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, 2009


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 001-32634




SMART
ONLINE, INC.


(Exact
name of registrant as specified in its charter)


Delaware
                (State
      or other jurisdiction of incorporation
                or
      organization)
              
              95-4439334
                (I.R.S.
      Employer Identification
                No.)4505
      Emperor Blvd., Ste. 320
                Durham,
      North Carolina
                (Address
      of principal executive offices)
              
              27703
                (Zip
      Code)


(919)
765-5000


(Registrant’s
telephone number, including area code)





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


Title
      of each class
                  
                  Name
      of each exchange on which registeredN/A
                  
                  N/A





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  ̈ No x





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, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





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





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





The
aggregate market value of common stock held by non-affiliates of the registrant
as of June  30, 2009 was approximately $28,415,412  (based
on the closing sale price of $1.55 per share).





The
number of shares of the registrant’s Common Stock, $0.001 par value per share,
outstanding as of April 14, 2010 was 18,332,543.





DOCUMENTS
INCORPORATED BY REFERENCE





Portions
of the definitive Proxy Statement to be delivered to stockholders in connection
with the Annual Meeting of Stockholders to be held June 22, 2010 are
incorporated by reference into Part III.





TABLE OF
CONTENTS





PART
      I
                    3Item
      1.
                    Business
                    3Item
      1A.
                    Risk
      Factors
                    9Item
      1B.
                    Unresolved
      Staff Comments
                    15Item
      2.
                    Properties
                    15Item
      3.
                    Legal
      Proceedings
                    15Item
      4.
                    Submission
      of Matters to a Vote of Security Holders
                    15PART
      II
                    15Item
      5.
                    Market
      for Registrant’s Common Equity, Related Stockholder Matters and
      IssuerPurchases
      of Equity Securities
                    15Item
      6.
                    Selected
      Financial Data
                    16Item
      7.
                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                    16Item
      7A.
                    Quantitative
      and Qualitative Disclosures About Market Risk
                    36Item
      8.
                    Financial
      Statements and Supplementary Data
                    37Item
      9.
                    Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                    66Item
      9A.
                    Controls
      and Procedures
                    66Item 9A(T).
                    Controls
      and Procedures
                    66Item
      9B.
                    Other
      Information
                    68PART
      III
                    68Item
      10.
                    Directors,
      Executive Officers and Corporate Governance
                    68Item
      11.
                    Executive
      Compensation
                    68Item
      12.
                    Security
      Ownership of Certain Beneficial Owners and Management and
      RelatedStockholder
      Matters
                    68Item
      13.
                    Certain
      Relationships and Related Transactions, and Director
      Independence
                    68Item
      14.
                    Principal
      Accounting Fees and Services
                    68PART
      IV
                    69Item
      15.
                    Exhibits
                    69SIGNATURES
                    74EXHIBIT
      INDEX
                    75


2




PART I





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 21E 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





General





In this
Annual Report on Form 10-K, we refer to Smart Online, Inc. as “Smart Online,”
the “Company,” “us,” “we,” and “our.” Smart Online was incorporated in Delaware
in August 1993 and became a public company through a self-registration in
February 2005. Smart Online’s common stock trades on the OTC Bulletin Board, or
the OTCBB, under the symbol “SOLN.”





We
develop and market software products and services targeted to small businesses
that are delivered via a Software-as-a-Service, or SaaS, model. We also provide
website consulting services, primarily in the e-commerce retail industry. In the
past we reached small businesses primarily through arrangements with channel
partners that private label our software applications and marketed them to their
customer bases through their corporate websites. We believe these relationships
provide a cost- and time-efficient way to market to a diverse and fragmented yet
very sizeable small-business sector. We continue to cultivate new channel
partners that will facilitate our efforts.  We also offer our products
directly to end-user small businesses through our OneBiz ® branded
website.





History





During
the early stages of our development, we offered application-specific software
using the “shrink-wrapped” method of distribution of diskettes and CD-ROMs,
primarily through large office supply retailers. In 2000, we undertook a
significant shift in our business strategy by moving away from the development
and sale of shrink-wrapped software products and began developing SaaS
applications for sale over the Internet.





Unlike
the shrink-wrapped distribution method that requires the end user to install,
configure, and maintain hardware, software, and network services internally to
support the software applications, or the ASP model that permits access to the
software resident on a server by a user from one dedicated PC, our proprietary
multi-tenant SaaS applications allow small businesses to subscribe and access
those applications via a browser from any PC on an as-needed basis, with no
installation or maintenance required by the end user.





In
October 2005, we acquired substantially all of the assets of Computility, Inc.,
or Computility, an Iowa-based, privately held developer and distributor of sales
force automation and customer relationship management, or SFA/CRM, software
applications. We operated this business under the name Smart CRM, Inc. (d/b/a
Computility), or Smart CRM. Upon our integration of Smart CRM’s SFA/CRM
application into our OneBiz ®
platform, we determined that the remaining operations of Smart CRM, specifically
consulting and network management, were not integral to our ongoing operations
and business model.


3


The Smart
CRM assets sold to Alliance included the 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 SaaS offerings.





In
October 2005, we purchased all of the capital stock of iMart Incorporated, or
iMart, a Michigan-based company providing multi-channel e-commerce systems.
Subsequently, we operated this business as our wholly owned subsidiary, Smart
Commerce, Inc., or Smart Commerce.





In 2007,
we operated our company as two segments. The two segments were our core
operations, or the Smart Online segment, and the operations of our
wholly owned subsidiary Smart Commerce, or the Smart Commerce segment. The
Smart Online segment generated revenues from the development and distribution of
Internet-delivered SaaS small-business applications through a variety of
channels. The Smart Commerce segment generated revenues primarily from
subscriptions to our multi-channel e-commerce systems, including domain name
registration and e-mail solutions, e-commerce solutions, and website design, as
well as website hosting and consulting services. We included costs that were not
allocated to specific segments, such as corporate general and administrative
expenses and share-based compensation expenses, in the Smart Online
segment. During late 2007 and the first quarter of 2008, we realigned
certain production and development functions and eliminated redundant
administrative functions and now report the consolidated business as a single
business segment.





In the
second half of 2007, we commenced an overall evaluation of our business model as
well as our current technologies, the outcome of which was our decision to
develop a core industry-standard platform for small business with an
architecture designed to integrate with a virtually unlimited number of other
applications, services, and existing infrastructures. These applications would
include not only our own small-business applications, which we are currently
optimizing, but also other applications we expect to arise from collaborative
partnerships with third-party developers and service providers. In addition, we
identified emerging-market opportunities in the small-business segment to
leverage social networking and community building. We are currently refining and
integrating these capabilities into the core platform to be readily available in
a “plug-and-play” fashion to meet any anticipated customer need or desire. We
believe that this platform and associated applications will provide
opportunities for new sources of revenue, including an increase in our
subscription fees. We also believe, because the platform is designed to follow
industry-standard protocol, that the customization efforts and associated
timeline previously necessary to meet a particular customer’s requirements will
diminish significantly, allowing us to shorten the sale-to-revenue
cycle.




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





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 channel
      partners’ needs.





Our SaaS
applications are designed to allow end users to access and work on information
securely from any location where an Internet browser can be accessed. These
applications include:





e-Commerce – Our e-commerce
applications are designed to give customers the capability to conduct
transactions online. These applications also include inventory query, shopping
cart, financial transactions, shipping, domain name registration and
business-to-business communication for small businesses. We provide consulting
services such as website design and launch, among others, in connection with
these applications. Our e-commerce offerings are designed to help direct
marketers increase sales, better leverage corporate resources, and deliver
superior customer service.


4


Our
OneBiz®platform
applications include





SFA/CRM – Our SFA/CRM
application allows end users to create standardized processes to define their
sales approach, create marketing plans, and monitor and guide sales activities.
Users can utilize the customer service management feature to create, monitor,
and track service requests. In addition, users can display and present their
business data with built-in report templates designed to provide information on
sales activity, pipeline activity, revenue, and other relevant business
data.





Business Dashboard – Our
Business Dashboard application provides a snapshot of real-time business data in
a single view, allowing users to monitor key information about their company and
employees. Examples of business information that end users may view on the
dashboard include a list of key documents for the user, daily events scheduled,
product shipments, and a list of new employees. The dashboard displays different
information to each user based upon his or her job function and access levels
within the company.





Accounting – Our Accounting
application is targeted for end users that want to create and maintain their
accounting records online in a secure fashion, but do not have the resources or
desire to utilize traditional accounting applications designed for larger
businesses. The Accounting application enables a user to create invoices, record
payments, print checks, produce real-time financial statements and reports, as
well as manage accounts receivable and payable.





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 leave under other policies
to each employee. The application allows an end-user manager to monitor and
approve or decline 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 end user to quickly browse to any date. Automated
e-mail reminders can be scheduled, indicating notification of an upcoming event.
In addition, employees may collaborate with their colleagues by sharing their
calendars and events. This application also includes a to-do list to set up
tasks, assign priorities and due dates, and mark tasks as complete.





Contacts – Our Contacts
application is designed to provide users with an online business contact
management system. Contacts can be sorted by group or alphabetically and may be
shared among colleagues. End users can add, edit, and remove contact groups as
needed, or they can use the default set of groups.





We also
provide services that are designed to complement our product offerings and allow
us to create custom business solutions that fit our channel partners’ needs.
These services include business consulting, graphic design, website content
syndication, specialized compensation calculations, online order management,
domain name registration, personalized e-mail creation, and warehouse order
fulfillment.





Mode
of Operations





Software-as-a-Service Model –
We follow the SaaS model for delivering our products and services to end users.
The on-demand SaaS model developed using multi-tenant architecture enables end
users to 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 and anywhere by the end user. Multi-tenant SaaS applications also permit
us to add needed functionality to our applications in one location for the
benefit of all end users. This capability allows us to provide upgrades
universally.


5


Integration and Sharing – Our
SaaS applications have the capability to allow sharing of information (with
selectivity and control options) among members of an organization. Each company
that subscribes to our SaaS applications can have multiple members or employees
who share information with one another. Information entered by one employee can
be shared and modified by one or more other employees who have the appropriate
access authority.





Target
Market and Sales Channels





Our
consistent focus has been to design software products and services to help start
and run small businesses in a more efficient and cost-effective manner. The
small-business market is diverse and fragmented, yet very large and, we believe,
underserved. We have focused on offering a wide range of software products that
combine simplicity and affordability and that meet the needs of small businesses
with capabilities that typically can be afforded only by much larger companies.
We follow a two-prong approach to target these small business and
entrepreneurial end users that access our software products and services via the
Internet. The first is an indirect approach via marketing partners that are
vertical intermediaries in industries such as agriculture, finance,
telecommunications, direct selling, retail, and technology as channels to reach
these small-business customers. The second is a direct approach via a website we
develop and maintain where our applications and business tools are marketed and
sold via monthly subscription under the OneBiz ®
brand.





Principal
Customers





During
2009, we consider four customers as our major customers, and the loss of any one
of these customers could have a material adverse effect on our business. Two of
these customers terminated their relationship with Company during
2009.





UR
Association, or URA, is a multi-level-marketing organization  that
sells memberships and subscriptions to independent business owners, or IBOs. The
net of the subscriptions from these IBOs represented approximately 29% of our
revenues for the year ended December 31, 2009. URA became a customer in 2007 and
represented 10% of our revenues in 2008.  Since our revenue is derived
from the IBOs, URA can directly influence the memberships and actions of the
IBOs, this revenue has been netted for purposes of this Annual Report on Form
10-K.





1-800-Pharmacy,
Inc. is a mail-order pharmacy that offers customers access both through a
toll-free number and website, and gives customers rebates on their
pharmaceutical and health & beauty purchases, as well as credit for
referring others.  1-800-Pharmacy accounted for approximately 13% of
our revenues for the year ended December 31, 2009. 1-800-Pharmacy became a
customer in 2007 and represented 3% of our revenues in 2008.





Britt
Worldwide, or BWW, is a multi-level-marketing entity that indirectly controls a
significant number of IBOs, who currently subscribe to our services. The
aggregate of the subscriptions from these IBOs represented approximately 25% of
our revenues for the year ended December 31, 2009. BWW became a customer after
we acquired iMart in October 2005 and represented 27% of our revenues in 2008.
Although our revenue is derived from the IBOs, BWW can influence the actions of
the IBOs, so this revenue has been aggregated for purposes of this Annual Report
on Form 10-K.  During 2009, BWW terminated its primary relationship
with our Company, as of December 31, 2009. Notwithstanding such termination,
several IBO’s have chosen to retain their subscription for our
services.





Vera
Bradley Designs, Inc., or Vera Bradley, is a manufacturer of high quality
handbags, luggage, and other accessories, accounted for approximately 19% of our
revenues for the year ended December 31, 2009. Vera Bradley became a customer in
2006 and represented 35% of our revenues in 2008.  During 2009, Vera
Bradley terminated its Services Agreement relationship with our Company. 
The fees for services and licensing paid by Vera Bradley under the Services
Agreement were $1,358,892 in 2008 and $275,111 for 2009.





Research
and Development





In the
second half of 2007, as part of a general restructuring, we began to conduct an
evaluation of our technology, platforms, and applications in an effort to
document and improve upon our current product offerings and determine which
applications, if any, should be discontinued. During 2008, we decided to develop
an industry-standard platform that would allow significant technological
flexibility with current and future customers. We devoted a substantial amount
of time and effort in 2008 and 2009 to developing this platform, updating and
migrating our business applications and tools to the new platform, and enhancing
the user interface of the products.  In addition, during 2009, we
continued the development work of SaaS applications for the not-for profit
segment of the marketplace.  We call this our LoyaltyClicksTM
product.





Our
research and development costs were approximately $0.6 million and $2.0 million
in 2009 and 2008, respectively. We have not engaged in any customer-sponsored
research and development.


6


Competition





The
market for small-business software applications in both the traditional and SaaS
environments is highly competitive and subject to rapid changes in technology
and delivery. 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 companies that offer only
one or two software products that compete with our broad range of software
products. Our principal direct competition is a number of very large vendors of
SaaS applications for small businesses that sell many products similar to ours.
These competitors include, but are not limited to, Microsoft, Oracle, NetSuite,
Intuit, SAP, Sage, Yahoo!, and Google.





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, ZOHO and
      others-
            Human
      resource software applications: ADP, Sage, and others-
            SFA/CRM
      applications: Microsoft, Sage, salesforce.com, NetSuite, and
      others-
            e-Commerce
      solutions: Register.com, GoDaddy.com, 1and1 Internet, eBay’s Storefront,
      Yahoo! Store, Microsoft, NetSuite, Intuit, and
  others





We also
expect to face competition from new entrants marketing SaaS applications similar
to ours to small businesses.





Although
we believe we offer highly competitive services and software, many of our
competitors do or may have greater resources and a larger number of total
customers for their products and services. In addition, a number of our
competitors already sell certain 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 adversely impact our revenue and profitability
targets and timetables.





On each
competitive front, we seek to compete against these larger and better-financed
companies primarily by offering an extensive 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 also believe a distinctive value proposition we offer is the integration of
our applications. To meet our business objectives, we will need to continue to
develop high quality and competitively priced new applications for our SaaS
offerings. If we are unable to do so, our revenue and profitability targets and
timetables could be adversely impacted.





To
compete effectively in the SaaS market, we leverage the marketing resources and
small-business customer relationships of our private-label marketing partners
that sell our SaaS applications by offering innovative and value-added products
and services.





Intellectual
Property





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 or design around certain aspects of our SaaS
offerings or to obtain and use information that we regard as proprietary, and
third parties may attempt to develop similar technology independently. In
addition, the laws of some foreign countries do not protect our proprietary
rights to the same 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 develop
an international presence.


7


We have
registered copyrights, trademarks, and registered service marks on several
products and data services. These marks include, but are not limited to Smart
Online ®, OneBiz
®,
Smart Attorney ®, Smart
Business Plan ®, Smart
Marketing Plan ®, iMart
TM,
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 for a period of three years. We also employ various physical and
technological security measures to protect our software source codes,
technology, and other proprietary information.





Employees





As of
December 31, 2009, we had 28 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.





Directors
and Executive Officers of the Company





The
members of our current Board of Directors are the following:




Dror
Zoreff


Chairman
of the Board and Interim President and Chief Executive Officer: President and
CEO of Donor Management Services, Inc., a New York-based company that provides
major donors, corporations, and foundations a unique set of tools and services
to ensure their charitable gifts are properly used and achieve the desired
impact.




Shlomo
Elia


Director
of 3Pen Ltd., a private holding company focusing on business opportunities in
Internet infrastructure and telecommunications.




Amir
Elbaz


Mr. Elbaz
currently advises technology and renewable energy companies on business
strategy, restructuring and business development initiatives.  Mr.
Elbaz served as the Executive Vice President & Chief Financial Officer of
Lithium Technology Corporation (“LTC”) until November 2008.  Mr. Elbaz
joined LTC in 2006 to oversee finances and marketing, as well as business
development.




C.
James Meese, Jr.


President
of Business Development Associates, Inc., a boutique investment bank that
provides enterprise level strategic advisory services to middle market companies
for business initiatives such as acquisitions, divestitures, valuations, interim
company management, growth capitalization and corporate governance.





Our
current executive officers are the following:




Dror
Zoreff


Interim
President and Chief Executive Officer




Thaddeus
Shalek


Interim
Chief Financial Officer


8


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 website current and accurate, there can be no guarantees
that the information on our website is up to date or correct. We make available,
free of charge, access to all reports filed with the U.S. Securities and
Exchange Commission, or SEC, including our Annual Reports on Form 10-K, our
Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and
amendments to these reports, filed or furnished pursuant to Section 13(a)
or 15(d) of the Exchange Act, as soon as reasonably practicable after we
electronically file such material with, or furnish it to, the SEC. These reports
may be accessed by following the link under “About Us - Investor Relations” on
our website.





ITEM
      1A.
            Risk
      Factors





We
operate in a dynamic and rapidly changing business environment that involves
substantial risk and uncertainty, and these risks may change over time. The
following discussion addresses some of the risks and uncertainties that could
cause, or contribute to causing, actual results to differ materially from
expectations. In evaluating our business, you should pay particular attention to
the descriptions of risks and uncertainties described below. 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 occur,
our business, financial condition, or results of operations could be materially
and adversely affected.





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





We have
had recurring losses from operations and continue to have negative cash flows.
If we do not become cash flow positive through additional financing or growth,
we may have to cease operations and liquidate our business. Our working capital,
which is dependent on our convertible note financing facility should fund our
operations for the next 12 to 18 months. As of April 14, 2010, we have
approximately $405,000 available on our line of credit and approximately $4.65
million available through our convertible note financing. Factors such as the
commercial success of our existing services and products, the timing and success
of any new services and products, the progress of our research and development
efforts, our results of operations, the status of competitive services and
products, the timing and success of potential strategic alliances or potential
opportunities to acquire technologies or assets, and expenses on account of
lawsuits brought by a former officer and a former employee for advancement of
indemnification expenses and the tentative settlement of the shareholder class
action lawsuit (see Part I, Item III, Legal Proceedings,below)
will require us to seek additional funding sooner than we expect. If we fail to
raise sufficient financing, we will not be able to implement our business plan
and may not be able to sustain our business.





In
addition, our current primary credit facilities consist of the Paragon line of
credit with a due date of August 14, 2010 and the convertible note financing
with a maturity date in November 2013. Should we be unable to repay the
principal then due from operations or from new or renegotiated capital funding
sources, we may not be able to sustain our business. As of April 14, 2010, we
have approximately $2.0 million outstanding on our line of credit and $10.65
million aggregate principal amount of convertible Notes
outstanding.





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





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


9


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





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





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





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





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




Our
future financial performance and revenue growth will depend, in part, upon the
successful development, integration, introduction, and customer acceptance of
our software applications. Thereafter, other new products, whether developed or
acquired, and enhanced versions of our existing applications will be critically
important to our business. Our business could be harmed if we fail to deliver
timely enhancements to our current and future solutions that our customers
desire. We also must continually modify and enhance our services and products to
keep pace with market demands regarding hardware and software platforms,
database technology, information security, and electronic commerce technical
standards. Our business could be harmed if we fail to achieve the improved
performance that customers want with respect to our current and future product
offerings. There can be no assurance that our products will achieve widespread
market penetration or that we will derive significant revenues from the sale or
licensing of our platforms or applications.





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





We have
invested significantly in infrastructure, operations, and strategic
relationships to support our SaaS delivery model, which represents a significant
departure from the delivery strategies that we and other software vendors have
traditionally employed. To maintain positive margins for our small-business
services, our revenues will need to continue to grow more rapidly than the cost
of such revenues. We anticipate that our future financial performance and
revenue growth will depend, in large part, upon our Internet-based SaaS business
model and the results of our sales efforts to reach agreements with marketing
partners with small-business customer bases, but this business model may become
ineffective due to forces beyond our control that we do not currently
anticipate. Although we currently have various agreements and continue to enter
into new agreements, our success depends in part on the ultimate success of our
marketing 
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 and may have difficulty retaining customers within certain
markets that we serve. In addition, some of these third parties have entered,
and may continue to enter, into strategic relationships with our competitors.
Further, many of our strategic partners have multiple strategic relationships,
and they may not regard us as significant for their businesses. Our strategic
partners may terminate their respective relationships with us, pursue other
partnerships or relationships, or attempt to develop or acquire products or
services that compete with our products or services. Our strategic partners also
may interfere with our ability to enter into other desirable strategic
relationships. If we are unable to maintain our existing strategic relationships
or enter into additional strategic relationships, we will have to devote
substantially more resources to the distribution, sales, and marketing of our
products and services.


10


In
addition, our end users currently do not sign long-term contracts. They have no
obligation to renew their subscriptions for our services after the expiration of
their initial subscription period and, in fact, they have often elected not to
do so. Our end users also may renew for a lower-priced edition of our services
or for fewer users. These factors make it difficult to accurately predict
customer renewal rates. Our customers’ renewal rates may decline or fluctuate as
a result of a number of factors, including when we begin charging for our
services, their dissatisfaction with our services, and their capability to
continue their operations and spending levels. If our customers do not renew
their subscriptions for our services or we are not able to increase the number
of subscribers, our revenue may decline and our business will
suffer.





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





Our
revolving line of credit from Paragon is secured by an irrevocable standby
letter of credit issued by HSBC Private Bank (Suisse) SA, or HSBC, with Atlas
Capital SA, or Atlas, as account party. Our secured subordinated convertible
notes are secured by a first priority lien on all of our unencumbered
assets.





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





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





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





The
SEC and criminal actions brought against certain former employees, and related
stockholder and other lawsuits have damaged our business, and they could damage
our business in the future.





The
SEC  lawsuit and criminal actions filed against a former officer and a
former employee, and the class action lawsuit filed against us and certain
current and former officers, directors, and employees have harmed our business
in many ways and may cause further harm in the future. Since the initiation of
these actions, our ability to raise financing from new investors on favorable
terms has suffered due to the lack of liquidity of our stock, the questions
raised by these actions, and the resulting drop in the price of our common
stock. As a result, we may not raise sufficient financing, if necessary, in the
future.





Legal and
other fees related to these actions have also reduced our available cash for
operations. We make no assurance that we will not continue to experience
additional harm as a result of these matters. The time spent by our management
team and directors dealing with issues related to these actions detracts, and
despite the tentative settlement of the class action continue to detract from
the time they spend on our operations, including strategy development and
implementation. These actions, more fully described in Part I, Item 3, “Legal
Proceedings“ in this Annual Report on Form 10-K, also have harmed our reputation
in the business community, jeopardized our relationships with vendors and
customers, and decreased our ability to attract qualified personnel, especially
given the media coverage of these events.


11


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





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





We
currently are required to comply with the requirements of Section 404 of
Sarbanes-Oxley involving management’s assessment of our internal control over
financial reporting, and our independent accountant’s audit of our internal
control over financial reporting is required for fiscal year 2010. To comply
with these requirements, we are evaluating and testing our internal controls,
and where necessary, taking remedial actions, to allow management to report
on, and our independent auditors to attest to, our internal control over
financial reporting. As a result, we have incurred and will continue to incur
expenses and diversion of management’s time and attention from the daily
operations of the business, which may increase our operating expenses
and impair our ability to achieve profitability.


12


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





Our  principal
stockholders beneficially own or control a large percentage of our outstanding
common stock. Certain of these principal stockholders hold warrants and
convertible notes, which may be exercised or converted into additional shares of
our common stock under certain conditions. The convertible noteholders have
designated a bond representative to act as their agent. We have agreed that the
bond representative shall be granted access to our facilities and personnel
during normal business hours, shall have the right to attend all meetings of our
Board of Directors and its committees, and shall receive all materials provided
to our Board of Directors or any committee of our Board. In addition, so long as
the notes are outstanding, we have agreed that we will not take certain material
corporate actions without approval of the bond representative.





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





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





We may
issue shares of our common stock in the future for a variety of reasons. For
example, under the terms of our stock purchase warrant and agreement with Atlas,
it may elect to purchase up to 444,444 shares of our common stock at $2.70 per
share upon termination of, or if we are in breach under the terms of, our line
of credit with Paragon. In connection with our private financing in February
2007, we issued warrants to the Investors (defined below) to purchase an
additional 1,176,471 shares of our common stock at $3.00 per share (which
warrants were not exercised and expired in February 2010) and a warrant to our
placement agent in that transaction to purchase 35,000 shares of our common
stock at $2.55 per share. Upon maturity of their convertible Notes, our
convertible noteholders may elect to convert all, a part of, or none of their
Notes into shares of our common stock at a floating conversion price. In
addition, we may raise funds in the future by issuing additional shares of
common stock or other securities.





Under
the  tentative class action settlement, the settlement consideration
would include 1,475,000 shares of Company common stock. Under the terms of the
tentative settlement, counsel for the settlement class may sell some or all of
the common stock received in the settlement before distribution to the class,
subject to the limitation that it cannot sell more than 10,000 shares on one day
or 50,000 shares in 30 calendar days. This issuance and sale may have a further
dilutive effect on the value of the Company’s outstanding shares.




If we
raise additional funds through the issuance of equity securities or debt
convertible into equity securities, the percentage of stock ownership by our
existing stockholders would be reduced. In addition, such securities could have
rights, preferences, and privileges senior to those of our current stockholders,
which could substantially decrease the value of our securities owned by them.
Depending on the share price we are able to obtain, we may have to sell a
significant number of shares in order to raise the necessary amount of capital.
Our stockholders may experience dilution in the value of their shares as a
result.





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





Future
sales of substantial amounts of our shares in the public market, or the
appearance that a large number of our shares are available for sale, could
adversely affect market prices prevailing from time to time and could impair our
ability to raise capital through the sale of our securities. At April 8, 2010,
18,332,543 shares of our common stock were issued and outstanding, and a
significant number of shares may be issued upon the exercise of outstanding
options, warrants, and convertible notes.


13


In
addition, our stock historically has been very thinly traded. Our stock price
may decline if the resale of shares under Rule 144, in addition to the resale of
registered shares, at any time in the future exceeds the market demand for our
stock.





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





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





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





Our
securities may be subject to “penny stock” rules, which could adversely affect
our stock price and make it more difficult for our stockholders to resell their
stock.





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





The penny
stock rules require a broker-dealer, prior to a transaction in a penny stock not
otherwise exempt from those rules, to deliver a standardized risk disclosure
document prescribed by the SEC and certain other information related to the
penny stock, the broker-dealer’s compensation in the transaction, and the other
penny stocks in the customer’s account.





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





The
executive management team is critical to the execution of our business plan, and
the frequency of management turnover has been disruptive to the success of the
business.





Our
executive management team has undergone significant changes
during  2008 and  2009, including the resignation of our
former Chief Executive Officer in December 2008, our former interim Chief
Executive Officers  in May 2009 and November 2009 and the resignation
of our former Chief Financial Officer in May 2009, among others. . Furthermore,
in light of the prior SEC charges filed against us, and the related adverse
publicity from the criminal trial and conviction of the Nouris (defined below),
it may be difficult to attract highly qualified candidates to serve on our
executive management team. If we cannot attract and retain qualified personnel
and integrate new members of our executive management team effectively into our
business, then our business and financial results may suffer. In addition, all
of our executive team works at the same location, which could make us vulnerable
to the loss of our entire team in the event of a natural or other disaster. We
do not maintain key man insurance policies on any of our employees.





Our
line of credit with Paragon Bank expires on August 14, 2010.





Paragon Bank has extended our line of
credit until August 14, 2010.  If we are unable to establish a new
line of credit we may have difficulty dealing with cash flow activities of daily
business operations that will be disruptive to the future success of the
business.


14





Item 1B.
            Unresolved
      Staff Comments





Not
applicable.




Item 2.
            Properties





Our
corporate headquarters and research and development facility is located in
Durham, North Carolina near Research Triangle Park and consists of approximately
9,837 square feet of office space held under a prepaid sublease that expires in
September 2011.





Item 3.
            Legal
      Proceedings




Gooden v. Smart Online, Inc.
– On October 18, 2007, Robyn L. Gooden filed a purported class action
lawsuit in the United States District Court for the Middle District of North
Carolina naming us, certain of our current and former officers and directors,
Maxim Group, LLC, and Jesup & Lamont Securities Corp. and Sherb & Co.
(our former independent registered accounting firm) as defendants. The lawsuit
was filed on behalf of all persons other than the defendants who purchased our
securities from May 2, 2005 through September 28, 2007 and were damaged. The
complaint asserts violations of federal securities laws, including violations of
Section 10(b) of the Exchange Act and Rule 10b-5. The complaint asserts
that the defendants made material and misleading statements with the intent to
mislead the investing public and conspired in a fraudulent scheme to manipulate
trading in our stock, allegedly causing plaintiffs to purchase the stock at an
inflated price. The complaint requests certification of the plaintiff as class
representative and seeks, among other relief, unspecified compensatory damages
including interest, plus reasonable costs and expenses including counsel fees
and expert fees. On June 24, 2008, the court entered an order appointing a lead
plaintiff for the class action. On September 8, 2008, the plaintiff filed an
amended complaint that added additional defendants who had served as our
directors or officers during the class period as well as our independent
auditor.  The Company and the lead plaintiff in the action have been
engaged in settlement negotiations, and have recently reached an agreement in
principle and tentative settlement which has not yet been signed providing for
the settlement of the  securities class action on the following terms.
The settlement, once signed, would be subject to court approval. The tentative
settlement contemplates a cash payment of $350,000 to be made by the Company and
the issuance to the class of 1,475,000 shares of Company common stock, in
consideration for which all claims against the settling defendants would be
dismissed with prejudice, with no admission of fault or wrongdoing by the
Company or the other defendants.  The Company's additional charge to
expenses for 2009 as a result of this tentative settlement is approximately
$2,150,000.




Nouri Indemnification Claims
- On July 2, 2009, Dennis Michael Nouri, a former officer of Smart Online,
Inc. (the “Company”), and Reza Eric Nouri, a former employee of the Company
(together, the “Nouris”), were convicted of nine counts of criminal activity in
a federal criminal action brought against them in the United States District
Court for the Southern District of New York involving a fraudulent scheme
to manipulate the Company’s stock price, and are presently awaiting
sentencing.  On September 24, 2009,  the Nouris filed a
motion in the Court of Chancery of the State of Delaware against the
Company  seeking  the appointment of a receiver for the Company
for the purpose of collecting on account of the Company’s failure to pay a
judgment in the amount of $826,798 entered against it by order of the Court of
Chancery on August 6, 2009 (the “Order”) for the advancement of legal expenses
incurred by the Nouris in their defense of criminal proceedings brought against
them by the United States, and in their defense of civil proceedings brought
against them by the Securities and Exchange Commission and the Company’s
stockholders.  Such legal expenses were in addition to legal fees and
costs of over $1.3 million paid by the Company’s insurance carrier for the
benefit of the Nouris in these matters prior to entry of the Order, which
insurance coverage has since been exhausted. The terms of the Order were
previously reported in the Form 10-Q filed by the Company for the quarterly
period ended June 30, 2009. The Company has recorded a total of unpaid legal
expense obligations of $1,798,595 for this matter based on invoices received
from the Nouris’ law firms through March 31, 2010 which figure does not include
invoices generated but not yet received.  The Company and the Nouris
have been engaged in settlement negotiations for the settlement of the Nouris’
advancement and indemnification claims against the Company, but no definitive
agreement has yet been signed.





At this
time, except as discussed above, we are not able to determine the outcome of the
legal matters described above, nor can we estimate our entire potential
financial exposure. If an unfavorable resolution of any of these matters occurs,
our business, results of operations, and financial condition could be materially
adversely affected.





Item 4.
            Submission
      of Matters to a Vote of Security
Holders





Not
applicable.




PART II





Item
      5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities





Our
common stock is quoted on the OTCBB under the symbol “SOLN.” The following table
sets forth the range of high and low sales prices of our common stock quoted on
the OTCBB for the quarterly periods indicated.


15





High
                  
                  
                  LowYear
      Ended December 31, 2008:First
      Quarter
                  
                  $
                  2.60
                  
                  
                  $
                  1.65Second
      Quarter
                  
                  $
                  3.40
                  
                  
                  $
                  1.32Third
      Quarter
                  
                  $
                  3.30
                  
                  
                  $
                  1.95Fourth
      Quarter
                  
                  $
                  3.15
                  
                  
                  $
                  1.50Year
      Ended December 31, 2009:First
      Quarter
                  
                  $
                  2.60
                  
                  
                  $
                  1.10Second
      Quarter
                  
                  $
                  2.00
                  
                  
                  $
                  1.01Third
      Quarter
                  
                  $
                  1.70
                  
                  
                  $
                  0.41Fourth
      Quarter
                  
                  $
                  1.50
                  
                  
                  $
                  1.11





At April
14, 2010, there were 198 holders of record of our common stock.





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. As long as our
convertible notes are outstanding, we must receive approval from the agent
designated by the noteholders in order to pay any dividend on our capital
stock.





During
2009, by private placements of convertible notes to accredited investors under
Regulation D, equity securities were sold 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, and more fully
described in Part II, Item VII, “Management’s Discussion and Analysis of
Financial Condition and Results of Operations”, under the sub-heading Debt Financing, in this
Annual Report on Form 10-K.





The
following table lists all repurchases during the fourth quarter of 2009 of any
of our securities registered under Section 12 of the Exchange Act by or on
behalf of us or any affiliated purchaser.





Issuer
Purchases of Equity Securities




Period
                                              
                                              Total
                                                Number of
                                                Shares
                                                Purchased
                                                (1)
                                              
                                              Average
                                                Price
                                                Paid Per
                                                Share
                                              
                                              Total Number of
                                                Shares Purchased as
                                                Part of Publicly
                                                Announced Plans or
                                                Programs
                                              
                                              Maximum
                                                Number of
                                                Shares That May
                                                Yet Be Purchased
                                                Under the Plans
                                                or ProgramsOctober
      1 – October 31, 2009
                                              
                                              -
                                              
                                              $
                                              -
                                              
                                              -
                                              
                                              -November
      1 – November 30, 2009
                                              
                                              -
                                              
                                              $
                                              -
                                              
                                              -
                                              
                                              -December
      1 – December 31, 2009
                                              
                                              -
                                              
                                              $
                                              -
                                              
                                              -
                                              
                                              -Total
                                              
                                              -
                                              
                                              $
                                              -
                                              
                                              -
                                              
                                              -




Item
      6.
            Selected
      Financial Data




Not
applicable.





Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations





Executive
Summary





The
following discussion is designed to provide a better understanding of our
consolidated financial statements, including a brief discussion of our business
and products, key factors that impacted our performance, and a summary of our
operating results. This executive summary should be read in conjunction with the
more detailed discussion and analysis of our financial condition and results of
operations in this Item 7; Item 1A, “Risk Factors”; and our consolidated
financial statements and the notes thereto included in Item 8, “Financial
Statements and Supplementary Data.”


16


Overview





We
develop and market software products and services targeted to small businesses
that are delivered via a SaaS model. We also provide website consulting
services, primarily in the e-commerce retail industry. We reach small businesses
primarily through arrangements with channel partners that private label our
software applications and market them to their customer bases through their
corporate websites. We believe these relationships provide a cost- and
time-efficient way to market to a diverse and fragmented yet very sizeable
small-business sector. We also offer our products directly to end-user small
businesses through our OneBiz ® branded
website.





In the
second half of 2007, we commenced an overall evaluation of our business model as
well as our current technologies, the outcome of which was our decision to
develop a core industry-standard platform for small business with an
architecture designed to integrate with a virtually unlimited number of other
applications, services, and existing infrastructures. These applications would
include not only our own small-business applications, which we are currently
optimizing, but also other applications we expect to arise from collaborative
partnerships with third-party developers and service providers. In addition, we
identified emerging-market opportunities in the small-business segment to
leverage social networking and community building. We are currently refining and
integrating these capabilities into the core platform to be readily available in
a “plug-and-play” fashion to meet any anticipated customer need or desire. On
July 14, 2009, we announced the release of OneBiz 1.1, a suite of web-based
business management tools designed for small business owners to operate and grow
their businesses. We believe that this platform and associated applications will
provide opportunities for new sources of revenue, including an increase in our
subscription fees. We also believe, because the platform is designed to follow
industry-standard protocol, that the customization efforts and associated
timeline previously necessary to meet a particular customer’s requirements will
diminish significantly, allowing us to shorten the sale-to-revenue cycle.  As
we neared completion of the development of our industry-standard platform, we
began shifting our focus from development toward the sales and marketing of the
new platform in the fourth quarter of 2008 and continued the effort throughout
2009.





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





Sources
of Revenue





We derive
revenues from the following sources:





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




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




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




·
            Hosting
      fees – fees charged for providing network accessibility  for our
      customers  using our customized
  platforms





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


17


Our
current primary focus is to target those established companies that have both a
substantial base of small-business customers as well as a recognizable and
trusted brand name in specific market segments. Our goal is to enter into
partnerships with these established companies whereby they private label our
products and offer them to their small-business customers. We believe the
combination of the magnitude of their customer bases and their trusted brand
names and recognition will help drive our subscription volume.
 
 Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. We make subscription sales either on a
subscription or on a “for fee” basis. Applications for which subscriptions are
available vary from our own direct sale website, OneBiz ®, to the
websites of our partners. Subscriptions are generally payable on a monthly basis
and are typically paid via credit card of the individual end user. We are
focusing our efforts on enlisting new channel partners as well as diversifying
with vertical intermediaries in various industries.  In the past, we
recognized all subscription revenue on a gross basis and in accordance with our
policy to periodically review our accounting policies we recognized that certain
contracts require the reporting of subscription revenue on a gross basis and
others on a net basis according to US GAAP.  On that basis, we
continue to report subscription revenue from certain contracts on a gross basis
and others on a net basis.  The net effect of this reclassification of
expenses only impacts gross revenue and certain gross expenses; it does not
change the net income.  We discuss this matter in more depth in
Footnote 1 to the financial statements.
 
 We
generate professional service fees from our consulting services. For example, a
partner may request that we re-design its website to better accommodate our
products or to improve its own website traffic. We typically bill professional
service fees on a time and material basis.
 
 License
fees consist of perpetual or term license agreements for the use of the Smart
Online platform or any of our applications.
 
 Hosting
fees charged for providing our customers with network
accessibility.
 
 Other
revenues primarily consist of non-core revenue sources such as syndication and
integration fees, miscellaneous web services, and OEM revenue generated through
sales of our applications bundled with products offered by other
manufacturers.
 
 Cost
of Revenues
 
 Cost of
revenues primarily is composed of salaries associated with maintaining and
supporting customers, the cost of domain name and e-mail registrations, and the
cost of external facilities where our applications and our customers’ customized
applications are hosted.
 
 Operating
Expenses
 
 In
previous years, we primarily focused our efforts on basic product development
and integration. In the early part of 2007, we also began to focus on licensing
our platform products and applications. During 2008, our primary business
initiatives included increasing subscription fee revenue and professional
services revenue, making organizational improvements, concentrating our
development efforts on enhancements and customization of our platforms and
applications, and shifting our strategic focus to the sales and marketing of our
products. In  2009, we launched our new industry-standard platform,
OneBiz, along with enhanced applications targeted to small businesses and
devoted significant resources to the sale and marketing of these applications
through both channel partners and direct sales efforts.
 
 General and Administrative –
General and administrative expenses are composed primarily of costs associated
with our executive, finance and accounting, legal, human resources, and
information technology personnel and consist of salaries and related
compensation costs; professional services (such as outside legal counsel fees,
audit, and other compliance costs); depreciation and amortization; facilities
and insurance costs; and travel and other costs. We anticipate general and
administrative expenses will decrease in 2010 as the legal expenses and other
professional fees we incurred in 2009 to resolve outstanding matters from
previous years and to assist with the transition between permanent financial
officers are offset in part by an increase in costs related to the growth of our
business and to our operations as a public company.
  18
  Sales and Marketing – Sales
and marketing expenses are composed primarily of costs associated with our sales
and marketing activities and consist of salaries and related compensation costs
of our sales and marketing personnel, travel and other costs, and marketing and
advertising expenses. In the past, sales and marketing also included the amounts
we paid to our marketing partners as part of the subscription revenue received;
in the past, the subscription revenue was presented as a gross amount as was the
amount included in the sales and marketing category.  As part of our
ongoing review of accounting pronouncements, we have reclassified the revenues
and sales and marketing expenses to reflect net revenue and expense – see
footnote 1 to the financial statements for further
details.  Historically, we spent limited funds on marketing,
advertising, and public relations, particularly due to our business model of
partnering with established companies with extensive small-business customer
bases. In June 2008, we engaged a public relations firm and, as a result, our
public relations expenses increased during the latter part of 2008 and 2009. As
we continue to execute our sales and marketing strategy to take our enhanced
products to market, we expect associated costs to increase in 2010 due to
targeting new partnerships, development of channel partner enablement programs,
advertising campaigns, additional sales and marketing personnel, and the various
percentages of revenues we may be required to pay to future partners as
marketing fees.
 
 Research and Development –
Research and development expenses include costs associated with the development
of new products, enhancements of existing products, and general technology
research. These costs are composed primarily of salaries and related
compensation costs of our research and development personnel as well as outside
consultant costs.
 
 Professional  accounting
standards require capitalization of certain software development costs
subsequent to the establishment of technological feasibility, with costs
incurred prior to this time expensed as research and development. Technological
feasibility is established when all planning, designing, coding, and testing
activities that are necessary to establish that the product can be produced to
meet its design specifications have been completed. Historically, we had not
developed detailed design plans for our SaaS applications, and the costs
incurred between the completion of a working model of these applications and the
point at which the products were ready for general release had been
insignificant. As a result of these factors, combined with the historically low
revenue generated by the sale of the applications that do not support the net
realizable value of any capitalized costs, we continued the expensing of
underlying costs as research and development.
 
 Beginning
in May 2008, we determined that it was strategically desirable to develop an
industry-standard platform and to enhance our current SaaS applications. A
detailed design plan indicated that the product was technologically feasible. In
July 2008, we commenced development, and from that point in time, we are
capitalizing all related costs in accordance with accounting
principles. Because of our scalable and secure multi-user architecture, we
are able to provide all customers with a service based on a single version of
our application. As a result, we do not have to maintain multiple versions,
which enables us to incur relatively low development costs as compared to
traditional enterprise software business models. We completed the core
development of our new applications during 2009 and we expect that future
research and development expenses will decrease in both absolute and relative
dollars as we amortize the capitalized costs associated with the new platform
and reduce our personnel to a core group focused on enhancements and custom
development work for customers.
 
 Stock-Based Expenses – Our
operating expenses include stock-based expenses related to options, restricted
stock awards, and warrants issued to employees and non-employees. These charges
have been significant and are reflected in our historical financial results.
Effective January 1, 2006, we adopted accounting standards that resulted and
will continue to result in material costs on a prospective basis as long as a
significant number of options are outstanding. In June 2007, we limited the
issuance of awards under our 2004 Equity Compensation Plan, or the 2004 Plan, to
awards of restricted or unrestricted stock. In June 2008, we made options
available for grant under the 2004 Plan once again, primarily due to the adverse
 tax
consequences to recipients of restricted stock upon the lapsing of
restrictions.
 
 Critical
Accounting Policies and Estimates
 
 Our
discussion and analysis of financial condition and results of operations are
based upon our financial statements, which we prepared in accordance with United
States Generally Accepted Accounting Principles (“US GAAP”). The preparation of
these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues, and expenses and
related disclosures of contingent assets and liabilities. “Critical accounting
policies and estimates” are defined as those most important to the financial
statement presentation and that require the most difficult, subjective, or
complex judgments. We base our estimates on historical experience and on various
other factors that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying value of
assets and liabilities that are not readily apparent from other sources. Under
different assumptions and/or conditions, actual results of operations may
materially differ. We periodically reevaluate our critical accounting policies
and estimates, including those related to revenue recognition, provision for
doubtful accounts, expected lives of customer relationships, useful lives of
intangible assets and property and equipment, provision for income taxes,
valuation of deferred tax assets and liabilities, and contingencies and
litigation reserves. We believe the following critical accounting policies
involve the most significant judgments and estimates used in the preparation of
our consolidated financial statements.
  19
  Revenue Recognition – We
derive revenue primarily from subscription fees charged to customers accessing
our SaaS applications; professional service fees, consisting primarily of
consulting; the perpetual or term licensing of software platforms or
applications; and hosting and maintenance services. These arrangements may
include delivery in multiple-element arrangements if the customer purchases a
combination of products and/or services. Because we license, sell, lease, or
otherwise market computer software, we use the residual method pursuant to US
GAAP.  This method allows us to recognize revenue for a delivered
element when such element has vendor specific objective evidence, or VSOE, of
the fair value of the delivered element. If we cannot determine or maintain VSOE
for an element, it could impact revenues, as we may need to defer all or a
portion of the revenue from the multiple-element arrangement.
 
 If
multiple-element arrangements involve significant development, modification, or
customization, or if we determine that certain elements are essential to the
functionality of other elements within the arrangement, we defer revenue until
we provide to the customer all elements necessary to the functionality. The
determination of whether the arrangement involves significant development,
modification, or customization could be complex and require the use of judgment
by our management.
 
 Under US
GAAP, provided the arrangement does not require significant development,
modification, or customization, we recognize revenue when all of the following
criteria have been met:
 
 1.     persuasive
evidence of an arrangement exists
 
 2.     delivery
has occurred
 
 3.     the
fee is fixed or determinable
 
 4.     collectability
is probable
 
 If at the
inception of an arrangement the fee is not fixed or determinable, we defer
revenue until the arrangement fee becomes due and payable. If we deem
collectability not probable, we defer revenue until we receive payment or
collection becomes probable, whichever is earlier. The determination of whether
fees are collectible requires judgment of our management, and the amount and
timing of revenue recognition may change if different assessments are
made.
 
 We
account for consulting, website design fees and application development services
separately from the license of associated software platforms when these services
have value to the customer and there is objective and reliable evidence of fair
value of each deliverable. When accounted for separately, we recognize revenue
as the services are rendered for time and material contracts, and when
milestones are achieved and accepted by the customer for fixed price or
long-term contracts. The majority of our consulting service contracts are on a
time and material basis, and we typically bill our customers monthly based upon
standard professional service rates.
 
 Application
development services are typically fixed price and of a longer term. As such, we
account for them as long-term construction contracts that require us to
recognize revenue based on estimates involving total costs to complete and the
stage of completion. Our assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, we capitalize the associated costs
of such projects and include them in costs in excess of billings on the balance
sheet until such time that we are permitted to recognize
revenue.
  20
  Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
marketing partners in order to encourage them to market our products and
services to their customers. Subscriptions are generally payable on a monthly
basis and are typically paid via credit card of the individual end user. We
accrue any payments received in advance of the subscription period as deferred
revenue and amortize them over the subscription period. In the past we
recognized all subscription revenue on a gross basis and in accordance with our
policy to periodically review our accounting policies we determined that certain
contracts require the reporting of subscription revenue on a gross basis and
others on a net basis according to US GAAP.  On that basis, we
continue to report subscription revenue from certain contracts on a gross basis
and others on a net basis.  The net effect of this reclassification of
expenses only impacts gross revenue and certain gross expenses; it does not
change the net income.  We discuss this matter in more depth in
Footnote 13 to the financial statements.
 
 Because
our customers generally do not have the contractual right to take possession of
the software we license or market at any time, we recognize revenue on hosting
and maintenance fees as we provide the services in accordance with US
GAAP.
 
 Provision for Doubtful Accounts
– We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability, failure, or refusal of our customers to make
required payments. We evaluate the need for an allowance for doubtful accounts
based on specifically identified amounts that we believe to be potentially
uncollectible. Although we believe that, our allowances are adequate, if the
financial conditions of our customers deteriorate, resulting in an impairment of
their ability to make payments, or if we underestimate the allowances required,
additional allowances may be necessary, which will result in increased expense
in the period in which such determination is made.
 
 Impairment of Long-Lived
Assets – We record our long-lived assets, such as intangibles, property
and equipment, at cost. We review the carrying value of our indefinite lived
intangibles for possible impairment at least annually in the fourth quarter, and
all long-lived assets whenever events or changes in circumstances indicate that
the carrying amount of assets may not be recoverable in accordance with the US
GAAP. We measure the recoverability of assets to be held and used by comparing
the carrying amount of the asset to the fair value. If we consider such assets
to be impaired, we measure the impairment as the amount by which the carrying
amount exceeds the fair value, and we recognize it as an operating expense in
the period in which the determination is made. We report assets to be disposed
at the lower of the carrying amount or fair value less costs to sell. Although
we believe that the carrying values of our long-lived assets are appropriately
stated, changes in strategy or market conditions or significant technological
developments could significantly impact these judgments and require adjustments
to recorded asset balances.
 
 In
addition to the recoverability assessment, we also routinely review the
remaining estimated useful lives of our long-lived assets. Any reduction in the
useful-life assumption will result in increased depreciation and amortization
expense in the period when such determinations are made, as well as in
subsequent periods.
 
 Income Taxes – We are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This involves estimating our current tax liabilities in each
jurisdiction, including the impact, if any, of additional taxes resulting from
tax examinations, as well as making judgments regarding our ability to realize
our deferred tax assets. Such judgments can involve complex issues and may
require an extended period to resolve. In the event we determine that we will
not be able to realize all or part of our net deferred tax assets, we would make
an adjustment in the period we make such determination. We recorded no income
tax expense in 2009 and 2008, as we have experienced significant operating
losses to date. If utilized, we may apply the benefit of our total net operating
loss carryforwards to reduce future tax expense. Since our utilization of these
deferred tax assets is dependent on future profits, which are not assured, we
have recorded a valuation allowance equal to the net deferred tax assets. These
carryforwards would also be subject to limitations, as prescribed by applicable
tax laws. As a result of prior equity financings and the equity issued in
conjunction with certain acquisitions, we have incurred ownership changes, as
defined by applicable tax laws. Accordingly, our use of the acquired net
operating loss carryforwards may be limited. Further, to the extent that any
single-year loss is not utilized to the full amount of the limitation, such
unused loss is carried over to subsequent years until the earlier of its
utilization or the expiration of the relevant carryforward
period.
  21
  2009
Summary
 
 The
following is a summary of key financial results and certain non-financial
results achieved for the year ended December 31, 2009:
 
 ·
              Our total revenues for the year
      were $1.4 million, a decrease from 2008 of $2.5 million, or 63%. This
      overall decrease in revenues was primarily attributable to decreases in
      professional and subscription fees. Professional fees decreased due to the
      loss of major client during
2009.
  ·
              Our gross loss for the year was
      $125,000, a decrease from 2008 of $ 1.9 million, or 107%. This decline was
      primarily attributable to lower revenue, but it was also impacted by
      higher costs incurred in connection with supporting existing
      direct-selling organization
customers.
  ·
              Operating expenses for the year
      were $8.8 million, a decrease from 2008 of $2.9 million, or 25%. A
      significant portion of this increase was a loss on impairment of
      intangible assets of $3.7 million that we recognized in 2008. The
      remaining increase was in research, development, sales and marketing
      expenses.
  ·
              Our loss from operations for the
      year was $8.9 million, a decrease from 2008 of $950,000, or 9%. Net loss
      per basic and fully diluted share was $0.52 in 2009 compared to $0.55 in
      2008.
  ·
              Cash and cash equivalents at
      December 31, 2009 were $120,000 compared to $19,000 at December 31, 2008.
      The primary reason for this increase is that in 2009, we received
      subscription revenue at the end of the accounting
      period.
  ·
              In the third quarter of 2008, we
      began capitalizing the costs associated with our new industry-standard
      platform and continued capitalization of expenses until the first release
      in the second half of 2009.
  Business
Outlook
 
 We
believe that the current economic recession will spawn a record number of new,
highly fragmented and underserved small businesses seeking low-cost tools and
applications to help them operate. We also believe that trade organizations and
other membership- or subscription-driven agencies and companies will recognize
an increased need for customer retention and will look for new and innovative
ways to achieve this. Both of these events could increase our ability to obtain
new channel partners and end-user businesses in 2010. However, we also believe
that competition for Internet-delivered business solutions will increase. We
anticipate focusing on the following key areas, among others, during 2010 in
response to these opportunities and competitive environment:
 
 ·
              Investment in
      technology, product development, and infrastructure.  We plan to enhance our
      industry-standard platform in 2010 and increase the number of applications
      for our business tools and continue the development of our products for
      the not-for-profit industry. In addition, we expect to continue investing
      in our production server infrastructure to ensure scalability and
      reliability through load balancing and redundancy as users are
      added.
  22
  ·
              Investment in
      marketing.  In
      2008 and 2009, we began to shift our focus from development to sales and
      marketing of our products. We expect to increase this effort in 2010
      through public relations, attendance at trade shows, print and electronic
      advertisements, e-mail marketing, white-paper placement, webcasts,
      blogging, and paid search, among other
  tactics.
 
 ·
              Expansion of
      our sales channels.
       We intend to expand our sales force and channel partner
      relationships to reach more small-business end
    users.
 
 ·
              Continuation
      of operating improvements.  We continue to streamline
      our operations in an effort to reduce cash burn, reach profitability, and
      improve efficiencies. We will continue to focus on this critical area in
      2010 by questioning current practices, closely scrutinizing
      actual-to-budget variances to identify deviations early, and realigning
      the business as required to meet the needs of our
      operations.
 
 Results
of Operations
 
 The
following table sets forth certain consolidated statements of operations data
for the periods indicated:
 
 2009
                            
                            
                            2008Dollars
                            
                            
                            % of
                              Revenue
                            
                            
                            Dollars
                            
                            
                            % of
                              RevenueTotal
      revenues
                            
                            $
                            1,419,502
                            
                            
                            
                            100.00
                            %
                            
                            $
                            3,879,179
                            
                            
                            
                            100.00
                            %Cost
      of revenues
                            
                            
                            1,544,861
                            
                            
                            
                            108.83
                            %
                            
                            
                            2,021,489
                            
                            
                            
                            52.11
                            %Gross
      (loss) profit
                            
                            $
                            (125,359
                            )
                            
                            
                            (8.83
                            )%
                            
                            $
                            1,857,690
                            
                            
                            
                            47.89
                            %Operating
      expenses
                            
                            
                            8,772,163
                            
                            
                            
                            617.97
                            %
                            
                            
                            11,705,668
                            
                            
                            
                            301.76
                            %Loss
      from operations
                            
                            $
                            (8,897,522
                            )
                            
                            
                            (626.81
                            )%
                            
                            $
                            (9,847,978
                            )
                            
                            
                            (253.87
                            )%Other
      income (expense), net
                            
                            
                            (643,349
                            )
                            
                            
                            (45.32
                            )%
                            
                            
                            (204,171
                            )
                            
                            
                            (5.26
                            )%Net
      loss
                            
                            $
                            (9,540,871
                            )
                            
                            
                            (672.13
                            )%
                            
                            $
                            (10,052,149
                            )
                            
                            
                            (259.13
                            )%Net
      loss per common share
                            
                            $
                            (.52
                            )
                            
                            
                            
                            
                            
                            $
                            (0.55
                            )
 
 Revenues
 
 Revenues
for 2009 and 2008 comprise the following:
 
 Years Ended December 31,
                                
                                
                                Year-Over-Year Change2009
                                
                                
                                2008
                                
                                
                                Dollars
                                
                                
                                PercentSubscription
      fees
                                
                                $
                                756,233
                                
                                
                                $
                                1,587,942
                                
                                
                                $
                                (831,709
                                )
                                
                                
                                (52.38
                                )%Professional
      service fees
                                
                                
                                335,079
                                
                                
                                
                                1,859,154
                                
                                
                                
                                (1,524,075
                                )
                                
                                
                                (81.98
                                )%License
      fees
                                
                                
                                45,000
                                
                                
                                
                                26,250
                                
                                
                                
                                18,750
                                
                                
                                
                                71.43
                                %Hosting
      fees
                                
                                
                                156,053
                                
                                
                                
                                259,675
                                
                                
                                
                                (103,622
                                )
                                
                                
                                (39.90
                                )%Other
      revenue
                                
                                
                                127,137
                                
                                
                                
                                146,158
                                
                                
                                
                                (19,021
                                )
                                
                                
                                (13.01
                                )%Total
      revenues
                                
                                $
                                1,419,502
                                
                                
                                $
                                3,879,179
                                
                                
                                $
                                (2,459,677
                                )
                                
                                
                                (63.41
                                )%
 
 Revenues
decreased 63% to $1.4 million in 2009 from $3.9 million in 2008. Our overall
decrease in revenues was the result of decreased professional service and
subscription fees.  Select items are discussed in detail
below.
  23
  Subscription
Fees
 
 Revenues
from subscription fees for 2009 and 2008 are as follows:
 
 Years Ended December 31,
                                              
                                              
                                              Year-Over-Year Change2009
                                              
                                              
                                              2008
                                              
                                              
                                              Dollars
                                              
                                              
                                              PercentSubscription
      fees
                                              
                                              $
                                              756,233
                                              
                                              
                                              $
                                              1,587,942
                                              
                                              
                                              $
                                              (831,709
                                              )
                                              
                                              
                                              (52.4
                                              )%Percent
      of total revenues
                                              
                                              
                                              53.3
                                              %
                                              
                                              
                                              40.9
                                              %
 
 Revenue
from subscription fees decreased 52% to $756,000 in 2009 from $1.6 million in
2008. This decrease is primarily attributable to the loss of a direct-selling
organization customer.
 
 Professional
Service Fees
 
 Revenues
from professional service fees for 2009 and 2008 are as follows:
 
 Years Ended December 31,
                                    
                                    
                                    Year-Over-Year
                                      Change2009
                                    
                                    
                                    
                                    2008
                                    
                                    
                                    Dollars
                                    
                                    
                                    PercentProfessional
      service fees
                                    
                                    $
                                    335,079
                                    
                                    
                                    $
                                    1,859,154
                                    
                                    
                                    $
                                    (1,524,075
                                    )
                                    
                                    (82.0
                                    )%Percent
      of total revenues
                                    
                                    
                                    23.6
                                    %
                                    
                                    
                                    47.9
                                    %
 
 Revenue
from professional service fees decreased 82% to $335,000 in 2009 from $1.9
million in 2008. This decrease was due to a decrease in customers requesting
additional project consulting services for their web initiatives and the loss of
a major customer in 2009.
 
 License
Fees
 
 Revenues
from license fees for 2009 and 2008 are as follows:
 
 Years Ended
                                    December 31,
                                  
                                  
                                  Year-Over-Year
                                    Change2009
                                  
                                  
                                  
                                  2008
                                  
                                  
                                  
                                  Dollars
                                  
                                  
                                  PercentLicense
      fees
                                  
                                  $
                                  45,000
                                  
                                  
                                  $
                                  26,250
                                  
                                  
                                  $
                                  18,750
                                  
                                  
                                  71.4
                                  %Percent
      of total revenues
                                  
                                  
                                  3.2
                                  %
                                  
                                  
                                  0.7
                                  %
 
 Revenue
from license fees increased 71% to $45,000 in 2009 from $26,000 in 2008. License
fee revenue recognized in 2009 comprised the receipt of fees from a license that
commenced in June 2008.  We expect that license fees will continue to
represent a small percentage of our revenues in future years as we focus on
increasing our subscription fees revenue derived from our SaaS
applications.
 
 Hosting
Fees
 
 Revenues
from hosting fees for 2009 and 2008 are as follows:
 
 Years Ended
                                    December 31,
                                  
                                  
                                  Year-Over-Year
                                    Change2009
                                  
                                  
                                  2008
                                  
                                  
                                  Dollars
                                  
                                  
                                  PercentHosting
      fees
                                  
                                  $
                                  156,053
                                  
                                  
                                  $
                                  259,675
                                  
                                  
                                  $
                                  (103,622
                                  )
                                  
                                  
                                  (39.9
                                  )%Percent
      of total revenues
                                  
                                  
                                  11.0
                                  %
                                  
                                  
                                  6.7
                                  %
 
 Hosting
fees for 2009 decreased to $156,000 from $260,000 due to the loss of a major
customer during 2009.
 
 Other
Revenue
 
 Revenues
from other sources for 2009 and 2008 are as follows:
 
 Years Ended
                          December 31,
                        
                        
                        Year-Over-Year
                          Change2009
                        
                        
                        2008
                        
                        
                        Dollars
                        
                        
                        PercentOther
      revenue
                        
                        $
                        127,137
                        
                        
                        $
                        146,158
                        
                        
                        $
                        (19,021
                        )
                        
                        
                        (13.0
                        )%Percent
      of total revenues
                        
                        
                        8.9
                        %
                        
                        
                        3.8
                        %
 
 Revenue
from non-core activities decreased 13% to $127,000 in 2009 from $146,000 in
2008. This decrease is primarily attributable to a reduction in commissions
derived from an existing customer.
  24
  Cost
of Revenues
 
 Cost of
revenues for 2009 and 2008 are as follows:
 
 Years Ended December 31,
                            
                            
                            Year-Over-Year Change2009
                            
                            
                            2008
                            
                            
                            Dollars
                            
                            
                            PercentCost
      of revenues
                            
                            $
                            1,544,861
                            
                            
                            $
                            2,021,489
                            
                            
                            $
                            (476,628
                            )
                            
                            
                            (23.6
                            )%Percent
      of total revenues
                            
                            
                            108.8
                            %
                            
                            
                            52.1
                            %
 
 Cost of
revenues decreased 24% to $1.5 million in 2009 from $2.0 million in 2008. This
decrease is primarily the result of the reduction in labor costs incurred due to
the loss of a significant customer in 2009.
 
 Operating
Expenses
 
 Operating
expenses for 2009 and 2008 comprise the following:
 
 Years Ended December 31,
                                  
                                  
                                  Year-Over-Year Change2009
                                  
                                  
                                  2008
                                  
                                  
                                  Dollars
                                  
                                  
                                  PercentGeneral
      and administrative
                                  
                                  $
                                  4,554,435
                                  
                                  
                                  $
                                  4,315,901
                                  
                                  
                                  $
                                  238,534
                                  
                                  
                                  
                                  5.5
                                  %Sales
      and marketing
                                  
                                  
                                  887,999
                                  
                                  
                                  
                                  1,736,064
                                  
                                  
                                  
                                  (848,065
                                  )
                                  
                                  
                                  (48.9
                                  )%Research
      and development
                                  
                                  
                                  586,254
                                  
                                  
                                  
                                  1,951,562
                                  
                                  
                                  
                                  (1,365,308
                                  )
                                  
                                  
                                  (69.9
                                  )%Loss
      on impairment of intangible assets
                                  
                                  
                                  626,685
                                  
                                  
                                  
                                  3,702,141
                                  
                                  
                                  
                                  (3,075,456
                                  )
                                  
                                  
                                  (83.1
                                  )%Loss
      on legal settlements
                                  
                                  
                                  2,139,364
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  2,139,364
                                  
                                  
                                  
                                  100.0
                                  %(Gain)
      on disposal of assets, net
                                  
                                  
                                  (22,574
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  (22,574
                                  )
                                  
                                  
                                  (100.0
                                  )%Total
      operating expenses
                                  
                                  $
                                  8,772,163
                                  
                                  
                                  $
                                  11,705,668
                                  
                                  
                                  $
                                  (2,933,505
                                  )
                                  
                                  
                                  (25.1
                                  )%
 
 Operating
expenses decreased 25% to $8.8 million in 2009 from $11.7 million in 2008. This
decrease was, in part related to the reduction in workforce, resulting in a
reduction of compensation related expenses of $2 million and the reduction in
the amount of loss on impairment of assets $3.1 million offset by the increase
in bad debt expense associated with advancement of legal fees totaling $1.8
million.
 
 General
and Administrative
 
 General
and administrative expenses for 2009 and 2008 are as follows:
 
 Years Ended December 31,
                            
                            
                            Year-Over-Year Change2009
                            
                            
                            2008
                            
                            
                            Dollars
                            
                            
                            PercentGeneral
      and administrative
                            
                            $
                            4,554,435
                            
                            
                            $
                            4,315,901
                            
                            
                            $
                            238,534
                            
                            
                            
                            5.5
                            %Percent
      of total revenues
                            
                            
                            320.8
                            %
                            
                            
                            111.3
                            %
 
 General
and administrative expenses increased 5% to $4.6 million in 2009 from $4.3
million in 2008. The expenses remained relatively flat between 2009 and 2008 as
significant decreases in compensation costs of $1,045,000 due to reductions in
headcount, the reduction  of amortization expense of $270,000 and
decrease in legal expenses of $58,000 offset by an increase in the amount of bad
debt of $1.8 million due to the obligation to advance legal fees for former
officer and employee of the Company which are likely not to be
repaid.
 
 Sales
and Marketing
 
 Sales and
marketing expenses for 2009 and 2008 are as follows:
  25
  Years Ended December 31,
                            
                            
                            Year-Over-Year Change2009
                            
                            
                            2008
                            
                            
                            Dollars
                            
                            
                            PercentSales
      and marketing
                            
                            $
                            887,999
                            
                            
                            $
                            1,736,064
                            
                            
                            $
                            (848,065
                            )
                            
                            
                            (48.9
                            )%Percent
      of total revenues
                            
                            
                            62.6
                            %
                            
                            
                            44.8
                            %
 
 Sales and
marketing expenses increased 49% to $.9 million in 2009 from
$1.7  million in 2008. This decrease is primarily attributable to
$310,000 in revenue-sharing arrangements with a former channel partners plus a
decrease in employee compensations costs of $309,000 and the reduction of
business travel and public relations costs.
 
 Research
and Development
 
 Research
and development expenses for 2009 and 2008 are as follows:
 
 Years Ended December
                          31,
                        
                        
                        Year-Over-Year Change2009
                        
                        
                        2008
                        
                        
                        Dollars
                        
                        
                        PercentResearch
      and development
                        
                        $
                        586,254
                        
                        
                        $
                        1,951,562
                        
                        
                        $
                        (1,365,308
                        )
                        
                        
                        (70.0
                        )%Percent
      of total revenues
                        
                        
                        41.3
                        %
                        
                        
                        50.3
                        %
 
 Research
and development expenses decreased 70% to $.6 million in 2009 from
$2.0  million in 2008. This net decrease is primarily attributable to
a decrease of $427,000 in outside contractor fees, a reduction of wages and
benefits of $229,000 and the reallocation of development costs of $609,000 to
the cost of revenue category as product is released to the
marketplace.
 
 Loss
on Impairment of Intangible Assets
 
 On a
periodic basis, we review our long-lived assets, including intangible assets,
for possible impairment. Loss on impairment of intangible assets for 2009 and
2008 are as follows:
 
 Years Ended
                          December 31,
                        
                        
                        Year-Over-Year
                          Change2009
                        
                        
                        2008
                        
                        
                        Dollars
                        
                        
                        PercentLoss
      on impairment of intangible assets
                        
                        $
                        626,685
                        
                        
                        $
                        3,702,141
                        
                        
                        $
                        (3,075,456
                        )
                        
                        
                        (83.1
                        )%Percent
      of total revenues
                        
                        
                        44.1
                        %
                        
                        
                        95.4
                        %
 
 The loss
on impairment of intangible assets in 2009 decreased to $627,000 from $3.7
million in 2008.  The decrease is due to the fact that our write-offs
of value of intangible assets in 2009 were significantly less than those in
2008.  In 2009, we recognized a loss of the intangible value of assets
associated with a major customer account, since it is no longer a client as well
as the value of intangibles from another client that no longer generates a
significant revenue stream.  In 2008, we determined that our iMart
trade name was impaired because its carrying value of $1,155,499 exceeded future
discounted cash flows of $150,000, calculated using the relief-from-royalty
method. As a result, we recognized a loss on impairment of intangible assets in
the amount of $1,005,499 as an operating expense in 2008. We also determined
that goodwill of $2,696,642 associated with our acquisition of iMart was fully
impaired due to a number of reasons, including the shutdown in 2008 of iMart’s
Grand Rapids, Michigan facility and the termination of all its employees; the
consolidation of our technology platforms; the deterioration in value of our
underlying stock that contributed to the initial value of goodwill; and general
economic and market conditions. As a result, we also recognized a loss on
impairment of intangible assets for this amount as an operating expense in
2008.
 
 Loss
on legal settlements
 
 Loss on
legal settlements for 2009 and 2008 are as follows:
 
 Years Ended
                          December 31,
                        
                        
                        Year-Over-Year
                          Change2009
                        
                        
                        2008
                        
                        
                        Dollars
                        
                        
                        PercentLoss
      on legal settlements
                        
                        $
                        2,139,364
                        
                        
                        $
                        -
                        
                        
                        $
                        2,139,364
                        
                        
                        
                        100.0
                        %Percent
      of total revenues
                        
                        
                        55.2
                        %
                        
                        
                        -
                        %
 
 The loss
on legal settlements is primarily attributable to the recognition of the loss
derived from the tentative settlement reached on the Class Action lawsuit that
was filed against the Company in 2007.
 
 (Gain)
on disposal of assets
 
 (Gain) on
disposal of assetsfor 2009 and 2008 are
as follows:
 
 Years Ended
                                          December 31,
                                        
                                        
                                        Year-Over-Year
                                          Change2009
                                        
                                        
                                        2008
                                        
                                        
                                        Dollars
                                        
                                        
                                        Percent(Gain)
      on disposal of assets
                                        
                                        $
                                        (22,574
                                        )
                                        
                                        $
                                        
                                        
                                        $
                                        (22,574
                                        )
                                        
                                        
                                        100.0
                                        %Percent
      of total revenues
                                        
                                        
                                        1.6
                                        %
                                        
                                        
                                        %
 
 During
2009, we sold computer equipment to a former customer and recognized a
gain.
 `
 Other
Income (Expense)
 
 Other
income (expense) for 2009 and 2008 comprise the following:
  26
  Years Ended
                                  December 31,
                                
                                
                                Year-Over-Year
                                  Change2009
                                
                                
                                2008
                                
                                
                                Dollars
                                
                                
                                PercentInterest
      expense, net
                                
                                $
                                (643,349
                                )
                                
                                $
                                (633,014
                                )
                                
                                $
                                (10,335
                                )
                                
                                
                                (1.6
                                )%Gain
      on legal settlements, net
                                
                                
                                -
                                
                                
                                
                                411,710
                                
                                
                                
                                (411,710
                                )
                                
                                
                                (100.0
                                )%Other
      income
                                
                                
                                -
                                
                                
                                
                                17,133
                                
                                
                                
                                (17,133
                                )
                                
                                
                                (100.0
                                )%Total
      other expense
                                
                                $
                                (643,349
                                )
                                
                                $
                                (204,171
                                )
                                
                                $
                                (439,178
                                )
                                
                                
                                (215.0
                                )%
 
 Net other
expense increased 215% to $643,000 in 2009 from $204,000 in 2008. This net
increase was primarily due to the fact that the Company had no significant gains
from legal settlements.  Select items are discussed in detail
below.
 
 Interest
Expense, Net
 
 Interest
expense, net of interest income, for 2009 and 2008 is as follows:
 
 Years Ended
                                          December 31,
                                        
                                        
                                        Year-Over-Year
                                          Change2009
                                        
                                        
                                        2008
                                        
                                        
                                        Dollars
                                        
                                        
                                        PercentInterest
      expense, net
                                        
                                        $
                                        643,349
                                        
                                        
                                        $
                                        633,014
                                        
                                        
                                        $
                                        10,335
                                        
                                        
                                        
                                        1.6
                                        %Percent
      of total revenues
                                        
                                        
                                        45.3
                                        %
                                        
                                        
                                        16.3
                                        %
 
 Net
interest expense increased 2% to $643,000 in 2009 from $633,000 in 2008 due
primarily to an increase in convertible bond interest of $23,000, offset by an
increase in interest income of $13,000 in 2009.
 
 Gain
on Legal Settlements, Net
 
 Gain on
legal settlements, net for 2009 and 2008 is as follows:
 
 Years Ended December 31,
                        
                        
                        Year-Over-Year Change2009
                        
                        
                        2009
                        
                        
                        Dollars
                        
                        
                        PercentGain
      on legal settlements, net
                        
                        $
                        -
                        
                        
                        $
                        411,710
                        
                        
                        $
                        (411,710
                        )
                        
                        
                        (100.0
                        )%Percent
      of total revenues
                        
                        
                        -
                        %
                        
                        
                        10.6
                        %
 
 The 2008
gain is related to the $395,000 in legal expense reimbursements that we received
in 2008 from our directors’ and officers’ insurance carrier related to
previously disclosed SEC matters.
 
 Other
Income
 
 Other
income for 2009 and 2008 is as follows:
 
 Years
      Ended December 31,
                        
                        
                        Year-Over-Year
      Change2009
                        
                        
                        2008
                        
                        
                        Dollars
                        
                        
                        PercentOther
      income
                        
                        $
                        -
                        
                        
                        $
                        17,133
                        
                        
                        $
                        (17,133
                        )
                        
                        
                        (100.0
                        )%Percent
      of total revenues
                        
                        
                        -
                        %
                        
                        
                        .44
                        %
  27




The
Company had no other income in 2009 compared to the $17,000 of other income in
2008.





Provision
for Income Taxes





We did
not record a provision for income tax expense in 2009 or 2008 because we have
been generating net losses. Furthermore, we have not recorded an income tax
benefit for 2009 or 2008 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 our ability
to realize deferred tax assets to warrant a full valuation allowance in our
financial statements. As of December 31, 2009, we had approximately $53 million
in net operating loss carryforwards, which may be utilized to offset future
taxable income.





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





Liquidity
and Capital Resources





Overview





We
require cash to fund our operating expenses and working capital requirements,
including outlays for capital expenditures and debt service. As of December 31,
2009, our principal sources of liquidity were cash and cash equivalents totaling
$120,000 and current accounts receivable of $13,000, as compared to $19,000 of
cash and cash equivalents and $185,000 in accounts receivable as of December 31,
2008. As of December 31, 2009, we had drawn approximately $1.9 million on the
$2.47 million line of credit, leaving approximately $570,000 available under the
line of credit for our operations. Deferred revenue at December 31, 2009 was
$46,000 as compared to $391,000 at December 31, 2008.





As of
April 8, 2010, our principal sources of liquidity were cash and cash equivalents
totaling approximately $583,000 and no accounts receivable. In addition, we had
drawn approximately $1.8 million on the Paragon line of credit, leaving
approximately $625,000 available under the line of credit to fund future
operations. As of April 8, 2010, we also have the ability to call up to
approximately $4.65 million of additional funding from our convertible
noteholders.





Cash
Flows





During
the year ended December 31, 2009, our working capital deficit increased by
approximately $3,586,000 to $6,575,000 from a working capital deficit of
$2,989,000 at December 31, 2008. As described more fully below, the working
capital deficit at December 31, 2009 is primarily attributable to negative cash
flows from operations, offset in part by net debt borrowings.





Cash
Flows from Operating Activities





Years
      Ended December 31,
                  
                  
                  Year-Over-Year
      Change2009
                  
                  
                  2008
                  
                  
                  Dollars
                  
                  
                  PercentNet
      cash used in operating activities
                  
                  $
                  3,821,193
                  
                  
                  $
                  5,041,255
                  
                  
                  $
                  (1,220,062
                  )
                  
                  
                  (24
                  )%





Net cash
used in operating activities decreased 24% to $3.8 million in 2009 from $5.0
million in 2008. This decrease is primarily attributable to the 2008 increase in
prepaid expenses due to the prepayment of 36 months of rent at our new
headquarters facility, an increase in notes receivable, and decreases in
outstanding accounts receivable, other assets, accounts payable, and deferred
revenue.


28


Cash
Flows from Investing Activities





Years
      Ended
                      December
      31,
                    
                    
                    Year-Over-Year
                      Change2009
                    
                    
                    2008
                    
                    
                    Dollars
                    
                    
                    PercentNet
      cash used in investing activities
                    
                    $
                    158,765
                    
                    
                    $
                    578,405
                    
                    
                    $
                    (419,640
                    )
                    
                    
                    (73
                    )%





Net cash
used in investing activities decreased 73% to $159,000 in 2008 from $578,000 in
2008. This decrease is attributable to the reduction in purchases of furniture
and equipment and capitalization of software in 2009 as compared to 2008 when we
acquired $331,000 of furniture and computer equipment in connection with the
relocation to our new headquarters facility and the capitalized software costs
of $261,000 related to our industry-standard platform.





Cash
Flows from Financing Activities





Years
      Ended
                      December
      31,
                    
                    
                    Year-Over-Year
                      Change2009
                    
                    
                    2008
                    
                    
                    Dollars
                    
                    
                    PercentNet
      cash provided by financing activities
                    
                    $
                    4,081,153
                    
                    
                    $
                    2,164,303
                    
                    
                    $
                    1,916,850
                    
                    
                    
                    89
                    %





Net cash
provided by financing activities increased 89% to $4 million in 2009 from $2.2
million in 2008. This increase is primarily due to cash raised in 2009 from
additional borrowing from bondholders.





The net
cash in 2008 from our financing activities was generated through both equity and
debt financing, as described below.





Equity Financing. In a
transaction that closed on February 21, 2007, we sold an aggregate of 2,352,941
shares of our common stock to two new investors, or the Investors. The private
placement shares were sold at $2.55 per share pursuant to a Securities Purchase
Agreement, or the SPA, between us and each of the Investors. The aggregate gross
proceeds to us were $6 million, and we incurred issuance costs of approximately
$667,000. 
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 expired February 21,2010.





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





On
February 20, 2008, the Company entered into a new revolving credit arrangement
with Paragon and delivered to Paragon a secured promissory note, dated February
20, 2008 (the “Paragon Note”).  The Paragon Note was renewed as of
February 22, 2010, pursuant to the Modification Agreement, dated February 25,
2010 (the “Modification Agreement”) between Paragon and the Company, which
extended the maturity date from February 11, 2010 to August11, 2010 and changed
the interest rate on the Paragon Note from a variable annual rate equal to The
Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual rate of
6.50%.  The total line of credit advanced by Paragon remains $2.5
million and can be used for general working capital.  The line of
credit is secured by an irrevocable standby letter of credit in the amount of
$2.5 million issued by HSBC with Atlas as account party, with an expiration date
of September 17, 2010, which was extended from the prior expiration date of
February 18, 2010.


29


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





Furthermore,
in connection with establishing the Paragon line of credit, Atlas and the
Company entered into a Reimbursement Agreement, dated November 14, 2006 (as
amended, the “Reimbursement Agreement”) to provide that, in the event of a
default by the Company in the repayment of the Paragon Note that results in the
letter of credit being drawn, the Company will reimburse Atlas any sums that
Atlas is required to pay under the letter of credit in either cash or stock, at
the Company’s election.  On January 19, 2010, Atlas and the Company
entered into the Second Amendment to the Reimbursement Agreement (the “Second
Amendment”) to provide that at the sole discretion of Atlas, any such payments
to Atlas may be made in cash, common stock of the Company, or convertible
reimbursement notes.




As
previously reported in the Company’s filings with the Securities and Exchange
Commission, Atlas is a beneficial owner of 10% or more of the Common Stock of
the Company, and the holder of a majority of the aggregate outstanding principal
amount (the “Requisite Percentage Holder”) of the convertible secured
subordinated notes (the “Notes”) under the Convertible Secured Subordinated Note
Purchase Agreement, dated November 14, 2007 (as amended, the “Note Purchase
Agreement”), between the Company and the convertible noteholders, under which
the Company is entitled to elect to sell to the convertible noteholders, and the
convertible noteholders are obligated to buy, Notes.  The terms of the
Note Purchase Agreement and the Notes were previously described, as applicable,
in the Form 10-Q filed by the Company on November 14, 2007, and the Forms 8-K
filed by the Company on November 21, 2008, February 25, 2009 and March
8, 2010.





The
Company entered into the Second Amendment in partial consideration for a waiver
from the Requisite Percentage Holder. Sales of Notes to the convertible
noteholders are subject to certain conditions, including the absence of events
or conditions that could reasonably be expected to have a material adverse
effect on the ability of the Company to perform its obligations under the Note
Purchase Agreement. The agent for the convertible noteholders had advised the
Company that the Company’s obligations to Dennis Michael Nouri and Reza Eric
Nouri may constitute such a material adverse effect. However, Atlas, as the
Requisite Percentage Holder, advised the Company that it would be willing to
waive the foregoing funding conditions relating to the judgment if, and for
so long as, the Nouris do not actively pursue enforcement of such judgment, and,
in addition, if the Company entered into the Second Amendment.


30


On November 14, 2007, in an initial closing, the Company sold
$3.3 million aggregate principal amount of Notes (the “Initial Notes”). In
addition, the noteholders committed to purchase on a pro rata basis up to $5.2
million aggregate principal of Notes in future closings upon approval and call
by our Board of Directors. On August 12, 2008, we exercised our option to sell
$1.5 million aggregate principal of additional Notes (the “Additional Notes”) to
existing noteholders, with substantially the same terms and conditions as the
Initial Notes. In connection with the sale of the Additional Notes, the
noteholders holding a majority of the aggregate principal amount of the Notes
then outstanding agreed to increase the aggregate principal amount of Notes that
they are committed to purchase from $8.5 million to $15.3 million. On November
21, 2008, we sold $500,000 aggregate principal amount of additional Notes due
November 14, 2010, to two new convertible noteholders, with substantially the
same terms and conditions as the Initial Notes and the Additional Notes. At
December 31, 2008, $5.3 million aggregate principal amount of Notes were
outstanding.





On
January 6, 2009, the Company sold $500,000 aggregate principal amount of Notes
to Atlas, on substantially the same terms and conditions as the previously
issued Notes.




On
February 24, 2009, the Company sold $500,000 aggregate principal amount of Notes
to Atlas on substantially the same terms and conditions as the previously issued
Notes. On the same date, the noteholders holding a majority of the aggregate
principal amount of the Notes outstanding agreed that the Company may sell up to
$6 million aggregate principal amount of Additional Notes to new convertible
noteholders or existing noteholders at any time on or before December 31, 2009
with a maturity date of November 14, 2010 or later. In addition, the maturity
date definition for each of the Notes was changed from November 14, 2010 to the
date upon which the note is due and payable, which is the earlier of (1)
November 14, 2010, (2) a change of control, or (3) if an event of default
occurs, the date upon which noteholders accelerate the indebtedness evidenced by
the Notes. The formula for calculating the conversion price of the Notes was
also amended such that the conversion price of each outstanding note and any
additional note sold in the future would be the same and set at the lowest
applicable conversion price, as described below.




On each
of April 3, 2009 and June 2, 2009, the Company sold a Note in the principal
amount of $500,000 to Atlas on substantially the same terms and conditions as
the previously issued Notes.  On each of July 16, 2009, August 26,
2009, September 8, 2009, and October 5, 2009, the Company sold a Note in the
principal amount of $250,000 to Atlas on substantially the same terms and
conditions as the previously issued Notes.  On October 9, 2009, the
Company sold a Note in the principal amount of $250,000 to UBP, Union Bancaire
Privee, an existing noteholder, on substantially the same terms and conditions
as the previously issued Notes.  On November 6, 2009, the Company sold
a Note to Atlas in the principal amount of $500,000, on December 23, 2009 the
Company sold a Note to Atlas in the principal amount of $750,000, and on
February 11, 2010, the Company sold a Note to Atlas in the principal amount of
$500,000, all upon substantially the same terms and conditions as the previously
issued Notes




On March
5, 2010, the Company and the Requisite Percentage Holder, among other
convertible noteholders, entered into the Fourth Amendment to Convertible
Secured Subordinated Note Purchase Agreement, Second Amendment to Convertible
Secured Subordinated Promissory Notes and Third Amendment to Registration Rights
Agreement (the “Fourth Amendment”).  The Fourth Amendment extends the
original maturity date of the Notes from November 14, 2010 to November 14, 2013,
and amends the Note Purchase Agreement and the Registration Rights Agreement,
dated November 14, 2007, to reflect this extension, as reported on the Form 8-K
filed by the Company on March 10, 2010.




On April
1, 2010, the Company sold a Note to Atlas in the principal amount of $350,000,
due November 14, 2013, upon substantially the same terms and conditions as
the previously issued Notes.





On the
earlier of the maturity date of November 14, 2013 or a merger or acquisition or
other transaction pursuant to which our existing stockholders hold less than 50%
of the surviving entity, or the sale of all or substantially all of our assets,
or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:


31





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





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





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




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




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




·
            the
      closing price of the Company’s common stock on the OTC Bulletin Board, the
      Nasdaq National Market, or the principal exchange on which the common
      stock is listed, as applicable, on the trading day immediately preceding
      the date such Note is converted, in each case as adjusted for stock
      splits, dividends or combinations, recapitalizations, or similar
      events.




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





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





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


32


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





No fees
are payable in connection with the offering of Notes.





We have
not yet achieved positive cash flows from operations, and our main sources of
funds for our operations are the sale of securities in private placements, the
sale of additional Notes, and bank lines of credit. We must continue to rely on
these sources until we are able to generate sufficient cash from revenues to
fund our operations. We believe that anticipated cash flows from operations,
funds available from our existing line of credit (which expires August 2010, as
described above), placement of a new line of credit and additional issuances of
notes, together with cash on hand, will provide sufficient funds to finance our
operations at least for the next 12 to 18 months, depending on our ability to
achieve strategic goals outlined in our annual operating budget approved by our
Board of Directors. Changes in our operating plans, lower than anticipated
sales, increased expenses, or other events may cause us to seek additional
equity or debt financing in future periods. There can be no guarantee that
financing will be available on acceptable terms or at all. Additional equity
financing could be dilutive to the holders of our common stock, and additional
debt financing, if available, could impose greater cash payment obligations and
more covenants and operating restrictions.  If the tentative Class
Action settlement is finalized, current shareholders will be further diluted due
to the issuance of an additional 1,475,000 shares of common stock pursuant to
the terms of the tentative agreement.





Going
Concern





Our
independent registered public accountants have issued an explanatory paragraph
in their report included in this Annual Report on Form 10-K for the year ended
December 31, 2009 in which they express substantial doubt as to our ability to
continue as a going concern. The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amounts or classification of liabilities that might be necessary
should we be unable to continue as a going concern. Our continuation as a going
concern depends on our ability to generate sufficient cash flows to meet our
obligations on a timely basis, to obtain additional financing that is currently
required, and ultimately to attain profitable operations and positive cash
flows. There can be no assurance that our efforts to raise capital or increase
revenue will be successful. If our efforts are unsuccessful, we may have to
cease operations and liquidate our business.





Recent
Developments





To fill a
vacancy in the Board of Directors (the “Board”), the members of the Board
unanimously appointed Amir Elbaz as a director of the Company, effective January
15, 2009, to serve until his successor is duly elected and
qualified.





Mr. Elbaz
currently advises technology and renewable energy companies on business
strategy, restructuring and business development initiatives.  Mr.
Elbaz served as the Executive Vice President & Chief Financial Officer of
Lithium Technology Corporation (“LTC”) until November 2008.  Mr. Elbaz
joined LTC in 2006 to oversee finances and marketing, as well as business
development.


33


On
January 19, 2010, the Company and Atlas entered into the Second Amendment to the
Reimbursement Agreement.  Atlas previously procured a letter of credit
in favor of Paragon Commercial Bank (“Paragon”) to serve as security under the
Company’s revolving credit arrangement between the Company, as
borrower, and Paragon, as lender. The Reimbursement Agreement sets forth
the terms by which Atlas may be reimbursed by the Company for any drawdowns by
Paragon on the letter of credit. The Second Amendment provides that Atlas may
elect, in its sole discretion, to be reimbursed by the Company for any such
drawdowns in either common stock of the Company, bonds, or
cash.  Prior to such amendment, the Reimbursement Agreement allowed
the Company to reimburse Atlas in either cash or stock, at the Company’s
election.





Atlas is
a beneficial owner of 10% or more of the Common Stock of the Company, and a
convertible noteholder of Notes under the Note Purchase Agreement, under which
the Company is entitled to elect to sell to the noteholders, and the noteholders
are obligated to buy convertible promissory Notes.  The terms of the
Note Purchase Agreement and the Notes are described in Footnote 6 to the
Financial Statements.





The
Company entered into the Second Amendment in consideration for a waiver from the
noteholders. Sales of Notes to the noteholders are subject to certain
conditions, including the absence of events or conditions that could reasonably
be expected to have a material adverse effect on the ability of the Company to
perform its obligations under the Note Purchase Agreement. The agent for the
convertible noteholders has advised the Company that the Company’s obligations
to Dennis Michael Nouri and Reza Eric Nouri, former officers of the Company who
have obtained a judgment against the Company for the advancement of expenses
incurred by them in connection with their defense of certain criminal and civil
actions, may constitute such a material adverse effect. However, Atlas, as the
Requisite Percentage Holder, advised the Company that it would be willing to
waive the foregoing funding conditions relating to the judgment if, and for
so long as, the Nouris do not actively pursue enforcement of such judgment, and,
in addition, if the Company entered into the Second Amendment.





On
February 11, 2010, the Company sold an additional convertible secured
subordinated Note due November 14, 2010 in the principal amount of $500,000
to a current noteholder upon substantially the same terms and conditions as the
previously issued Notes.  (See Note 6 to the Financial
Statements)





On March
5, 2010, the Company entered into the Fourth Amendment with the holders of a
majority of the aggregate outstanding principal amount of the Notes issued by
the Company under the Note Purchase Agreement.  The Fourth Amendment
extends the original maturity date of the Notes from November 14, 2010 to
November 14, 2013, and amends the Note Purchase Agreement, the Notes and the
Registration Rights Agreement, dated November 14, 2007, to reflect this
extension.





On April
1, 2010, the company sold a Note due November 14, 2013 in the principal amount
of $350,000 to a current noteholder upon substantially the same terms and
conditions as the previously issued Notes.





On
February 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to the
Paragon Note, delivered by the Company to Paragon in the maximum principal
amount of $2,500,000.  The Modification Agreement (i) extends
the maturity date of the Paragon Note from February 11, 2010 to August 11,
2010, and (ii) changes the interest rate from a variable annual rate equal to
The Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual
rate of 6.50%.  The Company has been advised that, effective January
28, 2010, the expiration date of the standby letter of credit in the amount of
$2,500,000 issued by HSBC securing the Paragon Note has been extended from
February 18, 2010 to September 17, 2010.





On March
26, 2010, the Board of Directors authorized grants of stock options and
restricted stock to certain directors of the Company pursuant to the
Company's 2004 Equity Compensation Plan, as follows:





Amir
Elbaz received a grant of non-qualified stock options to acquire up to 20,000
shares of common stock at an exercise price of $1.14 per share, representing
fair market value on the date of grant. The options vest quarterly in 25%
increments, commencing June 30, 2010.





Dror
Zoreff received a grant of non-qualified stock options to acquire up to 30,000
shares of common stock at an exercise price of $1.14 per share, representing
fair market value on the date of grant. The options vest quarterly in 25%
increments, commencing June 30, 2010.





Shlomo
Elia received a grant of 10,000 shares of restricted stock, whose transfer
restrictions lapse quarterly in 25% increments, commencing June 30,
2010.


34


In late
March 2010, the Company reached an agreement in principal and tentative
settlement with the lead plaintiff in the class action lawsuit brought against
the Company and certain of its current and former officers and directors, as
described in Note 7 to the Financial Statements, “Commitments and
Contingencies.”





On March
2, 2010, Nottingham Hall LLC, the primary landlord for the office space occupied
by the Company under a sublease between our Company and Advantis Real Estate
Services Company (Advantis), filed a Complaint in Summary Ejectment against
Advantis and our Company.  The suit seeks to recoup the funds not paid
by Advantis over term of the original lease between Nottingham Hall LLC and
Advantis in the amount of $121,000.  Representatives for Nottingham
Hall LLC have indicated that Advantis has defaulted on the terms of the lease
and Nottingham Hall is now pursuing our Company for the differential in rent
between our prepaid negotiated amount and the total actually due from
Advantis.  We are currently negotiating a settlement in the
matter.




The
Company entered into a license agreement with a customer in December 2009 that
included the payment of a monthly license fee of $30,000 starting in December
2009.  The customer informs us that they are unable to make the monthly
payments as they have not raised the additional capital required to continue
their operations.  We have not recognized any revenue in 2009 associated
with these license fees.


35





Item 7A.
            Quantitative and Qualitative
      Disclosures about Market
Risk





Not
applicable.


36





Item
    8.
            Financial Statements and
      Supplementary Data





INDEX TO
FINANCIAL STATEMENTS





PageREPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
                    
                    38CONSOLIDATED
      BALANCE SHEETS
                    
                    39CONSOLIDATED
      STATEMENTS OF OPERATIONS
                    
                    40CONSOLIDATED
      STATEMENTS OF CASH FLOWS
                    
                    41CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
                    
                    42NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS
                    
                    43


37




REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and


Stockholders
of Smart Online, Inc.





We have
audited the accompanying consolidated balance sheets of Smart Online, Inc. (the
“Company”) as of December 31, 2009 and 2008, and the related consolidated
statements of operations, stockholders’ equity (deficit), and cash flows for
each of the years in the two-year period ended December 31, 2009. The Company’s
management is responsible for these consolidated financial statements. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board of the United States of America. Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether the consolidated financial statements are free of material misstatement.
The Company is not required to have, nor were we engaged to perform, an audit of
its internal control over financial reporting. Our audits included consideration
of internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the company’s internal control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements, assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.





As
described in Note 13 to the financial statements, the Company has restated its
2008 financial statements due to a previous accounting policy error related to
revenue recognition and impairments of intangible assets. Previously, revenue
earned as an agent was not recognized in conformity with accounting principles
generally accepted in the United States of America which require revenue earned
as an agent to be reported net of amounts to be paid to others. The restatement
results in previously stated portions of subscription revenue of $1,611,290
being reduced by $1,095,828 with corresponding reductions in certain marketing
expense.  In addition, the Company recorded an additional impairment
charge of $230,000 related to the carrying value of its trade name.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of December
31, 2009 and 2008, and the results of their operations and their cash flows for
each of the years in the two-year period ended December 31, 2009 in conformity
with accounting principles generally accepted in the United States of
America.





The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company has suffered recurring losses from operations
and has a working capital deficiency as of December 31, 2009. These conditions
raise substantial doubt about the Company’s ability to continue as a going
concern. Management’s plans concerning these matters are described in Note 1.
The consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.





/s/
CHERRY, BEKAERT & HOLLAND, L.L.P.




Raleigh,
North Carolina


April 15,
2010


38





SMART
ONLINE, INC.


CONSOLIDATED
BALANCE SHEETS





December 31,
                                      2009
                                    
                                    
                                    December 31,
                                      2008ASSETSCurrent
      assets:Cash
      and cash equivalents
                                    
                                    $
                                    119,796
                                    
                                    
                                    $
                                    18,602Accounts
      receivable, net
                                    
                                    
                                    13,056
                                    
                                    
                                    
                                    184,930Unbilled
      receivable
                                    
                                    
                                    -
                                    
                                    
                                    
                                    60,000Prepaid
      expenses
                                    
                                    
                                    240,840
                                    
                                    
                                    
                                    289,372Total
      current assets
                                    
                                    
                                    373,692
                                    
                                    
                                    
                                    552,904Property
      and equipment, net
                                    
                                    
                                    258,450
                                    
                                    
                                    
                                    365,993Capitalized
      software, net
                                    
                                    
                                    450,782
                                    
                                    
                                    
                                    261,221Unbilled
      receivable, non-current
                                    
                                    
                                    -
                                    
                                    
                                    
                                    372,317Prepaid
      expenses, non-current
                                    
                                    
                                    110,700
                                    
                                    
                                    
                                    258,301Intangible
      assets, net
                                    
                                    
                                    150,000
                                    
                                    
                                    
                                    1,180,245Other
      assets
                                    
                                    
                                    2,496
                                    
                                    
                                    
                                    1,736TOTAL
      ASSETS
                                    
                                    $
                                    1,346,120
                                    
                                    
                                    $
                                    2,992,717LIABILITIES
      AND STOCKHOLDERS’ EQUITY (DEFICIT)Current
      liabilities:Accounts
      payable
                                    
                                    $
                                    518,309
                                    
                                    
                                    $
                                    398,237Notes
      payable
                                    
                                    
                                    1,964,281
                                    
                                    
                                    
                                    2,341,177Deferred
      revenue
                                    
                                    
                                    40,115
                                    
                                    
                                    
                                    323,976Accrued
      liabilities - Nouri
                                    
                                    
                                    1,802,379
                                    
                                    
                                    
                                    -Accrued
      liabilities
                                    
                                    
                                    2,623,959
                                    
                                    
                                    
                                    478,917Total
      current liabilities
                                    
                                    
                                    6,949,043
                                    
                                    
                                    
                                    3,542,307Long-term
      liabilities:Notes
      payable
                                    
                                    
                                    9,785,255
                                    
                                    
                                    
                                    5,327,211Deferred
      revenue
                                    
                                    
                                    5,601
                                    
                                    
                                    
                                    67,353Total
      long-term liabilities
                                    
                                    
                                    9,790,856
                                    
                                    
                                    
                                    5,394,564Total
      liabilities
                                    
                                    
                                    16,739,899
                                    
                                    
                                    
                                    8,936,871Commitments
      and contingenciesStockholders’
      equity (deficit):Common
      stock, $0.001 par value, 45,000,000 shares authorized, 18,332,542 and
      18,333,601 shares issued and outstanding at December 31, 2009 and December
      31, 2008, respectively
                                    
                                    
                                    18,333
                                    
                                    
                                    
                                    18,334Additional
      paid-in capital
                                    
                                    
                                    67,036,836
                                    
                                    
                                    
                                    66,945,588Accumulated
      deficit
                                    
                                    
                                    (82,448,948
                                    )
                                    
                                    
                                    (72,908,076
                                    )Total
      stockholders’ equity (deficit)
                                    
                                    
                                    (15,393,779
                                    )
                                    
                                    
                                    (5,944,154
                                    )TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                                    
                                    $
                                    1,346,120
                                    
                                    
                                    $
                                    2,992,717





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


39


SMART
ONLINE, INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS





Year Ended
                              December 31,
                              2009
                            
                            
                            Year Ended
                              December 31,
                              2008REVENUES:Subscription
      fees
                            
                            $
                            756,233
                            
                            
                            $
                            1,587,942Professional
      service fees
                            
                            
                            335,079
                            
                            
                            
                            1,859,154License
      fees
                            
                            
                            45,000
                            
                            
                            
                            26,250Hosting
      fees
                            
                            
                            156,053
                            
                            
                            
                            259,675Other
      revenue
                            
                            
                            127,137
                            
                            
                            
                            146,158Total
      revenues
                            
                            
                            1,419,502
                            
                            
                            
                            3,879,179COST
      OF REVENUES
                            
                            
                            1,544,861
                            
                            
                            
                            2,021,489GROSS
      PROFIT (LOSS)
                            
                            
                            (125,359
                            )
                            
                            
                            1,857,690OPERATING
      EXPENSES:General
      and administrative
                            
                            
                            4,554,435
                            
                            
                            
                            4,315,901Sales
      and marketing
                            
                            
                            887,999
                            
                            
                            
                            1,736,064Research
      and development
                            
                            
                            586,254
                            
                            
                            
                            1,951,562Loss
      on impairment of intangible assets
                            
                            
                            626,685
                            
                            
                            
                            3,702,141Loss
      on legal settlements
                            
                            
                            2,139,364
                            
                            
                            
                            -(Gain)
      on disposal of assets, net
                            
                            
                            (22,574
                            )
                            
                            
                            -Total
      operating expenses
                            
                            
                            8,772,163
                            
                            
                            
                            11,705,668LOSS
      FROM OPERATIONS
                            
                            
                            (8,897,522
                            )
                            
                            
                            (9,847,978
                            )OTHER
      INCOME (EXPENSE):Gain
      on legal settlements,  net
                            
                            
                            -
                            
                            
                            
                            411,710Interest
      expense, net
                            
                            
                            (643,349
                            )
                            
                            
                            (633,014
                            )Other
      income
                            
                            
                            -
                            
                            
                            
                            17,133Total
      other expense
                            
                            
                            (643,349
                            )
                            
                            
                            (204,171
                            )NET
      LOSS
                            
                            $
                            (9,540,871
                            )
                            
                            $
                            (10,052,149
                            )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                            
                            $
                            (0.52
                            )
                            
                            $
                            (0.55
                            )WEIGHTED-AVERAGE
      NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
    SHARE:Basic
      and fully diluted
                            
                            
                            18,332,542
                            
                            
                            
                            18,309,771





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


40


SMART ONLINE, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS





Year Ended
                                  December 31,
                                  2009
                                
                                
                                Year Ended
                                  December 31,
                                  2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                                
                                $
                                (9,540,871
                                )
                                
                                $
                                (10,052,149
                                )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                                
                                
                                502,881
                                
                                
                                
                                825,846Amortization
      of deferred financing costs
                                
                                
                                -
                                
                                
                                
                                301,249Bad
      debt expense
                                
                                
                                2,129,198
                                
                                
                                
                                430,505Stock-based
      compensation
                                
                                
                                92,339
                                
                                
                                
                                424,513Gain
      on disposal of assets
                                
                                
                                (22,574
                                )
                                
                                
                                (3,730
                                )Loss
      on impairment of intangible assets
                                
                                
                                626,685
                                
                                
                                
                                3,702142Changes
      in assets and liabilities:Accounts
      receivable
                                
                                
                                228,451
                                
                                
                                
                                199,667Unbilled
      receivables
                                
                                
                                (3,167,538
                                )
                                
                                
                                (152,317
                                )Prepaid
      expenses
                                
                                
                                196,132
                                
                                
                                
                                (456,787
                                )Other
      assets
                                
                                
                                (762
                                )
                                
                                
                                58,575Accounts
      payable
                                
                                
                                1,534,153
                                
                                
                                
                                (230,133
                                )Deferred
      revenue
                                
                                
                                (345,614
                                )
                                
                                
                                (185,788
                                )Accrued
      and other expenses
                                
                                
                                3,946,326
                                
                                
                                
                                97,152Net
      cash used in operating activities
                                
                                
                                (3,821,193
                                )
                                
                                
                                (5,041,255
                                )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of property and equipment
                                
                                
                                (14,565
                                )
                                
                                
                                (330,748
                                )Proceeds
      from sale of furniture and equipment
                                
                                
                                45,362
                                
                                
                                
                                13,564Capitalized
      software
                                
                                
                                (189,562
                                )
                                
                                
                                (261,221
                                )Net
      cash used in investing activities
                                
                                
                                (158,765
                                )
                                
                                
                                (578,405
                                )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from debt borrowings
                                
                                
                                11,284,045
                                
                                
                                
                                8,780,303Repayments
      of debt borrowings
                                
                                
                                (7,202,892
                                )
                                
                                
                                (6,713,500
                                )Issuance
      of common stock, net of costs
                                
                                
                                -
                                
                                
                                
                                97,500Net
      cash provided by financing activities
                                
                                
                                4,081,153
                                
                                
                                
                                2,164,303NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                                
                                
                                101,194
                                
                                
                                
                                (3,455,357
                                )CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
                                
                                
                                18,602
                                
                                
                                
                                3,473,959CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                                
                                $
                                119,796
                                
                                
                                $
                                18,602Supplemental
      disclosures of cash flow information:Cash
      paid during the year for:Interest
                                
                                $
                                657,644
                                
                                
                                $
                                360,692Income
      Taxes
                                
                                $
                                -
                                
                                
                                $
                                40,367Supplemental
      schedule of non-cash financing activities:Conversion
      of debt to equity
                                
                                $
                                -
                                
                                
                                $
                                228,546Assets
      acquired under capital lease
                                
                                $
                                200,000
                                
                                
                                $
                                48,214Shares
      issued in settlement of notes payable
                                
                                $
                                -
                                
                                
                                $
                                -





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


41


SMART ONLINE,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




Common
      StockShares
                      
                      
                      $0.001
                        Par
                        Value
                      
                      
                      AdditionalPaid-In
                        Capital
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      TotalsBALANCES,
      DECEMBER 31, 2007
                      
                      $
                      18,159,768
                      
                      
                      
                      18,160
                      
                      
                      $
                      66,202,179
                      
                      
                      $
                      (62,855,928
                      )
                      
                      $
                      3,364,411Exercise
      of options
                      
                      
                      206,069
                      
                      
                      
                      206
                      
                      
                      
                      97,294
                      
                      
                      
                      -
                      
                      
                      
                      97,500Issuance
      of common stock, net of expenses
                      
                      
                      19,608
                      
                      
                      
                      20
                      
                      
                      
                      228,527
                      
                      
                      
                      -
                      
                      
                      
                      228,547Equity-based
      compensation
                      
                      
                      70,000
                      
                      
                      
                      70
                      
                      
                      
                      424,443
                      
                      
                      
                      -
                      
                      
                      
                      424,513Cancellations
      of unvested restricted share issuances and forfeitures for payment of tax
      obligations
                      
                      
                      (121,844
                      )
                      
                      
                      (122
                      )
                      
                      
                      (6,855
                      )
                      
                      
                      -
                      
                      
                      
                      (6,977
                      )Net
      loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (10,052,149
                      )
                      
                      
                      (10,052,149
                      )BALANCES,
      DECEMBER 31, 2008
                      
                      $
                      18,333,601
                      
                      
                      
                      18,334
                      
                      
                      $
                      66,945,588
                      
                      
                      $
                      (72,908,077
                      )
                      
                      $
                      (5,944,155
                      )Exercise
      of options
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Issuance
      of common stock, net of expenses
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      -Equity-based
      compensation
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      92,340
                      
                      
                      
                      -
                      
                      
                      
                      92,340Cancellations
      of unvested restricted share issuances and forfeitures for payment of tax
      obligations
                      
                      
                      (1,059
                      )
                      
                      
                      (1
                      )
                      
                      
                      (1,092
                      )
                      
                      
                      -
                      
                      
                      
                      (1,093
                      )Net
      loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (9,540,871
                      )
                      
                      
                      (9,540,871
                      )BALANCES,
      DECEMBER 31, 2009
                      
                      $
                      18,332,542
                      
                      
                      
                      18,333
                      
                      
                      $
                      67,036,836
                      
                      
                      $
                      (82,448,948
                      )
                      
                      $
                      (15,393,779
                      )





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


42


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





1.
              SUMMARY OF
      BUSINESS  AND DESCRIPTION OF GOING
  CONCERN





Description
of Business and
Going Concern - Smart
Online, Inc. (the “Company”) was incorporated in the State of Delaware in 1993.
The Company develops and markets software products and services targeted to
small businesses that are delivered via a Software-as-a-Service (“SaaS”) model.
The Company sells its SaaS products and services primarily through private-label
marketing partners. In addition, the Company provides website consulting
services, primarily in the e-commerce retail industry. The Company maintains a
website for potential partners containing certain corporate information located
at www.smartonline.com.





The
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. During the years ended December 31, 2009 and
2008, the Company incurred net losses as well as negative cash flows, is
involved in a class action lawsuit (See Note 7, “Commitments and
Contingencies”), and at December 31, 2009, had deficiencies in working capital.
These factors indicate that the Company may be unable to continue as a going
concern.





The
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts or
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The Company’s continuation as a going
concern depends upon its ability to generate sufficient cash flows to meet its
obligations on a timely basis, to obtain additional financing as may be
required, and ultimately to attain profitable operations and positive cash
flows. At December 31, 2009, the Company does have a commitment from its secured
subordinated noteholders to purchase up to an additional $5.5 million in
convertible notes, of which $850,000 was issued through April 15, 2010 (footnote
12). The Company’s future plans include the introduction of its new
industry-standard platform, the development of additional new products and
applications, and further enhancement of its existing small-business
applications and tools.





2.
            SIGNIFICANT ACCOUNTING
      POLICIES





Fiscal
Year - The
Company’s fiscal year ends December 31. References to fiscal 2009, for example,
refer to the fiscal year ending December 31, 2009.





Use of
Estimates - The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States (“US. GAAP”) requires management to make
estimates and assumptions in the Company’s financial statements and notes
thereto. Significant estimates and assumptions made by management include the
determination of the provision for income taxes, the fair market value of stock
awards issued, the period over which revenue is generated and the determination
of allowances on our deferred tax assets. Actual results could differ materially
from those estimates.





Fair Value of
Financial Instruments -  US
GAAP requires disclosures of fair value information about financial instruments,
whether or not recognized in the balance sheet, for which it is practicable to
estimate that value. Due to the short period of time to maturity, the carrying
amounts of cash equivalents, accounts receivable, accounts payable, accrued
liabilities, and notes payable reported in the consolidated financial statements
approximate the fair value.





Reclassifications
-
Certain prior year and comparative period amounts have been reclassified to
conform to current year presentation. These reclassifications had no effect on
previously reported net income or stockholders’ equity.





Principles of
Consolidation - The accompanying consolidated financial statements
include the accounts of the Company and its wholly owned subsidiaries, Smart
CRM, Inc. (“Smart CRM”) and Smart Commerce, Inc. (“Smart Commerce”). All
significant intercompany accounts and transactions have been eliminated.
Subsidiary accounts are included only from the date of acquisition forward. On
December 31, 2008, each of Smart CRM and Smart Commerce were merged into the
Company.





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


43


Concentration of
Credit Risk - Financial instruments that potentially subject the Company
to concentrations of credit risk consist primarily of cash and accounts
receivable. At times, cash balances may exceed the Federal Deposit Insurance
Corporation (“FDIC”) insurable limits. See Note 10, “Major Customers and
Concentration of Credit Risk,” for further discussion of risk within accounts
receivable.





Allowance for
Doubtful Accounts - The Company maintains an allowance for doubtful
accounts for estimated losses resulting from the inability, failure, or refusal
of its customers to make required payments. The need for an allowance for
doubtful accounts is evaluated based on specifically identified amounts that
management believes to be potentially uncollectible. If actual collections
experience changes, revisions to the allowance may be required.





Prepaid Expenses
- Prepaid expenses consist primarily of a lump-sum rent payment on the
Company’s headquarters office space, advance payments to registries for domain
name registrations, and miscellaneous payments made in advance of the period to
which they relate. 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.





Property and
EquipmentOn September 4, 2009 we sold our computer hardware,
furniture and fixtures and office equipment (“personal property”) to our note
holders in exchange for a reduction in the outstanding note balances of
$200,000.  The personal property and equipment was then leased back
from the note holders under a ten (10) year lease.  The leased assets
are capitalized and depreciated.  Personal property and equipment are
stated at the cost, as established under the lease and are depreciated over the
term of the lease using the straight-line method.   We continue
to own and depreciate leasehold improvements that are stated at cost and
depreciated over the term of the office lease as follows:





Computer
      hardware
              10
      yearsComputer
      software
              10
      yearsFurniture
      and fixtures
              10
      yearsOffice
      equipment
              10
      yearsLeasehold
      improvements
              Shorter
      of the estimated useful life or the lease
term





Intangible Assets
and Goodwill - Intangible assets consist  of the iMart
trade name  obtained through the acquisition of iMart Incorporated
(“iMart”). The Company also owns several copyrights and trademarks related to
products, names, and logos used throughout its non-acquired product
lines. All assets are amortized on a straight-line basis over their
estimated useful lives with the exception of the iMart trade name, workforces in
place, and goodwill, which are deemed by management to have indefinite lives and
are not amortized.


44


Impairment of
Long-Lived Assets -
The Company evaluates the recoverability of its long-lived assets in accordance
with US GAAP. Long-lived assets are reviewed for possible impairment at the
earlier of annually in the fourth quarter or whenever events or changes in
circumstances indicate that, the carrying amount of such assets may not be
recoverable. Recoverability of assets to be held and used is measured by
comparing the carrying amount of the asset to the asset fair value. If such
assets are considered to be impaired, the impairment is measured as the amount
by which the carrying amount exceeds the fair value and is recognized as an
operating expense in the period in which the determination is made. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less
costs to sell.





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





In 2009,
management determined that the values assigned to two of  its customer
bases acquired  through the iMart acquisition were now impaired
because its carrying value of $626,685 exceeded future estimated fair
values.   As a result, a loss on impairment of intangible assets
in the amount of $626,685 was recognized as an operating expense in
2009.





In 2008,
management determined that its iMart trade name was impaired because its
carrying value of $1,155,499 exceeded its fair value of $150,000, calculated
using the relief-from-royalty method. As a result, a loss on impairment of
intangible assets in the amount of $1,155,499was recognized as an operating
expense in 2008. However, because the Company intends to continue to use the
iMart trade name and branding in sales and marketing activities indefinitely,
management concluded that an indefinite life was still appropriate.





The
Company evaluates the recoverability of goodwill in accordance with US GAAP, at
the earlier of annually in the fourth quarter or whenever events or changes in
circumstances indicate that, the balance may not be recoverable. Impairment may
result from, among other things, deterioration in the performance of the
acquired business, adverse market conditions, adverse changes in applicable laws
or regulations including changes that restrict the activities of the acquired
business, a change in the strategic direction of the Company, and a variety of
other circumstances.





In 2008,
management determined that goodwill of $2,696,642 associated with its
acquisition of iMart was fully impaired due to a number of reasons, including
the shutdown in 2008 of iMart’s Grand Rapids, Michigan facility and the
termination of all its employees; the consolidation of its technology platforms;
the deterioration in value of the Company’s underlying stock that contributed to
the initial value of goodwill; and general economic and market conditions. As a
result, a loss on impairment of intangible assets for this amount was recognized
as an operating expense in 2008.





Revenue
Recognition -
 The Company derives revenue primarily from subscription fees charged to
customers accessing its SaaS applications; professional service fees, consisting
primarily of consulting; the perpetual or term licensing of software platforms
or applications; and hosting and maintenance services. These arrangements
may include delivery in multiple-element arrangements if the customer purchases
a combination of products and/or services. Because the Company licenses, sells,
leases, or otherwise markets computer software, it uses the residual method
pursuant to US GAAP. This method allows the Company to recognize revenue for a
delivered element when such element has vendor specific objective evidence
(“VSOE”) of the fair value of the delivered element. If VSOE cannot be
determined or maintained for an element, it could impact revenues as all or a
portion of the revenue from the multiple-element arrangement may need to be
deferred.





If
multiple-element arrangements involve significant development, modification, or
customization or if it is determined that certain elements are essential to the
functionality of other elements within the arrangement, revenue is deferred
until all elements necessary to the functionality are provided by the Company to
a customer. The determination of whether the arrangement involves significant
development, modification, or customization could be complex and require the use
of judgment by management.





Under US
GAAP, provided the arrangement does not require significant development,
modification, or customization, revenue is recognized when all of the following
criteria have been met:


45


1.
            persuasive
      evidence of an arrangement exists





2.
            delivery
      has occurred





3.
            the
      fee is fixed or determinable





4.
            Collectability
      is probable





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





Under the
provisions of US GAAP , consulting, website design fees, and application
development services are accounted for separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, revenues are recognized as the services are rendered
for time and material contracts, and when milestones are achieved and accepted
by the customer for fixed price or long-term contracts. The majority of the
Company’s consulting service contracts are on a time and material basis and are
typically billed monthly based upon standard professional service
rates.





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





Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
marketing partners in order to encourage them to market our products and
services to their customers. Subscriptions are generally payable on a monthly
basis and are typically paid via credit card of the individual end user. We
accrue any payments received in advance of the subscription period as deferred
revenue and amortize them over the subscription period. In the past we
recognized all subscription revenue on a gross basis and in accordance with our
policy to periodically review our accounting policies we identifies the
fact  that certain contracts require the reporting of subscription
revenue on a gross basis and others on a net basis according to  US
GAAP.  On that basis, we continue to report subscription revenue from
certain contracts on a gross basis and others on a net basis.  The net
effect of this reclassification of expenses only impacts gross revenue and
certain gross expenses; it does not change the net income.  The
effects of these reclassifications are presented in detail in footnote
13.





Because
its customers generally do not have the contractual right to take possession of
the software it licenses or markets at any time, the Company recognizes revenue
on hosting and maintenance fees as the services are provided in accordance with
US GAAP related to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.





Deferred
Revenue

-

Deferred revenue consists of billings or payments received in advance of revenue
recognition, and it is recognized as the revenue recognition criteria are met.
Deferred revenue also includes certain professional services fees and licensing
revenues where all the criteria described earlier were not met. Deferred revenue
that will be recognized over the succeeding 12-month period is recorded as
current and the remaining portion is recorded as noncurrent.





Cost of
Revenues 
-
Cost of revenues primarily is composed of salaries associated with maintaining
and supporting customers, the cost of domain name and e-mail registrations, and
the cost of external facilities where the Company’s and its customers’
customized applications are hosted.


46


Software
Development Costs -  The
Company capitalizes certain costs of software developed in accordance with US
GAAP, which requires capitalization of certain software development costs
subsequent to the establishment of technological feasibility, with costs
incurred prior to this time expensed as research and development. Technological
feasibility is established when all planning, designing, coding, and testing
activities that are necessary to establish that the product can be produced to
meet its design specifications have been completed. The Company’s policy
provides for the capitalization of certain outside contractors’ fees and payroll
and payroll-related costs for employees who are directly associated with the
development of the Company’s software. Capitalized costs are ratably amortized
based on the greater of the revenue method or the straight-line method over the
estimated useful life of the software, generally three years. Management
evaluates the recoverability of its capitalized software at the earlier of
annually in the fourth quarter or whenever events or changes in circumstances
indicate that, the carrying amount of such assets may not be recoverable by
comparing the amount capitalized to the estimated net realizable value of the
software. If such evaluations indicate that the unamortized software development
costs exceed the net realizable value, the Company writes down the carrying cost
to net realizable value.





Historically,
the Company had not developed detailed design plans for its SaaS applications,
and the costs incurred between the completion of a working model of these
applications and the point at which the products were ready for general release
had been insignificant. These factors, combined with the historically low
revenue generated by the sale of the applications that do not support the net
realizable value of any capitalized costs, resulted in the continued expensing
of underlying costs as research and development.





Beginning
in May 2008, the Company determined that it was strategically desirable to
develop an industry-standard platform and to enhance the current SaaS
applications. A detailed design plan indicated that the product was
technologically feasible. In July 2008, development commenced, and as of
December 31, 2008, $261,221 in associated costs were capitalized in accordance
with US GAAP. As this platform was still under development, the Company
recognized no amortization expense during the year ended December 31,
2008.





The
Company capitalized additional costs of $222,436 through July 10, 2009 when the
product was released for sale to the marketplace.  The capitalized
cost is being amortized over a seven (7) year period.  Total
amortization expense in 2009 was $32,875.





US GAAP
establishes accounting and reporting standards for research and development.
Costs incurred to search for new revenue producing products or services, to
significantly improve an existing product, and to formulate design plans in an
effort to establish technological feasibility are expensed in the period they
are incurred.





Advertising
Costs - The Company expenses all advertising costs as they are incurred.
The amounts charged to sales and marketing expense during 2009 and 2008 were
$18,306 and $37,202, respectively.





Stock-Based
Compensation - Effective January 1, 2006, the Company began
recognizing stock based compensation, using the Modified Prospective Approach
based on the grant date fair value estimated in accordance with US GAAP. 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, and (ii) compensation cost
for all share-based payments that are granted subsequent to January 1,
2006. Stock-based compensation is recognized on the straight-line method over
the requisite service period. Total stock-based compensation expense recognized
was $93,339 and $424,513 for the years ended December 31, 2009 and 2008,
respectively. No stock-based compensation was capitalized in the
consolidated financial statements.





In
computing the impact of stock-based compensation expense, the fair value of each
award is estimated on the date of grant based on the Black-Scholes
option-pricing model utilizing certain assumptions for a risk-free interest
rate, volatility, and expected remaining lives of the awards. The assumptions
used in calculating the fair value of share-based payment awards represent
management’s best estimates, but these estimates involve inherent uncertainties
and the application of management’s judgment. As a result, if factors change and
the Company uses different assumptions, the Company’s stock-based compensation
expense could be materially different in the future. In addition, the Company is
required to estimate the expected forfeiture rate and only recognize expense for
those shares expected to vest. In estimating the Company’s forfeiture rate, the
Company analyzed its historical forfeiture rate, the remaining lives of unvested
options, and the amount of vested options as a percentage of total options
outstanding. If the Company’s actual forfeiture rate is materially different
from its estimate, or if the Company reevaluates the forfeiture rate in the
future, the stock-based compensation expense could be significantly different
from what the Company has recorded in the current period.


47


The fair value of option grants under the Company’s equity
compensation plan during the years ended December 31, 2009 and 2008 were
estimated using the following weighted average assumptions:





Year Ended December 31,2009
                    
                    
                    2008Dividend
      yield
                    
                    
                    0.0
                    %
                    
                    
                    0.0
                    %Expected
      volatility
                    
                    
                    200.0
                    %
                    
                    
                    46.0
                    %Risk-free
      interest rate
                    
                    
                    2.75
                    %
                    
                    
                    4.41
                    %Expected
      lives (years)
                    
                    
                    4.0
                    
                    
                    
                    4.3





Dividend yield – The Company
has never declared or paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.





Expected volatility –
Volatility is a measure of the amount by which a financial variable such as
share price has fluctuated (historical volatility) or is expected to fluctuate
(expected volatility). Expected volatility is partially based on the historical
volatility of the Company’s common stock since the end of the prior fiscal year
as well as management’s expectations for future volatility.





Risk - free interest rate – The
risk-free interest rate is based on the published yield available on U.S.
Treasury issues with an equivalent term remaining equal to the expected life of
the option.





Expected lives – The expected
lives of the options represent the estimated period of time until exercise or
forfeiture and are based on historical experience of similar
awards.





Net Loss
Per Share
-
Basic net loss per share is computed by dividing net loss by the weighted
average number of common shares outstanding during the periods. Diluted net loss
per share is computed using the weighted average number of common and dilutive
common equivalent shares outstanding during the periods. Common equivalent
shares consist of convertible notes, stock options, and warrants that are
computed using the treasury stock method. Shares issuable upon the exercise of
stock options, totaling 132,500 and 271,250 shares on December 31, 2009 and
2008, respectively, were excluded from the calculation of common equivalent
shares as the impact was anti-dilutive.





Recently Issued
Accounting Pronouncements - In April
2008, the US Financial Accounting Standards Board  suggested rules
concerning  the determination of the useful life of intangible
assets. The standard
requires entities to consider their own historical experience in renewing or
extending similar arrangements when developing assumptions regarding the useful
lives of intangible assets and also mandates certain related disclosure
requirements. The rules are effective for fiscal years beginning after
December 15, 2008, with early adoption prohibited. The Company has adopted
the rules.





All other
new and recently issued, but not yet, effective, accounting pronouncements have
been deemed to be not relevant to the Company and therefore are not expected to
have any impact once adopted.


48


Segment  reporting





The
Company’s chief operating decision maker is its Chief Executive Officer, who
reviews financial information presented on a consolidated basis. Accordingly, in
accordance with US GAAP , the Company has determined that it has a single
reporting segment and operating unit structure, specifically the provision of an
on-demand suite of integrated business management software
services.





Fair
Value Measurement





Fair
value is defined as the price that would be received to sell an asset or paid to
transfer a liability(an exit price) in the principal or most advantageous market
for the asset or liability in an orderly transaction between market participants
on the measurement date.  The value hierarchy prescribed by the
accounting literature contains  three levels as follows:





Level 1 –
Quoted prices in active markets for identical assets or
liabilities.





Level 2 –
Observable inputs other than Level 1 prices such as quoted prices for similar
assets or liabilities; quoted prices in markets that are not active; or other
inputs that are observable or can be corroborated by observable market data for
substantially the full term of the assets or liabilities.





Level 3 –
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities.  Level
3 assets and liabilities include financial instruments whose value is determined
using pricing models, discounted cash flow methodologies, or similar techniques,
as well as instruments for which the determination of fair value requires
significant management judgment or estimations.





The
Company reviews property and equipment impairment whenever events or changes in
circumstances indicate the carrying amount of an assets may not be
recoverable.  During 2009 and 2008 , the Company recognized impairment
charges of $626,685 and $3,702,141 respectively, based on Level 3
analysis.  In the current year impairment charges were recognized in
full against customer lists because of the loss of significant
customers.  (See Note 5)





3.
            BALANCE SHEET
      ACCOUNTS





Accounts
Receivable





December
      312009
                    
                    
                    2008Accounts
      receivable
                    
                    $
                    403,250
                    
                    
                    $
                    613,088Unbilled
      receivable
                    
                    
                    432,317
                    
                    
                    
                    432,317Total
      Accounts receivable
                    
                    
                    835,567
                    
                    
                    
                    1,045,405Allowance
      for doubtful accounts
                    
                    
                    (822,511
                    )
                    
                    
                    (428,158
                    )$
                    13,056
                    
                    
                    $
                    617,247




Unbilled
receivables represent costs incurred on a development agreement with
a Customer.  The company has not recognized any revenue as the
appropriate  revenue recognition criteria has not been
met.




Advance
      to Nouri (See Note 7)
                    
                    $
                    1,802,379
                    
                    
                    $
                    -Allowance
      for doubtful accounts
                    
                    
                    (1,802,379
                    )
                    
                    
                    -$
                    -
                    
                    
                    $
                    -





The
company has not paid the advance amount as of December 31, 2009 and the
corresponding amount has been included as an accrued liability as identified
below.


49


Prepaid
Expenses





In July
2008, the Company entered into a 36-month sublease agreement for approximately
9,837 square feet of office space in Durham, North Carolina near Research
Triangle Park, into which the Company relocated its headquarters in September
2008. The agreement included the conveyance of certain furniture to the Company
without a stated value and required a lump-sum, upfront payment of $500,000 that
was made in September 2008. Management has assessed the fair market value of the
furniture to be approximately $50,000, and this amount was capitalized and is
subject to depreciation in accordance with the Company’s fixed asset policies.
The remainder of the payment was recorded as prepaid expense; with the portion,
relating to rent for periods beyond the next 12 months classified as
non-current, and is being amortized to rent expense over the term of the
lease.  (See Note 7)





Deferred
Financing Costs





To assist
the Company in securing a modification to its line of credit with
Wachovia, Atlas provided Wachovia with a modified standby letter of credit. In
exchange for Atlas providing Wachovia with the modified letter of credit, on
January 15, 2007 the Company issued Atlas a warrant containing a provision for
cashless exercise to purchase up to 444,444 shares of the Company’s common stock
at $2.70 per share. The fair value of the warrant was $734,303 as measured using
the Black-Scholes option-pricing model at the time the warrant was issued. This
amount was recorded as deferred financing costs and was amortized to interest
expense in the amount of $37,657 per month over the remaining period of the
modified line of credit, which was scheduled to expire in August 2008. In
February 2008, the Wachovia line of credit was replaced by a new line of credit
with Paragon as described in Note 6, “Notes Payable.” Atlas agreed to
provide Paragon a new standby letter of credit and the Company agreed to amend
the Atlas warrant agreement to provide that the warrant is exercisable within 30
business days of the termination of the Paragon line of credit or if the Company
is in default under the terms of the line of credit with Paragon. As of
December 31, 2008, the deferred financing costs were fully amortized to
interest expense.





Accrued
Liabilities





At
December 31, 2009, the Company had accrued liabilities totaling $4,426,338. This
amount consisted primarily of $99,453 of liability accrued related to the
development of the Company’s custom accounting application; $1,802,379 related
to legal reserves for the settlement of legal fees on behalf of former officers
and employees, Michael Nouri and Eric Reza Nouri, both of whom were convicted on
criminal charges brought by the US Department of Justice; $ 152,657 for accrued
legal fees related to the defense; $71,159 for accrued payroll and related
costs; and $102,647 of convertible note interest payable and $2,149,500 for the
estimated settlement costs of the class action lawsuit.   (See
Note 12)





At
December 31, 2008, the Company had accrued liabilities totaling $478,917. This
amount consisted primarily of $117,102 of liability related to the development
of the Company’s custom accounting application; $137,500 related to legal
reserves; $30,198 for tax-related liabilities associated with the vesting of
restricted stock; $30,903 of estimated loss on a long-term customer contract;
$79,300 of cash collected through the Company's merchant account on behalf of a
customer; and $54,467 of convertible note interest payable.





Deferred
Revenue





Deferred
revenue comprises the following items:


50





·
            Subscription
      fees–Short-term and long-term
      portions of cash received related to one- or two-year subscriptions for
      domain names and/or e-mail
accounts.





·
            License
      fees–Licensing revenue where
      customers did not meet all the criteria for income recognition under
      current US GAAP. Such deferred revenue will be recognized when delivery
      has occurred and collectability becomes
  probable.





·
            Professional
      servicefees–A customer that purchased a
      license and paid professional service fees during 2008 to develop a
      customized application decided in the latter part of 2008 to move the
      application to the Company’s new technology platform. In connection with
      this new arrangement, the customer desires customization beyond the
      original scope of the project and will be responsible for a monthly fee to
      maintain the application starting in the first quarter of 2010. This
      deferred revenue represents the difference between earned fees and
      unearned license and professional service fees that were recognized as
      professional service fees revenue in
  2009.





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





December 31,
                          2009
                        
                        
                        December 31,
                          2008Subscription
      fees
                        
                        $
                        40,115
                        
                        
                        $
                        89,852License
      fees
                        
                        
                        5,601
                        
                        
                        
                        108,750Professional
      service fees
                        
                        
                        -
                        
                        
                        
                        192,727Totals
                        
                        $
                        45,716
                        
                        
                        $
                        391,329Current
      portion
                        
                        $
                        40,115
                        
                        
                        $
                        323,976Non-current
      portion
                        
                        
                        5,601
                        
                        
                        
                        67,353Totals
                        
                        $
                        45,716
                        
                        
                        $
                        391,329





4.
            PROPERTY AND EQUIPMENT AND
      CAPITALIZED SOFTWARE





Property
and equipment consists of the following:





December 31,
                          2009
                        
                        
                        December 31,
                          2008Computer
      hardware
                        
                        $
                        141,793
                        
                        
                        $
                        1,182,513Computer
      software
                        
                        
                        291,436
                        
                        
                        
                        480,262Furniture
      and fixtures
                        
                        
                        88,946
                        
                        
                        
                        115,167Office
      equipment
                        
                        
                        16,172
                        
                        
                        
                        68,850Leasehold
      improvements
                        
                        
                        53,279
                        
                        
                        
                        52,994591,626
                        
                        
                        
                        1,899,786Less
      accumulated depreciation
                        
                        
                        (333,176
                        )
                        
                        
                        (1,533,793
                        )Property
      and equipment, net
                        
                        $
                        258,450
                        
                        
                        $
                        365,993





Capitalized
software consists of the following:





December 31,
                        2009
                      
                      
                      December 31,
                        2008Capitalized
      software
                      
                      $
                      483,657
                      
                      
                      $
                      261,221Less
      accumulated amortization
                      
                      
                      (32,875
                      )
                      
                      
                      -Capitalized
      software, net
                      
                      $
                      450,782
                      
                      
                      $
                      261,221





Depreciation
expense for the years ended December 31, 2009 and 2008 was $99,320 and $129,539,
respectively.


51


As of July 10, 2009, the Company released the products previously
included in the capitalized software.  The Company recognized
amortization expense of $32,875 for the year ending December 31.
2009.





The
Company’s new technology platform was still under development at December 31,
2008 therefore no amortization expense relating to capitalized software has been
recognized





5.
            INTANGIBLE
      ASSETS





The
following table summarizes information about intangible assets at December 31,
2009:





Asset Category
                                    
                                    Value
                                      Assigned
                                    
                                    Weighted
                                      Average
                                      Amortization
                                      Period
                                      (in Years)
                                    
                                    Impairments
                                    
                                    
                                    Accumulated
                                      Amortization
                                    
                                    
                                    Carrying
                                      Value (Net of
                                      Impairments)Customer
      bases
                                    
                                    $
                                    1,944,347
                                    
                                    6.2
                                    
                                    $
                                    (626,685
                                    )
                                    
                                    $
                                    1,317,662
                                    
                                    
                                    $
                                    -Acquired
      technology
                                    
                                    
                                    501,264
                                    
                                    3
                                    
                                    
                                    -
                                    
                                    
                                    
                                    501,264
                                    
                                    
                                    
                                    -Non-compete
      agreement
                                    
                                    
                                    801,785
                                    
                                    4
                                    
                                    
                                    -
                                    
                                    
                                    
                                    801,785
                                    
                                    
                                    
                                    -Trademarks
      and copyrights
                                    
                                    
                                    52,372
                                    
                                    9.7
                                    
                                    
                                    -
                                    
                                    
                                    
                                    52,372
                                    
                                    
                                    
                                    -Trade
      name
                                    
                                    
                                    150,000
                                    
                                    N/A
                                    
                                    
                                    
                                    
                                    
                                    
                                    N/A
                                    
                                    
                                    
                                    150,000Goodwill
      and workforce
                                    
                                    
                                    -
                                    
                                    N/A
                                    
                                    
                                    
                                    
                                    
                                    
                                    N/A
                                    
                                    
                                    
                                    -Totals
                                    
                                    $
                                    3,449,768
                                    
                                    
                                    
                                    $
                                    (626,685
                                    )
                                    
                                    $
                                    2,673,083
                                    
                                    
                                    $
                                    150,000





The
following table summarizes information about intangible assets at December 31,
2008:





Asset Category
                                        
                                        Value
                                          Assigned
                                        
                                        Weighted
                                          Average
                                          Amortization
                                          Period
                                          (in Years)
                                        
                                        Impairments
                                        
                                        
                                        Accumulated
                                          Amortization
                                        
                                        
                                        Carrying
                                          Value (Net of
                                          Impairments)Customer
      bases
                                        
                                        $
                                        1,944,347
                                        
                                        6.2
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        1,076,740
                                        
                                        
                                        $
                                        867,607Acquired
      technology
                                        
                                        
                                        501,264
                                        
                                        3
                                        
                                        
                                        -
                                        
                                        
                                        
                                        501,264
                                        
                                        
                                        
                                        -Non-compete
      agreements
                                        
                                        
                                        801,785
                                        
                                        4
                                        
                                        
                                        -
                                        
                                        
                                        
                                        643,098
                                        
                                        
                                        
                                        158,687Trademarks
      and copyrights
                                        
                                        
                                        52,372
                                        
                                        9.7
                                        
                                        
                                        -
                                        
                                        
                                        
                                        48,421
                                        
                                        
                                        
                                        3,951Trade
      name
                                        
                                        
                                        1,155,499
                                        
                                        N/A
                                        
                                        
                                        (1,005,499
                                        )
                                        
                                        
                                        N/A
                                        
                                        
                                        
                                        150,000Goodwill
      and workforce
                                        
                                        
                                        2,696,642
                                        
                                        N/A
                                        
                                        
                                        (2,696,642
                                        )
                                        
                                        
                                        N/A
                                        
                                        
                                        
                                        -Totals
                                        
                                        $
                                        7,151,909
                                        
                                        
                                        
                                        $
                                        (3,702,141
                                        )
                                        
                                        $
                                        2,269,523
                                        
                                        
                                        $
                                        1,180,245





For the
years ended December 31, 2009 and 2008, the aggregate amortization expense on
the above intangibles was approximately $403,560 and $696,307, respectively. The
aggregate amortization expense for the years ended December 31, 2010 through
2014 is expected to be $0 for each respective year.





6.
            NOTES
    PAYABLE





As of
December 31, 2009, the Company had notes payable totaling $11,749,536. The
detail of these notes is as follows:





Note Description
                                        
                                        Short-Term
                                          Portion
                                        
                                        
                                        Long-Term
                                          Portion
                                        
                                        
                                        Total
                                        
                                        Maturity
                                        
                                        RateParagon
      Commercial Bank credit line
                                        
                                        $
                                        1,884,110
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        1,884,110
                                        
                                        Aug
      2010
                                        
                                        6.5
                                        %Insurance
      premium note
                                        
                                        
                                        42,632
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        42,632
                                        
                                        Jun
      2010
                                        
                                        5.4
                                        %Various
      capital leases
                                        
                                        
                                        37,539
                                        
                                        
                                        
                                        185,255
                                        
                                        
                                        
                                        222,794
                                        
                                        Various
                                        
                                        8.0-18.9
                                        %Convertible
      notes
                                        
                                        
                                        -
                                        
                                        
                                        
                                        9,600,000
                                        
                                        
                                        
                                        9,600,000
                                        
                                        Nov
      2013
                                        
                                        8.0
                                        %Totals
                                        
                                        $
                                        1,964,281
                                        
                                        
                                        $
                                        9,785,255
                                        
                                        
                                        $
                                        11,749,536


52


As of
December 31, 2008, the Company had notes payable totaling $7,668,388. The detail
of these notes is as follows:





Note Description
                        
                        Short-Term
                          Portion
                        
                        
                        Long-Term
                          Portion
                        
                        
                        Total
                        
                        Maturity
                        
                        RateParagon
      Commercial Bank credit line
                        
                        $
                        2,272,118
                        
                        
                        $
                        -
                        
                        
                        $
                        2,272,118
                        
                        Feb
      2009
                        
                        Prime less 0.5
                        %Insurance
      premium note
                        
                        
                        42,753
                        
                        
                        
                        -
                        
                        
                        
                        42,753
                        
                        Jul
      2009
                        
                        6.1
                        %Various
      capital leases
                        
                        
                        26,306
                        
                        
                        
                        27,211
                        
                        
                        
                        53,517
                        
                        Various
                        
                        18.9
                        %Convertible
      notes
                        
                        
                        -
                        
                        
                        
                        5,300,000
                        
                        
                        
                        5,300,000
                        
                        Nov
      2010
                        
                        8.0
                        %Totals
                        
                        $
                        2,341,177
                        
                        
                        $
                        5,327,211
                        
                        
                        $
                        7,668,388





Convertible
Notes





On
November 14, 2007, in an initial closing, the Company sold $3.3 million
aggregate principal amount of Initial Notes due November 14, 2010. In addition,
the noteholders committed to purchase on a pro rata basis up to $5.2 million
aggregate principal of convertible secured subordinated Notes in future closings
upon approval and call by our Board of Directors. On August 12, 2008, we
exercised our option to sell $1.5 million aggregate principal of Additional
Notes due November 14, 2010 to existing noteholders, with substantially the same
terms and conditions as the Initial Notes. In connection with the sale of the
Additional Notes, the noteholders holding a majority of the aggregate principal
amount of the convertible secured subordinated Notes then outstanding agreed to
increase the aggregate principal amount of convertible secured subordinated
Notes that they are committed to purchase from $8.5 million to $15.3 million. On
November 21, 2008, we sold $500,000 aggregate principal amount of New Notes due
November 14, 2010 to two new convertible noteholders, with substantially the
same terms and conditions as the Initial Notes and the Additional Notes. At
December 31, 2008, $5.3 million aggregate principal amount of Notes were
outstanding.




On
January 6, 2009, the Company sold $500,000 aggregate principal amount of Notes
to Atlas, on substantially the same terms and conditions as the previously
issued Notes.




On February 24, 2009, the Company sold
$500,000 aggregate principal amount of Notes to Atlas on substantially the same
terms and conditions as the previously issued Notes. On the same date, the
noteholders holding a majority of the aggregate principal amount of the Notes
outstanding agreed that the Company may sell up to $6 million aggregate
principal amount of Additional Notes to new convertible noteholders or existing
noteholders at any time on or before December 31, 2009 with a maturity date of
November 14, 2010 or later. In addition, the maturity date definition for each
of the Notes was changed from November 14, 2010 to the date upon which the note
is due and payable, which is the earlier of (1) November 14, 2010, (2) a change
of control, or (3) if an event of default occurs, the date upon which
noteholders accelerate the indebtedness evidenced by the Notes. The formula for
calculating the conversion price of the Notes was also amended such that the
conversion price of each outstanding note and any additional note sold in the
future would be the same and set at the lowest applicable conversion price, as
described below.




On each
of April 3, 2009 and June 2, 2009, the Company sold a Note in the principal
amount of $500,000 to Atlas on substantially the same terms and conditions as
the previously issued Notes.  On each of July 16, 2009, August 26,
2009, September 8, 2009, and October 5, 2009, the Company sold a Note in the
principal amount of $250,000 to Atlas on substantially the same terms and
conditions as the previously issued Notes.  On October 9, 2009, the
Company sold a Note in the principal amount of $250,000 to UBP, Union Bancaire
Privee, an existing noteholder, on substantially the same terms and conditions
as the previously issued Notes.  On November 6, 2009, the Company sold
a Note to Atlas in the principal amount of $500,000, on December 23, 2009 the
Company sold a Note to Atlas in the principal amount of $750,000, and on
February 11, 2010, the Company sold a Note to Atlas in the principal amount of
$500,000, all upon substantially the same terms and conditions as the previously
issued Notes.




On March
5, 2010, the Company and the Requisite Percentage Holder, among other
noteholders, entered into the Fourth Amendment.  The Fourth Amendment
extends the original maturity date of the Notes from November 14, 2010 to
November 14, 2013, and amends the Note Purchase Agreement and the Registration
Rights Agreement, dated November 14, 2007, to reflect this extension, as
reported on the Form 8-K filed by the Company on March 10, 2010.




On April
1, 2010, the Company sold a Note to Atlas in the principal amount of $350,000,
due November 14, 2013, upon substantially the same terms and conditions as
the previously issued Notes.





On the
earlier of the maturity date of November 14, 2013 or a merger or acquisition or
other transaction pursuant to which our existing stockholders hold less than 50%
of the surviving entity, or the sale of all or substantially all of our assets,
or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:


53





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





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





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




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




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




·
            the
      closing price of the Company’s common stock on the OTC Bulletin Board, the
      Nasdaq National Market, or the principal exchange on which the common
      stock is listed, as applicable, on the trading day immediately preceding
      the date such Note is converted, in each case as adjusted for stock
      splits, dividends or combinations, recapitalizations, or similar
      events.




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





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





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





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





No fees
to third parties are payable in connection with the sale of
Notes.


54





Lines
of Credit





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 was Prime plus 1.5% as periodically determined
by Fifth Third Bank. The loan was 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 was guaranteed by the Company, and
such guaranty was secured by all of the common stock of Smart Commerce. Under
the terms of the loan agreement, Smart Commerce established a lockbox account
with Fifth Third Bank but had 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 existed and was continuing. Such
restricted cash was 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 met certain debt covenants regarding
operating metrics for Smart Commerce. In November 2007, following the
convertible note offering described above, the Company repaid all principal and
interest owed to Fifth Third Bank in connection with this loan. All restricted
cash was released and used to repay part of the principal due.





On
November 14, 2006, the Company entered into a revolving credit arrangement with
Wachovia for $1.3 million to be used for general working capital. Any advances
made on the line of credit were to be paid off no later than August 1, 2007,
with monthly payments of accrued interest on any outstanding balance commencing
on December 1, 2006. The interest accrued on the unpaid principal balance at the
LIBOR Market Index Rate plus 0.9%. The line of credit was secured by the
Company’s deposit account at Wachovia and an irrevocable standby letter of
credit in the amount of $1.3 million issued by HSBC with Atlas, a current
stockholder, as account party.





On
January 24, 2007, the Company entered into an amendment to its line of credit
with Wachovia to increase the available principal from $1.3 million to $2.5
million and to extend the maturity date from August 1, 2007 to August 1, 2008.
The amended line of credit was secured by the Company’s deposit account at
Wachovia and a modified irrevocable standby letter of credit in the amount of
$2,500,000 issued by HSBC with Atlas as account party. On February 15, 2008, the
Company repaid the full outstanding principal balance of $2,052,000 and accrued
interest of $2,890.





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





On
February 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to  the
Paragon Note.  The Modification Agreement (i) extends
the maturity date of the Paragon Note from February 11, 2010 to August 11,
2010, and (ii) changes the interest rate from a variable annual rate equal to
The Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual
rate of 6.50%.   The Company has been advised that, effective
January 28, 2010, the expiration date of the standby letter of credit in the
amount of $2,500,000 issued by HSBC securing the Paragon Note has been extended
from February 18, 2010 to September 17, 2010.


55




7.
              COMMITMENTS
      AND CONTINGENCIES




Lease
Commitments





The
Company leases computers, office equipment and office furniture under capital
lease agreements that expire through July 2019. Total amounts financed under
these capital leases were $222,794 and $53,517 at December 31, 2009 and 2008,
respectively, net of accumulated amortization of $709 and $18,647, respectively.
The current and non-current portions of the capital leases have been recorded in
current and long-term portions of notes payable on the consolidated balance
sheets as of December 31, 2009 and 2008. See also Note 6, “Notes
Payable.”





In 2008,
the Company entered into a non-cancelable sublease with a remaining term of 36
months to relocate its North Carolina headquarters to another facility near
Research Triangle Park. As described in Note 3, “Balance Sheet Accounts,” the
Company prepaid the lease and purchased existing furniture and fixtures for a
lump-sum payment of $500,000, of which $450,080 was allocated to rent and is
being amortized monthly over the remaining term of the lease. ( See Note 12 –
Subsequent Events).  The Company also had a non-cancelable lease
through October 2009 for an apartment near its headquarters that is utilized by
its out of town executives and members of its Board of Directors. As of December
31, 2009, future annual minimum operating lease payments for 2010 are
$19,950.





Rent
expense for the years ended December 31, 2009 and 2008 was $186,515 and
$320,421, respectively.





On March
2, 2010, the owner of the subleased office space filed a Complaint in Summary
Ejectment against Advantis and our Company.  The parties are currently
engaged in settlement discussions with respect to this matter.  See
“Legal Proceedings”, below.





Development
Agreement





In August
2005, the Company entered into a software assignment and development agreement
with the developer of a customized accounting software application. In
connection with this agreement, the developer would be paid up to $512,500 and
issued up to 32,395 shares of the Company’s common stock based upon the
developer attaining certain milestones. This agreement was modified on
March 26, 2008 to adjust the total number of shares issuable under the agreement
to 29,014. As of December 31, 2009, the Company had paid $484,834 and issued
3,473 shares of common stock related to this obligation.


56


Legal
Proceedings





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





On
October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in the
United States District Court for the Middle District of North Carolina naming
the Company, certain of its current and former officers and directors, Maxim
Group, LLC, Jesup & Lamont Securities Corp. and Sherb & Co. ( our former
independent registered  accounting firm) as defendants. The lawsuit
was filed on behalf of all persons other than the defendants who purchased the
Company’s securities from May 2, 2005 through September 28, 2007 and were
damaged. The complaint asserts violations of federal securities laws, including
violations of Section 10(b) of the Securities Exchange Act of 1934, as
amended, and Rule 10b-5. The complaint asserts that the defendants made material
and misleading statements with the intent to mislead the investing public and
conspired in a fraudulent scheme to manipulate trading in the Company’s stock,
allegedly causing plaintiffs to purchase the stock at an inflated price. The
complaint requests certification of the plaintiff as class representative and
seeks, among other relief, unspecified compensatory damages including interest,
plus reasonable costs and expenses including counsel fees and expert fees. On
June 24, 2008, the court entered an order appointing a lead plaintiff for the
class action. On September 8, 2008, the plaintiff filed an amended complaint
that added additional defendants who had served as directors or officers of the
Company during the class period as well as the Company’s independent
auditor.





In late
March 2010, the Company reached a tentative agreement with the lead plaintiff in
the pending securities class action, and some of the defendants named in the
class action, which has not yet been signed, providing for the settlement of the
securities class action on the terms described below.  Once signed,
the settlement would be subject to preliminary and final court
approval.





The
tentative agreement provides for the certification of a class consisting of all
persons who purchased the Company's publicly-traded securities between May 2,
2005 and September 28, 2007, inclusive. The settlement class would receive from
the Company a cash payment of $350,000 to be made by the Company and 1,475,000
shares of Company common stock. All claims against the settling defendants would
be dismissed with prejudice.





On July
2, 2009, the Nouris were convicted of nine counts of criminal activity in a
federal criminal action brought against them in the United States District Court
for the Southern District of New York involving a fraudulent scheme to
manipulate the Company’s stock price, and are presently awaiting
sentencing.  On September 24, 2009,  the Nouris filed a
motion in the Court of Chancery of the State of Delaware against the
Company  seeking  the appointment of a receiver for the Company
for the purpose of collecting on account of the Company’s failure to pay a
judgment in the amount of $826,798 entered against it by the Order of the Court
of Chancery for the advancement of legal expenses incurred by the Nouris in
their defense of criminal proceedings brought against them by the United States,
and in their defense of civil proceedings brought against them by the Securities
and Exchange Commission and the Company’s stockholders.  Such legal
expenses were in addition to legal fees and costs of over $1.3 million paid by
the Company’s insurance carrier for the benefit of the Nouris in these
matters prior to entry of the Order, which insurance coverage has since
been exhausted. The Company has recorded a total of unpaid legal expense
obligations of $1,802,379 for this matter based on invoices received from the
Nouris’ law firms through March 31, 2010, which figure does not include invoices
generated but not yet received.  The Company is engaged in discussion
with the Nouris for the settlement of the Nouri’s advancement and
indemnification claims against the Company.





During
April 2008, the Company received approximately $95,000 in insurance
reimbursement for previously disputed legal expenses primarily related to
previously disclosed SEC matters. During August 2008, the Company and the
insurance carrier agreed that the carrier would reimburse it $300,000 for
previously disputed legal expenses primarily related to its previously disclosed
SEC matters. The reimbursement covered all disputed Company expenses prior to
September 11, 2007 as well as certain enumerated invoices in dispute for the
balance of 2007, and it was received by the Company. Because the outcome of the
dispute was unclear, the Company expensed as incurred all legal costs with
respect to the SEC matters and the Company’s 2006 internal investigation. For
the year ended December 31, 2008, both reimbursements have been recorded in the
consolidated statements of operations as a gain on legal
settlements.





On March
2, 2010, Nottingham Hall LLC, the primary landlord for the office space occupied
by the Company under a sublease between our Company and Advantis Real Estate
Services Company (Advantis), filed a Complaint in Summary Ejectment against
Advantis and our Company. The suit seeks to recoup the funds not paid by
Advantis over term of the original lease between Nottingham Hall LLC and
Advantis in the sum of approximately $121,000.  Representatives for
Nottingham Hall LLC have indicated that Advantis has defaulted on the terms of
the lease and Nottingham Hall is now pursuing our Company for the differential
in rent between our prepaid negotiated amount and the total actually due from
Advantis.  We are currently negotiating a settlement in the
matter.




8.
              STOCKHOLDERS’
      EQUITY





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, 2009, it had 18,332,542 shares of common
stock outstanding. Holders of common stock are entitled to one vote for each
share held.





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 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
proceeds were $6 million and the Company incurred issuance costs of
approximately $667,000.


57




The
Company and each of the Investors also entered into a Registration Rights
Agreement (the “Investor RRA”) whereby the Company had an obligation to register
the shares for resale by the Investors by filing a registration statement within
30 days of the closing of the private placement, and to have the registration
statement declared effective 60 days after actual filing, or 90 days after
actual filing if the SEC reviewed the registration statement. If a registration
statement was not timely filed or declared effective by the date set forth in
the Investor RRA, the Company would have been obligated to pay a cash penalty of
1% of the purchase price on the day after the filing or declaration of
effectiveness was due, and 0.5% of the purchase price per every 30-day period
thereafter, to be prorated for partial periods, until the Company fulfilled
these obligations. Under no circumstances could the aggregate penalty for late
registration or effectiveness exceed 10% of the aggregate purchase price. Under
the terms of the Investor RRA, the Company could not 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 did 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 11
calendar days. On April 3, 2007, the Company filed the Registration Statement on
Form S-1 (File No. 333-141853) (the “Registration Statement”) within the
extended filing obligation period, thereby avoiding the first potential penalty.
Effective July 2, 2007, the Company entered into another amendment to the
Investor RRA to extend the registration effectiveness obligation date to July
31, 2007. On July 31, 2007, the SEC declared the Registration Statement
effective. Accordingly, the Company met all of its requirements under the
amended Investor RRA and no penalties were incurred.





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 amendments to registration rights agreements between such investors
and the Company. On July 20, 2007, the Company issued 27,427 additional shares
as registration penalties to certain investors who did not enter into amendments
to certain registration rights agreements.





In
January 2008, the Company issued 19,608 shares of common stock to a consulting
firm as full payment of the outstanding obligation related to fees accrued for
services rendered in conjunction with the 2005 acquisitions of iMart and
Computility.




Preferred
Stock





The Board
of Directors is authorized, without further stockholder approval, to issue up to
5,000,000 shares of $0.001 par value preferred stock in one or more series and
to fix the rights, preferences, privileges, and restrictions applicable to such
shares, including dividend rights, conversion rights, terms of redemption, and
liquidation preferences, and to fix the number of shares constituting any series
and the designations of such series. There were no shares of preferred stock
outstanding at December 31, 2009.





Warrants





As
incentive to modify a letter of credit relating to the Wachovia line of credit
(see Note 6, “Notes Payable”), the Company entered into a Stock Purchase Warrant
and Agreement (the “Warrant Agreement”) with Atlas on January 15, 2007. Under
the terms of the Warrant Agreement, Atlas received a warrant containing a
provision for cashless exercise to purchase up to 444,444 shares of the
Company’s common stock at $2.70 per share at the termination of the line of
credit or if the Company is in default under the terms of the line of credit
with Wachovia. The fair value of the warrant was $734,303 as measured using the
Black-Scholes option-pricing model at the time the warrant was issued. This
amount was recorded as deferred financing costs and was amortized to interest
expense in the amount of $37,657 per month over the remaining period of the
modified line of credit, which expired in August 2008. In consideration for
Atlas providing the Paragon line of credit (see Note 6, “Notes Payable”), the
Company agreed to amend the Warrant Agreement to provide that the warrant is
exercisable within 30 business days of the termination of the Paragon line of
credit or if the Company is in default under the terms of the line of credit. If
the warrant is exercised in full, it will result in gross proceeds to the
Company of approximately $1,200,000.





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 expired February 21, 2010.





As part
of the commission paid to Canaccord Adams, Inc. (“CA”), the Company’s placement
agent in the transaction that closed in February 2007, 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 was obligated to file under the Investor RRA described
above, but CA was not entitled to any penalties for late registration or
effectiveness.


58




As of
December 31, 2009, warrants to purchase up to 1,655,915 shares were
outstanding.





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





During
2009, no shares of restricted stock were issued.  A total of 1,059
shares of restricted stock were canceled during the year ended December 31, 2009
due to resignations, terminations, payment of employee tax obligations resulting
from share vesting, and exchange for stock options.  At December 31,
2009, there remains no unvested expense yet to be recorded related to all
restricted stock outstanding.





On March
17, 2009, the Company granted 40,000 incentive stock options to a new
independent director joining the Company’s Board of Directors.  The
options call for a one-year vesting period and an exercise price at the market
price on the date of grant. The Company did not record any expense related to
the grant in 2009 because the director resigned from the Board in May 2009. A
total of 178,750 incentive stock options were canceled during the year ended
December 31, 2009 due to resignations and terminations.


During
2008, a total of 70,000 shares of restricted stock were issued at a price equal
to the fair market value of the stock on the date of grant. An aggregate of
35,000 shares of restricted stock were issued to the Company’s independent
directors in accordance with the Company’s board compensation policy with
restrictions that lapse ratably over a one-year period. A total of 35,000 shares
were issued to the newly appointed Chief Operating Officer with restrictions
that lapse in varying increments over a four-year period. Additionally, a
total of 121,844 shares of restricted stock were canceled during the year ended
December 31, 2008 due to resignations, terminations, payment of employee tax
obligations resulting from share vesting, and exchange for stock
options.





2001
Equity Compensation Plan





The
Company adopted the 2001 Equity Compensation Plan (the “2001 Plan”) as of May
31, 2001. The 2001 Plan provided for the grant of incentive stock options,
non-statutory stock options, restricted stock, and other direct stock awards to
employees (including officers) and directors of the Company as well as to
certain consultants and advisors. The total number of shares of common stock
reserved for issuance under the 2001 Plan is 795,000 shares, subject to
adjustment in the event of a stock split, stock dividend, recapitalization, or
similar change. The Company cannot make any further grants under the 2001
Plan.


59


1998
Stock Option Plan





At
December 31, 2009, no options to purchase shares of common stock were
outstanding under the 1998 Plan.





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 ten years, except for option
grants to 10% stockholders, which are subject to a maximum term of five years.
Non-statutory stock options have a term determined by either the Board of
Directors or the Compensation Committee. Options granted under the plans are not
transferable, except by will and the laws of descent and
distribution.





A summary
of the status of the stock option issuances as of December 31, 2009 and 2008,
and changes during the periods ended on these dates is as follows:





Shares
                              
                              
                              Weighted
                                Average
                                Exercise PriceBALANCE,
      December 31, 2007
                              
                              
                              1,644,300
                              
                              
                              $
                              5.07Granted
                              
                              
                              35,000
                              
                              
                              
                              3.19Exercised
                              
                              
                              (325,000
                              )
                              
                              
                              1.40Canceled
                              
                              
                              (1,083,050
                              )
                              
                              
                              5.90BALANCE,
      December 31, 2008
                              
                              
                              271,250
                              
                              
                              
                              5.89Granted
                              
                              
                              40,000
                              
                              
                              
                              1.10Exercised
                              
                              
                              -
                              
                              
                              
                              -Canceled
                              
                              
                              (178,750
                              )
                              
                              
                              6.02BALANCE,
      December 31, 2009
                              
                              
                              132,500
                              
                              
                              $
                              4.43





The
following table summarizes information about stock options outstanding at
December 31, 2009:





Currently ExercisableExercise Price
                    
                    Number of
                      Options
                      Outstanding
                    
                    
                    Average
                      Remaining
                      Contractual
                      Life (Years)
                    
                    
                    Weighted
                      Average
                      Exercise
                      Price
                    
                    
                    Number of
                      Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      PriceFrom
      $2.50 to $3.50
                    
                    
                    85,000
                    
                    
                    
                    6.8
                    
                    
                    $
                    3.15
                    
                    
                    
                    83,750
                    
                    
                    $
                    3.16$5.00
                    
                    
                    25,000
                    
                    
                    
                    4.3
                    
                    
                    $
                    5.00
                    
                    
                    
                    20,000
                    
                    
                    $
                    5.00From
      $8.61 to $9.00
                    
                    
                    22,500
                    
                    
                    
                    3.5
                    
                    
                    $
                    8.61
                    
                    
                    
                    18,000
                    
                    
                    $
                    8.61Totals
                    
                    
                    132,500
                    
                    
                    
                    6.1
                    
                    
                    $
                    4.43
                    
                    
                    
                    121,750
                    
                    
                    $
                    4.27





At
December 31, 2009, there remains $7,757 of unvested expense yet to be recorded
related to all incentive stock options outstanding.   The
outstanding options have no intrinsic value at December 31, 2009.  The
following table sets forth the weighted average exercise price and fair value of
options granted during the year ended December 31, 2009:





Shares
                      
                      
                      Weighted
                        Average
                        Exercise Price
                      
                      
                      Weighted
                        Average Fair
                        ValueExercise
      price exceeds market price
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Exercise
      price equals market price
                      
                      
                      40,000
                      
                      
                      $
                      1.10
                      
                      
                      $
                      1.10Exercise
      price is less than market price
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -





Dividends - The Company has
not paid any cash dividends through December 31, 2009.


60




9.
              INCOME
      TAXES





The
Company accounts for income taxes under the asset and liability method in
accordance with the requirements of US GAAP. 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,
                                2009
                              
                              
                              December 31,
                                2008Net
      current deferred income tax assets related to:Depreciation
                              
                              $
                              269,000
                              
                              
                              $
                              429,000Stock-based
      expenses
                              
                              
                              226,000
                              
                              
                              
                              226,000Accrued
      liabilities – litigation expenses
                              
                              
                              2,260,000
                              
                              
                              
                              (57,000
                              )Net
      operating loss carryforwards
                              
                              
                              19,241,000
                              
                              
                              
                              18,385,000Total
                              
                              
                              21,996,000
                              
                              
                              
                              18,983,000Less
      valuation allowance
                              
                              
                              (21,996,000
                              )
                              
                              
                              (18,983,000
                              )Net
      current deferred income tax
                              
                              $
                              -
                              
                              
                              $
                              -





Under US
GAAP, 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,
                            2009
                          
                          
                          Year Ended
                            December 31,
                            2008Tax
      benefit computed at statutory rate of 34%
                          
                          $
                          (3,244,000
                          )
                          
                          $
                          (3,417,000
                          )State
      income tax benefit, net of federal effect
                          
                          
                          (434,000
                          )
                          
                          
                          (460,000
                          )Change
      in valuation allowance
                          
                          
                          3,480,000
                          
                          
                          
                          2,592,000Permanent
      differences:Stock
      based compensation
                          
                          
                          (36,000
                          )
                          
                          
                          (63,000
                          )Intangible
      impairment
                          
                          
                          233,000
                          
                          
                          
                          1,339,000Other
      permanent differences
                          
                          
                          1,000
                          
                          
                          
                          9,000Totals
                          
                          $
                          -
                          
                          
                          $
                          -





As of
December 31, 2009, the Company had U.S. federal net operating loss (“NOL”)
carryforwards of approximately $47.3 million, which expire between 2010 and
2029. For state tax purposes, the NOL carryforwards expire between 2010 and
2022. 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.





The
Company has reviewed its tax position and has determined that it has no
significant uncertain tax positions at December 31, 2009.


61




10.
              MAJOR
      CUSTOMERS AND CONCENTRATION OF CREDIT
  RISK





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





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





Year Ended December 31, 2009Revenue Type
                    
                    Revenues
                    
                    % of Total
                      RevenuesCustomer
      A
                    Professional
      services
                    
                    $
                    275,111
                    
                    19
                    %Customer
      B
                    Subscription
      fees
                    
                    
                    404,485
                    
                    29
                    %Customer
      C
                    Subscription
      fees
                    
                    
                    353,293
                    
                    25
                    %Customer
      D
                    Professional
      services
                    
                    
                    186,478
                    
                    13
                    %Others
                    Others
                    
                    
                    200,135
                    
                    14
                    %Total
                    
                    
                    $
                    1,419,502
                    
                    100
                    %





Year Ended December 31, 2008Revenue Type
                                    
                                    Revenues
                                    
                                    % of Total
                                      RevenuesCustomer
      A
                                    Professional
      services
                                    
                                    $
                                    1,358,893
                                    
                                    35
                                    %Customer
      B
                                    Subscription
      fees
                                    
                                    
                                    387,312
                                    
                                    10
                                    %Customer
      C
                                    Subscription
      fees
                                    
                                    
                                    1,036,870
                                    
                                    27
                                    %Others
                                    Others
                                    
                                    
                                    1,096,104
                                    
                                    28
                                    %Total
                                    
                                    
                                    $
                                    3,879,179
                                    
                                    100
                                    %





As of
December 31, 2009, one customer accounted for 91% of accounts receivable. As of
December 31, 2008, three customers accounted for 42%, 28%, and 17% of accounts
receivable, respectively.




11.
              EMPLOYEE
      BENEFIT PLAN





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 salaries. The Company contributed a total of $8,756
and $38,943 to the plan during 2009 and 2008, respectively.




12.
              SUBSEQUENT
      EVENTS





To fill a
vacancy in the Board, the members of the Board unanimously appointed Amir Elbaz
as a director of the Company, effective January 15, 2009, to serve until his
successor is duly elected and qualified.




Mr.
Elbaz currently advises technology and renewable energy companies on business
strategy, restructuring and business development initiatives.  Mr.
Elbaz served as the Executive Vice President & Chief Financial Officer of
Lithium Technology Corporation (“LTC”) until November 2008.  Mr. Elbaz
joined LTC in 2006 to oversee finances and marketing, as well as business
development.





On
January 19, 2010, the Company and Atlas entered into the Second Amendment to the
Reimbursement Agreement.  Atlas previously procured a letter of credit
in favor of Paragon to serve as security under the Company’s revolving credit
arrangement between the Company, as borrower, and Paragon, as lender. The
Reimbursement Agreement sets forth the terms by which Atlas may be reimbursed by
the Company for any drawdowns by Paragon on the letter of credit. The Second
Amendment provides that Atlas may elect, in its sole discretion, to be
reimbursed by the Company for any such drawdowns in either common stock of the
Company, bonds, or cash.  Prior to such amendment, the Reimbursement
Agreement allowed the Company to reimburse Atlas in either cash or stock, at the
Company’s election.


62





Atlas is
a beneficial owner of 10% or more of the Common Stock of the Company, and the
Requisite Percentage Holder of Notes under the Note Purchase Agreement, under
which the Company is entitled to elect to sell to the noteholders, and the
noteholders are obligated to buy convertible promissory Notes.  The
terms of the Note Purchase Agreement and the Notes are described in Footnote
6.





The
Company entered into the Second Amendment in consideration for a waiver from the
noteholders. Sales of Notes to the noteholders are subject to certain
conditions, including the absence of events or conditions that could reasonably
be expected to have a material adverse effect on the ability of the Company to
perform its obligations under the Note Purchase Agreement. The agent for the
convertible noteholders has advised the Company that the Company’s obligations
to Dennis Michael Nouri and Reza Eric Nouri, former officers of the Company who
have obtained a judgment against the Company for the advancement of expenses
incurred by them in connection with their defense of certain criminal and civil
actions, may constitute such a material adverse effect. However, Atlas, as the
Requisite Percentage Holder, advised the Company that it would be willing to
waive the foregoing funding conditions relating to the judgment if, and for
so long as, the Nouris do not actively pursue enforcement of such judgment, and,
in addition, if the Company entered into the Second Amendment.





On
February 11, 2010, the Company sold an additional convertible secured
subordinated Note due November 14, 2010 in the principal amount of $500,000
to a current noteholder upon substantially the same terms and conditions as the
previously issued Notes.  (See Note 6)





On March
5, 2010, the Company entered into the Fourth Amendment with the holders of a
majority of the aggregate outstanding principal amount of the Notes issued by
the Company under the Note Purchase Agreement.  The Fourth Amendment
extends the original maturity date of the Notes from November 14, 2010 to
November 14, 2013, and amends the Note Purchase Agreement, the Notes and the
Registration Rights Agreement, dated November 14, 2007, to reflect this
extension.





On April
1, 2010, the company sold a Note due November 14, 2013 in the principal amount
of $350,000 to a current noteholder upon substantially the same terms and
conditions as the previously issued Notes.





The
Company entered into a license agreement with an existing customer on February
16, 2010 that included the payment of a monthly license fee of $30,000 starting
on December 1, 2009.  The customer has informed us that they are
unable to make the monthly payments as they have not raised additional capital
required to continue their operations.  We have not recognized any
revenue in 2009 associated with these license fees and the receipt of
contractual payments in 2010 is uncertain.





On
February 25, 2010, the Company entered into a Modification Agreement with
Paragon, with an effective date of February 22, 2010, relating to the
Paragon Note, delivered by the Company to Paragon in the maximum principal
amount of $2,500,000.  The Modification Agreement (i) extends
the maturity date of the Paragon Note from February 11, 2010 to August 11,
2010, and (ii) changes the interest rate from a variable annual rate equal to
The Wall Street Journal Prime Rate, with a floor of 5.50%, to a fixed annual
rate of 6.50%.  The Company has been advised that, effective January
28, 2010, the expiration date of the standby letter of credit in the amount of
$2,500,000 issued by HSBC securing the Paragon Note has been extended from
February 18, 2010 to September 17, 2010.





On March
26, 2010, the Board of Directors authorized grants of stock options and
restricted stock to certain directors of the Company pursuant to the
Company's 2004 Equity Compensation Plan, as follows:




Amir
Elbaz received a grant of non-qualified stock options to acquire up to 20,000
shares of common stock at an exercise price of $1.14 per share, representing
fair market value on the date of grant. The options vest quarterly in 25%
increments, commencing June 30, 2010.




Dror
Zoreff received a grant of non-qualified stock options to acquire up to 30,000
shares of common stock at an exercise price of $1.14 per share, representing
fair market value on the date of grant. The options vest quarterly in 25%
increments, commencing June 30, 2010.




Shlomo
Elia received a grant of 10,000 shares of restricted stock, whose transfer
restrictions lapse quarterly in 25% increments, commencing June 30,
2010.


63





In late
March 2010, the Company reached a tentative settlement with the lead plaintiff
in the class action lawsuit brought against the Company and certain of its
current and former officers and directors, as described in Note 7, “Commitments and
Contingencies,” above





On March
2, 2010, Nottingham Hall LLC, the primary landlord for the office space occupied
by the Company under a sublease between our Company and Advantis, filed a
Complaint in Summary Ejectment against Advantis and our Company.  The
suit seeks to recoup the funds not paid by Advantis over term of the original
lease between Nottingham Hall LLC and Advantis in the amount of
$121,000.  Representatives for Nottingham Hall LLC have indicated that
Advantis has defaulted on the terms of the lease and Nottingham Hall is now
pursuing our Company for the differential in rent between our prepaid negotiated
amount and the total actually due from Advantis. We are currently negotiating a
settlement in the matter.




13.
              RESTATEMENT





Subsequent
to the originally issued financial statements, audited by our former auditors
for the year ended December 31, 2008, we identified and made the following
adjustments and reclassifications in our financial statements:





The
financial statements have been restated to include net subscription revenue as
compared to the gross subscription revenue as presented in prior filings for
2009 and 2008.  Subscription fees primarily consist of sales of
subscriptions through private-label marketing partners to end users. We
typically have a revenue-share arrangement with these marketing partners in
order to encourage them to market our products and services to their customers.
Subscriptions are generally payable on a monthly basis and are typically paid
via credit card of the individual end user. We accrue any payments received in
advance of the subscription period as deferred revenue and amortize them over
the subscription period. In the past we recognized all subscription revenue on a
gross basis and in accordance with our policy to periodically review our
accounting policies we identified the fact  that certain contracts
require the reporting of subscription revenue on a gross basis and others on a
net basis according to US GAAP.  On that basis, we continue to report
subscription revenue from certain contracts on a gross basis and others on a net
basis.  The net effect of this reclassification of expenses only
impacts gross revenue and certain gross expenses; it does not change the net
income.  The effects of these reclassifications for 2009 and 2008 are
presented in detail below:





2009
                                        
                                        
                                        2008As Reported
                                        
                                        
                                        As Restated
                                        
                                        
                                        As Reported
                                        
                                        
                                        As RestatedQuarter Ended March 31REVENUES:Subscription
      fees
                                        
                                        $
                                        473,579
                                        
                                        
                                        $
                                        241,783
                                        
                                        
                                        $
                                        742,839
                                        
                                        
                                        $
                                        479,341Professional
      service fees
                                        
                                        
                                        118,773
                                        
                                        
                                        
                                        118,773
                                        
                                        
                                        
                                        504,083
                                        
                                        
                                        
                                        504,083License
      fees
                                        
                                        
                                        11,250
                                        
                                        
                                        
                                        11,250
                                        
                                        
                                        
                                        100,000
                                        
                                        
                                        
                                        100,000Hosting
      fees
                                        
                                        
                                        72,211
                                        
                                        
                                        
                                        72,211
                                        
                                        
                                        
                                        59,482
                                        
                                        
                                        
                                        59,482Other
      revenue
                                        
                                        
                                        37,671
                                        
                                        
                                        
                                        37,671
                                        
                                        
                                        
                                        40,759
                                        
                                        
                                        
                                        40,759Total
      revenues
                                        
                                        
                                        713,484
                                        
                                        
                                        
                                        481,688
                                        
                                        
                                        
                                        1,447,163
                                        
                                        
                                        
                                        1,183,665COST
      OF REVENUES
                                        
                                        
                                        492,601
                                        
                                        
                                        
                                        492,601
                                        
                                        
                                        
                                        711,667
                                        
                                        
                                        
                                        711,667GROSS
      PROFIT
                                        
                                        
                                        220,883
                                        
                                        
                                        
                                        (10,913
                                        )
                                        
                                        
                                        735,496
                                        
                                        
                                        
                                        471,998OPERATING
      EXPENSES
                                        
                                        
                                        1,703,804
                                        
                                        
                                        
                                        1,472,008
                                        
                                        
                                        
                                        2,390,622
                                        
                                        
                                        
                                        2,127,124LOSS
      FROM OPERATIONS
                                        
                                        
                                        (1,482,921
                                        )
                                        
                                        
                                        (1,482,921
                                        )
                                        
                                        
                                        (1,655,126
                                        )
                                        
                                        
                                        (1,655,126
                                        )OTHER
      INCOME (EXPENSE)
                                        
                                        
                                        (111,732
                                        )
                                        
                                        
                                        (111,732
                                        )
                                        
                                        
                                        (175,757
                                        )
                                        
                                        
                                        (175,757
                                        )NET
      LOSS
                                        
                                        $
                                        (1,594,653
                                        )
                                        
                                        $
                                        (1,594,653
                                        )
                                        
                                        $
                                        (1,830,883
                                        )
                                        
                                        $
                                        (1,830,883
                                        )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                                        
                                        $
                                        (0.09
                                        )
                                        
                                        $
                                        (0.09
                                        )
                                        
                                        $
                                        (0.10
                                        )
                                        
                                        $
                                        (0.10
                                        )




64




2009
                                    
                                    
                                    2008As Reported
                                    
                                    
                                    As Restated
                                    
                                    
                                    As Reported
                                    
                                    
                                    As RestatedQuarter Ended June 30REVENUES:Subscription
      fees
                                    
                                    $
                                    668,344
                                    
                                    
                                    $
                                    209,819
                                    
                                    
                                    $
                                    747,068
                                    
                                    
                                    $
                                    464,456Professional
      service fees
                                    
                                    
                                    79,726
                                    
                                    
                                    
                                    79,726
                                    
                                    
                                    
                                    932,444
                                    
                                    
                                    
                                    932,444License
      fees
                                    
                                    
                                    11,250
                                    
                                    
                                    
                                    11,250
                                    
                                    
                                    
                                    3,750
                                    
                                    
                                    
                                    3,750Hosting
      fees
                                    
                                    
                                    33,045
                                    
                                    
                                    
                                    33,045
                                    
                                    
                                    
                                    36,196
                                    
                                    
                                    
                                    36,196Other
      revenue
                                    
                                    
                                    36,806
                                    
                                    
                                    
                                    36,806
                                    
                                    
                                    
                                    36,173
                                    
                                    
                                    
                                    36,173Total
      revenues
                                    
                                    
                                    829,171
                                    
                                    
                                    
                                    370,646
                                    
                                    
                                    
                                    1,755,631
                                    
                                    
                                    
                                    1,473,019COST
      OF REVENUES
                                    
                                    
                                    202,333
                                    
                                    
                                    
                                    202,333
                                    
                                    
                                    
                                    647,528
                                    
                                    
                                    
                                    647,528GROSS
      PROFIT
                                    
                                    
                                    626,838
                                    
                                    
                                    
                                    168,313
                                    
                                    
                                    
                                    1,108,103
                                    
                                    
                                    
                                    825,491OPERATING
      EXPENSES
                                    
                                    
                                    2,202,532
                                    
                                    
                                    
                                    1,744,007
                                    
                                    
                                    
                                    2,232,752
                                    
                                    
                                    
                                    1,950,140LOSS
      FROM OPERATIONS
                                    
                                    
                                    (1,575,694
                                    )
                                    
                                    
                                    (1,575,694
                                    )
                                    
                                    
                                    (1,124,649
                                    )
                                    
                                    
                                    (1,124,649
                                    )OTHER
      INCOME (EXPENSE)
                                    
                                    
                                    (158,343
                                    )
                                    
                                    
                                    (158,343
                                    )
                                    
                                    
                                    (177,410
                                    )
                                    
                                    
                                    (177,410
                                    )NET
      LOSS
                                    
                                    $
                                    (1,734,037
                                    )
                                    
                                    $
                                    (1,734,037
                                    )
                                    
                                    $
                                    (1,302,059
                                    )
                                    
                                    $
                                    (1,302,059
                                    )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                                    
                                    $
                                    (0.09
                                    )
                                    
                                    $
                                    (0.09
                                    )
                                    
                                    $
                                    (0.08
                                    )
                                    
                                    $
                                    (0.08
                                    )







2009
                                
                                
                                2008As Reported
                                
                                
                                As Restated
                                
                                
                                As Reported
                                
                                
                                As RestatedQuarter Ended September 30REVENUES:Subscription
      fees
                                
                                $
                                908,007
                                
                                
                                $
                                159,149
                                
                                
                                $
                                642,880
                                
                                
                                $
                                364,136Professional
      service fees
                                
                                
                                63,200
                                
                                
                                
                                63,200
                                
                                
                                
                                574,970
                                
                                
                                
                                574,970License
      fees
                                
                                
                                11,250
                                
                                
                                
                                11,250
                                
                                
                                
                                291,250
                                
                                
                                
                                291,250Hosting
      fees
                                
                                
                                33,751
                                
                                
                                
                                33,751
                                
                                
                                
                                70,856
                                
                                
                                
                                70,856Other
      revenue
                                
                                
                                26,300
                                
                                
                                
                                26,300
                                
                                
                                
                                31,501
                                
                                
                                
                                31,501Total
      revenues
                                
                                
                                1,042,508
                                
                                
                                
                                293,650
                                
                                
                                
                                1,611,457
                                
                                
                                
                                1,332,713COST
      OF REVENUES
                                
                                
                                430,967
                                
                                
                                
                                430,967
                                
                                
                                
                                409,414
                                
                                
                                
                                409,414GROSS
      PROFIT
                                
                                
                                611,541
                                
                                
                                
                                (137,317
                                )
                                
                                
                                1,202,043
                                
                                
                                
                                923,299OPERATING
      EXPENSES
                                
                                
                                3,309,069
                                
                                
                                
                                2,560,211
                                
                                
                                
                                2,736,424
                                
                                
                                
                                2,457,680LOSS
      FROM OPERATIONS
                                
                                
                                (2,697,528
                                )
                                
                                
                                (2,697,528
                                )
                                
                                
                                (1,534,381
                                )
                                
                                
                                (1,534,381
                                )OTHER
      INCOME (EXPENSE)
                                
                                
                                (169,609
                                )
                                
                                
                                (169,609
                                )
                                
                                
                                141,962
                                
                                
                                
                                141,962NET
      LOSS
                                
                                $
                                (2,867,137
                                )
                                
                                $
                                (2,867,137
                                )
                                
                                $
                                (1,392,419
                                )
                                
                                $
                                (1,392,419
                                )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                                
                                $
                                (0.16
                                )
                                
                                $
                                (0.16
                                )
                                
                                $
                                (0.08
                                )
                                
                                $
                                (0.08
                                )




• In
addition to the restatement of subscription revenue, we restated the value of
the iMart trade name as of December 31, 2008 because of a recalculation of the
net royalty method of valuation.  The restatement caused an increase
in the amount of loss on impairment of intangible assets for the year ended
December 31, 2008 in the amount of $230,000.  The restated total loss
on impairment of intangible assets is $3,702,141 as compared to the original
loss of $3,472,141.  The restated amounts are presented in the
accompanying financial statements.The
effect on the balance sheet for the affected periods are as
follows:


65





2008As Reported
                            
                            
                            As RestatedFor the Year Ended December
    31,REVENUES:Subscription
      fees
                            
                            $
                            2,683,770
                            
                            
                            $
                            1,587,942Professional
      service fees
                            
                            
                            2,045,508
                            
                            
                            
                            1,859,154License
      fees
                            
                            
                            26,250
                            
                            
                            
                            26,250Hosting
      fees
                            
                            
                            -
                            
                            
                            
                            259,675Other
      revenue
                            
                            
                            117,457
                            
                            
                            
                            146,158Total
      revenues
                            
                            
                            4,872,985
                            
                            
                            
                            3,879,179COST
      OF REVENUES
                            
                            
                            837,789
                            
                            
                            
                            2,021,489GROSS
      PROFIT
                            
                            
                            4,035,196
                            
                            
                            
                            1,857,690OPERATING
      EXPENSES
                            
                            
                            13,653,175
                            
                            
                            
                            11,705,668LOSS
      FROM OPERATIONS
                            
                            
                            (9,617,979
                            )
                            
                            
                            (9,847,978
                            )OTHER
      INCOME (EXPENSE)
                            
                            
                            (204,171
                            )
                            
                            
                            (204,171
                            )NET
      LOSS
                            
                            $
                            (9,822,150
                            )
                            
                            $
                            (10,052,149
                            )NET
      LOSS PER COMMON SHARE:Basic and fully diluted
                            
                            $
                            (0.54
                            )
                            
                            $
                            (0.55
                            )





2008As
      of December 31,
                    
                    As Reported
                    
                    
                    As RestatedIntangible
      Assets, net
                    
                    $
                    380,000
                    
                    
                    $
                    150,000Accumulated
      deficit
                    
                    $
                    (72,678,076
                    )
                    
                    $
                    (72,908,077
                    )





Item 9.
            Changes in and Disagreements with
      Accountants on Accounting and Financial
  Disclosure





Not applicable.





Item 9A.
            Controls and
      Procedures





Not
applicable.





Item 9A(T).
            Controls and
      Procedures




Evaluation
of Disclosure Controls and Procedures





Our
management, with the participation of our interim Chief Executive Officer and
interim Chief Financial Officer, evaluated the effectiveness of our disclosure
controls and procedures as of December 31, 2009. The term “disclosure
controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under
the Exchange Act, means controls and other procedures of a company that are
designed to ensure that information required to be disclosed by a company in the
reports that it files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the SEC’s rules
and forms. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by a company in the reports that it files or submits under the
Exchange Act is accumulated and communicated to the company’s management,
including its principal executive and principal financial officers, as
appropriate to allow timely decisions regarding required disclosure. Management
recognizes that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives, as ours are designed to do, and management necessarily applies its
judgment in evaluating the cost-benefit relationship of possible controls and
procedures. Based on the evaluation of our disclosure controls and procedures as
of December 31, 2009, our interim Chief Executive Officer and interim Chief
Financial Officer concluded that, as of such date, our disclosure controls and
procedures were not effective at the reasonable assurance level due to the
material weaknesses described below.





In light
of the material weaknesses described below, we performed additional analysis and
other post closing procedures to ensure our financial statements were prepared
in accordance with generally accepted accounting
principles.  Accordingly, we believe that the financial statements
included in this report fairly present in all material respects, our financial
condition, results of operations and cash flows for the periods
presented.




66




Changes
in Internal Control Over Financial Reporting





We have
made the following changes to our internal controls over financial reporting and
continue to monitor the changes made during the fourth quarter of 2009 that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting:





·
            Updated our general ledger chart
      of accounts segregated by department to more closely align our 2009 budget
      with actual results and to assign accountability for expenses to
      departmental managers;





·
            Monitored the accounting system,
      put in place during 2008, that (a) allows assignment by our Chief
      Financial Officer of role-specific permission rights, thereby mitigating
      certain segregation of duties control weaknesses; and (b) allows the
      customization of financial reports to improve the monitoring controls by
      our executive management and our Board of
  Directors;





·
            Continued the fraud deterrent
      system, called Positive Pay service (implemented in 2008) with our bank to
      ensure all checks or other debits that are presented for payment are
      approved by us in advance;





·
            Monitored the accrual analysis
      systems, implemented in 2008, by which the Controller prepares all
      accruals on a rollforward basis, and the Chief Financial Officer reviews
      and approves monthly financial statements prior to release to internal
      users; and where applicable, entries to be reversed in the following
      period are notated as such in the supporting accounting
      records.





Management’s
Report on Internal Control Over Financial Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act Rules
13a-15(f) and 15d-15(f). Our internal control system was designed to provide
reasonable assurance to our management and Board of Directors regarding the
preparation and fair presentation of published financial
statements.





Our
internal control over financial reporting includes those policies and procedures
that:





(i)
            pertain to the maintenance of
      records that in reasonable detail accurately and fairly reflect the
      transactions and dispositions of our
  assets;





(ii)
            provide reasonable assurance that
      transactions are recorded as necessary to permit preparation of financial
      statements in accordance with generally accepted accounting principles,
      and that our receipts and expenditures are being made only in accordance
      with authorizations of our management and directors;
      and





(iii)
            provide reasonable assurance
      regarding prevention or timely detection of unauthorized acquisition, use
      or disposition of our assets that could have a material effect on the
      financial statements.




67




All
internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation.





In making
the assessment of internal control over financial reporting, our management used
the criteria issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) in Internal
Control-Integrated Framework. Based on that assessment and those
criteria, management believes that our internal control over financial reporting
was not effective as of December 31, 2009.





A
material weakness is a deficiency, or a combination of deficiencies in internal
control over financial reporting such that there is a reasonable possibility
that a material misstatement of the company’s annual or interim financial
statements will not be prevented or detected on a timely basis.





We
identified the following deficiencies in internal control that we consider
material weaknesses.





Review of
our revenue recognition procedures caused the financial statements to be
restated to include net subscription revenue as compared to the gross
subscription revenue as presented in prior filings for 2009 and
2008.  In the past we recognized all subscription revenue on a gross
basis and in accordance with our policy to periodically review our accounting
procedures we identified the fact  that certain contracts require the
reporting of subscription revenue on a gross basis and others on a net basis
according to US GAAP.  As a result of our review during the fourth
quarter of 2009, we continue to report subscription revenue from certain
contracts on a gross basis and others on a net basis.  The net effect
of this reclassification of expenses only impacts gross revenue and certain
gross expenses; it does not change the net income.





Review of
our intangible asset values caused the financial statements to be
restated.  The value of the iMart trade name as of December 31, 2008
was restated because of a recalculation of the net royalty method of
valuation.





In order
to address these material weaknesses we have implemented a system whereby each
new contract entered into by the company must be reviewed and approved by the
Chief Financial Officer and in the fourth quarter of each accounting period we
will perform appropriate valuation procedures on all assets to be reviewed by
our independent auditors.





This
Annual Report on Form 10-K does not include an attestation report of our
registered public accounting firm regarding internal control over financial
reporting. Management’s report was not subject to attestation by our registered
public accounting firm pursuant to temporary rules of the SEC that permit us to
provide only management’s report in this Annual Report on Form
10-K.





Item 9B.
            Other
      Information









PART III





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
2009.





Item 10.
            Directors, Executive Officers and
      Corporate Governance





Item 11.
            Executive
      Compensation





Item 12.
            Security Ownership of Certain
      Beneficial Owners and Management and Related Stockholder
      Matters





Item 13.
            Certain Relationships and Related
      Transactions, and Director
Independence





Item 14.
            Principal Accounting Fees and
      Services




68





PART IV




Item
      15.
              Exhibits,
      Financial Statement Schedules





(a)(1)
and (2). The financial statements and report 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.
                  
                  Description3.1
                  
                  Amended
      and Restated Certificate of Incorporation (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
                  
                  Sixth
      Amended and Restated Bylaws (incorporated herein by reference to Exhibit
      3.1 to our Current Report on Form 8-K, as filed with the SEC on January
      20, 2010)4.1
                  
                  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)4.2
                  
                  Convertible
      Secured Subordinated Note Purchase Agreement, dated November 14, 2007, by
      and among Smart Online, Inc. and certain investors named therein
      (incorporated herein by reference to Exhibit 4.1 to our Quarterly Report
      on Form 10-Q, as filed with the SEC on November 14,
  2007)4.3
                  
                  Form
      of Convertible Secured Subordinated Promissory Note (incorporated herein
      by reference to Exhibit 4.2 to our Quarterly Report on Form 10-Q, as filed
      with the SEC on November 14, 2007)4.4
                  
                  First
      Amendment to Convertible Secured Subordinated Note Purchase Agreement,
      dated August 12, 2008, by and among Smart Online, Inc. and certain
      investors (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 12,
      2008)4.5
                  
                  Second
      Amendment and Agreement to Join as a Party to Convertible Secured
      Subordinated Note Purchase Agreement and Registration Rights Agreement,
      dated November 21, 2008, by and among Smart Online, Inc. and certain
      investors (incorporated herein by reference to Exhibit 4.5 to our Annual
      Report on Form 10-K, as filed with the SEC on March 30,
    2009)4.6
                  
                  Third
      Amendment to Convertible Secured Subordinated Note Purchase Agreement and
      Registration Rights Agreement and Amendment to Convertible Secured
      Subordinated Promissory Notes, dated February 24, 2009, by and among Smart
      Online, Inc. and certain investors (incorporated herein by reference to
      Exhibit 4.6 to our Annual Report on Form 10-K, as filed with the SEC on
      March 30, 2009)4.7
                  
                  Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      January 2009 (incorporated herein by reference to Exhibit 4.7 to our
      Annual Report on Form 10-K, as filed with the SEC on March 30,
      2009)4.8
                  
                  Fourth
      Amendment to Convertible Secured Subordinated Note Purchase Agreement,
      Second Amendment to Convertible Secured Subordinated Promissory Notes and
      Third Amendment to Registration Rights Agreement, dated March 5, 2010, by
      and among Smart Online, Inc. and certain Investors4.9
                  
                  Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      March 5, 201010.1*
                  
                  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 Incentive Stock Option Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.7 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.4*
            
            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)




69




10.5*
            
            Form
      of Non-Qualified Stock Option Agreement under Smart Online, Inc.’s 2004
      Equity Compensation Plan (incorporated herein by reference to Exhibit 10.8
      to our Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.6*
            
            Form
      of revised Non-Qualified Stock Option Agreement under Smart Online, Inc.’s
      2004 Equity Compensation Plan10.7*
            
            Form
      of Restricted Stock Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.6 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.8*
            
            Form
      of Restricted Stock Award Agreement for Employees (incorporated herein by
      reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed with
      the SEC on August 21, 2007)10.9*
            
            Form
      of Restricted Stock Agreement for Employees (incorporated herein by
      reference to Exhibit 10.1 to Amendment No. 1 to our Current Report on Form
      8-K, as filed with the SEC on February 11, 2008)10.10*
            
            Form
      of Restricted Stock Agreement (Non-Employee Directors) (incorporated
      herein by reference to Exhibit 10.1 to our Current Report on Form 8-K, as
      filed with the SEC on May 31, 2007)10.11*
            
            Form
      of Restricted Stock Agreement (Non-Employee Directors) (incorporated
      herein by reference to Exhibit 10.3 to our Current Report on Form 8-K, as
      filed with the SEC on December 3, 2007)10.12*
            
            Form
      of revised Restricted Stock Agreement under Smart Online, Inc.’s 2004
      Equity Compensation Plan (Non-Employee Director)10.13*
            
            2001
      Equity Compensation Plan (terminated as to future grants effective 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)10.14*
            
            1998
      Stock Option 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)10.15*
            
            Cash
      Bonus Program (incorporated herein by reference to Exhibit 10.4 to our
      Current Report on Form 8-K, as filed with the SEC on December 3,
      2007)10.16*
            
            Equity
      Award Program (incorporated herein by reference to Exhibit 10.5 to
      Amendment No. 1 to our Current Report on Form 8-K, as filed with the SEC
      on February 11, 2008)10.17*
            
            Employment
      Agreement, dated November 30, 2007, with David E. Colburn (incorporated
      herein by reference to Exhibit 10.2 to our Current Report on Form 8-K, as
      filed with the SEC on December 3,
2007)





10.18*
              
              Separation
      and General Release Agreement, dated December 9, 2008, with David E.
      Colburn (incorporated herein by reference to Exhibit 10.1 to our Current
      Report Form 8-K, as filed with the SEC on December 10,
    2008)10.19*
              
              Smart
      Online, Inc. Revised Board Compensation Policy, effective February 2, 2007
      (incorporated herein by reference to Exhibit 10.45 to our Registration
      Statement on Form S-1, as filed with the SEC on April 3,
    2007)10.20*
              
              Smart
      Online, Inc. Revised Board Compensation Policy, effective April 1, 2009
      (incorporated herein by reference to Exhibit 10.21 to our Annual Report on
      Form 10-K, as filed with the SEC on March 30, 2009)10.21*
              
              Smart
      Online, Inc. Revised Board Compensation Policy, effective March 26,
      201010.22*
              
              Indemnification
      Agreement, dated April 14, 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)10.23
              
              Stock
      Purchase Warrant and Agreement, dated January 15, 2007, by and between
      Smart Online, Inc. and Atlas Capital, SA (incorporated herein by reference
      to Exhibit 10.44 to our Registration Statement on Form S-1, as filed with
      the SEC on April 3, 2007)





70




10.24
            
            Amendment
      No. 1 to Stock Purchase Warrant and Agreement, effective February 20,
      2008, by and between Smart Online, Inc. and Atlas Capital SA (incorporated
      herein by reference to Exhibit 10.6 to our Quarterly Report on Form 10-Q,
      as filed with the SEC on May 13, 2008)10.25
            
            Form
      of Securities Purchase Agreement, Registration Rights Agreement, and
      Warrant to Purchase Common Stock of Smart Online, Inc., dated February 21,
      2007, by and between Smart Online, Inc. and each of Magnetar Capital
      Master Fund, Ltd. and Herald Investment Management Limited on behalf of
      Herald Investment Trust PLC (incorporated herein by reference to Exhibit
      10.46 to our Registration Statement on Form S-1, as filed with the SEC on
      April 3, 2007)10.26
            
            Form
      of Amendment to Registration Rights Agreement, dated March 26, 2007, by
      and between Smart Online, Inc. and each of Magnetar Capital Master Fund,
      Ltd. and Herald Investment Management Limited on behalf of Herald
      Investment Trust PLC ( incorporated herein by reference to Exhibit 10.54
      to Amendment No. 3 to our Registration Statement on Form S-1, as filed
      with the SEC on July 31, 2007)10.27
            
            Form
      of Amendment to Registration Rights Agreement, dated July 2, 2007, by and
      between Smart Online, Inc. and each of Magnetar Capital Master Fund, Ltd.
      and Herald Investment Management Limited on behalf of Herald Investment
      Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
      No. 3 to our Registration Statement on Form S-1, as filed with the SEC on
      July 31, 2007)10.28
            
            Warrant
      to Purchase Common Stock of Smart Online, Inc., and Registration Rights
      Agreement, dated February 27, 2007, by and between Smart Online, Inc. and
      Canaccord Adams Inc. (incorporated herein by reference to Exhibit 10.47 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.29
            
            Form
      of Registration Rights Agreement, of various dates, by and between Smart
      Online, Inc. and certain parties in connection with the sale of shares by
      Dennis Michael Nouri (incorporated herein by reference to Exhibit 10.48 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.30
            
            Registration
      Rights Agreement, dated November 14, 2007, by and among Smart Online, Inc.
      and certain investors (incorporated herein by reference to Exhibit 10.6 to
      our Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.31
            
            Security
      Agreement, dated November 14, 2007, among Smart Online, Inc. and Doron
      Roethler, as agent for certain investors (incorporated herein by reference
      to Exhibit 10.7 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on November 14, 2007)10.32
            
            Promissory
      Note, Loan Agreement, and Security Agreement, dated November 14, 2006, by
      and between Smart Online, Inc. and Wachovia Bank, NA (incorporated herein
      by reference to Exhibit 10.43 to our Annual Report on Form 10-K, as filed
      with the SEC on March 30, 2007)




71





10.33
            
            Promissory
      Note, Modification Number One to Loan Agreement, and Security Agreement,
      dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
      Bank, NA (incorporated herein by reference to Exhibit 10.8 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.34
            
            Commercial
      Note, dated February 20, 2008, payable by Smart Online, Inc. to Paragon
      Commercial Bank (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 13,
      2008)10.35
            
            Modification
      Agreement, made as of February 22, 2010, between Smart Online, Inc. and
      Paragon Commercial Bank10.36
            
            Reimbursement
      Agreement, dated November 10, 2006, by and between Smart Online, Inc. and
      Atlas Capital SA (incorporated herein by reference to Exhibit 10.48 to our
      Annual Report on Form 10-K, as filed with the SEC on March 25,
      2008)10.37
            
            Amendment
      to Reimbursement Agreement, effective February 20, 2008, by and between
      Smart Online, Inc. and Atlas Capital SA (incorporated herein by reference
      to Exhibit 10.5 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on May 13, 2008)  10.38
                
                Second
      Amendment to Reimbursement Agreement, dated January 19, 2010, by and
      between Smart Online, Inc. and Atlas Capital, SA10.39
                
                Sublease
      Agreement, dated July 30, 2008, between Smart Online, Inc. and Advantis
      Real Estate Services Company (incorporated herein by reference to Exhibit
      10.1 to our Quarterly Report on Form 10-Q, as filed with the SEC on
      November 12, 2008) (asterisks located within the exhibit denote
      information which has been deleted pursuant to a request for confidential
      treatment filed with the Securities and Exchange
    Commission)23.1
                
                Consent
      of Independent Registered Public Accounting Firm31.1
                
                Certification
      of Principal 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 Principal 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 Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]32.2
                
                Certification
      of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]




72





*
Management contract or compensatory plan.




73




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.By:
                    /s/
      Dror ZoreffApril
      15, 2010
                    Dror
      Zoreff, Interim Chief  Executive
  Officer
 
 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.
 
 April
      15, 2010
                              By:
                              /s/
      Dror ZoreffDror
      ZoreffInterim
      Chief  Executive Officer and Chairman of the
    BoardApril
      15, 2010
                              By:
                              /s/
      Thaddeus J. ShalekThaddeus
      J. ShalekInterim
      Chief Financial Officer and Principal Accounting
OfficerApril
      15, 2010
                              By:
                              /s/
      Shlomo EliaShlomo
      EliaDirectorApril
      15, 2010
                              By:
                              /s/
      C. James Meese, Jr.C.
      James Meese, Jr.DirectorApril
      15, 2010
                              By:
                              /s/
      Amir ElbazAmir
      ElbazDirector
  74
 
 EXHIBIT
INDEX
 Exhibit No.
                    
                    Description3.1
                    
                    Amended
      and Restated Certificate of Incorporation (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
                    
                    Sixth
      Amended and Restated Bylaws (incorporated herein by reference to Exhibit
      3.1 to our Current Report on Form 8-K, as filed with the SEC on January
      20, 2010)4.1
                    
                    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)4.2
                    
                    Convertible
      Secured Subordinated Note Purchase Agreement, dated November 14, 2007, by
      and among Smart Online, Inc. and certain investors named therein
      (incorporated herein by reference to Exhibit 4.1 to our Quarterly Report
      on Form 10-Q, as filed with the SEC on November 14,
  2007)4.3
                    
                    Form
      of Convertible Secured Subordinated Promissory Note (incorporated herein
      by reference to Exhibit 4.2 to our Quarterly Report on Form 10-Q, as filed
      with the SEC on November 14, 2007)4.4
                    
                    First
      Amendment to Convertible Secured Subordinated Note Purchase Agreement,
      dated August 12, 2008, by and among Smart Online, Inc. and certain
      investors (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 12,
      2008)4.5
                    
                    Second
      Amendment and Agreement to Join as a Party to Convertible Secured
      Subordinated Note Purchase Agreement and Registration Rights Agreement,
      dated November 21, 2008, by and among Smart Online, Inc. and certain
      investors (incorporated herein by reference to Exhibit 4.5 to our Annual
      Report on Form 10-K, as filed with the SEC on March 30,
    2009)4.6
                    
                    Third
      Amendment to Convertible Secured Subordinated Note Purchase Agreement and
      Registration Rights Agreement and Amendment to Convertible Secured
      Subordinated Promissory Notes, dated February 24, 2009, by and among Smart
      Online, Inc. and certain investors (incorporated herein by reference to
      Exhibit 4.6 to our Annual Report on Form 10-K, as filed with the SEC on
      March 30, 2009)4.7
                    
                    Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      January 2009 (incorporated herein by reference to Exhibit 4.7 to our
      Annual Report on Form 10-K, as filed with the SEC on March 30,
      2009)4.8
                    
                    Fourth
      Amendment to Convertible Secured Subordinated Note Purchase Agreement,
      Second Amendment to Convertible Secured Subordinated Promissory Notes and
      Third Amendment to Registration Rights Agreement, dated March 5, 2010, by
      and among Smart Online, Inc. and certain investors4.9
                    
                    Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      March 5, 201010.1*
                    
                    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 Incentive Stock Option Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.7 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.4*
                
                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)10.5*
                
                Form
      of Non-Qualified Stock Option Agreement under Smart Online, Inc.’s 2004
      Equity Compensation Plan (incorporated herein by reference to Exhibit 10.8
      to our Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.6*
                
                Form
      of Non-Qualified Stock Option Agreement , dated March 26, 2010, under
      Smart Online, Inc.’s 2004 Equity Compensation Plan
  75
  10.7*
                        
                        Form
      of Restricted Stock Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.6 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.8*
                        
                        Form
      of Restricted Stock Award Agreement for Employees (incorporated herein by
      reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed with
      the SEC on August 21, 2007)10.9*
                        
                        Form
      Restricted Stock Agreement for Employees (incorporated herein by reference
      to Exhibit 10.1 to Amendment No. 1 to our Current Report on Form 8-K, as
      filed with the SEC on February 11, 2008)10.10*
                        
                        Form
      of Restricted Stock Agreement (Non-Employee Directors) (incorporated
      herein by reference to Exhibit 10.1 to our Current Report on Form 8-K, as
      filed with the SEC on May 31, 2007)10.11*
                        
                        Form
      of Restricted Stock Agreement (Non-Employee Directors) (incorporated
      herein by reference to Exhibit 10.3 to our Current Report on Form 8-K, as
      filed with the SEC on December 3, 2007)10.12*
                        
                        Form
      of Restricted Stock Agreement, dated March 26, 2010, under Smart Online,
      Inc.’s 2004 Equity Compensation Plan (Non-Employee
    Director)10.13*
                        
                        2001
      Equity Compensation Plan (terminated as to future grants effective 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)10.14*
                        
                        1998
      Stock Option 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)10.15*
                        
                        Cash
      Bonus Program (incorporated herein by reference to Exhibit 10.4 to our
      Current Report on Form 8-K, as filed with the SEC on December 3,
      2007)10.16*
                        
                        Equity
      Award Program (incorporated herein by reference to Exhibit 10.5 to
      Amendment No. 1 to our Current Report on Form 8-K, as filed with the SEC
      on February 11, 2008)10.17*
                        
                        Employment
      Agreement, dated November 30, 2007, with David E. Colburn (incorporated
      herein by reference to Exhibit 10.2 to our Current Report on Form 8-K, as
      filed with the SEC on December 3,
2007)
  10.18*
                
                Separation
      and General Release Agreement, dated December 9, 2008, with David E.
      Colburn (incorporated herein by reference to Exhibit 10.1 to our Current
      Report Form 8-K, as filed with the SEC on December 10,
    2008)10.19*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective February 2, 2007
      (incorporated herein by reference to Exhibit 10.45 to our Registration
      Statement on Form S-1, as filed with the SEC on April 3,
    2007)10.20*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective April 1, 2009
      (incorporated herein by reference to Exhibit 10.21 to our Annual Report on
      Form 10-K, as filed with the SEC on March 30, 2009)10.21*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective March 26,
      201010.22*
                
                Indemnification
      Agreement, dated April 14, 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)10.23
                
                Stock
      Purchase Warrant and Agreement, dated January 15, 2007, by and between
      Smart Online, Inc. and Atlas Capital, SA (incorporated herein by reference
      to Exhibit 10.44 to our Registration Statement on Form S-1, as filed with
      the SEC on April 3, 2007)10.24
                
                Amendment
      No. 1 to Stock Purchase Warrant and Agreement, effective February 20,
      2008, by and between Smart Online, Inc. and Atlas Capital SA (incorporated
      herein by reference to Exhibit 10.6 to our Quarterly Report on Form 10-Q,
      as filed with the SEC on May 13, 2008)10.25
                
                Form
      of Securities Purchase Agreement, Registration Rights Agreement, and
      Warrant to Purchase Common Stock of Smart Online, Inc., dated February 21,
      2007, by and between Smart Online, Inc. and each of Magnetar Capital
      Master Fund, Ltd. and Herald Investment Management Limited on behalf of
      Herald Investment Trust PLC (incorporated herein by reference to Exhibit
      10.46 to our Registration Statement on Form S-1, as filed with the SEC on
      April 3, 2007)
  76
  10.26
                  
                  Form
      of Amendment to Registration Rights Agreement, dated March 26, 2007, by
      and between Smart Online, Inc. and each of Magnetar Capital Master Fund,
      Ltd. and Herald Investment Management Limited on behalf of Herald
      Investment Trust PLC ( incorporated herein by reference to Exhibit 10.54
      to Amendment No. 3 to our Registration Statement on Form S-1, as filed
      with the SEC on July 31, 2007)10.27
                  
                  Form
      of Amendment to Registration Rights Agreement, dated July 2, 2007, by and
      between Smart Online, Inc. and each of Magnetar Capital Master Fund, Ltd.
      and Herald Investment Management Limited on behalf of Herald Investment
      Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
      No. 3 to our Registration Statement on Form S-1, as filed with the SEC on
      July 31, 2007)10.28
                  
                  Warrant
      to Purchase Common Stock of Smart Online, Inc., and Registration Rights
      Agreement, dated February 27, 2007, by and between Smart Online, Inc. and
      Canaccord Adams Inc. (incorporated herein by reference to Exhibit 10.47 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.29
                  
                  Form
      of Registration Rights Agreement, of various dates, by and between Smart
      Online, Inc. and certain parties in connection with the sale of shares by
      Dennis Michael Nouri (incorporated herein by reference to Exhibit 10.48 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.30
                  
                  Registration
      Rights Agreement, dated November 14, 2007, by and among Smart Online, Inc.
      and certain investors (incorporated herein by reference to Exhibit 10.6 to
      our Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.31
                  
                  Security
      Agreement, dated November 14, 2007, among Smart Online, Inc. and Doron
      Roethler, as agent for certain investors (incorporated herein by reference
      to Exhibit 10.7 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on November 14, 2007)10.32
                  
                  Promissory
      Note, Loan Agreement, and Security Agreement, dated November 14, 2006, by
      and between Smart Online, Inc. and Wachovia Bank, NA (incorporated herein
      by reference to Exhibit 10.43 to our Annual Report on Form 10-K, as filed
      with the SEC on March 30,
2007)
 
 10.33
                  
                  Promissory
      Note, Modification Number One to Loan Agreement, and Security Agreement,
      dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
      Bank, NA (incorporated herein by reference to Exhibit 10.8 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.34
                  
                  Commercial
      Note, dated February 20, 2008, payable by Smart Online, Inc. to Paragon
      Commercial Bank (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 13,
      2008)10.35
                  
                  Modification
      Agreement, made as of February 22, 2010, between Smart Online, Inc. and
      Paragon Commercial Bank10.36
                  
                  Reimbursement
      Agreement, dated November 10, 2006, by and between Smart Online, Inc. and
      Atlas Capital SA (incorporated herein by reference to Exhibit 10.48 to our
      Annual Report on Form 10-K, as filed with the SEC on March 25,
      2008)10.37
                  
                  Amendment
      to Reimbursement Agreement, effective February 20, 2008, by and between
      Smart Online, Inc. and Atlas Capital SA (incorporated herein by reference
      to Exhibit 10.5 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on May 13, 2008)10.38
                  
                  Second
      Amendment to Reimbursement Agreement, dated January 19, 2010, by and
      between Smart Online, Inc. and Atlas Capital, SA10.39
                  
                  Sublease
      Agreement, dated July 30, 2008, between Smart Online, Inc. and Advantis
      Real Estate Services Company (incorporated herein by reference to Exhibit
      10.1 to our Quarterly Report on Form 10-Q, as filed with the SEC on
      November 12, 2008) (asterisks located within the exhibit denote
      information which has been deleted pursuant to a request for confidential
      treatment filed with the Securities and Exchange
    Commission)23.1
                  
                  Consent
      of Independent Registered Public Accounting Firm31.1
                  
                  Certification
      of Principal Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  2002
  77
  31.2
                      
                      Certification
      of Principal 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 Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]32.2
                      
                      Certification
      of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]
 *
Management contract or compensatory plan.
  78