**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


**Washington,
DC 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, 2005**





**OR**





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





**Commission
File Number: 333-119385**





**_________________**





**SMART
ONLINE, INC.**


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





**_________________**








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











**2530
Meridian Parkway, 2** **nd** **Floor**


**Durham,
North Carolina 27713**


**(Address
of principal executive offices)**





**(919)
765-5000**


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


**_________________**





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





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





As of
March 31, 2005, there were approximately 12,286,832 million shares of the
Registrant’s Common Stock outstanding.














Table of Contents











**Smart
Online, Inc.**





**INDEX**








**PART
I. FINANCIAL INFORMATION**





**Page
      No.****Item
      1.**
    **Financial Statements:**
    3Balance Sheets as of March 31, 2005 (unaudited) and
      December 31, 2004
    3Statements of Operations (unaudited) for the three months
      ended March 31, 2005 and 2004
    4Statements of Cash Flows (unaudited) for the three months
      ended March 31, 2005 and 2004
    5Notes to Financial Statements
      (unaudited)
    6**Item
      2.**
    **Management’s Discussion and Analysis of Financial Condition
      and Results of Operations (including Risk
      Factors)**
    16**Item
      3.**
    **Quantitative and Qualitative Disclosures About Market
      Risk**
    50**Item
      4.**
    **Controls and Procedures**
    50**PART
      II. OTHER INFORMATION****Item
      1.**
    **Legal Proceedings**
    52**Item
      2.**
    **Unregistered Sales of Equity Securities and Use of
      Proceeds**
    52**Item
      3.**
    **Defaults Upon Senior
    Executives**
    53**Item
      4.**
    **Submission of Matters to a Vote of Securities
      Holders**
    53**Item
      5.**
    **Other Information**
    53**Item
      6.**
    **Exhibits**
    53**Signatures**
    54








2
 Table of Contents











**PART
I. FINANCIAL INFORMATION**





**Item
1. FINANCIALSTATEMENTS**





**Smart
Online, Inc.**


**BalanceSheets**








**Assets**
    
    
    **March
      31,**
      **2005**
      **(unaudited)**
    
    
    **December
      31**,
      **2004**CURRENT
      ASSETS:Cash
      and cash equivalents
    
    $
    1,386,783
    
    $
    173,339Marketable
      securities
    
    
    -
    
    
    395,000Accounts
      receivable, net
    
    
    12,189
    
    
    30,904Other
      accounts receivable
    
    
    -
    
    
    43,455Prepaid
      expenses
    
    
    69,318
    
    
    24,850Total
      current assets
    
    
    1,468,290
    
    
    667,548PROPERTY
      AND EQUIPMENT, net
    
    
    115,956
    
    
    75,636INTANGIBLE
      ASSETS, net
    
    
    16,473
    
    
    16,623OTHER
      ASSETS
    
    
    16,114
    
    
    13,894TOTAL
      ASSETS
    
    $
    1,616,833
    
    $
    773,701CURRENT
      LIABILITIES:Accounts
      payable
    
    $
    222,336
    
    $
    186,382Accrued
      payroll
    
    
    122,299
    
    
    110,079Accrued
      payroll taxes, penalties and interest
    
    
    49,341
    
    
    574,827Deferred
      revenue
    
    
    673,861
    
    
    721,689Total
      current liabilities
    
    
    1,067,837
    
    
    1,592,977LONG-TERM
      LIABILITIES:Deferred
      compensation, notes payable and interest
    
    
    -
    
    
    1,091,814Total
      long-term liabilities
    
    
    -
    
    
    1,091,814Total
      liabilities
    
    
    1,067,837
    
    
    2,684,791COMMITMENTS
      AND CONTINGENCIES
    
    
    -
    
    
    -STOCKHOLDERS'
      EQUITY (DEFICIT):Common
      stock, $.001 par value, 45,000,000 shares authorized, shares issued and
      outstanding:
      March
      31, 2005 - 12,286,832; December 31, 2004 —11,631,832
    
    
    12,287
    
    
    11,632Additional
      paid-in capital
    
    
    37,563,408
    
    
    34,809,832Accumulated
      equity (deficit)
    
    
    (37,026,699
    )
    
    (36,732,554
    )Total
      stockholders' equity (deficit)
    
    
    548,996
    
    
    (1,911,090
    )TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
    
    $
    1,616,833
    
    $
    773,701








See Notes
to Financial Statements





3
 Table of Contents





**SMART
ONLINE, INC.**


**STATEMENTS
OF OPERATIONS**


(unaudited)


**Three
      Months**
      **Ended**
      **March
      31, 2005**
    
    **Three
      Months**
      **Ended**
      **March
      31, 2004**REVENUES:Integration
      fees
    
    $
    129,522
    
    $
    103,819Syndication
      fees
    
    
    92,040
    
    
    30,621OEM
      revenue
    
    
    12,000
    
    
    14,686Web
      services
    
    
    15,159
    
    
    16,714Other
      revenues
    
    
    4,517
    
    
    1,375Related
      party revenues
    
    
    -
    
    
    82,513Total
      revenues
    
    
    253,238
    
    
    249,728COST
      OF REVENUES
    
    
    31,727
    
    
    57,019GROSS
      PROFIT
    
    
    221,511
    
    
    192,709OPERATING
      EXPENSES:General
      and administrative
    
    
    519,036
    
    
    449,257Sales
      and marketing
    
    
    294,732
    
    
    98,399Development
    
    
    255,227
    
    
    164,378Total
      operating expenses
    
    
    1,068,995
    
    
    712,034LOSS
      FROM OPERATIONS
    
    
    (847,484
    )
    
    (519,325
    )OTHER
      INCOME (EXPENSE):Interest
      income (expense), net
    
    
    5,998
    
    
    (107,652
    )Gain
      on debt forgiveness
    
    
    547,341
    
    
    27,548Total
      other income (expense)
    
    
    553,339
    
    
    (80,104)NET
      LOSS
    
    
    (294,145
    )
    
    (599,429
    )Preferred
      stock dividends and
      accretion
      of discount on
      preferred
      stock
    
    
    -
    
    
    (2,215,625
    )Accretive
      dividend issued
      in
      connection with registration
      rights
      agreement
    
    
    -
    
    
    (3,225,410
    )Net
      loss attributed to
      common
      stockholders
    
    $
    (294,145
    )
    $
    (6,040,464
    )NET
      LOSS PER SHARE:Net
      loss attributed to
      common
      stockholders -
      Basic
      and Diluted
    
    $
    (.02
    )
    $
    (0.83
    )SHARES
      USED IN COMPUTING NET LOSS PER SHARE:Basic
      and Diluted
    
    
    11,829,610
    
    
    7,321,707





See notes
to financial statements.











4
 Table of Contents














**SMART
ONLINE, INC.**


**STATEMENTS
OF CASHFLOWS**


(unaudited)


**Three
      Months**
      **Ended**
      **March
      31, 2005**
    
    **Three
      Months**
      **Ended**
      **March
      31, 2004**CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
    
    $
    (294,145
    )
    $
    (599,429
    )Adjustments
      to reconcile net loss to net cashused
      in operating activities:Depreciation
    
    
    11,093
    
    
    10,104Common
      shares or options issued in lieu of compensation
    
    
    -
    
    
    161,000Common
      shares issued for extension of loan
    
    
    -
    
    
    75,000Issuance
      of warrants
    
    
    19,231
    
    
    -Gain
      on debt forgiveness
    
    
    (547,341
    )
    
    (27,548
    )Changes
      in assets and liabilities:Accounts
      receivable
    
    
    18,715
    
    
    58,226Related
      party receivable
    
    
    -
    
    
    33,057Other
      accounts receivable
    
    
    -
    
    
    (18,333
    )Prepaid
      expenses
    
    
    (44,468
    )
    
    (25,675
    )Other
      assets
    
    
    41,235
    
    
    -Deferred
      revenue
    
    
    (47,828
    )
    
    (183,720
    )Accounts
      payable
    
    
    57,809
    
    
    (342,694
    )Accrued
      payroll
    
    
    12,220
    
    
    1,372Accrued
      payroll taxes payable
    
    
    -
    
    
    (990,858
    )Accrued
      interest payable
    
    
    -
    
    
    (138,164
    )Deferred
      compensation, notes payable, and interest
    
    
    (1,091,814
    )
    
    111,992Net
      cash used in operating
    
    
    (1,865,293
    )
    
    (1,875,670
    )ActivitiesCASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of furniture and equipment
    
    
    (51,263
    )
    
    (644
    )Redemption
      of marketable securities
    
    
    395,000
    
    
    -Net
      cash provided by (used in) investing activities
    
    
    343,737
    
    
    (644
    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Repayments
      on notes payable
    
    
    -
    
    
    (350,000
    )Repayments from
      stockholder
    
    
    -
    
    
    (86,480
    )Issuance
      of common stock
    
    
    2,735,000
    
    
    2,288,499Net
      cash provided by financing activities
    
    
    2,735,000
    
    
    1,852,019NET
      INCREASE IN CASH
      AND
      CASH EQUIVALENTS
    
    
    1,213,444
    
    
    (24,295
    )CASH
      AND CASH EQUIVALENTS,
      BEGINNING
      OF PERIOD
    
    
    173,339
    
    
    101,486CASH
      AND CASH EQUIVALENTS,
      END
      OF PERIOD
    
    $
    1,386,783
    
    $
    77,191Supplemental
      disclosures:Cash
      payment during the period for interest:
    
    $
    154,288
    
    $
    164,055Non-cash
      financing activities:Non-cash
      accretion of preferred stock redemption value
    
    $
    -
    
    $
    2,215,625Conversion
      of preferred stock into common stock
    
    $
    -
    
    $
    19,724,839





See notes
to financial statements.





5
 Table of Contents







**Smart
Online, Inc.**





**Notesto Financial Statements - Unaudited**





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


******


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

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

The accompanying financial statements have been prepared assuming
that the Company will continue as a going concern.  As such, they do not
include adjustments relating to the recoverability of recorded asset amounts and
classification of recorded assets and liabilities.  The Company had
accumulated losses of approximately $37,036,699 at March 31, 2005 and will be
required to make significant expenditure in connection with continuing
development and marketing efforts along with general and administrative
expenses.  The Company's ability to continue its operations is dependant
upon its raising of capital through equity financing in order to meet its
working needs.

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

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


******


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





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


******


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





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





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








6
 Table of Contents








We
recognize revenue when all of the following conditions are satisfied: (1) there
is persuasive evidence of an arrangement; (2) the service has been provided to
the customer; (3) the collection of our fees is probable; and (4) the amount of
fees to be paid by the customer is fixed or determinable. EITF 00-21 states that
revenue arrangements with multiple deliverables should be divided into separate
units of accounting if the deliverables in the arrangement meet the following
criteria: (1) the delivered item has value to the customer on a standalone
basis; (2) there is objective and reliable evidence of the fair value of the
undelivered item; and (3) if the arrangement includes a general right of return
relative to the delivered item, deliver or performance of the undelivered item
is considered probable and substantially in control of the vendor. Smart
Online’s syndication and integration agreements typically include multiple
deliverables including the grant of a non-exclusive license to distribute, use
and access the Smart Online platform, fees for the integration of content into
the Smart Online platform, maintenance and hosting fees,documentation
and training, and technical support and customer support fees. Smart Online
cannot establish fair value of the individual revenue deliverables based on
objective and reliable evidence because the Company does not have a long,
consistent history of standard syndication and integration contractual
arrangements, there have only been a few contracts that have continued past the
initial contractual term, the Company does not have any contracts in which these
elements have been sold as stand-alone items, and there is no third-party
evidence of fair value for products or services that are interchangeable and
comparable to Smart Online’s products and services. As such, Smart Online can
not allocate revenue to the individual deliverables and must record all revenues
received as a single unit of accounting as further described below.
Additionally, Smart Online has evaluated the timing and substantive nature of
the performance obligations associated with the multiple deliverables noted
above, including the determination that the remaining obligations are essential
to the on-going usability and functionality of the delivered products, and
determined that revenue should be recognized over the life of the contracts due
to such factors as the length of time over which the remaining obligations will
be performed, the complex nature of integrating and maintaining customer content
with Smart Online’s platform, which services are unavailable from other vendors,
and the timing of payment of a portion of the contract price such as monthly
hosting payments.





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





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





7
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Both
syndication and integration fees are recognized on a monthly basis over the life
of the contract, although a significant portion of the fee from integration is
received upfront. Our contract and support contracts are non-cancelable, though
customers typically have the right to terminate their contracts for cause if we
fail to perform. We generally invoice our customers in annual or monthly
installments and typical payment terms provide that our customers pay us within
30 days of invoice. Amounts that have been invoiced are recorded in accounts
receivable and in deferred revenue or revenue depending on whether the revenue
recognition criteria have been met. In general, we collect our billings in
advance of the service period. Online marketing, which consists of marketing
services provided to our integration and syndication partners have in the past
generated additional revenue. In addition, certain users have requested that
Smart Online implement online marketing initiatives for them, such as promoting
their products through Google or Overture Services. Online marketing has not
been a material source of past income. We intend to seek an increase in the
level of online marketing services in the future.





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





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





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





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





***Barter
Transactions*** - Barter
revenue relates to syndication and integration services provided by Smart Online
to business customers in exchange for advertising in the customers’ trade
magazines and on their Web sites. Barter expenses reflect the expense offset to
barter revenue. The amount of barter revenue and expense is recorded at the
estimated fair value of the services received or the services provided,
whichever is more objectively determinable, in the month the services and
advertising are exchanged. Smart Online applies APB 29, Accounting for
Non-Monetary Transactions, the provisions of EITF 93-11, “Accounting for Barter
Transactions Involving Barter Credits” and EITF 99-13 “Accounting for
Advertising Barter Transactions” and, accordingly, recognizes barter revenues
only to the extent that Smart Online has similar cash transactions within a
period not to exceed six months prior to the date of the barter transaction. To
date, the amount of barter revenue to be recognized has been more objectively
determinable based on integration and syndication services provided rather than
based upon the value of advertising received. For revenue from integration and
syndication services provided for cash to be considered similar to the
integration and syndication services provided in barter transactions, the
services rendered must have been in the same media and similar term as the
barter transaction. Further, the quantity or volume of integration or
syndication revenue received in a qualifying past cash transaction can only
evidence the fair value of an equivalent quantity or volume of integration or
syndication revenue received in subsequent barter transactions. In other words,
a past cash transaction can only support the recognition of revenue on
integration and syndication contracts transactions up to the dollar amount of
the cash transactions. When the cash transaction has been used to support an
equivalent quantity and dollar amount of barter revenue, that transaction cannot
serve as evidence of fair value for any other barter
transaction. Once the value of the barter revenue has been determined, Smart
Online follows the same revenue recognition principals as it applies to cash
transactions with unearned revenues being deferred as described more fully
above. At the time the barter revenue is recorded, an offsetting pre-paid barter
advertising asset is recorded on Smart Online’s balance sheet. This pre-paid
barter advertising asset is amortized to expense as advertising services are
received such as when an advertisement runs in a magazine. Where more than one
deliverable exists, such as when the barter partner is to provide advertising in
four issues of a magazine, the expense is recognized pro-rata as the advertising
deliverable is provided. Barter revenues totaled $3,333 and $107,665 in the
first quarter of 2004 and 2005, respectively.





8
 Table of Contents








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





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





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





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





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





Office
      equipment
    5
      yearsFurniture
      and fixtures
    7
      years





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





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





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





9
 Table of Contents








***Advertising
Costs*** - Smart
Online expenses all advertising costs as they are incurred. The amount charged
to expense during the first quarter of 2005 and 2004 were $136,335 and
$(10,525), respectively. The 2005 period included $135,000 of barter advertising
expenses and the 2004 period reflected a credit related to prior advertising
activities.





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





***Stock-Based
Compensation*** - Smart
Online accounts for its stock-based compensation plans in accordance with the
intrinsic value provisions of Accounting Principles Board Opinion (“APB”) No.
25, “Accounting for Stock Issued to Employees.” Stock Options are generally
granted at prices equal to the fair value of Smart Online’s common stock on the
grant dates (see Note 9). Accordingly, Smart Online did not record any
compensation expense in the accompanying financial statements for its
stock-based compensation plans. Had compensation expense been recognized
consistent with the fair value provisions of SFAS No. 123, “Accounting for
Stock-Based Compensation,” Smart Online’s net loss attributed to common
stockholders and net loss attributed to common stockholders per share for the
quarters ended March 31, 2005 and 2004 would have been changed to the pro forma
amounts indicated below:





Three
      Months Ended March 31, 2005
    
    Three
      Months Ended March 31, 2004Net
      loss attributed tocommon
      stockholders:As
      reported
    
    $
    (294,145
    )
    $
    (6,040,464
    )Add:   Compensation
      cost
    
    
    -
    
    
    161,000recorded
      at intrinsic valueLess:  
      Compensation cost using
    
    
    (34,052
    )
    
    (268,825
    )the
      fair value methodPro
      forma
    
    $
    (328,197
    )
    $
    (6,148,289
    )










**Three****months****ended**
      **March
      31, 2005**
    
    **Three****months****ended**
      **March
      31, 2004**Reported
      net loss attributed tocommon
      stockholders:Basic
      and diluted
    
    $
    (0.02
    )
    $
    (0.83
    )Pro
      forma net loss per share:Basic
      and diluted
    
    $
    (0.03
    )
    $
    (0.84
    )








10
 Table of Contents











The fair
value of option grants under Smart Online’s plan and other stock option issuance
during the quarters ended March 31, 2005 and 2004 was estimated using the
Black-Scholes option-pricing model with the following weighted-average
assumptions were used:





**Quarter
      Ended**
      **March
      31,**
      **2005**
    
    **Quarter
      Ended**
      **March
      31,**
      **2004**Dividend
      yield
    
    0.
      00
    %
    
    
    0.
      00
    %Expected
      volatility
    
    0.00
    %
    
    
    0.00
    %Risk
      free interest rate
    
    4.23
    %
    
    
    4.23
    %Expected
      lives (years)
    
    9.0
    
    
    
    5.0





****


***New
Accounting Standards***


**


In December 2004, the FASB issued SFAS No. 123 (revised
2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R), a revision of SFAS
123, “Accounting for Stock-Based Compensation”, supersedes APB Opinion No. 25,
“Accounting for Stock Issued to Employees”, and amends SFAS No. 95, “Statement
of Cash Flows.” SFAS 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the financial
statements based on their fair values. SFAS 123(R) is effective for the
beginning of the first interim or annual period beginning after June 15, 2005.
Therefore the Company plans to adopt SFAS 123(R) on July 1, 2005. The Company is
currently evaluating the two fair value pricing methods permitted by SFAS 123(R)
and has not selected a final fair value pricing model nor determined the impact
such model will have on the Company’s financial statements.


****


**2.
Balance Sheets Accounts**


******


***Marketable
Securities***





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





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





Smart
Online did not hold any marketable securities on March 31, 2005.





***Receivables***





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





***Property
and Equipment***





Property
and equipment consists of the following at:





**March
      31,**
      **2005**
    
    
    **December
      31,**
      **2004**Office
      equipment
    
    $
    16,187
    
    $
    16,187Furniture
      and fixtures
    
    
    7,125
    
    
    7,125Computer
      software
    
    
    420,656
    
    
    393,629Computer
      equipment
    
    
    687,030
    
    
    663,723Automobiles
    
    
    29,504
    
    
    29,5041,160,502
    
    
    1,110,168Less
      accumulated depreciation
    
    
    (1,044,546
    )
    
    (1,034,532
    )Property
      and equipment, net
    
    $
    115,956
    
    $
    75,636





Depreciation
expense for the quarters ended March 31, 2005 and 2004 was $11,093 and $10,104,
respectively.





11
 Table of Contents





***Deferred
Compensation***


**


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





**3.
Stockholders’ Deficit**




***Common
Stock and Warrants***


**


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





During
February 2005, a consulting firm that was issued 350,000 warrants in November
2003, acquired 50,000 shares of Smart Online’s Common Stock as a result of the
cashless exercise of warrants. Warrants to purchase 67,568 shares of Common
Stock were cancelled in this cashless exercise. The fair market value of Smart
Online’s Common Stock at the time of exercise was $5.00.





As an
inducement to an investor who purchased shares of Common Stock during the first
half of 2004, an officer of Smart Online and a shareholder entered into a Put
Agreement dated March 10, 2004 with the investor. Smart Online was not a party
to this agreement, but the agreement was entered into at the time of the
investment into Smart Online to provide comfort to the investor that Smart
Online would fulfill its obligation to cause its Common Stock to be publicly
traded. As a result of Smart Online registering its Common Stock, this Put
Agreement was cancelled in March 2005.





***Stock
Option Plans***


**


Smart
Online maintains three equity compensation plans. During the first quarter of
2005 there were no stock option grants.





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





**Shares**
    
    **Weighted**
      **Average**
      **Exercise**
      **Price**BALANCE,
      December 31, 2004
    
    
    1,768,900
    
    $
    2.78Forfeited
    
    
    (30,500
    )
    $
    5.00BALANCE,
      March 31, 2005
    
    
    1,738,400
    
    $
    4.69








12
 Table of Contents








The
following table summarizes information about stock options outstanding at March
31, 2005:





**Currently
      Exercisable****Exercise**
      **Price**
    **Number
      of**
      **Shares**
      **Outstanding**
    **Average**
      **Remaining**
      **Contractual
      Life**
      **(Years)**
    **Weighted**
      **Average
      Exercise**
      **Price**
    **Number
      of**
      **Shares**
    **Weighted**
      **Average**
      **Exercise**
      **Price**$
      1.30 - $ 1.43
    870,000
    3.8
    $
      1.37
    870,000
    $
      1.37$
      3.50
    514,000
    9.1
    $
      3.50
    150,250
    $
      3.50$
      5.00
    354,400
    0.7
    $
      5.00
    354,400
    $
      5.00$
      1.30 - $ 5.00
    1,738,400
    4.7
    $
      2.74
    1,374,650
    $
      2.54





***Dividends***





Smart
Online has not paid any cash dividends through March 31, 2005.





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





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





3
      Months Ended March 31, 2005Revenues
    
    %
      of Total
      RevenuesCustomer
      A
    
    
    Integration/Barter
    
    $
    41,250
    
    
    16.3
    %Customer
      B
    
    
    Syndication/Barter
    
    
    26,727
    
    
    10.6
    %Customer
      C
    
    
    Syndication/Barter
    
    
    34,688
    
    
    13.7
    %Customer
      D
    
    
    Syndication
    
    
    30,625
    
    
    12.1
    %Others
    
    
    Various
    
    
    119,948
    
    
    47.3
    %Total
    
    
    
    
    $
    253,238
    
    
    100.0
    %





3
      Months Ended March 31, 2004Revenues
    
    %
      of Total
      RevenuesCustomer
      E
    
    
    Integration
    
    
    82,513
    
    
    33.0
    %Customer
      F
    
    
    Integration
    
    
    25,000
    
    
    10.0
    %Customer
      G
    
    
    Integration
    
    
    25,000
    
    
    10.0
    %Others
    
    
    Various
    
    
    117,215
    
    
    47.0
    %Total
    
    
    
    
    $
    249,728
    
    
    100.0
    %








Smart
Online had one customer that accounted for 100% of receivables at December 31,
2004 and substantially all of the accounts receivable at March 31,
2005.





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





American
Investment Holding Group, Inc., which is wholly-owned by two officers of Smart
Online, owns approximately 23% of the outstanding Common Stock of Smart Online
as of March 31, 2005. The same officers also own a controlling interest in other
companies.








13
 Table of Contents





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





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





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





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





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





In March
2004, SIL ceased further development of its technology and laid-off its
employees.  SIL is currently seeking opportunities to license or sell its
technology. The Company continues to support this technology on behalf of SIL.
The revenues derived from this agreement with SIL were recognized as income on a
straight line basis over the life of the agreement. Smart Online recognized
$330,051of revenue related to the aforementioned integration, co-development and
reseller agreements during 2004.





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








14
 Table of Contents








The
following is a summary of related party revenues for the quarters ended March
31, 2005 and 2004:








**Quarter
      ended**
      **March
      31,**
      **2005**
    
    **Quarter
      ended**
      **March
      31,**
      **2004**Smart
      II, Ltd. ("SIL"), formerly
      known
      as Smart Revenue Europe Ltd.
      -
      Integration fees
    
    $
    -
    
    $
    82,513Total
      Related Party Revenues
    
    $
    -
    
    $
    82,513





The
following is a summary of related party expenses for the quarters ended March
31, 2005 and 2004:





**Quarter
      ended**
      **March
      31,**
      **2005**
    
    **Quarter
      ended**
      **March
      31,**
      **2004**Nen,
      Inc. - consulting fees included
      in
      sales and marketing expense
      related
      to strategic international sales
      and
      marketing services
    
    $
    17,500
    
    $
    17,500Nen,
      Inc. - consulting fees included
      in
      general and administrative
      expense
      related to assisting Smart
      Online
      with obtaining additional
      equity
      financing
    
    
    -
    
    
    2,500Small
      Business Loan Institute -
      consulting
      fees included in general
      and
      administrative expense
    
    
    -
    
    
    30,000Smart
      II, Ltd. - Moving expenses,
      reseller
      payment, and technical co-
      development
      work
    
    
    -
    
    
    45,000Interest
      expense incurred on
      loans
      from officer
    
    
    -
    
    
    3,123Total
      Related Party Expenses
    
    $
    -
    
    $
    98,123





**6.
Commitments and Contingencies**





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





15
 Table of Contents








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





**7.
Subsequent Events**





***Stock
Option and Warrants***


**


During
April 2005 Smart Online granted options to purchase 180,000 shares of Common
Stock to a consultant, 34,000 shares of Common Stock to new Board members,
25,000 shares to an officer, and 2,500 shares to an employee. All options were
granted under Smart Online’s 2004 Equity Compensation Plan at an exercise price
of $5.00 per share.





Also
during April 2005, a holder of warrants to purchase Common Stock exercised
warrants to purchase 500 shares of Smart Online’s Common Stock.





***Commencement
of Trading of Smart Online’s Common Stock***





Smart
Online’s Common Stock began trading on the Over-the-Counter Electronic Bulletin
Board (“OTCBB”) on April 15, 2005.





***Legal
Settlements***





During
April 2005 the Company reached a settlement with U.S. News & World Report
and paid $50,000 to resolve all outstanding claims and the case was dismissed
with prejudice.  During May 2005, Smart Online settled for $30,000 claims
made by Infopia, Inc. and the case was dismissed with prejudice.





***New
Integration Agreement***





During
April 2005, the Company signed an agreement with Capital One. Commencing with
the second quarter of 2005, we anticipate that greater than 10% of our total
revenue will be derived from this agreement.





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





*The
following discussion in Management’s Discussion and Analysis of Financial
Condition as Results of Operations (“MD&A”) and elsewhere in this report
contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 12E of the Securities Exchange Act of 1934.
Forward-looking statements consist of, among other things, trend analyses,
statements regarding future events, future financial performance, our plan to
build our business and the related expenses, our anticipated growth, trends in
our business, the effect of foreign currency exchange rate and interest rate
fluctuations on our business, the potential impact of current litigation or any
future litigation, the potential availability of tax assets in the future and
related matters, and the sufficiency of our capital resources, all of which are
based on current expectations, estimates, and forecasts, and the beliefs and
assumptions of our management. Words such as “expects, “ “anticipates,”
“projects,” “intends,” “plans,” “estimates,” variations of such words, and
similar expressions are also intended to identify such forward-looking
statements. These forward-looking statements are subject to risks, uncertainties
and assumptions that are difficult to predict. Therefore, actual results may
differ materially and adversely from those expressed in any forward-looking
statements. Readers are directed to risks and uncertainties identified below,
under “Risk Factors” and elsewhere in this report, for factors that may cause
actual results to be different than those expressed in these forward-looking
statements. Except as required by law, we undertake no obligation to revise or
update publicly any forward-looking statements for any reason.*








16
 Table of Contents











**Overview**





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





Smart
Online has developed numerous sources of revenue as its business plan has
changed to adapt to changing business circumstances. These sources of revenue
include syndication partners, integration partners, OEMs, subscriptions from
small businesses, one-time purchases by small businesses and barter transactions
with media companies. Currently, each of these revenue streams is small. Our
business plan is designed to utilize existing and future relationships in each
revenue source to ratchet up the amount of revenue we derive from all sources.
We have described in this prospectus the key elements of how we plan to achieve
this.





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





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





Our
objective is to be a leading provider of on-demand business software application
services for small businesses. We also believe that, when we complete
development of OneBiz Conductor SM later
this year, our products may be more attractive to middle size companies with up
to 500 employees. At that time, we intend to begin marketing to such middle size
companies. To address the significant market opportunity, our management team is
focused on a number of short and long-term challenges, including strengthening
and extending our service offerings, converting our registered users to paying
customers, beginning when we release the second version of OneBiz
Conductor SM , which
we expect will occur before the end of the third quarter of 2005, and expanding
our sales efforts by focusing on the specific need of our customers. Since 2000,
Smart Online’s major focus has been on developing and validating our online
content, applications, services, delivery platform and user interface. To
validate the platform, services, and products, many customers received access to
the Smart Online products and portal free-of-charge in exchange for their
evaluation and feedback. We have also used a number of different marketing
approaches to test and validate the best techniques to acquire and retain small
business customers.





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











17
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During
fiscal 2004, Smart Online entered into several new syndication and integration
agreements totaling approximately $1.2 million, including $640,000 of barter
transactions. During the first quarter of 2005, Smart Online continued its
efforts to expand its syndication and integration partnership reach. These
efforts resulted in the Company signing an agreement with Capital One during
April 2005. We are planning to substantially increase our advertising and
marketing in future years. We have started to enter into new syndication
partnerships that target strategic
partners for bartering arrangements for advertising and joint marketing programs
to take advantage of discounted advertising rates and to provide an opportunity
for us to share in the revenue generated by our syndication partners from use of
our platform. We began targeting small business media companies during the first
quarter of 2004, such as Inc. Magazine, FastCompany Magazine, and
BusinessWeek, which have small-business customer bases. Smart Online
anticipates the revenue share arrangements with the media companies will enable
it to increase web services revenue for both Smart Online and its private label
syndication partners as we begin to share in the revenue our partners generate
from their websites. We expect to create these arrangements in the future with
media companies which offer the ability to reach small-business customers
and assist in off-setting Smart Online’s cash expenditures for print and online
advertising and marketing. While we intend to derive a majority of our
syndication revenue from traditional non-barter transactions, we will evaluate
barter transactions on a case-by-case basis when we believe such transactions
make economic or strategic sense. Pursuant to the requirements of Emerging
Issues Task Force (EITF) No. 93-11, “Accounting for Barter Transactions
Involving Barter Credits,” and EITF 99-13, “Accounting for Advertising Barter
Transactions,” Smart Online recognized approximately $107,665 and $3,000 of
barter revenue in the first quarter of 2005 and 2004, respectively.





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





We expect
sales and marketing costs to increase substantially in dollars and as a percent
of total expenses commencing with the second half of 2005 as we prepare for the
launch of the second and third versions of OneBiz Conductor SM later
this year and as we seek to add and manage more paying subscribers, build brand
awareness and increase the number of marketing and sales programs implemented.
We expect we will have to increase marketing and sales expenses before we can
substantially increase our revenues from sales of subscriptions.





**Fiscal
Year**





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





**Sources
of Revenue**





Smart
Online currently derives revenues from the following sources:





·
    Syndication
      Fees - fees consisting of:





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





o
    Barter
      revenue derived from syndication agreements with media
      companies.





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





·
    Web
      Services fees - comprised of the following:





o
    E-commerce
      sales directly to end-users:





·
    Subscription





·
    Multiuser
      subscription paid by enterprises for their business
    customers





·
    A
      la carte





·
    E-commerce
      revenue sharing with integration partners





18
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·
    One
      Biz ConductorSMlicensing





·
    Contextual
      integration (“CI”) advertising fee





o
    Hosting
      and maintenance fees





o
    E-commerce
      Website Design and Build





o
    Loan
      origination fees





o
    Online
      marketing to our syndication/integration
partners





o
    Marketing
      fee for loan request through the integrated
platform





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





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





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





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





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





During
2004, we entered into several new syndication and integration partnerships with
targeted strategic partners, whereby we will receive a percentage of the revenue
generated by our partners from their websites. During the first quarter of 2005,
Smart Online continued its efforts to expand its syndication and integration
partnership reach. These efforts resulted in the Company signing an agreement
with Capital One during April 2005. Certain of these agreements also included
bartering arrangements for advertising and joint marketing programs to take
advantage of discounted advertising rates and to provide an opportunity for
revenue sharing. With these new partnerships more than 4 million small
businesses utilize the websites of our syndication partners for various
purposes. We intend to focus our future marketing and sales efforts on selling
our products to the users of the websites of our syndication partners. Smart
Online embarked on this program based on the success of the revenue share
strategy, illustrated by Google, Overture, and Career Builder, where media
companies provide these services to their customers to increase revenue for both
companies. Smart Online began targeting small business media companies during
the first quarter of 2004, who have small business customer bases. We estimate
our revenue share arrangements with the media companies will enable us to
increase web services revenue for both Smart Online and our private label
syndication partners while creating an advantage over potential competitors.
Smart Online expects to create certain types of these arrangements in the future
with media companies who offer the ability to reach small business customers and
will assist in off-setting Smart Online’s outlay of cash for more costly print
and online advertising and marketing. While we intend to derive a majority of
our syndication revenue from traditional non-barter transactions, we will
evaluate barter transactions on a case-by-case basis when we believe such
transactions make economic or strategic sense. During 2004, Smart Online signed
syndication contracts with Inc. Magazine, FastCompany Magazine, and
BusinessWeek. In addition we have embarked on a telesales effort to upsell
current users to additional Smart Online services and to bring former users back
to Smart Online.





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





19
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Web
Services revenues are comprised of e-commerce sales directly to end-users,
hosting and maintenance fees, e-commerce website design fees and online loan
origination fees. E-commerce sales are made either on a subscription or a la
carte basis. Subscription, which is access to most Smart Online offering is
payable in advance on a monthly basis and is targeted at small companies or
divisions of large companies. We will seek to grow our revenue, including
monthly subscription volume, substantially over the next 24 months as new
versions of Smart Online’s platforms (OneBiz Conductor SM ) are
released. To date, most of our users have been given free use of our products.
We plan to change that policy when we release the second version of OneBiz
Conductor SM , which
is planned to occur at the end of the third quarter of 2005. We expect monthly
subscription fees will typically be $29.95 to $49.95 for new subscribers direct
through www.smartonline.com after a
free trial period.  We expect lower fees from subscribers at the private
label syndication websites of our partners.  Currently, most of our
syndication agreements call for us to receive 50% of revenue generated. A la
carte pricing, which allows customers to purchase one-time use of a specific
software or content service, ranges from $10 to $300, which can include
third-party charges when applicable, such as state and federal fees associated
with incorporating a business or additional fees associated with having a press
release written and revised.





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





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





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





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





**Revenue
From Related Parties**





Approximately
33.0% of total revenues for the quarter ended March 31, 2004 were from a single
customer, Smart IL Ltd. (“SIL”), formerly known as Smart Revenue Europe Ltd., an
Israeli based software company that specialized in secured instant messaging
products. During March 2004 SIL ceased further development of its technology and
laid-off all employees after SIL completed development of, and delivered to us,
its instant messenger product. SIL is currently seeking to license or sell its
technology, however, we do not expect to receive substantial revenue from SIL in
the future. SIL is owned by Doron Roethler, a shareholder of Smart Online. Smart
Online did not derive any revenue from related parties during the first quarter
of 2005.





20
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The
following is a summary of related party revenues for the quarters ended March
31, 2005 and 2004:


**Quarter
      ended**
      **March
      31,**
      **2005**
    
    **Quarter
      ended March 31,**
      **2004**Smart
      II, Ltd. ("SIL"), formerly known as Smart Revenue Europe Ltd.
      -
      Integration fees
    
    $
    -
    
    $
    82,513Total
      Related Party Revenues
    
    $
    -
    
    $
    82,513











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





**Cost
of Revenues**





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





**Operating
Expenses**





During
the first quarter of 2005 and fiscal 2004 our efforts were primarily focused on
product development and integration. During 2004 and the first quarter of 2005,
Smart Online added 5 additional members to its development team and had 21
full-time employees as of March 31, 2005. Smart Online had 16 employees at March
31, 2004. Most employees performed multiple functions. As noted below, during
the first quarter of 2004, Smart Online’s employees were transferred to another
entity and leased back.





*Research
and Development* . We have
historically focused our research and development activities on increasing the
functionality and enhancing the ease of use of our on-demand application
service. Because of our proprietary, scalable and secure multi-user
architecture, we are able to provide all customers with a service based on a
single version of our application. As a result, we do not have to maintain
multiple versions, which enables us to have relatively low research and
development expenses as compared to traditional enterprise software business
models. We expect that in the future, research and development expenses will
increase substantially in absolute dollars as we upgrade and extend our service
offerings and develop new technologies. We expect this to be particularly true
during 2005 as we incur expenses to develop our next generation services portal,
OneBiz Conductor SM . OneBiz
Conductor SM will
include significant enhancements to the technology platform and add additional
applications to our product offerings. We plan to accomplish this through a
combination of internal development, joint development, licensing from other
companies, and acquisitions. OneBiz
Conductor SM will be
released in three versions. The first version was released during the first
quarter of 2005. The second and third versions are expected to be released at
the end of the third quarter of 2005 and the end of the fourth quarter of 2005,
respectively. We had 8
development team members at March 31, 2004 and 13 development team members at
March 31, 25005. During the second quarter of 2005 we expect to hire 1 to 3 new
developers, and to add 2 to 5 additional development team members during the
second half of 2005.





21
 Table of Contents








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





Generally,
we expect we will have to increase marketing and sales expenses before we can
substantially increase our revenue from sales of subscriptions. We plan to
continue to invest heavily in marketing and sales by increasing the number of
direct sales personnel and increase penetration within our existing customer
base, expanding our domestic and international selling and marketing activities,
building brand awareness and participating in additional marketing programs.
During the second quarter of 2005 we expect to hire 3 to 5 new sales people, and
to add 5 to 10 additional sales people during the second half of 2005. As a
result, we expect that in the future, marketing and sales expenses will increase
in absolute dollars and will be a significant cost.





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





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





**Critical
Accounting Policies and Estimates**





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





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





22
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We
recognize revenue when all of the following conditions are satisfied: (1) there
is persuasive evidence of an arrangement; (2) the service has been provided to
the customer; (3) the collection of our fees is probable; and (4) the amount of
fees to be paid by the customer is fixed or determinable. EITF 00-21 states that
revenue arrangements with multiple deliverables should be divided into separate
units of accounting if the deliverables in the arrangement meet the following
criteria: 1) the delivered item has value to the customer on a standalone basis;
2) there is objective and reliable evidence of the fair value of the undelivered
item; and 3) if the arrangement includes a general right of return relative to
the delivered item, delivery or performance of the undelivered item is
considered probable and substantially in control of the vendor. Smart Online’s
syndication and integration agreements typically include multiple deliverables
including the grant of a non-exclusive license to distribute, use and access the
Smart Online platform, fees for the integration of content into the Smart Online
platform, maintenance and hosting fees, documentation and training, and
technical support and customer support fees. Smart Online cannot establish fair
value of the individual revenue deliverables based on objective and reliable
evidence because Smart Online does not have a long, consistent history of
standard syndication and integration contractual arrangements, there have only
been a few contracts that have continued past the initial contractual term,
Smart Online does not have any contracts in which these elements have been sold
as stand-alone items, and there is no third-party evidence of fair value for
products or services that are interchangeable and comparable to the Smart
Online’s products and services. As such, Smart Online cannot allocate revenue to
the individual deliverables and must record all revenues received as a single
unit of accounting as further described below. Additionally, Smart Online has
evaluated the timing and substantive nature of the performance obligations
associated with the multiple deliverables noted above, including the
determination that the remaining obligations are essential to the on-going
usability and functionality of the delivered products, and determined that
revenue should be recognized over the life of the contracts, commencing on the
date the site goes on-line, due to such factors as the length of time over which
the remaining obligations will be performed, the complex nature of integrating
and maintaining customer content with Smart Online’s platform which services are
unavailable from other vendors, and the timing of payment of a portion of the
contract price such as monthly hosting payments.





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











23
 Table of Contents





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





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





Web
Services revenues are comprised of e-commerce sales directly to end-users,
hosting and maintenance fees, e-commerce website design fees and online loan
origination fees. E-commerce sales are made either on a subscription or a la
carte basis. Subscription, which provides users with access to most of our
products is payable in advance on a monthly basis and is targeted at small
companies or small divisions of large companies. At present, we provide free
access to our subscribers. We will seek to grow our monthly subscription volume
substantially over the 24 months after new versions of Smart Online’s platforms
(OneBiz Conductor SM ) are
released and we have time to market and invest more in marketing and sales. We
expect monthly subscription fees will typically be $29.95 to $49.95, for new
subscribers at www.smartonline.com ,
although to date we have given free access to our web services to most users. We
expect lower fees from subscribers at the private label syndication websites of
our partners.  Currently, most of our syndication agreements call for us to
receive 50% of revenue generated. A la carte pricing, which allows
customers to purchase one-time use of a specific software or content service,
ranges from $10 to $300, which includes third-party charges when applicable,
such as state and federal fees associated with incorporating a business or
additional fees associated with having a press release written and
revised.





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





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





24
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OEM
revenues are recorded based on the greater of actual sales or contractual
minimum guaranteed royalty payments. Smart Online records the minimum guaranteed
royalties monthly and receives payment of the royalties on a quarterly basis,
thirty days in arrears. To the extent actual royalties exceed the minimum
guaranteed royalties, the excess is recorded in the quarter Smart Online
receives notification of such additional royalties.





*Barter
Transactions* - Barter
revenue relates to syndication and integration services provided by Smart Online
to business customers in exchange for advertising in the customers’ trade
magazines and on their Web sites. Barter expenses reflect the expense offset to
barter revenue. The amount of barter revenue and expense is recorded at the
estimated fair value of the services received or the services provided,
whichever is more objectively determinable, in the month the services and
advertising are exchanged. Smart Online applies APB 29, Accounting for
Non-Monetary Transactions, the provisions of EITF 93-11, “Accounting for
Advertising Barter Transactions Involving Barter Credits” and EITF 99-13,
“Accounting for Advertising and Barter Transactions” and, accordingly,
recognizes barter revenues only to the extent that Smart Online has similar cash
transactions within a period not to exceed six months prior to the date of the
barter transaction. To date the amount of barter revenue to be recognized has
been more objectively determinable based on integration and syndication services
provided. For revenue from integration and syndication services provided for
cash to be considered similar to the integration and syndication services
provided in barter transactions, the services rendered must have been in the
same media and similar term as the barter transaction. Further, the quantity or
volume of integration or syndication revenue recorded in a qualifying past cash
transaction can only evidence the fair value of an equivalent quantity or volume
of integration or syndication revenue recorded in subsequent barter
transactions. In other words, a past cash transaction can only support the
recognition of revenue on integration and syndication contracts barter
transactions up to the dollar amount of the cash transactions. When the cash
transaction has been used to support an equivalent quantity and dollar amount of
barter revenue, that transaction cannot serve as evidence of fair value for any
other barter transaction. Once the value of the barter revenue has been
determined, Smart Online follows the same revenue recognition principals as it
applies to cash transactions with unearned revenues being deferred as described
more fully under the caption “ *Revenue
Recognition* ” above.
At the time the barter revenue is recorded, an offsetting pre-paid barter
advertising asset is recorded on Smart Online’s balance sheet. This pre-paid
barter advertising asset is amortized to expense as advertising services are
received such as when an advertisement runs in a magazine. Where more than one
deliverable exists, such as when the barter partner is to provide advertising in
four issues of a magazine, the expense is recognized pro-rata as the advertising
deliverable is provided. Barter revenues totaled $3,333 and $107,665 in the
first quarter of 2004 and 2005, respectively.





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





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











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*Income
Taxes.*We are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This involves estimating our current tax liabilities in each
jurisdiction, including the impact, if any, of additional taxes resulting from
tax examinations as well as making judgments regarding our ability to realize
our deferred tax assets. Such judgments can involve complex issues and may
require an extended period to resolve. In the event we determine that we will
not be able to realize all or part of our net deferred tax assets, an adjustment
would be made in the
period such determination is made. We recorded no income tax expense in any of
the periods presented, as we have experienced significant operating losses to
date. If utilized, the benefit of our total net operating loss carryforwards may
be applied to reduce future tax expense. Since our utilization of these deferred
tax assets is dependent on future profits, which are not assured, we have
recorded a valuation allowance equal to the net deferred tax assets. These
carryforwards would also be subject to limitations, as prescribed by applicable
tax laws. As a result of prior equity financings and the equity issued in
conjunction with certain acquisitions, we have incurred ownership changes, as
defined by applicable tax laws. Accordingly, our use of the acquired net
operating loss carryforwards may be limited. Further, to the extent that any
single year loss is not utilized to the full amount of the limitation, such
unused loss is carried over to subsequent years until the earlier of its
utilization or the expiration of the relevant carryforward period.





**Overview
of Results of Operations for the Quarters Ended March 31, 2005 and
2004**





Revenue
totaled $253,238 for the first quarter of 2005 as compared to $249,728 for the
first quarter of 2004. These revenues reflect a 24.8 percent increase in
integration revenues and a 200.6 percent increase in syndication revenues.
During the first quarter of 2005, no revenues were derived from related parties
as compared to $82,513 for the comparable 2004 period. Gross margin improved
from $192,709, or 77.2 percent of revenues, during the 2004 period to $221,511,
or 87.5 percent of revenues, for the 2005 primarily as a result of a decrease in
stock based consulting expenses.





Operating
expenses increased from $712,034 during the first quarter of 2004 to $1,068,995
for the first quarter of 2005. As discussed below, the principal factors
resulting in the increase in operating expense were (1) an increase in legal and
professional fees included in general and administrative expenses, (2) increased
barter advertising, consulting fees, and additional sales staff in sales and
marketing, and (3) additional programming, database management, quality
assurance, and project management resources in the development function to
support the on-going development of the OneBiz Conductor SM product.





Net loss
decreased from $6,040,464 in the first quarter of 2004 to $294,145 in the first
quarter of 2005. In addition to the revenue and expense factors noted above, the
decrease in net loss was also attributable to $520,000 increase in one-time
gains resulting from debt forgiveness. Additionally, the first quarter 2004 net
loss included $2,215,625 of expense related to preferred stock dividends and
accretion of discount on the preferred stock prior to its conversion to Common
Stock later during the same quarter and $3,225,410 of expense related to an
accretive dividend issued in connection with a registration rights
agreement.





The above
net losses equated to a loss per share of $0.02 during the first quarter of 2005
and a loss per share of $0.83 during the first quarter of 2004 based on
11,829,610 and 7,321,707 weighted average shares outstanding,
respectively.





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





**Revenues**




**For
      the quarters ended March 31:****2005**
    
    
    **2004**Integration
      fees
    
    $
    129,522
    
    $
    103,819Syndication
      fees
    
    
    92,040
    
    
    30,621OEM
      revenue
    
    
    12,000
    
    
    14,686Web
      services
    
    
    15,159
    
    
    16,714Other
      revenues
    
    
    4,517
    
    
    1,375Related
      party revenues
    
    
    -
    
    
    82,513**Total
      Revenues**
    
    $
    253,238
    
    $
    249,728








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Three
Months Ended March 31, 2005 and 2004





Total
revenues were $253,238 for the first quarter of 2005 compared to $249,728 for
the first quarter 2004 representing an increase of $3,510 or 1.4 percent.





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





At March
31, 2005, Smart Online had nine integration agreements and six syndication
agreements. At March 31, 2004, Smart Online had eight integration agreements and
three syndication agreements.





Substantially
all of the integration and syndication revenue for the quarter ended March 31,
2005, was derived from six integration partners and three syndication partners.





Substantially
all the integration and syndication revenue for the quarter ended March 31,
2004, was derived from seven integration partners and two syndication
partners.





Integration
revenues for the first quarter of 2005 totaled $129,522 as compared to $103,819
for the same period in 2004 representing an increase of $25,703 or 25%.
Approximately 70.5% of the 2005 revenues were from three integration agreements
each of which accounted for greater than 10% of total first quarter revenues.
The 2005 and 2004 periods included $46,250 and $3,333 of revenue derived from
barter transactions, respectively.





Syndication
revenues for the first quarter of 2005 totaled $92,040 as compared to $30,621
for the same period in 2004 representing an increase of $61,419 or 200%. All of
the 2005 revenues were from three syndication agreements each of which accounted
for greater than 10% of total first quarter revenues. The 2005 and 2004 periods
included $61,415 and $0 of revenue derived from barter transactions,
respectively.





Web
services and other revenues increased by $1,587 in the first quarter 2005 as
compared to the same period in 2004.





Smart
Online did not derive any revenue from related parties during the first quarter
of 2005. During the first quarter of 2004, revenues from related parties
accounted for $82,513, or 33.0%, of total revenue. Management does not expect
related party revenues to be a significant source of income going
forward.





**Cost
of Revenues**





**Three
      months ended 31:****2005**
    
    
    **2004****Cost
      of Revenues**
    
    $
    31,727
    
    $
    57,019





Three
months ended March 31, 2005 and 2004





Cost of
revenues is comprised primarily of salaries and the cost of an external hosting
facility associated with maintaining and supporting integration and syndication
partners. Cost of revenues decreased 44% from $57,019 in the first quarter 2004
to $31,727 in the first quarter of 2005 primarily as a result of consulting
stock based expenses totaling $21,979 in the first quarter of 2004 which were $0
in the first quarter of 2005. Salaries and wages increased from
$8,806 in the first quarter of 2004 to $14,417 in the same period of 2005 and
are expected to grow in the future commensurate with growth in integration and
syndication partners and as users are added following the 2005 release of OneBiz
Conductor SM . In
addition, Smart Online had a first quarter 2005 external hosting expense
totaling $8,919 as compared to $0 for the same period in 2004. During the third
quarter of 2004, Smart Online migrated certain of its hosting services from its
in-house operations to a third party that has a global reach and provides
superior data hosting, data access, security, and back-up
capabilities.





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**Operating
Expenses**





**For
      the months ended March 31******
      **2005**
    
    **2004****Operating
      Expenses**General
      and administrative
    
    $
    519,036
    
    $
    449,257Sales
      and marketing
    
    
    294,732
    
    
    98,399Development
    
    
    255,227
    
    
    164,378**Total
      Operating Expenses**
    
    $
    1,068,995
    
    $
    712,034





Three
months ended March 31, 2005 and 2004





*General
and Administrative* - General
and administrative expenses increased by $69,779 from $449,257 in the first
quarter of 2004 to $519,036 in the same period of 2005 primarily as a result of
increased legal and professional expenses. Legal and professional services
totaled $175,924 in the first quarter of 2005 as compared to $66,371 in the same
period of 2004. The $109,553 increase was a result of expenses associated with
preparing to become a public company in the first quarter of 2005 and fees such
as conducting financial statement audits.





Smart
Online anticipates hiring additional administrative and finance staff during the
remainder of 2005. Management anticipates that the incremental cost of these
additions will be partially offset by a reduction in legal and professional fees
and certain consulting expenses. However, certain costs, such as compliance with
the Sarbanes-Oxley Act, which totaled $61,700 in the first quarter of 2005, and
other public company-related expenses including investor relations, public
relations, shareholder related expenses and insurance will increase general and
administrative expenses during the remaining fiscal 2005 as compared to the 2004
period.





Consulting
fees totaled $10,500 in the first quarter of 2005 as compared to $72,808 for the
same period in 2004. Consulting fees during the 2004 period included $30,000
paid to Small Business Lending Institute (SBLI), of which an officer of Smart
Online is also an officer and in which another officer of Smart Online is a
minority shareholder. SBLI paid Smart Online’s employees during the first
quarter of 2004 while Smart Online was dealing with a tax matter with the
Internal Revenue Service. Additionally, Smart Online paid $11,750 to a financial
consulting firm to assist with restructuring our capitalization, evaluating
financing alternatives and assisting Smart Online to raise additional capital.





During
the first quarter of 2004, Smart Online accrued $24,378 for penalties owed to
the Internal Revenue Service. There was no similar accrual during the first
quarter 2005 as on February 18, 2005, the Internal Revenue Service agreed to
accept Smart Online’s offer in compromise (Form 656) in settlement of all of
Smart Online’s outstanding federal tax liabilities. Pursuant to the terms of the
agreement, Smart Online, Inc. paid $26,100 to the IRS.





The 2004
period included $66,288 of stock based compensation expense related to the
issuance of stock options to certain officers, as compared to $0 of stock based
compensation in the 2005 period.





*Sales
and Marketing* - Sales
and marketing increased from $98,399 in the first quarter 2004 to $294,732 in
the first quarter of 2005, an increase of approximately $196,333. The first
quarter 2005 increase was primarily attributable to barter advertising,
consulting fees, and additional sales staff. Barter advertising expense totaled
$136,335 during the first quarter of 2005 compared to a ($10,525) during the
first quarter 2004. The 2004 period reflects a credit related to prior
advertising activities. Consulting fees increased to $42,333 in the first
quarter of 2005 as compared to $17,500 from the same period in 2004 due to the
engagement of three consultants to assist the company with syndication and
integration prospects, small business customer prospects, and identification of
additional sales opportunities. Salary related expenses totaled $54,667 in the
first quarter of 2005 as compared to $45,455 in the same period in 2004
primarily as a result of compensation adjustments and personnel changes.





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Generally,
we expect we will have to increase marketing and sales expenses before we can
substantially increase our revenue from sales of subscriptions. We plan to
invest heavily in marketing and sales by increasing the number of direct sales
personnel and increase penetration within our existing customer base, expanding
our domestic and international selling and marketing activities, building brand
awareness and participating in additional marketing programs. During the second
quarter of 2005 we expect to hire 3 to 5 new sales people, and to add 5 to 10
additional sales people during the second half of 2005. This increase is being
timed to coincide with the planned release of the second version our Next
Generation Platform, OneBiz Conductor sm .





*Development* -
Development expense increased from $164,378 in the first quarter of 2004 to
$255,227 in the first quarter of 2005. The 2004 period included approximately
$41,077 of stock based compensation expense related to stock options issued to
an officer as compared to approximately $0 included in the first quarter of
2005. Excluding stock based compensation expense, development expense increased
by approximately $90,849 from first quarter 2004 to first quarter 2005 as Smart
Online added additional programming, database management, quality assurance, and
project management resources to support the on-going development of the OneBiz
Conductor SM product.





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





**Other
Income (Expense)**





**2005**
    
    **2004****Other
      Income & Expenses**Interest
      expense, net
    
    $
    5,998
    
    $
    (107,652
    )Gain
      from debt forgiveness
    
    
    547,341
    
    
    27,548**Total
      Other Income & Expenses**
    
    $
    553,339
    
    $
    (80,104
    )





Three
months end March 31, 2005 vs. 2004





Smart
Online incurred net interest expense of $5,998 and $(107,652) during the first
quarters of 2005 and 2004, respectively. The 2004 interest expense
amounts included $75,000 of interest related to the issuance of 150,000
shares of common stock to a relative of one of Smart Online’s officers in
consideration for extending the term of a loan and loaning additional funds to
the corporation. The remainder of the 2004 interest expense is primarily
attributable to interest due on deferred compensation owed to officers of Smart
Online and interest related to unpaid payroll tax obligations. Both the deferred
compensation and income tax obligations were relieved during the first quarter
of 2005, therefore, management expects that interest expense will be
significantly lower in 2005. The first quarter 2005 interest income totaling
$5,998 was issued from interest earned on money market account
deposits.





During
the first quarter of 2005, Smart Online realized a gain of $546,922 compared to
a gain of $27,548 during the first quarter of 2004, from negotiated and
contractual releases of outstanding liabilities. The gains from debt forgiveness
resulted from unrelated third parties. During the first quarter of 2005, the
gain resulted from a settlement of Internal Revenue Service claims for penalty
and interest. During the first quarter of 2004, the gain resulted primarily from
trade creditors who had performed services for Smart Online, agreeing to accept
as payment in full a lesser amount than the stated liability in consideration
for timely payment of the negotiated settlement. Smart Online does not expect
gains from debt forgiveness to be material in future periods.








**Provision
for Income Taxes**





We have
not recorded a provision for income tax expense because we have been generating
net losses. Furthermore, we have not recorded an income tax benefit for the
first quarter of 2005 or fiscal 2004 primarily due to continued substantial
uncertainty regarding our ability to realize our deferred tax assets. Based upon
available objective evidence, there has been sufficient uncertainty regarding
the ability to realize our deferred tax assets, which warrants a full valuation
allowance in our financial statements. Smart Online has approximately
$29,000,000 in net operating loss carryforwards, which may utilized to offset
future taxable income.





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 Table of Contents








**Liquidity
and Capital Resources**





At March
31, 2005, our principal sources of liquidity were cash and cash equivalents
totaling $1,386,783 and accounts receivable of $12,189. We do not have a bank
line of credit.





At March
31, 2005, we had working capital of approximately $400,000. Our working capital
is not sufficient to fund our operations beyond the end of July 2005,
unless we substantially increase our revenue, limit expenses or raise
substantial additional capital.





Our
primary source of liquidity during 2004 and the first quarter of 2005 was from
sales of our securities. During 2004, Smart Online generated net cash from
financing activities, including the sales of common stock, of approximately $4.2
million. During the same period Smart Online consumed approximately $3.7 million
of cash in operations, including payment of $1,126,485 paid related to
outstanding payroll tax liabilities. During the first quarter of 2005, Smart
Online raised an additional $2,735,000 of proceeds, net of stock issuance costs
of $290,000, through the sale of additional shares of Common Stock and a warrant
to purchase 50,000 shares of Common Stock. Approximately $1.1 million of the
proceeds were used in the first quarter of 2005 to pay deferred compensation to
our officers and related accrued interest amounts. Additionally, during February
2005, Smart Online reached a settlement with the Internal Revenue Service, paid
$26,100, surrendered all credits and refunds for 2005 or earlier tax periods,
and agreed to remain in compliance with all federal tax obligations for a term
of five years to resolve all outstanding federal tax issues.





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





**Deferred
Revenue.** At March
31, 2005 Smart Online had deferred revenue totaling $673,861, net of offsetting
amounts receivable. Deferred revenue represents amounts collected in advance of
the revenue being recognized. Based upon current conditions, Smart Online
expects that approximately 70% of this amount will be recognized in 2005 with
the remainder expected to be recognized during 2006.





**Going
Concern.** Our
auditors have issued an explanatory paragraph in their report included in our
Form 10-K for the year ended December 31, 2004 in which they express substantial
doubt as to our ability to continue as a going concern. The financial statements
do not include any adjustments relating to the recoverability and classification
of recorded asset amounts or the amounts or classification of liabilities that
might be necessary should Smart Online be unable to continue as a going concern.
Smart Online’s continuation as a going concern is dependent upon its ability to
generate sufficient cash flows to meets its obligations on a timely basis, to
obtain additional financing as may be required and ultimately to attain
profitable operations and positive cash flows. As is discussed below, management
has plans which it believes will enable Smart Online to raise capital and
generate greater cash flows from operations. However, there can be no assurance
that these efforts will be successful. If our efforts are unsuccessful, we may
have to cease operations and liquidate our business.





**Recent
Developments.** In April
2005, Smart Online settled for $50,000 claims made by U.S. News & World
Reports and the case was dismissed with prejudice. In May 2005, Smart Online
settled for $30,000 the claims made by Infopia, Inc. and the case was dismissed
with prejudice.





**Future
Capital Raising and Acquisitions.** Although
we are currently not a party to any agreement or letter of intent with respect
to potential investments in, or acquisitions of, complementary businesses,
services or technologies, we may enter into these types of arrangements in the
future, which could also require us to seek additional equity or debt financing.
Additional funds may not be available on terms favorable to us or at all. If we
cannot raise the capital we need, we may be forced to liquidate our business and
investors could lose their entire investment.





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 Table of Contents





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





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





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





**Integration,
Syndication and Other Contracts.** Upfront
payments totaling approximately $330,000, primarily related to new integration
and syndication contracts, positively impacted operating cash flows for the
year-ended December 31, 2004. We are devoting greater efforts to enter into
syndication and integration agreements as we release our Next Generation
Platform, OneBiz Conductor SM . Smart
Online is in discussions with several potential integration and syndication
partners that, if successful, could result in positive cash flow from
operations, including greater upfront payments, although there can be no
assurance that our efforts will result in signed new contracts.





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





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





**End
User Customer Revenue.** We
currently allow many users of our web-based products to access our products
without charge. Our primary marketing strategy to date has been price-based
promotions, which gains us users, but limits our revenue. For example, CD-ROM
products are provided to OEMs for a nominal charge. In addition, Smart Online
has permitted many customers to use its web-based products for free, either by
offering free initial service or by allowing users that fail to pay our monthly
subscription fees to continue to access our web-based products. We plan to
continue to offer free or discounted pricing on our products until we introduce
the second version of our Next Generation Platform, OneBiz Conductor SM , which
is expected to occur at the end of the third quarter of 2005.  We will seek
to grow our monthly subscription volume substantially over the 24 months
following the release of later versions of OneBiz Conductor SM ,
although we expect substantial increases only after we have sufficient time to
sell our new product and after we invest substantially greater amounts in
marketing and sales.  We expect monthly subscription fees will typically be
$29.95 to $49.95 for new subscribers at www.smartonline.com ,
although to date we have given free access to our web services to most users. We
expect lower fees from subscribers at the private label syndication websites of
our syndication partners.  Currently, most of our syndication agreements
call for us to receive 50% of revenue generated.  A la carte pricing, which
allows customers to purchase one-time use of a specific software or content
service, ranges from $10 to $300, which includes third-party charges when
applicable, such as state and federal fees associated with incorporating a
business or additional fees associated with having a press release written and
revised. However, here can be no assurance that we will be successful in
attracting new customers or that customers will pay for our products after we
introduce our Second Generation Platform.





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





**Gains
From Debt Foregiveness.** During
the first quarter of 2005 and 2004 Smart Online realized gains totaling $547,241
and $27,548, respectively, resulting from negotiated and contractual releases of
outstanding liabilities. The 2005 gain was primarily from the settlement with
the Internal Revenue Service. The 2004 gains were primarily related to unrelated
third parties, primarily trade creditors who had performed services for Smart
Online, agreeing to accept as payment in full a lesser amount than the stated
liability in consideration for timely payment of the negotiated settlement. Had
Smart Online been unable to reach agreement with the Internal Revenue Service
and these creditors, Smart Online’s liabilities and future cash flow
requirements would have been higher by the amount of the debt
foregiven.





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





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





**Risk
Factors**




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






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







32
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**We
have organized these factors into the following categories
below:**




·
    Our
      Financial Condition





·
    Our
      Products and Operations





·
    Our
      Market, Customers and Partners





·
    Our
      Officers, Directors, Employees and
Shareholders





·
    Regulatory
      Matters that Affect Our Business





·
    Matters
      Related to The Market for Our Securities







**RISKS
ASSOCIATED WITH OUR FINANCIAL CONDITION**




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





Through
March 31, 2005, we have lost an aggregate of $37.0 million since inception on
August 10, 1993. During the quarter ended March 31, 2005 and the year ended
December 31, 2004, we suffered a net loss of approximately $0.3 million and $2.7
million, respectively. At March 31, 2005, we had a $0.4 million surplus in
working capital. However, our working capital is not sufficient to fund our
operations for the next year, unless we substantially increase our revenue,
limit expenses or raise substantial additional capital. At March 31, 2005, we
had cash and cash equivalents totaling $1,386,783 and we had only nominal
tangible assets. If we do not rectify these deficiencies, we may have to cease
operations and liquidate our business. Because we have only nominal tangible
assets, you may lose your entire investment.





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





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





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





In the
future, we will be required to seek additional financing to fund our operations
or growth. Factors such as the commercial success of our existing services and
products, the timing and success of any new services and products, the progress
of our research and development efforts, our results of operations, the status
of competitive services and products, and the timing and success of potential
strategic alliances or potential opportunities to acquire technologies or assets
may require us to seek additional funding sooner than we expect. We cannot
assure you that such funding will be available. If sufficient capital is not
raised, our ability to achieve or sustain positive cash flows, maintain current
operations, fund any potential growth, take advantage of unanticipated
opportunities, develop or enhance services or products, or otherwise respond to
competitive pressures would be significantly limited. If we fail to raise
sufficient capital, we will not be able to implement our business plan, we may
have to liquidate our business and you may lose your investment **.**





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





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





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





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





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





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





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





We had
planned to release the first version of our Next Generation Platform during the
fourth quarter of 2004. Testing by some customers of the first version began at
the end of 2004, but commercial release was delayed until March 2005. In
addition to the factors that may delay or prevent completion of any new product
development project, some existing factors may further delay or prevent
development of our next generation product, OneBiz Conductor SM . These
factors include the following. OneBiz Conductor SM requires
both enhancing our existing technology platform and adding many new software
applications. Integrating so many new applications at the same time is
difficult. Another factor that might delay or prevent development of OneBiz
Conductor SM is that
we have to hire, train and manage new development personnel to complete internal
development on time. In addition, for many of the
most important new applications of OneBiz Conductor SM , such as
sales automation, we intend to rely on third party sources, whether through
licensing, joint development or purchase. The willingness of third parties to
enter into agreements with us and the ability of third parties to perform
agreements are totally outside our control. Development of OneBiz
Conductor SM is
progressing according to schedule as described under “Business-Next Generation
Product Development-OneBiz Conductor SM ”. Our
business could be harmed if we fail to deliver the improved performance that
customers want with respect to our current and future offerings. There can be no
assurance that our next generation platform will achieve widespread market
penetration or that we will derive significant revenues from sales of OneBiz
Conductor SM .


34
 Table of Contents








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





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





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





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





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




Our
future operating results will depend, in part, on our ability to manage changing
business conditions, including such conditions as the general economic slowdown,
reduced investment in information technology by customers and prospective
customers, and reduced business travel and entertainment budgets. If we are
unable to manage changing business conditions effectively, our business,
financial condition, and results of operations could be materially and adversely
affected. Failure to manage our operations with reduced staffing levels may
strain our management, financial, and other resources, and could have a material
adverse effect on our business, financial condition, and results of
operations.




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





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





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 Table of Contents





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





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





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





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





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





·
    diversion
      of financial and managerial resources from existing
      operations;





·
    risk
      of entering new markets;





·
    potential
      write-offs of acquired assets;





·
    potential
      loss of key employees;





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





·
    delays
      in customer purchases due to uncertainty.





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





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





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





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We also
use certain software from leading opensource communities like Sun Microsystems,
Apache Group, GNU, Suse (Novell) that are free and available in the public
domain. The OneBiz Conductor SM product
will use additional public domain software, if needed for successful
implementation and deployment. Using such software does not guarantee us support
and upgrades of the software, and therefore could cause disruption in our
service, if certain critical defects are discovered in the software at a future
date.





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





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





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





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





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





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





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





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





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





**(18)
If Our On-Demand Application Service is Not Widely Accepted, Our Operating
Results Will Be Harmed.**





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





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





·
    the
      price and performance of our service;





·
    the
      level of customization we can offer;





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





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





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





**(19)
The Market for Our Technology Delivery Model and On-Demand Application Services
Is Immature And Volatile, and if It Does Not Develop or Develops More Slowly
Than We Expect, Our Business Will Be Harmed.**





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





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**(20)
We Do Not Have an Adequate History With Our Subscription Model To Predict the
Rate of Customer Subscription Renewals and the Impact These Renewals Will Have
on Our Revenue or Operating Results.**





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





**(21)
We Depend on Small Businesses for Our Revenue. Small Businesses are Often
Financially Unstable, Have High Rates of Attrition and can be Expensive
Customers to Which to Market Products.**





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





**(22)
If We Fail to Develop Our Brand Cost-Effectively, Our Business May
Suffer.**





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





**(23)
We Depend on Corporate Partners to Market Our Products Through Their Web Sites
and OEM or Integration Relationships Under Relatively Short Term Agreements.
Termination of These Agreements Could Cause A Substantial Decline in Our Revenue
and a Substantial Increase in Customer Acquisition Costs.**





Approximately
92% of total revenue during the first quarter of 2005, 93% of total revenue
during year 2004, and approximately 83% of total revenue during year 2003 was
derived from syndication, integration and OEM agreements with large companies
whereby our content, software applications and technology platform are
integrated into the web sites of our syndication partners and the software and
services of our integration partners is sold on our website, and our CD-Rom
products are bundled with the products of others through our OEM relationships.
Under these agreements we both derive revenue and we utilize the resources of
our partners to reduce our customer acquisition costs. As of April 15,
2005, we have six syndication agreements, where we currently or will have our
content and software on the website of large corporate partners. As of April 15,
2005, we have nine integration partnership agreements where we integrate the
content or services of our partners into our technology platform. As of April
15, 2005, we have one OEM relationship through our distributor, PC
Treasures. Not all these agreements generate revenue for us at this time. These
agreements typically have initial terms of from one to three years. In
the event these agreements were to terminate or not be renewed, or their terms
substantially renegotiated, we expect that our
revenues would decline and our customer acquisition costs would increase.
Although our partners are important to our business on a collective basis, no
single partner is material to our business. The syndication, integration, and
OEM agreement revenue described above includes revenue from an integration
agreement between Smart Online and Smart IL, a related party owned by a
shareholder of Smart Online. Smart IL accounted for approximately 0% our total
revenues in the first quarter of 2005, 27.2% of our total revenue in 2003, and
approximately 32.9% of total revenue during 2004. We do not expect to receive
revenue from Smart IL after 2004. Our dealings with Smart IL are described under
“Management Discussion and Analysis of Financial Condition and Results of
Operations - Revenue From Related Parties.”





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**(24)
It is Important for Us to Continue to Develop and Maintain Strategic
Relationships. Failure to Do So Could Harm Our Business.**





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





**(25)
Our Lengthy Sales Cycle with Syndication, Integration Partners and OEM
Relationships Could Adversely Affect Our Financial
Results.**





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





**(26)
We Face Significant Competition, Which Could Adversely Affect Our
Business.**





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





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**(27)
We Depend on Nonrecurring Revenue, Which May Cause Our Revenue to Fluctuate
Substantially From One Quarter to Another or to Decline Permanently as Market
Conditions Change.**





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





**(28)
We Depend on Web Services Revenues; Our Future Growth is Substantially Dependent
on Customer Demand for Our Subscription Services Delivery Models. Failure to
Increase This Revenue Could Harm Our Business.**





Revenues
from small businesses for our Web Services, which include subscriptions, revenue
share, e-commerce fees, hosting fees, loan origination fees and marketing fees,
represented approximately 6.0% of our total revenue for the first quarter of
2005, 6.2% of our total revenue for 2004, and approximately 16.5% of total
revenue for fiscal 2003. We anticipate that Web Services revenues will continue
to represent a significant percentage of our total revenues and that our future
financial performance and revenue growth will depend, in large part, upon the
growth in customer demand for our outsourced services delivery models. As such,
we have invested significantly in infrastructure, operations, and strategic
relationships to support these models, which represent a significant departure
from the delivery strategies that other software vendors and we have
traditionally employed. To maintain positive margins for our small business
services, our revenues will need to continue to grow more rapidly than the cost
of such revenues. There can be no assurance that we will be able to maintain
positive gross margins in our subscription services delivery models in future
periods. If our subscription services business does not grow sufficiently, we
could fail to meet expectations for our results of operations, which could harm
our business.





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





**(29)
There are Risks Associated with International Operations, Which We Expect Will
Become a Bigger Part of Our Business in the Future.**





We
currently do not generate substantial revenue from international operations, but
we plan to conduct greater international operations in the future. Our
international operations will be subject to risks associated with operating
abroad. We expect international operations will become an important component of
our business. These international operations are subject to a number of
difficulties and special costs, including:





·
    costs
      of customizing products for foreign
countries;





·
    laws
      and business practices favoring local
competitors;





·
    uncertain
      regulation of electronic commerce;





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





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








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·
    import
      and export restrictions and tariffs;





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





·
    difficulties
      staffing and managing foreign operations;





·
    multiple
      conflicting tax laws and regulations; and





·
    political
      and economic instability.





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





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





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





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





**(30)
Historically Substantial Amounts of Our Revenue Was Derived From Transactions
with Related Parties, Which Means That Our Revenue May Not Reflect the True
Commercial Viability of Our Business and That Our Revenue May Decline If We
Cannot Replace this Revenue With Revenue From Unrelated Third
Parties.**





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





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





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





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





**(31)
Any Failure to Adequately Expand Our Direct Sales Force Will Impede Our Growth,
Which Could Harm Our Business.**





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





**(32)
Because Competition for Our Target Employees Is Intense, We May Not Be Able to
Attract and Retain the Highly Skilled Employees We Need to Support Our Planned
Growth, Which Could Harm Our Business.**





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





**(33)
Our Growth Could Strain Our Personnel and Infrastructure Resources, and if We
Are Unable to Implement Appropriate Controls and Procedures To Manage Our
Growth, We May Not Be Able to Successfully Implement Our Business
Plan.**





We plan
to have a period of rapid growth in our headcount and operations, which has
placed, and will continue to place, a significant strain on our management,
administrative, operational and financial infrastructure. We anticipate that
further growth will be required to address increases in our customer base, as
well as our expansion into new geographic areas.





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





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**(34)
Our Executive Management Team is Critical to the Execution of Our Business Plan
and the Loss of Their Services Could Severely Impact Negatively on Our
Business.**





Our
success depends significantly on the continued services of our management
personnel, including Michael Nouri, who is our chairman of the board, president
and chief executive officer, and Henry Nouri, our Executive Vice President,
Research and Development. Losing any one of our officers could seriously harm
our business. Competition for executives is intense. If we had to replace any of
our officers, we would not be able to replace the significant amount of
knowledge that they have about our operations. We do not maintain key man
insurance policies on anyone.





**(35)
Officers, Directors and Principal Stockholders Control Us. This Might Lead Them
to Make Decisions that do not Benefit the Stockholder
Interests.**





At April
15, 2005, our officers and directors beneficially owned approximately 4,783,995
(approximately 34%) of our outstanding stock, which includes approximately
730,000 shares which can be acquired upon exercise of options within sixty (60)
days after April 15, 2005. These shares included approximately 3,892,658
shares beneficially owned by Michael Nouri and Henry Nouri, who are brothers and
Ronna Loprete, who is Michael Nouri’s wife.  In addition, 95,000 shares are
subject to issuance upon exercise of options owned by the officers and
directors, which options cannot be exercised within sixty days after April
15, 2005, and therefore are not counted as being beneficially owned at that
date. As a result, these persons, acting together, will have the ability to
control substantially all matters submitted to our stockholders for approval
(including the election and removal of directors and any merger, consolidation
or sale of all or substantially all of our assets) and to control our management
and affairs. Accordingly, this concentration of ownership may have the effect of
delaying, deferring or preventing a change in control of us, impeding a merger,
consolidation, takeover or other business combination involving us or
discouraging a potential acquirer from making a tender offer or otherwise
attempting to obtain control of us, which in turn could materially and adversely
affect the market price of the common stock.





**(36)
Sales by Officers and Directors Could Adversely Affect of Our Stock
Price.**





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





**(37)
All of the Shares of Common Stock Owned by Our Officers, Directors and
Consultants Will be Registered Later in a Registration on Form S-8 and May be
Resold by Them, Which May Have a Negative Impact on Their Interest in Smart
Online’s Future.**





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





**Regulatory
Risks**





**(38)
Our Revenue Recognition Policy May Change And Affect Our Earnings, Which Could
Adversely Affect Our Stock Price.**





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





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**(39)
Compliance With New Regulations Governing Public Company Corporate Governance
and Reporting is Uncertain and Expensive. Our Difficulties in Complying with
Public Company Reporting Obligations Are Greater, Because Our Chief
Financial Officer Does Not Have Prior Experience with a Public
Company.**





As a
public company, we have incurred and will incur significant legal, accounting
and other expenses that we did not incur as a private company. We will incur
costs associated with our public company reporting requirements. We also
anticipate that we will incur costs associated with recently adopted corporate
governance requirements, including requirements under the Sarbanes-Oxley Act of
2002, as well as new rules implemented by the Securities and Exchange Commission
and the NASD. We expect these rules and regulations to increase our legal and
financial compliance costs and to make some activities more time-consuming and
costly. Any unanticipated difficulties in preparing for and implementing these
reforms could result in material delays in complying with these new laws and
regulations or significantly increase our costs. Our ability to fully comply
with these new laws and regulations is also uncertain. Our failure to timely
prepare for and implement the reforms required by these new laws and regulations
could significantly harm our business, operating results, and financial
condition. Our current chief financial officer does not have public company
experience. Consequently, we will have greater difficulty complying with public
company reporting requirements than most public companies. We also expect these
new rules and regulations may make it more difficult and more expensive for us
to obtain director and officer liability insurance and we may be required to
accept reduced policy limits and coverage or incur substantially higher costs to
obtain the same or similar coverage. As a result, it may be more difficult for
us to attract and retain qualified individuals to serve on our board of
directors or as executive officers. We are currently evaluating and monitoring
developments with respect to these new rules. We estimate this will add
approximately $500,000 to our expenses during our first year as a public
company, but there can be no assurance that costs will not be
higher.





**(40)
Our Reported Financial Results May Be Adversely Affected By Changes in
Accounting Principles Generally Accepted in the United States, Which Could
Adversely Affect the Price of Our Stock.**





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





For example, we are not required to record
stock-based compensation charges, if the employee's stock option exercise price
is equal to or exceeds the deemed fair value of our Common Stock at the date of
grant.  Some companies have recently elected to change their accounting
policies and have begun to record the fair value of stock options expense. 
However, in December 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment" ("SFAS 123(R)").  SFAS 123(R), a revision of SFAS
123, "Accounting for Stock-Based Compensation", supersedes APB Opinion No. 25,
"Accounting for Stock Issued to Employees", and amends SFAS No. 95, "Statement
of Cash Flows." SFAS 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the financial
statements based on their vair values.  SFAS 123(R) is effective for the
beginning of the first interim or annual period beginning after June 15,
2005.  Therefore the Company plans to adopt SFAS 123(R) on July 1,
2005.  The Company is currently evaluating the two fair value pricing
methods permitted by SFAS 123(R) and has not selected a final fair value pricing
model nor determined the impact such model will have on the Company's financial
statements.





**(41)
Privacy Concerns are Increasing, Which Could Result in Regulatory Changes that
may Harm Our Business.**





Personal
privacy has become a significant issue in the United States and many other
countries in which we operate or plan to operate. The United States and various
other countries have recommended limitations on, or taken actions to limit, the
use of personal information by those collecting such information. For example,
in 1999, Congress enacted the Gramm-Leach-Bliley Act, which contains provisions
protecting the privacy of consumer non-public personal information collected by
financial institutions. Any new or existing privacy laws, if applicable to our
business, could impose additional costs and could limit our use and disclosure
of such information. If such privacy laws were deemed to apply to us, we may be
required to change our activities and revise or eliminate our services, which
could significantly harm our business.





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**(42)
Evolving Regulation of the Internet May Harm Our Business.**





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





**(43)
Our Ability to Protect Our Intellectual Property is Limited and Our Products may
be Subject to Infringement Claims by Third Parties.**





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





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





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





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





**(44)
Anti-Takeover Effects of Charter Documents and Delaware Law Could Discourage or
Prevent a Change in Control, Even If a Change of Control Would Be Beneficial to
Shareholders and Investors.**





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





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








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





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





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





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





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





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





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





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





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





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





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





**(46)
If Securities Analysts Do Not Publish Research or Reports About Our Business or
If They Downgrade Our Stock, the Price of Our Stock Could
Decline.**





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





**(47)
Our Quarterly Revenues and Operating Results may Fluctuate in Future Periods and
We may Fail to Meet Expectations of Investors and Public Market Analysts, Which
Could Cause the Price of Our Common Stock to Decline.**





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





·
    the
      evolving demand for our services and
software;





·
    spending
      decisions by our customers and prospective
customers;





·
    our
      ability to manage expenses;





·
    the
      timing of new product releases;





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





·
    the
      timing of execution of large contracts;





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





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





·
    costs
      of developing new products and enhancements;
and





·
    global
      economic and political conditions.





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





**(48)
Our Stock Price is Likely to be Highly Volatile and May
Decline.**





The
trading price of our common stock is expected to fluctuate widely as a result of
a number of factors, many of which are outside our control, such as:





·
    variations
      in our actual and anticipated operating
results;





·
    changes
      in our earnings estimates by analysts;








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





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





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





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





**(49)
Shares Eligible for Public Sale After this Offering Could Adversely Affect Our
Stock Price.**





At April
15, 2005, 12,286,832 shares of our common stock were issued and outstanding
and 2,552,010 shares may be issued pursuant to the exercise of warrants and
options that are exercisable within 60 days of April 15, 2005. Of these
shares, 1,925,265 shares registered on Form S-1 are freely tradable,
except for any shares purchased by our “affiliates” as defined in Rule 144 under
the Securities Act. The remaining shares are “restricted securities,”
subject to the volume limitations and other conditions of Rule 144 under the
Securities Act.





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





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





**(50)
Our Securities May Be Subject to "Penny Stock" Rules, Which Could Adversely
Affect Our Stock Price and Make It More Difficult for You to Resell Our
Stock.**





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





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





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





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








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





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





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





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





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





·
    with
      bid and offer quotations for the penny
stock;





·
    the
      compensation of the broker-dealer and its salesperson in the
      transaction;·
    the
      number of shares to which such bid and ask prices apply, or other
      comparable information relating to the depth and liquidity of the market
      for such stock; and





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





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





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





***Foreign
currency exchange risk***





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





***Interest
rate sensitivity***





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





**Item
4. Controlsand Procedures**





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








50
 Table of Contents








**Evaluation
of Disclosure Controls and Procedures**





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





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





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





**Internal
Controls**





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





**Inherent
Limitations on Effectiveness of Controls**





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





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**PART
II.  OTHER INFORMATION**





**Item.
1.  LegalProceedings**





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





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





Smart
Online, Inc. v. Genuity, Inc. - Smart
Online instituted this action against Genuity on May 22, 2001, in the Superior
Court of Wake County, North Carolina, Civil Action No. 01-CVS-06277. Smart
Online brought claims against Genuity for breached of contract, breach of
express warranty, breach of implied warranty of merchantability, breach of
warranty of fitness for a particular purpose, conversion, unfair and deceptive
trade practices, negligent misrepresentation and fraud arising from Genuity’s
failure to perform properly under contracts between the parties, from Genuity’s
failure to return certain property belonging to Smart Online, and from certain
representations made by Genuity with regard to the services needed by Smart
Online under the contracts. On or about July 23, 2001, Genuity
filed its answer to the complaint along with counterclaims against Smart Online.
In its counterclaims, Genuity brought claims for breach of contract alleging
that Smart Online failed to pay for the services rendered by Genuity. On October
22, 2002, the court denied Genuity’s request to dismiss Smart Online’s breach of
contract claim, allowed Smart Online to amend its complaint to restate its claim
for breach of contract, and dismissed Smart Online’s claims for breach of
implied warranties. The parties were completing discovery and preparing for
trial when the case was automatically stayed as a result of Genuity’s filing for
bankruptcy. This case is still subject to the automatic stay.





Internal
Revenue Service Claim. - Smart
Online, Inc. resolved a federal employment tax liability of approximately
$560,000 relating to the periods beginning December 31, 2000 and continuing
through December 31, 2003. On February 18, 2005, the Internal Revenue Service
agreed to accept Smart Online, Inc.’s offer in compromise (Form 656) in
settlement of all of Smart Online’s outstanding federal tax liabilities.
Pursuant to the terms of the agreement, Smart Online, Inc. paid $26,100,
and agreed to surrender all credits and refunds for 2005 or earlier tax periods,
and remain in compliance with all federal tax obligations for a term of five
years.





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







(1) During February 2005 through April 2005, Smart Online sold 580,000
shares of its common stock for a price of $5.00 per share, for an aggregate
of $2,900,000. Concurrently, Smart Online issued a warrant to purchase
50,000 shares of its common stock for an exercise price of $5.00 per share, in
consideration for an investor agreeing to certain restrictions on the
ability to sell the shares.





This
offering was conducted pursuant to Regulation S in an offshore transaction (as
defined in Regulation S). None of the investors are U.S. Persons (as defined in
Regulation S). A legend was placed on the stock certificates stating that the
securities have not been registered under the Securities Act and cannot be sold
or otherwise transferred except pursuant to Regulation S or pursuant
to an effective registration or exemption from registration.







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During
February and March 2005, Smart Online used a portion of the proceeds from this
offering to pay in full $949,777 of deferred compensation, plus all accrued
interest of $154,288, owed to certain officers of the Company. The remainder of
the proceeds will be used to fund Smart Online’s working capital
requirements.





(2) From the end of March through April 2005, Smart Online sold 25,000
shares of its common stock to investors in a private placement for a price of
$5.00 per share, for an aggregate of $ 125,000.





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





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





**Item
3.  DefaultsUpon Senior
Securities**





Not
applicable.





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





By
written consent dated January 1, 2005 the stockholders approved the election of
four members of the Board of Directors in lieu of the 2005 annual meeting of
stockholders. Proxies were not solicited. Stockholders who owned 6,750,286 of
the 11,631,832 shares eligible to vote executed the written
consent.





**Item
5.  OtherInformation**





None.





**Item
6.  Exhibits**





**Exhibits**





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





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 Table of Contents





**SIGNATURES**





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





Dated:
May 15, 2005








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











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**SMART
ONLINE, INC.**


**EXHIBIT
INDEX**





**Exhibit
      Number**
    **Exhibit
      Description**
    **Form**
    **File**
      **Number**
    **Exhibit**
    **Filing**
      **Date**
    **Filed**
      **Herewith**3.1
    Amended
      and Restated
      Certification
      of Incorporation
    SB-2
    333-119385
    3.1
    9/30/043.2
    Amended
      and Restated By-Laws
    SB-2
    333-119385
    3.1
    9/30/0410.1
    2004
      Equity Compensation Plan
    SB-2
    333-119385
    10.1
    9/30/0410.2
    2001
      Equity Compensation Plan
    SB-2
    333-119385
    10.2
    9/30/0410.3
    1998
      Stock Option Plan
    SB-2
    333-119385
    10.3
    9/30/0410.4
    Form
      of Reorganization Lock-up Proxy and Release Agreement dated 1/01/04
      between Online and stockholders of Smart Online
    SB-2
    333-119385
    10.4
    9/30/0410.5
    Form
      of Lock-up Agreement dated 01/01/04, between Online and stockholders of
      Smart Online
    SB-2
    333-119385
    10.5
    9/30/0410.6
    Form
      of Subscription Agreement with lock-up provisions between Smart Online and
      investors
    SB-2
    333-119385
    10.6
    9/30/0410.7
    Form
      of Registration Rights Agreement dated as of 02/01/04 between Smart Online
      and investors
    SB-2
    333-119385
    10.7
    9/30/0410.8
    Employment
      Agreement dated 04/01/04 with Michael Nouri
    SB-2
      Amendment
      1
    333-119385
    10.8
    11/24/0410.9
    Employment
      Agreement dated 04/01/04 with
      Henry
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.9
    11/24/0410.10
    Employment
      Agreement dated 04/01/04 with Ronna Loprete
    SB-2
      Amendment
      1
    333-119385
    10.10
    11/24/0410.11
    Employment
      Agreement dated 05/01/04 with Jose Collazo
    SB-2
      Amendment
      1
    333-119385
    10.11
    11/24/0410.12
    Employment
      Agreement dated 05/01/04 with Anil Kamath
    SB-2
      Amendment
      1
    333-119385
    10.12
    11/24/04





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10.13
    Security
      Agreement dated 10/13/03 with Smart Online as the Debtor and Michael
      Nouri, Henry Nouri, Thomas Furr, Ronna Loprete and Eric Nouri as the
      Secured Parties
    SB-2
      Amendment
      1
    333-119385
    10.13
    11/24/0410.14
    $418,749.93
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Michael
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.14
    11/24/0410.15
    $64,602.90
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Michael
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.15
    11/24/0410.16
    $398,383.27
      Promissory Note dated 04/01/04 from Smart Online as the Debtor to Henry
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.16
    11/24/0410.17
    $116,507.60
      Promissory Note dated 04/30/04 from Smart Online as the Debtor Thomas
      Furr
    SB-2
      Amendment
      1
    333-119385
    10.17
    11/24/0410.18
    $92,500
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Ronna
      Loprete
    SB-2
      Amendment
      1
    333-119385
    10.18
    11/24/0410.19
    $47,740.18
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Eric
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.19
    11/24/0410.20
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Michael
      Nouri
    SB-2
      Amendment
      2
    333-119385
    10.20
    12/23/0410.21
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Henry
      Nouri
    SB-2
      Amendment
      2
    333-119385
    10.21
    12/23/0410.22
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Thomas
      Furr
    SB-2
      Amendment
      2
    333-119385
    10.22
    12/23/0410.23
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Ronna
      Loprete
    SB-2
      Amendment
      2
    333-119385
    10.23
    12/23/0410.24
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Eric
      Nouri
    SB-2
      Amendment
      2
    333-119385
    10.24
    12/23/0410.25
    Amended
      and Restated Integration Program Agreement for Vmail and Internet
      Messenger Engine dated 04/30/03 with Smart IL, Ltd.
    SB-2
      Amendment
      1
    333-119385
    10.25
    11/24/04





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10.26
    Amendment
      to Amended and Restated Integration Program Agreement dated 10/29/03 with
      Smart IL, Ltd.
    SB-2
      Amendment
      1
    333-119385
    10.25
    11/24/0431.1
    Certification
      of Principal Executive Officer of Periodic Report Pursuant to Rule
      13a-14(a) or Rule 15d-14(a)
    
    
    
    
    X31.2
    Certification
      of Principal Financial Officer of Periodic Report Pursuant to Rule
      13a-14(a) or Rule 15d-14(a)
    
    
    
    
    X32.1
    Certification
      of Principal Executive Officer of Periodic Report Pursuant to Rule
      13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350
    
    
    
    
    X32.2
    Certification
      of Principal Financial Officer of Periodic Report Pursuant to Rule
      13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350
    
    
    
    
    X












57