**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**_________________**





**FORM
      10-Q**


**_________________**





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





**For
      the quarterly period ended March 31, 2006**





**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     þNo     o


Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of accelerated
      filer and large accelerated filer in Rule 12b-2 of the Exchange Act.


(Check
      one): Large
      Accelerated Filer      o Accelerated Filer     o Non-accelerated
      Filer     þ





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





As
      of
      July 26, 2006, there were approximately 16,537,000 shares of the Registrant's
      Common Stock outstanding.


1











**Smart
      Online, Inc.**


**INDEX**








**Page
                No.****PART
                I. FINANCIAL INFORMATION****Item
                1.**
            **Financial
                Statements:**
            3Balance
                Sheets as of March 31, 2006 (unaudited) and December 31, 2005
            3Statements
                of Operations (unaudited) for the three months ended March 31, 2006
                and
                2005
            4Statements
                of Cash Flows (unaudited) for the three months ended March 31, 2006
                and
                2005
            5Notes
                to Financial Statements (unaudited)
            6**Item
                2.**
            **Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations**
            15**Item
                3.**
            **Quantitative
                and Qualitative Disclosures About Market
                Risk**
            25**Item
                4.**
            **Controls
                and Procedures**
            25**PART
                II. OTHER INFORMATION****Item
                1.**
            **Legal
                Proceedings**
            26**Item
                1A.**
            **Risk
                Factors**
            26**Item
                2.**
            **Unregistered
                Sales of Equity Securities and Use of
                Proceeds**
            35**Item
                6.**
            **Exhibits**
            36**Signatures**
            37








2


**PART
      I.   FINANCIALINFORMATION**




**Item
      1.** **FINANCIALSTATEMENTS**





**Smart
      Online, Inc.**


**Consolidated
      BalanceSheets**





**Assets**
            
            **March
                31,**
              **2006**
              **(unaudited)**
            
            **December
                31**,
              **2005**CURRENT
                ASSETS:Cash
                and Cash Equivalents
            
            $
            898,521
            
            $
            1,434,966Restricted
                Cash
            
            
            530,000
            
            
            230,244Accounts
                Receivable, Net
            
            
            760,912
            
            
            504,979Other
                Accounts Receivable
            
            
            80,237
            
            
            74,876Prepaid
                Expenses
            
            
            249,527
            
            
            370,225Total
                Current Assets
            
            
            2,519,197
            
            
            2,615,290PROPERTY
                AND EQUIPMENT, net
            
            
            666,376
            
            
            664,062INTANGIBLE
                ASSETS, net
            
            
            10,787,693
            
            
            11,032,129OTHER
                ASSETS
            
            
            265,054
            
            
            246,598TOTAL
                ASSETS
            
            $
            14,238,320
            
            $
            14,558,079**Liabilities
              and Stockholders’
              Equity**CURRENT
                LIABILITIES:Accounts
                Payable
            
            $
            1,115,482
            
            $
            855,904Short-Term
                Portion of Capital Lease
            
            
            12,333
            
            
            14,707Short-Term
                Portion of Subscription Financing Payable
            
            
            933,623
            
            
            855,060Accrued
                Registration Rights Penalty
            
            
            237,843
            
            
            129,945Current
                Portion of Notes Payable
            
            
            3,617,867
            
            
            2,189,986Accrued
                Liabilities
            
            
            173,240
            
            
            91,233Deferred
                Revenue
            
            
            598,110
            
            
            785,324Total
                Current Liabilities
            
            
            6,688,498
            
            
            4,922,159LONG-TERM
                LIABILITIES:Long-Term
                Portion of Notes payable
            
            
            352,785
            
            
            2,331,152Subscription
                Financing Payable
            
            
            769,498
            
            
            541,110Deferred
                Revenue
            
            
            74,266
            
            
            91,027Total
                Long-Term Liabilities
            
            
            1,196,549
            
            
            2,963,289Total
                Liabilities
            
            
            7,885,047
            
            
            7,885,448COMMITMENTS
                AND CONTINGENCIESSTOCKHOLDERS'
                EQUITY:Common
                stock, $.001 par value, 45,000,000 shares authorized, shares issued
                and
                outstanding:
              March
                31, 2006 - 16,029,030; December 31, 2005 -15,607,230
            
            
            16,029
            
            
            15,607Additional
                Paid-In Capital
            
            
            60,261,759
            
            
            58,982,617Accumulated
                Equity (Deficit)
            
            
            (53,924,515
            )
            
            (52,325,593
            )Total
                Stockholders' Equity
            
            
            6,353,273
            
            
            6,672,631TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY
            
            $
            14,238,320
            
            $
            14,558,079





The
      accompanying notes are an integral part of the consolidated financial
      statements .


3


**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTSOF** **OPERATIONS**


**(unaudited)**


**Three
                Months**
              **Ended**
              **March
                31, 2006**
            
            **Three
                Months**
              **Ended**
              **March
                31, 2005**REVENUES:Integration
                Fees
            
            $
            149,743
            
            $
            129,522Syndication
                Fees
            
            
            68,915
            
            
            92,040OEM
                Revenue
            
            
            9,000
            
            
            12,000Subscription
                Fees
            
            
            999,199
            
            
            15,159Professional
                Services Fees
            
            
            601,967
            
            
            -Other
                Revenues
            
            
            66,845
            
            
            4,517Total
                Revenues
            
            
            1,895,669
            
            
            253,238COST
                OF REVENUES
            
            
            348,932
            
            
            31,727GROSS
                PROFIT
            
            
            1,546,737
            
            
            221,511OPERATING
                EXPENSES:General
                and Administrative
            
            
            2,156,230
            
            
            519,036Sales
                and Marketing
            
            
            328,468
            
            
            294,732Research
                and Development
            
            
            514,386
            
            
            255,227Total
                Operating Expenses
            
            
            2,999,084
            
            
            1,068,995LOSS
                FROM OPERATIONS
            
            
            (1,452,347
            )
            
            (847,484
            )OTHER
                INCOME (EXPENSE):Interest
                Income (Expense), Net
            
            
            (121,576
            )
            
            5,998Write-off
                of Investment
            
            
            (25,000
            )
            
            -Gain
                on Debt Forgiveness
            
            
            -
            
            
            547,341Total
                Other Income (Expense)
            
            
            (146,576
            )
            
            553,339NET
                LOSS
            
            
            (1,598,923
            )
            
            (294,145
            )Net
                Loss Attributed to Common Stockholders
            
            $
            (1,598,923
            )
            $
            (294,145
            )NET
                LOSS PER SHARE:Net
                loss Attributed to Common Stockholders -
              Basic
                and Diluted
            
            $
            (0.11
            )
            $
            (.02
            )SHARES
                USED IN COMPUTING NET LOSS PER SHARE:Basic
                and Diluted
            
            
            14,984,228
            
            
            11,829,610





The
      accompanying notes are an integral part of the consolidated financial
      statements .


4








**SMART
      ONLINE, INC.**


**CONSOLIDATEDSTATEMENTS
      OF** **CASH FLOWS**


**(unaudited)**




**Three
                Months**
              **Ended**
              **March
                31, 2006**
            
            **Three
                Months**
              **Ended**
              **March
                31, 2005**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (1,598,923
            )
            $
            (294,145
            )Adjustments
                to reconcile Net Loss to Net Cash
              used
                in Operating Activities:Depreciation
                and Amortization
            
            
            335,634
            
            
            11,093Amortization
                of Deferred Financing Costs
            
            
            42,357
            
            
            -Bad
                Debt Expense
            
            
            65,317
            
            
            -Stock
                Option Related Compensation Expense
            
            
            257,464
            
            
            -Write-off
                of Investment
            
            
            25,000
            
            
            -Registration
                Rights Penalty
            
            
            107,898
            
            
            -Issuance
                of Warrants
            
            
            -
            
            
            19,231Gain
                on Debt Forgiveness
            
            
            -
            
            
            (547,341
            )Changes
                in Assets and Liabilities:Accounts
                Receivable
            
            
            (354,834
            )
            
            18,715Prepaid
                Expenses
            
            
            62,789
            
            
            (44,468
            )Other
                Assets
            
            
            (596
            )
            
            41,235Deferred
                Revenue
            
            
            (115,772
            )
            
            (47,828
            )Accounts
                Payable
            
            
            237,161
            
            
            57,809Accrued
                and Other Expenses
            
            
            74,531
            
            
            12,220Deferred
                Compensation, Notes Payable, and Interest
            
            
            -
            
            
            (1,091,814
            )Net
                Cash used in Operating Activities
            
            
            (861,974
            )
            
            (1,865,293
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of Furniture and Equipment
            
            
            (71,662
            )
            
            (51,263
            )Redemption
                of Marketable Securities
            
            
            -
            
            
            395,000Net
                cash provided by (used in) Investing Activities
            
            
            (71,662
            )
            
            343,737CASH
                FLOWS FROM FINANCING ACTIVITIES:Repayments
                on Notes Payable
            
            
            (547,271
            )
            
            -Borrowings
                from Factors
            
            
            526,727
            
            
            -Repayments
                to Factors
            
            
            (304,993
            )
            
            -Restricted
                Cash
            
            
            (299,756
            )
            
            -Issuance
                of Common Stock
            
            
            1,022,100
            
            
            2,735,000Net
                Cash provided by Financing Activities
            
            
            396,807
            
            
            2,735,000NET
                INCREASE (DECREASE) IN CASH
              AND
                CASH EQUIVALENTS
            
            
            (536,829
            )
            
            1,213,444CASH
                AND CASH EQUIVALENTS,
              BEGINNING
                OF PERIOD
            
            
            1,435,350
            
            
            173,339CASH
                AND CASH EQUIVALENTS,
              END
                OF PERIOD
            
            $
            898,521
            
            $
            1,386,783Supplemental
                Disclosures:Cash
                Paid during the Period for Interest:
            
            $
            112,399
            
            $
            154,288





The
      accompanying notes are an integral part of the consolidated financial
      statements .


5







**Smart
      Online, Inc.**


**Notesto
      Consolidated Financial Statements -
      Unaudited**





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




***Basis
      of Presentation*** -
      The
      accompanying balance sheet as of March 31, 2006 and the statements of operations
      and cash flows for the three months ended March 31, 2006 and 2005 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 our Annual Report
      on Form 10-K for the year ended December 31, 2005.





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 our
      management, the unaudited statements in this Quarterly Report on Form 10-Q
      include all normal and recurring adjustments necessary for the fair presentation
      of our statement of financial position as of March 31, 2006, its results of
      operations and its cash flows for the three months ended March 31, 2006 and
      2005. The results for the three months ended March 31, 2006 are not necessarily
      indicative of the results to be expected for the fiscal year ending December
      31,
      2006.




The
      accompanying financial statements have been prepared assuming that we 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.  We had accumulated losses of
      approximately $54 million at March 31, 2006 and will be required to make
      significant expenditure in connection with continuing development and marketing
      efforts along with general and administrative expenses including, but not
      limited to, increased legal fees related to the SEC investigations. We do not
      expect legal fees related to the internal investigation to significantly
      increase general and administrative expenses on a going forward basis.  Our
      ability to continue our operations is dependant upon our raising of capital
      through equity financing in order to meet our working needs.




These
      conditions raise substantial doubt about our 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. We
      may
      raise additional capital by the sale of its equity securities or other financing
      avenues.




***Significant
      Accounting Policies -*** In
      the
      opinion of our management, the significant accounting policies used for the
      three-months ended March 31, 2006 are consistent with those used for the years
      ended December 31, 2005, 2004 and 2003. Accordingly, please refer to our Annual
      Report on Form 10-K for the year ended December 31, 2005, filed with the
      Securities and Exchange Commission (“SEC”) on July 11, 2006, for our significant
      accounting policies.




***Description
      of Business -*** Smart
      Online, Inc. was incorporated in the State of Delaware in 1993. We develop
      and
      market Internet-delivered Software-as-a-Service (SaaS) software applications
      and
      data resources to start and run small businesses. Our subscribers access our
      products through the websites of our private label syndication partners,
      including major companies and financial institutions, and our main portal
      at www.SmartOnline.com .





***Fiscal
      Year -*** Our
      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 our 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 materially from those estimates.





***Software
      Development Costs*** -
      We have
      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 our product development
      process, technological feasibility is established upon completion of a working
      model. Costs related to software development incurred between completion of
      the
      working model and the point at which the product is ready for general release
      have been insignificant.


6





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





***Advertising
      Costs*** -
      We
      expense all advertising costs as they are incurred. The amount charged to
      expense during the first quarter of 2006 and 2005 were $42,566 and $136,335,
      respectively. The 2006 period included $37,915 of barter advertising expenses
      and the 2005 period reflected $135,000 of barter advertising.





***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. We excluded shares issuable 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***





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





We
      maintain stock-based compensation arrangements under which employees,
      consultants and directors may be awarded grants of stock options and restricted
      stock. Prior to January 1, 2006, we accounted for these awards under the
      provisions of APB No. 25 as permitted under SFAS No. 123. Accordingly,
      compensation expense for stock options was not recognized because stock options
      granted had an exercise price equal to or greater than the market price of
      our
      common stock on the date of grant.





Effective
      January 1, 2006, we adopted SFAS No. 123R using the Modified Prospective
      Approach. Under the Modified Prospective Approach, the amount of compensation
      cost recognized includes: (i) compensation cost for all share-based
      payments granted prior to, but not yet vested as of January 1, 2006, based
      on the grant date fair value estimated in accordance with the provisions of
      SFAS
      No. 123 and (ii) compensation cost for all share-based payments that
      will be granted subsequent to January 1, 2006, based on the grant date fair
      value estimated in accordance with the provisions of SFAS No. 123R. Upon
      adoption, we recognize the stock-based compensation of previously granted
      share-based options and new share based options under the straight-line method
      over the requisite service period. Total stock-based compensation expense
      recognized under SFAS No. 123R, was approximately $257,500 for the three
      months ended March 31, 2006. No stock-based compensation was
      capitalized in the consolidated financial statements. The
      fair
      value of option grants under our plan and other stock option issuance during
      the
      quarters ended March 31, 2006 and 2005 was estimated the following
      weighted-average assumptions:





**Quarter**
              **Ended**
              **March
                31,**
              **2006**
            
            **Quarter**
              **Ended**
              **March
                31,**
              **2005**Dividend
                yield
            
            
            0.00%
            
            
            0.
                00%Expected
                volatility
            
            
            150%
            
            
            0.00%Risk
                free interest rate
            
            
            4.85%
            
            
            4.23%Expected
                lives (years)
            
            
            4.9%
            
            
            9.0%








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


7





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





For
      periods prior to January 1, 2006, we accounted for our stock-based
      compensation plans in accordance with the intrinsic value provisions of APB
      No.
      25. Stock Options are generally granted at prices equal to the fair value of
      our
      common stock on the grant dates. Accordingly, we did not record any compensation
      expense in the accompanying financial statements for the three-months ended
      March 31, 2005 for its stock-based compensation plans. Had compensation expense
      been recognized consistent with the fair value provisions of SFAS No. 123R,
      our
      net loss attributed to common stockholders and net loss attributed to common
      stockholders per share for the quarter ended March 31, 2005 would have been
      changed to the pro forma amounts indicated below:








**Three
                Months**
              **Ended**
              **March
                31, 2005**Net
                  loss attributed tocommon
                  stockholders:As
                reported
            
            $
            (294,145
            )Add:   Compensation
                costrecorded
                at intrinsic valueLess:  
                Compensation cost using
            
            
            (34,052
            )the
                fair value methodPro
                forma
            
            $
            (328,197
            )








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





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                December 31, 2005
            
            
            2,727,950
            
            $
            5.34Forfeited
            
            
            30,000
            
            
            3.50Granted
            
            
            251,500
            
            
            7.70BALANCE,
                March 31, 2006
            
            
            2,949,450
            
            $
            5.73








**Recently
      Issued Accounting Pronouncements**







FAS
      154 -
      Accounting Changes and Error Corrections - a replacement of APB Opinion No.
      20
      and FASB Statement No. 3




8


In
      June
      2005, the Financial Accounting Standards Board issued FAS No. 154, “Accounting
      Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB
      Statement No. 3". This Statement generally requires retrospective application
      to
      prior periods’ financial statements of changes in accounting principle.
      Previously, Opinion No. 20 required that most voluntary changes in accounting
      principle were recognized by including the cumulative effect of changing to
      the
      new accounting principle in net income of the period of the change. FAS 154
      applies to all voluntary changes in accounting principle. It also applies to
      changes required by an accounting pronouncement in the unusual instance that
      the
      pronouncement does not include specific transition provisions. When a
      pronouncement includes specific transition provisions, those provisions should
      be followed. This Statement became effective for accounting changes and
      corrections of errors made in fiscal years beginning after December 15, 2005.
      The adoption of this statement did not have a material effect on the results
      of
      operations or financial position.





**2.  
      PRESENTATION OF SUBSIDIARIES**





As
      more
      fully detailed in our 2005 Form 10-K, Smart Online completed two acquisitions
      in
      October 2005. On October 4, 2005, Smart Online purchased substantially all
      of
      the assets of Computility, Inc. (“Computility”). In consideration for the
      purchased assets, we issued the seller 484,213 shares of our Common Stock and
      assumed certain liabilities of Computility totaling approximately $1.9 million.
       The shares were valued at $7.30 per share which was the median trading
      price on the acquisition date. The total purchase price, including liabilities
      assumed, was approximately $5.8 million including approximately $228,000 of
      acquisition fees.





On
      October 18, 2005, we completed our purchase of all of the capital stock of
      iMart
      Incorporated (“iMart”), a Michigan based company providing multi-channel
      electronic commerce systems, pursuant to a Stock Purchase Agreement, dated
      as of
      October 17, 2005 by and among us, iMart and the shareholders of iMart. We
      issued
      to iMart’s stockholders 205,767 shares of our Common Stock and agreed to pay
      iMart’s stockholders approximately $3,462,000 in cash installments. This amount
      is payable in four equal payments of $432,866 on the first business day of
      each
      of January 2006, April 2006, July 2006 and October 2006. The
      final
      installment payment of approximately $1.7 million is payable in January 2007. The
      shares were valued at $8.825 per share which was the median trading price on
      the
      acquisition date. The total purchase price for 100% of the outstanding iMart
      Incorporated shares was approximately $5.3 million including approximately
      $339,000 of acquisition fees.





Part
      of
      the stock purchase agreement required that cash collected and held by iMart
      be
      restricted for the purpose of paying all iMart operating expenses, purchase
      price installment payments and non-compete payments before any cash can be
      used
      by us for other purposes. Accordingly, $530,000 has been classified as
      restricted cash on the balance sheet as of March 31, 2006.





The
      financial statements for the three months ended March 31, 2005 do not contain
      any accounts of these acquired companies as this was a pre-acquisition period.
      The financial statements for the three months ended March 31, 2006 contain
      a
      full quarter of operations of these two acquired companies. Accordingly, the
      statement of operations for the two periods presented in this form 10-Q can
      only
      be compared by taking these acquisitions into account.





***Pro
      forma of Results from Operations (unaudited)***





The
      following pro formas show the results of operations for the first quarter of
      2005 if our subsidiaries had been acquired as of January 1, 2005.





Smart
                CRM
            
            Smart
                Commerce
            
            Smart
                Online
            
            Pro
                Form
              (unaudited)Revenue
            
            $
            488,603
            
            $
            862,304
            
            $
            253,238
            
            $
            1,604,145Net
                Income (Loss)
            
            $
            (27,927
            )
            $
            421,744
            
            $
            (294,145
            )
            $
            99,672EPS
            
            
            
            
            
            
            
            
            
            
            $
            0.01





**3.  
      Industry Segment Information**





SFAS
      131, *“Disclosures
      about Segments of an Enterprise and Related Information,”* establishes
      standards for the way in which public companies disclose certain information
      about operating segments in their financial reports. Consistent with SFAS 131,
      we have defined three reportable segments, described below, based on factors
      such as geography, how we manage our operations and how our chief operating
      decision maker views results.





9


Smart
      Commerce, Inc (d/b/a iMart) revenue is derived primarily from the development
      and distribution of multi-channel e-commerce systems including domain name
      registration and email solutions, e-commerce solutions, website design and
      website hosting.





Smart
      CRM, Inc. (Computility) revenue is derived primarily from the development and
      distribution of sales force automation and customer relationship management
      software as well as from software and hardware subscription agreements (software
      and network maintenance).





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





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





At
      December 31, 2005, we considered Smart Online, Inc. to have operated as one
      segment, primarily due to the fact that the acquisitions that now make up our
      reportable segments were only acquired in October of 2005 and management at
      that
      time was actively involved in the planning and allocation of resources. Upon
      integrating the newly acquired subsidiaries’ operations, we have deemed Smart
      Online to now operate in segments. No segment information is presented for
      the
      three months ended March 31, 2005 as this period was pre-acquisition and Smart
      Online was operating in one segment.





The
      following tables show our financial results by reportable segment for the three
      months ended March 31, 2006:





Smart
                Online,
              Inc.
            
            Smart
                CRM,
              Inc.
            
            Smart
                Commerce,
              Inc.
            
            ConsolidatedREVENUES:Integration
                Fees
            
            $
            149,743
            
            $
            -
            
            $
            -
            
            $
            149,743Syndication
                Fees
            
            
            68,915
            
            
            -
            
            
            -
            
            
            68,915Subscription
                Fees
            
            
            20,457
            
            
            453,525
            
            
            525,217
            
            
            999,199Professional
                Services Fees
            
            
            -
            
            
            30,236
            
            
            571,731
            
            
            601,967Other
                Revenues
            
            
            9,567
            
            
            53,949
            
            
            12,329
            
            
            75,845Total
                Revenues
            
            
            248,681
            
            
            537,710
            
            
            1,109,277
            
            
            1,895,669COST
                OF REVENUES
            
            
            17,815
            
            
            246,829
            
            
            84,288
            
            
            348,932OPERATING
                EXPENSES
            
            
            2,236,644
            
            
            285,827
            
            
            476,613
            
            
            2,999,084OPERATING
                INCOME
            
            
            (2,005,778
            )
            
            5,054
            
            
            548,376
            
            
            (1,452,347
            )OTHER
                INCOME (EXPENSE)
            
            
            (74,760
            )
            
            (47,115
            )
            
            (24,701
            )
            
            (146,576
            )NET
                INCOME/(LOSS) BEFORE INCOME TAXES
            
            $
            (2,080,538
            )
            $
            (42,061
            )
            $
            523,675
            
            $
            (1,598,923
            )TOTAL
                ASSETS
            
            $
            7,113,587
            
            $
            5,791,603
            
            $
            1,333,130
            
            $
            14,238,320








**4.** **SEC
      INVESTIGATION**





On
      January 17, 2006, the SEC temporarily suspended the trading of our securities.
      In its “Order of Suspension of Trading,” the SEC stated that the reason for the
      suspension was a lack of current and accurate information concerning our
      securities because of possible manipulative conduct occurring in the market
      for
      the our stock By its terms, that suspension ended on January 30, 2006 at 11:59
      p.m. EST. As a result of the SEC’s suspension, NASDAQ
      withdrew its acceptance of our application to have our common stock traded
      on
      the NASDAQ Capital Market Simultaneously with the suspension, the SEC advised us that it is conducting
      a
      non-public investigation. While we continue to cooperate with the SEC, w e
      are
      unable to predict at this time whether the SEC will take any adverse action
      against us. In
      March
      2006, our Board of Directors authorized its Audit Committee to conduct an
      internal investigation of matters relating to the SEC suspension and
      investigation. The Audit Committee retained independent outside legal counsel
      to
      assist in conducting the investigation. See Note 11 - Subsequent Events for
      additional details about these two matters.


10





**5.** **CURRENT
      ASSETS**





***Receivables***





We
      evaluate the need for an allowance for doubtful accounts based on specifically
      identified amounts that management believes to be uncollectible. Management
      also
      records an additional allowance based on management's assessment of the general
      financial conditions affecting its customer base. If actual collections
      experience changes, revisions to the allowance may be required. Based on these
      criteria, management has recorded an allowance for doubtful accounts of
      approximately $65,000 and $0 as of March 31, 2006 and December 31, 2005,
      respectively.





***Restricted
      Cash***





Under
      the
      terms of the purchase agreement between iMart and us, cash collected by iMart
      is
      restricted so that cash can only be used for the following purposes, in the
      order of priority presented: (1) to fund the operating expenses of Smart
      Commerce, Inc. (d/b/a iMart), our wholly owned subsidiary, (2) to fund purchase
      price installment payments, and (3) to fund non-compete installment payments.
      Only after all these funding requirements are met are we permitted to use excess
      cash for general operating purposes. At March 31, 2006, $530,000 was classified
      as restricted.





**6** . **INTANGIBLE
      ASSETS**





Intangible
      assets consists primarily of intangibles acquired during the Computility and
      iMart acquisitions which occurred in October 2005. In addition to these assets
      acquired, we have copyrights and trademarks related to certain products, names
      and logos used throughout our product lines. The assets acquired through the
      acquisitions include customer bases, technology, non-compete agreements, trade
      names, workforces in place, and goodwill. Trade names, work forces in place,
      and
      goodwill are not subject to amortization and for the purpose of presentation,
      work forces in place are combined with goodwill.





**Asset
                Category**
            **Value
                Assigned**
            **Residual**
              **Value**
            **Weighted**
              **Avg
                Useful**
              **Life**
            **Accumulated**
              **Amortization**
              **At
                3/31/06**
            **Carrying**
              **Value**
              **At
                3/31/06**Customer
                Base
            $     
                2,504,989
            $0
            5.9
            $
                228,907
            $      
                2,276,082Technology
            $     
                1,249,842
            $0
            3
            $
                208,554
            $      
                1,041,288Non-Compete
            $      
                  891,785
            $0
            3.9
            $
                106,871
            $        
                784,914Copyright
                & Trademark
            $       
                   50,339
            $0
            10
            $  
                35,392
            $          
                14,947Trade
                Name *
            $    
                 1,180,499
            n/a
            n/a
            n/a
            $    
                 1,180,499Work
                Force &
              Goodwill
                *
            $    
                 5,489,963
            n/a
            n/a
            n/a
            $   
                 5,489,963**TOTALS**
            **$
                11,367,417**
            
            
            **$579,724**
            **$10,787,693**





*
      Trade
      Name and Work Force & Goodwill are not subject to amortization and are
      deemed to have an indefinite life in accordance with SFAS No.142 - *Goodwill
      and Other Intangible Assets.*





Goodwill
      was calculated as the difference between the purchase price of the and the
      value
      of the identifiable tangible and intangible assets acquired. Trademarks and
      copyrights were capitalized using the costs of all legal and application fees
      incurred.


11


For
      the
      three months ended March 31, 2006 and 2005, the aggregate amortization expense
      on the above intangibles was approximately $242,086 and $1,079, respectively.





**7.   
      NOTES PAYABLE**





As
      of
      March 31, 2006, we had Notes Payable totaling $5,673,773. The detail of these
      notes is as follows:





Note
                Description
            
            S/T
                Portion
            
            L/T
                Portion
            
            Total
            
            Maturity
            
            RateiMart
                Purchase Price Note
            
            $
            2,845,020
            
            
            -
            
            $
            2,845,020
            
            
            Jan
                2007
            
            
            8.0
            %iMart
                Non-Compete Note
            
            
            349,368
            
            
            281,094
            
            
            630,462
            
            
            Oct
                2007
            
            
            8.0
            %Acquisition
                Fee - iMart
            
            
            199,986
            
            
            9,191
            
            
            209,177
            
            
            Oct
                2007
            
            
            8.0
            %Acquisition
                Fee - Computility
            
            
            148,493
            
            
            -
            
            
            148,493
            
            
            Mar
                2007
            
            
            8.0
            %Subscription
                Factor Payable
            
            
            933,623
            
            
            769,498
            
            
            1,703,121
            
            
            Various
                thru 2008
            
            
            9%
                - 10.5
            %Floor
                Plan Agreement
            
            
            75,000
            
            
            62,500
            
            
            137,500
            
            
            Feb
                2008
            
            
            Prime+4





As
      detailed in our Annual Report on Form 10-K for fiscal 2005, the iMart stock
      purchase agreement called for certain cash installment payments to be made
      to
      iMart’s selling individuals. The final installment payment of approximately $1.7
      million is payable in January 2007. Accordingly, such amount was classified
      as
      part of long-term liabilities at December 31, 2005. As of March 31, 2006, such
      amount is classified as a current liability.





**8.
      Stockholders' Equity**




***Common
      Stock and Warrants***




On
      March
      30, 2006, we sold 400,000 shares of its common stock to Atlas Capital, S.A.,
      an
      existing stockholder, for a price of $2.50 per share resulting in gross proceeds
      of $1,000,000. We incurred immaterial issuance costs related to this stock
      sale.
      As part of this sale, Atlas received contractual rights to purchase shares
      at a
      lower price should we enter into a private placement agreement in the future
      in
      which we sell shares of our common stock for less than $2.50 per share. In
      connection with this financing, Berkley Financial Services, Ltd. (“Berkley”) may
      claim that it is entitled to a fee under an investment banking letter agreement
      dated February 23, 2005.





During
      the first quarter of 2006, warrants to purchase 7,500 shares of our common
      stock
      expired. In March 2006, there was a cashless exercise of a warrant to purchase
      10,000 shares of our common stock, resulting in the issuance of 4,800 shares.
      Also in March 2006, four warrants to purchase a total of 17,000 shares of our
      common stock were exercised on a cash basis, resulting in the issuance of 17,000
      shares and gross proceeds of $22,100 to us. We incurred immaterial costs related
      to these exercises.





***Stock
      Option Plans***




We
      maintain three equity compensation plans. During the first quarter of 2006,
      we
      issued a total of 251,500 options to employees. Of
      these
      options, a total of 100,000 were issued to two officers of the Company. A total
      of 201,500 options were granted with a strike price of $9.00 and the fair market
      value on the date of grant was also $9.00. The March 21, 2006, grant to purchase
      50,000 shares of common stock was granted to a newly elected officer. The strike
      price and fair market value on the date of grant was $2.50. All options vest
      over five (5) years and have a ten (10) year life.


12








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








The
      following table summarizes information about stock options outstanding at March
      31, 2006:





**Currently
                Exercisable****Exercise**
              **Price**
            **Number
                of**
              **Shares**
              **Outstanding**
            **Average**
              **Remaining**
              **Contractual
                Life**
              **(Years)**
            **Weighted**
              **Average
                Exercise**
              **Price**
            **Number
                of**
              **Shares**
            **Weighted**
              **Average**
              **Exercise**
              **Price**From
                $1.30 to $1.43
            670,000
            2.8
            $
                1.40
            670,000
            $
                1.40From
                $2.50 to $3.50
            517,500
            7.1
            $
                3.40
            245,873
            $
                3.50$5.00
            286,700
            8.6
            $
                5.00
            124,700
            $
                4.95From
                $7.00 to $7.75
            200,500
            9.4
            $
                7.17
            64,250
            $
                1.68From
                $8.20 to $8.61
            811,750
            9.2
            $
                8.57
            10,000
            $
                8.61From
                $9.00 to $9.82
            463,000
            5.5
            $
                9.46
            55,000
            $
                9.82





***Dividends***





We
      have
      not paid any cash dividends through March 31, 2006.





**9.
      Major Customers and Concentration of Credit Risk**





We
      derive
      a significant portion of our 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, 2006Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Professional
                Services
            
            $
            537,760
            
            
            28
            %Customer
                B
            
            
            Subscription
            
            
            521,809
            
            
            28Others
            
            
            Various
            
            
            836,100
            
            
            44Total
            
            
            
            
            $
            1,895,669
            
            
            100
            %










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





We
      had
      one customer that accounted for $337,995, or 44%, of net receivables at March
      31, 2006. Another customer accounted for $105,971, or 14%, of net receivables
      at
      March 31, 2006; and i n
      the
      first quarter of 2006, we
      learned that this customer underwent a restructuring that could result in a
      decrease of approximately 30% in their business for our e-Commerce applications.
      We had one customer that accounted for 100% of receivables at December 31,
      2005.





13


**10.
      Commitments and Contingencies**





We
      did
      not pay our payroll taxes for the period from the fourth quarter of 2000 through
      the fourth quarter of 2003. In March 2004, we notified the Internal Revenue
      Service of our delinquent payroll tax filings and voluntarily paid the
      outstanding balance of our 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 us that we owed penalties plus accrued interest related
      to the above matter. At December 31, 2004, we had recorded a liability for
      accrued penalties and interest of $573,022. On February 18, 2005, the Internal
      Revenue Service agreed to accept our offer in compromise (Form 656) in
      settlement of all of our outstanding federal tax liabilities. Pursuant to the
      terms of the agreement, we 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. We paid $26,100 to the
      Internal Revenue Service on February 25, 2005, as required under the settlement
      terms. As a result of the settlement, we recorded a gain on legal settlement
      of
      approximately $547,000 during the first quarter of 2005.





On
      August
      30, 2002, we entered into a reseller agreement with Smart IL Ltd., formerly
      known as Smart Revenue Europe Ltd., an Israel based software company that
      specialized in secured instant messaging products (“SIL”), whereby SIL paid us
      $200,000 for nonexclusive rights to distribute our products in certain foreign
      territories in exchange for our marketing support and a twenty percent (20%)
      commission from the gross sales generated by SIL. Under the terms of this
      agreement, we are to collect the revenue, if any, from SIL’s customers and then
      make the required payments to SIL. On May 1, 2003, this reseller agreement
      was
      terminated. However, under the terms of that termination agreement, certain
      payment obligations of us to SIL survive termination with regard to a limited
      number of prospective business candidates. Under our integration agreement
      with
      SIL, dated April 2003, we would have to issue Doron Roethler 80,000 shares
      of
      our common stock if we integrate certain third party products into our own,
      and
      we may have to pay SIL a portion of revenue from sales of products and services
      of SIL through a revenue sharing arrangement.





During
      August 2005, we acquired rights to an accounting software engine from a software
      development company and co-developed our accounting software application with
      that developer. We have exclusive rights to the accounting application, and
      non-exclusive rights to the software engine included in the application. In
      connection with this agreement, we agreed to pay the developer up to $512,500
      and issue up to $287,500 worth of our Common Stock based upon the developer
      attaining certain milestones. As of March 31, 2006 the developer had earned
      and
      been paid $255,000 ($225,000 in cash and $30,000 of our Common Stock). Although
      this product was integrated into the OneBiz SM application suite in December 2005, we did not accept the completion of the
      software application because, in our judgment and based on feedback we received
      from both customers and an accounting consultant, certain modifications and
      features were needed to improve the usability of the accounting application.
      As
      a result, we are continuing to work with the software development company to
      complete and improve the accounting application. Under an amendment to this
      agreement, on May 5, 2006 we deposited $37,500 into escrow, which will be
      released to the software development company upon acceptance of the accounting
      application. Also upon acceptance, we have agreed to pay the developer the
      remaining $257,500 of our common stock, at a per share price of $8.88, with
      $250,000 in two equal installments to be paid up to 100 days after acceptance
      and up to 190 days after acceptance .





In
      connection with private sales of our common stock to Atlas Capital, S.A. and
      The
      BlueLine Fund during the first half of 2006, Berkley may claim that it is
      entitled to a fee under an investment banking letter agreement dated February
      23, 2005. No amounts have been accrued related to these matters. Also, we are
      currently negotiating with Berkley to modify the consulting agreement we entered
      into with Berkley. We are seeking a release from Berkley of any and all claims
      to the shares of common stock issued to them.  Berkley would be allowed to
      keep the entire cash fee paid to Berkley under its investor relations
      contract.  There can be no assurance we will be successful in achieving
      these goals. Also, if we are successful, we may suffer adverse treatment for
      this transaction or the accounting treatment may be challenged by the SEC or
      others.





**11.
      Subsequent Events**





On
      May
      31, 2006, we entered into a “Settlement Agreement” with General Investments
      Capital, Ltd. (“GIC”) with regard to a ”Consulting Agreement,” dated October 26,
      2005. Under the Consulting Agreement, GIC was to receive 625,000 shares of
      our
      common stock (the “Shares”) and a cash payment of $250,000 (the “Cash Fee”) for
      investor relations consulting services. We paid the entire $250,000, and the
      625,000 shares were issued to GIC, but were never delivered. Under the
      Settlement Agreement, GIC agreed, in part, to release its claim to the Shares,
      but retained the entire Cash Fee as consideration for services performed under
      the Consulting Agreement and for entering into the Settlement Agreement. The
      terms of this Settlement Agreement are more fully set forth in our Current
      Report on Form 8-K filed on June 6, 2006, and that form is hereby incorporated
      by reference.





On
      June
      29, 2006, we sold 400,000 shares of its common stock to an existing investor
      for
      a price of $2.50 per share resulting in gross proceeds of $1,000,000. We
      incurred immaterial issuance costs related to this stock sale. In
      connection with this financing, Berkley may claim that it is entitled to a
      fee
      under an investment banking letter agreement dated February 23,
      2005.


14





On
      July
      6, 2006, we
      sold
      100,000 shares of its common stock to an existing investor for a price of $2.50
      per share resulting in gross proceeds of $250,000. We incurred immaterial
      issuance costs related to this stock sale. In
      connection with this financing, Berkley may claim that it is entitled to a
      fee
      under an investment banking letter agreement dated February 23,
      2005.





All
      of
      the above noted shares were issued directly by us pursuant to offerings and
      sales exemption from registration under the Securities Act of 1933, as amended,
      pursuant to Section 4(2) of the Act, as they were not transactions involving
      public offerings. We gave the purchasers the opportunity to ask questions and
      receive answers concerning the terms and conditions of the transactions and
      to
      obtain any additional information which we possessed or could obtain without
      unreasonable effort or expense that is necessary to verify the information
      furnished. We advised the purchasers of limitations on resale, and neither
      we
      nor any person acting on our behalf sold the securities by any means of general
      solicitation or general advertising.





On
      July
      7, 2006, the independent outside legal counsel conducting our internal
      investigation shared final findings with the Audit Committee, which were then
      shared with the full Board of Directors. The Audit Committee did not conclude
      that any of our officers or directors have engaged in fraudulent or criminal
      activity. However, it did conclude that we lacked an adequate control
      environment, and has taken action to address certain conduct of management
      that
      was revealed as a result of the investigation. The Audit Committee concluded
      that the control deficiencies primarily resulted from our transition from a
      private company to a publicly reporting company and insufficient preparation
      for, focus on and experience with compliance requirements for a publicly
      reporting company. As one of the results of these findings, Mr.
      Jeffrey LeRose was appointed to the position of non-executive Chairman of
      the
      Board of Directors to separate the leadership of the Board of Directors from
      the
      management of the Company, which is a recommended best practice for solid
      corporate governance. Mr. Nouri has stepped down as Chairman of the Board of
      Directors, but will continue to serve as our president, chief executive officer
      and as a member of the Board of Directors. A discussion of the significant
      deficiencies that were identified by the Audit Committee and related remediation
      efforts can be found in Item 9A of our 2005 Form 10-K.





After
      the
      end our fiscal year, two of our directors resigned because of the time
      commitments required to adequately perform their duties as a directors, and
      the
      Audit Committee is currently made up of one independent director. Our Audit
      Committee is currently conducting a search for additional independent Board
      members.





**Item
      2.** **MANAGEMENT’SDISCUSSION
      AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS**





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





**Overview**





We
      develop and market Internet-delivered Software-as-a-Services (“SaaS”) software
      applications and data resources for small businesses. We reach small businesses
      through syndication arrangements with other companies that private-label our
      software applications through their corporate web sites and our own website, www.smartonline.com .
      Our
      syndication relationships provide a cost and time efficient way to market our
      products and services to the small business sector.




At
      December 31, 2005, we considered Smart Online,
      Inc. to operate as one segment, primarily due to the fact that the acquisitions
      that now make up our reportable segments were only acquired in October 2005
      and
      management, at that time, was actively involved in the planning and allocation
      of resources.  Upon integration of these operations, we now deem Smart
      Online to operate in segments.




Except
      as
      noted below, all financial information for periods prior to our acquisition
      of
      Computility, Inc. (“Computility”) and iMart Incorporated (“iMart”) contained in
      this section refer to the financial performance of Smart Online only, and does
      not include the financial performance of either Computility or iMart before
      the
      acquisitions occurred in October of 2005. All financial information for periods
      after these acquisitions include the financial performance of the businesses
      we
      acquired, unless otherwise noted.


15





**Sources
      of Revenue**





We
      currently derive revenue from the following sources:





·
            Subscription
                Fees - Monthly fees charged to customers for access to our suite
                of
                applications, including those applications acquired in the iMart
                and
                Computility acquisitions. Subscription fees through our syndication
                partners will be the primary focus of our revenue growth strategies.
                Revenue from subscription fees represented $999,199 or 53% of our
                total
                revenue for the first quarter of 2006, as compared to $15,159 or
                6% of our
                total revenue for the first quarter of
                2005.





·
            Integration
                Fees - Fees charged to partners to integrate their products into
                our
                syndication platform. Integrating third-party content and products
                has
                been a key component of our strategy to continuously expand and enhance
                its platform offered to syndication partners and our own customer
                base.
                Revenue from integration fees represented $149,743 or 8% of our total
                revenue for the first quarter of 2006, as compared to $129,522 or
                51% of
                our total revenue for the first quarter of 2005. As our focus shifts
                to
                increasing revenue from subscription fees, we anticipate a decrease
                in
                revenue from integration fees for the foreseeable
                future.





·
            Syndication
                Fees - Fees consisting of:





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





·
            Barter
                revenue derived from syndication agreements with media
                companies.





Our
      syndication agreements also provide that we receive a percentage of the revenue
      generated by our partners from their websites, which are classified as
      subscription fees. We receive substantial revenue from one of these revenue
      sharing agreements. These agreements also include bartering arrangements for
      advertising and joint marketing programs to take advantage of discounted
      advertising rates and to provide an opportunity for revenue sharing. 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. Revenue from syndication fees represented $68,915 or 4% of our total
      revenue for the first quarter of 2006, as compared to $92,040 or 36% of our
      total revenue for the first quarter of 2005. As
      our
      focus shifts to increasing revenue from subscription fees, we anticipate a
      decrease in revenue from syndication fees for the foreseeable
      future.




·
            Professional
                Service Fees - Fees charged to customers for consulting services
                and
                services rendered and charged for on an hourly or contractual basis.
                Professional fees are currently generated by iMart, through services
                such
                as website design and IT consulting services, as well as by Computility
                through services such as networking consulting services. Revenue
                from
                professional service fees represented $601,967 or 32% of our total
                revenue
                for the first quarter of 2006, as compared to $0 or 0% of our total
                revenue for the first quarter of
                2005.





·
            OEM
                Revenues - OEM revenues consist of royalties paid for a license to
                distribute some of our software products. OEM revenues represented
                $9,000
                or 0.5% of our total revenue for the first quarter of 2006, as compared
                to
                $12,000 or 5% of our total revenue for the first quarter of
                2005.





·
              Other
                  revenues consist primarily of traditional shrink-wrap sales, which
                  are not
                  a significant revenue source for
                  us.





We
      are
      planning to engage in cross selling our services to customers of the two
      businesses we acquired in October of 2005 as part of our integration process.
      However, this initiative is not in place as we focus on other aspects of the
      integration. We started evaluating the potential of cross-selling during the
      second half of 2006.





Subscription
      revenues are comprised of sales of subscriptions directly to end-users, or
      to
      others for distribution to end-users, hosting and maintenance fees, and
      e-commerce website design fees. Subscription sales are made either on a
      subscription or on a “for fee” basis. Subscriptions, which include access to
      most of our offerings are payable in advance on a monthly basis and are targeted
      at small companies. Additional time is required to leverage existing and new
      syndication partners and to invest more on marketing and sales before
      significant revenue is generated.  During past years, most of our
      users have been given free use of our products for extended


16


time
      periods. During the fourth quarter of 2005, we changed that policy to a limited
      30-day free use period, after which we terminate access for users who fail
      to
      become paid subscribers. We expect lower fees from subscribers at the private
      label syndication websites of our partners since our agreements call for us
      to
      share revenue generated on each respective site. We began to offer our suite
      of
      OneBiz SM software
      applications on November 4, 2005 on our own website, and have migrated the
      syndication site of one of our partners to OneBiz SM and plan
      to migrate all of the OneBiz SM applications to our other syndication sites.  In May of 2006, we released a
      simplified version of our SFA/CRM application as part of the subscription to
      our
      suite of applications available on our core website. We are evaluating whether
      we can integrate certain parts of our new e-Commerce software applications
      into
      our application suite during 2006. Until then, these applications will be
      offered only on a “for fee” basis through our wholly owned subsidiary, Smart
      Commerce, Inc. (d/b/a iMart).  These and other “for fee” services allows
      customers to purchase for one-time use of a specific software or content
      service.





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      is
      received upfront. Our contracts are typically non-cancelable, though customers
      usually 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 as
      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, 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 revenue. We intend to seek an increase in the
      level of online marketing services in the future. We
      have
      not signed a new significant strategic partner relationship for the applications
      we sell via our OneBiz SM platform
      since the beginning of the second quarter of 2005. We plan to enter into new
      integration and syndication agreements that are advantageous to improving our
      business and increasing our subscription revenue.





Additionally,
      we receive a portion of third-party sales of products and services by our
      integration partners 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. Domain
      name registration fees are recognized over the term of the registration period.





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





For
      additional information, please refer to the “Revenue” section of the “Overview
      of Results of Operations for the Quarters Ended March 31, 2006 and 2005,”
below.





**Cost
      of Revenues**





Cost
      of
      revenue is comprised primarily of salaries associated with maintaining and
      supporting integration and syndication partners and the cost of an external
      hosting facility associated with maintaining and supporting integration and
      syndication partners. Additionally, during 2005, a portion of cost of revenue
      included third-party fees. Historically,
      we do not capitalize any costs associated with the development of our products
      and platform. 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 our product development
      process, technological feasibility is established upon completion of a working
      model. Costs related to software development incurred between completion of
      the
      working model and the point at which the product is ready for general release
      have been insignificant.





**Operating
      Expenses**





Our
      operating expenses included expenses for research and development, sales and
      marketing, and general and administrative costs. Our net loss for the first
      quarter of 2006 was primarily the result of an increase of $1,637,194, or 315%,
      in general and administrative expenses over the first quarter of
      2005.


17





*Research
      and Development* . Research
      and development expenses consist primarily of salaries for our development
      team. 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. For example, we are improving our accounting application and we
      recently redesigned our website to increase the ease of accessing our services.
      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 in absolute dollars
      as
      we upgrade and extend our service offerings and develop new technologies. We
      expect this to be particularly true during 2006. In 2006, we integrated a
      simplified version of the SFA/CRM application we acquired from a recent
      acquisition into our application suite. We are currently evaluating whether
      we
      will integrate the e-Commerce applications we acquired in our other recent
      acquisition.





*Sales
      and Marketing* . Sales
      and
      marketing expenses consist primarily of salaries for sales and marketing staff
      and other advertising related expenses. We
      expect
      these expenditures to increase significantly, assuming we are successful in
      raising capital in 2006, as we launch and begin marketing our latest version
      of
      the applications. We have also embarked on an effort to develop programs where
      media companies provide our Private Label Syndication services to their small
      business end users. We began targeting small business media companies in the
      first quarter of 2004, such as Inc. Magazine, FastCompany Magazine, and Business
      Week, who have small business customer bases. The strategy is to implement
      Private Label Syndication platforms in exchange for advertising and joint
      marketing programs with these companies. We expect 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 our outlay of
      cash
      for print and online advertising and marketing while providing reduced
      advertising prices.





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
      increase penetration within our existing private label customer base, expand
      our
      domestic selling and marketing activities, build brand awareness and participate
      in additional marketing programs. If we are able to raise additional capital,
      we
      expect that in the future, marketing and sales expenses will increase in
      absolute dollars and will be a significant cost. However, we anticipate that
      raising such capital will be difficult, and we can offer no assurances that
      we
      will be successful in our efforts to do so.





*General
      and Administrative* .
      General
      and administrative expenses consist primarily of salaries and related expenses
      for executive, finance and accounting, human resources, 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. Non-recurring general and administrative expenses are also
      expected to increase as a result of legal fees related to the SEC’s suspension
      of trading of our securities and the continuing SEC matter. We expect to incur
      increased and significant costs in upcoming periods related to our compliance
      with Section 404 of the Sarbanes-Oxley Act of 2002, and the implementation
      of
      changes made in our internal controls and procedures as detailed in Item 9A
      of
      or Annual Report on Form 10-K for fiscal 2005, filed with the SEC on July 11,
      2006.





As
      of
      January 1, 2006, 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.
      Effective January 1, 2006, we adopted Statement of Financial Accounting
      Standards (“SFAS”) No. 123R (revised 2004), “Share-Based Payment” (“SFAS 123R”)
      using the modified-prospective-transition method. We will continue to use the
      Black Scholes fair value pricing method as had been previously used for our
      pro
      forma disclosures prescribed by SFAS 123R prior to its official January 1,
      2006
      adoption date. For periods prior to January 1, 2006, we accounted for our
      stock-based compensation plans in accordance with the intrinsic value provisions
      of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to
      Employees” (“APB 25”). Under APB 25, we were not required to compensation
      expense for options granted with exercise prices equal to the fair market value
      of our common stock on the date of the grant. Accordingly, we did not record
      any
      compensation expense in the accompanying financial statements for the
      three-months ended March 31, 2005 for our stock-based compensation
      plans.





**Factoring
      Agreements**





During
      the first half of 2006, we, through our wholly-owned subsidiary Smart CRM,
      Inc.,
      entered into multiple factoring agreements. The factoring arrangements resulting
      in gross aggregate proceeds of approximately $623,000 and a debt payable to
      the
      factor in the total amount of approximately $729,000. The interest rate related
      to these arrangements is fixed at 10.5% and the debt will be paid off over
      the
      lives of the factored contracts which range from 28 to 44 months. These
      factoring agreements provide for a security interest in equipment provided
      to
      customers, if such equipment is provided under the factored contracts. Should
      any customer fail to make their scheduled payments, Smart CRM, Inc. will be
      liable to the factor for the full amount of the interest assigned to the factor.
      Such factoring agreements are typical and within the normal course of business
      for Smart CRM and its predecessor corporation, Computility. Smart CRM purchased
      the assets of Computility on October 4, 2005. Prior to being purchased by Smart
      CRM, Computility factored the majority of their contracts.


18





**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. Management has
      consistently applied the same critical accounting policies and estimates which
      are fully described in our Annual Report on Form 10-K for the year ended
      December 31, 2005, which is hereby incorporated by reference.





**Overview
      of Results of Operations for the Quarters Ended March 31, 2006 and
      2005**





The
      following table shows our consolidated statements of operations data expressed
      as a percentage of revenue for the periods indicated:




**Three
                Months**
              **Ended**
              **March
                31,**
              **2006**
            
            
            **Three
                Months E****nded**
              **March
                31,**
              **2005**REVENUES:Integration
                fees
            
            7.90%
            
            
            51.15%Syndication
                fees
            
            3.64%
            
            
            36.35%OEM
                revenue
            
            0.47%
            
            
            4.74%Subscription
                Fees
            
            52.71%
            
            
            5.99%Professional
                Services Fees
            
            31.75%
            
            
            0.00%Other
                revenues
            
            3.53%
            
            
            1.78%Total
                revenues
            
            100%
            
            
            100.00%COST
                OF REVENUES
            
            18.41%
            
            
            12.53%GROSS
                PROFIT
            
            81.59%
            
            
            87.47%OPERATING
                EXPENSES:General
                and administrative
            
            113.74%
            
            
            204.96%Sales
                and marketing
            
            17.33%
            
            
            116.39%Development
            
            27.13%
            
            
            100.79%Total
                operating expenses
            
            158.20%
            
            
            422.13%LOSS
                FROM OPERATIONS
            
            (76.61%
            )
            
            (334.66%
            )OTHER
                INCOME (EXPENSE):Interest
                income (expense), net
            
            (6.41%
            )
            
            2.37%Write-off
                of Investment
            
            (1.32%
            )
            
            0.00%Gain
                on debt forgiveness
            
            0.00%
            
            
            216.14%Total
                other income (expense)
            
            (7.73%
            )
            
            218.51%





19





**Revenue.** Total
      revenue was $1,895,669 for the first quarter of 2006 compared to $253,238 for
      the first quarter of 2005 representing an increase of $1,642,431 or 649%. This
      increase is primarily attributable to revenue from our two newly acquired
      subsidiaries; specifically, $537,710 of revenue from Computility and $1,109,277
      of revenue from iMart. The revenue generated by these two subsidiaries is
      generally composed of subscription fees and professional services fees related
      to domain name subscriptions, e-commerce or networking consulting or network
      maintenance agreements. There was no comparable revenue generated by these
      two
      subsidiaries for the first quarter of 2005 as that was a pre-acquisition
      period.





Subscription
      revenues increased 6,491% to $999,199 for the first quarter of 2006 from $15,159
      for the first quarter of 2005. This increase was primarily due to $525,217
      in
      subscription revenue from iMart and $453,525 of subscription revenue from
      Computility. In the first quarter of 2006, we
      learned that one customer that accounted for approximately $522,000, or 28%,
      of
      subscription revenue at March 31, 2006, underwent a restructuring that could
      result in a decrease of approximately 30% in their business for our e-Commerce
      applications. In
      addition, there was an immaterial increase in subscription revenue from Smart
      Online’s sale of online subscriptions to OneBiz.





Revenue
      from professional services fees increased to $601,967 for the first quarter
      of
      2006 from $0 for the first quarter of 2005. This increase was primarily due
      $571,731 of revenue from professional services fees generated by iMart, of
      which
      approximately $450,000 was a one time payment for a perpetual license. In
      addition, $30,236 of revenue from professional services fees was generated
      by
      Computility.





Integration
      revenues increased 16% to $149,743 for the first quarter of 2006 as compared
      to
      $129,522 for the same period in 2005. This increase is primarily due to fees
      from three integration agreements, each of which accounted for greater than
      10%
      of total first quarter revenues. The 2006 and 2005 periods also included $5,000
      and $46,250 of revenue derived from barter transactions, respectively. As
      revenue from integration agreements is recognized over the terms of the
      agreements, the increase in revenue is attributable to the terms and timing
      of
      the agreements, and does not reflect actual cash flow. We
      had
      nine integration agreements and five integration agreements at March 31, 2005
      and March 31, 2006, respectively. One of these five integration agreements
      was
      not renewed and therefore expired in the first quarter of 2006.





Syndication
      revenue decreased 25% to $68,915 for the first quarter of 2006 as compared
      to
      $92,040 for the same period in 2005. This decrease was primarily due to timing
      differences in revenue recognition on the same contracts relating to the
      beginning or termination of a contract. The 2006 and 2005 periods included
      $38,290 and $61,415 of revenue derived from barter transactions, respectively.
      Similarly, as revenue from syndication agreements is recognized over the terms
      of the agreements, the increase in revenue is attributable to the terms and
      timing of the agreements and does not reflect actual cash flow. We
      had
      six syndication agreements and six syndication agreements at March 31, 2005
      and
      March 31, 2006, respectively.





Other
      revenue increased 1,380% to $66,845 for the first quarter of 2006 from $4,517
      for the first quarter of 2005. This increase is primarily due to other revenue
      sources of our newly acquired subsidiaries; specifically $53,949 and $12,329
      of
“Other Revenue” for Computility and iMart, respectively.





**Cost
      of Revenue**





Cost
      of
      revenue increased $317,205, or 999%, to $348,932 in the first quarter of 2006,
      up from $31,727 in the first quarter 2005, primarily as a result of the
      inclusion of the cost of revenues of our subsidiaries; specifically $246,829
      and
      $84,288 for Computility and iMart, respectively, for the three months ended
      March 31, 2006.





**Operating
      Expenses**





Operating
      expenses increased to $2,999,084 for the first quarter of 2006 from $1,068,995
      during the first quarter of 2005. 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 related to both the
      increased expense of being a public company as well as increased legal fees
      related to the SEC investigation as well as our own internal investigation,
      (2)
      consulting fees, and additional sales staff in sales and marketing, (3)
      additional programming, database management, quality assurance, and project
      management resources in the development function to support the on-going
      development of the OneBiz SM product,
      (4) the inclusion of compensation expense related to options which are now
      accounted for under SFAS 123R, and (5) the inclusion of amortization expense
      related to the intangible assets acquired as part of the iMart and Computility
      acquisitions. The following table sets forth our the three primary components
      of
      our operating expenses for the first quarter of 2006 and 2005,
      respectively:


20





**For
                the three months ended March 31****2006**
            
            **2005****Operating
                Expenses**General
                and administrative
            
            $
            2,156,230
            
            $
            519,036Sales
                and marketing
            
            
            328,468
            
            
            294,732Development
            
            
            514,386
            
            
            255,227**Total
                Operating Expenses**
            
            $
            2,999,084
            
            $
            1,068,995





*General
      and Administrative* -
      General
      and administrative expenses increased by $1,637,194, or 315%, to $2,156,230
      for the first quarter of 2006 from $519,036 in the same quarter of 2005. This
      increase was primarily due to approximately $289,000 of additional amortization
      expense related to the intangible assets acquired from Computility and iMart;
      approximately $470,000 of additional legal expense related to the SEC matter
      and
      our own internal investigation; approximately $156,000 of additional wages
      related to additional administrative personnel; approximately $257,500 of
      additional compensation expense related to stock options as accounted for under
      the newly adopted SFAS No. 123R; increase of approximately $64,000 of bad debt
      expense; approximately $20,000 of additional insurance expense related to the
      creation of our in-house legal department; approximately $22,000 for an
      independent appraisal of intangible assets acquired from Computility and iMart,
      that was performed in the first quarter of 2006; and approximately $50,900
      for
      market research on our securities.





We
      are
      currently disputing our insurance carrier’s refusal to cover certain legal
      expenses related to the SEC matter. We contend that these legal expenses should
      be reimbursed by our insurance carrier. Because the outcome of this dispute
      is
      unclear, we have expensed all legal costs incurred and we will account for
      any
      insurance reimbursement, should there be any, in the period such amounts are
      reimbursed. In the second quarter of 2006, our insurance carrier made payments
      of approximately $380,000.





*Sales
      and Marketing* -
      Sales
      and marketing increased to $328,468 in the first quarter of 2006 from $294,732
      in the first quarter 2005, an increase of $33,736, or 10%. This increase is
      primarily due to the addition of $36,877 and $116,907 of first quarter sales
      and
      marketing expense of Computility and iMart, respectively, offset by a reduction
      in Smart Online’s barter advertising expense of approximately
      $135,000.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. Assuming we
      are
      successful in raising additional capital, we plan to invest heavily in marketing
      and sales by increasing the number of direct sales personnel and increasing
      penetration within our existing customer base, expanding our domestic selling
      and marketing activities, building brand awareness and participating in
      additional marketing programs.





*Research
      and Development* -
      Research and development expense increased to $514,387 in the first quarter
      of
      2006 from $255,227 in the first quarter of 2005, an increase of approximately
      $259,160 or 102%. This increase is primarily due to the inclusion of the
      research and development expense of our subsidiaries of approximately $85,000
      and $160,000 for Computility and iMart, respectively. We expect development
      expenses to increase during the last three quarters of 2006 as a result of
      anticipated hiring of additional development personnel.





**Other
      Income (Expense)**





The
      following table sets forth the three main components of other income (expense)
      for the first quarter of 2006 and 2005, respectively:





**2006**
            
            **2005****Other
                Income & Expenses**Interest
                expense, net
            
            $
            (121,576
            )
            $
            5,998Write-off
                of Investment
            
            
            (25,000
            )
            
            -Gain
                from debt forgiveness
            
            
            -
            
            
            547,341**Total
                Other Income & Expenses**
            
            $
            (146,576
            )
            $
            553,339





We
      incurred net interest expense of $121,576 during the first quarter of 2006
      and
      $5,998 of net interest income during the first quarter of 2005. Interest expense
      increased as a direct result of the notes payables related to the iMart and
      Computility acquisitions, including notes related to non-compete agreements.
      Also included is approximately $47,000 of interest expense related to
      Computility’s Subscription Factor Payable. The first quarter 2005 interest
      income totaling $5,998 was from interest earned on money market account
      deposits.


21








We
      realized a gain of $546,922 during the first quarter of 2005 from negotiated
      and
      contractual releases of outstanding liabilities. During the first quarter of
      2005, the gain resulted from a settlement of Internal Revenue Service claims
      for
      penalty and interest. There was no gain from debt forgiveness in the first
      quarter of 2006.





One
      of
      the assets purchased as part of the iMart acquisition was a $25,000 investment
      in a privately held company that was a customer of iMart’s. Management
      determined that it is likely that such investment is currently worthless, so
      the
      entire $25,000 investment has been written off. We also reserved for 100% of
      the
      accounts receivable due from that customer of approximately
      $63,000.





**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 2006 or fiscal 2005 primarily due to continued substantial
      uncertainty regarding our ability to realize our deferred tax assets. Based
      upon
      available objective evidence, there has been sufficient uncertainty regarding
      the ability to realize our deferred tax assets, which warrants a full valuation
      allowance in our financial statements. We have approximately $35,000,000 in
      net
      operating loss carryforwards, which may be utilized to offset future taxable
      income.





**Liquidity
      and Capital Resources**





At
      March
      31, 2006, our principal sources of liquidity were cash and cash equivalents
      totaling $898,521 and accounts receivable and other receivables of $841,149.
      As
      of July 21, 2006, our principal sources of liquidity were cash and cash
      equivalents totaling approximately $863,000 and accounts receivable of
      approximately $305,000. However, $125,000 of our cash is restricted and can
      only
      be used to pay the installment of $530,000 due under the iMart acquisition
      contract at the beginning of October 2006. We do not have a bank line of
      credit.





At
      March
      31, 2006, we had working capital deficit of approximately $4.2 million. Our
      working capital is not sufficient to fund our operations beyond the end
      of September 2006, unless we substantially increase our revenue, limit
      expenses or raise substantial additional capital.





Our
      primary source of liquidity during 2005 and the first quarter of 2006 has been
      from sales of our securities. During 2005, we generated net cash from financing
      activities, including the sales of common stock, of approximately $7.7 million.
      During the same period we consumed approximately $6.4 million of cash in
      operations. During the first quarter of 2006, we raised an additional $1 million
      of proceeds through the sale of additional shares of common stock, and $22,100
      on the exercise of warrants. In addition, we raised approximately $527,000
      through the factoring of receivables of our wholly owned subsidiary, Smart
      CRM.
      Subsequent to March 31, 2006, we raised an additional $1.25 million through
      the
      sales of additional shares of Common Stock to two existing investors. All
      proceeds were used to pay existing operating liabilities and to fund current
      operations.





Our
      long
      term debt obligations consist primarily of payments to be made under the terms
      of the iMart acquisition and the factoring of several subscription agreements
      through Smart CRM. For further information about these obligations, please
      see
      Note 7 to the Consolidated Financial Statements. Our capital lease obligations
      relate primarily to a piece of equipment by our wholly owned subsidiary Smart
      CRM, while our operating lease expenses consist primarily of office leases
      for
      both Smart Online and Smart CRM. Our purchase obligations consist primarily
      of
      payments relating to the co-development of our accounting application. The
      following chart summarizes these contractual obligations:





Payments
                Due by PeriodTotal
            
            
            Less
                than
              1-year
            
            
            1
                -
                3 years
            
            
            3
                -
                5 years
            
            
            More
                than
              5-yearsLong-Term
                Debt Obligations
            $
            5,673,773
            
            $
            4,551,490
            
            $
            1,122,283
            
            $
            -
            
            $
            -Capital
                Lease Obligations
            
            12,333
            
            
            12,333
            
            
            -
            
            
            -
            
            
            -Operating
                Lease Obligations
            
            129,340
            
            
            129,340
            
            
            -
            
            
            -
            
            
            -Purchase
                Obligations
            
            287,500
            
            
            287,500
            (1)(2)
            
            -
            
            
            -
            
            
            -





22





(1)  This
      amount relates to the rights we acquired when we co-developed our accounting
      application with a developer. This amount includes three payments in the
      following amounts: $37,500, $125,000, and $125,000. These payments are due
      within 30, 90, and 180 days, respectively, of our acceptance of the accounting
      application. Although exact payment dates are uncertain, they are included
      as
      short term to be conservative.





(2)  This
      amount does not include the requirement that we issue approximately 28,360
      shares of our common stock to the accounting application
      co-developer.





As
      a
      result of the 2006 cash infusions from stock sales, factoring arrangements,
      settlement of various claims and lawsuits, and based upon current cash-on-hand
      and contracts signed to date, our management believes we have sufficient working
      capital to fund operations into September 2006. Management is actively
      evaluating additional financing options for 2006, including investment from
      existing and new shareholders, signing additional syndication partners, signing
      additional integration partners, and continuing to grow our base of subscription
      customers.





**Deferred
      Revenue.** At March
      31, 2006, we had deferred revenue totaling $672,376, net of offsetting amounts
      receivable. Deferred revenue represents amounts collected in advance of the
      revenue being recognized. Based upon current conditions, we expects that
      approximately 89% of this amount will be recognized in 2006 with the remainder
      expected to be recognized during 2007.





**Going
      Concern.** Our
      auditors have issued an explanatory paragraph in their report included in our
      Annual Report on Form 10-K for the year ended December 31, 2005 in which they
      express substantial doubt as to our ability to continue as a going concern.
      The
      financial statements do not include any adjustments relating to the
      recoverability and classification of recorded asset amounts or the amounts
      or
      classification of liabilities that might be necessary should we be unable to
      continue as a going concern. Our continuation as a going concern is dependent
      upon our ability to generate sufficient cash flows to meet our obligations
      on a
      timely basis, to obtain additional financing as may be required, and ultimately
      to attain profitable operations and positive cash flows. As discussed below,
      management has plans which it believes will enable us 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.





**Fiscal
      2006 Outlook.** With the
      release of our OneBiz SM platform, the integration of the businesses we acquired in October 2005, and
      the
      expenses associated with becoming a public company, we believe our capital
      requirements in 2006 and beyond will be greater than in past years. As such,
      our
      historical cash flows may not be indicative of future cash flows.





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.





If
      we are
      successful in signing new contracts during the remainder of 2006, we anticipate
      our receivables and collections from integration, syndication, and end-user
      licensing opportunities to increase significantly starting the first quarter
      of
      2007.





Until
      the
      fourth quarter of 2005, we allowed most of our web-based products to be used
      without charge for extended time periods. This gained us users, but limited
      our
      revenue. In the fourth quarter of 2005, we limited our free use policy to a
      30-day free use period, after which we terminate access for users who fail
      to
      become paid subscribers. However, there can be no assurance that we will be
      successful in attracting new customers or that customers will pay for our
      products. The number of subscribers to our main portal has decreased since
      mid-January of 2006, and failure to reverse this decrease may substantially
      harm
      our business.





Smart
      Online's receivables are from major companies or banking institutes
      (approximately $189,415 of A/R as of March 31, 2006), while the receivables
      of
      our subsidiaries, Computility and iMart are primarily from individual; small
      businesses and end users, (approximately $651,734 of A/R as of March 31, 2006).
      Management has evaluated the need for an allowance for doubtful accounts and
      determined that an allowance for doubtful accounts of approximately $65,000
      is
      adequate as of March 31, 2006. There was no allowance for doubtful accounts
      as
      of December 31, 2005.





During
      the first quarter of 2006 and 2005, we realized gains totaling $0 and $547,241,
      respectively, resulting from negotiated and contractual releases of outstanding
      liabilities. The 2005 gain was primarily from the settlement with the Internal
      Revenue Service. Had we been unable to reach an agreement with the Internal
      Revenue Service, our liabilities and future cash flow requirements would have
      been higher by the amount of the debt forgiven.





From
      time
      to time, we evaluate strategic opportunities, potential investments in
      complementary businesses and divestitures of assets outside our evolving
      business strategy. We anticipate continuing to make such evaluations in the
      coming fiscal year.


23





**Recent
      Developments.**





On
      January 17, 2006, the SEC temporarily suspended the trading of our securities.
      In its “Order of Suspension of Trading,” the SEC stated that the reason for the
      suspension was a lack of current and accurate information concerning our
      securities because of possible manipulative conduct occurring in the market
      for
      our stock By its terms, that suspension ended on January 30, 2006 at 11:59
      p.m.
      EST. As a result of the SEC’s suspension, NASDAQ
      withdrew its acceptance of our application to have our common stock traded
      on
      the NASDAQ Capital Market Simultaneously with the suspension, the SEC advised us that it is conducting
      a
      non-public investigation. While we continue to cooperate with the SEC, w e
      are
      unable to predict at this time whether the SEC will take any adverse action
      against us. In
      March
      2006, our Board of Directors authorized its Audit Committee to conduct an
      internal investigation of matters relating to the SEC suspension and
      investigation. The Audit Committee retained independent outside legal counsel
      to
      assist in conducting the investigation. On July 7, 2006, the independent outside
      legal counsel shared its final findings with the Audit Committee, which were
      then shared with the full Board of Directors. The Audit Committee did not
      conclude that any of our officers or directors have engaged in fraudulent or
      criminal activity. However, it did conclude that we lacked an adequate control
      environment, and has taken action to address certain conduct of management
      that
      was revealed as a result of the investigation. The Audit Committee concluded
      that the control deficiencies primarily resulted from our transition from a
      private company to a publicly reporting company and insufficient preparation
      for, focus on and experience with compliance requirements for a publicly
      reporting company. As one of the results of these findings, Mr.
      Jeffrey LeRose was appointed to the position of non-executive Chairman of
      the
      Board of Directors to separate the leadership of the Board of Directors from
      the
      management of the Company, which is a recommended best practice for solid
      corporate governance. Mr. Nouri has stepped down as Chairman of the Board of
      Directors, but will continue to serve as our President, Chief Executive Officer
      and as a member of the Board of Directors. A discussion of the significant
      deficiencies that were identified by the Audit Committee and related remediation
      efforts can be found in Item 9A of our 2005 Form 10-K.





In
      March
      2006, a new Chief Financial Officer was appointed by our Board of Directors.
      Nicholas Sinigaglia was appointed Chief Financial Officer on March 21, 2006.
      He
      is a Certified Public Accountant with fifteen years accounting and financial
      experience as well as public company audit experience having spent six (6)
      years
      with Arthur Anderson.





In
      March
      2006, we sold 400,000 shares of its common stock to an existing investor for
      a
      price of $2.50 per share resulting in gross proceeds of $1,000,000. We incurred
      immaterial issuance costs related to this stock sale. As part of this sale,
      the
      existing investor received contractual rights to purchase shares at a lower
      price should we enter into a Private Placement Agreement in the future with
      a
      per share price less than $2.50 per common share. In
      connection with this financing, Berkley may claim that it is entitled to a
      fee
      under an investment banking letter agreement dated February 23,
      2005.





On
      May
      31, 2006, we entered into a “Settlement Agreement” with GIC with regard to a
”Consulting Agreement,” dated October 26, 2005. Under the Consulting Agreement,
      GIC was to receive 625,000 shares of our common stock (the “Shares”) and a cash
      payment of $250,000 (the “Cash Fee”) for investor relations consulting services.
      We paid the entire $250,000, and the 625,000 shares were issued to GIC, but
      were
      never delivered. Under the Settlement Agreement, GIC agreed, in part, to release
      its claim to the Shares, but retained the entire Cash Fee as consideration
      for
      services performed under the Consulting Agreement and for entering into the
      Settlement Agreement. The terms of this Settlement Agreement are more fully
      set
      forth in our Current Report on Form 8-K filed on June 6, 2006, and that form
      is
      hereby incorporated by reference. We are currently negotiating with Berkley
      to
      modify the consulting agreement we entered into with Berkley. We are seeking
      a
      release from Berkley of any and all claims to the shares of common stock issued
      to them. Berkley would be allowed to keep the entire cash fee paid to Berkley
      under its investor relations contract.  There can be no assurance we will
      be successful in achieving these goals. Also, if we are successful, we may
      suffer adverse treatment for this transaction or the accounting treatment may
      be
      challenged by the SEC or others.





On
      June
      29, 2006, we sold 400,000 shares of our common stock to an existing investor
      for
      a price of $2.50 per share resulting in gross proceeds of $1,000,000. We
      incurred immaterial issuance costs related to this stock sale. In
      connection with this financing, Berkley may claim that it is entitled to a
      fee
      under an investment banking letter agreement dated February 23,
      2005.





On
      July
      6, 2006, we
      sold
      100,000 shares of our common stock to an existing investor for a price of $2.50
      per share resulting in gross proceeds of $250,000. We incurred immaterial
      issuance costs related to this stock sale. In
      connection with this financing, Berkley may claim that it is entitled to a
      fee
      under an investment banking letter agreement dated February 23,
      2005.


24





**Item
      3.**  **QUANTITATIVEAND
      QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**




***Foreign
      currency exchange risk***





For
      the
      three-months ended March 31, 2006 and 2005, 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 $1,434,966, $173,339, and
      $101,486 at December 31, 2005, 2004, and 2003, respectively. At March 31, 2006,
      our unrestricted cash was $898,521. 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**





**Evaluation
      of Disclosure Controls and Procedures**




We
      maintain disclosure controls and procedures (as
      defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
      of
      1934, as amended (the “Exchange Act”)) that
      are
      designed to provide reasonable assurances that the information required to
      be
      disclosed by us in reports we file or submit under the Exchange Act is
      recorded, processed, summarized and reported within the time periods specified
      by the SEC's rules and forms, and that such information is accumulated and
      communicated to our management, including our Chief Executive Officer and new
      Chief Financial Officer, as appropriate to allow timely decisions regarding
      required disclosure. In
      designing and evaluating the disclosure controls and procedures, management
      recognizes that disclosure controls and procedures, no matter how well designed
      and operated, can provide only reasonable assurances of achieving the desired
      control objectives, as ours are designed to do, and management necessarily
      is
      required to apply its judgment in evaluating the cost-benefit relationship
      of
      possible controls and procedures.




Our
      management, with the participation of our Chief Executive Officer and Chief
      Financial Officer, has evaluated the effectiveness of our disclosure controls
      and procedures as of the end of the period covered by this Form 10-Q. Based
      on
      this evaluation, and in particular the final findings of our Audit Committee’s
      investigation, our Chief Executive Officer and Chief Financial Officer concluded
      that our disclosure controls and procedures were not effective as of March
      31,
      2006 because of the significant deficiencies that we are in the process of
      remediating. These significant deficiencies and the related changes to our
      controls were described under Item 9A of Part II of our Annual Report on Form
      10-K for the fiscal year ended December 31, 2005, filed with the Securities
      and
      Exchange Commission on July 11, 2006 .




**Changes
      to Internal Control Over Financial Reporting**





Except
      for the changes in our internal control over financial reporting that were
      implemented after December 31, 2005 and that are described in Item 9A of Part
      II
      of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005,
      filed with the Securities and Exchange Commission on July 11, 2006, there have
      been no significant changes
      in our internal control over financial reporting that occurred during the first
      quarter of fiscal 2006 that have materially affected, or are reasonably likely
      to materially affect, our internal control over financial
      reporting.


25





**PART
      II.  OTHERINFORMATION**





**Item.
      1.** **** **LEGALPROCEEDINGS**





During
      the three months ended March 31, 2006, there were no material developments
      in
      the legal proceedings which were not previously reported in our Annual Report
      on
      Form 10-K for the fiscal year ended December 31, 2005. Please refer to Part
      I,
      Item 3 of our Annual Report on Form 10-K for the fiscal year ended December
      31,
      2005.




**Item
      1A. RISKFACTORS**





**Risk
      Factors**




An
      investment in us involves significant risks. You should read the risks described
      below very carefully before deciding whether to invest in us. The following
      is a
      description of what we consider our primary 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 SEC. These risks
      and uncertainties are not the only ones we face. Additional risks and
      uncertainties not presently known to us, that we currently deem immaterial
      or
      that are similar to those faced by other companies in our industry or business
      in general may also affect our business. If any of the risks described below
      actually occurs, our business, financial condition or results of future
      operations could be materially and adversely affected.




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




·
            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, 2006, we have lost an aggregate of approximately $54 million since
      inception on August 10, 1993. During the quarter ended March 31, 2006 and the
      quarter ended March 31, 2005, we suffered a net loss of approximately $1.6
      million and $300,000, respectively. Losses do not include the pre-acquisition
      losses, or profit, of the two companies we acquired during 2005. At March 31,
      2006, we had a $4.2 million working capital deficit. Our working capital is
      not
      sufficient to fund our operations beyond September of 2006, unless we
      substantially increase our revenue, limit expenses or raise substantial
      additional capital. Because we have only nominal tangible assets, you may lose
      your entire investment.




**(2)
      Our Independent Registered Public Accountants Indicate That They Have
      Substantial Doubts That We 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.**




26





Sherb
      & Co., LLP, our independent registered public accountants, has expressed
      substantial doubt, in their report included with our Annual Report on Form
      10-K
      for fiscal 2005 filed with the SEC on July 11, 2006, about our ability to
      continue as a going concern given our recurring losses from operations and
      deficiencies in working capital and equity, which are described in the first
      risk factor above. This opinion could materially limit our ability to raise
      additional funds by issuing new debt or equity securities or otherwise. If
      we
      fail to raise sufficient capital, we will not be able to implement our business
      plan, we may have to liquidate our business and you may lose your investment.
      You should consider our independent registered public accountants' comments
      when
      determining if an investment in us is suitable.




**(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.**




We
      lack
      sufficient cash to find operations past September of 2006. We will be required
      to seek additional financing to fund our operations both immediately and through
      the remainder of 2006. Factors such as the suspension of trading of shares
      of
      our Common Stock by the SEC and the resulting drop in share price, trading
      volume and liquidity, 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. Restrictions
      on
      resale of over nine million shares of our Common Stock terminated on October
      1,
      2005, and the volume of re-sales may adversely affect the market value of our
      Common Stock and may make it more difficult to raise capital.




In
      addition, on January 17, 2006, the SEC temporarily suspended trading in our
      securities. As a result, NASDAQ withdrew its acceptance of our application
      to be
      traded on the NASDAQ Capital Market. Following that suspension, the SEC alerted
      brokers and dealers that, pursuant to Rule 15c2-11 promulgated under the
      Securities Exchange Act of 1934, brokers and dealers are prohibited from
      directly or indirectly offering quotations in our Common Stock unless such
      broker or dealer has strictly complied with Rule 15c2-11. As of July 7, 2006,
      no
      broker or dealer has submitted a form that would allow any quotation in our
      Common Stock, and our common stock is only traded on a limited basis without
      any
      broker, dealer or market maker providing quotations. This restriction on the
      market for our securities may also make it more difficult to raise
      capital.




**(4)
      If We Are Able To Raise Capital, But Are Not Able To Obtain Terms That are
      Favorable To Us, Existing Stockholders 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. For example, in March and June 2006, we sold
      an
      aggregate of 800,000 shares of common stock to an existing investor for a price
      of $2.50 per share for total aggregate proceeds of $2 million. Because of the
      share price, we had to sell a significant number of shares to raise the
      necessary amount of capital.




**Risks
      Associated with Our Products and Operations**




**(5)
      Our Operating Results are Highly Dependent Upon the Development and Market
      Acceptance of Our New Applications, Which Have Rapidly Evolving Technological
      Demands.**




Internet-based
      products are growing in sophistication and customer expectations are rising
      as
      new products are introduced. Our future financial performance and revenue growth
      will depend in part, upon the successful development, integration, introduction,
      and customer acceptance of our recently introduced software applications.
      Thereafter other new products either developed or acquired and enhanced versions
      of our existing web-native business applications will be critically important
      to
      our business. Our business could be harmed if we fail to timely deliver
      enhancements to our current and future solutions that our customers desire.


27


From
      time
      to time, we have experienced delays in the planned release dates of our
      applications and technology platform and upgrades, and we have discovered
      software defects in new releases both before and after their introduction.
      For
      example, the third version of our new applications, including enhanced
      accounting software, and the OneBiz SM platform
      was released at the end of 2005, but with fewer features than we originally
      planned. 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. We
      also
      must continually modify and enhance our services and products to keep pace
      with
      market demands regarding hardware and software platforms, database technology,
      and electronic commerce technical standards. In addition, 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. There
      can
      be no assurance that we will be able to successfully develop new services or
      products, or to introduce in a timely manner and gain acceptance of such new
      services or products in the marketplace. We are evaluating our development
      priorities in light of its recent acquisitions of Computility and iMart and
      expect that some previously planned features will be modified, delayed or
      eliminated in light of new development priorities.




Our
      business could be harmed if we fail to achieve the improved performance that
      customers want with regard to our current and future offerings. We cannot assure
      you that our next generation product will achieve widespread market penetration
      or that we will derive significant revenues from the sale of our
      applications.




**(6)
      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 continually
      revise our business models and operating plans as a result of changes in our
      market, the expectations of customers and the behavior of
      competitors .
      For
      example, in 2006, we changed our focus away from deriving up front revenue
      from
      integration and syndication agreements and towards direct sales to small
      businesses and sales of pre-paid subscriptions to our syndication partners.
      Today, we anticipate that our future financial performance and revenue growth
      will depend, in large part, upon our Internet-based SaaS business model and
      the
      results of our direct sales efforts to small businesses and pre-paid
      subscription sales to syndication partners, but these business models may again
      become ineffective due to forces beyond our control that we do not currently
      anticipate. Despite our sales efforts, the number of small business subscribers
      to our main portal has declined since January 2006 and no syndication partners
      have purchased pre-paid subscriptions. 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. There
      can
      be no assurance that our revised business model will allow us to capture
      significant future market potential. Investors
      in our securities should consider all the risks and uncertainties that are
      commonly encountered by companies in this stage of business operations,
      particularly companies, such as ours, that are in emerging and rapidly evolving
      markets.




**(7)
      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 2005, approximately 4% of our
      revenue was derived from such third party software and services. During 2003
      and
      2004 approximately 16% and 6%, 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. 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.




**(8)
      We Have Acquired Certain Products, and We Recently Purchased Two Other
      Companies. We May Consider Other Strategic Opportunities in the Future. We
      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.**




From
      time
      to time we evaluate strategic opportunities available to us for product,
      technology or business acquisitions, investments and divestitures. For example,
      in 2005, we acquired iMart and Computility. In
      the
      future, we may acquire other products or technologies or divest ourselves of
      products or technologies that are not within our continually evolving business
      strategy. We may not realize the anticipated benefits of our current or future
      acquisitions, divestitures or investments to the extent that we anticipate,
      or
      at all. We may have to issue debt or issue equity securities to pay for future
      acquisitions or investments, the issuance of which could


28


be
      dilutive to our existing stockholders and investors in this offering. If any
      acquisition, divestitures 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 or divestitures would also require
      significant integration or separation efforts, diverting our attention from
      our
      business operations and strategy. Our limited acquisition experience is very
      recent, and therefore our ability as an organization to integrate the acquired
      companies into our business is unproven. Acquisitions and investments involve
      numerous risks, including:




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





**·**
            diversion
                of financial and managerial resources from existing
                operations;





**·**
            cash
                requirements for purchase price reduces the cash available for
                operations;




**·**
              risk
                    of entering new markets;
 **·**
                  potential
                          write-offs of acquired
                          assets;
 **·**
                inability
                        to generate sufficient revenue to offset acquisition or investment
                        costs;
                        and
  **·**
                    delays
                              in customer purchases due to
                              uncertainty.


In
      addition, if we finance future 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, divestitures or investments,
      our business and prospects may be seriously harmed.




**(9)
      Our Agreements in the Acquisition of iMart Incorporated Contain Installment
      Payments, Lock Box, License, Noncompetition and Control Provisions That Could
      Have A Material Adverse Effect on Us.**




When
      we
      purchased iMart Incorporated in October 2005, we committed to make installment
      payments of approximately $3,462,000 and non-competition payments to two key
      employees of $780,000. The cash flow we received from the business we purchased
      from iMart during the fourth quarter of 2005 was insufficient to cover the
      first
      installment payment we made in January 2006 to iMart's shareholders and we
      had
      to fund 83% of this installment from its working capital. These funds were
      also
      insufficient to cover the entire payment that we had to make in April 2006
      and
      July 2006, and we had to fund 6% and 31%, respectively, of those installment
      payments from our working capital. If the acquired business continues to not
      generate sufficient cash flow, our working capital could be substantially
      depleted. To secure the approximately $3,462,000 of acquisition purchase price
      installment payments, all the revenue of Smart Commerce, Inc., our wholly owned
      subsidiary that operates the e-Commerce business we acquired from iMart, is
      being deposited in lock box with the use limited to specified purposes. In
      addition, if we default in any payments, key employees of Smart Commerce will
      have a nonexclusive license to certain software of Smart Commerce, their
      non-competition restrictions will terminate and their non-solicitation and
      nondisclosure comments will be limited in scope. In addition, a key employee
      of
      iMart has received contractual rights to operate our e-Commerce subsidiary
      within agreed upon financial parameters. All of these provisions are
      interrelated and pose certain risks for us.




Most
      of
      the consideration being paid to the iMart key employees, who were shareholders
      of iMart and are now employees of Smart Commerce, is in cash in installments
      over a two-year period, and the value of our shares owned by the key employees
      is substantially less than the cash payments required to be made to the key
      employees. Due to several of the acquisition contract provisions, conflict
      of
      interest situations may arise between the key employee's personal interests
      and
      the interests of our shareholders as the key employee exercises the contractual
      authority granted to him in the acquisition agreements. The acquisition
      agreements address conflict of interest situations and provide that until all
      the acquisition purchase price installment payments are made, the key employee
      will determine what is in the best interest of Smart Commerce, Smart Online
      and
      the selling shareholders of iMart, but he must identify any conflicts of
      interest to Smart Commerce's Chief Executive Officer, in which case Smart
      Commerce's Chief Executive Officer (who is currently also our Chief Executive
      Officer ) can make the decision with respect to which a conflict of interest
      exists, except that if the decision would cause Smart Commerce's EBITDA to
      be
      substantially below $1,452,795, then Smart Commerce's Chief Executive Officer
      can make the decision only if either the amount in the lock box account is
      at
      least $500,000 or we provide an irrevocable letter of credit or cash for payment
      of the remaining acquisition purchase price installment obligations. We would
      not have to provide the letter of credit or cash, if the decision relates to
      compliance with applicable laws, rules or regulations applicable to Smart
      Commerce.


29





Without
      agreement by the authorized people to release funds from the lock box account,
      we will be required to find other resources to pay the operating expenses of
      Smart Commerce, which we expect will exceed the $146,000 of monthly expenses
      targeted to be paid from the lock box account. Consequently, we expect the
      iMart
      acquisition will initially have a negative impact on our cash resources. If
      the
      authorized signatories fail to reach agreement, the lock box revenue will be
      frozen and Smart Commerce and Smart Online may be unable to pay their
      obligations, which could substantially harm their businesses.




These
      provisions of the iMart acquisition agreements described above may have a
      material adverse effect on us and present many risks for us and its investors.
      For example, lenders may refuse to extend credit because of the security
      interest granted to iMart's selling shareholders or because the lock box release
      provisions may create cash flow problems for us. Financial parameters contained
      in the agreements may impair our ability to integrate the e-Commerce business
      we
      acquired into our overall business strategy . Contractual decision-making
      ability granted to the key employee may lead to disputes with officers and
      directors of Smart Online that interfere with operation of the business. Since
      the key employee established iMart's relationships with substantially all of
      iMart's customers and we do not have long-term contracts with these customers,
      our ability to retain the customers we acquired from iMart may be at substantial
      risk if the key employee's non-competition and non-solicitation restrictions
      are
      terminated and he obtains the license to the e-Commerce products we acquired
      from iMart. Potential acquirors may decide not to purchase us because of these
      provisions or may substantially lower their offering price, in which case we
      may
      seek to renegotiate with the key employee. The substantial acquisition price
      installments payments and non-competition payments required to be paid may
      drain
      our financial resources or we may fail to make such payments, which may trigger
      the termination of non-competition provisions and the grant of a license that
      would enable the key employee to compete with us. Investors may fear that
      conflicts of interest may cause the key employee to make decisions that are
      not
      in the interest of our shareholders.




**(10)
      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. These software and hardware systems will need
      periodic upgrades in the future as part of normal operation of business, which
      will be an added expense.




We
      also
      use key systems software from leading open source communities that are free
      and
      available in the public domain. Our products will use additional public domain
      software, if needed for successful implementation and deployment. In addition,
      we co-developed our accounting software with a development company. This
      accounting software application will be a critical element in selling our suite
      of software applications. However, our integration of this accounting software
      application has not gone according to plan due to usability issues which we
      are
      working to resolve. As a result, there is a possibility that our entire sales
      campaign may be substantially damaged. 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 currently do not have support contracts or upgrade subscriptions with some
      of
      our key vendors. We are not currently aware of any immediate issues, but any
      loss of the right to use any of this 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.




Our
      systems software and hardware need periodic upgrades as part of regular
      maintenance. We are in the project planning phase to port the database tier
      of
      our web based applications to use the opensource MySQL database engine, but
      any
      delays in the database porting could harm our business.




**(11)
      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


30


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.
      We
      are currently developing a project plan in conjunction with the database
      upgrade/porting initiative to achieve partial and then eventually full hot
      failover of our www.smartonline.com portal. This will alleviate to a certain
      extent the risk of interruption of our operations. Until we achieve this hot
      failover strategy, we still have a significant risk regarding interruption
      of
      our business.




**(12)
      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. In addition to technical defects, our products could have errors
      related to the subject matter they address. For example, our accounting
      applications might cause users to make accounting mistakes due to our software
      not incorporating correct accounting practices, or our HR software may have
      mistakes that cause users to have liability to their employees. Even if the
      initial releases of our applications do not contain errors, changes in
      accounting practices or rules related to employers could cause our applications
      to become outdated. If any of the foregoing occurs and customers elect not
      to
      renew, 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. In addition, the fear that
      any
      of the foregoing could occur may cause customers to choose to purchase the
      products of our larger competitors in the belief that larger companies are
      more
      reliable.




**(13)
      Security and Other Concerns May Discourage Use of Our Internet-Based SaaS Model,
      Which Could Harm Our Business.**




Our
      service involves the storage and transmission of customers' proprietary
      information (such
      as
      credit card, employee, purchasing, supplier, and other financial and accounting
      data) ,
      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.
      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 Markets, Customers and Partners**






**(14)
      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.**




We
      derive
      subscription revenue primarily from our stand alone SFA/CRM application and
      our
      stand alone e-Commerce application. At the end of 2005, we began to generate
      a
      small amount of revenue from subscriptions to our main portal. 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. Since the beginning of 2006, the number
      of
      paying subscribers at out main portal has declined. If our customers do not
      renew their subscriptions for our service, our revenue may decline and our
      business will suffer.


31




**(15)
      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 subscribers are small business customers with fifty or fewer employees,
      whether directly or indirectly through our partners who do business with small
      businesses. Although this is a large market, it can be very expensive to
      penetrate. 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.




**(16)
      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
      46% of total revenue during year 2005, approximately 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 short terms. Under
      these agreements, we both derive revenue and we utilize the resources of our
      partners to reduce our customer acquisition costs. We anticipate that revenue
      from syndication, integration and OEM fees will not be a significant part of
      our
      business going forward. However, termination or non-renewal of any current
      agreements could cause a decline in our revenues and a substantial increase
      in
      customer acquisition costs.




We
      also
      depend on our 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. We have
      not
      signed a new significant strategic partner relationship for the applications
      we
      sell via our OneBiz SM platform
      since the beginning of the second quarter of 2005. 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. If
      we
      are unable to maintain our existing strategic relationships or enter into
      additional strategic relationships, we will have to devote substantially more
      resources to the distribution, sales, and marketing of our products and
      services.




**(17)
      We Depend on Subscription 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 subscription revenue represented approximately
      51%
      for the first quarter of 2006, 7.7% of our total revenue for 2005, and 6.2%
      of
      our total revenue for 2004. With the launch of our new applications and the
      acquisitions of iMart and Computility, subscription revenues represent a
      significant percentage of our total revenues and our future financial
      performance and revenue growth depends, in large part, upon the growth in
      customer demand for our outsourced services delivery models. 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.


32




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




**(18)
      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.
      In conjunction with the shift in sales focus from integration and syndication
      partners to direct sales to small businesses and sales of pre-paid subscriptions
      to our syndication partners, we recently restructured our sales department,
      which included scaling back the number of sales people we employ. 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.




**(19)
      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;
      We Need to Attract Independent Members to Join Our Board of
      Directors.**




Our
      success depends significantly on the continued services of our management
      personnel, including Michael Nouri, who is President and Chief Executive
      Officer, and Henry Nouri, our Executive Vice President. 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.
      All of our executive team work at the same location, which could make us
      vulnerable to loss of our entire management team in the event of a natural
      or
      other disaster. We do not maintain key man insurance policies on
      anyone.





In
      addition, in March 2006, our Board of Directors authorized its Audit Committee
      to conduct an internal investigation of matters relating to the SEC suspension
      and investigation. Final findings of the independent outside legal counsel
      were
      shared with the full Board of Directors on July 7, 2006. As one results of
      these
      findings, Mr. Jeffrey LeRose was appointed to the position of non-executive
      Chairman of the Board of Directors. Mr. Nouri has stepped down as Chairman
      of
      the Board of Directors, but will continue to serve as our President, Chief
      Executive Officer and as a member of the Board of Directors. This internal
      investigation has placed considerable time demands upon our independent
      directors. After the end our fiscal year, two of our directors resigned because
      of the time commitments required to adequately perform their duties as a
      directors. We currently have three directors, only one of whom is independent.
      We are conducting a search for additional independent directors with public
      company expertise and financial experience to add to our Board of Directors.
      However, given the unresolved status of the SEC matter, there can be no
      guarantee that we will be able to attract independent directors to join the
      Board of Directors.




The
      SEC
      matter may result in the loss of services of one or more of our officers or
      directors, and it and the Audit Committee investigation have resulted in changes
      to our additional internal controls and procedures as set forth in Item 9a
      of
      our Annual Report on Form 10-K for fiscal 2005, filed with the SEC on July
      11,
      2006. Any such change may have a material adverse impact on our
      business.




**(20)
      Officers, Directors and Principal Stockholders Control Us. This Might Lead
      Them
      to Make Decisions That Do Not Benefit the Stockholder
      Interests.**




Our
      officers, directors and principal stockholders beneficially own or control
      a
      significant portion of our outstanding stock. 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 our
      common stock.




33





**Regulatory
      Risks**




**(21)
      Compliance With New Regulations Governing Public Company Corporate Governance
      and Reporting is Uncertain and Expensive.**




As
      a
      public company, we have incurred and will incur significant legal, accounting
      and other expenses that we did not incur as a private company. We will incur
      costs associated with our public company reporting requirements. We also
      anticipate that we will incur costs associated with recently adopted corporate
      governance requirements, including requirements under the Sarbanes-Oxley Act
      of
      2002, the changes in our internal controls and procedures, 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
      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 have also incurred,
      and will continue to incur, substantial additional professional fees and
      expenses associated with the SEC's suspension of trading of our securities
      in
      January 2006, and with the internal investigation authorized by our Board of
      Directors in March 2006. Although our insurance carrier has paid a portion
      of
      these fees, not all such fees and expenses will be covered by our
      insurance.





By
      the
      end of fiscal 2007, we are required to comply with the Sarbanes-Oxley Act of
      2002 requirements involving the assessment of our internal control over
      financial reporting and our independent accountant's audit of that assessment.
      In March 2006, we retained a new Chief Financial Officer. His review of our
      internal control over financial reporting to date and the final findings of
      our
      Audit Committee investigation have identified several deficiencies in our
      internal control over financial reporting, which we are working to remediate.
      Although we believe our on-going review and testing of our internal control
      and
      financial reporting will enable us to be compliant with these requirements,
      we
      have identified some deficiencies and may identify others that we may not
      be able to remediate and test by the end of fiscal 2007. If we cannot assess
      our
      internal controls over financial reporting as effective, or our external
      auditors are unable to provide an unqualified attestation report on such
      assessment, our stock price could decline.




**(22)
      The SEC Suspension of Trading of Our Securities Has Damaged Our Business, and
      It
      Could Damage Our Business in the Future.**





On
      January 17, 2006, the Securities and Exchange Commission issued an Order of
      Suspension of Trading in our securities . According to the order, the SEC
      believed that there was a lack of current and accurate information concerning
      our securities because of possible manipulative conduct occurring in the market
      for our stock. By its terms, that suspension ended on January 30, 2006 at 11:59
      p.m. EST. From the beginning, we have cooperated with the SEC's efforts with
      regard to the suspension.




The
      suspension of trading by the SEC has already harmed our business in many ways,
      and may cause further harm in the future. In part, we have experienced a
      decreased ability to raise capital due to the lack of liquidity of our stock
      and
      to questions raised by the SEC's action. Our decreased ability to raise capital
      has already prevented us from making the investments we need to make in sales
      and marketing and may in the future cause us to reduce research and development.
      Legal and other fees related to the SEC's action also reduces our cash flow.
      Reduced cash flow jeopardizes our ability to make the installment payments
      required by the agreements to acquire iMart and Computility. The time spent
      by
      our management team and our Directors dealing with issues related to the SEC
      action also detracts from the time they spend on our operations. Since the
      commencement of the SEC action and the related Audit Committee investigation,
      two of our independent Board members have resigned due to the time commitments
      required to adequately perform their Board duties. One of these Board members
      was our Audit Committee's chairman and our audit committee financial expert.
      We
      currently conducting a search to replace these two independent directors, but
      there can be no assurances that we will attract new independent directors.
      Finally, an important part of our business plan is to enter into private label
      syndication agreements with large companies. The SEC's action and related
      matters may cause us to be a less attractive partner for large companies and
      may
      cause us to lose important opportunities. The SEC's action and related matters
      may cause other problems in our operations.


34





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




**(23)
      Our Common Stock is Currently Not Listed on a National Exchange or Quoted in
      an
      Interdealer Quotation System. The Company Cannot Make Any Assurance That Its
      Common Stock Will Be Listed On a National Exchange or Quoted in Any Interdealer
      Quotation System. Therefore, You May Be Unable to Sell Your
      Shares.**





From
      April 15, 2005 until January 16, 2006, our stock was traded on the Over the
      Counter Electronic Bulletin Board (“OTCBB” or “Bulletin Board”). On January 17,
      2006, the Securities and Exchange Commission issued an Order of Suspension
      of
      Trading in our securities. According to the order, the SEC believed that there
      was a lack of current and accurate information concerning our securities because
      of possible manipulative conduct occurring in the market for the Company's
      stock. By its terms, that suspension ended on January 30, 2006 at 11:59 p.m.
      EST. As a result, NASDAQ withdrew its acceptance of our application to be traded
      on the NASDAQ Capital Market.




The
      SEC
      also alerted brokers and dealers that, pursuant to Rule 15c2-11 promulgated
      under the Securities Exchange Act of 1934, brokers and dealers are prohibited
      from directly or indirectly offering quotations in our Common Stock unless
      such
      broker or dealer has strictly complied with Rule 15c2-11. Prior to the
      publication of any quotation, such broker or dealer must submit a form to the
      interdealer quotation system indicating the broker or dealer has the information
      required under Rule 15c2-11. Therefore,
      our common stock currently is only
      traded on a limited basis in the “grey market,” without any broker, dealer or
      market maker providing quotations. We cannot estimate when or if our Common
      Stock will be quoted on an interdealer quotation system.




Since
      our
      securities currently are not eligible for listing on NASDAQ or quotation in
      an
      interdealer quotation system, there is currently no significant public trading
      volume, and there is no guarantee that our securities will be eligible for
      listing on an exchange or for quotation in an interdealer quotation system,
      purchasers of the shares may have difficulty selling their securities should
      they wish to do so. Companies quoted on the OTCBB must continue to file reports
      with the SEC pursuant to Section 13 or 15(d) of the Securities Act of 1933,
      while companies quoted on the “pink sheets” need not do so. Trading volume for
      securities traded only on the “pink sheets” is generally lower than for
      securities traded on the OTCBB. If our securities were quoted for trading only
      on the “pink sheets,” an investor may find it more difficult to dispose of, or
      to obtain accurate quotations as to the price of, the securities offered
      hereby.




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




**(24)
      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
      SEC
      has adopted rules that regulate broker-dealer practices in connection with
      transactions in penny stocks. Penny stocks are generally equity securities
      with
      a price of less than $5.00 (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 SEC.) We
      currently are subject to these rules because our Common Stock has ceased to
      be
      listed for trading on NASDAQ or quotation in any “Over the Counter”
markets.




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 SEC and follow certain other regulations regarding
      transactions in penny stock.




**Item
      2.** **** **UNREGISTEREDSALES
      OF EQUITY SECURITIES AND USE OF
      PROCEEDS**





On
      March
      30, 2006, we sold 400,000 shares of our common stock to Atlas Capital, S.A.,
      an
      existing stockholder, for a price of $2.50 per share resulting in gross proceeds
      of $1,000,000. We incurred immaterial issuance costs related to this stock
      sale.
      As part of this sale, Atlas received contractual rights to purchase shares
      at a
      lower price should we enter into a private placement agreement in the future
      in
      which we sell shares of our common stock for less than $2.50 per share. In
      connection with this financing, Berkley may claim that it is entitled to a
      fee
      of $100,000 under an investment banking letter agreement dated February 23,
      2005.


35





The
      shares were issued directly by us pursuant to an offering and sale exemption
      from registration under the Securities Act of 1933, as amended, pursuant to
      Section 4(2) of the Act, as it was not a transaction involving a public
      offering. We gave Atlas the opportunity to ask questions and receive answers
      concerning the terms and conditions of the transaction and to obtain any
      additional information which we possessed or could obtain without unreasonable
      effort or expense that is necessary to verify the information furnished. We
      advised Atlas of limitations on resale, and neither we nor any person acting
      on
      our behalf sold the securities by any means of general solicitation or general
      advertising.





**Item
      6.** **** **EXHIBITS**




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





Exhibit
                No.
            Description10.1*
            Employment
                Agreement dated March 21, 2006 with Nicholas A. Sinigaglia (incorporated
                herein by reference to Exhibit 10.1 to our Current Report on Form
                8-K, as
                filed with the SEC on March 27, 2006)10.2
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated March 30, 2006, by and between Smart Online, Inc.
                and
                Atlas Capital, SA (incorporated herein by reference to Exhibit 10.37
                to
                our Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)31.1
            Certification
                of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200231.2
            Certification
                of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200232.1
            Certification
                of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
                exhibit
                is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                Act of
                2002 and shall not, except to the extent required by that Act, be
                deemed
                to be incorporated by reference into any document or filed herewith
                for
                the purposes of liability under the Securities Exchange Act of 1934,
                as
                amended, or the Securities Act of 1933, as amended, as the case may
                be.]32.2
            Certification
                of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350,
                as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
                [This
                exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                Act of 2002 and shall not, except to the extent required by that
                Act, be
                deemed to be incorporated by reference into any document or filed
                herewith
                for the purposes of liability under the Securities Exchange Act of
                1934,
                as amended, or the Securities Act of 1933, as amended, as the case
                may
                be.]





36


**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:
      August 2, 2006








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




37


**SMART
      ONLINE, INC.**


**EXHIBIT
      INDEX**








Exhibit
                No.
            Description10.1*
            Employment
                Agreement dated March 21, 2006 with Nicholas A. Sinigaglia (incorporated
                herein by reference to Exhibit 10.1 to our Current Report on Form
                8-K, as
                filed with the SEC on March 27, 2006)10.2
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated March 30, 2006, by and between Smart Online, Inc.
                and
                Atlas Capital, SA (incorporated herein by reference to Exhibit 10.37
                to
                our Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)31.1
            Certification
                of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200231.2
            Certification
                of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted
                Pursuant to Section 302 of the Sarbanes-Oxley Act of
                200232.1
            Certification
                of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
                exhibit
                is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                Act of
                2002 and shall not, except to the extent required by that Act, be
                deemed
                to be incorporated by reference into any document or filed herewith
                for
                the purposes of liability under the Securities Exchange Act of 1934,
                as
                amended, or the Securities Act of 1933, as amended, as the case may
                be.]32.2
            Certification
                of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350,
                as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
                [This
                exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                Act of 2002 and shall not, except to the extent required by that
                Act, be
                deemed to be incorporated by reference into any document or filed
                herewith
                for the purposes of liability under the Securities Exchange Act of
                1934,
                as amended, or the Securities Act of 1933, as amended, as the case
                may
                be.]












38