.





Any
issuance of shares of our common stock in the future could have a dilutive
effect on the value of our existing stockholders’ shares.





We may
issue shares of our common stock in the future for a variety of reasons. For
example, under the terms of our stock purchase warrant and agreement with Atlas,
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 Paragon. 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 of, or none of their notes into shares of our common
stock at a floating conversion price. 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.
Our stockholders may experience dilution in the value of their shares as a
result.


45





Shares
eligible for public sale could adversely affect our stock price.





Future
sales of substantial amounts of our shares in the public market, or the
appearance that a large number of our shares are available for sale, could
adversely affect market prices prevailing from time to time and could impair our
ability to raise capital through the sale of our securities. At August 10, 2009,
18,332,542 shares of our common stock were issued and outstanding, and a
significant number of shares may be issued upon the exercise of outstanding
options, warrants, and convertible notes.





In
addition, our stock historically has been very thinly traded. 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.




Our
stock price is likely to be highly volatile and may decline.





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 generally
include the risk factors described in this report.





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.





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 and certain other information related to the
penny stock, the broker-dealer’s compensation in the transaction, and the other
penny stocks 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.


46


Our
executive management team is critical to the execution of our business plan and
the inability to attract and retain qualified personnel could have a severely
negative impact on our business.





Our
executive management team has undergone significant changes since 2008,
including the resignation of our Chief Executive Officer on December 9, 2008,
the resignation of our Chairman of the Board and Interim Chief Executive Officer
on May 19, 2009. It may be difficult to attract highly qualified candidates to
serve on our executive management team on a permanent basis. If we cannot
attract and retain qualified personnel and integrate new members of our
executive management team effectively into our business, then our business and
financial results may suffer. In addition, all of our executive team works at
the same location, which could make us vulnerable to the loss of our entire team
in the event of a natural or other disaster. We do not maintain key man
insurance policies on any of our employees.





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





During
the first and second quarter of fiscal 2009, we sold equity securities totaling
$219 and $876, respectively, that were not registered under the Securities Act,
as described in our Current Reports on Form 8-K filed in connection with such
transactions.





The
following table lists all repurchases during the first and second quarters of
fiscal 2009 of any of our securities registered under Section 12 of the
Exchange Act by or on behalf of us or any affiliated purchaser.





Issuer
Purchases of Equity Securities




Period
                                                    
                                                    Total
                                                      Number of
                                                      Shares
                                                      Purchased
                                                    
                                                    Average
                                                      Price
                                                      Paid Per
                                                      Share
                                                    
                                                    Total Number of
                                                      Shares Purchased as
                                                      Part of Publicly
                                                      Announced Plans or
                                                      Programs
                                                    
                                                    Maximum
                                                      Number of
                                                      Shares That May
                                                      Yet Be Purchased
                                                      Under the Plans or
                                                      ProgramsJanuary 1
      – January 31, 2009
                                                    
                                                    -
                                                    
                                                    $
                                                    -
                                                    
                                                    -
                                                    
                                                    -February
      1 – February 28, 2009
                                                    
                                                    -
                                                    
                                                    $
                                                    -
                                                    
                                                    -
                                                    
                                                    -March
      1 – March 31, 2009 (1)
                                                    
                                                    146
                                                    
                                                    $
                                                    1.50
                                                    
                                                    -
                                                    
                                                    -April
      1 – June 30, 2009
                                                    
                                                    580
                                                    
                                                    
                                                    1.51
                                                    
                                                    -
                                                    
                                                    -Total
                                                    
                                                    726
                                                    
                                                    $
                                                    1.50
                                                    
                                                    -
                                                    
                                                    -





(1)
            Represents 146 and 580 shares
      repurchased in connection with tax withholding obligations under the 2004
      Plan.





ITEM
4.          SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS




As reported in a Form 8-K
filed by the Company on June 12, 2009, the Annual Meeting of Stockholders of the
Company was convened as scheduled on June 16, 2009, and then immediately
adjourned and held on July 15, 2009. The annual meeting was held for the
purposes of electing directors to serve until the next annual meeting of
stockholders or until their successors are appointed and qualified. As reported
in the reports on Form 8-K filed by the Company on May 22, 2009 and June 12,
2009, two of the director nominees named in the Company’s April 30, 2009
proxy statement has resigned as directors prior to the Annual Meeting, and were
not candidates for re-election.








For
                WithheldC.
      James Meese, Jr.
                13,451,661
                290Dror
      Zoreff
                13,451,461
                490Shlomo
      Elia
                13,451,461
                490




Item
6.            Exhibits





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





Exhibit No.
                
                Description31.1
                
                Certification
      of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200231.2
                
                Certification
      of Principal Financial Officer/Principal Accounting Officer Pursuant to
      Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002


47





32.1
              
              Certification
      of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.32.2
              
              Certification
      of Principal Financial Officer/Principal Accounting Officer Pursuant to 18
      U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002. This exhibit is being furnished pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the
      extent required by that Act, be deemed to be incorporated by reference
      into any document or filed herewith for the purposes of liability under
      the Securities Exchange Act of 1934, as amended, or the Securities Act of
      1933, as amended, as the case may
be.


48


SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





SMART
      ONLINE, INC.By:
              /s/ C. James Meese, Jr.August
      12, 2009
              
              C.
      James Meese, Jr.Principal
      Executive Officer


49


EXHIBIT
INDEX





Exhibit No.
                
                Description31.1
                
                Certification
      of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200231.2
                
                Certification
      of Principal Financial Officer/Principal Accounting Officer Pursuant to
      Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 200232.1
                
                Certification
      of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.32.2
                
                Certification
      of Principal Financial Officer/Principal Accounting Officer Pursuant to 18
      U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002. This exhibit is being furnished pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the
      extent required by that Act, be deemed to be incorporated by reference
      into any document or filed herewith for the purposes of liability under
      the Securities Exchange Act of 1934, as amended, or the Securities Act of
      1933, as amended, as the case may
be.


50