**Table
      of Contents**


**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**


(Mark
      One)


[
      X
      ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT
      OF 1934


For
      the fiscal year ended December 31, 2006


or


[
 ]
      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT
      OF 1934


For
      the transition period from __________ to __________







**Commission
      file number 333-119385**







**SMART
      ONLINE, INC.**


(Exact
      name of registrant as specified in its charter)


Delaware
              (State
                or other jurisdiction of incorporation)
            
            **95-4439334**
              (I.R.S.
                Employer Identification No.)2530
                Meridian Parkway, 2ndFloor
              Durham,
                North Carolina
              (Address
                of principal executive offices)
            
            27713
              (Zip
                Code)


**(919)
      765-5000**


(Registrant's
      telephone number, including area code)





Securities
      registered pursuant to Section 12(b) of the Act: **None**


Securities
      registered pursuant to Section 12(g) of the Act:


**Common
      Stock, $0.001 par value**


(Title
      of Class)





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes [ ] No [ X ]





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or 15(d) of the Act. Yes [ X ] No [  ]





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





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. [  ]





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 [  ]
            Accelerated
                filer [  ]
            Non-accelerated
                filer [ X ]





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). Yes [ ] No [ X ]





The
      aggregate market value of common stock held by non-affiliates of the registrant
      as of March 15, 2007 was approximately $24,010,000 (based on the closing sale
      price of $2.80 per share).





The
      number of shares of the registrant’s Common Stock, $0.001 par value per share,
      outstanding as of March 15, 2007 was 17,766,971.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





Portions
      of the definitive Proxy Statement to be delivered to shareholders in connection
      with the Annual Meeting of Shareholders to be held June 21, 2007  are
      incorporated by reference into Part III.


1


**TABLEOF
      CONTENTS**





**PART
                I**
            3**Item
                1. Business**
            3**Item
                1A. Risk Factors**
            9**Item
                2. Properties**
            18**Item
                3. Legal Proceedings**
            19**Item
                4. Submission of Matters to a Vote of Security
                Holders**
            19**PART
                II**
            19**Item****5.
                Market for Registrant’s Common Equity, Related Stockholder Matters and
                Issuer Purchases of Equity Securities**
            19**Item
                6. Selected Financial Data**
            20**Item****7.
                Management’s Discussion and Analysis of Financial Condition and Results of
                Operations**
            21**Item****7A.
                Quantitative and Qualitative Disclosures about Market
                Risk**
            36**Item****8.
                Financial Statements and Supplementary Data**
            F-1**Item****9.
                Changes in and Disagreements with Accountants on Accounting and Financial
                Disclosure**
            37**Item****9A.
                Controls and Procedures**
            37**Item****9B.
                Other Information**
            38**PART
                III**
            39**Item****10.
                Directors, Executive Officers and Corporate
                Governance**
            39**Item****11.
                Executive Compensation**
            39**Item****12.
                Security Ownership of Certain Beneficial Owners and Management and
                Related
                Stockholder Matters**
            39**Item****13.
                Certain Relationships and Related Transactions and Director
                independence**
            39**Item****14.
                Principal Accounting Fees and Services**
            39**PART
                IV**
            39**Item****15.
                Exhibits, Financial Statement Schedules**
            39**Signatures**
            43**Exhibit
                Index**
            45


2


**PARTI**





**Special
      Note Regarding Forward-Looking Statements**





This
      Annual Report on Form 10-K contains forward-looking statements, within the
      meaning of Section 27A of the Securities Act of 1933, or the Securities Act,
      and
      Section 12E of the Securities Exchange Act of 1934, or the Exchange Act,
      regarding our plans, objectives, expectations, intentions, future financial
      performance, future financial condition, and other statements that are not
      historical facts. You can identify these statements by our use of the future
      tense, or by forward-looking words such as “may,” “will,” “expect,”
“anticipate,” “believe,” “intend,” “estimate,” “continue,” and other similar
      words and phrases. Examples of sections containing forward-looking statements
      include “Part I - ITEM 1. BUSINESS” and “Part II - ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.” 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 in “Part I - ITEM
      1A. 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.








**ITEM** **1.
      BUSINESS**





OVERVIEW




Smart
      Online, Inc. develops and markets products and services targeted to small
      businesses (less than 50 employees) that are delivered via a
      Software-as-a-Service, or SaaS, model. Our goal is to be the leading provider
      of
      on-demand SaaS applications for small businesses. We sell our products and
      services primarily through private
      label syndication and original equipment manufacturer, or OEM, distribution
      channels, although small businesses may purchase products and services directly
      through our main portal located at www.smartonline.com .




Our
      primary source of revenue currently comes from sales of our SaaS applications
      for business management, web marketing, and e-commerce, which represented 63%,
      77%, and 55% of our revenue from continuing operations for the fiscal years
      ended December 31, 2006, 2005, and 2004, respectively. We derive revenue from
      sales of services that are designed to complement our product offerings and
      allow us to create custom business solutions that fit our end-users’ and our
      channel partners’ needs, which represented 35%, 19%, and 0% of our revenue from
      continuing operations for the fiscal years ended December 31, 2006, 2005, and
      2004, respectively.





We
      offer
      two technology
      platforms that communicate via web service and serve as the foundation for
      delivery of our business solutions: OneBiz SM and iDirect
      Architecture TM ,
      or iDA.
      Each is described more fully below. Both platforms
      allow integrated applications to share data with the
      other
      products and/or services running on our platforms. Our
      products and services are primarily offered on a subscription basis using the
      on-demand SaaS model.





HISTORY





We
      were
      incorporated in Delaware in 1993 and initially offered our software applications
      using traditional distribution methods of diskettes and later CD-ROMs. In 2000,
      we moved away from the traditional distribution model and began primarily
      offering on-demand SaaS applications over the Internet. Unlike the traditional
      distribution method that requires a customer to install, configure, and maintain
      hardware, software, and network services internally to support the software
      applications, our proprietary SaaS applications allow small businesses to
      subscribe to a wide variety of applications that have been developed
      specifically for delivery over the Internet on an on-demand basis with very
      little or no installation or maintenance required.





During
      October 2005, we acquired substantially all of the assets of Computility, Inc.,
      or Computility, a privately held developer and distributor of sales force
      automation and customer relationship management, or SFA/CRM, software
      applications based in Des Moines, Iowa. We operated this business under the
      name
      Smart CRM, Inc. (d/b/a Computility), or Smart CRM. Also during October 2005,
      we
      acquired all the stock of iMart Incorporated, or iMart, a privately held
      developer and distributor of multi-channel e-commerce systems based in Grand
      Rapids, Michigan. We operate this subsidiary as Smart Commerce.





Upon
      our
      integration of Smart CRM’s SFA/CRM application into our OneBiz SM platform, management determined that the remaining operations of Smart CRM,
      specifically consulting and network management, were not integral to our ongoing
      operations and business model. On September 29, 2006, we sold these non-integral
      Smart CRM assets to Alliance Technologies, Inc., or Alliance, and reclassified
      Smart CRM as a discontinued operation. For further information about this
      business closure, see Note 17, “Acquisitions & Dispositions” in our
      consolidated financial statements included in this report.


3





The
      Smart
      CRM assets sold to Alliance included the traditional SFA/CRM software
      application developed and sold by Smart CRM and its predecessor in interest,
      Computility. We retained all rights relating to the derivative SFA/CRM SaaS
      application developed by us with Smart CRM and incorporated into our
      OneBiz SM platform.





Consistent
      with SFAS No. 131, *Disclosures
      About Segments of an Enterprise and Related Information* ,
      or SFAS
      No. 131, we have defined two reportable segments based on factors such as
      geography, products, customers, how operations are managed, and how our chief
      executive officer, the chief operating decision-maker, views results. Those
      segments are our core operations, or the Smart Online segment, and the
      operations of our wholly-owned subsidiary, or the Smart Commerce
      segment.





The
      Smart
      Commerce segment's revenues are derived primarily from the development and
      distribution of multi-channel e-commerce systems including domain name
      registration and e-mail solutions, e-commerce solutions, website design and
      website hosting. In 2006, our Smart Commerce segment generated 86% of our total
      consolidated revenue and 96% and 100% of our subscription and professional
      services revenue, respectively.





The
      Smart
      Online segment generates revenues from the development and distribution of
      internet-delivered SaaS small business applications through a variety of
      subscription, integration and syndication channels. In 2006, our Smart Online
      segment generated 14% of our total consolidated revenue and 100% of our
      integration and syndication revenue, and 4% of our subscription
      revenue.





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.





During
      the period from 2000 to 2006, we were functioning primarily in a research and
      development mode as we adapted our products for the SaaS model. We began
      shifting our focus to the marketing of our most current products in the fourth
      quarter of 2006. During fiscal 2006, the operations we acquired following the
      iMart acquisition, which we operate as Smart Commerce, were revenue-generating
      operations. Accordingly, the majority of current revenues is generated by our
      Smart Commerce segment.





PRINCIPAL
      PRODUCTS AND SERVICES





Our
      principal products and services include:





·
            SaaS
                applications for business management, web marketing, and
                e-commerce;





·
            software
                business tools that assist customers in developing written content;
                and





·
            services
                that are designed to complement our product offerings and allow us
                to
                create custom business solutions that fit our end-users’ and our channel
                partners’ needs.





**Business
      Management SaaS Applications**





Our
      business management SaaS applications are designed to allow users to access
      and
      work on information securely from anywhere with an Internet browser. These
      applications include:





Business
      Dashboard :
      Our
      Business Dashboard application provides a snapshot of real-time business
      information in a single view, allowing users to monitor key business information
      about their company and employees. The dashboard automatically aggregates data
      from multiple sources and summarizes the information for the user quickly and
      efficiently. Examples of business information that users may view on the
      dashboard include: a list of key documents for the user, daily events scheduled,
      FedEx packages shipped by a user, or a list of new employees. The dashboard
      is
      entirely role-based, and displays different information to each user based
      upon
      their role and access levels within the company.





Accounting :
      Our
      Accounting application is targeted for users that want to create and maintain
      their accounting books online in a secure fashion but do not have the time
      or
      resources to learn and understand the intricacies of traditional accounting
      applications designed for larger businesses. The Accounting application
      functions allow a user to create invoices, record payments, print checks,
      produce real-time financial statements and reports, as well as manage accounts
      receivable and payable.





SFA/CRM :
      Our
      SFA/CRM application is designed to allow users to create standardized processes
      to define their sales approach, create SFA marketing plans, and monitor and
      guide sales activities. Companies can utilize the customer service management
      feature to create, monitor, and track service requests and execute issue
      escalation and notification. Users can display and present their business data
      with built-in report templates designed to provide information on sales
      activity, pipeline funnels, revenue and other relevant business
      data.


4





Human
      Resource Center :
      Our
      Human Resource, or HR, Center application is designed to allow companies to
      manage their daily human resources needs, including employee information, HR
      documents, performance reviews and compensation. The HR Center application
      also
      allows employers to manage the attendance records of each employee by creating
      and assigning vacation, sick leave, civil leave, and other different policies
      to
      each individual employee. The application can monitor and approve or decline
      as
      needed time-off requests and automatically track how much time each employee
      has
      available on a per policy basis.





Calendar :
      Our
      Calendar application is a full function, easy-to-use online calendar. The
      Calendar application features daily, weekly, and monthly views, together with
      a
      mini-calendar that allows the user to quickly browse to any other date. Users
      can set up automated email reminders at their convenience, indicating how early
      they would like to be notified of an upcoming event. In addition, users have
      the
      option to collaborate with their colleagues by sharing their calendar and
      events. This application also includes a to-do list, allowing users to setup
      tasks, assign priorities and due dates, and mark tasks as complete as they
      work
      through them.





Contacts :
      Our
      Contacts application is designed to provide users with an online business
      contact management system. Contacts can be sorted by group or alphabetically.
      Users also have the option to add, edit, and remove contact groups at their
      own
      convenience, or they can use the default set of groups that is already provided
      for them when they sign up. Furthermore, users have the option to share their
      contacts between colleagues. Using the intuitive sharing system built into
      the
      application, users select whether they would like a contact to remain private
      or
      shared.





e-Commerce :
      Our
      e-commerce applications, OneDomain TM and
      OneDomainX TM ,
      are
      designed to give customers the ability to conduct their business online and
      include website design and launch, inventory query, shopping cart, financial
      transactions, shipping, domain name registration and business to business
      communication for small businesses. Our e-commerce applications also include
      our
      Direct Marketing Architecture, or iDMA, which is a technology platform that
      is
      designed to help direct marketers increase sales, better leverage corporate
      resources, and deliver superior customer service, and our Direct Selling
      Architecture, or iDSA, which is a system available for direct selling and
      network marketing companies.





**Business
      Tools**





We
      offer
      a variety of business tools through our website to aid small businesses. Most
      of
      these tools are also available through the private-label sites of our partners.
      Our business tools include Business Plan Writer, Business Letters, Business
      and
      Legal Forms, Marketing Plan Writer, Job Description Writer, Employee Policy
      Manual Writer, Government Forms, and Business Guides.





**Additional
      Services**





These
      services are designed to complement our product offerings and allow us to create
      custom business solutions that fit our end-users’ and our channel partners’
needs. The services offered to our partners include business consulting,
      graphics design, website content syndication, specialized compensation
      calculation, inventory management, domain name registration, and personalized
      email creation, FedEx tracking, loan center, press release writing, business
      plan writing & evaluation, e-commerce tax services, e-mail marketing, web
      analytics, warehouse order fulfillment, and business and personal
      calculators.





MODE
      OF
      OPERATIONS





**“Software-as-a-Service”
      Model**





We
      follow
      the SaaS model for delivering our products and services to our customers. The
      Internet allows for delivery of software in new ways. For example, a company
      can
      download a software application instead of buying it from the local retail
      store. However, software purchased in this fashion still needs to be installed,
      updated, and the data backed-up, all by the end-user. The on-demand SaaS model
      eliminates these additional tasks. Instead, end users visit a website and use
      the SaaS applications, all via a web browser, with no installation, no special
      information technology knowledge, and no maintenance. The SaaS application
      is
      transformed into a service that can be used anytime, anywhere by the end-user.
      Multi-tenant SaaS applications have the additional benefit of allowing
      functionality to be added to our applications in one place to the benefit of
      all
      users. This allows us to have easier maintenance, universal upgrading, and
      quick
      deployment of new features.





**Revenue
      Stream**





We
      charge
      small businesses who use our SaaS applications a subscriber fee on a monthly
      subscription basis, rather than the large upfront cost typically charged for
      traditional software applications.


5





**Platforms**





We
      have
      designed two technology
      platforms to serve as the foundation for delivery of our business solutions:
      OneBiz SM and
      iDA.





OneBiz SM is our
      business management platform offered though our main portal and through the
      sites of our private-label partners. This allows us to offer our proprietary
      products, as well as certain integration partner products, to our partners’
small business customers in the “look” and “feel” of the partner’s website. iDA
      is our web marketing and web selling platform offered through Smart Commerce. Both platforms
      communicate with each other via web services and have the ability to allow
      integrated applications to share data with the
      rest
      of the products and/or services running on our platforms. The platforms
      also allow
      users to seamlessly login to multiple SaaS applications/services without having
      to re-enter a user ID and password or navigate to another site. Both
      platforms use
      a
      modular methodology, which allows various components to be assembled for rapid
      new application development and enhancement. Our OneBiz SM platform
      has a distinct profile feature that is created for every company when users
      sign
      up and register. This profile is continually updated based on operations
      performed and information requested by each company as its users operate on the
      platform .





**Integration
      and Sharing**





Our
      platforms allow end-users to share information (with selectivity and control
      options) with other members of their organization. Each user that subscribes
      to
      our platform can have multiple members or employees who share information with
      one another. Information entered by one user can be shared and modified by
      one
      or more other users, promoting collaboration within a company.





Several
      of the applications within our platforms are integrated with one another.
      Integration means that certain applications communicate and share information
      with other applications.





TARGET
      MARKET AND SALES CHANNELS





Our
      consistent focus from the beginning has been to design software products and
      services to help start and run small businesses. The small business market
      is
      diverse, fragmented, yet very large and, we believe, underserved. We define
      small businesses as those having less than 50 employees. Even within this
      definition, there exists a large variety of businesses. Therefore, we have
      focused on offering a wide range of software products that combine simplicity
      and affordability. We realize that many new small businesses will fail
      relatively quickly, which forces us to continuously seek out new end-users
      to
      replace existing end-user attrition. Another characteristic of small businesses
      is that they are typically late adopters of technology. Internet adoption is
      well past critical mass, and we believe the growth rate of small businesses
      using web-based applications will exceed the growth rate of large enterprises.
      These businesses may even leapfrog traditional software and go straight from
      paper-based management to a SaaS solution.





Although
      our ultimate end-users are small businesses and entrepreneurs who access our
      software products and services via the web, we use channel partners such as
      financial institutions, telecommunication companies, direct selling
      organizations, retailers, technology companies, and small business consultants
      as channels to reach small business customers. These partnerships can be
      constructed in a variety of formats - from resellers to co-branded offerings
      to
      private label or OEM solutions. We
      typically seek partnerships with organizations that already have a relationship
      with small businesses. We have successfully targeted our applications to direct
      selling organizations, financial companies as
      well
      as business media companies.





Our
      plan
      for 2007 is to increase our revenue through a combination of four sales and
      marketing initiatives:





·
            soliciting
                additional syndication partners,





·
            actively
                managing relationships with our partners to increase sales,





·
            bundling
                our software in packages targeted to different types of
                industries******within
                the small business market, and





·
            introducing
                new applications and products of greater value to small businesses.





We
      have
      not yet implemented all of these marketing strategies, and others have not
      been
      implemented until recently. At this time, we cannot determine how successful
      these strategies will be.





We
      also
      plan to continue to update, enhance, and add to the functionality of our
      platforms, and add sales and marketing personnel to implement our syndication
      partner strategy.


6





PRINCIPAL
      CUSTOMERS





Currently,
      two customers are considered major customers the loss of whom could have a
      material adverse effect on our business. Both of these customers currently
      subscribe to the applications offered by, and purchase professional services
      from, our Smart Commerce segment.





Britt
      Worldwide, or BWW, is an entity that indirectly controls a significant number
      of
      independent business owners, or IBOs, who currently subscribe to our services.
      The aggregate of the subscriptions from these IBOs represented approximately
      45%
      of our consolidated revenue for the fiscal year ended December 31, 2006. BWW
      was
      not a customer of ours in 2004, and was a customer of ours only after we
      acquired iMart in October 2005. Accordingly, BWW represented 0% and 15% of
      our
      revenues in 2004 and 2005, respectively. Although our revenue is derived from
      the IBO, because BWW can influence the actions of the IBOs, this revenue has
      been aggregated for purposes of this annual report on Form 10-K.





Vera
      Bradley Designs, Inc., or Vera Bradley, a manufacturer of high quality handbags,
      luggage and other accessories, is also a major customer. Vera Bradley accounted
      for approximately 28% of our consolidated revenues for fiscal year ended
      December 31, 2006. Vera Bradley was not a customer of ours in either 2004 or
      2005, and therefore represented 0% of our revenue in those years.





RESEARCH
      & DEVELOPMENT





Between
      1999 and 2000, we made a strategic decision to shift our focus from traditional
      software delivery to the SaaS model. From that point until the present, we
      have
      devoted substantially all of our development personnel’s time and efforts toward
      the research and development of our OneBiz SM platform
      and the associated applications. In the fourth quarter of 2006, we began to
      shift our focus from research and development to the marketing of our latest
      products.





In
      2004,
      we spent approximately $563,000 on research and development. In 2005, our
      research and development costs increased to approximately $1.6 million as we
      increased our efforts to develop our OneBiz SM applications for new partners. In 2006, our research and development costs
      were
      approximately $2.0 million with the increase over 2005 primarily related to
      development efforts in Smart Commerce.





We
      have
      not engaged in any customer sponsored research and development.





COMPETITION





The
      market for small business software applications is highly competitive and
      subject to rapid change. The direct competition we face depends on the software
      application within our platforms and the delivery model capabilities of our
      competitors.





We
      have
      two primary categories of competitors: large companies that offer a wide range
      of products for small to medium size businesses and other companies that offer
      only one or two software products that compete with our broad range of software
      products.





Our
      principal direct competition comes from several large vendors of SaaS
      applications for small businesses that sell many products similar to ours.
      Most
      of these competitors also sell other products and services not specifically
      targeted to small businesses, although some of their products have been modified
      for small business use or are marketed as small business products. These
      competitors include, but are not limited to, Microsoft, Oracle, NetSuite,
      Intuit, SAP, Sage and Yahoo!.





We
      also
      expect to face competition from new entrants that will market SaaS applications
      similar to ours to small businesses. As we introduce more software products,
      we
      expect to encounter more competitors. Companies that offer only one or two
      products that compete with our suite of SaaS applications include:





·
            Accounting
                software applications: Netsuite, Intuit, SAP, Sage, Microsoft and
                others.




·
            Human
                resource software applications: Employease, Oracle, Sage and
                others.




·
            e-Commerce
                solutions: Register.com, GoDaddy.com, 1and1 Internet, Yahoo!, eBay's
                Storefront, Yahoo! Store, Microsoft, NetSuite, Homestead and
                others.




·
            SFA/CRM
                applications: Microsoft, Oracle, Sage, Salesforce.com, Netsuite,
                and
                others.





Although
      we believe we offer highly competitive services and software, many of our
      competitors have greater resources, and a larger number of total customers
      for
      their products and services. In addition, a number of our competitors sell
      many
      products to our current and potential customers, as well as to systems
      integrators and other vendors and service providers. These competitors may
      be
      able to respond more quickly to new or emerging technologies and changes in
      customer requirements, or to devote greater resources to the development,
      promotion, and sale of their products, than we can. It is also possible that
      new
      competitors or alliances among competitors or other third parties may emerge
      and
      rapidly acquire market share. Increased competition may result in price
      reductions, reduced gross margins, and change in market share, any of which
      could harm our business.


7





On
      each
      competitive front, we seek to compete against these larger and better financed
      companies primarily by offering a suite of SaaS applications that are useful
      to
      small businesses. We believe we offer more SaaS applications and features
      specifically targeted to small businesses than most of our competitors. We
      believe one distinctive value our applications offer is the integration of
      the
      applications. By integrating data sharing across applications through our
      platform, small businesses can enter or change data once. However, our
      individual applications must also be competitive with the applications offered
      by industry leaders in those specific segments which will require additional
      development work by us. If we are unable to develop new and enhances
      applications that are competitive, our business may be harmed.





We
      also
      plan to leverage our private label syndication partners to sell our SaaS
      applications to their small business customers. We offer these partners and
      potential partners the ability for large corporations to private-label our
      products to offer their small business customers value added products and
      services. While we may lack the marketing budget or resources to compete with
      industry giants, we believe our corporate syndication partners will allow us
      to
      compete effectively if we are able to motivate our partners to devote resources
      to selling subscriptions. This strategy will require us to hire additional
      personnel to develop and manage these relationships and to sign additional
      partners to private label our SaaS applications.





We
      also
      believe that our focus on delivering our products and service via the SaaS
      business model enables us to compete with these companies. This model requires
      very little initial investment by small businesses and we believe it is cost
      competitive with the products of many competitors over the long-term. SaaS
      applications provide our customers with access to their important business
      data
      from any location via the Internet and can be updated automatically and without
      a charge to the customer. This functionality enables us to continually improve
      the ease of use and performance of our SaaS applications as we receive feedback
      from our customers. However, this functionality may also make the SaaS model
      more attractive to competitors that currently offer their products through
      traditional methods of software delivery. As a result, we expect the number
      of
      competitors offering software via the SaaS model to increase in the
      future.





WORKING
      CAPITAL PRACTICES





Due
      to
      the nature of the model we have adopted for the delivery of our products, our
      working capital needs are primarily cash and equivalents and accounts
      receivable, which are necessary to support and sustain our operations. We do
      not
      carry any significant inventory nor do we maintain substantial reserves for
      returns or credit terms.





INTELLECTUAL
      PROPERTY RIGHTS





Our
      success depends, in part, upon our proprietary technology, processes, trade
      secrets, and other proprietary information, and our ability to protect this
      information from unauthorized disclosure and use. We rely on a combination
      of
      copyright, trade secret, and trademark laws, confidentiality procedures,
      contractual provisions, and other similar measures to protect our proprietary
      information. We do not own any issued patents or have any patent applications
      pending.





Despite
      our efforts to protect our proprietary rights, unauthorized parties may attempt
      to copy aspects of our products or to obtain and use information that we regard
      as proprietary, and third parties may attempt to develop similar technology
      independently. Policing unauthorized use of our products is difficult,
      particularly because the global nature of the Internet makes it difficult to
      control the ultimate destination or security of software or other data
      transmitted. While we are unable to determine the extent to which piracy of
      our
      software products exists, software piracy can be expected to be a persistent
      problem. In addition, the laws of some foreign countries do not protect our
      proprietary rights to as great an extent as do the laws of the United States,
      and we expect that it will become more difficult to monitor use of our products
      if we increase our international presence.





We
      have
      registered copyrights, trademarks and registered service marks on more than
      a
      dozen products and data services. These marks include, but are not limited
      to:
      Smart Online, OneBiz, Smart Attorney, Smart Business Plan, iMart, and
      OneDomain.





As
      part
      of our efforts to protect our proprietary information, we enter into license
      agreements with our customers and nondisclosure agreements with certain of
      our
      employees, consultants and corporate partners. These agreements generally
      contain restrictions on disclosure, use, and transfer of our proprietary
      information. We also employ various physical security measures to protect our
      software source codes, technology, and other proprietary
      information.


8





EMPLOYEES





As
      of
      March 15, 2007, we had 56 full-time employees. No employees are known by us
      to
      be represented by a collective bargaining agreement, and we have never
      experienced a strike or similar work stoppage.





AVAILABLE
      INFORMATION





Our
      corporate information is accessible through our main web portal at
      www.smartonline.com. We are not including the information contained on our
      website as a part of, or incorporating it by reference into this annual report
      on Form 10-K. Although we endeavor to keep our Internet website current and
      accurate, there can be no guarantees that the information on the Internet
      website is up to date or correct. We make available free of charge through
      our
      website our annual reports on Form 10-K, quarterly reports on Form 10-Q, and
      current reports on Form 8-K, amendments to those reports filed or furnished
      pursuant to Section 13(a) or 15(d) of the Exchange Act, and beneficial ownership
      reports filed by officers, directors, and principal security holders under
      Section 16(a) of the Exchange Act as soon as reasonably practicable after we
      electronically file such material with, or furnish such material to, the SEC.
      These reports may be accessed by following the link under “Investors--SEC
      Filings” on our website.




**ITEM** **1A.
      RISK FACTORS**




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




We
      operate in a dynamic and rapidly changing business environment that involves
      substantial risk and uncertainty and these risks may change over time. The
      following discussion addresses some of the risks and uncertainties that could
      cause, or contribute to causing, actual results to differ materially from
      expectations. In evaluating our business, you should pay particular attention
      to
      the descriptions of risks and uncertainties described below and in other
      sections of this document and our other filings. These risks and uncertainties
      are not the only ones we face. Additional risks and uncertainties not presently
      known to us, 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 operations could be materially and adversely
      affected.




We
      have
      organized these factors into the following categories below:





·
            Our
                Financial Condition





·
            Our
                Products and Operations





·
            Our
                Market, Customers and Partners





·
            Our
                Officers, Directors, Employees and
                Stockholders





·
            Regulatory
                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 through additional financing or growth, we may have to cease
      operations and liquidate our business. Because we have only nominal tangible
      assets, you may lose your entire investment.**




Through
      December 31, 2006, we have lost an aggregate of approximately $57 million since
      inception on August 10, 1993. During the years ended December 31, 2006 and
      2005,
      we incurred a net loss of approximately $5.0 million and $15.6 million,
      respectively. Losses do not include the pre-acquisition losses, or profit,
      of
      the two companies we acquired during the fourth quarter of 2005. At December
      31,
      2006, we had a $3.8 million working capital deficit. Our working capital,
      including our line of credit and recent financing transaction for $6 million,
      is
      not sufficient to fund our operations beyond July 2008, unless we substantially
      increase our revenue, limit expenses or raise substantial additional financing.
      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. If we fail to raise sufficient
      financing, we will not be able to implement our business plan, we may have
      to
      liquidate our business and you may lose your investment.


9




**(2)
      Any issuance of shares of our common stock in the future could have a dilutive
      effect on your investment.**




We
      may
      issue shares of our common stock in the future for a variety of reasons. For
      example, under the terms of the stock purchase warrant and agreement we recently
      entered into with Atlas Capital, S.A., or Atlas, Atlas may elect to purchase
      up
      to 444,444 shares of our common stock at $2.70 per share upon termination of,
      or
      if we are in breach under the terms of our line of credit with Wachovia Bank,
      NA, or Wachovia. In connection with our recent private financing, we issued
      warrants to the investors to purchase an additional 1,176,471 shares of our
      common stock at $3.00 per share, and warrants to our placement agent in that
      transaction to purchase 35,000 shares of our common stock at $2.55 per share.
      In
      addition, we may raise funds in the future by issuing additional shares of
      common stock or other securities.





If
      we
      raise additional funds through the issuance of equity securities or debt
      convertible into equity securities, the percentage of stock ownership by our
      existing stockholders would be reduced. In addition, such securities could
      have
      rights, preferences, and privileges senior to those of our current stockholders,
      which could substantially decrease the value of our securities owned by them.
      For example, from March through August 2006, we sold an aggregate of 1,000,000
      shares of common stock to investors for a price of $2.50 per share for total
      aggregate proceeds of $2.5 million. Similarly, in February 2007, we sold an
      aggregate of 2,352,941 shares of common stock to investors for a price of $2.55
      per share, and issued the investors warrants for the purchase of an aggregate
      of
      1,176,471 shares of common stock at an exercise price of $3.00 per share, for
      total aggregate proceeds of $6 million. ****** Because
      of the share price, we had to sell a significant number of shares to raise
      the
      necessary amount of capital. You
      may
      experience dilution in the value of your shares as a result.





**(3)
      In the future, we may enter into certain debt financing transactions with third
      parties that could adversely affect our financial health.**





We
      currently have a secured loan arrangement from Fifth Third Bank. Under the
      terms
      of this agreement, Smart Commerce borrowed $1.8 million to be repaid in
      twenty-four (24) monthly installments of $75,000 plus interest beginning in
      December 2006. The interest rate is prime plus 1.5% as periodically determined
      by Fifth Third. The loan is secured by all of the assets of Smart Commerce
      and
      all of Smart Commerce’s intellectual property. The loan is guaranteed by us and
      such guaranty is secured by all the common stock of Smart Commerce.





We
      also
      have a revolving line of credit from Wachovia. The line of credit advanced
      by
      Wachovia is $2.5 million, and as
      of
      March 14, 2007, we have drawn down approximately $2.1 million .
      Any
      advances made on the line of credit must be repaid no later than August 1,
      2008,
      with monthly payments of accrued interest only commencing on December 1, 2006
      on
      any outstanding balance. The interest shall accrue on the unpaid principal
      balance at the LIBOR Market Index Rate plus 0.9%. The line of credit is secured
      by Smart Online's deposit account at Wachovia and an irrevocable standby letter
      of credit in the amount of $2.5 million issued by HSBC Private Bank (Suisse)
      S.A. with Atlas Capital, S.A. as account party.





We
      are
      evaluating various equity and debt financing options and in the future may
      incur
      indebtedness that could adversely affect our financial health. For example,
      indebtedness could:




•
            increase
                our vulnerability to general adverse economic and industry
                conditions;





•
            require
                us to dedicate a substantial portion of our cash flow from operations
                to
                payments on our debt, thereby reducing the availability of our cash
                flow
                to fund working capital, capital expenditures and other general corporate
                purposes;




•
            limit
                our flexibility in planning for, or reacting to, changes in our business
                and the industry in which we
                operate;





•
            result
                in the loss of a significant amount of our assets or the assets of
                our
                subsidiary if we are unable to meet the obligations of these
                arrangements;




•
            place
                us at a competitive disadvantage compared to our competitors that
                have
                less indebtedness or better access to capital by, for example, limiting
                our ability to enter into new markets;
                and




•
            limit
                our ability to borrow additional funds in the
                future.





**Risks
      Associated with Our Products and Operations**




**(4)
      Our business is dependent upon the development and market acceptance of our
      applications, including the acceptance of using some of our applications to
      conduct business. Our business models and operating plans have changed as a
      result of forces beyond our control. Consequently, we have not yet demonstrated
      that we have a successful business model or operating
      plan.**


10




We
      continually revise our business models and operating plans as a result of
      changes in our market, the expectations of customers and the behavior of
      competitors. Today, we anticipate that our future financial performance and
      revenue growth will depend, in large part, upon our Internet-based SaaS business
      model and the results of our sales efforts to reach agreements with syndication
      partners with small business customer bases, but these business models may
      become ineffective due to forces beyond our control that we do not currently
      anticipate. We recently entered into agreements with two new syndication
      partners, but we have not yet derived any revenue under these agreements.
      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
      operations under our current business model, particularly companies, such as
      ours, that are in emerging and rapidly evolving markets.





Our
      future financial performance and revenue growth will depend, in part, upon
      the
      successful development, integration, introduction, and customer acceptance
      of
      our software applications. Thereafter, other new products either developed
      or
      acquired and enhanced versions of our existing applications will be critically
      important to our business. Our business could be harmed if we fail to deliver
      timely enhancements to our current and future solutions that our customers
      desire. We also must continually modify and enhance our services and products
      to
      keep pace with market demands regarding hardware and software platforms,
      database technology, information security, and electronic commerce technical
      standards. There can be no assurance that we will be able to successfully
      develop new services or products, or to introduce in a timely manner and gain
      acceptance of our new services or products in the marketplace.





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





Certain
      of our services involve the storage and transmission of customers’ proprietary
      information (such as credit card, employee, purchasing, supplier, and other
      financial and accounting data). If customers determine that our services do
      not
      provide adequate security for the dissemination of information over the Internet
      or corporate extranets, or are otherwise inadequate for Internet or extranet
      use, or if, for any other reason, customers fail to accept our products for
      use,
      our business will be harmed. Our failure to prevent security breaches, or
      well-publicized security breaches affecting the Internet in general, could
      significantly harm our business, operating results, and financial
      condition.




**(5)
      We may consider strategic divestiture, acquisition or investment opportunities
      in the future. We face risks associated with any such
      opportunity.**




From
      time
      to time we evaluate strategic opportunities available to us for product,
      technology or business acquisitions, investments and divestitures. In the
      future, we may divest ourselves of products or technologies that are not within
      our continually evolving business strategy or acquire other products or
      technologies. We may not realize the anticipated benefits of any such current
      or
      future opportunity to the extent that we anticipate, or at all. We may have
      to
      issue debt or equity securities to pay for future acquisitions or investments,
      the issuance of which could be dilutive to our existing stockholders. If any
      opportunity is not perceived as improving our earnings per share, our stock
      price may decline. In addition, we may incur non-cash amortization charges
      from
      acquisitions, which could harm our operating results. Any completed acquisitions
      or divestitures would also require significant integration or separation
      efforts, diverting our attention from our business operations and strategy.
      Our
      limited acquisition experience is from 2005, and therefore our ability as an
      organization to integrate any acquired companies into our business is unproven.
      Acquisitions and investments involve numerous risks, including:




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





•
            diversion
                of financial and managerial resources from existing
                operations;





•
            reduction
                of available cash;





•
            risk
                of entering new markets;





•
            potential
                write-offs of acquired assets;





•
            potential
                loss of key employees;


11





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





•
            delays
                in customer purchases due to
                uncertainty.




If
      we
      fail to properly evaluate and execute acquisitions, divestitures or investments,
      our business and prospects may be seriously harmed.




**(6)
      We entered into a debt financing transaction in order to make certain
      installment payments under our agreement in the iMart acquisition. Failure
      to
      comply with the provisions of this loan agreement could have a material adverse
      effect on us.**




When
      we
      purchased iMart 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. Prior to the loan agreement described below, the cash flow we received
      from the business we purchased from iMart has been insufficient to cover any
      of
      the installment payments we have been required to make, and we have had to
      fund
      the difference. ****** We
      recently amended the lock box agreement, terminating the iMart shareholders’
security interest in the amounts in the lock box account, and agreed to pay
      the
      installment payments and noncompetition payments in three non-equal installments
      by February 2007, which have been paid in full.





In
      order
      to make these payments, we entered into a loan agreement with Fifth Third Bank
      in order to finance a portion of the payments to the iMart shareholders. Under
      the terms of this agreement, Smart Commerce borrowed $1.8 million to be repaid
      in twenty-four (24) monthly installments of $75,000 plus interest. The interest
      rate is prime plus 1.5% as periodically determined by Fifth Third Bank.
      Currently and at closing, the prime rate was 8.25%. The loan is secured by
      all
      of the assets of Smart Commerce, including a security account of $250,000 and
      all of Smart Commerce’s intellectual property. The loan is guaranteed by us and
      such guaranty is secured by all the common stock of Smart Commerce. If an event
      of default occurs and remains uncured, then the lender could foreclose on the
      assets securing the loan. If that were to occur, it would have a substantial
      adverse effect on our business. Making the payments on the loan used to finance
      part of these payments may drain our financial resources or cause other material
      harm to our business if the lender forecloses on the secured assets.




**(7)
      We rely on third-party software that may be difficult to repair should errors
      or
      failures occur. Such an error or failure, or the process undertaken by us to
      correct such an error or failure, could disrupt our services and harm our
      business.**




We
      rely
      on software licensed from third parties in order to offer our services. We
      use
      key systems software from commercial vendors. The software we use may not
      continue to be available on commercially reasonable terms, or at all, or
      upgrades may not be available when we need them. We currently do not have
      support contracts or upgrade subscriptions with some of our key vendors. We
      are
      not currently aware of any immediate issues, but any loss of the right to use
      any of this software could result in delays in providing our services until
      equivalent technology is either developed by us, or, if available, is
      identified, obtained and integrated, which could harm our business. Any errors
      or defects in, or unavailability of, third-party software could result in errors
      or a failure of our services, which could harm our business.





We
      also
      use key systems software from leading open source communities that are free
      and
      available in the public domain. Our products will use additional public domain
      software, if needed for successful implementation and deployment. We currently
      do not have support contracts for the open source software that we use. We
      rely
      on our own research and development personnel and the open source community
      to
      discover and fix any errors and bugs that may exist in the software we use.
      As a
      result, if there are errors in such software of which we are unaware or are
      unable to repair in a timely manner, there could be a disruption in our services
      if certain critical defects are discovered in the software at a future date.





**Risks
      Associated with Our Markets, Customers and Partners**




**(8)
      The structure of our subscription model makes it difficult to predict the rate
      of customer subscription renewals or the impact non-renewals will have on our
      revenue or operating results.**




Our
      small
      business customers do not sign long-term contracts. Our customers have no
      obligation to renew their subscriptions for our services after the expiration
      of
      their initial subscription period and in fact, customers have often elected
      not
      to do so. In addition, our customers may renew for a lower-priced edition of
      our
      services or for fewer users. Many of our customers utilize our services without
      charge. These factors make it difficult to accurately predict customer renewal
      rates. Our customers’ renewal rates may decline or fluctuate as a result of a
      number of factors, including when we begin charging for our services, their
      dissatisfaction with our services and their capability to continue their
      operations and spending levels. The number of current subscribers is less than
      the number of subscribers in mid-January 2006, but has been relatively constant
      since September 2006. ****** If
      our
      customers do not renew their subscriptions for our services, or we are not
      able
      to increase the number of subscribers, our revenue may decline and our business
      will suffer.


12




**(9)
      We depend on corporate partners to market our products through their web sites
      under relatively short-term agreements in order to increase subscription fees
      and grow revenue. Failure of our partners’ marketing efforts or termination of
      these agreements could harm our business.**




Subscription
      fees represented approximately 52%, 22% and 0% of total revenues for 2006,
      2005
      and 2004, respectively. With the launch of our new applications and the
      acquisition of iMart, subscription fees represent a significant percentage
      of
      our total revenues and our future financial performance and revenue growth
      depends, in large part, upon the growth in customer demand for our outsourced
      services delivery models. We depend on our syndication partners and referral
      relationships to offer our core products and services to a larger customer
      base
      than we can reach through direct sales or other marketing efforts. Although
      we
      recently entered into agreements with two new syndication partners and a
      marketing referral agreement, we have not yet derived any revenue under these
      agreements. Our success depends in part on the ultimate success of our
      syndication partners and referral partners and their ability to market our
      products and services successfully. Our partners are not obligated to provide
      potential customers to us. In addition, some of these third parties have
      entered, and may continue to enter into, strategic relationships with our
      competitors. Further, many of our strategic partners have multiple strategic
      relationships, and they may not regard us as significant for their businesses.
      Our strategic partners may terminate their respective relationships with us,
      pursue other partnerships or relationships, or attempt to develop or acquire
      products or services that compete with our products or services. Our strategic
      partners also may interfere with our ability to enter into other desirable
      strategic relationships. If we are unable to maintain our existing strategic
      relationships or enter into additional strategic relationships, we will have
      to
      devote substantially more resources to the distribution, sales, and marketing
      of
      our products and services.




**(10)
      Our future growth is substantially dependent on customer demand for our
      subscription services delivery models. Failure to increase this revenue could
      harm our business.**




We
      have
      invested significantly in infrastructure, operations, and strategic
      relationships to support our SaaS delivery model, which represents a significant
      departure from the delivery strategies that other software vendors and we have
      traditionally employed. To maintain positive margins for our small business
      services, our revenues will need to continue to grow more rapidly than the
      cost
      of such revenues. There can be no assurance that we will be able to maintain
      positive gross margins in our subscription services delivery models in future
      periods. If our subscription services business does not grow sufficiently,
      we
      could fail to meet expectations for our results of operations, which could
      harm
      our business.




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





**(11)
      There are risks associated with international operations, which may become
      a
      bigger part of our business in the future.**




We
      currently do not generate revenue from international operations. Although we
      have recently signed an agreement with a company to market our products and
      services in a foreign country, this agreement has not yet generated any revenue
      for us. ****** We
      are
      currently evaluating whether and how to expand into additional international
      markets. If we continue to develop our international operations, these
      operations will be subject to risks associated with operating abroad. These
      international operations are subject to a number of difficulties and special
      costs, including:




•
            costs
                of customization and localization of products for foreign
                countries;





•
            laws
                and business practices favoring local
                competitors;





•
            uncertain
                regulation of electronic commerce;





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





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





•
            import
                and export restrictions and
                tariffs;





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


13





•
            difficulties
                staffing and managing foreign
                operations;





•
            multiple
                conflicting tax laws and regulations;
                and





•
            political
                and economic instability.





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




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




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




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




**(12)
      Our executive management team is critical to the execution of our business
      plan
      and the loss of their services could severely impact negatively on our
      business.**




Our
      success depends significantly on the continued services of our executive
      management personnel. Losing any 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 any of our employees.








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




Our
      officers, directors and principal stockholders beneficially own or control
      approximately 51% of our outstanding common 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 acquiror
      from making a tender offer or otherwise attempting to obtain control of us,
      which in turn could materially and adversely affect the market price of our
      common stock.




**Regulatory
      Risks**




**(14)
      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, or Sarbanes-Oxley, the changes in our internal controls and procedures,
      as
      well as new rules implemented by the SEC and the NASD. We expect these rules
      and
      regulations to increase our legal and financial compliance costs and to make
      some activities more time consuming and costly. Any unanticipated difficulties
      in preparing for and implementing these reforms could result in material delays
      in complying with these new laws and regulations or significantly increase
      our
      costs. Our ability to fully comply with


14


these
      new
      laws and regulations is also uncertain. Our failure to prepare timely 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 that 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. We have
      also
      incurred 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 Sarbanes-Oxley requirements
      involving management’s assessment of our internal control over financial
      reporting and our independent accountants’ audit of that assessment is required
      for fiscal 2008. 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. While we have
      made some progress on this remediation effort, we continue to work on addressing
      all the issues raised in these findings. Although we believe our on-going review
      and testing of our internal control over 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, it may affect our management’s assessment of our internal control
      environment as it will be disclosed in our Annual Report on Form 10-K for fiscal
      year 2007 and our stock price could decline.





**(15)
      The SEC suspension of trading of our securities has damaged our business, and
      it
      could damage our business in the future.**





The
      suspension of trading by the SEC has harmed our business in many ways, and
      may
      cause further harm in the future. Prior to our re-entry onto the Over the
      Counter Bulletin Board, or the OTC-BB, for quotation, our ability to raise
      financing on favorable terms to us and our existing stockholders suffered due
      to
      the lack of liquidity of our stock, the questions raised by the SEC’s action,
      and the resulting drop in the price of our common stock. As a result, we did
      not
      raise sufficient financing to make the sales and marketing investments we felt
      were needed in 2006 to substantially increase revenue. Legal and other fees
      related to the SEC’s action also reduced our cash flow which jeopardized our
      ability to make the installment payments required by the agreements to acquire
      iMart. We recently completed a private placement financing for $6 million,
      however we make no assurance that we will not continue to experience additional
      harm as a result of the SEC matter. The time spent by our management team and
      directors dealing with issues related to the SEC action also detracted from
      the
      time they spent on our operations, including strategy development and
      implementation. 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 have caused us to be a less attractive partner for large
      companies and to lose important opportunities. The SEC’s action and related
      matters may cause other problems in our operations.





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





**(16)
      If securities analysts do not publish research or reports about our business
      or
      if they downgrade our stock, the price of our stock could
      decline.**





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





**(17)
      Our revenues and operating results may fluctuate in future periods and we may
      fail to meet expectations of investors and public market analysts, which could
      cause the price of our common stock to decline.**





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





·
            the
                evolving demand for our services and
                software;




·
            spending
                decisions by our customers and prospective
                customers;




15


·
            our
                ability to manage expenses;




·
            the
                timing of product releases;




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




·
            the
                timing of execution of contracts;




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




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




·
            costs
                of developing product enhancements;




·
            global
                economic and political conditions;




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




·
            the
                renewal rates for our service;




·
            the
                rate of expansion and effectiveness of our sales force;




·
            the
                length of the sales cycle for our
                service;




·
            new
                product and service introductions by our
                competitors;




·
            technical
                difficulties or interruptions in our
                service;




·
            regulatory
                compliance costs;




·
            integration
                of acquisitions; and




·
            extraordinary
                expenses such as litigation or other dispute-related settlement
                payments.





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





**(18)
      Our stock price is likely to be highly volatile and may
      decline.**





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





·
            variations
                in our actual and anticipated operating
                results;




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




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




·
            recruitment
                or departure of key personnel;




·
            changes
                in the estimates of our operating results or changes in recommendations
                by
                any securities analysts that elect to follow our common
                stock;




·
            market
                conditions in our industry, the industries of our customers and the
                economy as a whole; and




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


16





In
      addition, the stock market from time to time has experienced extreme price
      and
      volume fluctuations that have affected the trading prices of many emerging
      growth companies. Such fluctuations have often been unrelated or
      disproportionate to the operating performance of these companies. These broad
      trading fluctuations could adversely affect the trading price of our common
      stock.





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





**(19)
      Shares eligible for public sale could adversely affect our stock price. Certain
      holders of shares of our common stock signed agreements that prohibit resales
      of
      our common stock. If substantial numbers of shares are resold as lock-up periods
      expire, the market price of our common stock is likely to decrease
      substantially.**





At
      March
      15, 2007, 17,766,971 shares
      of our common stock were issued and outstanding and 3,996,015 shares may be
      issued pursuant to the exercise of warrants and options. During May 2005, we
      registered on Form S-8 5,000,000 shares of our common stock for issuance to
      our
      officers, directors and consultants under our 2004 Equity Compensation Plan,
      of
      which at March 15, 2007, 51,500 shares were outstanding and 2,340,100 shares
      are
      subject to outstanding stock options of the 5,000,000 shares reserved for
      issuance under such plan. The remaining outstanding shares of our common stock
      are restricted and may be sold in the public market only if they qualify for
      an
      exemption from registration under Rules 144 ****** or
      701
      promulgated under the Securities Act.





We
      entered into agreements that limit the number of shares that may be sold during
      specific time periods, or Dribble Out Agreements, with all of the investors
      who
      purchased shares of our stock from us in private placements during 2005 and
      2006, a total of approximately 2,497,000 shares. Under these Dribble Out
      Agreements, sales of shares are limited to 25% during a rolling 30-day period.
      Such limitations terminate six months after the effective date of the
      registration statement registering these shares.





Our
      stock
      is very thinly traded. The average daily trading volume for our common
      stock between October 2006 and January 2007 was approximately 18,000 shares
      per day. The number of shares that could be sold during this period was
      restrained by Dribble Out Agreements and other contractual limitations imposed
      on some of our shares, while there was no similar contractual restraint on
      the
      number of buyers of our common stock. This means that market supply may increase
      more than market demand for our shares when lock-up and dribble-out periods
      expire. Many companies experience a decrease in the market price of their shares
      when such events occur.





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





Market
      conditions and market makers may cause your investment in our common stock
      to
      significantly diminish and become very illiquid.





We
      can
      offer no assurance that the volume of trading of our shares in the public
      markets will be sufficient to allow all sellers to sell at the times or prices
      sellers desire. Future sales of substantial amounts of our shares in the public
      market could adversely affect market prices prevailing from time to time and
      could impair our ability to raise capital through the sale of our equity
      securities.





**(20)
      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 $4.00 per share(other than securities registered on certain
      national securities exchanges or quotation systems, provided that reports with
      respect to transactions in such securities are provided by the exchange or
      quotation system pursuant to an effective transaction reporting plan approved
      by
      the SEC).





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


17





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




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




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




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




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




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




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




·
            bid
                and ask quotations for the penny
                stock;




·
            the
                compensation of the broker-dealer and its salesperson in the
                transaction;




·
            the
                number of shares to which such bid and ask prices apply, or other
                comparable information relating to the depth and liquidity of the
                market
                for such stock; and




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





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





**ITEM** **2.** **PROPERTIES**





Our
      principal administrative and research and development facility is located in
      Durham, North Carolina near Research Triangle Park and consists of approximately
      5,800 square feet of office space held under a lease that expires on October
      31,
      2007. We also lease approximately 1,500 square feet of office space in Clive,
      Iowa under a lease that expires on October 31, 2008, and approximately 6,800
      square feet of office space in Grand Rapids, Michigan. The Michigan facility
      is
      currently leased on a month-to-month basis.





**ITEM** **3.** **LEGAL
      PROCEEDINGS**





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





Suit
      Against Michael Nouri Regarding Smart Online, S.A. On or
      about March 7, 2002, we petitioned (as is required under French law) a court
      in
      France to allow us to liquidate our French subsidiary, Smart Online S.A. As
      a
      result, we paid $113,056.83 to Smart Online S.A. in settlement of all claims
      against us. Michael Nouri, our President and CEO and the former President and
      CEO of Smart Online S.A., was subsequently sued personally as the legal
      representative of Smart Online S.A. The Liquidateur for Smart Online, S.A.
      has
      agreed to a proposal for settlement offered by Mr. Nouri in the amount of
€15,000 (approximately US $18,500 based on an exchange rate of approximately
      US
      $1.23 per €1.00 on March 7, 2006). On October 19, 2006, the court officially
      recorded the withdrawal of the claims asserted by the Liquidateur. Our Board
      of
      Directors has authorized us to indemnify Mr. Nouri for the amount of any
      settlement and all legal costs and fees and other expenses associated with
      the
      defense of Mr. Nouri in relation to this matter, because Mr. Nouri was acting
      on
      our behalf in the liquidation of our French subsidiary.


18





Order
      of Securities and Exchange Commission Suspending the Trading of Smart Online
      Securities .
      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, and our securities did not automatically return
      to
      quotation on the OTC-BB. After
      the filing of the required paperwork by a market maker, our common stock
      returned to quotation on the OTC-BB on September 11, 2006. Simultaneously with
      the suspension, the SEC advised us that it was ****** 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 .





**ITEM4.** **SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS**




Our
      Annual Meeting of Stockholders was held on December 11, 2006. The following
      matters were submitted to a vote of the stockholders with the results shown
      below:




(a)  Election
      of six directors, each elected to serve until the later of the next Annual
      Meeting of Stockholders or until such time as his successor has been duly
      elected and qualified.





**Name**
            
            **Votes
                For**
            
            **Votes
                Withheld**Dennis
                Michael Nouri
            
            10,143,539
            
            300Thomas
                P. Furr
            
            10,143,539
            
            300Jeffrey
                W. LeRose
            
            10,143,739
            
            100Shlomo
                Elia
            
            10,143,539
            
            300Philippe
                Pouponnot
            
            10,143,539
            
            300C.
                James Meese, Jr.
            
            10,143,639
            
            200





(b)  Ratification
      of the appointment of Sherb & Co., LLP as independent auditors for the
      fiscal year ended December 31, 2006.




**Votes
                For**
            
            **Votes
                Against**
            
            **Abstained**10,143,739
            
            100
            
            0





The
      matters listed above are described in detail in our definitive proxy statement
      dated November 29, 2006 for the Annual Meeting of Stockholders held on December
      11, 2006.





**PARTII**





**ITEM5.** **MARKET
      FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
      OF EQUITY SECURITIES**





Our
      common stock was approved for quotation on the OTC-BB under the symbol “SOLN” on
      March 15, 2005, but trading did not begin until mid-April 2005. The following
      table sets forth the high and low bid prices for our common stock for the
      quarterly periods since trading began until December 31, 2006. The prices set
      forth below reflect inter-dealer quotations, without retail mark-up, mark-down,
      or commission and may not necessarily represent actual
      transactions.





**For
                the Quarter Ending**
            
            
            **High**
            
            
            **Low**June
                30, 2005
            
            $
            8.05
            
            $
            1.05September
                30, 2005
            
            $
            11.50
            
            $
            8.05December
                31, 2005
            
            $
            11.25
            
            $
            6.30March
                31, 2006
            
            $
            10.00
            
            $
            8.05June
                30, 2006
            
            $
            n/a
            
            $
            n/aSeptember
                30, 2006
            
            $
            2.80
            
            $
            1.75December
                31, 2006
            
            $
            2.75
            
            $
            0.90





19





Due
      to
      the suspension in trading of our securities, from January 17, 2006 until
      September 11, 2006, our common stock was not listed on any exchange or included
      in any interdealer quotation system. Our common stock resumed trading on the
      OTC-BB on September 11, 2006. For the quarter ended March 31, 2006, the high
      and
      low bid prices in the table above reflect bids made on the OTC-BB during the
      period from January 1, 2006 through and including January 13, 2006. For the
      quarter ended June 30, 2006, there are no high and low bid prices for our common
      stock on the OTC-BB. The high and low bid prices for this period were $4.25
      and
      $1.05, respectively. For the quarter ended September 30, 2006, the high and
      low
      bid prices in the table above reflect bids made on the OTC-BB during the period
      from September 11, 2006 through and including September 30, 2006.





We
      have
      not repurchased any shares of our stock since December 31, 2004.





At
      March
      15, 2007, there were approximately 280 ****** record
      holders of our common stock.  Record holders do not include owners whose
      shares are held in street name by a broker or other nominee.





We
      have
      never declared or paid any cash dividends on our common stock and do not intend
      to declare or pay dividends for the foreseeable future.





During
      2006, we sold equity securities that were not registered under the Securities
      Act, as described in our quarterly reports on Form 10-Q and current reports
      on
      Form 8-K filed in connection with such transactions.





**ITEM6** **.
      SELECTED FINANCIAL DATA**





The
      following table sets forth selected consolidated financial data that has been
      derived from our audited financial statements for the years ended December
      31,
      2006, 2005, 2004, 2003, and 2002. The following selected financial data should
      be read in conjunction with our financial statements and related notes thereto,
      and with “Item 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS .”





**Income
      Statement Data**





INCOME
                STATEMENT DATA
            Fiscal
                Year Ended
              December
                31,2006
            2005
            
            2004
            
            2003
            
            2002Revenues
            $
            3,644,890
            
            $
            2,155,425
            
            $
            1,002,970
            
            $
            1,261,223
            
            $
            1,391,645Loss
                from Continuing Operations
            $
            (2,498,144
            )
            $
            (15,554,874
            )
            $
            (2,671,929
            )
            $
            (1,558,773
            )
            $
            (805,406
            )Loss
                per Share from Continuing Operations
            $
            (0.17
            )
            $
            (1.20
            )
            $
            (0.26
            )
            $
            (0.61
            )
            $
            (0.25
            )Net
                Loss Attributable to Common
              Stockholders
            $
            (5,023,707
            )
            $
            (15,590,609
            )
            $
            (8,319,049
            )
            $
            (4,375,836
            )
            $
            (1,766,606
            )Net
                Loss per Share - Basic and Diluted
            $
            (0.33
            )
            $
            (1.20
            )
            $
            (0.82
            )
            $
            (0.61
            )
            $
            (0.25
            )Number
                of Shares Used in Per Share
              Calculation
            
            15,011,830
            
            
            12,960,006
            
            
            10,197,334
            
            
            7,145,047
            
            
            7,181,759BALANCE
                SHEET DATA
            
            As
                of December 31,2006
            
            
            2005
            
            2004
            
            2003
            
            
            2002Total
                Assets
            $
            7,433,009
            
            $
            14,558,079
            
            $
            773,701
            
            $
            306,072
            
            $
            252,579Long-term
                Obligations
            $
            836,252
            
            $
            2,963,289
            
            $
            1,091,814
            
            $
            1,193,211
            
            $
            958,925Redeemable
                Preferred Stock
            $
            -
            
            $
            -
            
            $
            -
            
            $
            17,509,214
            
            $
            14,692,150Stockholders’
                Equity (Deficit)
            $
            1,825,998
            
            $
            6,672,631
            
            $
            (1,911,090
            )
            $
            (22,014,156
            )
            $
            (19,268,323
            )










During
      October 2005, we acquired substantially all of the assets of Computility, a
      privately held developer and distributor of SFA/CRM software applications,
      based
      in Des Moines, Iowa. We operated this SFA/CRM business under the name Smart
      CRM.
      In September 2006, we sold substantially all of the assets of Smart CRM to
      Alliance Technologies, Inc. We retained rights to the SFA/CRM application that
      we developed and added to our OneBiz SM platform.


20





Also
      during October 2005, we acquired all the stock of iMart Incorporated, a
      privately held developer and distributor of multi-channel e-commerce systems
      based in the Great Lakes region of the United States. We operate this e-commerce
      business under the name Smart Commerce, Inc.





**ITEM7.
      MANAGEMENT’S DISCUSSION AND
      ANALYSIS**


**OF
      FINANCIAL CONDITION AND RESULTS OF OPERATIONS**





**Overview**





We
      develop and market Internet-delivered SaaS applications and data resources
      for
      small businesses. We reach small businesses through syndication arrangements
      with large corporations that private-label our software applications through
      their corporate websites and through our own website, www.smartonline.com.
      We
      believe our syndication relationships provide a cost and time efficient way
      to
      market to the extremely diverse and large, yet fragmented small business
      sector.





Consistent
      with SFAS No. 131, we have defined two reportable segments based on factors
      such
      as geography, products, customers, how operations are managed, and how the
      chief
      operating decision-maker views results. Those segments are our core operations,
      or the Smart Online segment, and the operations of our wholly-owned subsidiary,
      or the Smart Commerce segment. Substantially all of our revenues are generated
      by the Smart Commerce segment as the resources of our Smart Online segment
      were
      focused primarily on research and development efforts from 2000 to late 2006,
      and in 2006, on the SEC suspension and resulting investigations.





The
      Smart
      Commerce segment's revenues are derived primarily from the development and
      distribution of multi-channel e-commerce systems including domain name
      registration and e-mail solutions, e-commerce solutions, website design and
      website hosting. In 2006, our Smart Commerce segment generated 86% of our total
      consolidated revenue and 96% and 100% of our subscription and professional
      services revenue, respectively.





The
      Smart
      Online segment generates revenues from the development and distribution of
      internet-delivered SaaS small business applications through a variety of
      subscription, integration and syndication channels. In 2006, our Smart Online
      segment generated 14% of our total consolidated revenue and 100% of our
      integration and syndication revenue, and 4% of our subscription
      revenue.





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





Except
      as
      noted below, all financial information for periods prior to our acquisition
      of
      Computility and iMart contained in this annual report on Form 10-K refers 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
      contained in this annual report on Form 10-K includes the financial performance
      of the businesses we acquired, unless otherwise noted. Due to the sale of
      substantially all of the assets of Smart CRM on September
      29, 2006 , Smart
      CRM is classified throughout this annual report on Form 10-K as discontinued
      operations and the assets and liabilities related to Smart CRM are classified
      as
      available for sale.





During
      2006, we made significant improvements to our applications and
      platforms, including enhancements to the OneBiz SM dashboard, the iDA marketing features and adding additional software
      applications to OneBiz SM such as
      our SFA/CRM and Accounting applications. We recently redesigned our website
      to
      provide greater ease-of-use. We began offering our primary products as part
      of
      the second version of our new applications in November 2005.  As of
      December 31, 2006, certain bundles of our applications are offered on our
      website and the websites of three private label partners. In May of 2006, we
      integrated a simplified version of the SFA/CRM software applications that we
      acquired in October of 2005 into our OneBiz SM application suite, and we will integrate applications from one platform into
      the
      other as requested by our customers. We have not yet received any request to
      do
      so.





We
      derive
      subscription revenue primarily from our stand alone e-commerce application,
      which is offered through our subsidiary, Smart Commerce. We generate a small
      amount of revenue from subscriptions through our Smart Online segment. In the
      first half of 2006, the number of subscribers to our software products had
      declined. We are not certain what caused this decline. Some customers had
      indicated they had difficulty accessing our software applications on our
      website. Consequently, we redesigned our website and product bundling to address
      this problem. As of March 2007, the decline in the number of subscribers has
      ceased, but the level of subscribers is still significantly lower than the
      number from January 2006. It is critical that we grow our subscriber base,
      which
      we expect will be done primarily through our private-label partners. Failure
      to
      do so will negatively affect our business.





On
      January 17, 2006, the SEC temporarily suspended the trading of our securities.
      By its terms, that suspension ended on January 30, 2006. Simultaneously with
      the
      suspension, the SEC advised us that it would be conducting a non-public
      investigation. 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 did not conclude that any
      of
      our officers or directors have engaged in fraudulent


21


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. As a result of the SEC matter
      and
      the Audit Committee investigation, our management was distracted from our daily
      operations and obtaining
      adequate sources of financing to sustain our operations ,
      and the
      uncertainty surrounding the situation caused us to be a less attractive partner
      for businesses with whom we were looking to affiliate. As of March 26, 2007,
      the
      SEC has not provided us with any communication indicating that its investigation
      has concluded or that we or any of our officers or directors have engaged in
      any
      criminal or fraudulent conduct with respect to Smart Online. As described in
      ITEM 9A - Controls and Procedures of this annual report on Form 10-K, we
      continue to improve our controls and procedures in line with the recommendations
      of the Audit Committee.





During
      October 2005, we acquired substantially all of the assets of Computility. We
      operated this SFA/CRM business under the name Smart CRM. During 2006, we
      integrated a simplified version of the SFA/CRM product we acquired from
      Computility into our OneBiz SM platform. Following this successful integration, in September 2006 we sold
      to a
      strategic buyer the remaining assets of Computility, which primarily related
      to
      computer networking and software businesses. These businesses were not strategic
      to our long-term business model. Also during October 2005, we acquired all
      the
      stock of iMart. We operate this e-commerce business under the name Smart
      Commerce.





The
      initial effect of these acquisitions on our working capital has been negative
      with approximately $200,000 negative cash flow through December 31, 2005 and
      approximately $1,100,000 cumulative, net negative cash flow through December
      31,
      2006. Approximately $800,000 of the negative cash flow has been principal
      payments of purchase price towards the iMart acquisition. As of February 2007,
      the previous owners of iMart have been paid all installment payments required
      under the purchase agreement, including non-compete payments. We were able
      to
      make these payments by ****** conducting
      a ****** refinancing
      of the payments with a loan of approximately $1.8 million from Fifth Third
      Bank,
      as well as through a drawdown of approximately $1.0 million from our revolving
      line of credit with Wachovia, described below. The loan from
      Fifth Third Bank is to be paid back in 24 monthly installments. The loan is
      secured by all of the assets of Smart Commerce and all of Smart Commerce’s
      intellectual property and is guaranteed by us and such guaranty is secured
      by
      all the common stock of Smart Commerce.





In
      November 2006, we established a$1.3 million revolving line of credit with
      Wachovia, which we subsequently increased to $2.5 million. Any advances made
      on
      the line of credit are to be paid off no later than August 1, 2008, with monthly
      payments of accrued interest on any outstanding balance commencing on December
      1, 2006. The line of credit is secured by the Company’s deposit account at
      Wachovia and an irrevocable standby letter of credit in the amount of $2.5
      million issued by HSBC Private Bank (Suisse) S.A. with Atlas, a current
      stockholder, as account party. As
      of
      March 14, 2007, we have drawn down $2.1 million of the $2.5 million Wachovia
      line of credit.





In
      connection with the increase in the letter of credit to obtain the increase
      of
      the Wachovia line of credit, we entered into a warrant purchase agreement with
      Atlas. Under the terms of this agreement, we issued a warrant to Atlas to
      purchase up to 444,444 shares of common stock at a price of $2.70
      per
      share at the termination of the line of credit or if we are in default under
      the
      terms of the line of credit .





In
      January 2007, several of our executive officers entered into new compensation
      arrangements with us. Under the terms of these new agreements, these executive
      officers agreed to a reduction in their base salaries to $100,000 per year.
      In
      exchange for this reduction, these executive officers will be paid an equal
      amount from a bonus pool of 10% of our "Free Cash Flow," defined as our total
      revenue, less operating expenses (with non-cash items added back), less
      principal debt payments.





In
      February 2007, we completed a private placement with two new investors. We
      sold
      an aggregate of 2,352,941 shares of common stock for $2.55 per share, issued
      warrants to purchase 1,176,471 shares of common stock with an exercise price
      of
      $3.00 per share, and received $6 million in gross proceeds from the sale. In
      connection with this transaction, we paid our placement agent 7% of the gross
      proceeds and issued the agent warrants to purchase 35,000 shares of our common
      stock at an exercise price of $2.55.





**Fiscal
      Year**





Our
      fiscal year ends on December 31. References to fiscal 2006, for example, refer
      to the calendar year ended December 31, 2006.





**Sources
      of Revenue**





We
      derive
      revenues from the following sources:





·
            Subscription
                fees - monthly fees charged to customers for access to our SaaS
                applications.·
            Integration
                fees - fees charged to partners to integrate their products into
                our
                syndication platform.·
            Syndication
                fees - fees consisting of:


22





·
            fees
                charged to syndication partners to create a customized private-label
                site.·
            barter
                revenue derived from syndication agreements with media
                companies.·
            Professional
                service fees - fees related to consulting services which complement
                our
                other products and applications.·
            Other
                revenues - revenues generated from non-core activities such as sales
                of
                shrink-wrapped products, OEM contracts and miscellaneous other
                revenues.





Our
      current primary focus is to target those established companies that have both
      a
      substantial base of small business customers as well as a recognizable and
      trusted brand name. Our goal is to enter into partnerships with these
      established companies whereby they private label our products and offer them
      to
      their base of small business customers. We believe the combination of the
      magnitude of their customer bases and their trusted brand names and recognition
      will help drive our subscription volume.





Subscription
      revenues consist of sales of subscriptions directly to end-users, or to others
      for distribution to end-users, hosting and maintenance fees, and e-commerce
      website design fees. Subscription sales are made either on a subscription or
      on
      a “for fee” basis. Subscriptions, which include access to most of our offerings
      are payable in advance on a monthly basis and are typically paid via credit
      card
      of the individual end-user or their aggregating entity. During past years,
      most
      of our OneBiz SM users
      have been given free use of our products for extended 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 have delayed the termination of access for those subscribers
      as
      we were not yet able to offer the complete suite of applications which we deemed
      as necessary in order to convince free customers to convert to paying customers.
      However, we do not expect to convert a significant number of these free users
      into paying subscribers as we have shifted our focus to forging strategic
      partnerships with other companies that have small business customer bases.
      We
      expect lower net fees from subscribers at the private label syndication websites
      of our partners than from our main portal since our agreements call for us
      to
      share revenue generated on each respective site. In 2006, 96% of our
      subscription revenue was generated by our Smart Commerce segment, and the
      remaining 4% by our Smart Online segment.





When
      appropriate, we charge our partners a fee for private-labeling our website
      in
      their own customized interface (i.e., in the “look and feel” of our partners’
sites). This fee is based on the extent of the modifications required as well
      as
      the revenue sharing ratio that has been negotiated between us and our partner.
      If a fee is charged for the production of the website and the modifications,
      it
      is recorded as Syndication Revenue.





In
      certain instances, we have integrated products offered by other companies into
      our products or websites. This is a means for the partner to generate additional
      traffic to their own website or revenue for their own product. Such revenue
      is
      recorded as integration revenue. Our integration contracts also provide for
      us
      to receive a percentage of revenue generated by our partner. Such revenues
      to
      date have been immaterial.





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of integration fees is received
      upfront. Our contracts and support contracts are non-cancelable, though
      customers typically have the right to terminate their contracts for cause if
      we
      fail to perform. We generally invoice our paying syndication or integration
      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. As we have
      shifted our focus toward driving subscription revenue, which we deem to have
      the
      greatest potential for future revenue growth, we have seen a decrease in
      syndication and integration revenue through 2006 and we expect to this decrease
      to continue through 2007. In 2006, 100% of our syndication and integration
      revenue was generated by our Smart Online segment.





Professional
      service fees are fees generated from consulting services often directly
      associated with other projects which will generate subscription revenue. For
      example, a partner may request that we re-design its website to better
      accommodate our products or to improve its own website traffic. Such fees are
      typically billed on a time and material basis and are recognized as revenue
      when
      these services are performed and the customer is invoiced. In 2006, 100% of
      our
      professional services revenue was generated by our Smart Commerce
      segment





Other
      revenues consist primarily of non-core revenue sources such as traditional
      shrink-wrap software sales and miscellaneous web services. It also includes
      OEM
      revenue generated through sales of our applications bundled with products
      offered by manufacturers such as Dell, Gateway and CompUSA. Revenues from OEM
      arrangements are reported and paid to us on a quarterly basis and are
      subject to certain contractual minimum volumes.





23


**Revenue
      From Related Parties**





In
      the
      past, we entered into a number of business transactions with related parties
      (as
      described below). Although we have little intention of entering into new related
      party transactions, we might do so if the transaction was for the benefit of
      our
      stockholders.





Approximately
      0%, 0%, and 32.9% of total revenues for the years ended December 31, 2006,
      2005,
      and 2004, respectively, were from a single customer, Smart IL Ltd., or SIL,
      formerly known as Smart Revenue Europe Ltd., an Israel based software company
      that specialized in secured instant messaging products. During March 2004,
      SIL
      ceased further development of its technology and laid-off all employees after
      SIL delivered to us a version of its instant messenger product. SIL is currently
      seeking to license or sell its technology. If our private label partners require
      that this instant messenger to be bundled with our platform, then certain
      revenue must be shared with SIL. SIL is owned by Doron Roethler, one of our
      stockholders.





We
      paid
      $221,517 to the Small Business Lending Institute, Inc. , or SBLI, during the
      first three months of 2004, because SBLI paid our employees during the first
      quarter of 2004 while we were dealing with a tax matter with the Internal
      Revenue Service. The temporary transfer of our employees to SBLI allowed us
      to
      obtain a clean cut off to determine the extent of our tax liability. Tamir
      Sagie, an officer of Smart Online at the time, was an officer of SBLI. Michael
      Nouri, our Chief Executive Officer, is a shareholder in SBLI.





The
      following is a summary of related party revenues for years ended December 31,
      2006, 2005 and 2004.





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**SIL
                Integration fees
            
            $
            -
            
            $
            -
            
            $
            330,050SBLI
                Consulting Services
            
            
            -
            
            
            -
            
            
            -Total
                Related Party Revenues
            
            $
            -
            
            $
            -
            
            $
            330,050





**Cost
      of Revenues**





Cost
      of
      revenues consists primarily of salaries and related employee expenses associated
      with employees who provide maintenance and support services. Additionally,
      during 2005, a portion of cost of revenues included third-party
      fees.





During
      2005, we acquired rights to an accounting software engine from a software
      development company and co-developed our accounting software with that
      developer. We have exclusive rights to the accounting application and
      non-exclusive rights to the software engine included in the application. During
      the third quarter of 2005, we capitalized $105,000 of costs associated with
      this
      acquired software **.** During
      the fourth quarter of
      2005, management changed its estimate as to the realizability of the value of this
      asset and determined that the full value of the asset capitalized to date should
      be written off and all future costs incurred related to this same software
      should be expensed in the period incurred until the criteria of SFAS No. 86, *Accounting
      for the Costs of Software to be Sold, Leased, or Otherwise
      Marketed* ,
      or SFAS
      No. 86, for
      capitalizing software costs are met. No amounts were capitalized in
      2006.





**Operating
      Expenses**





During
      2006, 2005, and 2004 our efforts were primarily focused on product development
      and integration. We employed approximately 18 full-time development employees
      during 2004. During 2005, we completed two acquisitions and hired additional
      development and sales staff bringing the total to 72 full-time employees at
      December 31, 2005. As of March 15, 2007, we had 56 employees. Most employees
      perform multiple functions.





*Research
      and Development* .
      Historically, we have not capitalized any costs associated with the development
      of our products and platform. SFAS No. 86 requires capitalization of certain
      software development costs subsequent to the establishment of technological
      feasibility. Because any such costs that would be capitalized following the
      establishment of technological feasibility would immediately be written off
      due
      to uncertain realizability, all such costs have been recorded as research and
      development costs and expensed as incurred. Because of our proprietary, scalable
      and secure multi-user architecture, we are able to provide all customers with
      a
      service based on a single version of our application. As a result, we do not
      have to maintain multiple versions, which enables us to have relatively low
      research and development expenses as compared to traditional enterprise software
      business models. We expect that in the future, research and development expenses
      will increase substantially in absolute dollars but decrease as a percentage
      of
      total revenue as we upgrade and extend our service offerings, develop new
      technologies and transition from development stage to revenue generation.


24





*Marketing
      and Sales* .
      During
      2006, 2005, and 2004, we spent limited funds on marketing, advertising, and
      public relations. Our business model of partnering with established companies
      with extensive small business customer bases allows us to leverage the marketing
      dollars spent by our partners rather than requiring us to incur such costs.
      We
      do not conduct any significant direct marketing or advertising programs. Our
      sales and marketing costs are expected to increase significantly in 2007 due
      to
      the addition of several sales persons, including a Vice President of Sales
      and
      Marketing. As we begin to grow the number of subscribers to our products, sales
      and marketing expense will increase due to the various percentages of revenue
      we
      may be required to pay to partners.





*General
      and Administrative* .
      General
      and administrative expenses consist of salaries and related expenses for
      executive, finance and accounting, legal, human resources, and information
      technology personnel, professional fees, and other corporate expenses, including
      facilities costs. General and administrative expenses have increased and will
      continue to increase as we add personnel and incur additional professional
      fees
      and insurance costs related to the growth of our business and to our operations
      as a public company. Non-recurring general and administrative expenses increased
      in 2006 as a result of the SEC’s suspension of trading of our securities, the
      continuing SEC action, and the internal investigation of matters relating to
      that suspension. Our expenses related to these matters have continued to
      decrease to an immaterial amount in the fourth quarter of 2006. We expect to
      incur additional material costs in 2007 as we take the necessary steps to comply
      with Section 404 of the Sarbanes-Oxley Act.





*Stock-Based
      Expenses* .
      Our
      operating expenses include stock-based expenses related to options and warrants
      issued to employees and non-employees. These charges have been significant
      and
      are reflected in our historical financial results. Effective January 1, 2006,
      we
      adopted SFAS No. 123  (revised
      2004), *Share-Based
      Payment* ,
      or SFAS
      No. 123R, which
      has resulted and will continue to result in material costs on a prospective
      basis. See Note 11, “Stockholders’ Deficit,” of the Consolidated Financial
      Statements in this report. In addition, in connection with the issuance of
      1,273,000 shares of our common stock issued pursuant to investor relations
      services contracts, including 1,250,000 of which were issued in the fourth
      quarter of 2005, we have incurred non-cash expenses equal to the market value
      of
      the shares of approximately $9.9 million.  In 2006, the 1,250,000 shares
      issued in the fourth quarter of 2005 were redeemed by Smart Online, resulting
      in
      other income of $3,125,000. This was done in connection with the settlement
      agreements between the parties issued these shares and us. Under these
      agreements, these parties retained the cash fee paid to them, totaling $500,000,
      for their services.





**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, expected lives of customer
      relationships, useful lives of intangible assets and property and equipment,
      provision for income taxes, valuation of deferred tax assets and liabilities,
      and contingencies and litigation reserves. We presently believe the following
      critical accounting policies involve the most significant judgments and
      estimates used in the preparation of our consolidated financial
      statements.





*Revenue
      Recognition* -
      We
      recognize revenue in accordance with accounting standards for software and
      service companies including the SEC’s Staff Accounting Bulletin 104, *Revenue
      Recognition,* or SAB
      104,, Emerging Issues Task Force Issue No. 00-21, *Revenue
      Arrangements with Multiple Deliverables,* or EITF
      00-21 *,* Emerging
      Issues Task Force Issue No. 99-19, *Reporting
      Revenue Gross as a Principal or Net as an Agent,* or EITF
      99-19 *,* and
      related interpretations including American Institute of Certified Public
      Accountants, or AICPA, Technical Practice Aids. We also utilize interpretative
      guidance from regulatory and accounting bodies, which include, but are not
      limited to, the SEC, the AICPA, the Financial Accounting Standards Board, or
      FASB, and various professional organizations.





We
      recognize revenue when all of the following conditions are satisfied: (1) there
      is persuasive evidence of an arrangement; (2) the service has been provided
      to
      the customer; (3) the collection of our fees is probable; and (4) the amount
      of
      fees to be paid by the customer is fixed or determinable. EITF 00-21 states
      that
      revenue arrangements with multiple deliverables should be divided into separate
      units of accounting if the deliverables in the arrangement meet the following
      criteria: (1) the delivered item has value to the customer on a stand-alone
      basis; (2) there is objective and reliable evidence of the fair value of the
      undelivered item; and (3) if the arrangement includes a general right of return
      relative to the delivered item, delivery or performance of the undelivered
      item
      is considered probable and substantially in control of the vendor. Our
      syndication and integration agreements typically include multiple deliverables
      including the grant of a non-exclusive license to distribute, use and access
      to
      our platform, fees for the integration of


25


content
      into our platform, maintenance and hosting fees, documentation and training,
      and
      technical support and customer support fees. We cannot establish fair value
      of
      the individual revenue deliverables based on objective and reliable evidence
      because we do not have a long, consistent history of standard syndication and
      integration contractual arrangements, there have only been a few contracts
      that
      have continued past the initial contractual term, we do not have any contracts
      in which these elements have been sold as stand-alone items, and there is no
      third-party evidence of fair value for products or services that are
      interchangeable and comparable to our products and services. As such, we cannot
      allocate revenue to the individual deliverables and must record all revenues
      received as a single unit of accounting as further described below.
      Additionally, we have evaluated the timing and substantive nature of the
      performance obligations associated with the multiple deliverables noted above,
      including the determination that the remaining obligations are essential to
      the
      ongoing usability and functionality of the delivered products, and determined
      that revenue should be recognized over the life of the contracts, commencing
      on
      the date the site goes on-line.





Syndication
      fees consist primarily of fees charged to syndication partners to create and
      maintain a customized private-label site and ongoing support, maintenance and
      customer service. Syndication agreements typically include an advance fee and
      monthly hosting fees. Integration fees consist primarily of fees charged to
      integration partners to integrate their products into our syndication platform.
      Amounts that have been invoiced are recorded as accounts receivable and in
      deferred revenue and the revenue is recognized ratably over the specified lives
      of the contracts, commencing on the date the site goes on-line. Syndication,
      integration and support contracts typically provide for early termination only
      upon a material breach by either party that is not cured in a timely manner.
      If
      a contract terminates earlier than its term, the remaining deferred revenue
      is
      recognized upon termination. It is possible that the estimates of expected
      duration of customer contract lives may change and the period over which such
      syndication revenues are amortized could be adjusted. Any such change in
      specified contract lives could affect future results of operations.





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      agreements is received upfront. Customers are generally invoiced in annual
      or
      monthly installments and typical payment terms provide that customers pay within
      30 days of invoice. In general, billings are collected in advance of the service
      period.





Other
      revenues, which include traditional shrink-wrap sales and OEM arrangements,
      are
      recorded based on the greater of actual sales or contractual minimum guaranteed
      royalty payments. For OEM contracts, we record the minimum guaranteed royalties
      monthly and receive payment of the royalties on a quarterly basis, thirty (30)
      days in arrears. To the extent actual royalties exceed the minimum guaranteed
      royalties, the excess is recorded in the quarter we receive notification of
      such
      additional royalties.





Subscription
      revenues consist of subscription sales directly to end-users, or to others
      for
      distribution to end-users, hosting and maintenance fees, e-commerce website
      design fees and online loan origination fees. Subscription sales are made either
      on a monthly subscription or a one-time for fee basis. Subscriptions, which
      include access to most of our offerings, are payable in advance on a monthly
      basis. Currently, most of our syndication agreements call for us to receive
      a
      percentage of revenue generated. Depending on the criteria of each individual
      contract and in accordance with EITF 99-19, a determination is made as to
      whether we should recognize the gross revenue with a corresponding expense
      for
      the portion paid to or retained by the partner or recognize only our net portion
      as revenue. At this time, we are still selling certain products and services
      on
      a “for fee” basis. We also recently began to offer to our potential syndication
      partners volume discounts for pre-paid subscriptions, which they can either
      resell or contribute to their small business customers, but no volume sales
      have
      occurred. 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.
      Online loan origination fees are charged to provide users online financing
      options. We receive payments for loans or credit provided.





Professional
      service fees are recognized over the term of the consulting engagement as
      services are performed, which is typically one to three months. Advance payments
      for consulting services, if billed and paid prior to completion of the project,
      are recorded as deferred revenue when received. If the fees are not fixed or
      determinable, revenue is recognized as work is performed and billed. In
      determining whether the professional service fees can be accounted for
      separately from subscription and support revenues, we consider the following
      factors for each consulting agreement: availability of the consulting services
      from other vendors, whether objective and reliable evidence for fair value
      exists of the undelivered elements, the nature of the consulting services,
      the
      timing of when the consulting contract was signed in comparison to the
      subscription service start date, and the contractual dependence of the
      subscription service on the customer’s satisfaction with the consulting
      work.





*Barter
      Transactions* -
      Barter
      revenue relates to syndication and integration services provided by us to
      business customers in exchange for advertising in the customers’ trade magazines
      and on their websites. Barter expenses reflect the expense offset to barter
      revenue. The amount of barter revenue and expense is recorded at the estimated
      fair value of the services received or the services provided, whichever is
      more
      objectively determinable, in the month the services and advertising are
      exchanged. We apply APB 29, *Accounting
      for Non-Monetary Transactions* ,
      the
      provisions of EITF 93-11, *Accounting
      for Barter Transactions Involving Barter Credits* and EITF
      99-17, *Accounting
      for Advertising and Barter Transactions* and,
      accordingly, recognize barter revenues only to the extent that we
      have


26


similar
      cash transactions within a period not to exceed six months prior to the date
      of
      the barter transaction. To date the amount of barter revenue to be recognized
      has been more objectively determinable based on integration and syndication
      services provided. For revenue from integration and syndication services
      provided for cash to be considered similar to the integration and syndication
      services provided in barter transactions, the services rendered must have been
      in the same media and similar term as the barter transaction. Once the value
      of
      the barter revenue has been determined, we follow the same revenue recognition
      principles as we apply to cash transactions with unearned revenues being
      deferred as described more fully under the caption “Revenue Recognition” above.
      Barter revenues totaled approximately $103,000, $424,000 and $113,000, for
      the
      years ended December 31, 2006, 2005 and 2004, respectively.





*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.





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





**Results
      of Operations**





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





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**REVENUES:Integration
                Fees
            
            $
            182,660
            
            $
            798,178
            
            $
            374,055Syndication
                Fees
            
            
            218,386
            
            
            402,847
            
            
            176,471Subscription
                Fees
            
            
            1,904,192
            
            
            468,621
            
            
            -Professional
                Services Fees
            
            
            1,269,300
            
            
            401,677
            
            
            -Other
                Revenue
            
            
            70,352
            
            
            84,102
            
            
            122,394Related
                Party Revenues
            
            
            -
            
            
            -
            
            
            330,050Total
                Revenues
            
            
            3,644,890
            
            
            2,155,425
            
            
            1,002,970COST
                OF REVENUES
            
            
            329,511
            
            
            154,892
            
            
            211,616GROSS
                PROFIT
            
            
            3,315,379
            
            
            2,000,533
            
            
            791,354OPERATING
                EXPENSES:General
                and Administrative
            
            
            5,648,377
            
            
            15,038,563
            
            
            2,432,928Sales
                and Marketing
            
            
            1,016,107
            
            
            1,386,019
            
            
            596,989Research
                and Development
            
            
            2,016,507
            
            
            1,649,956
            
            
            563,372


27





Total
                Operating Expenses
            
            
            8,680,991
            
            
            18,074,538
            
            
            3,593,289LOSS
                FROM CONTINUING OPERATIONS
            
            
            (5,365,612
            )
            
            (16,074,005
            )
            
            (2,801,935
            )OTHER
                INCOME (EXPENSE):Interest
                Expense, Net
            
            
            (254,381
            )
            
            (37,502
            )
            
            (119,389
            )Gain
                on Debt Forgiveness
            
            
            144,351
            
            
            556,215
            
            
            249,395Redemption
                of Investor Relations Shares
            
            
            3,125,000
            
            
            -
            
            
            -Writeoff
                of Investment
            
            
            (25,000
            )
            
            -
            
            
            -Other
                Income (Expense)
            
            
            (122,502
            )
            
            418
            
            
            -Total
                Other Income
            
            
            2,867,468
            
            
            519,131
            
            
            130,006NET
                LOSS FROM CONTINUING OPERATIONS
            
            
            (2,498,144
            )
            
            (15,554,874
            )
            
            (2,671,929
            )DISCONTINUED
                OPERATIONSLoss
                of Operations of Smart CRM (2006 includes gain on sale of assets
                of
                $563,835, write-off of goodwill of $2,793,321 and loss on operations
                of
                $296,077), net of tax ($0)
            
            
            (2,525,563
            )
            
            
            
            
            -Loss
                on Discontinued Operations
            
            
            (2,525,563
            )
            
            (35,735
            )Preferred
                stock dividends and accretion of discount on preferred
                stock
            
            
            -
            
            
            -
            
            
            (2,215,625
            )Accretive
                dividend issued in connection with registration rights
                agreement
            
            
            -
            
            
            -
            
            
            (206,085
            )Converted
                preferred stock inducement cost
            
            
            -
            
            
            -
            
            
            (3,225,410
            )NET
                LOSSNet
                loss attributed to common stockholders
            
            $
            (5,023,707
            )
            $
            (15,590,609
            )
            $
            (8,319,049
            )











The
      following tables set forth selected consolidated statements of operations data
      for each of the periods indicated as a percentage of total
      revenues.





**Year
                Ended December 31,**REVENUES:
            
            
            
            **2006**
            
            **2005**
            
            **2004**Integration
                Fees
            
            
            5%
            
            37%
            
            37%Syndication
                Fees
            
            
            6%
            
            19%
            
            18%Subscription
                Fees
            
            
            52%
            
            22%
            
            -Professional
                Services Fees
            
            35%
            
            19%
            
            -Other
                Revenue
            
            
            2%
            
            3%
            
            12%Related
                Party Revenues
            
            -
            
            -
            
            33%Total
                Revenues
            
            
            100%
            
            100%
            
            100%


28





COST
                OF REVENUES
            
            
            
            9%
            
            7%
            
            21%GROSS
                PROFIT
            
            
            
            91%
            
            93%
            
            79%OPERATING
                EXPENSES:G&A
            
            
            
            155%
            
            698%
            
            243%Sales
                & Marketing
            
            
            28%
            
            64%
            
            60%Development
            
            
            55%
            
            77%
            
            56%Total
                Operating Expenses
            
            238%
            
            839%
            
            359%Net
                Income (Loss) from Operations
            
            -147%
            
            -746%
            
            -279%OTHER
                INCOME (EXPENSES):Interest
                Income (Expense), net
            
            -7%
            
            -2%
            
            -12%Gain
                / Loss on Legal Settlements
            
            4%
            
            26%
            
            25%Other
                Income
            
            
            82%
            
            -
            
            -Writeoff
                of Investment
            
            
            -1%
            
            -
            
            -Gain
                on Sale of Assets
            
            -
            
            -
            
            -DISCONTINUED
                OPERATIONSGain
                from Operations of Smart CRM(including
                Loss on Sale of $2,140,054)
            -69%
            
            -2%
            
            -Income
                Tax
            
            
            -
            
            -
            
            -Income
                from Discontinued Operations
            -69%
            
            -2%
            
            -NET
                INCOME (LOSS)
            
            
            
            -138%
            
            -723%
            
            -266%Preferred
                Stock Dividends and Accretionof
                Discount on Preferred Stock
            
            -
            
            -
            
            -221%Accretive
                dividend issued in connectionwith
                Reg Rights Statement
            
            -
            
            -
            
            -21%Converted
                Preferred Stock Inducement Cost
            
            -
            
            -
            
            -322%Net
                Loss Attributed to Common Stockholders
            -138%
            
            -723%
            
            -830%





**Overview
      of Results of Operations for the Fiscal Year Ended December 31,
      2006**





Total
      revenues for the year ended December 31, 2006 were $3.6 million, an increase
      of
      $1.4 million or 69% over 2005. Subscription revenue for 2006 was $1.9 million,
      an increase of $1.4 million or 305% over 2005. For 2006, we reported in two
      segments for the first time and derived $513,000 and $3.1 million of our
      consolidated revenue from our Smart Online segment and Smart Commerce segment,
      respectively.





Our
      net
      loss for 2006 was $5.0 million, a decrease of $10.6 million from a net loss
      of
      $15.6 million in 2005. Net loss for 2006 included a loss from discontinued
      operations of $2.5 million, and $3,125,000 of other income from the redemption
      of investor relations shares. For 2005, the loss from discontinued operations
      was approximately $36,000. Net loss for 2006 also included non-cash charges
      of
      $782,000 related to amortization and depreciation and $780,000 related to
      compensation costs for stock options as accounted for under SFAS No. 123R.
      During 2005, we incurred depreciation and amortization expense of $217,000
      and
      no stock option expense as SFAS No. 123R was not yet adopted. 2005 included
      a
      non-cash charge of $9.7 million related to investor relations contracts that
      we
      cancelled during 2006.


29





During
      2006, substantial costs were incurred related to the SEC’s suspension of the
      trading of our common stock and the resulting SEC and internal investigation.
      Legal expense related to the SEC and internal investigations was approximately
      $1.0 million for 2006.





In
      the
      first quarter of 2006, we learned that one of our major customers for the Smart
      Commerce segment underwent a restructuring. During 2006, this restructuring
      resulted in a loss of approximately 45% of the revenue generated by this
      customer. Revenue from this customer decreased in the months following the
      restructuring, then leveled off for the last three months of 2006.





As
      of
      January 1, 2006, we offered our OneBiz SM and iDA
      platforms to small businesses through four total syndication partners. During
      2006, one of these partners, Union Bank of California, N.A., renewed its
      contract for a one year term. As of December 31, 2006, our OneBiz SM and iDA
      platforms were available through four syndication partners and our main portal.





In
      September 2006, we sold substantially all of the assets of Smart CRM to
      Alliance. This sale resulted in $600,000 cash proceeds and the elimination
      of
      approximately $1.7 million in liabilities. We recorded an impairment of goodwill
      of approximately $2.8 million resulting in a net loss on sale of approximately
      $2.1 million. As a result, we reported results of operations for Smart CRM
      prior
      to the sale of assets as discontinued operations.





During
      the first half of 2006, the number of subscribers to our products and services
      through our main portal and the web sites of our partners declined. Over the
      second half of 2006 and into 2007, the number of subscribers has been relatively
      constant. We are not aware of all the factors that led to the decrease in the
      number of subscribers, but we are aware that some complained about the ease
      of
      use of our website. We subsequently redesigned our main portal to address these
      concerns. Also, in the fourth quarter of 2006, we began focusing on increasing
      these subscription numbers by contracting with new partners to market our
      applications to their small business customers.





At
      December 31, 2006, we had $577,000 in cash of which $250,000 was restricted
      as
      compared to cash of $1.7 million at December 31, 2005, of which $230,000 was
      restricted. Accounts receivable at December 31, 2006 was $248,000 as compared
      to
      $505,000 at December 31, 2005. Deferred revenue at December 31, 2006 was
      $325,000 as compared to $766,000 at December 31, 2005.





**Comparison
      of the Results of Operations for the Years Ended December 31, 2006 and
      2005**





*Revenues* - Total
      revenues were $3.6 million in 2006 as compared to $2.2 million in 2005, an
      increase of $1.4 million or 69%. Subscription revenue for 2006 was $1.9 million,
      an increase of $1.4 million or 305% over 2005. This increase was primarily
      attributable to the subscription revenue of Smart Commerce, which was
      operational as our subsidiary for the full twelve months of 2006 as compared
      to
      only two and one half months during 2005 (October 18, 2005 to December 31,
      2005). In the first quarter of 2006, we learned that one customer of Smart
      Commerce, constituting approximately 40% of iMart’s 2005 revenue, underwent a
      restructuring that resulted in a decrease of approximately 45% in its business
      with Smart Commerce between April 2006 and December 2006. Although this customer
      restructuring has had a negative effect on Smart Commerce, we are targeting
      to
      offset this loss by securing new customers in 2007. As of March 15, 2007, we
      have secured one new customer for Smart Commerce. Integration revenue decreased
      $615,000, or 77%, to $183,000 in 2006. Syndication revenue decreased $185,000,
      or 46%, to $218,000 in 2006 compared to 2005. This decrease was primarily
      attributable to our shift away from integration and syndication revenue as
      we
      began focusing on building subscription revenue. Accordingly, we have let the
      majority of our integration and syndication contracts expire in 2006. We expect
      our integration and syndication revenue to continue to decline as we work to
      increase our subscription revenue. Professional services fees increased $867,000
      or 216% to $1,269,000 in 2006 compared to 2005. This increase was primarily
      attributable to the professional service fees of Smart Commerce, which was
      operational as our subsidiary for the full twelve months of 2006 as compared
      to
      only two and one half months during 2005 (October 18, 2005 to December 31,
      2005), and revenue for a perpetual license of approximately $500,000. We
      did not derive any material revenue from related parties during
      2005.





*Cost
      of Revenues -* Cost
      of
      revenues were $330,000 in 2006 as compared to $155,000 in 2005, an increase
      of
      $175,000 or 113%. The Smart Commerce segment contributed $271,000 to cost of
      revenues in 2006 as compared to $56,000 in 2005, an increase of $215,000. This
      increase was offset by a decrease in cost of revenues of $43,000 in the Smart
      Online segment over 2005, which was the result of headcount reductions in
      personnel directly responsible for integration and syndication contract
      maintenance.





*General
      and Administrative -* General
      and administrative expenses were $5.6 million in 2006 as compared to $15 million
      in 2005, a decrease of $9.4 million or 62%. This decrease was primarily due
      to
      decreases in investor relations, management consultant, travel, meal and
      entertainment and bonus expenses, which was offset by increases in total
      compensation expense, legal and professional fees and expenses related to Smart
      Commerce.





Our
      investor relations expenses decreased by $10,285,000, from $10,318,000 in 2005
      to $33,000 in 2006. The expenses for 2005 were extraordinarily high as a result
      of shares that we issued ** to
      investor relations firms. Pursuant to settlement agreements with these investor
      relations firms in 2006, we redeemed these shares in 2006, resulting in a $3.125
      million increase in our other income. Our management consulting expenses
      decreased by $1,295,000, from $1,320,000 in 2005 to $25,000 in 2006. This
      decrease resulted from


30


our
      termination or non-renewal of contracts with a substantial number of management
      consulting firms. Travel expenses decreased by $146,000, from $220,000 in 2005
      to $74,000 in 2006. This decrease was the combined result of higher than normal
      expense in 2005 when our executives were traveling frequently related to
      financing and investing activity, specifically with Atlas and the Blueline
      Fund,
      combined with lower than normal expense in 2006 when travel was greatly
      curtailed as management focused on the SEC and internal investigation. For
      those
      same reasons, our meals and entertainment expenses decreased by $44,000, from
      $60,000 in 2005 to $16,000 in 2006. Our bonus expenses also decreased by
      $51,000, from $52,000 in 2005 to $1,000 in 2006 as we curtailed our cash
      incentive programs due to, in part, the following factors (1) the suspension
      in
      the trading of our securities by the SEC and the related investigation, (2)
      the
      repeated need to enter into various financing transactions in order to continue
      operations, (3) we had immaterial revenues other than those generated by Smart
      Commerce and Smart CRM, and (4) we have only experienced net losses to
      date.





The
      decreases in our general and administrative expenses were offset by a $1,022,000
      increase in total compensation expense, from $645,000 in 2005 to $1,667,000
      in
      2006. Of this increase, $794,000 is attributable to the non-cash stock option
      expense now required by our adoption of SFAS No. 123R and the remaining $228,000
      of the increase is attributable to salaries paid to our CFO, COO and Corporate
      Counsel. As a result of hiring a full-time CFO, third party accounting and
      bookkeeping fees decreased by $405,000, from $669,000 in 2005 to $264,000 in
      2006.





The
      decreases in our general and administrative expenses also were offset by a
      $827,000 increase in legal and professional fees, from $421,000 in 2005 to
      $1,248,000 in 2006. This increase was primarily attributable to the legal costs
      related to the SEC and internal investigations. Management anticipates an
      increase in legal and professional fees in 2007 for non-recurring expenses
      related to the costs of compliance with the Sarbanes-Oxley Act and other public
      company-related expenses. The increased expenses associated with the SEC’s
      suspension of trading of our securities, the continuing SEC action, and the
      internal investigation of matters relating thereto are all non-recurring
      expenses, but may continue to be significant expenses in 2007. To date, our
      insurers have only agreed to cover a portion of the fees and expenses related
      to
      the SEC action and the internal investigation.





Finally,
      our Smart Commerce segment contributed an additional $237,000 of general and
      administrative expense in 2006 as compared to 2005, because Smart Commerce
      was
      operational as our subsidiary for the full twelve months of 2006 as compared
      to
      only two and one half months during 2005 (October 18, 2005 to December 31,
      2005).





*Sales
      and Marketing -* Sales
      and
      marketing expense decreased by $370,000, from $1,386,000 in 2005 to $1,016,000
      in 2006. This decrease was primarily attributable to decreases in our
      advertising, sales and marketing wages, management consulting, commission,
      marketing and public relations expenses, which were offset by increased expenses
      related to our Smart Commerce segment.





Advertising
      expense decreased by $289,000, from $290,000 in 2005 to $1,000 in 2006 primarily
      due to reduced barter advertising expense. Sales and marketing wages decreased
      by $263,000, from $402,000 in 2005 to $139,000 in 2005, primarily due to the
      promotion to Chief Operating Officer of an individual whose salary has now
      been
      re-allocated to general and administrative expenses as well as the elimination
      of several sales positions. ****** Management
      consulting expense decreased by $73,000, from $79,000 in 2005 to $6,000 in
      2006,
      as we relied less on outside consultants. Commission expense decreased by
      $46,000, from $52,000 in 2005 to $6,000 in 2006, as we reduced our sales staff
      due to workforce reductions. We expect commission expense to increase in 2007
      as
      we anticipate hiring additional sales staff as we renew our focus on revenue
      generation. Marketing expense decreased by $90,000, from $96,000 in 2005 to
      $6,000 in 2006, as we reduced our direct marketing efforts in 2006 and shifted
      to leveraging the marketing power of our partners. Public relations expense
      decreased by $90,000, from $103,000 in 2005 to $12,000 in 2006, as we greatly
      reduced our utilization of third party public relations firms and focused our
      expenditures on our core operations.





These
      decreases in our sales and marketing expenses in 2006 were offset by the
      contribution of an additional $492,000 by our Smart Commerce segment to sales
      and marketing expense in 2006 as compared to 2005, because Smart Commerce was
      operational as our subsidiary for the full twelve months of 2006 as compared
      to
      only two and one half months during 2005 (October 18, 2005 to December 31,
      2005).





*Development
      Expense* -
      Development expense increased by $367,000, from $1,650,000 in 2005 to $2,017,000
      in 2006. This increase was primarily attributable to an additional $706,000
      in
      development expense from our Smart Commerce segment in 2006 as compared to
      $116,000 in 2005, because Smart Commerce was operational as our subsidiary
      for
      the full twelve months of 2006 as compared to only two and one half months
      during 2005 (October 18, 2005 to December 31, 2005). This increase was offset
      by
      a $185,000 decrease in accounting application development expense, from $293,000
      in 2005 to $108,000 in 2006. This decrease was the result of a reevaluation
      of
      our efforts regarding the accounting application in 2006. During the second
      half
      of 2006 when our needs pertaining to the accounting application were being
      re-evaluated and re-designed, no significant development expense related to
      the
      accounting application was incurred as no significant designing or programming
      was taking place.





Development
      bonus expense decreased by $150,000 from $150,000 in 2005 as bonuses were
      suspended in 2006.


31





*Other
      Income (Expense)* - In
      2005, we paid an aggregate $500,000 in cash and issued an aggregate of 1,250,000
      shares of our common stock to two investor relations consultants pursuant to
      consulting agreements with each. At the time of issuance, the aggregate value
      of
      the shares of common stock was approximately $9,738,000. In 2006, we entered
      into settlement agreements with each of these investors relations consultants.
      Under the terms of the settlement agreements, the consultants retained all
      of
      the cash fees paid to them, but released any interest in the shares that were
      issued. These shares were redeemed by us in 2006, resulting in other income
      of
      $3,125,000.





We
      incurred net interest expense of $254,000, net of interest income of $11,000,
      in
      2006 as compared to net interest expense of $38,000, net of $33,000 of interest
      income in 2005. This increase in net interest expense of $174,000, or 218%,
      is
      primarily attributable to the carrying cost for a full year of the debt
      associated with the iMart and Computility acquisitions. The decrease in interest
      income is primarily the result of reduced cash balances in interest-earning
      accounts.





Due
      to
      our financing activities related to the iMart purchase price as well as the
      establishment and use of our Wachovia line of credit, we anticipate that
      interest expense will be significantly higher in 2007.





**Comparison
      of the Results of Operations for the Years Ended December 31, 2005 and
      2004**





*Revenues
      -* Total
      revenues were $2.2 million in 2005 as compared to $1.0 million in 2004, an
      increase of $1.2 million, or 115%. Our subscription revenue increased from
      zero
      in 2004 to $469,000 in 2005. Revenues from professional services increased
      from
      zero in 2004 to $402,000 in 2005. These increases were primarily attributable
      to
      our acquisition of all of the stock of iMart, which became our subsidiary,
      Smart
      Commerce, in October 2005.





Integration
      revenues in 2005 totaled $798,000 as compared to $374,000 in 2004, representing
      an increase of $424,000, or 113%. This increase was primarily due to two new
      integration contracts that accounted for approximately 43% of the 2005
      integration revenues. Syndication revenues in 2005 totaled $403,000, as compared
      to $176,000 in 2004, representing an increase of $227,000, or 128%, due
      primarily to our entering into new syndication agreements. All of the 2005
      syndication revenues were from three agreements. The 2005 and 2004 integration
      and syndication revenues also included $424,000 and $113,000,
      respectively, of revenue derived from barter transactions.





We
      did
      not derive any material revenue from related parties during 2005. In 2004,
      revenues from related parties accounted for $330,050, or 33%, of total revenue.
      Management does not expect related party revenues to be a significant source
      of
      income going forward.





*Cost
      of Revenues -* Cost
      of
      revenues was $155,000 in 2005 as compared to $212,000 in 2004, a decrease of
      $57,000, or 27%. This decrease was primarily a result of a decrease in the
      costs
      of wages associated with maintaining and supporting integration and syndication
      partners due to a reduction in the number of active contracts. These wages
      decreased by $96,000, from $129,000 in 2004 to $33,000 in 2005. In addition,
      stock-based consulting expense decreased by $22,000, from $22,000 in 2004 to
      zero in 2005 because we no longer used these consultants. However, these
      decreases were offset due to the acquisition of iMart, which increased the
      cost
      of revenues by $56,000 for 2005 primarily due to third-party domain registration
      fees and personnel costs associated with supporting subscription services.
      This
      increase in costs of revenues for the Smart Commerce segment represented 7%
      of
      Smart Commerce’s revenue for 2005.





*General
      and Administrative* -
      General
      and administrative expenses increased by approximately $12.6 million, from
      $2.4
      million in 2004 to $15 million in 2005. Approximately $10.2 million of this
      increase is attributable to two investor relations contracts of which $9.7
      million was paid in stock and $500,000 was paid in cash. As described above,
      we
      subsequently entered into settlement agreement with these parties and redeemed
      the shares. Additionally, in 2005 we paid a total of $499,000 in cash and issued
      23,000 shares of common stock valued at a total of $216,000 to other investor
      relations consultants. Approximately $159,000 of the increase in general and
      administration expense is attributable to amortization expense related to
      intangible assets acquired from iMart. 2004 included $350,000 of general and
      administrative expense associated with the conversion of certain warrants to
      common stock and $66,000 of stock-based compensation expense. Finally, general
      and administrative expense increased due to a $319, 000 increase in legal and
      professional fees, from $770,000 in 2004 to $1,089,000 in 2005, which was
      primarily due to costs associated with conducting financial statements audits
      for 2002 and 2003 and one-time expenses associated with preparing to become
      a
      public company.





*Sales
      and Marketing* -
      Sales
      and marketing increased by $789,000, from $597,000 in 2004 to $1,386,000 in
      2005, as we increased our sales and marketing staff and activities. 2004
      included approximately $206,000 of barter advertising expense as compared to
      $274,000 for 2005.


32





*Development* -
      Development expense increased by $1,087,000, from $563,000 in 2004 to $1,650,000
      in 2005. This increase is primarily the result of our adding additional
      programming, database management, quality assurance, and project management
      resources to support the on-going development of the applications.





*Other
      Income (Expense) -* We
      incurred net interest expense of $38,000, net of $33,000 of interest income,
      in
      2005 and $119,000 of interest expense in 2004. The 2005 interest expense of
      approximately $71,000 was primarily the result of interest expense on the
      non-compete and purchase price notes related to our acquisitions of iMart and
      Computility. We earned approximately $33,000 of interest income related to
      bank
      deposits during 2005, compared to zero in 2004. 2004 interest expense included
      $75,000 of interest related to the issuance of 150,000 shares of common stock
      to
      a relative of one of our officers in consideration for extending the term of
      a
      loan and loaning additional funds to us as described in Note 8, Loans, to the
      accompanying audited financial statements. The remainder of the 2004 interest
      expense was primarily attributable to interest due on deferred compensation
      owed
      to certain of our officers and interest related to unpaid payroll tax
      obligations. There was no interest income in 2004. Both the deferred
      compensation and income tax obligations were relieved during the first quarter
      of 2005.





During
      2005 and 2004, we realized gains totaling $556,000 and $249,000, respectively,
      from negotiated and contractual releases of outstanding liabilities. The gains
      from debt forgiveness resulted from unrelated third parties, primarily trade
      creditors who had performed services for us, agreeing to accept as payment
      in
      full a lesser amount than the stated liability in consideration for timely
      payment of the negotiated settlement.





**Provision
      for Income Taxes**





We
      did
      recorded a provision for income tax expense in 2006, 2005 or 2004 because we
      have been generating net losses. Furthermore, we have not recorded an income
      tax
      benefit for 2006, 2005, and 2004, primarily due to continued substantial
      uncertainty regarding our ability to realize our deferred tax assets. Based
      upon
      available objective evidence, there has been sufficient uncertainty regarding
      the ability to realize our deferred tax assets, which warrants a full valuation
      allowance in our financial statements. As of December 31, 2006, we had
      approximately $42 million in net operating loss carryforwards, which may
      utilized to offset future taxable income.





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





**Liquidity
      and Capital Resources**





As
      of
      December 31, 2006, our principal sources of liquidity were cash and cash
      equivalents totaling $577,000 and accounts receivable of $248,000. As of March
      15, 2007, our principal sources of liquidity were cash and cash equivalents
      totaling approximately $5,114,000 and accounts receivable of approximately
      $209,000. This increase in cash and cash equivalents from December 31, 2006
      to
      March 15, 2007 is primarily due to total aggregate proceeds of $6,000,000 from
      our sale of 2,352,941
      shares of common stock to investors for a price of $2.55 per share, which
      included warrants for the purchase of an aggregate of 1,176,471 shares of common
      stock at an exercise price of $3.00 per share. Of this,
      $250,000 of our cash is restricted in accordance with our promissory note with
      Fifth Third Bank, or Fifth Third, described below. As of March 15, 2007, we
      have
      drawn approximately $2.1 million of our $2.5 million line of credit, leaving
      approximately $400,000 available for our operations.





**Cash
      Flow from Operations** . Cash
      flows used in operations in 2006 totaled $3.25 million, down from $6.35 million
      in 2005 and $3.69 million in 2004. This decrease was primarily attributable
      to
      cash flows from the two companies we acquired in October 2005.





**Cash
      Flow from Financing Activity** .
      In
      2006, we generated a total of $1.72 million net cash from our financing
      activities. This net cash was generated through both equity and debt financing,
      as described below.





*Equity
      Financing* .
      Our
      primary source of cash during 2006, 2005 and 2004, as well as prior years,
      was
      from the sale of our securities. Between March 2006 and August 2006, we sold
      an
      aggregate of 1 million shares of our common stock to four investors, three
      of
      whom were current stockholders, for a price of $2.50 per share resulting in
      gross proceeds of $2,500,000. We incurred immaterial issuance costs related
      to
      these stock sales. During 2005, we generated net cash from financing activities,
      including the sales of shares of our common stock, of approximately $7.7
      million. During the first half of 2004, we sold shares of common stock to new
      and existing shareholders resulting in net proceeds of $3.33 million. During
      the
      second half of 2004, we sold shares of common stock to new and existing
      investors in a private placement resulting in net proceeds of $1.4
      million.





33


*Debt
      Financing* .
      In
      2006, we entered into two debt financing transactions. On November 9, 2006,
      Smart Commerce entered into a loan agreement with Fifth Third Bank. Under the
      terms of this agreement, Smart Commerce borrowed $1.8 million to be repaid
      in 24
      monthly installments of $75,000 plus interest beginning in December 2006. The
      interest rate is prime plus 1.5% as periodically determined by Fifth Third.
      Currently and at closing, the prime rate was 8.25%. The loan is secured by
      all
      of the assets of Smart Commerce, including a security account of $250,000 with
      Fifth Third, and all of Smart Commerce’s intellectual property. The loan is
      guaranteed by us and such guaranty is secured by all the common stock of Smart
      Commerce. Under the terms of the loan agreement, Smart Commerce has established
      a lock box account with Fifth Third, but has the right to use the amounts
      deposited therein for any purpose not inconsistent with the loan agreement
      and
      related documents so long as no event of default exists and is continuing.
      Further, the $250,000 in the security account will be released in 3 installments
      of approximately $83,000 if on June 30, 2007, December 31, 2007, and June 30,
      2008 Smart Commerce meets certain debt
      covenants regarding operating metrics for Smart Commerce .





On
      November 14, 2006, we entered into a revolving credit arrangement with Wachovia.
      The line of credit advanced by Wachovia was $1.3 million, and can be used for
      general working capital. This was increased to $2.5 million in January 2007.
      Any
      advances made on the line of credit must be paid off no later than August 1,
      2008, with monthly payments of accrued interest commencing on December 1, 2006
      on any outstanding balance. The interest shall accrue on the unpaid principal
      balance at the LIBOR Market Index Rate plus 0.9%. The line of credit is secured
      by our deposit account at Wachovia and an irrevocable standby letter of credit
      in the amount of $2.5 million issued by HSBC Private Bank (Suisse) S.A. with
      Atlas as account party. We have separately agreed with Atlas that in the event
      of a default by us in the repayment of the line of credit that results in the
      letter of credit being drawn, we shall reimburse Atlas any sums that Atlas
      is
      required to pay under such letter of credit. At our sole discretion, these
      payments may be made in cash or by issuing shares of our common stock at a
      set
      per share price of $2.50.





**Deferred
      Revenue.** At
      December 31, 2006, we had deferred revenue totaling $325,000, net of offsetting
      amounts receivable. Deferred revenue represents amounts collected in advance
      of
      the revenue being recognized. Based upon current conditions, we expect that
      approximately 96% of this amount will be recognized during 2007.





We
      have
      not yet achieved positive cash flows from operations, and our main sources
      of
      funds for our operations have been the sale of securities in private placements
      and the Wachovia line of credit. We must continue to rely on these sources
      until
      we are able to generate sufficient revenue to fund our operations. We
      believe that anticipated cash flows from operations, funds available from our
      existing line of credit, together with cash on hand, will provide sufficient
      funds to finance our operations at least for the next 12 months. Changes in
      our
      operating plans, lower than anticipated sales, increased expenses, or other
      events may cause us to need to seek additional equity or debt financing in
      future periods. There can be no guarantee that financing will be available
      on
      acceptable terms or at all. Additional equity financing could be dilutive to
      the
      holders of our common stock, and additional debt financing, if available, could
      impose greater cash payment obligations and more covenants and operating
      restrictions. We have no current plans to seek any such additional
      financing.





**Recent
      Developments**





**New
      Contracts.** During
      the first quarter of 2007, we entered into the following new
      contracts:





·
            Two
                syndication agreements, one through our Smart Online segment which
                will
                offer a private label suite of branded food safety compliance applications
                for industry associations. The partnership will incorporate our partner’s
                food industry traceability and compliance functionality into our
                business
                application suite. The other through our Smart Commerce segment with
                a
                leading direct selling
                organization.


·
            Marketing
                referral agreement through our Smart Online segment with a firm that
                provides IT services to financial service companies in Caribbean
                countries. We entered into this partnership to offer a Spanish version
                of
                our applications to financial service companies, which will be offered
                as
                a private labeled site to the partner’s small business
                customers.





**Sales
      of Securities** . On
      February 21, 2007, we sold an aggregate of 2,352,941 shares of our common stock
      at $2.55 per share to two new investors for aggregate gross proceeds of
      $6,000,000. Under the purchase agreement, we issued the investors warrants
      for
      the purchase of an aggregate of 1,176,471 shares of common stock at an exercise
      price of $3.00 per share. We also entered into registration rights agreements
      with the investors that obligate us to register the shares sold for resale
      by
      the investors by a certain date. If a registration statement is not timely
      made,
      we are obligated to pay a cash penalty up to 10% of the aggregate purchase
      price. Under the terms of the registration rights agreement, we cannot offer
      for
      sale or sell any securities until May 22, 2007, subject to certain limited
      exceptions, unless, in the opinion of our outside counsel, such offer or sale
      would not jeopardize the availability of exemptions from the registration and
      qualification requirements under applicable securities laws with respect to
      this
      placement. We incurred issuance costs of approximately $500,000 related to
      this
      private placement, excluding warrants issued to our private placement agent.





As
      part
      of the issuance costs of this transaction, we issued our placement agent a
      warrant to purchase 35,000 shares of our common stock at an exercise price
      of
      $2.55 per share. We also entered into a registration rights agreement with
      the
      agent. Under this agreement, the shares issuable upon exercise of the warrant
      must be included on the same registration statement we are obligated to file
      as
      described above, but with no provisions for the payment of any penalties for
      late registration or effectiveness.


34








On
      January 15, 2007, we entered into a "Stock Purchase Warrant and Agreement"
      with
      Atlas as incentive to modify an irrevocable standby letter of credit underlying
      our revolving line of credit arrangement with Wachovia. Under the terms of
      this
      agreement, Atlas receives a warrant to purchase up to 444,444 shares of our
      common stock at $2.70 per share at the termination of the Wachovia line of
      credit or if we are in default under the terms of the Wachovia line of credit.
      If the warrant is exercised in full, it will result in gross proceeds to the
      Company of approximately $1,200,000.





On
      March
      29, 2007, we issued 55,666 shares of our common stock to certain investors
      as
      registration penalties for our failure to timely file a registration statement
      covering shares owned by those investors as required pursuant to registration
      rights agreements between such investors and us.





**Wachovia
      Revolving Line of Credit** .
      As of
      March 14, 2007, we have drawn down $2.1 million of the $2.5 million Wachovia
      line of credit.





**Outlook
      for 2007**





With
      the
      release of our new applications and the expenses associated with becoming a
      public company, we believe our capital requirements in 2007 and beyond will
      be
      greater than in past years. Although we do not anticipate these needs to be
      substantial, the non-recurring costs associated with the SEC’s suspension of
      trading of our securities and related investigation, and the internal
      investigation of matters relating thereto, may increase our capital requirements
      in 2007. ****** As
      such,
      our historical cash flows may not be indicative of future cash flows. The
      following is a discussion of factors that we consider important to our future
      capital requirements and which will affect the amount of additional capital
      we
      need to raise. Our future capital requirements will depend on many factors,
      including our rate of revenue growth, the expansion of our marketing and sales
      activities, the timing and extent of spending to support product development
      efforts and expansion into new territories, the timing of introductions of
      new
      services and enhancements to existing services, and the market acceptance of
      our
      services.





Primary
      drivers for future operating cash flows include the commercial success of our
      existing services and products and the timing and success of any new services
      and products and our ability to maintain and grow the revenues from the
      companies we acquired. We will continue to seek additional integration and
      syndication customers who typically pay an upfront fee and to increase revenues
      generated from small business end users, and increase our effort in regard
      to
      direct sales and cross selling of pre-paid subscriptions.





Generally,
      we expect we will need to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We have
      increased our sales and marketing department as of December 2006 and added
      personnel in January 2007. We also expect increased expenses from the revenue
      share component of our recently executed contracts.





As
      a
      public company, we will incur significant legal, accounting and other expenses
      that we did not incur as a private company. We will incur costs associated
      with
      our public company reporting requirements. We incurred costs in excess of $1
      million associated with the SEC suspension of trading described above; recently
      adopted corporate governance requirements, including requirements under the
      Sarbanes-Oxley Act of 2002; as well as new rules implemented by the SEC, the
      NASD, and national securities exchanges. 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.
      Historically, we have failed to file our SEC periodic reports on time and our
      ability to fully comply with these new laws and regulations is also uncertain.
      Our failure to timely prepare for and implement the reforms required by these
      new laws and regulations could significantly harm our business, operating
      results, and financial condition. We are currently evaluating and monitoring
      developments with respect to these new rules, and we cannot predict or estimate
      the amount of additional costs we may incur or the timing of such
      costs.





In
      accordance with the provisions of SFAS No. 131, as we continue to integrate
      the
      operations and management of our subsidiaries, we may periodically re-assess
      the
      manner in which we report our segment data. Changes in our internal organization
      or the manner in which we monitor and manage our business and the business
      of
      our subsidiaries may result in the identification of different segments that
      provide more meaningful data than our current segment presentation.





**Contractual
      Obligations.** The
      following table lists certain of our contractual obligations as of December
      31,
      2006:


Payments
                  Due By PeriodTotal
              Less
                  than 1 year
              1
                  -
                  3 years
              3
                  -
                  5 years
              More
                  than 5 yearsLong-Term
                  Debt Obligations
              $3,062,631
              $2,237,631
              $825,000
              -
              -Capital
                  Lease Obligations
              -
              -
              -
              -
              -Operating
                  Lease Obligations
              33,000
              18,000
              15,000
              -
              -Purchase
                  Obligations
              250,000
              250,000
              -
              -
              -Other
                  Long-Term Liabilities
              -
              -
              -
              -
              -**TOTAL**
              $3,345,631
              $2,505,631
              $840,000
              -
              -





35








**ITEM7A.** **QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**




***Interest
      rate sensitivity***




We
      had
      unrestricted cash and cash equivalents totaling $327,000, $1,435,000, and
      $173,000 at December 31, 2006, 2005, and 2004, respectively. These amounts
      were
      invested primarily in demand deposit accounts and money market funds. The cash
      and cash equivalents are held for working capital purposes. We do not enter
      into
      investments for trading or speculative purposes. Due to the short-term nature
      of
      these investments, we believe that we do not have any material exposure to
      changes in the fair value of our investment portfolio as a result of changes
      in
      interest rates. Declines in interest rates, however, will reduce future
      investment income.





Two
      debt
      instruments have variable interest rates; one is prime + 1.5% and the other
      is
      LIBOR + .9% (See Note 9 - “Notes Payable,” to the Consolidated Financial
      Statements). At December 31, 2006, the outstanding principal balance on these
      loans was $1,725,000 and $602,000, respectively. Due to the relatively short
      term of these debt instruments combined with the relative stability of interest
      rates, we do not expect interest rate or market volatility will have a material
      effect on our cash flows.


36


**ITEM
      8. FINANCIAL STATEMENTS AND SUPPLEMENTARY
      DATA**





INDEX
      TO
      FINANCIAL STATEMENTS





Page
                numberREPORT
                OF INDEPENDENT REGISTEREDPUBLIC
                ACCOUNTING FIRM
            F-2CONSOLIDATED
                BALANCE SHEETS
            F-3CONSOLIDATED
                STATEMENTS OF OPERATIONS
            F-4CONSOLIDATED
                STATEMENTS OFSTOCKHOLDERS’
                (DEFICIT) EQUITY
            F-5CONSOLIDATED
                STATEMENTS OF CASH FLOWS
            F-7NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
            F-9












F-1





REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 Stockholders
        and Directors
 Smart
        Online, Inc.
 Durham,
        North Carolina
 
 We
        have
        audited the accompanying consolidated balance sheets of Smart Online, Inc.
        as of
        December 31, 2006 and 2005, and the related consolidated statement of
        operations, stockholders’ (deficit) equity, cash flows for each of the years
        then ended December 31, 2006, 2005 and 2004. These financial statements are
        the
        responsibility of the Company’s management. Our responsibility is to express an
        opinion on these financial statements based on our audit.
 
 We
        conducted our audit in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit includes examining,
        on a
        test basis, evidence supporting the amounts and disclosures in the financial
        statements. An audit also includes assessing the accounting principles used
        and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audit provides a
        reasonable basis for our opinion.
 
 In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the financial position of Smart Online, Inc. as
        of
        December 31, 2006 and 2005, and the results of its operations and its cash
        flows
        for each of the years then ended December 31, 2006, 2005 and 2004, in conformity
        with accounting principles generally accepted in the United States.
 
 
 
 /s/
                  Sherb & Co., LLP
                Certified
                  Public Accountants
   New
        York,
        New York
 March
        28,
        2007







F-2





**SMART
      ONLINE, INC.**


**CONSOLIDATED
      BALANCE SHEETS**





**Assets**
            
            **December
                31,**
              **2006**
            
            **December
                31,**
              **2005**CURRENT
                ASSETS:Cash
                and Cash Equivalents
            
            $
            326,905
            
            $
            1,434,966Restricted
                Cash
            
            
            250,000
            
            
            230,244Accounts
                Receivable, Net
            
            
            247,618
            
            
            504,979Prepaid
                Expenses
            
            
            100,967
            
            
            370,225Assets
                Available for Sale
            
            
            -
            
            
            74,876Total
                current assets
            
            
            925,490
            
            
            2,615,290PROPERTY
                AND EQUIPMENT, Net
            
            
            180,360
            
            
            216,969INTANGIBLE
                ASSETS, Net
            
            
            3,617,477
            
            
            4,298,358GOODWILL
            
            
            2,696,642
            
            
            5,489,963OTHER
                ASSETS
            
            
            13,040
            
            
            40,400ASSETS
                AVAILABLE FOR SALE
            
            
            -
            
            
            1,897,099TOTAL
                ASSETS
            
            $
            7,433,009
            
            $
            14,558,079**Liabilities
                and Stockholders' Equity**CURRENT
                LIABILITIES:Accounts
                Payable
            
            $
            850,730
            
            $
            855,904Accrued
                Registration Rights Penalty
            
            
            465,358
            
            
            129,945Current
                Portion of Notes Payable
            
            
            2,839,631
            
            
            2,127,486Deferred
                Revenue
            
            
            313,774
            
            
            687,222Accrued
                Liabilities
            
            
            301,266
            
            
            91,233Liabilities
                Held for Sale
            
            
            -
            
            
            1,030,369Total
                Current Liabilities
            
            
            4,770,759
            
            
            4,922,159LONG-TERM
                LIABILITIES:Long-Term
                Portion of Notes Payable
            
            
            825,000
            
            
            2,243,652Deferred
                Revenue
            
            
            11,252
            
            
            78,771Liabilities
                Held for Sale
            
            
            -
            
            
            640,866Total
                Long-Term Liabilities
            
            
            836,252
            
            
            2,963,289Total
                Liabilities
            
            
            5,607,011
            
            
            7,885,448COMMITMENTS
                AND CONTINGENCIESSTOCKHOLDERS'
                EQUITY:Common
                stock, $.001 Par Value, 45,000,000 Shares Authorized, Shares Issued
                and
                Outstanding:
              December
                31, 2006 - 15,379,030, December 31, 2005 --15,607,230
            
            
            15,379
            
            
            15,607Additional
                Paid-in Capital
            
            
            59,159,919
            
            
            58,982,617Accumulated
                Deficit
            
            
            (57,349,300
            )
            
            (52,325,593
            )Total
                Stockholders' Equity
            
            
            1,825,998
            
            
            6,672,631TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY
            
            $
            7,433,009
            
            $
            14,558,079





See
      notes
      to financial statements.





F-3


**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**REVENUES:Integration
                Fees
            
            $
            182,660
            
            $
            798,178
            
            $
            374,055Syndication
                Fees
            
            
            218,386
            
            
            402,847
            
            
            176,471Subscription
                Fees
            
            
            1,904,192
            
            
            468,621
            
            
            -Professional
                Services Fees
            
            
            1,269,300
            
            
            401,677
            
            
            -Other
                Revenue
            
            
            70,352
            
            
            84,102
            
            
            122,394Related
                Party Revenues
            
            
            -
            
            
            -
            
            
            330,050Total
                Revenues
            
            
            3,644,890
            
            
            2,155,425
            
            
            1,002,970COST
                OF REVENUES
            
            
            329,511
            
            
            154,892
            
            
            211,616GROSS
                PROFIT
            
            
            3,315,379
            
            
            2,000,533
            
            
            791,354OPERATING
                EXPENSES:General
                and Administrative
            
            
            5,648,377
            
            
            15,038,563
            
            
            2,432,928Sales
                and Marketing
            
            
            1,016,107
            
            
            1,386,019
            
            
            596,989Research
                and Development
            
            
            2,016,507
            
            
            1,649,956
            
            
            563,372Total
                Operating Expenses
            
            
            8,680,991
            
            
            18,074,538
            
            
            3,593,289LOSS
                FROM CONTINUING OPERATIONS
            
            
            (5,365,612
            )
            
            (16,074,005
            )
            
            (2,801,935
            )OTHER
                INCOME (EXPENSE):Interest
                Expense, Net
            
            
            (254,381
            )
            
            (37,502
            )
            
            (119,389
            )Gain
                on Debt Forgiveness
            
            
            144,351
            
            
            556,215
            
            
            249,395Redemption
                of Investor Relations Shares
            
            
            3,125,000
            
            
            -
            
            
            -Writeoff
                of Investment
            
            
            (25,000
            )
            
            -
            
            
            -Other
                Income (Expense)
            
            
            (122,502
            )
            
            418
            
            
            -Total
                Other Income
            
            
            2,867,468
            
            
            519,131
            
            
            130,006NET
                LOSS FROM CONTINUING OPERATIONS
            
            
            (2,498,144
            )
            
            (15,554,874
            )
            
            (2,671,929
            )DISCONTINUED
                OPERATIONSLoss
                of Operations of Smart CRM (2006 includes gain on sale of assets
                of
                $563,835, write-off of goodwill of $2,793,321 and loss on operations
                of
                $296,077), net of tax ($0)
            
            
            (2,525,563
            )
            
            
            
            
            -Loss
                on Discontinued Operations
            
            
            (2,525,563
            )
            
            (35,735
            )Preferred
                stock dividends and accretion of discount on preferred
                stock
            
            
            -
            
            
            -
            
            
            (2,215,625
            )Accretive
                dividend issued in connection with registration rights
                agreement
            
            
            -
            
            
            -
            
            
            (206,085
            )Converted
                preferred stock inducement cost
            
            
            -
            
            
            -
            
            
            (3,225,410
            )NET
                LOSS




Net
                  loss attributed to common stockholders
              
              $
              (5,023,707
              )
              $
              (15,590,609
              )
              $
              (8,319,049
              )NET
                  LOSS PER SHARE:Continuing
                  Operations
                Basic
                  and Diluted
              
              $
              (0.17
              )
              $
              (1.20
              )
              $
              (0.26
              )Discontinued
                  Operations
                Basic
                  and Diluted
              
              
              (0.17
              )
              
              0.00
              
              
              0.00Net
                  Loss Attributed to common stockholders
                Basis
                  and Diluted
              
              
              (0.33
              )
              
              (1.20
              )
              
              (0.82
              )SHARES
                  USED IN COMPUTING NET LOSS PER SHARE:Basic
                  and Diluted
              
              
              15,011,830
              
              
              12,960,006
              
              
              10,197,334
 
 See
        notes
        to financial statement.





F-4







**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ DEFICIT**


**FOR
      THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**






**Common**
              **Stock**
            
            
            **Additional**
              **Paid-**
            
            
            **Accumulated****Shares**
            
            
            **$.001
                Par**
            
            
            **In
                Capital**
            
            
            **Deficit**
            
            
            **Total**BALANCE,
                DECEMBER 31, 2003
            
            
            7,261,965
            
            
            7,262
            
            
            8,607,712
            
            
            (30,629,130
            )
            
            (22,014,156
            )Conversion
                of Preferred Stock into common stock
            
            
            2,948,608
            
            
            2,949
            
            
            19,721,890
            
            
            -
            
            
            19,724,839Conversion
                of Preferred Stock Inducement Cost
            
            
            -
            
            
            -
            
            
            3,225,410
            
            
            (3,225,410
            )
            
            -Interest
                Expense Associated with Notes Payable
            
            
            -
            
            
            -
            
            
            75,000
            
            
            -
            
            
            75,000Accretion
                of Redeemable preferred
            
            
            -
            
            
            -
            
            
            (2,215,625
            )
            
            -
            
            
            (2,215,625
            )Issuance
                of common stock, Net of Issuance Costs of $183,350
            
            
            1,288,744
            
            
            1,289
            
            
            4,762,355
            
            
            -
            
            
            4,763,644Issuance
                of common stock Rescinded
            
            
            (28,572
            )
            
            (29
            )
            
            (99,973
            )
            
            -
            
            
            (100,002
            )Issuance
                of Stock Options to Officers
            
            
            -
            
            
            -
            
            
            161,000
            
            
            -
            
            
            161,000Issuance
                of Stock Options to Members of Advisory Board
            
            
            -
            
            
            -
            
            
            6,034
            
            
            -
            
            
            6,034Issuance
                of common stock to Former Holders of Preferred Stock Pursuant to
                Registration Rights Agreement
            
            
            58,230
            
            
            58
            
            
            206,027
            
            
            (206,085
            )
            
            -Conversion
                of Bank One Warrant into common stock
            
            
            100,000
            
            
            100
            
            
            349,900
            
            
            -
            
            
            350,000Issuance
                of Stock Option to Consultant
            
            
            
            
            
            -
            
            
            1,495
            
            
            -
            
            
            1,495Exercise
                of Warrants
            
            
            2,857
            
            
            3
            
            
            8,607
            
            
            -
            
            
            8,610Net
                Loss
            
            
            
            
            
            
            
            
            
            
            
            (2,671,929
            )
            
            (2,671,929
            )BALANCE,
                DECEMBER 31, 2004
            
            
            11,631,832
            
            
            11,632
            
            
            34,809,832
            
            
            (36,732,554
            )
            
            (1,911,090
            )Issuance
                of common stock, Net of Issuance Costs of $630,525
            
            
            1,391,642
            
            
            1,392
            
            
            6,719,614
            
            
            -
            
            
            6,721,006Exercise
                of Warrants
            
            
            579,717
            
            
            580
            
            
            1,305,518
            
            
            -
            
            
            1,306,098Issuance
                of Warrants
            
            
            -
            
            
            -
            
            
            19,231
            
            
            -
            
            
            19,231Issuance
                of common stock for Services
            
            
            39,886
            
            
            40
            
            
            343,408
            
            
            -
            
            
            343,448Issuance
                of common stock to Employees as Bonus
            
            
            4,200
            
            
            4
            
            
            40,106
            
            
            -
            
            
            40,110Exercise
                of Stock Options
            
            
            16,500
            
            
            16
            
            
            57,734
            
            
            -
            
            
            57,750Issuance
                of IR Shares-GIC
            
            
            625,000
            
            
            625
            
            
            5,174,375
            
            
            -
            
            
            5,175,000


Issuance
                  of IR Shares-Berkley
              
              
              625,000
              
              
              625
              
              
              4,561,875
              
              
              -
              
              
              4,562,500iMart
                  Acquisition
              
              
              205,767
              
              
              205
              
              
              1,815,688
              
              
              -
              
              
              1,815,893Computility
                  Acquisition
              
              
              484,213
              
              
              484
              
              
              3,534,271
              
              
              -
              
              
              3,534,755Issuance
                  of Shares to Spectrum Technologies
              
              
              3,473
              
              
              4
              
              
              299,996
              
              
              -
              
              
              30,000Elimination
                  of iMart (Bayberry) Equity Not Acquired
              
              
              -
              
              
              -
              
              
              -
              
              
              (2,430
              )
              
              (2,430
              )Issuance
                  of Options to Consultants
              
              
              -
              
              
              -
              
              
              570,014
              
              
              -
              
              
              570,014Gift
                  of Shares to Charitable Organization
              
              
              -
              
              
              -
              
              
              955
              
              
              -
              
              
              955Net
                  Loss
              
              
              
              
              
              
              
              
              
              
              
              (15,590,609
              )
              
              (15,590,609
              )
 BALANCE
                  DECEMBER 31, 2005
              
              
              15,607,230
              
              
              15,607
              
              
              58,982,617
              
              
              (52,325,593
              )
              
              6,672,631Cashless
                  Exercise of Options
              
              
              4,800
              
              
              5
              
              
              (5
              )
              
              -
              
              
              0.00Issuance
                  of Warrants
              
              
              17,000
              
              
              17
              
              
              22,083
              
              
              -
              
              
              22,100Cancellation
                  of GIC Shares
              
              
              (625,000
              )
              
              (625
              )
              
              (1,561,875
              )
              
              -
              
              
              (1,562,500
              )Issuance
                  of common stock
              
              
              1,000,000
              
              
              1,000
              
              
              2,499,000
              
              
              -
              
              
              2,500,000Cancellation
                  of Berkley Shares
              
              
              (625,000
              )
              
              (625
              )
              
              (1,561,875
              )
              
              -
              
              
              (1,562,500
              )SFAS
                  123 Expense
              
              
              
              
              
              
              
              
              779,974
              
              
              
              
              
              779,974Net
                  Loss
              
              
              
              
              
              
              
              
              
              
              
              (5,023,707
              )
              
              (5,023,707
              )BALANCE
                  DECEMBER 31 2006
              
              
              15,379,030
              
              $
              15,379
              
              $
              59,159,919
              
              $
              (57,349,300
              )
              $
              1,825,998
 
 See
        notes
        to financial statements.





F-5






**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss from continuing operations
            
            $
            (2,498,144
            )
            $
            (15,554,874
            )
            $
            (2,671,929
            )Adjustments
                to reconcile net loss to netcash
                provided by (used in) operatingactivities:Depreciation
                & amortization
            
            
            727,922
            
            
            260,852
            
            
            51,531Shares
                issued for services in lieu of cash payments
            
            
            -
            
            
            9,767,500
            
            
            -Write-off
                of investment
            
            
            25,000
            
            
            -
            
            
            -Bad
                Debt Expense
            
            
            63,317
            
            
            -
            
            
            -Redemption
                of investor relations shares
            
            
            (3,125,000
            )
            
            -
            
            
            -Stock
                option expense
            
            
            779,974
            
            
            -
            
            
            -Registration
                rights penalty expense
            
            
            335,413
            
            
            129,947
            
            
            -Loss
                on disposal of property and equipment
            
            
            -
            
            
            -
            
            
            8,855Common
                shares, warrants, or options issued in lieu of
                Compensation
            
            
            -
            
            
            826,739
            
            
            168,530Common
                shares issued for extension of loan
            
            
            
            
            
            
            
            
            75,000Common
                shares issued in exchange for warrants
            
            
            -
            
            
            -
            
            
            350,000Issuance
                of warrants
            
            
            -
            
            
            19,231
            
            
            -Gain
                on debt forgiveness
            
            
            (144,351
            )
            
            (556,634
            )
            
            -Changes
                in assets and liabilities:Accounts
                receivable
            
            
            183,386
            
            
            (101,541
            )
            
            51,672Related
                party receivable
            
            
            -
            
            
            -
            
            
            38,682Other
                accounts receivable
            
            
            -
            
            
            4,687
            
            
            (43,455
            )Prepaid
                expenses
            
            
            264,333
            
            
            (194,519
            )
            
            (24,850
            )Other
                assets
            
            
            8,308
            
            
            45,187
            
            
            (500
            )Legal
                settlement obligation
            
            
            -
            
            
            -
            
            
            (181,563
            )Deferred
                revenue
            
            
            (440,964
            )
            
            (592,010
            )
            
            (225,951
            )Accounts
                payable
            
            
            121,699
            
            
            482,261
            
            
            (321,274
            )Accrued
                payroll
            
            
            -
            
            
            (110,079
            )
            
            46,946Accrued
                payroll taxes payable
            
            
            -
            
            
            (30,741
            )
            
            (961,196
            )Accrued
                interest payable
            
            
            -
            
            
            -
            
            
            (126,871
            )Accrued
                expenses
            
            
            234,601
            
            
            44,572
            
            
            -Deferred
                compensation payable
            
            
            -
            
            
            (1,091,814
            )
            
            80,166Cash
                flow from operations of discontinued
              operations
            
            
            212,201
            
            
            300,744
            
            
            -Net
                cash (used in) provided by operatingActivities
            
            
            (3,252,305
            )
            
            (6,350,492
            )
            
            (3,686,207
            )






See notes to financial statements


F-6




**SMART
        ONLINE, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 (continued)






**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchase
                of property and equipment
            
            
            (8,457
            )
            
            (224,757
            )
            
            (82,710
            )Smart
                CRM Non-Compete Agreement
            
            
            -
            
            
            (90,000
            )
            
            -Cash
                acquired from iMart at acquisition
            
            
            -
            
            
            32,028
            
            
            -Redemption
                (Purchase) of marketable securities
            
            
            -
            
            
            395,000
            
            
            (395,000
            )


Cash
                flow from investing activities of discontinued operations
            
            
            432,545
            
            
            (154,105
            )Net
                cash used in investing activities
            
            
            424,088
            
            
            (41,834
            )
            
            (477,710
            )CASH
                FLOWS FROM FINANCING ACTIVITIES:Borrowings
                on notes payable
            
            
            2,402,000
            
            
            -
            
            
            -Repayments
                on notes payable
            
            
            (3,102,918
            )
            
            (65,000
            )
            
            (350,000
            )Restricted
                cash
            
            
            (21,211
            )
            
            (230,244
            )
            
            -Advances
                from (to) Smart CRM
            
            
            570,923
            
            
            (123,829
            )
            
            -Cash
                flow from financing activities of discontinued
              operations
            
            
            (650,738
            )
            
            (139,615
            )(Repayments)
                borrowings from stockholder
            
            
            -
            
            
            -
            
            
            (86,480
            )Issuance
                of Common Stock
            
            
            2,522,100
            
            
            8,212,641
            
            
            4,672,250Net
                cash provided by financing activities
            
            
            1,720,156
            
            
            7,653,953
            
            
            4,235,770NET
                INCREASE IN CASH
              AND
                CASH EQUIVALENTS
            
            
            (1,108,061
            )
            
            1,261,627
            
            
            71,853CASH
                AND CASH EQUIVALENTS,
              BEGINNING
                OF PERIOD
            
            
            1,434,966
            
            
            173,339
            
            
            101,486CASH
                AND CASH EQUIVALENTS,
              END
                OF PERIOD
            
            $
            326,905
            
            $
            1,434,966
            
            $
            173,339Supplemental
                disclosures:Cash
                payment during the year for interest:
            
            $
            292,807
            
            $
            158,232
            
            $
            47,447Cash
                payment during the year for income taxes:
            
            $
            -
            
            $
            -
            
            
            -Non-cash
                financing activities:Debt
                Assumed by Purchaser of Assets of Smart CRM
            
            $
            1,733,190
            
            $
            -
            
            $
            -Notes
                Payables issued related to Acquisitions
            
            $
            -
            
            $
            3,659,301
            
            
            -Notes
                Payable for iMart Non-Compete Agreements
            
            $
            -
            
            $
            715,998
            
            
            -Assets
                and Liabilities of Computility acquired for stock:Accounts
                Receivable, net
            
            $
            -
            
            $
            6,894
            
            
            -Other
                Current Assets
            
            $
            -
            
            $
            10,742
            
            
            -Property,
                Plant and Equipment, net
            
            $
            -
            
            $
            388,128
            
            
            -Other
                Assets
            
            $
            -
            
            $
            246,228
            
            
            -Accounts
                Payable
            
            $
            -
            
            $
            109,897
            
            
            -Subscription
                and Notes Payable
            
            $
            -
            
            $
            1,807,327
            
            
            -Other
                Liabilities
            
            $
            -
            
            $
            29,549
            
            
            -Non-cash
                accretion of preferred
            
            
            
            
            
            
            
            
            -stock
                redemption value
            
            $
            -
            
            $
            -
            
            $
            2,215,625Conversion
                of preferred stockinto
                Common Stock
            
            $
            -
            
            $
            -
            
            $
            19,724,839Conversion
                of preferred stockinducement
                cost
            
            $
            -
            
            $
            -
            
            $
            3,225,410





See
      notes
      to financial statements


F-7







**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**FOR
      THE YEARS ENDED DECEMBER 31, 2006, 2005 and 2004.**





**1.    NATURE
      OF BUSINESS**





Smart
      Online, Inc. (the “Company”) develops and markets products and services targeted
      towards small businesses (less than 50 employees) that are delivered via a
      Software-as-a-Service (“SaaS”) model. The Company sells its products and
      services primarily through private
      label syndication and OEM distribution channels, although small businesses
      may
      purchase products and services directly through its main portal located at
      www.smartonline.com .




The
      Company’s primary source of revenue currently comes from sales of SaaS
      applications for business management, web marketing, and e-commerce, which
      represented 63%, 77%, and 55% of its revenue from continuing operations for
      the
      fiscal years ended December 31, 2006, 2005, and 2004, respectively. The Company
      derives revenue from sales of professional services which represented 35%,
      19%,
      and 0% of revenue from continuing operations for the fiscal years ended December
      31, 2006, 2005, and 2004, respectively.





In
      previous years, the Company’s auditors expressed doubt about our ability to
      continue as a going concern. The Company has been able to address these concerns
      such that no similar doubt exists at this time. Actions taken by the Company
      that effect this determination include (1) raising substantial additional
      capital in February 2007 (See Note 18 - Subsequent Events); (2) selling
      substantially all the assets of its wholly owned subsidiary, Smart CRM, Inc.,
      and (3) controlling expenses and anticipated loses.





The
      Company continues to incur development expenses to enhance and expand its
      products by focusing on establishing its Internet-delivered SaaS applications
      and data resources. All allocable expenses to establish the technical
      feasibility of the software have been recorded as research expense. The ability
      of the Company to successfully develop and market its products is dependent
      upon
      certain factors, including the timing and success of any new services and
      products, the progress of research and development efforts, results of
      operations, the status of competitive services and products, and the timing
      and
      success of potential strategic alliances or potential opportunities to acquire
      technologies or assets, any of which may require the Company to seek additional
      funding sooner than expected.





**2.    SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES**





*Principles
      of Consolidation -* The
      accompanying consolidated financial statements include the accounts of the
      Company and its wholly-owned subsidiaries, Smart CRM, Inc., and Smart Commerce,
      Inc. All significant intercompany accounts and transactions have been
      eliminated. Subsidiary accounts are included only from the date of acquisition
      forward. See Note 17, Acquisitions & Dispositions.





*Revenue
      Recognition* -
      The
      Company recognizes revenue in accordance with accounting standards for software
      and service companies including the Securities and Exchange Commission’s (the
“SEC”) Staff Accounting Bulletin 104 *Revenue
      Recognition* (“SAB
      104”), Emerging Issues Task Force Issue No. 00-21 *Revenue
      Arrangements with Multiple Deliverables* (“EITF
      00-21”) *,* Emerging
      Issues Task Force Issue No. 99-19 *Reporting
      Revenue Gross as a Principal or Net as an Agent* (“EITF
      99-19”) *,* and
      related interpretations including American Institute of Certified Public
      Accountants (“AICPA”) Technical Practice Aids. The Company utilizes
      interpretative guidance from regulatory and accounting bodies, which include,
      but are not limited to, the SEC, the AICPA, the Financial Accounting Standards
      Board (“FASB”), and various professional organizations.





Revenue
      is recognized when all of the following conditions are satisfied: (1) there
      is
      persuasive evidence of an arrangement; (2) the service has been provided to
      the
      customer; (3) the collection of fees is probable; and (4) the amount of fees
      to
      be paid by the customer is fixed or determinable. EITF 00-21 states that revenue
      arrangements with multiple deliverables should be divided into separate units
      of
      accounting if the


F-8


deliverables
      in the arrangement meet the following criteria: (1) the delivered item has
      value
      to the customer on a stand-alone basis; (2) there is objective and reliable
      evidence of the fair value of the undelivered item; and (3) if the arrangement
      includes a general right of return relative to the delivered item, delivery
      or
      performance of the undelivered item is considered probable and substantially
      in
      control of the vendor. Syndication and integration agreements typically include
      multiple deliverables including the grant of a non-exclusive license to
      distribute, use and access the Company’s platform, fees for the integration of
      content into the platform, maintenance and hosting fees, documentation and
      training, and technical support and customer support fees. The Company cannot
      establish fair value of the individual deliverables based on objective and
      reliable evidence due to the lack of a consistent history of standard
      syndication and integration contractual arrangements, there have only been
      a few
      contracts that have continued past the initial contractual term, there have
      not
      been any contracts in which these elements have been sold as stand-alone items,
      and there is no third-party evidence of fair value for products or services
      that
      are interchangeable and comparable to the Company’s products and services. As
      such, revenue is not allocated to the individual deliverables and must be
      recorded as a single unit of accounting as further described below.
      Additionally, the Company has evaluated the timing and substantive nature of
      the
      performance obligations associated with the multiple deliverables noted above,
      including the determination that the remaining obligations are essential to
      the
      ongoing usability and functionality of the delivered products, and determined
      that revenue should be recognized over the life of the contracts, commencing
      on
      the date the site goes online.





Subscription
      revenues consist primarily of subscription sales directly to end-users, or
      to
      others for distribution to end-users, hosting and maintenance fees, and
      e-commerce website design. Subscription sales are made either on a monthly
      subscription or a one-time for fee basis. Subscriptions are payable in advance
      on a monthly basis. Currently, most syndication agreements call for the Company
      to receive a percentage of revenue generated. Depending on the criteria of
      each
      individual contract and in accordance with EITF 99-19, a determination is made
      as to whether revenue should be recognized gross with a corresponding expense
      for the portion paid to or retained by the partner, or if only the net portion
      should be recognized as revenue. At this time, the Company is still selling
      certain products and services on a “for fee” basis. The Company also recently
      stopped offering to its potential syndication partners volume discounts for
      pre-paid subscriptions, which they can either market or contribute to their
      small business customers, because no volume sales occurred. 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. Online loan origination fees are charged to provide
      users online financing options. The Company receives payments for loans or
      credit provided.





Professional
      service fees are recognized over the term of the consulting engagement as
      services are performed, which is typically one to three months. Advance payments
      for consulting services, if billed and paid prior to completion of the project,
      are recorded as deferred revenue when received. If the fees are not fixed or
      determinable, revenue is recognized as work is performed and billed. In
      determining whether the professional service fees can be accounted for
      separately from subscription and support revenues, the following factors are
      considered for each consulting agreement: availability of the consulting
      services from other vendors, whether objective and reliable evidence for fair
      value exists of the undelivered elements, the nature of the consulting services,
      the timing of when the consulting contract was signed in comparison to the
      subscription service start date, and the contractual dependence of the
      subscription service on the customer’s satisfaction with the consulting
      work.





Syndication
      fees consist primarily of fees charged to syndication partners to create and
      maintain a customized private-label site and ongoing support, maintenance and
      customer service. Syndication agreements typically include an advance fee and
      monthly hosting fees. Integration fees consist primarily of fees charged to
      integration partners to integrate their products into the Company’s platform.
      Amounts that have been invoiced are recorded as accounts receivable and in
      deferred revenue and the revenue is recognized ratably over the specified lives
      of the contracts, commencing on the date the site goes online. Syndication,
      integration and support contracts typically provide for early termination only
      upon a material breach by either party that is not cured in a timely manner.
      If
      a contract terminates earlier than its term, the remaining deferred revenue
      is
      recognized upon termination. It is possible that the estimates of expected
      duration of customer contract lives may change and the period over which such
      revenues are amortized could be adjusted. Any such change in specified contract
      lives could affect future results of operations.


F-9





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      agreements is received upfront. Customers are generally invoiced in annual
      or
      monthly installments and typical payment terms provide that customers pay within
      30 days of invoice. In general, billings are collected in advance of the service
      period.





OEM
      revenues are recorded based on the greater of actual sales or contractual
      minimum guaranteed royalty payments. The Company 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 the Company receives
      notification of such additional royalties.





*Barter
      Transactions -* Barter
      revenue relates to syndication and integration services provided to business
      customers in exchange for advertising in the customers' trade magazines and
      on
      their Web sites. Barter expenses reflect the expense offset to barter revenue.
      The amount of barter revenue and expense is recorded at the estimated fair
      value
      of the services received or the services provided, whichever is more objectively
      determinable, in the month the services and advertising are exchanged. The
      Company applies APB 29, *Accounting for Non-Monetary Transactions* ,
      the
      provisions of EITF 93-11, *Accounting for Barter Transactions Involving Barter Credits,* and EITF
      99-17, *Accounting
      for Advertising Barter Transactions* and,
      accordingly, recognizes barter revenues only to the extent that there have
      been
      similar cash transactions within a period not to exceed six months prior to
      the
      date of the barter transaction. To date the amount of barter revenue to be
      recognized has been more objectively determinable based on integration and
      syndication services provided. For revenue from integration and syndication
      services provided for cash to be considered similar to the integration and
      syndication services provided in barter transactions, the services rendered
      must
      have been in the same media and similar term as the barter transaction. Further,
      the quantity or volume of integration or syndication revenue received in a
      qualifying past cash transaction can only evidence the fair value of an
      equivalent quantity or volume of integration or syndication revenue received
      in
      subsequent barter transactions. In other words, a past cash transaction can
      only
      support the recognition of revenue on integration and syndication contracts
      transactions up to the dollar amount of the cash transactions. When the cash
      transaction has been used to support an equivalent quantity and dollar amount
      of
      barter revenue, that transaction cannot serve as evidence of fair value for
      any
      other barter transaction. Once the value of the barter revenue has been
      determined, the same revenue recognition principles are followed that apply
      to
      cash transactions with unearned revenues being deferred as described more fully
      above. At the time the barter revenue is recorded, an offsetting pre-paid barter
      advertising asset is recorded. This pre-paid barter advertising asset is
      amortized to expense as advertising services are received such as when an
      advertisement runs in a magazine. Barter revenues totaled approximately
      $103,000, $424,000, and $113,000 in 2006, 2005, and 2004, respectively.





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





*Restricted
      Cash* - Under
      the terms of a promissory note between Smart Commerce and Fifth Third Bank,
      $250,000 on deposit at Fifth Third Bank serves as loan collateral and is
      restricted. Such restricted cash is scheduled to be released from the
      restrictions in three equal installments of approximately $83,000, on June
      30,
      2007, December 31, 2007 and June 30, 2008, if the Company meets certain debt
      covenants regarding operating metrics for Smart Commerce.





*Allowance
      for Doubtful Accounts -* The
      need
      for an allowance for doubtful accounts is evaluated based on specifically
      identified amounts that management believes to be uncollectible. Management
      also
      records an additional allowance based on an assessment of the general financial
      conditions affecting its customer base. If actual collections experience
      changes, revisions to the allowance may be required. Based upon the
      aforementioned criteria, management has recorded an allowance of approximately
      $65,000, zero, and zero as of December 31, 2006, 2005 and 2004,
      respectively.


F-10





*Concentration
      of Credit Risk* -
      Financial instruments which potentially subject the Company to concentrations
      of
      credit risk consist principally of cash and accounts receivable. At times,
      cash
      balances may exceed the FDIC insurable limits of $100,000. See Note 13 - “Major
      Customers and Concentration of Credit Risk” for further discussion of risk
      within accounts receivable.





*Prepaid
      Expenses* -
      Prepaid expenses primarily represent advance payments to registries for domain
      name registrations as well as other advance payments for various other expenses.
      Prepaid expenses are amortized to expense on a straight-line basis over the
      period covered by the expenses. In the case of prepaid registry fees, the
      amortization period is consistent with the revenue recognition of the related
      domain name registration.





*Software
      Development Costs -* SFAS No.
      86, *Accounting for the Costs of Software to be Sold, Leased or Otherwise
      Marketed* ,
      requires capitalization of certain software development costs subsequent to
      the
      establishment of technological feasibility. Based on the Company’s product
      development process, technological feasibility is established upon completion
      of
      a working model. Costs related to software development incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant. During 2005, the Company acquired
      certain rights to an accounting software application that has been integrated
      with its OneBiz SM platform, but is still under development. All amounts related to the development
      and modification of this engine have been expensed as research and development
      costs. The remaining portion of the software assignment and development fees
      is
      expected to be earned and payable during 2007.





SFAS
      No.
      2, *Accounting
      for Research and Development Costs,* establishes accounting and reporting standards for research and development.
      In
      accordance with SFAS No. 2, costs to enhance existing products or costs incurred
      after the general release of the service using the product are expensed in
      the
      period they are incurred.





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





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





Office
                equipment
            5
                yearsComputer
                software
            3
                yearsComputer
                hardware
            5
                yearsFurniture
                and fixtures
            7
                yearsAutomobiles
            5
                years





*Intangible
      Assets -* Intangible assets consists primarily of assets obtained through the acquisitions
      of Computility, Inc. (“Computility”) and iMart Incorporated (iMart”). Those
      acquired assets include customer bases, technology, non-compete agreements,
      work
      forces in place and goodwill. The Company also has several patents, copyrights
      and trademarks related to products, names and logos used throughout the product
      lines. All assets are amortized over their estimated useful lives with the
      exception of work forces in place and goodwill which are deemed to have
      indefinite lives and are not amortized.





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


F-11





*Advertising
      Costs -* All
      advertising costs are expensed as incurred. Advertising expense during 2006,
      2005, and 2004 was $49,000, $403,669 and $170,774, respectively. The 2006 period
      includes $38,000 of barter advertising expense. The 2005 period included
      $273,751 of barter advertising expenses. The 2004 period included $205,833
      of
      barter advertising expenses and a credit of $58,400 related to prior advertising
      activities. .





*Net
      Loss per Share -* Basic
      loss per share is computed using the weighted-average number of common shares
      outstanding during the periods. Diluted loss per share is computed using the
      weighted-average number of common and dilutive common equivalent shares
      outstanding during the periods. Common equivalent shares consist of redeemable
      preferred stock, stock options and warrants that are computed using the treasury
      stock method. Shares issuable upon the exercise of redeemable preferred stock,
      stock options and warrants, totaling 2,360,100, 2,791,500, and 2,405,078 shares
      on December 31, 2006, 2005 and 2004, respectively, are excluded from the
      calculation of common equivalent shares as the impact was
      anti-dilutive.





*Stock-Based
      Compensation -* Prior to
      January 1, 2006, the Company accounted for its stock-based compensation plans
      in
      accordance with the intrinsic value provisions of Accounting Principles Board
      Opinion (“APB”) No. 25, *Accounting for Stock Issued to Employees.* Stock
      options are generally granted at prices equal to the fair value of the Company’s
      common stock on the grant dates. Accordingly, no compensation expense was
      recorded in 2005 and 2004. Had compensation expense been recognized consistent
      with the fair value provisions of SFAS No. 123, *Accounting for Stock-Based Compensation* ,
      net
      loss attributed to common stockholders and net loss attributed to common
      stockholders per share for the years ended December 31, 2005 and 2004 would
      have
      been changed to the pro forma amounts indicated below:





**Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**Net
                loss attributed tocommon
                stockholders:As
                reported
            
            $
            (15,590,609
            )
            $
            (8,319,049
            )Add:
                Compensation costrecorded
                at intrinsicValue
            
            
            -
            
            
            161,000Less:
                Compensation cost usingthe
                fair value method
            
            
            (581,494
            )
            
            (455,301
            )Pro
                forma
            
            $
            (16,172,103
            )
            $
            (8,613,350
            )








**Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**Reported
                net loss attributed tocommon
                stockholders:Basic
                and diluted
            
            $
            (1.20
            )
            $
            (0.82
            )Pro
                forma net loss per share:Basic
                and diluted
            
            $
            (1.25
            )
            $
            (0.84
            )





Effective
      January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), *Share-Based
      Payment* (“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


F-12


accordance
      with the provisions of SFAS No. 123 and (ii) compensation cost for all
      share-based payments that are granted subsequent to January 1, 2006, based
      on the grant date fair value estimated in accordance with the provisions of
      SFAS
      No. 123R. Upon adoption, the Company recognized 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 $780,000 for the year ended December 31, 2006.
      No stock-based compensation was capitalized in the consolidated financial
      statements.





The
      fair
      value of option grants under the Company’s equity compensation plan and other
      stock option issuances during the years ended December 31, 2006, 2005 and 2004
      were estimated using the Black-Scholes option-pricing model with the following
      weighted-average assumptions:





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**Dividend
                yield
            
            0.00%
            
            0.00%
            
            0.00%Expected
                volatility
            
            150%
            
            60.20%
            
            0.00%Risk
                free interest rate
            
            4.56%
            
            4.25%
            
            4.23%Expected
                lives (years)
            
            4.7
            
            9.5
            
            8.9





*Management
      Estimates -* The
      financial statements have been prepared in accordance with accounting principles
      generally accepted in the United States of America. In preparing the financial
      statements, management is required to make estimates and assumptions that affect
      the reported amounts of assets and liabilities as of the date of the balance
      sheet and income and expense for the period then ended. Certain estimates made
      pertain to allowance for doubtful accounts, returns, and litigation reserves.
      Actual results could differ from those estimates.





*Reclassifications -* Certain
      2005 balances have been reclassified to conform with their 2006 presentation.
      These reclassifications did not result in a change to total assets, total
      liabilities, equity or net loss as previously reported.





**3.  
      INDUSTRY SEGMENT INFORMATION**





SFAS
      No.
      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 No. 131, the Company has defined two reportable segments, described below,
      based on factors such as geography, how it manages its operations and how the
      chief operating decision-maker views results.





The
      Smart
      Commerce segment's revenues are derived primarily from the development and
      distribution of multi-channel e-commerce systems including domain name
      registration and e-mail solutions, e-commerce solutions, website design and
      website hosting.





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





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





The
      following table shows the Company's financial results by reportable segment
      for
      the year ended December 31, 2006:


F-13





Smart
                Online
            
            Smart
                Commerce
            
            ConsolidatedREVENUES:Integration
                fees
            
            $
            182,660
            
            $
            -
            
            $
            182,660Syndication
                fees
            
            
            218,386
            
            
            -
            
            
            218,386Subscription
                fees
            
            
            73,978
            
            
            1,830,214
            
            
            1,904,192Professional
                services fees
            
            
            -
            
            
            1,269,300
            
            
            1,269,300Other
                Revenues
            
            
            38,114
            
            
            32,238
            
            
            70,352Total
                Revenues
            
            
            513,138
            
            
            3,131,752
            
            
            3,644,890COST
                OF REVENUES
            
            
            58,560
            
            
            270,951
            
            
            329,511OPERATING
                EXPENSES
            
            
            6,864,287
            
            
            1,816,704
            
            
            8,680,991OPERATING
                INCOME (LOSS)
            
            
            (6,409,709
            )
            
            1,044,097
            
            
            (5,365,612
            )OTHER
                INCOME (LOSS)
            
            
            2,899,310
            
            
            (31,842
            )
            
            2,867,468DISCONTINUED
                OPERATIONS
            
            
            (2,525,563
            )
            
            -
            
            
            (2,525,563
            )NET
                INCOME/(LOSS) BEFORE INCOME TAXES
            
            $
            (6,035,962
            )
            $
            1,012,255
            
            $
            (5,023,707
            )TOTAL
                ASSETS
            
            $
            6,554,944
            
            $
            878,065
            
            $
            7,433,009











**4.    MARKETABLE
      SECURITIES**





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





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





The
      Company did not hold any marketable securities as of December 31,
      2006.





**5.     PROPERTY
      AND EQUIPMENT**





Property
      and equipment consists of the following at:





**December
                31,**
              **2006**
            
            
            **December
                31,**
              **2005**Office
                equipment
            $
            88,715
            
            $
            144,290Furniture
                and fixtures
            
            7,125
            
            
            7,125Computer
                software
            
            552,585
            
            
            550,775Computer
                hardware and equipment
            
            803,225
            
            
            746,499Automobiles
            
            29,504
            
            
            29,5041,481,154
            
            
            1,478,193Less
                accumulated depreciation
            
            (1,300,794
            )
            
            (1,261,224
            )Property
                and equipment, net
            $
            180,360
            
            $
            216,969





F-14





Depreciation
      expense for the years ended December 31, 2006, 2005 and 2004 was $79,313,
      $150,204 and $47,167, respectively.





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





Intangible
      assets consist primarily of intangibles acquired during the Computility and
      iMart acquisitions in October 2005 (See Note 17 - “Acquisitions &
Dispositions” for details on intangible assets sold during 2006). In addition to
      these assets acquired, the Company has copyrights and trademarks related to
      products, names and logos used throughout the 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**
            **Carrying**
              **Value**Customer
                Base
            $ 
                1,944,347
            $0
            5.9
            $  
                405,525
            $ 
                 1,538,822Technology
            $
                    501,264
            $0
            3
            $ 
                 201,898
            $  
                  299,366Non-Compete
            $  
                  891,785
            $0
            3.9
            $  
                279,706
            $  
                  612,079Copyright
                & Trademark
            $  
                    50,339
            $0
            10
            $
                    38,629
            $  
                    11,710Trade
                Name *
            $
                 1,155,500
            n/a
            n/a
            n/a
            $ 
                1,155,500Work
                Force &
              Goodwill
                *
            $  
                2,696,642
            n/a
            n/a
            n/a
            $   2,696,642**TOTALS**
            **$
                7,239,877**
            
            
            **$
                925,758**
            **$
                6,314,119**





*
      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.*





Intangible
      assets acquired, excluding goodwill, were valued based on the results of an
      independent valuation performed by a certified appraiser. Goodwill was
      calculated as the difference between the purchase price of the acquisition
      (which was negotiated in an arms-length transaction) 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.





For
      the
      years ended December 31, 2006, 2005 and 2004, the aggregate amortization expense
      on the above intangibles was approximately $702,886, $260,788 and $4,365,
      respectively. The estimated aggregate amortization expense for the years ended
      December 31, 2007 through 2011 will be approximately $737,457, $695,147,
      $469,253, $200,639 and $200,639 for each respective year. All intangible assets
      are amortized using the straight-line method over their estimated useful
      lives.





**7.** **.** **DEFERRED
      COMPENSATION**





Certain
      officers of the Company deferred a portion of their compensation, including
      commissions and interest charges on previously earned but unpaid compensation,
      from the second quarter of 2001 until September, 2003. In October 2003, these
      salary deferrals plus interest were converted to promissory notes (the “2003
      Notes”) in the aggregate amount of $1,049,765. These notes were payable on or
      before May 31, 2004 and bore interest at a rate of 15% per annum. During the
      fourth quarter of 2003 and the first quarter of 2004, these officers deferred
      an
      additional $141,771. Additionally, during this period $50,135 of the original
      notes payable were repaid. In April 2004, the holders of the 2003 Notes agreed
      to exchange the existing notes for new promissory notes payable on or before
      December 31, 2005 ("2004 Notes"). The principal amount of the 2004 Notes,
      $1,141,401, included the unpaid principal from the original notes plus the
      subsequent deferrals. Subsequently during 2004, $191,624 was repaid against
      the 2004 Notes and an additional $2,302 of compensation was deferred. The
      2004 Notes bore interest at a rate of 15% per annum through June 1, 2004 at
      which time the holders voluntarily reduced the rate to 8% per annum. On April
      30, 2004,
      the
      2004 Notes were extended until May 31, 2005, but later during 2004 the officers
      entered into standstill agreements not to demand payment until June 30, 2006.
      The standstill agreement was again amended on December 22, 2004, to provide
      that
      demand for payment could be made upon the earlier of June 30, 2006 or the
      closing after January 1, 2005 of a financing with gross proceeds to the Company
      of $2,000,000 or more. After the Company raised $2,500,000 from a sale of
      securities to a foreign investor in February 2005, it paid in full the $949,777
      of deferred compensation, plus all accrued interest of $154,288, and cancelled
      the related promissory notes to these officers.


F-15





**8.    LOANS**





During
      2000, the Company borrowed $125,000 from a stockholder, David Williams. The
      loan
      accrued interest at a rate of 8.0% per annum and was repaid in March 2004
      including accrued interest of $33,534.





During
      2002, William Furr, a relative of one of the Company’s officers, loaned the
      Company $270,000. In consideration for this loan, the Company issued 20,000
      shares of restricted stock to this individual without additional consideration
      by Mr. Furr. The value of these shares was not significant. Subsequently during
      2002, the Company repaid $225,000 of this indebtedness. In 2003, it borrowed
      an
      additional $190,000 from this individual and repaid $10,000. In consideration
      for extending the term of the 2002 borrowings and for loaning the additional
      $190,000, the Company issued this individual an additional 150,000 shares of
      common stock. It recorded interest expense of $75,000 in 2003 and 2004 related
      to this issuance. In addition, this note accrued interest at a rate of 15%
      per
      annum. In March 2004, the Company repaid this indebtedness in full plus accrued
      interest of $10,264.





**9.    NOTES
      PAYABLE**





On
      November 9, 2006, Smart Commerce entered into a loan agreement with Fifth Third
      Bank. Under the terms of this agreement, Smart Commerce borrowed $1.8 million
      to
      be repaid in 24 monthly installments of $75,000 plus interest beginning in
      December 2006. The interest rate is prime plus 1.5% as periodically determined
      by Fifth Third Bank. The loan is secured by all of the assets of Smart Commerce,
      including a cash security account of $250,000 and all of Smart Commerce’s
      intellectual property. The loan is guaranteed by the Company and such guaranty
      is secured by all the common stock of Smart Commerce. Under the terms of the
      loan agreement, Smart Commerce established a lock box account with Fifth Third
      Bank, but has the right to use the amounts deposited in the account for any
      purpose not inconsistent with the loan agreement and related documents so long
      as no event of default exists and is continuing. Such restricted cash is
      scheduled to be released from the restrictions in three equal installments
      of
      approximately $83,000, on June 30, 2007, December 31, 2007 and June 30, 2008,
      if
      the Company meets certain debt covenants regarding operating metrics for Smart
      Commerce.





On
      November 14, 2006, the Company entered into a revolving credit arrangement
      with
      Wachovia Bank, NA ("Wachovia") for $1.3 million which can be used for general
      working capital. Any advances made on the line of credit are to be paid off
      no
      later than August 1, 2007, with monthly payments of accrued interest on any
      outstanding balance commencing on December 1, 2006. The interest shall accrue
      on
      the unpaid principal balance at the LIBOR Market Index Rate plus 0.9%. The
      line
      of credit is secured by the Company’s deposit account at Wachovia and an
      irrevocable standby letter of credit in the amount of $1,300,000 issued by
      HSBC
      Private Bank (Suisse) S.A. with Atlas Capital, S.A. (“Atlas”), a current
      stockholder, as account party. Atlas and the Company have separately agreed
      that
      in the event of a default by the Company in the repayment of the line of credit
      that results in the letter of credit being drawn, it shall reimburse Atlas
      any
      sums that Atlas is required to pay under such letter of credit. At the sole
      discretion of the Company, these payments to Atlas may be made in cash or by
      issuing shares of the Company’s common stock at a set per share price of $2.50.
      As of December 31, 2007, the unused line of credit with Wachovia was
      $698,000.





As
      of
      December 31, 2006, the Company had Notes Payable totaling $3,664,631. The detail
      of these notes is as follows:


F-16





Note
                Description
            S/T
                Portion
            L/T
                Portion
            Total
            Maturity
            RateiMart
                Purchase Price Note
            $   
                601,435
            $             
                -
            $   
                601,435
            Jan
                2007
            8.0%iMart
                Non-Compete Note
            378,526
            -
            378,526
            Oct
                2007
            8.0%Acquisition
                Fee - iMart
            209,177
            -
            209,177
            Oct
                2007
            8.0%Acquisition
                Fee - Computility
            148,493
            -
            148,493
            Mar
                2007
            8.0%Fifth
                Third Note
            900,000
            825,000
            1,725,000
            Nov
                2008
            Prime
                + 1.5%Wachovia
                Credit Line
            602,000
            -
            602,000
            Aug
                2007
            Libor
                + 0.9%**TOTALS**
            **$2,839,631**
            **$825,000**
            **$3,664,631**








As
      of
      December 31, 2006, the prime rate was 8.25% and LIBOR was 5.32%.





The
      five-year schedule of note maturity is as follows:




2007:
            
            $
            2,839,6312008:
            
            
            825,000TOTAL:
            
            $
            3,664,631





Prior
      to
      the purchase of Computility and for the period following the acquisition, new
      customer contracts were typically factored to provide working capital.
      Subscription financing payable represents the amount of customer contracts
      that
      had been factored. Contracts were typically factored with 30 to 36 months
      remaining. In February 2005, Computility entered into a Floor Plan Agreement
      with a finance company that provided additional debt financing of $150,000
      for
      working capital. The debt was secured by subscription revenues and was required
      to be repaid in 12 equal monthly installments beginning in March 2006. Interest
      was at the corporate prime rate plus 4%. The Company assumed this debt as part
      of the October 2005 acquisition (asset purchase) of Computility. As part of
      the
      sale of substantially all of the assets of Smart CRM in September 2006, both
      of
      these liabilities were assumed by the purchaser.





**10.    LEASES**




*Operating
      Leases* -
      The
      Company leases two facilities, one in Iowa and one in North Carolina, under
      renewable operating lease agreements which current terms expire in October
      2008
      and October 2007, respectively. As of December 31, 2006, future annual minimum
      operating lease payments are as follows:




2007
            
            $
            128,0002008
            
            $
            15,000Total
            
            $
            143,000





Rent
      expense for the years ended December 31, 2006, 2005, and 2004 was $258,623,
      $251,800 and $99,606, respectively.





**11.    STOCKHOLDERS'
      DEFICIT**





*Corporate
      Reorganization*





During
      the first quarter of 2004, the Company completed a corporate reorganization
      of
      its capital stock, which eliminated its Series A Preferred Stock. All holders
      of
      Series A Preferred Stock who participated in the reorganization received 2.218
      shares of common stock for each share of Series A Preferred Stock they held
      prior to the reorganization, and also received the right to receive cash
      payments from the Company equal to a percentage of the net proceeds the Company
      raised in excess of $5 million of net proceeds from sales of equity securities
      and convertible debt securities during calendar year 2004. The Company received
      net proceeds of $4,763,644 from the sale of equity and convertible debt
      securities during calendar year 2004, and therefore had no liability to the
      former holders of Series A Preferred Stock.


F-17





Participating
      holders of Series A Preferred Stock who signed the Reorganization Agreements
      also agreed to transfer restrictions on a portion of the common stock they
      received in the reorganization that include, among other restrictions, a
“lock-up” agreement preventing the sale or transfer of the shares (other than
      transfers to certain related parties). Pursuant to the lock-up agreement
      commencing October 1, 2005 through September 30, 2006 each holder could transfer
      up to 8.5% of such holder's shares that are subject to the restrictions during
      each calendar month. The Reorganization Agreements also contained mutual
      releases by the Company and participating holders of Series A Preferred
      Stock.





*Common
      Stock*





The
      Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
      value per share. As of December 31, 2006, it had 15,379,030 shares of
      common stock outstanding. Holders of common stock are entitled to one vote
      for
      each share held.





During
      the first half of 2004, following the conversion of its Series A Preferred
      Stock
      as described above, the Company sold 999,141 shares of common stock to new
      and
      existing stockholders at a purchase price of $3.50 per share, resulting in
      gross
      proceeds of $3,496,994. It incurred issuance costs of $163,350 related to these
      sales, including $31,000 paid to an officer of the Company. As an inducement
      to
      one of the investors that participated in this round of financing, an officer
      of
      the Company and a stockholder entered into a Put Agreement, dated March 10,
      2004, with the investor. The Company was not a party to this agreement, but
      this
      agreement was entered into at the time of the investment into the Company to
      provide comfort to the investor that the Company would fulfill its obligation
      to
      cause its common stock to be publicly traded. The Put Agreement gave the
      investor the right to require the grantors to purchase for $2.2 million the
      628,571 shares of common stock and warrants to purchase 188,571 shares of common
      stock held by the investor. The Put Agreement could have been exercised at
      the
      sole discretion of the investor during the month of March 2005 or during the
      month of March 2006. The Put Agreement terminated and the put option cannot
      be
      exercised after (i) the common stock of the Company is listed or quoted for
      public trading, or (ii) the Company’s stockholders vote to approve any action
      reasonably necessary to cause the Company’s common stock to be publicly traded,
      but the aforementioned investor votes against the action, or (iii) the
      aforementioned investor transfers any of its common stock or warrants to a
      third
      party.  The Put Agreement cannot be assigned and terminates if the investor
      transfers the securities covered by the Put Agreement. As a result the
      registration of the Company’s common stock, this Put Agreement was cancelled in
      March 2005.





On
      August
      6, 2004, the Company made a rescission offer to stockholders who purchased
      999,141 shares of common stock and warrants to acquire an additional 288,638
      shares of common stock for $3.50 per share in a private placement conducted
      during March through June of 2004. The rescission offer was made because in
      connection with the audit of its financial statements and due diligence review
      of information in connection with the registration of shares sold in the private
      placement described above, the Company identified certain inaccuracies and
      omissions in the information it provided to investors in the private placement.
      These inaccuracies and omissions included changes to how the Company recognized
      revenue, establishing reserves for contingent liabilities, inventory, accounts
      receivable, and equipment write downs and other accounting adjustments, failing
      to disclose the effects of anti-dilution provisions after dilutive issuances
      and
      failure to disclose information about customers, discounting, promotions and
      other product price information. In the rescission offer, the Company offered
      to
      repurchase all the shares and warrants sold in the private placement for the
      original purchase price, plus interest, and afforded stockholders a thirty-day
      period in which to accept the rescission offer. One stockholder accepted the
      rescission offer and the Company paid that stockholder $102,610 as payment
      in
      full of the purchase price, including interest thereon of $2,608 in exchange
      for
      28,572 shares of common stock and warrants to purchase 7,500 shares of common
      stock. No other stockholders accepted the rescission offer and all stockholders
      to whom the offer was made executed and delivered releases for any potential
      liabilities arising out of disclosures made by the Company in the private
      placement.





In
      connection with the private placement conducted during March through June of
      2004, the Company and the investors executed registration rights agreements.
      This registration rights agreement required the Company to pay investors 2%
      of
      their investment for each thirty-day period after July 1, 2004 in which the
      Company failed to file a registration statement registering shares sold in
      the
      private placement, which amount is prorated for partial 30-day periods. The
      registration rights agreements provided that the Company could choose to pay
      this by issuing shares of its common stock in lieu of cash, which it chose
      to
      do. On September 29, 2004, the Company issued 58,226 shares of its common stock
      to satisfy amounts that accrued through September 29, 2004 at the rate of one
      share for each $3.50 of accrued penalty liability. The Company recorded the
      issuance of these shares, at the fair value of $206,085, as a dividend to the
      respective stockholders.


F-18





During
      August and September 2004, the Company sold 290,000 shares of its common stock
      to new and existing investors in a private placement for a price of $5.00 per
      share resulting in gross proceeds of $1,450,000. The Company incurred issuance
      costs of $20,000 related to these sales and also incurred $31,000 in consulting
      expense that was paid to an officer of the Company related to this financing.
      As
      an inducement to one of the investors that participated in this round of
      financing, an officer of the Company and a stockholder entered into a Put
      Agreement dated August 13, 2004 with the investor. The Company was not a party
      to this agreement, but this agreement was entered into at the time of the
      investment in the Company to provide comfort to the investor that the Company
      would fulfill its obligation to cause its common stock to be publicly traded.
      The Put Agreement gave the investor the right to require the grantors to
      purchase 100,000 shares of common stock held by the investor for $500,000.
      The
      Put Agreement could have been exercised at the sole discretion of the investor
      during the month of March 2005 or during the month of March 2006. The Put
      Agreement terminates and the put option cannot be exercised after (i) the common
      stock of the Company became listed or quoted for public trading, or (ii) the
      stockholders of the Company vote to approve any action reasonably necessary
      to
      cause the Company's stock to be publicly traded, but the aforementioned investor
      votes against the action, or (iii) the aforementioned investor transfers any
      of
      its common stock or warrants to a third party.  The Put Agreement cannot be
      assigned and terminates if the investor transfers the securities covered by
      the
      Put Agreement. As a result of the Company registering its common stock, this
      put
      agreement was cancelled in March 2005.





During
      February and March 2005, the Company sold 500,000 and 80,000 shares of common
      stock, respectively, to foreign investors in sales exempt under Regulation
      S.
      The February and March 2005 stock sales resulted in gross proceeds of $2,500,000
      and $400,000, respectively. A portion of those funds was used to repay deferred
      compensation, including interest thereon, as more fully discussed in Note 7.
      In
      connection with this financing, the Company incurred stock issuance costs
      of $290,000 to an entity that is an existing stockholder. Concurrent with
      the sale of common stock, the Company issued warrants to purchase 50,000 shares
      of common stock to this investor in consideration for the investor agreeing
      to
      certain restrictions on their ability to sell the shares. These warrants have
      an
      exercise price of $5.00 per share and terminate on January 1, 2007. During
      February 2005, the Company raised an additional $125,000 in gross proceeds
      from
      the sale of 25,000 shares of common stock at $5.00 per share in a private
      placement.





During
      the third quarter of 2005, the Company sold 786,642 shares of its common stock
      to new and existing investors for a price of $5.50 per share resulting in gross
      proceeds of $4,326,531. In connection with this financing, the Company incurred
      stock issuance costs of $340,525 to an entity introduced to it by an existing
      stockholder, Doron Roethler. Additionally, in connection with these offerings,
      the Company entered into Registration Rights Agreements with these stockholders
      under which the Company is required to file a registration statement with the
      SEC to register the shares sold in the offering no later than September 30,
      2005. As of December 31, 2006, the Company had accrued $465,347 of registration
      rights penalties which the Company expects to pay in stock. The accrual of
      this
      penalty has been treated as a period cost as part of general and administrative
      expenses.





During
      2005, the Company paid a bonus of 4,200 shares of its common stock to
      non-officer employees. The Company recorded approximately $40,000 of
      compensation expense related to this bonus payment.  The expense associated
      with the stock bonus was calculated based upon the fair market value of the
      common stock on the date the bonus was awarded.





On
      March
      30, 2006, the Company sold 400,000 shares of its common stock to Atlas, an
      existing stockholder, for a price of $2.50 per share resulting in gross proceeds
      of $1,000,000. The Company 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 the Company enter into a private placement
      agreement in the future in which the Company sells shares of common stock for
      less than $2.50 per share.


F-19





On
      May
      31, 2006, the Company entered into a Settlement Agreement with General
      Investments Capital, Ltd. (“GIC”) with respect to a Consulting Agreement, dated
      October 26, 2005. Under the Consulting Agreement, GIC was to receive 625,000
      shares of the Company's common stock (the “GIC Shares”) and a cash payment of
      $250,000 (the “GIC Cash Fee”) for investor relations consulting services. The
      Company paid the entire GIC Cash Fee, and the GIC Shares were, but never
      delivered. Under the Settlement Agreement, GIC agreed, in part, to release
      its
      claim to the GIC Shares, but retained the GIC Cash Fee as consideration for
      services performed under the Consulting Agreement and for entering into the
      Settlement Agreement. The parties also mutually released each other from any
      additional payment or services under the Consulting Agreement. The Company
      recorded a gain of $1,562,500 related to this settlement.





On
      June
      29, 2006, the Company sold 400,000 shares of its common stock to Atlas for
      a
      price of $2.50 per share resulting in gross proceeds of $1,000,000. The Company
      incurred immaterial issuance costs related to this stock sale.





On
      July
      6, 2006, the Company sold 100,000 shares of common stock to the Blueline Fund
      (“Blueline”), an existing investor for a price of $2.50 per share resulting in
      gross proceeds of $250,000. The Company incurred immaterial issuance costs
      related to this stock sale.





In
      August
      2006, the Company sold an aggregate of 100,000 shares of its common stock to
      Blueline and Phillippe Pouponnot, for a price of $2.50 per share, resulting
      in
      gross proceeds of $250,000. The Company incurred immaterial issuance costs
      related to these stock sales.





On
      August
      30, 2006, the Company entered into a Settlement Agreement with Berkley Financial
      Services, Ltd. (“Berkley”) with respect to a Consulting Agreement, dated October
      26, 2005. Under the Consulting Agreement, Berkley was to receive 625,000 shares
      of the Company's common stock (the “Berkley Shares”) and a cash payment of
      $250,000 (the “Berkley Cash Fee”) for investor relations consulting services.
      The Company paid the entire Berkley Cash Fee, and the Berkley Shares were
      issued, but never delivered. Under the Settlement Agreement, Berkley agreed,
      in
      part, to release its claim to the Berkley Shares, but retained the Berkley
      Cash
      Fee as consideration for services performed under the Consulting Agreement
      and
      for entering into the Settlement Agreement. The parties also mutually released
      each other from any additional payment or services under the Consulting
      Agreement. The Company recorded a gain of $1,562,500 related to this
      settlement.





*Preferred
      Stock*





The
      Board
      of Directors is authorized, without further stockholder approval, to issue
      up to
      5,000,000 shares of $0.001 par value preferred stock in one or more series
      and
      to fix the rights, preferences, privileges and restrictions applicable to such
      shares, including dividend rights, conversion rights, terms of redemption and
      liquidation preferences, and to fix the number of shares constituting any series
      and the designations of such series.





In
      March
      2004, the outstanding shares of the Company's Series A Preferred Stock were
      converted to common stock pursuant to a plan of reorganization approved by
      the
      Company's Board of Directors and stockholders. The carrying value of $19,724,839
      for the Series A Preferred Stock at date of conversion was re-classed to common
      stock and additional paid-in capital. The Series A Preferred Stock was
      convertible into common stock at an initial rate of one share of common stock
      for each share of Series A Preferred Stock but the conversion rate increased
      to
      approximately 1.22 shares of common stock for each share of Series A Preferred
      Stock at the time of conversion pursuant to weighted average antidilution
      provisions. Additionally, the Series A Preferred Stock had a non-cumulative
      dividend rate of $0.35 per quarter, a liquidation preference of $15.12 per
      share, plus declared unpaid dividends, was entitled to cast one vote for each
      share of common stock into which it was convertible voting as a single class
      with the common stock, had class voting rights with respect to certain major
      corporate events and was redeemable at the option of its holders after August
      31, 2004 for a price equal to $14 per share, plus 7% compounded annually. There
      were no shares of Preferred Stock outstanding at December 31,
      2006.


F-20





In
      connection with the 2004 conversion of the Series A Preferred Stock, the Company
      offered an inducement of one share of common stock in exchange for contractual
      commitments in addition to the contractual conversion noted in the preceding
      paragraph. In accordance with SFAS No. 84, *Induced Conversions of Convertible Debt* ,
      the
      Company recorded the $3.2 million premium as a charge to arrive at net loss
      available to common stockholders.





*Warrants*





On
      September 3, 2004, Bank One exchanged a warrant for 100,000 shares of common
      stock of the Company, which were issued to J P Morgan Chase & Co., an
      affiliate of Bank One. The fair value of the shares issued was $350,000 which
      was recorded as an expense in the 2004 statement of operations.





During
      2004, the Company issued warrants to purchase an aggregate of 288,638 shares
      of
      common stock (7,500 of which were cancelled as part of the rescission offer
      previously described) to stockholders in connection with the 2004 common stock
      issuance previously described. These warrants have an exercise price of $3.50
      per share. During November 2004, warrants to purchase 2,460 shares of common
      stock at $3.50 per share were exercised resulting in proceeds of
      $8,610.





During
      February 2005, a consulting firm that was issued warrants to purchase 350,000
      shares of common stock in November 2003 acquired 50,000 shares of the Company's
      common stock as a result of the cashless exercise of warrants. Warrants to
      purchase 67,568 shares of common stock were cancelled in this cashless exercise.
      The fair market value of the Company's common stock at the time of exercise
      was
      $5.00. During May 2005, this same consulting firm acquired 48,617 shares of
      the
      Company's common stock as a result of the cashless exercise of warrants.
      Warrants to purchase 62,432 shares of common stock were cancelled in this
      cashless exercise. The fair market value of the Company's common stock at the
      time of exercise was $5.875.





During
      2005, holders of warrants to purchase 355,428 shares of common stock exercised
      their warrants resulting in gross proceeds to the Company of $1,175,998. The
      warrants had exercise prices that ranged from $1.30 to $5.00 per
      share.





During
      2006, holders of warrants to purchase 17,000 shares of common stock exercised
      their warrants resulting in gross proceeds to the Company of $22,100. The
      warrants had an exercise price of $1.30 per share.





All
      the
      foregoing warrants contain cashless exercise provisions, and as of December
      31,
      2006, all had either been exercised or expired.





*Stock
      Option Plans*





*2004
      Equity Compensation Plan*





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





During
      the second quarter of 2004, the Company granted options to purchase 394,000
      shares of common stock to its employees and officers at an exercise price of
      $3.50 per share. Additionally, during May 2004, the Company issued options
      to
      purchase 50,000 shares of common stock to a consultant at an exercise price
      of
      $3.50 per share. The fair value of the options at the grant date was not
      significant.


F-21





On
      July
      1, 2004, the Company granted options to purchase 75,000 shares of common stock
      to an officer of the Company. This option had an exercise price of $3.50 per
      share and a term of ten years. The fair value of the option, issued to the
      consultant, at the grant date was not significant.





During
      the third quarter of 2004, the Company granted options to purchase 80,000 shares
      of common stock under the 2004 Plan to members of the Company's advisory
      committee. These options had an exercise price of $3.50 per share, a term of
      five years, and vest 12.5% per meeting each committee member attends. The
      Company recorded consulting expense of $6,034 during 2004 related to these
      options.





During
      November 2004, the Company granted options to purchase 6,000 shares of common
      stock under the 2004 Plan to a consultant. These options had an exercise price
      of $5.00 per share, a term of ten years, and vested and became exercisable
      on
      December 1, 2004. The Company recorded consulting expense of $1,495 during
      the
      fourth quarter of 2004 related to these options.





During
      April 2005, the Company granted options to purchase 180,000 shares of common
      stock to a consultant, 34,000 shares of common stock to new Board members,
      25,000 shares to an officer, and 2,500 shares to an employee. All options were
      granted at an exercise price of $5.00 per share.





During
      July 2005, the Company granted options to purchase 721,250 shares of common
      stock to employees and officers and an additional 20,000 options to members
      of
      the Board of Directors. These options contain an exercise price of $8.61 per
      share. Also during July 2005, options to purchase 150,000 shares at a weighted
      average exercise price of $5.00 per share expired unexercised.





At
      December 31, 2006, options to purchase 1,494,200 shares of common stock were
      outstanding under the 2004 Plan with a weighted-average exercise price of $6.14
      per share.





*2001
      Equity Compensation Plan*





The
      Company adopted the 2001 Equity Compensation Plan (the “2001 Plan”) as of May
      31, 2001. The 2001 Plan provides for the grant of incentive stock options,
      nonstatutory stock options, restricted stock, and other direct stock awards
      to
      employees (including officers) and directors of the Company as well as to
      certain consultants and advisors. The total number of shares of common stock
      reserved for issuance under the 2001 Plan is 870,000 shares, subject to
      adjustment in the event of stock split, stock dividend, recapitalization or
      similar change.





During
      February 2004, the Company granted options to purchase 150,000 shares of common
      stock to two officers of the Company at an exercise price of $1.30 per share.
      The Company recorded $161,000 of compensation expense during 2004 related to
      the
      grant of these options.





At
      December 31, 2006, options to purchase 670,000 shares of common stock were
      outstanding under the 2001 Plan. As of April 15, 2004, the Company cannot make
      any further grants under the 2001 Plan.





*1998
      Stock Option Plan*





The
      Company adopted the 1998 Equity Compensation Plan (the “1998 Plan”) as of
      November 12, 1998. The 1998 Plan provides for the grant of options intended
      to
      qualify as “incentive stock options,” and options that are not intended to so
      qualify or “nonstatutory stock options.” As of December 31, 2006, the total
      number of shares of common stock reserved for issuance under the 1998 Plan
      is
      288,900 shares, subject to adjustment in the event of stock split, stock
      dividend, recapitalization or similar change. Options to purchase 21,200 shares
      were outstanding under the 1998 Plan at December 31, 2006. As of April 15,
      2004,
      the Company may not make any further grants under the 1998 plan.





*Additional
      Options Granted*





Additionally,
      at December 31, 2006, options to purchase 250,000 shares of common stock issued
      in the third quarter of 2005 were outstanding outside any of the aforementioned
      stock option plans.


F-22





The
      exercise price for incentive stock options granted under the above plans is
      required to be no less than the fair market value of the common stock on the
      date the option is granted, except for options granted to 10% stockholders,
      which are required to have an exercise price of not less than 110% of the fair
      market value of the common stock on the date the option is granted. Incentive
      stock options typically have a maximum term of 10 years, except for option
      grants to 10% stockholders, which are subject to a maximum term of 5 years.
      Nonstatutory stock options have a term determined by either the Board of
      Directors or the Compensation Committee. Options granted under the plans are
      not
      transferable, except by will and the laws of descent and
      distribution.





A
      summary
      of the status of the plan and other stock option issuances as of December 31,
      2004, 2005 and 2006, and changes during the periods ended on these dates is
      as
      follows:





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                January 1, 2004
            
            
            1,358,900
            
            $
            3.16Granted
            
            
            755,000
            
            $
            3.07Forfeited
            
            
            (345,000
            )
            $
            4.12BALANCE,
                December 31, 2004
            
            
            1,768,900
            
            $
            2.78Granted
            
            
            1,535,950
            
            $
            7.98Exercised
            
            
            (16,500
            )
            
            3.50Forfeited
            
            
            (560,400
            )
            $
            3.61BALANCE,
                December 31, 2005
            
            
            2,727,950
            
            $
            5.34Granted
            
            
            256,500
            
            $
            7.61Forfeited
            
            
            (624,350
            )
            $
            7.13BALANCE,
                December 31, 2006
            
            
            2,360,100
            
            $
            5.33





The
      following table summarizes information about stock options outstanding at
      December 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**$
                1.30 - $ 1.43
            595,000
            3.0
            $ 
                1.41
            595,000
            $  
                1.41$
                2.50 - $ 3.50
            512,500
            8.2
            $ 
                3.39
            322,540
            $  
                3.49$
                5.00
            252,400
            8.8
            $ 
                5.00
            170,400
            $  
                5.00$
                7.00
            153,000
            9.7
            $ 
                7.00
            53,000
            $  
                7.00$
                8.61 - $ 9.00
            586,000
            9.5
            $ 
                8.70
            88,900
            $  
                8.61$
                9.60 to $ 9.82
            261,200
            2.5
            $ 
                9.82
            110,240
            $  
                 9.82





At
      December 31, 2006, there remains $2,529,044 of unvested expense yet to be
      recorded related to all options outstanding. Information, based on the date
      of
      issuance, regarding options for the year ended December 31, 2006:





Shares
            
            Weighted
              Average
              Exercise
                Price
            
            Weighted
                Average
              Fair
                ValueYear
                Ended December 31, 2006Exercise
                price exceeds market price
            -
            
            -
            
            -Exercise
                price equals market price
            256,500
            $
            7.61
            $
            6.97Exercise
                price is less than market price
            -
            
            -
            
            -





F-23








The
      number of options exercisable at December 31, 2006, 2005 and 2004 were
      1,340,080, 1,057,698 and 1,367,560, respectively. The weighted average exercise
      price was $5.33 at December 31, 2006





*Dividends* - The
      Company has not paid any cash dividends through December 31, 2006.





**12.    INCOME
      TAXES**





The
      Company accounts for income taxes under the asset and liability method in
      accordance with the requirements of SFAS No. 109, *Accounting
      for Income Taxes* (“SFAS
      No. 109”). Under the asset and liability method, deferred income taxes are
      recognized for the tax consequences of “temporary differences” by applying
      enacted statutory tax rates applicable to future years to differences between
      the financial statement carrying amounts and the tax bases of existing assets
      and liabilities.





The
      balances of deferred tax assets and liabilities are as follows:





**December
                31,**
              **2006**
            
            **December
                31,**
              **2005**
            
            **December
                31,**
              **2004**Net
                current deferred income tax
              assets
                relate to:Depreciation
            
            $
            159,000
            
            $
            6,000
            
            $
            3,000Stock
                Based Expenses
            
            
            226,000
            
            
            226,000
            
            
            226,000Net
                operating loss carryforwards
            
            
            14,275,000
            
            
            13,111,000
            
            
            11,015,000Total
            
            
            14,660,000
            
            
            13,343,000
            
            
            11,244,000Less
                valuation allowance
            
            
            14,660,000
            
            
            13,343,000
            
            
            11,244,000Net
                current deferred income tax
            
            $
            -
            
            $
            -
            
            $
            -





Under
      SFAS No. 109, a valuation allowance is provided when it is more likely than
      not
      that the deferred tax asset will not be realized.





Total
      income tax expense differs from expected income tax expense (computed by
      applying the U.S. federal corporate income tax rate of 34% to profit (loss)
      before taxes) as follows:





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**Statutory
                federal tax rate
            
            
            34
            %
            
            34
            %
            
            34
            %Tax
                benefit computed at statutory rate
            
            $
            (1,708,000
            )
            $
            (5,257,000
            )
            $
            (908,000
            )State
                income tax benefit, net of federal effect
            
            
            (229,000
            )
            
            (704,000
            )
            
            (121,000
            )Change
                in valuation allowance
            
            
            1,317,000
            
            
            2,140,000
            
            
            927,000SFAS
                No. 123R permanent difference
            
            
            265,000
            
            
            -
            
            
            -Investor
                relations shares permanent difference
            
            
            (1,205,000
            )
            
            3,808,000Book
                loss in excess of tax on disposal of assets
            
            
            1,425,000
            
            
            -
            
            
            -Other
                adjustments
            
            
            -
            
            
            -
            
            
            77,000Other
                permanent differences
            
            
            135,000
            
            
            13,000
            
            
            25,000Total
            
            $
            -
            
            $
            -
            
            $
            -








F-24


As
      of
      December 31, 2006, the Company had U.S. federal net operating loss (“NOL”)
      carryforward of approximately $38 million, which expires between 2009 and 2020.
      For state tax purposes, the NOL expires between 2009 and 2020. In accordance
      with Section 382 of the Internal Revenue Code of 1986, as amended, a change
      in
      equity ownership of greater than 50% of the Company within a three-year period
      can result in an annual limitation on the Company's ability to utilize its
      NOL
      carryforwards that were created during tax periods prior to the change in
      ownership.





**13.    MAJOR
      CUSTOMERS AND CONCENTRATION OF CREDIT RISK**





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





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





Year
                Ended December 31, 2006Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Professional
                Services
            
            $
            1,011,181
            
            
            27.7
            %Customer
                B
            
            
            Subscription
            
            
            1,649,703
            
            
            45.3
            %Others
            
            
            Various
            
            
            984,006
            
            
            27.0
            %Total
            
            
            
            
            $
            3,644,890
            
            
            100.0
            %








Year
                Ended December 30, 2005Revenues
            
            %
                of Total
              RevenuesCustomer
                B
            
            
            Subscription
            
            $
            319,874
            
            
            14.8
            %Others
            
            
            Various
            
            
            1,835,551
            
            
            85.2
            %Total
            
            
            
            
            $
            2,155,425
            
            
            100.0
            %








Year Ended
                December 30, 2004Revenues
            
            %
                of Total
              RevenuesCustomer
                C
            
            
            Integration
            
            $
            330,050
            
            
            32.9
            %Others
            
            
            Various
            
            
            672,920
            
            
            67.1
            %Total
            
            
            
            
            $
            1,002,970
            
            
            100.0
            %





One
      customer accounted for substantially all of the accounts receivable at December
      31, 2004. As of December 31, 2005, three customers accounted for 25%, 22%,
      and
      10% of accounts receivable, respectively. As of December 31, 2006, three
      customers accounted for 47%,26%, and 21% of accounts receivable,
      respectively.





**14.    RELATED
      PARTY TRANSACTIONS**





American
      Investment Holding Group, Inc., which is wholly owned by two officers of the
      Company, owned approximately 18.5% of the outstanding common stock of the
      Company as of December 31, 2006. The same officers also own a controlling
      interest in other companies.


F-25





In
      February 2005, the Company entered into an investment banking agreement with
      Berkley whereby Berkley served as nonexclusive agent in connection with the
      negotiations and closing of one or more transactions with investors outside
      the
      United States. Pursuant to this agreement, Berkley was paid approximately
      $290,000 in cash in 2005. The Company sent a notice of termination of this
      agreement to Berkley on March 22, 2006. In addition, in October 2005, the
      Company entered into an investor relations agreement with Berkley, under which
      Berkley was paid $250,000 and issued 625,000 shares of stock. On August 30,
      2006, the Company entered into a Settlement Agreement with Berkley with respect
      to the investor relations agreement. Under the Settlement Agreement, Berkley
      agreed, in part, to release its claim to the Berkley Shares, but retained the
      Berkley Cash Fee as consideration for services performed under the Consulting
      Agreement and for entering into the Settlement Agreement. The parties also
      mutually released each other from any additional payment or services under
      the
      Consulting Agreement. The Company believes there is a business relationship
      between Doron Roethler (a stockholder who beneficially owns more than 10% of
      our
      stock) and Berkley.





During
      2005, the following loans were made by certain investors, consultants and/or
      stockholders of the Company to the Company’s Chief Executive Officer: (i)
      $809,736.49 was borrowed from Leon Sokolic, one of our stockholders, (ii)
      $77,971.20 was borrowed from Atlas, one of our stockholders, (iii) $80,000
      was
      borrowed from Pete Coker, the principal of Tryon Capital, which provided
      financial consulting services to us and received a warrant and cash fees, and
      (iv) $296,589 was borrowed from Berkley, which was paid substantial amounts
      of
      cash and stock (such stock subsequently being redeemed) from us, including
      during the period in which Berkley was making loans to our Chief Executive
      Officer.





In
      March
      2005, the Company entered into a consulting agreement with Hadar, LLC (“Hadar”).
      David E.Y. Sarna, a member of Hadar, was appointed as a member of the Board
      of
      Directors on April 18, 2005, elected Chairman of the Audit Committee of the
      Board September 13, 2005, and resigned from the Board and all Committees of
      the
      Board on June 23, 2006. The Company’s understanding is that Mr. Sarna and Isaac
      Nussen were and remain partners of Hadar. Under the terms of the consulting
      agreement, Hadar was to act as a financial advisor to the Company regarding
      the
      introduction and evaluation of potential investors. Payment for these services
      was to be 8% of proceeds for investors who invest $5 million or less, and 6%
      of
      proceeds for investors who invest over $5 million. Upon Mr. Sarna's election
      to
      the Board of Directors, no further business was conducted between Hadar and
      the
      Company. No monies were ever paid to Hadar by the Company, and no monies are
      payable to the Company. The Company does not believe that Hadar provided
      services to us under the consulting agreement.





An
      officer of the Company and a trust established by this officer for the benefit
      of his children have from time to time provided loans to the Company. During
      2003, the Company borrowed $796,568 and repaid $759,165 to these same parties
      leaving an outstanding liability to the officer and the trust of $47,798 at
      December 31, 2003. During the first six months of 2004, the Company borrowed
      an
      additional $186,335. During 2004, the Company repaid the entire outstanding
      balance of $234,133. Until October 2003, the Company did not pay any interest
      on
      these loans; thereafter the loans accrued interest at a rate of
      15.0%.





During
      2003 and 2004, the Company contracted with a consulting firm owned by one of
      its
      officers to provide strategic international sales and marketing services.
      Consulting fees of $70,000 and $27,083 were paid during 2004 and 2003,
      respectively, related to these services. Additionally, the Company paid the
      same
      consulting firm $31,000 related to the sale of certain shares of common stock
      during the first half of 2004. In addition, during the third quarter of 2004,
      the Company paid this same consultant an additional $31,000 in consulting fees
      for assisting the Company with obtaining additional equity financing during
      the
      quarter.





In
      March
      2004, Smart IL, Ltd. (“SIL”) ceased further development of its technology and
      laid off its employees. SIL is currently seeking opportunities to license or
      sell its technology. The Company continues to support this technology on behalf
      of SIL with the current integration agreement running into October 2006. The
      revenues derived from this agreement with SIL were recognized as income on
      a
      straight-line basis over the life of the agreement. The Company recognized
      zero,
      zero and $330,051 of revenue related to the integration, co-development and
      reseller agreements with SIL during 2006, 2005 and 2004,
      respectively.


F-26





The
      Company paid $158,384 in 2004 to the Small Business Lending Institute, Inc.
      (“SBLI”) because SBLI paid the Company’s employees during the first quarter of
      2004 while the Company was dealing with a tax matter with the Internal Revenue
      Service. Tamir Sagie, a former officer of the Company, was also an officer
      of
      SBLI, and the Company’s Chief Executive Officer is a minority shareholder of
      SBLI.





During
      2004, the Company borrowed $4,793 from an officer and repaid $91,273 to this
      officer which included the amount borrowed plus all amounts owed under previous
      loans. The loans accrued interest at a rate of 15%. During 2004, the Company
      lent a trust established by an officer $142,860, and the trust repaid the entire
      balance owed, totaling $181,542. As of December 31, 2005, all borrowings from
      and loans to the officer and the trust were repaid in full. The Company recorded
      interest expense of zero and $4,649 during 2005 and 2004, respectively,
      related to these loans.





The
      following is a summary of related party revenues for the years ended December
      31, 2006, 2005 and 2004:





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**Smart
                II, Ltd. ("SIL"), formerly
              known
                as Smart Revenue Europe
              Ltd.
                - Integration fees
            
            $
            -
            
            $
            -
            
            $
            330,050Total
                Related Party Revenues
            
            $
            -
            
            $
            -
            
            $
            330,050





The
      following is a summary of related party expenses for the years ended December
      31, 2006, 2005 and 2004:





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**Nen,
                Inc. - consulting fees included in sales and marketing expense related
                to
                strategic international sales and marketing ervices
            
            $
            -
            
            $
            17,500
            
            $
            70,000Nen,
                Inc. - consulting fees included in general and administrative expense
                related to assisting the Company with obtaining additional equity
                financing
            
            
            -
            
            
            -
            
            
            62,000SBLI
                - consulting fees included in general and administrative
                expense
            
            
            -
            
            
            -
            
            
            30,000SIL
                - moving expenses, reseller payment, and technical co-development
                work
            
            
            -
            
            
            -
            
            
            75,000Interest
                expense incurred on loans from officer
            
            
            -
            
            
            -
            
            
            4,649Total
                Related Party Expenses
            
            $
            -
            
            $
            17,500
            
            $
            241,649





F-27


**15.    EMPLOYEE
      BENEFIT PLANS**





All
      full-time employees who meet certain age and length of service requirements
      are
      eligible to participate in the Company’s 401(k) Plan. The plan provides for
      contributions by the Company in such amounts as the Board of Directors may
      annually determine, as well as a 401(k) option under which eligible participants
      may defer a portion of their salary. The Company did not make any contributions
      to the plan during 2006, 2005 or 2004.





**16.    COMMITMENTS
      & CONTINGENCIES**





The
      Company is subject to claims and suits that arise from time to time in the
      ordinary course of business.





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





In
      August
      2005, the Company entered into a software assignment and development agreement
      with the developer of a customized accounting software application.  In
      connection with this agreement, the developer would be paid up to $512,500
      and
      issued up to 32,395 shares of the Company common stock based upon the developer
      attaining certain milestones.  As of December 31, 2006, the Company had
      paid $262,500 and issued 3,473 shares of common stock related to this
      obligation.





On
      January 17, 2006, the SEC temporarily suspended the trading of the Company’s
      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 the Company’s securities because of possible manipulative conduct
      occurring in the market for its stock. By its terms, that suspension ended
      on
      January 30, 2006 at 11:59 p.m. EST. Simultaneously with the suspension, the
      SEC
      advised the Company that the SEC was ****** conducting
      a non-public investigation. As of March 26, 2007, the SEC has not provided
      the
      Company with any communication indicating that its investigation has concluded
      or that the Company or any of its officers or directors have engaged in any
      criminal or fraudulent conduct with respect to Smart Online.





**17.    ACQUISITIONS
      & DISPOSITIONS**





**Computility
      Acquisition & Disposition**





On
      October 4, 2005, the Company purchased substantially all of the assets of
      Computility, Inc. (“Computility”). In consideration for the purchased assets,
      the seller was issued 484,213 shares of common stock and the Company assumed
      certain liabilities 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 $228k of acquisition fees. Of the total
      shares issued, 84,213 were delivered to Computility at the closing of the
      acquisition and 400,000 were held in escrow to cover certain indemnification
      provisions of Computility. The initial escrow period expired on September 24,
      2006 as to 250,000 shares, while the remaining 150,000 shares are subject to
      a
      second escrow scheduled to expire on March 24, 2007.


F-28





In
      addition, two key employees of Computility entered into employment agreements
      with Smart CRM, Inc., a wholly-owned subsidiary of the Company, pursuant to
      which each earned $91,800 over and above their base compensation during the
      fifteen months ending December 31, 2006, for meeting certain performance goals.
      Also as part of these employment agreements, the Company paid these two key
      employees $45,000 each in October of 2005 in exchange for their covenants not
      to
      compete. These two employees were each granted an option to purchase 75,000
      shares of the Company's common stock at $7.00 per share. Each of the options
      vest and become exercisable in six equal, quarterly increments of 12,500 shares
      upon the achievement of certain quarterly performance milestones. As of December
      31, 2006, options to purchase an aggregate of 50,000 shares of common stock
      had
      vested under these agreements. **





A
      condensed balance sheet of Computility on October 4, 2005 is presented
      below:





Assets:Accounts
                Receivable, net
            
            $
            6,894Other
                Current Assets
            
            
            10,742P,P
                & E, net
            
            
            388,128Other
                Assets
            
            
            246,228**TOTAL
                ASSETS**
            
            **$**
            **651,992**Liabilities
                & EquityAccounts
                Payable
            
            $
            109,897Subscriptions
                Payable
            
            
            1,657,327Note
                Payable
            
            
            150,000Other
                Liabilities
            
            
            29,549**TOTAL
                LIABILITIES**
            
            
            **1,946,773**Equity
            
            
            (1,294,781
            )**TOTAL
                LIABILITIES AND EQUITY**
            
            **$**
            **651,992**








The
      book
      values shown above were determined to be the appropriate fair market values,
      so
      no adjustment was required to mark-to-market. Goodwill acquired as part of
      this
      acquisition was determined to be approximately $3.7 million based on an
      independent valuation performed in accordance with SFAS No. 141, *Business Combinations* (“SFAS
      No. 141”). Goodwill was determined as follows:





Consideration
                Paid (including acquisition costs and liabilities assumed)
            
            $
            5,800,640Tangible
                Assets Acquired
            
            
            (651,992
            )Identifiable
                Intangible Assets Acquired
            
            
            (1,424,220
            )Goodwill
            
            $
            3,724,428





Historically,
      Computility derived substantially all of its revenue from software and hardware
      subscription agreements which typically have three year terms with substantial
      penalties for early termination. Until the date of the acquisition, Computility
      factored substantially all of its subscription agreements and received
      approximately 65% of the expected cash flow from the subscription period upfront
      and used the cash to fund ongoing operations. As a result of the factor
      arrangements, the Company was required to provide services to the customers,
      but
      only received approximately 35% of the corresponding customer payments to fund
      ongoing operations. The remaining 65% of the monthly customer payments was
      used
      to offset approximately $1.7 million of the factor liabilities of Computility
      assumed by the Company. In addition, the shares issued as part of the purchase
      price held in escrow secure the customer payments used to offset this liability.





Upon
      our
      successful integration of the SFA/CRM application into the
      Company's OneBiz SM platform, management deemed the remaining operations of Smart CRM, specifically
      consulting and network management, to be non-strategic to ongoing operations.
      On
      September 29, 2006, the Company, Smart CRM and Alliance Technologies, Inc.
      ("Alliance") executed and delivered an Asset Purchase Agreement pursuant to
      which Alliance acquired substantially all of the assets of Smart CRM. In
      accordance with SFAS No. 144, *Accounting for the Impairment and Disposal of Long-Lived Assets* , the
      Company has reported the operating results for Smart CRM as discontinued
      operations and the assets and liabilities ultimately sold or disposed as
      available for sale.


F-29








The
      Smart
      CRM assets sold to Alliance included the traditional SFA/CRM application
      developed and sold by Smart CRM and its predecessor in interest, Computility.
      The Company retained all rights relating to the derivative SaaS application
      developed by the Company with Smart CRM and incorporated into its
      OneBiz SM platform. The other assets sold included substantially all of the fixed assets
      and computer hardware and software of Smart CRM, and certain identifiable
      intangible assets, including technology, customer bases, and common law
      trademarks relating to Computility. Further, Alliance agreed to hire
      substantially all of the employees of Smart CRM following the asset sale, with
      the exception of two key employees who remained with the Company.





In
      consideration for the transfer of these assets, Alliance paid the Company
      $600,000 in cash and assumed approximately $1.7 million in total liabilities
      related to Smart CRM, including all liabilities associated with the factoring
      activity of Smart CRM, for total compensation of approximately $2.3 million.
      In
      exchange, Alliance received assets valued at approximately $1.7 million,
      resulting in a gain on sale of $653,267. The goodwill associated with the
      disposed assets has been written down to zero resulting in an additional
      non-cash charge to “Other Income/Expense” in the amount of $2,793,321. The
      combined effect is a net loss on the sale of substantially all of the assets
      of
      Smart CRM totaling $2,140,054.





The
      major
      classes and carrying amounts of the assets and liabilities disposed of are
      as
      follows:





Carrying
              Value
                at
              9/29/06**ASSETS**Accounts
                Receivable, net
            
            $
            82,290Fixed
                Assets, net
            
            
            400,624Identifiable
                Intangibles, net
            
            
            972,566Deferred
                Financing Costs
            
            
            224,443TOTAL
                ASSETS SOLD
            
            $
            1,679,923**LIABILITIES**Notes
                & Factor Debt Payable
            
            $
            1,610,478Customer
                Prepaid Services
            
            
            122,712TOTAL
                LIABILITIES ASSUMED BY BUYER
            
            $
            1,733,190CASH
                PAID BY BUYER
            
            $
            600,000TOTAL
                CONSIDERATION
            
            $
            2,333,190Gain
                on sale of Assets and Liabilities before Goodwill
                Write-down
            
            
            653,267Write-down
                of Goodwill related to Assets Sold
            
            
            (2,793,321
            )Net
                Loss on Sale of Assets
            
            $
            2,140,054





In
      addition, two key employees of Smart CRM entered into consulting and non-compete
      agreements with Alliance. Under these agreements, each key employee will provide
      certain consulting services to Alliance to assist with the transition of the
      purchased assets. Both key employees are prohibited from competing with Alliance
      with regard to the business associated with the assets purchased, but each
      is
      specifically allowed to continue his employment with the Company. In exchange,
      each key employee will receive a payment from Alliance of
      $50,000.


F-30





The
      Company and an entity controlled by the same key employees also entered into
      an
      agreement whereby this entity was paid $55,000 immediately
      following the closing of the asset sale described herein for assistance
      with identifying Alliance as an acquirer of the assets.





There
      is
      no relationship between the Company, Smart CRM and their affiliates, and
      Alliance and its affiliates.





**iMart
      Incorporated Acquisition**





On
      October 18, 2005, the Company completed its purchase of all of the capital
      stock
      of iMart Incorporated (“iMart”), a Michigan-based company providing
      multi-channel electronic commerce systems, pursuant to a Stock Purchase
      Agreement, dated as of October 17, 2005, by and among the Company, iMart and
      the
      stockholders of iMart. The Company currently operates this business as its
      wholly-owned subsidiary, Smart Commerce.





iMart's
      stockholders were issued 205,767 shares of common stock and the Company agreed
      to pay iMart's stockholders approximately $3,462,000 in cash installments.
      This
      amount was payable in four equal payments of $432,866 on the first business
      day
      of each of January 2006, April 2006, July 2006 and October 2006. The remaining
      $1,731,465 was 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 shares was approximately $5.3
      million including approximately $339,000 of acquisition fees.





A
      condensed balance sheet for iMart on October 18, 2005 is presented
      below:





AssetsCash
            
            $
            32,035Accounts
                Receivable
            
            
            356,781Prepaid
                Registration
            
            
            77,038Other
                Current Assets
            
            
            8,882Total
                Current Assets
            
            
            474,736P,P&E,
                net
            
            
            64,099Other
                Assets
            
            
            25,000**TOTAL
                ASSETS**
            
            **$**
            **563,835**LiabilitiesAccounts
                Payable
            
            $
            36,759Deferred
                Revenue
            
            
            533,447Other
                Current Liabilities
            
            
            1,641Total
                Current Liabilities
            
            
            571,847Loan
                Payable
            
            
            65,000**TOTAL
                LIABILITIES**
            
            **$**
            **636,847**Equity
            
            
            (73,012
            )**TOTAL
                LIABILITIES & EQUITY**
            
            **$**
            **563,835**





The
      book
      values shown above were determined to be the appropriate fair market values,
      so
      no adjustment was required to mark-to-market. Goodwill acquired as part of
      this
      acquisition was determined to be approximately $1.8 million based on an
      independent valuation performed in accordance with SFAS No. 141. Goodwill was
      determined as follows:


F-31





Consideration
                Paid (including acquisition costs and liabilities assumed)
            
            $
            6,732,265Tangible
                Assets Acquired
            
            
            (563,835
            )Identifiable
                Intangible Assets Acquired
            
            
            (4,402,895
            )Goodwill
            
            $
            1,765,535





In
      addition, the Company was required to pay $780,000 for non-competition
      agreements to key personnel of the acquired company in eight equal quarterly
      installments during the period beginning in January 2006 and ending October
      2007. The purchase price installment payments were secured by the net proceeds
      of customer contracts of Smart Commerce. On November 9, 2006, Smart Commerce
      entered into a loan agreement with Fifth Third Bank. Under the terms of the
      loan
      agreement, Smart Commerce established a lock box and a cash security account
      of
      $250,000. This limited the Company’s ability to use cash derived from this
      revenue until all payments and indebtedness was paid in full. See Note 9, “Notes
      Payable,” for additional information about this transaction. The former CEO of
      iMart had contractual rights to operate Smart Commerce, Inc. within agreed
      financial parameters.





The
      results of operations of iMart are included in the Company's consolidated
      statements of operations for the period October 18, 2005 through December 31,
      2005.





**Pro
      Forma Results of Operations (Unaudited)**





The
      following pro forma results of operations show the results of operations had
      the
      acquisition of iMart and disposition of Smart CRM been completed at the
      beginning of each of the periods presented below:





For
      the
      Year Ended December 31, 2004:








**Smart**
              **Commerce**
            **Smart**
              **Online**
            **Pro
                forma**
              **Unaudited**Revenue
            $
                3,380,609
            $
                1,002,970
            $4,383,579Net
                Income / (Loss)
            1,423,691
            (2,671,929)
            (1,248,238)Net
                Income / (Loss) Attributable
              to
                common stockholders
            1,423,691
            (8,319,049)
            (6,895,358)EPS
            
            
            $
                (.63)





For
      the
      Year Ended December 31, 2005:





**Smart**
              **Commerce**
            **Smart**
              **Online**
            **Pro
                forma**
              **Unaudited**Revenue
            $
                3,706,738
            $ 
                1,353,107
            $  5,059,845Net
                Income / (Loss)
            1,487,279
            (15,919,694)
            (14,460,441)Net
                Income / (Loss) Attributable
              to
                common stockholders
            1,487,279
            (15,919,694)
            (14,432,415)EPS
            
            
            $
                (1.07)





F-32


For
      the
      Year Ended December 31, 2006:





**Smart**
              **Commerce**
            **Smart**
              **Online**
            **Pro
                forma**
              **Unaudited**Revenue
            $
                3,131,752
            $
                513,138
            $
                3,644,556Net
                Income / (Loss)
            1,012,255
            (3,510,399)
            (2,498,144)Net
                Income / (Loss) Attributable
              to
                common stockholders
            1,012,255
            (3,510,399)
            (2,498,144)EPS
            
            
            $
                (0.17)





The
      2005
      and 2006 pro formas exclude the losses from discontinued operations related
      to
      Smart CRM. For 2005 and 2006, those losses were $35,735 and $2,525,563,
      respectively.





**18.    SUBSEQUENT
      EVENTS**





In
      a
      transaction that closed on February 21, 2007, the Company sold an aggregate
      of
      2,352,941 shares of its common stock to two new investors (the "Investors").
      The
      private placement shares were sold at $2.55 per share pursuant to a Securities
      Purchase Agreement (the "SPA") between the Company and each of the Investors.
      The aggregate gross process were $6 million and the Company incurred issuance
      costs of approximately $585,000. Under the SPA, the Investors were issued
      warrants for the purchase of an aggregate of 1,176,471 shares of common stock
      at
      an exercise price of $3.00 per share. These warrants contain a provision for
      cashless exercise and must be exercised by February 21, 2010.





The
      Company and each of the Investors also entered into a Registration Rights
      Agreement (the "Investor RRA") whereby the Company has an obligation to register
      the shares for resale by the Investors by filing a registration statement within
      thirty (30) days of the closing of the private placement, and to have the
      registration statement declared effective sixty (60) days after actual filing,
      or ninety (90) days after actual filing if the SEC reviews the registration
      statement. If a registration statement is not timely filed or declared effective
      by the date set forth in the Investor RRA, the Company is obligated to pay
      a
      cash penalty of 1% of the purchase price on the day after the filing or
      declaration of effectiveness is due, and 0.5% of the purchase price per every
      thirty (30) day period thereafter, to be prorated for partial periods, until
      the
      Company fulfills these obligations. Under no circumstances can the aggregate
      penalty for late registration or effectiveness exceed 10% of the aggregate
      purchase price. Under the terms of the Investor RRA, the Company cannot offer
      for sale or sell any securities until May 22, 2007, subject to certain limited
      exceptions, unless, in the opinion of the Company’s counsel, such offer or sale
      does not jeopardize the availability of exemptions from the registration and
      qualification requirements under applicable securities laws with respect to
      this
      placement. On
      March
      28, 2007, the Company entered into an amendment to the Investor RRA with each
      Investor to extend the registration filing obligation date by an additional
      eleven calendar days.





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





On
      January 24, 2007, the Company entered into an amendment to its line of credit
      with Wachovia described in Note 9, Notes Payable. The amendment resulted in
      an
      increase in the line of credit from $1.3 million to $2.5 million. The pay-off
      date for the line of credit was also extended from August 1, 2007 to August
      1,
      2008. The line of credit is secured by the Company's deposit account at Wachovia
      and an irrevocable standby letter of credit (the "Letter of Credit") in the
      amount of $2,500,000 issued by HSBC Private Bank (Suisse) S.A. with Atlas as
      account party. As of
      March
      15, 2007, the Company has drawn down approximately $2.1 million on the line
      of
      credit .


F-33





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




On
      January 12, 2007, the Compensation Committee of the Company's Board of Directors
      approved five executive level managers modifying their compensation, each
      reducing their salary for the remainder of 2007 to $100,000. In
      consideration for these modifications, the employees have agreed to a
      performance based aggregate quarterly bonus. The aggregate bonus will be ten
      percent (10%) of any "Free Cash Flow" which will be divided equally among these
      five officers (i.e., 2% of Free Cash Flow each). For these purposes, "Free
      Cash
      Flow" is defined as the Company’s total revenue, less operating expenses (with
      non-cash items added back), less principal debt payments. These
      bonuses relate only to "Free Cash Flow" during  2007 as this bonus
      arrangement expires on December 31, 2007.  On January 1, 2008, compensation
      for these officers is scheduled to return to pre-reduction levels. The
      aggregate savings from these modifications, including payroll tax effects and
      without taking any potential bonus into account, will be approximately $260,000
      annually.





In
      January 2007, the Company entered into employment agreements with its new Vice
      President - Sales and Vice President - Business Development. These two
      individuals were the co-founders of Computility and operated Smart CRM after
      the
      Company’s purchase of the assets of Computility, described in Note 17 -
      Acquisitions & Dispositions.





Under
      the
      terms of these agreements, the Company agreed to pay an annual salary of
      $150,000 to each of these individuals. They also have the ability to earn a
      net
      commission of zero to 10% each and a bonus of zero to $200,000 each, based
      on
      revenue ranging from less than $2 million to over $10 million in 2007. Any
      commission paid to these individuals will be net of any commission paid by
      the
      Company to any and all other individuals. For purposes of these agreements,
      “revenue” is defined as net cash received by the Company, excluding any revenue
      received by any present or future subsidiary of the Company.





On
      March
      29, 2007, the Company issued 55,666 shares of its common stock to certain
      investors as registration penalties for its failure to timely file a
      registration statement covering shares owned by those investors as required
      pursuant to registration rights agreements between such investors and the
      Company.




**19.**  **Summary
      of Operations by Quarters (Unaudited)**








2006
            
            
            20051stQtr.
            
            
            2ndQtr.
            
            
            3rdQtr.
            
            
            4thQtr.
            
            
            1stQtr.
            
            
            2ndQtr.
            
            
            3rdQtr.
            
            
            4thQtr.Revenues
            $
            1,357,959
            
            $
            840,820
            
            $
            749,206
            
            $
            696,905
            
            $
            253,238
            
            $
            406,116
            
            $
            344,692
            
            $
            1,151,379Gross
                Profit
            $
            1,255,856
            
            $
            761,720
            
            $
            717,895
            
            $
            579,908
            
            $
            221,511
            
            $
            384,205
            
            $
            318,892
            
            $
            1,075,925Loss
                from Operations
            $
            (1,457,401
            )
            $
            (1,509,185
            )
            $
            (1,081,173
            )
            $
            (1,317,853
            )
            $
            (847,484
            )
            $
            (874,306
            )
            $
            (2,188,462
            )
            $
            (12,163,753
            )Net
                Income (Loss ) From Continuing Operations Attributable to common
                stockholders
            $
            (1,556,862
            )
            $
            133,023
            
            $
            429,581
            
            $
            (1,503,886
            )
            $
            (294,145
            )
            $
            (860,819
            )
            $
            (2,180,856
            )
            $
            (12,254,789
            )Discontinued
                Operations
            
            (39,563
            )
            
            (156,571
            )
            
            (2,329,429
            )Net
                Loss
            
            (1,596,425
            )
            
            (23,548
            )
            
            (1,899,848
            )
            
            (1,503,886
            )
            
            (294,145
            )
            
            (860,819
            )
            
            (2,180,856
            )
            
            (12,254,789
            )


F-34





Net
                Loss Per Share-Continuing
                OperationsBasic
            
            (0.11
            )
            
            (0.00
            )
            
            0.03
            
            
            (0.10
            )
            
            (0.02
            )
            
            (0.07
            )
            
            (0.17
            )
            
            (0.84
            )Fully
                Diluted
            
            (0.11
            )
            
            (0.00
            )
            
            0.03
            
            
            (0.10
            )
            
            (0.02
            )
            
            (0.07
            )
            
            (0.17
            )
            
            (0.84
            )Discontinued
                OperationsBasic
            
            
            
            
            (0.01
            )
            
            (0.15
            )Fully
                Diluted
            
            
            
            
            (0.01
            )
            
            (0.15
            )Net
                Loss Attributed to common stockholdersBasic
            
            (0.11
            )
            
            (0.00
            )
            
            (0.13
            )
            
            (0.10
            )
            
            (0.02
            )
            
            (0.07
            )
            
            (0.17
            )
            
            (0.84
            )Fully
                Diluted
            
            (0.11
            )
            
            (0.00
            )
            
            (0.12
            )
            
            (0.10
            )
            
            (0.02
            )
            
            (0.07
            )
            
            (0.17
            )
            
            (0.84
            )Number
                of Shares Used in Per Share CalculationBasic
            
            14,984,228
            
            
            15,117,967
            
            
            15,127,510
            
            
            14,914,233
            
            
            11,829,610
            
            
            12,387,333
            
            
            12,832,365
            
            
            14,667,137Fully
                Diluted
            
            14,984,228
            
            
            15,117,967
            
            
            15,387,110
            
            
            14,914,233
            
            
            11,829,610
            
            
            12,387,333
            
            
            12,832,365
            
            
            14,667,137


F-35








**ITEM9.** **CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





None.





**ITEM9A.** **CONTROLS
      AND 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 Exchange Act) that are designed to provide reasonable
      assurances that information required to be disclosed by us in the reports that
      we file or submit under the Exchange Act is recorded, processed, summarized
      and
      reported, within the time periods specified in the SEC’s rules and forms, and
      that such information is accumulated and communicated to management, including
      our Chief Executive Officer and Chief Financial Officer, as appropriate, to
      allow timely decisions regarding required disclosure. In designing and
      evaluating the disclosure controls and procedures, management recognized 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 was 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-K. Based
      on
      such evaluation, our Chief Executive Officer and Chief Financial Officer
      concluded that, as of the end of the period covered by this Form 10-K, our
      disclosure controls and procedures were not effective because of the significant
      deficiencies described below under “Changes in Internal Control Over Financial
      Reporting,” which we are in the process of remediating.





**Changes
      in Internal Controls Over Financial Reporting**





As
      described in our Annual Report on Form 10-K for the fiscal year ending December
      31, 2005, filed with the SEC on July 11, 2006, or the 2005 Annual Report, we
      have begun to implement controls in response to the final findings of our Audit
      Committee’s investigation related to the SEC’s suspension of trading of our
      common stock in January 2006.





As
      a
      result of the findings of the Audit Committee investigation, we have made the
      following changes to our internal controls:





·
            Mr.
                Jeffrey LeRose was appointed to the position of non-executive Chairmanof
                the Board of Directors to separate the leadership of the Board of
                Directors from the management of the Company, replacing Mr. Michael
                Nouri,
                who remained as President, Chief Executive Officer, and a member
                of the
                Board.


·
            Mr.
                Nouri has repaid all amounts outstanding to several noteholders,
                including
                Berkley Financial Services through sales of shares of our common
                stock
                from Mr. Nouri’s personal holdings.


·
            Our
                Chief Financial Officer has been involved in communications with
                investment professionals, including analysts, brokers and potential
                institutional investors.


·
            Our
                Chief Financial Officer has been given direct reporting responsibility
                to
                the Audit Committee with respect to any such
                communications.


·
            Three
                additional, non-management directors have been appointed to our Board
                of
                Directors, two of whom qualify as “independent” under Item 407(a) of
                Regulation S-K. One of these “independent” directors also qualifies as an
                “audit committee financial expert” under Item 407(d)(5)(ii) of Regulation
                S-K and is serving as the Chairman of the Audit
                Committee.


·
            Our
                outside counsel has provided periodic educational training for management
                and directors by outside legal counsel and other appropriate professional
                advisors.


·
            We
                have adopted a revised Securities Trading
                Policy.


37





·
            Controls
                have been implemented regarding the review and approval of material
                contracts by our Chief Financial Officer, Corporate Counsel, and
                where
                appropriate, our outside counsel and Board of Directors, including
                the
                creation of a contract checklist to be completed by our Chief Financial
                Officer and Corporate Counsel for each material
                agreement.


·
            We
                have instituted a program requiring written confirmation of compliance
                with our Code of Ethics and Conflicts of Interest Policy on a quarterly
                basis from all members of management and the Board of
                Directors.


·
            We
                entered into a contract with Ethical Advocates, Inc. for confidential
                and
                anonymous incident reporting.


·
            Multiple
                control systems have been put in place to review checks paid to officers
                and directors in excess of $2,500.


·
            We
                now have three members of our Board who are members of the National
                Association of Corporate Directors
                (“NACD”).





Two
      other
      measures identified in the 2005 Annual Report were our evaluation of whether
      we
      would add two positions to our company in order to help with our internal
      controls and procedures. At this time, we have decided not to hire a new General
      Counsel. We concluded that the controls described above and the retention of
      new
      outside legal counsel augmenting the work of our current Corporate Counsel
      provides sufficient controls. We have also completed our evaluation of whether
      the responsibilities and duties of a Chief Compliance Officer can be fulfilled
      by a current member of management or whether it is necessary to seek a qualified
      outside candidate. We have determined that this function can be filled by a
      current member of our management team, and have assigned the primary
      responsibility to administer and set compliance policy, monitor and assess
      control deficiency identification and remediation and report to the Audit
      Committee on matters concerning legal, corporate governance and ethical
      compliance to our Corporate Counsel.





We
      have
      not yet implemented or effectively tested all of the measures described above
      and expect that their full implementation and testing will take significant
      time
      and effort. We expect to make additional changes to our controls as we continue
      to integrate our acquired businesses and respond to the final findings of the
      Audit Committee investigation. We recognize that “tone at the top” is a key
      element to an organization’s control environment and are focused and committed
      to providing the correct tone and structure within the company. We cannot assure
      you that we will not in the future identify further deficiencies in our
      controls. However, we plan to continue to review and make any necessary changes
      to the overall design of our control environment in order to enhance our
      corporate governance and reporting practices.





Other
      than those described above, there have been no significant changes in our
      internal control over financial reporting that occurred during the last fiscal
      quarter of the fiscal year ended December 31, 2006 that have materially
      affected, or are reasonably likely to materially affect, our internal control
      over financial reporting.





**ITEM9B.** **OTHER
      INFORMATION**




There
      is
      no information required to be disclosed on a current report on Form
      8-K during the fourth quarter of 2006 that was not disclosed on a current
      report on Form 8-K.





On
      March
      28, 2007, we entered into amendments to the registration rights agreements
      dated
      February 21, 2007 with the investors to which we sold shares of our common
      stock
      for aggregate proceeds of $6,000,000. The original registration rights
      agreements obligated us to register the shares sold for resale by the investors
      by March 23, 2007. The investors agreed to extend the registration obligation
      date to April 3, 2007.





38


**PARTIII**





Information
      called for in Items 10, 11, 12, 13, and 14 is incorporated by reference from
      our
      definitive proxy statement relating to our Annual Meeting of Stockholders,
      which
      will be filed with the SEC within 120 days after the end of fiscal
      2006.





**ITEM10.** **DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**








**ITEM11.** **EXECUTIVE
      COMPENSATION**





**ITEM12.
      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT AND RELATED STOCKHOLDER MATTERS**





**ITEM13.
      CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND
      DIRECTOR INDEPENDENCE**





**ITEM** **14.** **PRINCIPAL
      ACCOUNTING FEES AND SERVICES**





**PARTIV**





**ITEM** **15.
      EXHIBITS, FINANCIAL STATEMENT
      SCHEDULES**





(a)(1)
      and (2). The financial statements and reports of our independent registered
      public accounting firm are filed as part of this report (see “Index to Financial
      Statements,” at Part II, Item 8). The financial statement schedules are not
      included in this Item as they are either not applicable or are included as
      part
      of the consolidated financial statements.





(a)(3)
      The following exhibits have been or are being filed herewith and are numbered
      in
      accordance with Item 601 of Regulation S-K:





Exhibit
                No.
            Description2.1
            Asset
                Purchase Agreement, dated September 30, 2006, by and between Alliance
                Technologies, Inc., Smart CRM, Inc., and Smart Online, Inc. (incorporated
                herein by reference to Exhibit 2.1 to our Quarterly Report on Form
                10-Q,
                as filed with the SEC on November 14, 2006)3.1
            Articles
                of Incorporation, as restated (incorporated herein by reference to
                Exhibit
                3.1 to our Registration Statement on Form SB-2, as filed with the
                SEC on
                September 30, 2004))3.2
            Bylaws,
                as amended4.1
            Specimen
                Common Stock Certificate (incorporated herein by reference to Exhibit
                4.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)10.1*
            2004
                Equity Compensation Plan (incorporated herein by reference to Exhibit
                10.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)10.2*
            Form
                of Incentive Stock Option Agreement under 2004 Equity Compensation
                Plan
                (incorporated herein by reference to Exhibit 10.2 to our Annual Report
                on
                Form 10-K, as filed with the SEC on July 11, 2006)10.3*
            Form
                of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
                Plan (incorporated herein by reference to Exhibit 10.3 to our Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.4*
            2001
                Equity Compensation Plan (terminated as to future grants April 15,
                2004)
                (incorporated herein by reference to Exhibit 10.2 to our Registration
                Statement on Form SB-2, as filed with the SEC on September 30,
                2004)


39





10.5*
            1998
                Equity Compensation Plan (terminated as to future grants effective
                April
                15, 2004) (incorporated herein by reference to Exhibit 10.3 to our
                Registration Statement on Form SB-2, as filed with the SEC on September
                30, 2004)10.6
            Form
                of Reorganization, Lock-Up Proxy and Release Agreement, dated January
                1,
                2004, between Smart Online, Inc. and certain stockholders (incorporated
                herein by reference to Exhibit 10.4 to our Registration Statement
                on Form
                SB-2, as filed with the SEC on September 30, 2004)10.7
            Form
                of Lock-up Agreement dated January 1, 2004 between Smart Online,
                Inc. and
                certain stockholders (incorporated herein by reference to Exhibit
                10.5 to
                our Registration Statement on Form SB-2, as filed with the SEC on
                September 30, 2004)10.8
            Form
                of Subscription Agreement with lock-up provisions between Smart Online,
                Inc. and certain investors (incorporated herein by reference to Exhibit
                10.6 to our Registration Statement on Form SB-2, as filed with the
                SEC on
                September 30, 2004)10.9
            Form
                of Registration Rights Agreement dated as of February 1, 2004 between
                Smart Online, Inc. and certain investors (incorporated herein by
                reference
                to Exhibit 10.7 to our Registration Statement on Form SB-2, as filed
                with
                the SEC on September 30, 2004)10.10*
            Employment
                Agreement dated April 1, 2004 with Michael Nouri (incorporated herein
                by
                reference to Exhibit 10.8 to our Registration Statement on Form SB-2,
                as
                filed with the SEC on September 30, 2004)10.11*
            Employment
                Agreement dated April 1, 2004 with Henry Nouri (incorporated herein
                by
                reference to Exhibit 10.9 to our Registration Statement on Form SB-2,
                as
                filed with the SEC on September 30, 2004)10.12*
            Employment
                Agreement dated April 1, 2004 with Ronna Loprete (incorporated herein
                by
                reference to Exhibit 10.10 to our Registration Statement on Form
                SB-2, as
                filed with the SEC on September 29, 2004)10.13*
            Employment
                Agreement dated April 1, 2004 with Scott Whitaker10.14*
            Employment
                Agreement dated April 1, 2004 with Thomas Furr10.15*
            Amendment
                to the Employment Agreement dated November 9, 2005 with Thomas
                Furr10.16*
            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)10.17*
            Description
                of Salary Reduction Agreements10.18
            Asset
                Purchase Agreement dated as of October 4, 2005 by and among Smart
                Online,
                Inc., Smart CRM, Computility, Inc. and certain shareholders of
                Computility, Inc. (incorporated herein by reference to Exhibit 2.1
                to our
                Current Report on Form 8-K, as filed with the SEC on October 7,
                2005)10.19
            Stock
                Purchase Agreement dated as of October 17, 2005 by and among Smart
                Online,
                Inc., iMart Incorporated and the shareholders of iMart Incorporated
                (incorporated herein by reference to Exhibit 2.1 to our Current Report
                on
                Form 8-K, as filed with the SEC on October 24, 2005)10.20*
            Employment
                Agreement dated as of October 17, 2005 by and among Smart Online,
                Inc.,
                iMart Incorporated and Gary Mahieu (incorporated herein by reference
                to
                Exhibit 2.2 to our Current Report on Form 8-K, as filed with the
                SEC on
                October 24, 2005)10.21
            Letter
                Agreement dated February 23, 2005 by and between Smart Online, Inc.
                and
                Berkley Financial Services (BFS) Ltd. for financial advisory services
                (incorporated herein by reference to Exhibit 10.32 to our Annual
                Report on
                Form 10-K, as filed with the SEC on July 11, 2006)10.22
            Consulting
                Agreement, dated October 4, 2005, by and between Smart Online, Inc.
                and
                Berkley Financial Services Ltd. (incorporated herein by reference
                to
                Exhibit 99.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                November 10, 2005)10.23
            Consulting
                Agreement, dated October 26, 2005, by and between Smart Online, Inc.
                and
                General Investments Capital (GIC) Ltd. (incorporated herein by reference
                to Exhibit 99.2 to our Current Report on Form 8-K, as filed with
                the SEC
                on November 10, 2005)


40





10.24
            Settlement
                Agreement, effective May 31, 2006, by and between Smart Online, Inc.
                and
                General Investments Capital (GIC) Ltd. (incorporated herein by reference
                to Exhibit 99.1 to our Current Report on Form 8-K, as filed with
                the SEC
                on June 6, 2006)10.25
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated August 17 and 21, 2006, by and between Smart Online,
                Inc.
                and certain investors (incorporated herein by reference to Exhibit
                10.2 to
                our Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2006)10.26
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated June 29 and July 6, 2006, by and between Smart Online,
                Inc. and certain investors (incorporated herein by reference to Exhibit
                10.36 to our Annual Report on Form 10-K, as filed with the SEC on
                July 11,
                2006)10.27
            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)10.28
            Settlement
                Agreement, dated August 25, 2006, by and between Smart Online, Inc.
                and
                Berkley Financial Services, Ltd. (incorporated herein by reference
                to
                Exhibit 99.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                August 28, 2006)10.29
            Form
                of Subscription Agreement, Registration Rights Agreement, and Dribble
                Out
                Agreement, dated July 19, September 7 and September 13, 2005, by
                and
                between Smart Online, Inc. and Atlas Capital, SA (incorporated herein
                by
                reference to Exhibit 10.38 to our Annual Report on Form 10-K, as
                filed
                with the SEC on July 11, 2006)10.30
            Form
                of Subscription Agreement, Registration Rights Agreement, and Dribble
                Out
                Agreement, dated September 7, 2005, by and between Smart Online,
                Inc. and
                Credit Suisse Zurich (incorporated herein by reference to Exhibit
                10.39 to
                our Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.31
            Form
                of Subscription Agreement, Registration Rights Agreement, and Dribble
                Out
                Agreement, and Exhibits thereto, dated February 25, 2005, by and
                between
                Smart Online, Inc. and The Blueline Fund (incorporated herein by
                reference
                to Exhibit 10.40 to our Annual Report on Form 10-K, as filed with
                the SEC
                on July 11, 2006)10.32*
            Indemnification
                Agreement, dated April ,14 2006, by and between Smart Online, Inc.
                and
                David E.Y. Sarna (incorporated herein by reference to Exhibit 10.42
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.33*
            Indemnification
                Agreement, dated April ,14 2006, by and between Smart Online, Inc.
                and
                Joan Keston (incorporated herein by reference to Exhibit 10.43 to
                our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.34*
            Indemnification
                Agreement, dated January 26, 2006, by and between Smart Online, Inc.
                and
                Tom Furr (incorporated herein by reference to Exhibit 10.44 to our
                Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.35*
            Indemnification
                Agreement, dated January 26, 2006, by and between Smart Online, Inc.
                and
                Henry Nouri (incorporated herein by reference to Exhibit 10.45 to
                our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.36*
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and
                Scott Whitaker (incorporated herein by reference to Exhibit 10.46
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.37*
            Indemnification
                Agreement, dated January 26, 2006, by and between Smart Online, Inc.
                and
                Michael Nouri (incorporated herein by reference to Exhibit 10.47
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.38*
            Smart
                Online, Inc. Revised Board Compensation Policy, effective August
                1, 2006
                (incorporated herein by reference to Exhibit 10.3 to our Quarterly
                Report
                on Form 10-Q, as filed with the SEC on November 14,
                2006)10.39*
            Smart
                Online, Inc. Revised Board Compensation Policy, effective November
                17,
                200610.40
            Form
                of Amendments to Registration Rights Agreements and Amendments to
                Subscriber Rights Agreements, dated from October 2, 2006 through
                January
                26, 2007, by and between Smart Online, Inc. and certain
                investors


41





10.41*
            Amendment
                to Lock Box Agreement, dated November 8, 2006, by and between Smart
                Online, Inc., Smart Commerce, Inc. and certain former shareholders
                of
                iMart Incorporated10.42
            Business
                Loan Agreement, Promissory Note, Guaranty, Security Agreements and
                Collateral Assignments dated October 17, 2006 by and between Smart
                Online,
                Inc., Smart Commerce and Fifth Third Bank10.43
            Promissory
                Note, Loan Agrement, Agreement and Security Agreement dated November
                14,
                2006, by and between Smart Online, Inc. and Wachovia Bank,
                NA21.1
            Subsidiaries
                of Smart Online, Inc.23.1
            Consent
                of Independent Registered Public Accounting Firm31.1
            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.]





*
      Management contract or compensatory plan.





42


**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.





SMART
                ONLINE, INC.
              RegistrantBy:
            /s/
                Michael NouriMichael
                Nouri, Principal Executive Officer
              March
                30, 2007





Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the Registrant and in the
      capacities and on the dates indicated.








/s/
      Nicholas A. Sinigaglia





Nicholas
      A. Sinigaglia, Principal Financial Officer and


Principal
      Accounting Officer


March
      30,
      2007








/s/
      Michael Nouri





Michael
      Nouri


Principal
      Executive Officer and Director


March
      30,
      2007








/s/
      Jeffrey W. LeRose





Jeffrey
      W. LeRose


Director


March
      30,
      2007








/s/
      Tom
      Furr





Tom
      Furr


Director


March
      30,
      2007











43


/s/
      C.
      James Meese, Jr.





C.
      James
      Meese, Jr.


Director


March
      30,
      2007











/s/
      Shlomo Elia





Shlomo
      Elia


Director


March
      30,
      2007











/s/
      Philippe Pouponnot





Philippe
      Pouponnot


Director


March
      30,
      2007


44





**EXHIBITINDEX**





Exhibit
                No.
            Description2.1
            Asset
                Purchase Agreement, dated September 30, 2006, by and between Alliance
                Technologies, Inc., Smart CRM, Inc., and Smart Online, Inc. (incorporated
                herein by reference to Exhibit 2.1 to our Quarterly Report on Form
                10-Q,
                as filed with the SEC on November 14, 2006)3.1
            Articles
                of Incorporation, as restated (incorporated herein by reference to
                Exhibit
                3.1 to our Registration Statement on Form SB-2, as filed with the
                SEC on
                September 30, 2004)3.2
            Bylaws,
                as amended4.1
            Specimen
                Common Stock Certificate (incorporated herein by reference to Exhibit
                4.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)10.1*
            2004
                Equity Compensation Plan (incorporated herein by reference to Exhibit
                10.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)10.2*
            Form
                of Incentive Stock Option Agreement under 2004 Equity Compensation
                Plan
                (incorporated herein by reference to Exhibit 10.2 to our Annual Report
                on
                Form 10-K, as filed with the SEC on July 11, 2006)10.3*
            Form
                of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
                Plan (incorporated herein by reference to Exhibit 10.3 to our Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.4*
            2001
                Equity Compensation Plan (terminated as to future grants April 15,
                2004)
                (incorporated herein by reference to Exhibit 10.2 to our Registration
                Statement on Form SB-2, as filed with the SEC on September 30,
                2004)10.5*
            1998
                Equity Compensation Plan (terminated as to future grants effective
                April
                15, 2004) (incorporated herein by reference to Exhibit 10.3 to our
                Registration Statement on Form SB-2, as filed with the SEC on September
                30, 2004)10.6
            Form
                of Reorganization, Lock-Up Proxy and Release Agreement, dated January
                1,
                2004, between Smart Online, Inc. and certain stockholders (incorporated
                herein by reference to Exhibit 10.4 to our Registration Statement
                on Form
                SB-2, as filed with the SEC on September 30, 2004)10.7
            Form
                of Lock-up Agreement dated January 1, 2004 between Smart Online,
                Inc. and
                certain stockholders (incorporated herein by reference to Exhibit
                10.5 to
                our Registration Statement on Form SB-2, as filed with the SEC on
                September 30, 2004)10.8
            Form
                of Subscription Agreement with lock-up provisions between Smart Online,
                Inc. and certain investors (incorporated herein by reference to Exhibit
                10.6 to our Registration Statement on Form SB-2, as filed with the
                SEC on
                September 30, 2004)10.9
            Form
                of Registration Rights Agreement dated as of February 1, 2004 between
                Smart Online, Inc. and certain investors (incorporated herein by
                reference
                to Exhibit 10.7 to our Registration Statement on Form SB-2, as filed
                with
                the SEC on September 30, 2004)10.10*
            Employment
                Agreement dated April 1, 2004 with Michael Nouri (incorporated herein
                by
                reference to Exhibit 10.8 to our Registration Statement on Form SB-2,
                as
                filed with the SEC on September 30, 2004)10.11*
            Employment
                Agreement dated April 1, 2004 with Henry Nouri (incorporated herein
                by
                reference to Exhibit 10.9 to our Registration Statement on Form SB-2,
                as
                filed with the SEC on September 30, 2004)10.12*
            Employment
                Agreement dated April 1, 2004 with Ronna Loprete (incorporated herein
                by
                reference to Exhibit 10.10 to our Registration Statement on Form
                SB-2, as
                filed with the SEC on September 29, 2004)10.13*
            Employment
                Agreement dated April 1, 2004 with Scott Whitaker10.14*
            Employment
                Agreement dated April 1, 2004 with Thomas
                Furr


45





10.15*
            Amendment
                to the Employment Agreement dated November 9, 2005 with Thomas
                Furr10.16*
            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)10.17*
            Description
                of Salary Reduction Agreements10.18
            Asset
                Purchase Agreement dated as of October 4, 2005 by and among Smart Online,
                Inc., Smart CRM, Computility, Inc. and certain shareholders of
                Computility, Inc. (incorporated herein by reference to Exhibit 2.1
                to our
                Current Report on Form 8-K, as filed with the SEC on October 7,
                2005)10.19
            Stock
                Purchase Agreement dated as of October 17, 2005 by and among Smart
                Online,
                Inc., iMart Incorporated and the shareholders of iMart Incorporated
                (incorporated herein by reference to Exhibit 2.1 to our Current Report
                on
                Form 8-K, as filed with the SEC on October 24, 2005)10.20*
            Employment
                Agreement dated as of October 17, 2005 by and among Smart Online,
                Inc.,
                iMart Incorporated and Gary Mahieu (incorporated herein by reference
                to
                Exhibit 2.2 to our Current Report on Form 8-K, as filed with the
                SEC on
                October 24, 2005)10.21
            Letter
                Agreement dated February 23, 2005 by and between Smart Online, Inc.
                and
                Berkley Financial Services (BFS) Ltd. for financial advisory services
                (incorporated herein by reference to Exhibit 10.32 to our Annual
                Report on
                Form 10-K, as filed with the SEC on July 11, 2006)10.22
            Consulting
                Agreement, dated October 4, 2005, by and between Smart Online, Inc.
                and
                Berkley Financial Services Ltd. (incorporated herein by reference
                to
                Exhibit 99.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                November 10, 2005)10.23
            Consulting
                Agreement, dated October 26, 2005, by and between Smart Online, Inc.
                and
                General Investments Capital (GIC) Ltd. (incorporated herein by reference
                to Exhibit 99.2 to our Current Report on Form 8-K, as filed with
                the SEC
                on November 10, 2005)10.24
            Settlement
                Agreement, effective May 31, 2006, by and between Smart Online, Inc.
                and
                General Investments Capital (GIC) Ltd. (incorporated herein by reference
                to Exhibit 99.1 to our Current Report on Form 8-K, as filed with
                the SEC
                on June 6, 2006)10.25
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated August 17 and 21, 2006, by and between Smart Online,
                Inc.
                and certain investors (incorporated herein by reference to Exhibit
                10.2 to
                our Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2006)10.26
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated June 29 and July 6, 2006, by and between Smart Online,
                Inc. and certain investors (incorporated herein by reference to Exhibit
                10.36 to our Annual Report on Form 10-K, as filed with the SEC on
                July 11,
                2006)10.27
            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)10.28
            Settlement
                Agreement, dated August 25, 2006, by and between Smart Online, Inc.
                and
                Berkley Financial Services, Ltd. (incorporated herein by reference
                to
                Exhibit 99.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                August 28, 2006)10.29
            Form
                of Subscription Agreement, Registration Rights Agreement, and Dribble
                Out
                Agreement, dated July 19, September 7 and September 13, 2005, by
                and
                between Smart Online, Inc. and Atlas Capital, SA (incorporated herein
                by
                reference to Exhibit 10.38 to our Annual Report on Form 10-K, as
                filed
                with the SEC on July 11, 2006)10.30
            Form
                of Subscription Agreement, Registration Rights Agreement, and Dribble
                Out
                Agreement, dated September 7, 2005, by and between Smart Online,
                Inc. and
                Credit Suisse Zurich (incorporated herein by reference to Exhibit
                10.39 to
                our Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)


46





10.31
            Form
                of Subscription Agreement, Registration Rights Agreement, and Dribble
                Out
                Agreement, and Exhibits thereto, dated February 25, 2005, by and
                between
                Smart Online, Inc. and The Blueline Fund (incorporated herein by
                reference
                to Exhibit 10.40 to our Annual Report on Form 10-K, as filed with
                the SEC
                on July 11, 2006)10.32*
            Indemnification
                Agreement, dated April ,14 2006, by and between Smart Online, Inc.
                and
                David E.Y. Sarna (incorporated herein by reference to Exhibit 10.42
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.33*
            Indemnification
                Agreement, dated April ,14 2006, by and between Smart Online, Inc.
                and
                Joan Keston (incorporated herein by reference to Exhibit 10.43 to
                our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.34*
            Indemnification
                Agreement, dated January 26, 2006, by and between Smart Online, Inc.
                and
                Tom Furr (incorporated herein by reference to Exhibit 10.44 to our
                Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.35*
            Indemnification
                Agreement, dated January 26, 2006, by and between Smart Online, Inc.
                and
                Henry Nouri (incorporated herein by reference to Exhibit 10.45 to
                our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.36*
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and
                Scott Whitaker (incorporated herein by reference to Exhibit 10.46
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.37*
            Indemnification
                Agreement, dated January 26, 2006, by and between Smart Online, Inc.
                and
                Michael Nouri (incorporated herein by reference to Exhibit 10.47
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.38*
            Smart
                Online, Inc. Revised Board Compensation Policy, effective August
                1, 2006
                (incorporated herein by reference to Exhibit 10.3 to our Quarterly
                Report
                on Form 10-Q, as filed with the SEC on November 14,
                2006)10.39*
            Smart
                Online, Inc. Revised Board Compensation Policy, effective November
                17,
                200610.40
            Form
                of Amendments to Registration Rights Agreements and Amendments to
                Subscriber Rights Agreements, dated from October 2, 2006 through
                January
                26, 2007, by and between Smart Online, Inc. and certain
                investors10.41*
            Amendment
                to Lock Box Agreement, dated November 8, 2006, by and between Smart
                Online, Inc., Smart Commerce, Inc. and certain former shareholders
                of
                iMart Incorporated10.42
            Business
                Loan Agreement, Promissory Note, Guaranty, Security Agreements and
                Collateral Assignments, dated October 17, 2006 by and between Smart
                Online, Inc., Smart Commerce and Fifth Third Bank10.43
            Promissory
                Note, Loan Agreement and Security Agreement dated November 14, 2006,
                by
                and between Smart Online, Inc. and Wachovia Bank, NA21.1
            Subsidiaries
                of Smart Online, Inc.23.1
            Consent
                of Independent Registered Public Accounting Firm31.1
            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.]


*
      Management contract or compensatory plan.






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