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 March 31, 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: Yesx  Noo





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  ̈       
No  ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





Large
      accelerated filer
             ̈
            
            Accelerated
      filer  ̈Non-accelerated
      filer
             ̈
            (Do
      not check if a smaller reporting company)
            Smaller
      reporting company x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yeso Nox





As of May
11, 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 March 31, 2009





TABLE
OF CONTENTS





Page
      No.PART
      I – FINANCIAL INFORMATIONItem
      1.
                Financial
      StatementsBalance
      Sheets as of March 31, 2009 (unaudited) and December 31,
    2008
                3Statements
      of Operations (unaudited) for the three months ended March 31, 2009 and
      2008
                4Statements
      of Cash Flows (unaudited) for the three months ended March 31, 2009 and
      2008
                5Notes
      to Financial Statements (unaudited)
                6Item
      2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                18Item
      3.
                Quantitative
      and Qualitative Disclosures About Market Risk
                32Item
      4.
                Controls
      and Procedures
                32Item
      4T.
                Controls
      and Procedures
                32PART
      II – OTHER INFORMATIONItem
      1.
                Legal
      Proceedings
                33Item
      1A.
                Risk
      Factors
                33Item
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                39Item
      6.
                Exhibits
                39Signatures
                41


2


PART
I – FINANCIAL INFORMATION





Item
1.              Financial
Statements





SMART
ONLINE, INC.


BALANCE
SHEETS





March 31,
                    2009
                    (unaudited)
                  
                  
                  December 31,
                    2008ASSETSCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  38,289
                  
                  
                  $
                  18,602Accounts
      receivable, net
                  
                  
                  134,286
                  
                  
                  
                  184,930Note
      receivable
                  
                  
                  -
                  
                  
                  
                  60,000Prepaid
      expenses
                  
                  
                  246,716
                  
                  
                  
                  289,372Total
      current assets
                  
                  
                  419,291
                  
                  
                  
                  552,904Property
      and equipment, net
                  
                  
                  316,557
                  
                  
                  
                  365,993Capitalized
      software, net
                  
                  
                  375,299
                  
                  
                  
                  261,221Note
      receivable, non-current
                  
                  
                  217,783
                  
                  
                  
                  372,317Prepaid
      expenses, non-current
                  
                  
                  221,401
                  
                  
                  
                  258,301Intangible
      assets, net
                  
                  
                  1,274,863
                  
                  
                  
                  1,410,245Other
      assets
                  
                  
                  2,987
                  
                  
                  
                  1,736TOTAL
      ASSETS
                  
                  $
                  2,828,181
                  
                  
                  $
                  3,222,717LIABILITIES
      AND STOCKHOLDERS’ EQUITY (DEFICIT)Current
      liabilities:Accounts
      payable
                  
                  $
                  408,654
                  
                  
                  $
                  398,237Notes
      payable
                  
                  
                  2,336,210
                  
                  
                  
                  2,341,177Deferred
      revenue
                  
                  
                  287,692
                  
                  
                  
                  323,976Accrued
      liabilities
                  
                  
                  675,783
                  
                  
                  
                  478,917Total
      current liabilities
                  
                  
                  3,708,339
                  
                  
                  
                  3,542,307Long-term
      liabilities:Notes
      payable
                  
                  
                  6,320,038
                  
                  
                  
                  5,327,211Deferred
      revenue
                  
                  
                  55,686
                  
                  
                  
                  67,353Total
      long-term liabilities
                  
                  
                  6,375,724
                  
                  
                  
                  5,394,564Total
      liabilities
                  
                  
                  10,084,063
                  
                  
                  
                  8,936,871Commitments
      and contingenciesStockholders’
      equity (deficit):Preferred
      stock, $0.001 par value, 5,000,000 shares authorized, no shares issued and
      outstanding at March 31, 2009 and December 31, 2008
                  
                  
                  -
                  
                  
                  
                  -Common
      stock, $0.001 par value, 45,000,000 shares authorized, 18,333,122 and
      18,333,601 shares issued and outstanding at March 31, 2009 and December
      31, 2008, respectively
                  
                  
                  18,333
                  
                  
                  
                  18,334Additional
      paid-in capital
                  
                  
                  66,998,514
                  
                  
                  
                  66,945,588Accumulated
      deficit
                  
                  
                  (74,272,729
                  )
                  
                  
                  (72,678,076
                  )Total
      stockholders’ deficit
                  
                  
                  (7,255,882
                  )
                  
                  
                  (5,714,154
                  )TOTAL
      LIABILITIES AND STOCKHOLDERS’ DEFICIT
                  
                  $
                  2,828,181
                  
                  
                  $
                  3,222,717





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


3


SMART
ONLINE, INC.


STATEMENTS
OF OPERATIONS


(unaudited)




Three Months EndedMarch 31,
                                2009
                              
                              
                              March 31,
                                2008REVENUES:Subscription
      fees
                              
                              $
                              473,579
                              
                              
                              $
                              742,839Professional
      service fees
                              
                              
                              118,773
                              
                              
                              
                              504,083License
      fees
                              
                              
                              11,250
                              
                              
                              
                              100,000Hosting
      fees
                              
                              
                              72,211
                              
                              
                              
                              59,482Other
      revenue
                              
                              
                              37,671
                              
                              
                              
                              40,759Total
      revenues
                              
                              
                              713,484
                              
                              
                              
                              1,447,163COST
      OF REVENUES
                              
                              
                              492,601
                              
                              
                              
                              711,667GROSS
      PROFIT
                              
                              
                              220,883
                              
                              
                              
                              735,496OPERATING
      EXPENSES:Sales
      and marketing
                              
                              
                              531,335
                              
                              
                              
                              695,225Research
      and development
                              
                              
                              276,879
                              
                              
                              
                              452,124General
      and administrative
                              
                              
                              895,590
                              
                              
                              
                              1,243,273Total
      operating expenses
                              
                              
                              1,703,804
                              
                              
                              
                              2,390,622LOSS
      FROM OPERATIONS
                              
                              
                              (1,482,921
                              )
                              
                              
                              (1,655,126
                              )OTHER
      INCOME (EXPENSE):Interest
      expense, net
                              
                              
                              (127,999
                              )
                              
                              
                              (178,314
                              )Gain
      on disposal of assets, net
                              
                              
                              10,267
                              
                              
                              
                              2,665Gain
      on legal settlements, net
                              
                              
                              6,000
                              
                              
                              
                              -Other
      expense
                              
                              
                              -
                              
                              
                              
                              (108
                              )Total
      other expense
                              
                              
                              (111,732
                              )
                              
                              
                              (175,757
                              )NET
      LOSS
                              
                              $
                              (1,594,653
                              )
                              
                              $
                              (1,830,883
                              )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                              
                              $
                              (0.09
                              )
                              
                              $
                              (0.10
                              )WEIGHTED-AVERAGE
      NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
    SHARE:Basic
      and fully diluted
                              
                              
                              18,333,518
                              
                              
                              
                              18,201,171





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


4


SMART
ONLINE, INC.


STATEMENTS
OF CASH FLOWS


(unaudited)





Three Months EndedMarch 31,
                  2009
                
                
                March 31,
                  2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                
                $
                (1,594,653
                )
                
                $
                (1,830,883
                )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                
                
                164,288
                
                
                
                207,630Amortization
      of deferred financing costs
                
                
                -
                
                
                
                112,971Provision
      for doubtful accounts
                
                
                223,993
                
                
                
                35,468Equity-based
      compensation
                
                
                53,144
                
                
                
                170,499Gain
      on disposal of assets
                
                
                (10,267
                )
                
                
                (2,665
                )Changes
      in assets and liabilities:Accounts
      receivable
                
                
                44,435
                
                
                
                21,849Notes
      receivable
                
                
                (3,250
                )
                
                
                -Prepaid
      expenses
                
                
                79,556
                
                
                
                (40,758
                )Other
      assets
                
                
                (1,251
                )
                
                
                15,000Accounts
      payable
                
                
                10,417
                
                
                
                (84,425
                )Deferred
      revenue
                
                
                (47,951
                )
                
                
                (89,276
                )Accrued
      and other expenses
                
                
                196,647
                
                
                
                (86,968
                )Net
      cash used in operating activities
                
                
                (884,892
                )
                
                
                (1,571,558
                )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of property and equipment
                
                
                (14,565
                )
                
                
                (9,439
                )Proceeds
      from sale of equipment
                
                
                45,362
                
                
                
                12,500Capitalized
      software
                
                
                (114,078
                )
                
                
                -Net
      cash provided by (used in) investing activities
                
                
                (83,281
                )
                
                
                3,061CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from debt borrowings
                
                
                2,925,511
                
                
                
                500,000Repayments
      of debt borrowings
                
                
                (1,937,651
                )
                
                
                (2,053,704
                )Net
      cash provided by (used in) financing activities
                
                
                987,860
                
                
                
                (1,553,704
                )NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                
                
                19,687
                
                
                
                (3,122,201
                )CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
                
                
                18,602
                
                
                
                3,473,959CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                
                $
                38,289
                
                
                $
                351,758Supplemental
      disclosures of cash flow information:Cash
      paid during the period for:Interest
                
                $
                127,750
                
                
                $
                79,878Income
      taxes
                
                $
                10
                
                
                $
                11,000Supplemental
      schedule of non-cash financing activities:Conversion
      of debt to equity
                
                $
                -
                
                
                $
                228,546





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


5


SMART
ONLINE, INC.


NOTES
TO FINANCIAL STATEMENTS


(unaudited)





1.            SUMMARY
OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES





Description of
Business- Smart
Online, Inc. (the “Company”) was incorporated in the State of Delaware in 1993.
The Company develops and markets software products and services 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 website consulting
services, primarily in the e-commerce retail and direct-selling organization
industries. The Company maintains a website for potential partners containing
certain corporate information located at www.smartonline.com.





Basis of
Presentation- The financial statements as of and for the three months
ended March 31, 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 March 31,
2009, and its results of operations and cash flows for the three months ended
March 31, 2009 and 2008. The results for the three months ended March 31, 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 months ended March 31, 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 May 11, 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
industry-standard 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 ability 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 months ended March 31, 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.


6





Fair Value
ofFinancial 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
months ended March 31, 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 March 31, 2009, an allowance for
doubtful accounts of $652,152 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.


7


Revenue
Recognition- The
Company derives revenue primarily from subscription fees charged to customers
accessing its SaaS applications; professional service fees, consisting primarily
of consulting; 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.     collectibility
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 collectibility 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 contracts are on a time and material basis and are
typically billed monthly based upon standard professional service
rates.





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


8


Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. The Company typically has a revenue-share arrangement
with these marketing partners in order to encourage them to market the Company’s
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user. Any payments received in advance of the subscription period are accrued as
deferred revenue and amortized over the subscription period. The Company
recognizes 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 months ended March 31, 2009 was approximately
$53,144, of which $26,583 related to the issuance of restricted stock and
$26,561 was expense associated with stock options. Total stock-based
compensation expense during the three months ended March 31, 2008 was
approximately $170,499, of which $122,237 related to the issuance of restricted
stock and $48,262 was expense associated with stock options. 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 months ended March 31, 2009 and 2008 were estimated using the following
weighted average assumptions:


9





Three Months Ended March 31,2009
                  
                  
                  2008Dividend
      yield
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %Expected
      volatility
                  
                  
                  100.5
                  %
                  
                  
                  63.0
                  %Risk-free
      interest rate
                  
                  
                  2.00
                  %
                  
                  
                  3.45
                  %Expected
      lives (years)
                  
                  
                  4.0
                  
                  
                  
                  3.1





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 1,913,615 on March 31, 2009, 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 near Research
Triangle Park, 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 March 31,
2009:


10





Asset Category
                      
                      Value
                        Assigned
                      
                      
                      Residual
                        Value
                      
                      
                      Weighted
                        Average
                        Amortization
                        Period
                        (in Years)
                      
                      
                      Accumulated
                        Amortization
                      
                      
                      Carrying
                        ValueCustomer bases
                      
                      $
                      1,944,347
                      
                      
                      $
                      -
                      
                      
                      
                      6.2
                      
                      
                      $
                      1,160,642
                      
                      
                      $
                      783,705Acquired
      technology
                      
                      
                      501,264
                      
                      
                      
                      -
                      
                      
                      
                      3.0
                      
                      
                      
                      501,264
                      
                      
                      
                      -Non-compete
      agreements
                      
                      
                      801,785
                      
                      
                      
                      -
                      
                      
                      
                      4.0
                      
                      
                      
                      693,209
                      
                      
                      
                      108,576Trademarks
      and copyrights
                      
                      
                      52,372
                      
                      
                      
                      -
                      
                      
                      
                      9.7
                      
                      
                      
                      49,790
                      
                      
                      
                      2,582Trade
      name
                      
                      
                      380,000
                      
                      
                      
                      N/A
                      
                      
                      
                      N/A
                      
                      
                      
                      N/A
                      
                      
                      
                      380,000Totals
                      
                      $
                      3,679,768
                      
                      
                      $
                      -
                      
                      
                      
                      
                      
                      
                      $
                      2,404,905
                      
                      
                      $
                      1,274,863





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 March
31, 2009, the Company had accrued liabilities totaling $675,783. 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;
$27,241 for tax-related liabilities associated with the vesting of restricted
stock; $125,646 of estimated loss on a long-term customer contract; $98,205 of
cash collected through the Company's merchant account on behalf of a customer;
$52,049 for professional services performed but not yet invoiced; $23,180 for
accrued payroll; and $64,378 of convertible note interest payable.





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.





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 collectibility becomes
      probable.





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





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


11





March 31,
                    2009
                  
                  
                  December 31,
                    2008Subscription
      fees
                  
                  $
                  66,603
                  
                  
                  $
                  89,852License
      fees
                  
                  
                  97,500
                  
                  
                  
                  108,750Professional
      service fees
                  
                  
                  179,275
                  
                  
                  
                  192,727Totals
                  
                  $
                  343,378
                  
                  
                  $
                  391,329Current
      portion
                  
                  $
                  287,692
                  
                  
                  $
                  323,976Non-current
      portion
                  
                  
                  55,686
                  
                  
                  
                  67,353Totals
                  
                  $
                  343,378
                  
                  
                  $
                  391,329





3.           NOTES
PAYABLE





Convertible
Notes





As of
March 31, 2009, the Company had $6.3 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
January 6, 2009 and February 24, 2009, the Company sold $500,000 and $500,000,
respectively, aggregate principal amount of notes 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:


12


·
            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 became Chairman of the Company’s Board
of Directors and Interim President and Chief Executive Officer 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.


13





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 May 11, 2009, the Company had an outstanding
balance of $2.28 million under the line of credit.





As of
March 31, 2009, the Company had notes payable totaling $8,656,248. The detail of
these notes is as follows:





Note Description
                    
                    Short-Term
                      Portion
                    
                    
                    Long-Term
                      Portion
                    
                    
                    Total
                    
                    Maturity
                    
                    RateParagon
      Commercial Bank credit line
                    
                    $
                    2,287,429
                    
                    
                    $
                    -
                    
                    
                    $
                    2,287,429
                    
                    Feb
      2010
                    
                    Prime, not less
                      than 5.5
                    %Insurance
      premium note
                    
                    
                    21,538
                    
                    
                    
                    -
                    
                    
                    
                    21,538
                    
                    Jul
      2009
                    
                    
                    6.1
                    %Various
      capital leases
                    
                    
                    27,243
                    
                    
                    
                    20,038
                    
                    
                    
                    47,281
                    
                    Various
                    
                    
                    10.7-18.9
                    %Convertible
      notes
                    
                    
                    -
                    
                    
                    
                    6,300,000
                    
                    
                    
                    6,300,000
                    
                    Nov
      2010
                    
                    
                    8.0
                    %Totals
                    
                    $
                    2,336,210
                    
                    
                    $
                    6,320,038
                    
                    
                    $
                    8,656,248





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
$47,281 and $53,517 at March 31, 2009 and December 31, 2008, respectively, net
of accumulated amortization of $24,883 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 March 31, 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 North Carolina headquarters to another facility near
Research Triangle Park. As described in Note 2, “Balance Sheet Accounts,” the
Company prepaid the lease and purchased existing furniture and fixtures for a
lump-sum payment of $500,000, of which $450,080 was allocated to rent and is
being amortized monthly over the remaining term of the lease. The Company also
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 March 31, 2009, future annual minimum operating lease
payments for 2009 are $13,965.





Rent
expense for the three months ended March 31, 2009 and 2008 was $43,889 and
$77,130, respectively.


14


Development
Agreement





In August
2005, the Company entered into a software assignment and development agreement
with the developer of a customized accounting software application. In
connection with this agreement, the developer would be paid up to $512,500 and
issued up to 32,395 shares of the Company’s common stock based upon the
developer attaining certain milestones. This agreement was modified on
March 26, 2008 to adjust the total number of shares issuable under the agreement
to 29,014. As of March 31, 2009, the Company had paid $470,834 and issued 3,473
shares of common stock related to this obligation.





Legal
Proceedings





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





At this
time, the Company is not able to determine the likely outcome of the Company’s
current pending legal matters, nor can it estimate its potential financial
exposure. Management has made an initial estimate based upon its knowledge,
experience and input from legal counsel, and the Company has accrued
approximately $137,500 of additional legal reserves. Such reserves will be
adjusted in future periods as more information becomes available. If an
unfavorable resolution of any of these matters occurs, the Company’s business,
results of operations, and financial condition could be materially adversely
affected.





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 March 31, 2009.





Common
Stock





The
Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
value per share. As of March 31, 2009, it had 18,333,122 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 was scheduled to expire in 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.


15





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
March 31, 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 quarter of 2009, no shares of restricted stock were issued. A total of 479
shares of restricted stock were canceled during the first quarter of 2009 due to
terminations and payment of employee tax obligations resulting from share
vesting. At March 31, 2009, there remains $62,577 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 three months ended
March 31, 2009:





Shares
                  
                  
                  Weighted
                    Average
                    Exercise PriceBALANCE, December
      31, 2008
                  
                  
                  271,250
                  
                  
                  $
                  5.89Granted
                  
                  
                  40,000
                  
                  
                  
                  1.10Exercised
                  
                  
                  -
                  
                  
                  
                  -Canceled
                  
                  
                  (53,550
                  )
                  
                  
                  7.36BALANCE,
      March 31, 2009
                  
                  
                  257,700
                  
                  
                  $
                  4.84





The
following table summarizes information about stock options outstanding at March
31, 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





16





At March
31, 2009, there remains $227,251 of unvested expense yet to be recorded related
to all options outstanding.





Dividends - The Company has
not paid any cash dividends through March 31, 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
                                March 31, 2009Revenue Type
                              
                              Revenues
                              
                              % of Total
                                RevenuesCustomer A
                              Subscription fees
                              
                              $
                              289,398
                              
                              41
                              %Customer
      B
                              Professional
      service fees
                              
                              
                              149,265
                              
                              21
                              %Customer
      C
                              Subscription
      fees
                              
                              
                              125,138
                              
                              18
                              %Others
                              Various
                              
                              
                              149,683
                              
                              20
                              %Total
                              
                              
                              $
                              713,484
                              
                              100
                              %








Three Months Ended
                            March 31, 2008Revenue Type
                          
                          Revenues
                          
                          % of Total
                            RevenuesCustomer A
                          Subscription
      fees
                          
                          $
                          300,884
                          
                          21
                          %Customer
      B
                          Professional
      service fees
                          
                          
                          383,191
                          
                          26
                          %Customer
      C
                          Subscription
      fees
                          
                          
                          361,090
                          
                          25
                          %Customer
      D
                          Professional
      service fees
                          
                          
                          216,283
                          
                          15
                          %Others
                          Various
                          
                          
                          185,715
                          
                          13
                          %Total
                          
                          
                          $
                          1,447,163
                          
                          100
                          %





As of
March 31, 2009, one customer accounted for 92% of accounts receivable. As of
December 31, 2008, one customer accounted for 93% of accounts
receivable.





7.           SUBSEQUENT
EVENTS





On April
3, 2009, the Company sold $500,000 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.”


17


On April
17, 2009, the Company dismissed Sherb & Co., LLP as the Company’s
independent registered public accounting firm and appointed Cherry, Bekaert
& Holland, L.L.P. (“CB&H”) as its independent registered public
accounting firm for the fiscal year ending December 31, 2009. The decision to
change accountants was approved by the Audit Committee of the Company’s Board of
Directors at a meeting held on April 16, 2009 and was due to the desire to
rotate accounting firms as well as for CB&H’s closer geographic proximity to
the Company.





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





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 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
OneBiz® 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 to be readily available to
meet any anticipated customer need or desire. We believe that this platform and
associated applications will provide opportunities for new sources of revenue,
including an increase in our subscription fees. We also believe, because the
platform is designed to follow industry-standard protocol, that the
customization efforts and associated timeline previously necessary to meet a
particular customer’s requirements will diminish significantly, allowing us to
shorten the sale-to-revenue cycle.As
we near completion of the development of our industry-standard platform, we have
begun increasing our focus toward the sales and marketing of the new
platform.


18





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 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. We make subscription sales either on a
subscription or on a “for fee” basis. Applications for which subscriptions are
available vary from our own direct-sale website, OneBiz®, to the
websites of 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 services. For example, a
partner may request that we re-design its website to better accommodate our
products or to improve its own website traffic. 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.


19


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





In
previous years, we primarily focused our efforts on basic product development
and integration. In the early part of 2007, we also began to focus on licensing
our platform products and applications. During 2008, our primary business
initiatives included increasing subscription fees revenue and professional
service fees revenue, making organizational improvements, concentrating our
development efforts on enhancements and customization of our platforms and
applications, and shifting our strategic focus to the sales and marketing of our
products. We expect to launch in the second quarter of 2009 our new
industry-standard platform along with enhanced applications targeted to small
businesses and to devote significant resources to the sale and marketing of
these applications through both channel partners and direct sales
efforts.





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 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 to take our enhanced
products to market, we expect associated costs to increase in 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 ofComputerSoftware 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 are
capitalizing 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 enables us to incur
relatively low development costs as compared to traditional enterprise software
business models. As we complete the core development of our new applications
through the first half of 2009, we expect that future research and development
expenses will decrease in both absolute and relative dollars as we continue to
capitalize costs associated with the new platform, reduce our personnel to a
core group focused on enhancements and custom development work for customers,
and achieve scalability of our applications through subscription
revenue.


20





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 the legal expenses and
other professional fees we incurred in 2008 to resolve outstanding matters from
previous years and to assist with the transition between permanent financial
officers are offset in part by an increase in costs related to the growth of our
business and to our operations as a public company. 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, 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; 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.


21


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.     collectibility
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
collectibility 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.


22


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 ofLong-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 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 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 March 31, 2009 and March 31,
2008





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





Three Months Ended
                    March 31, 2009
                  
                  
                  Three Months Ended
                    March 31, 2008Dollars
                  
                  
                  % of
                    Revenue
                  
                  
                  Dollars
                  
                  
                  % of
                    RevenueTotal
      revenues
                  
                  $
                  713,484
                  
                  
                  
                  100.0
                  %
                  
                  $
                  1,447,163
                  
                  
                  
                  100.0
                  %Cost
      of revenues
                  
                  
                  492,601
                  
                  
                  
                  69.0
                  %
                  
                  
                  711,667
                  
                  
                  
                  49.2
                  %Gross
      profit
                  
                  $
                  220,883
                  
                  
                  
                  31.0
                  %
                  
                  $
                  735,496
                  
                  
                  
                  50.8
                  %Operating
      expenses
                  
                  
                  1,703,804
                  
                  
                  
                  238.8
                  %
                  
                  
                  2,390,622
                  
                  
                  
                  165.2
                  %Loss
      from operations
                  
                  $
                  (1,482,921
                  )
                  
                  
                  -207.8
                  %
                  
                  $
                  (1,655,126
                  )
                  
                  
                  -114.4
                  %Other
      income (expense), net
                  
                  
                  (111,732
                  )
                  
                  
                  -15.7
                  %
                  
                  
                  (175,757
                  )
                  
                  
                  -12.1
                  %Net
      loss
                  
                  $
                  (1,594,653
                  )
                  
                  
                  -223.5
                  %
                  
                  $
                  (1,830,883
                  )
                  
                  
                  -126.5
                  %Net
      loss per common share
                  
                  $
                  (0.09
                  )
                  
                  
                  
                  
                  
                  $
                  (0.10
                  )


23


Revenues





Revenues
for the three months ended March 31, 2009 and 2008 comprise the
following:





Three Months Ended
                    March 31,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentSubscription
      fees
                  
                  $
                  473,579
                  
                  
                  $
                  742,839
                  
                  
                  $
                  (269,260
                  )
                  
                  
                  -36
                  %Professional
      service fees
                  
                  
                  118,773
                  
                  
                  
                  504,083
                  
                  
                  
                  (385,310
                  )
                  
                  
                  -76
                  %License
      fees
                  
                  
                  11,250
                  
                  
                  
                  100,000
                  
                  
                  
                  (88,750
                  )
                  
                  
                  -89
                  %Hosting
      fees
                  
                  
                  72,211
                  
                  
                  
                  59,482
                  
                  
                  
                  12,729
                  
                  
                  
                  21
                  %Other
      revenue
                  
                  
                  37,671
                  
                  
                  
                  40,759
                  
                  
                  
                  (3,088
                  )
                  
                  
                  -8
                  %Total
      revenues
                  
                  $
                  713,484
                  
                  
                  $
                  1,447,163
                  
                  
                  $
                  (733,679
                  )
                  
                  
                  -51
                  %





Revenues
decreased 51% to $713,000 for the three months ended March 31, 2009 from
$1,447,000 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 March 31, 2009 and 2008 are as
follows:





Three Months Ended
                    March 31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentSubscription fees
                  
                  $
                  473,579
                  
                  
                  $
                  742,839
                  
                  
                  $
                  (269,260
                  )
                  
                  
                  -36
                  %Percent
      of total revenues
                  
                  
                  66.4
                  %
                  
                  
                  51.3
                  %





Revenues
from subscription fees decreased 36% to $474,000 for the three months ended
March 31, 2009 from $743,000 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 March 31, 2009 and
2008 are as follows:





Three Months Ended
                    March 31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentProfessional service
      fees
                  
                  $
                  118,773
                  
                  
                  $
                  504,083
                  
                  
                  $
                  (385,310
                  )
                  
                  
                  -76
                  %Percent
      of total revenues
                  
                  
                  16.6
                  %
                  
                  
                  34.8
                  %





Revenues
from professional service fees decreased 76% to $119,000 for the three months
ended March 31, 2009 from $504,000 for the same period in 2008. This decrease is
primarily due to a significant decline in web consulting services provided to a
customer during the first quarter of 2008 that were billed at substantially
higher hourly rates than the contracted rate with this customer for maintenance
services.





24




License
Fees





Revenues
from license fees for the three months ended March 31, 2009 and 2008 are as
follows:





Three Months Ended
                    March 31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentLicense fees
                  
                  $
                  11,250
                  
                  
                  $
                  100,000
                  
                  
                  $
                  (88,750
                  )
                  
                  
                  -89
                  %Percent
      of total revenues
                  
                  
                  1.6
                  %
                  
                  
                  6.9
                  %





Revenues
from license fees decreased 89% to $11,000 for the three months ended March 31,
2009 from $100,000 for the same period in 2008. License fee revenue recognized
in the first quarter of 2009 comprised the ratable recognition of a term license
that commenced in June 2008. License fee revenue recognized in the first quarter
of 2008 comprised one installment of a perpetual license agreement to a single
customer. 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 March 31, 2009 and 2008 are as
follows:





Three
      Months Ended
                    March
      31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentHosting
      fees
                  
                  $
                  72,211
                  
                  
                  $
                  59,482
                  
                  
                  $
                  12,729
                  
                  
                  
                  21
                  %Percent
      of total revenues
                  
                  
                  10.1
                  %
                  
                  
                  4.1
                  %





Revenues
from hosting fees increased 21% to $72,000 for the three months ended March 31,
2009 from $59,000 for the same period in 2008. This increase is primarily due to
redundancy services provided to a customer starting in the latter part of 2008
and into 2009 that resulted in higher monthly invoiced fees. We expect hosting
fees to increase on an overall basis as we add new channel partners and expand
our base of subscribing end users.





Other
Revenue





Revenues
from other sources for the three months ended March 31, 2009 and 2008 are as
follows:





Three Months Ended
                      March 31,
                    
                    Change2009
                    
                    
                    2008
                    
                    Dollars
                    
                    
                    PercentOther
      revenue
                    
                    $
                    37,671
                    
                    
                    $
                    40,759
                    
                    
                    $
                    (3,088
                    )
                    
                    
                    -8
                    %Percent
      of total revenues
                    
                    
                    5.3
                    %
                    
                    
                    2.8
                    %





Revenues
from non-core activities decreased 8% to $38,000 for the three months ended
March 31, 2009 from $41,000 for the same period in 2008. This decrease is
primarily attributable to lower billed credit card and payment gateway fees
resulting from lower revenue. 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 March 31, 2009 and 2008 are as
follows:


25





Three Months Ended
                    March 31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentCost
      of revenues
                  
                  $
                  492,601
                  
                  
                  $
                  711,667
                  
                  
                  $
                  (219,066
                  )
                  
                  
                  -31
                  %Percent
      of total revenues
                  
                  
                  69.0
                  %
                  
                  
                  49.2
                  %





Cost of
revenues decreased 31% to $493,000 for the three months ended March 31, 2009
from $712,000 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 March 31, 2009 and 2008 comprise the
following:





Three Months Ended
                    March 31,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentSales
      and marketing
                  
                  $
                  531,335
                  
                  
                  $
                  695,225
                  
                  
                  $
                  (163,890
                  )
                  
                  
                  -24
                  %Research
      and development
                  
                  
                  276,879
                  
                  
                  
                  452,124
                  
                  
                  
                  (175,245
                  )
                  
                  
                  -39
                  %General
      and administrative
                  
                  
                  895,590
                  
                  
                  
                  1,243,273
                  
                  
                  
                  (347,683
                  )
                  
                  
                  -28
                  %Total
      operating expenses
                  
                  $
                  1,703,804
                  
                  
                  $
                  2,390,622
                  
                  
                  $
                  (686,818
                  )
                  
                  
                  -29
                  %





Operating
expenses decreased 29% to $1,704,000 for the three months ended March 31, 2009
from $2,391,000 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.
Select items are discussed in detail below.





Sales
and Marketing





Sales and
marketing expenses for the three months ended March 31, 2009 and 2008 are as
follows:





Three Months Ended
                    March 31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentSales
      and marketing
                  
                  $
                  531,335
                  
                  
                  $
                  695,225
                  
                  
                  $
                  (163,890
                  )
                  
                  
                  -24
                  %Percent
      of total revenues
                  
                  
                  74.5
                  %
                  
                  
                  48.0
                  %





Sales and
marketing expenses decreased 24% to $531,000 for the three months ended March
31, 2009 from $695,000 for the same period in 2008. This variance is primarily
attributable to reductions of $147,000 associated with revenue-sharing
arrangements with our channel partners, $51,000 in commission expense, and
$13,000 in travel-related expenses, all due to lower revenue and sales
headcount, offset in part by an increase in salaries of $55,000 resulting from
the reclassification in the latter part of 2008 of our Chief Operating Officer’s
salary from general and administrative expense in the first quarter of 2008 to
sales and marketing expense upon his appointment to Vice President, Sales and
Marketing.





Research
and Development





Research
and development expenses for the three months ended March 31, 2009 and 2008 are
as follows:


26





Three
      Months Ended
                    March
      31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentResearch
      and development
                  
                  $
                  276,879
                  
                  
                  $
                  452,124
                  
                  
                  $
                  (175,245
                  )
                  
                  
                  -39
                  %Percent
      of total revenues
                  
                  
                  38.8
                  %
                  
                  
                  31.2
                  %





Research
and development expenses decreased 39% to $277,000 for the three months ended
March 31, 2009 from $452,000 for the same period in 2008. This decrease is
primarily attributable to $170,000 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 March 31, 2009 and 2008
are as follows:





Three
      Months Ended
                    March
      31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentGeneral
      and administrative
                  
                  $
                  895,590
                  
                  
                  $
                  1,243,273
                  
                  
                  $
                  (347,683
                  )
                  
                  
                  -28
                  %Percent
      of total revenues
                  
                  
                  125.5
                  %
                  
                  
                  85.9
                  %





General
and administrative expenses decreased 28% to $896,000 for the three months ended
March 31, 2009 from $1,243,000 for the same period in 2008. This decrease is
primarily attributable to reductions of $181,000 in personnel costs and $40,000
in rent due to lower headcount and the consolidation of our Grand Rapids
facility; $150,000 in stock-based compensation expense resulting from employee
turnover and a decrease in new equity grants; $31,000 in travel-related expenses
as a result of cost containment efforts; and $124,000 in legal expenses as
events related to the previously reported 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 had peaked in the first quarter of 2008. These decreases were offset in
part by a net increase of $189,000 in bad debt expense on trade accounts and
notes receivable.





Other
Income (Expense)





Other
income (expense) for the three months ended March 31, 2009 and 2008 comprise the
following:





Three
      Months Ended
                    March
      31,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentInterest
      expense, net
                  
                  $
                  (127,999
                  )
                  
                  $
                  (178,314
                  )
                  
                  $
                  (50,315
                  )
                  
                  
                  -28
                  %Gain
      on disposal of assets, net
                  
                  
                  10,267
                  
                  
                  
                  2,665
                  
                  
                  
                  7,602
                  
                  
                  
                  285
                  %Gain
      on legal settlements, net
                  
                  
                  6,000
                  
                  
                  
                  -
                  
                  
                  
                  6,000
                  
                  
                  
                  -Other
      expense
                  
                  
                  -
                  
                  
                  
                  (108
                  )
                  
                  
                  (108
                  )
                  
                  
                  -100
                  %Total
      other expense
                  
                  $
                  (111,732
                  )
                  
                  $
                  (175,757
                  )
                  
                  $
                  (64,025
                  )
                  
                  
                  -36
                  %





Net other
expense decreased 36% to $112,000 for the three months ended March 31, 2009 from
$176,000 for the same period in 2008. This net decrease was primarily
attributable to a decrease in net interest expense, which is discussed in detail
below.





Interest
Expense, Net





Interest
expense, net of interest income, for the three months ended March 31, 2009 and
2008 is as follows:


27





Three
      Months Ended
                    March
      31,
                  
                  Change2009
                  
                  
                  2008
                  
                  Dollars
                  
                  
                  PercentInterest
      expense, net
                  
                  $
                  127,999
                  
                  
                  $
                  178,314
                  
                  
                  $
                  (50,315
                  )
                  
                  
                  -28
                  %Percent
      of total revenues
                  
                  
                  17.9
                  %
                  
                  
                  12.3
                  %





Net
interest expense decreased 28% to $128,000 for the three months ended March 31,
2009 from $178,000 for the same period in 2008. This decrease is primarily
attributable to $113,000 of interest expense recognized in the first quarter of
2008 relating to the warrant 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 $52,000, an increase
in the Paragon Commercial Bank, or Paragon, line of credit interest of $5,000
due to a higher average balance and a higher interest rate, and $2,000 in
interest associated with capital leases.





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 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 $47.3 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





We
require cash to fund our operating expenses and working capital requirements,
including outlays for capital expenditures and debt service. As of March 31,
2009, our principal sources of liquidity were cash and cash equivalents totaling
$38,000 and current accounts receivable of $134,000, 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 March 31, 2009, we had drawn approximately $2,287,000 on
the $2,470,000 line of credit, leaving approximately $183,000 available under
the line of credit for our operations. Deferred revenue at March 31, 2009 was
$343,000 as compared to $391,000 at December 31, 2008.





As of May
11, 2009, our principal sources of liquidity were cash and cash equivalents
totaling approximately $42,000 and accounts receivable of approximately $94,000.
In addition, we had drawn approximately $2,276,000 on the Paragon line of
credit, leaving approximately $194,000 available under the line of credit for
operations. As of May 11, 2009, we also have a commitment from our convertible
secured subordinated noteholders to purchase up to an additional $8.5 million in
convertible notes upon approval and call by our Board of Directors.





Cash
Flows





During
the three months ended March 31, 2009, our working capital deficit increased by
approximately $300,000 to $3,289,000 from a working capital deficit of
$2,989,000 at December 31, 2008. As described more fully below, the working
capital deficit at March 31, 2009 is primarily attributable to negative cash
flows from operations, offset in part by net debt borrowings.


28


Cash
Flows from Operating Activities





Three
      Months Ended
                    March
      31,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentNet
      cash used in operating activities
                  
                  $
                  884,892
                  
                  
                  $
                  1,571,558
                  
                  
                  $
                  (686,666
                  )
                  
                  
                  -44
                  %





Net cash
used in operating activities decreased 44% to $885,000 for the three months
ended March 31, 2009 from $1,572,000 for the same period in 2008. This decrease
is primarily attributable to a lower net loss for the period, a decrease in
accounts receivable, and an increase in accrued liabilities, offset in part by
an increase in prepaid expenses and decreases in accounts payable and deferred
revenue.





Cash
Flows from Investing Activities





Three
      Months Ended
                    March
      31,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentNet
      cash provided by (used in) investing activities
                  
                  $
                  (83,281
                  )
                  
                  $
                  3,061
                  
                  
                  $
                  (86,342
                  )
                  
                  
                  2,821
                  %





Net cash
used in investing activities increased 2,821% to $83,000 for the three months
ended March 31, 2009 from net cash provided by investing activities of $3,000
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





Three
      Months Ended
                    March
      31,
                  
                  
                  Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentNet
      cash provided by (used in) financing activities
                  
                  $
                  987,860
                  
                  
                  $
                  (1,553,704
                  )
                  
                  $
                  2,541,564
                  
                  
                  
                  164
                  %





Net cash
provided by financing activities increased 164% to $988,000 for the three months
ended March 31, 2009 from net cash used in financing activities of $1,554,000
for the same period in 2008. This net source of cash is primarily due to net
debt borrowings in the first quarter 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 first 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.


29




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
March 31, 2009, we had $6.3 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 January 6, 2009 and February 24, 2009, we sold $500,000 and $500,000,
respectively, aggregate principal amount of notes 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 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.


30


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 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 approved by our Board of Directors. Changes in our
operating plans, lower than anticipated sales, increased expenses, or other
events may cause us to seek additional equity or debt financing in future
periods. There can be no guarantee that financing will be available on
acceptable terms or at all. Additional equity financing could be dilutive to the
holders of our common stock, and additional debt financing, if available, could
impose greater cash payment obligations and more covenants and operating
restrictions.


31


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 April
3, 2009, we sold $500,000 aggregate principal amount of notes to Atlas with
substantially the same terms and conditions as the previously outstanding
notes.





On April
17, 2009, we dismissed Sherb & Co., LLP as our independent registered public
accounting firm and appointed Cherry, Bekaert & Holland, L.L.P., or
CB&H, as our independent registered public accounting firm for the fiscal
year ending December 31, 2009. The decision to change accountants was approved
by the Audit Committee of our Board of Directors at a meeting held on April 16,
2009 and was due to the desire to rotate accounting firms as well as for
CB&H’s closer geographic proximity to us.





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 Chief Executive Officer and Chief
Financial 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
Chief Executive Officer and 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 March 31, 2009 that we believe materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.


32


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.





At this
time, we are not able to determine the likely outcome of our currently pending
legal matters, nor can we estimate our potential financial exposure. Our
management has made an initial estimate based upon its knowledge, experience and
input from legal counsel, and we have accrued approximately $137,500 of
additional legal reserves. Such reserves will be adjusted in future periods as
more information becomes available. If an unfavorable resolution of any of these
matters occurs, our business, results of operations, and financial condition
could be materially adversely affected.





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 May 11,
2009, we have approximately $194,000 available on our line of credit and $8.5
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 May 11, 2009, we have approximately $2.28 million outstanding on
our line of credit and $6.8 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.


33





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 enter
into 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.


34


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 when we begin charging for our
services, their dissatisfaction with our services, and their capability to
continue their operations and 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 to fraudulently 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 preventative measures. If an actual or perceived breach of
our security occurs, the market perception of the effectiveness of our security
measures could be harmed and we could lose sales and customers. 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, 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.


35





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 indemnify, and in certain circumstances 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, unless such
person (i) did not act in good faith and in a manner the person reasonably
believed to be in or not opposed to our best interests; or (ii) had reasonable
cause to believe his conduct was unlawful. As of May 11, 2009, there are SEC and
criminal actions pending against a former executive officer and a former
employee who have requested that we indemnify them and advance expenses incurred
by them in the defense of those actions. Also, a stockholder class action
lawsuit has been filed against us and certain of our 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 individual’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 of May
7, 2009, our insurance coverage for these claims has been exhausted. We have
been contacted by the defense attorneys in the criminal action against our
former officer and former employee about advancement of defense expenses, and we
have indicated to the defense attorneys that we will not advance any defense
expenses for the criminal action for the named defendants. Therefore, we face
the risk of being the subject of a potential lawsuit seeking advancement of
defense expenses and/or making substantial payments related to the defense of
the actions noted above. In addition, a number of our current and former
employees have been asked to appear as witnesses in the criminal action and may
seek advancement of legal expenses from us. Any of these events 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 May 11, 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.


36





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.





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





Our
officers, 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. 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. The Chairman of our Board of Directors currently is serving
as the bond representative.





Our
officers, directors, and principal stockholders, acting together, would have the
ability to control substantially all matters submitted to our stockholders for
approval (including the election and removal of directors and any merger,
consolidation, or sale of all or substantially all of our assets) and to control
our management and affairs. Accordingly, this concentration of ownership may
have the effect of delaying, deferring, or preventing a change in control of us;
impeding a merger, consolidation, takeover, or other business combination
involving us; or discouraging a potential acquirer from making a tender offer or
otherwise attempting to obtain control of us, which in turn could materially and
adversely affect the market price of our common stock.





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.


37


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 May 11, 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 prices of the securities of technology companies have been highly
volatile. Accordingly, the trading price of our common stock has been and is
likely to continue to be subject to wide fluctuations. Further, our common stock
has a limited trading history. Factors affecting the trading price of our common
stock 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.





Further,
securities class action litigation has often been brought against companies that
experience periods of volatility in the market prices of their securities. A
securities class action was filed against us in October 2007. This securities
class action litigation could result in substantial costs and diversion of our
management’s attention and resources. We may determine, like many defendants in
such lawsuits, that it is in our best interest to settle the lawsuit, even if we
believe that the plaintiffs’ claims have no merit, to avoid the cost and
distraction of continued litigation. Any liability we incur in connection with
this or any other potential lawsuit could materially harm our business and
financial position and, even if we defend ourselves successfully, there is a
risk that management’s distraction in dealing with this type of lawsuit could
harm our results.





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.


38





Our
executive management team is critical to the execution of our business plan and
the loss of their services could have a severely negative impact on our
business.





Our
executive management team has undergone significant changes since the last half
of 2007, including the resignation of our Chief Executive Officer in December
2008. Although we have resolved the SEC charges filed against us, it may be
difficult to attract highly qualified candidates to serve on our executive
management team. 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 quarter of fiscal 2009, we sold equity securities 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 quarter 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
                                
                                -
                                
                                -Total
                                
                                146
                                
                                $
                                1.50
                                
                                -
                                
                                -





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





Item
6.            Exhibits





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





Exhibit No.
                
                Description4.1
                
                Third
      Amendment to Convertible Secured Subordinated Note Purchase Agreement and
      Registration Rights Agreement and Amendment to Convertible Secured
      Subordinated Promissory Notes, dated February 24, 2009, by and among Smart
      Online, Inc. and certain investors (incorporated herein by reference to
      Exhibit 4.6 to our Annual Report on Form 10-K, as filed with the SEC on
      March 30, 2009)4.2
                
                Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      January 2009 (incorporated herein by reference to Exhibit 4.7 to our
      Annual Report on Form 10-K, as filed with the SEC on March 30,
      2009)31.1
                
                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


39





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.


40


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/
      Doron RoethlerMay
      14, 2009
              
              Doron
      RoethlerPrincipal
      Executive OfficerBy:
              /s/
      Timothy L. KristMay
      14, 2009
              
              Timothy
      L. KristPrincipal
      Financial Officer and Principal Accounting
                Officer


41


EXHIBIT
INDEX





Exhibit No.
                
                Description4.1
                
                Third
      Amendment to Convertible Secured Subordinated Note Purchase Agreement and
      Registration Rights Agreement and Amendment to Convertible Secured
      Subordinated Promissory Notes, dated February 24, 2009, by and among Smart
      Online, Inc. and certain investors (incorporated herein by reference to
      Exhibit 4.6 to our Annual Report on Form 10-K, as filed with the SEC on
      March 30, 2009)4.2
                
                Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      January 2009 (incorporated herein by reference to Exhibit 4.7 to our
      Annual Report on Form 10-K, as filed with the SEC on March 30,
      2009)31.1
                
                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.


42