**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, 2004.**o
    **Transition Report Pursuant to Section
      13 or 15(d) of the Securities Exchange Act of 1934For
      the transition period from ____________________ to ____________________.**





**Commission
File Number 333-119385**








**SMART
ONLINE, INC.**


(Exact
name of registrant as specified in its charter)








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





Registrant’s
telephone number, including area code (919) 765-5000





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


None





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


Common
stock, $0.001 par value











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   o No 
x





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.  x





Indicate
by check mark whether the registrant is an accelerated filer (as defined in
Exchange Act Rule 12b-2). Yes 
o No x





Aggregate
market value of voting and non-voting common equity held by non-affiliates of
the registrant as of March 31, 2005 was approximately $40 million based upon the
last sale by the registrant of its Common Stock for $5.00 per share and
8,003,012 shares of Common Stock outstanding as of March 31, 2005 held by
non-affiliates.





**DOCUMENTS
INCORPORATED BY REFERENCE**





1




**SMART
ONLINE, INC.**





**FORM
10-K**





**FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2004**





**INDEX**








**Page****PART
      I**Item
      1.
    Business
    3Item
      2.
    Properties
    18Item
      3.
    Legal
      Proceedings
    18Item
      4.
    Submission
      of Matters to a Vote of Security Holders
    19**PART
      II**Item
      5.
    Market
      for Registrant’s Common Equity and Related Stockholder
    Matters
    19Item
      6.
    Selected
      Financial Data
    21Item
      7.
    Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
    22(including
      risk factors and statements about forward looking
    statements)Item
      7A.
    Quantitative
      and Qualitative Disclosures about Market Risk
    54Item
      8.
    Financial
      Statements and Supplementary Data
    55Item
      9.
    Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
    81Item
      9A.
    Controls
      and Procedures
    81Item
      9B.
    Other
      Information
    82**PART
      III**Item
      10.
    Directors
      and Executive Officers of the Registrant
    82Item
      11.
    Executive
      Compensation
    85Item
      12.
    Security
      Ownership of Certain Beneficial Owners and Management
    91Item
      13.
    Certain
      Relationships and Related Transactions
    93Item
      14.
    Principal
      Accounting Fees and Services
    96**PART
      IV**Item
      15.
    Exhibits
      and Financial Statement Schedules
    97







2








**Item
1.**  **Business**





Smart
Online, Inc. (" **Smart
Online** ") was
incorporated under the laws of Delaware on August 10, 1993. Our executive
offices are located at 2530 Meridian Parkway, 2 nd Floor,
Durham, North Carolina 27713, and our telephone number is (919) 765-5000.





Refer to
the end of Item 7 for “Risk Factors” and a “Special Note Regarding Forward
Looking Statements.”




**Overview**




Smart
Online develops and markets Internet-delivered Software-as-Service (SaS)
software applications and data resources to start, run, protect and grow small
businesses (one to fifty employees). When we release the second and third
version of our OneBiz ConductorSM  product, we intend to begin
marketing our products to middle size companies of up to 500
employees.  Many small business users access our product directly
through our portal at www.SmartOnline.com , and we
reach many small businesses through private label syndication partnering
agreements pursuant to which we offer our products on the web sites of major
companies and financial institutions and through barter and other transactions
with media companies. Expanding this network of relationships with large
companies is one of our key strategies to generate revenue while minimizing our
marketing and sales expenses.  We also offer the services and software of
other companies on our websites, through integration agreements under which we
share revenue from sales of products and services of our integration
partners.  Our CD-Rom products are sold primarily through OEM
arrangements.




Incorporated
in Delaware in 1993, Smart Online pioneered the market for small business
software applications. Our initial offerings were on diskettes and later became
CD-ROM-based. Since inception, we have distributed over two million copies of
CD-ROM based products through direct sales, distributors and other means. Since
year 2000, our products have been primarily offered through an Internet-based
platform.




Smart
Online has developed numerous sources of revenue as its business plan has
changed to adapt to changing business circumstances. These sources of revenue
include syndication partners, integration partners, OEMs, monthly subscriptions
from small businesses, one-time purchases by small businesses and barter
transactions with media companies.   Syndication fees consist
primarily of fees charged to syndication partners to create a customized
private-label site.  We also share in revenue generated by our integration
partners in some cases.  Integration fees are charged to partners to
integrate their products into the Smart Online syndication platform. Integrating
third-party content and products has been a component of Smart Online’s strategy
to continuously expand and enhance its platform offered to syndication partners
and its own customer base.   OEM arrangements are through a
distributor with third-party computer manufacturers for various individual Smart
Online applications on CD-Roms.   Currently, each of these revenue
streams is small. Our business plan is designed to utilize existing and future
relationships in each revenue source to ratchet up the amount of revenue we
derive from all sources. We have described below the key elements of how we plan
to achieve this.




**Software-as-Service
(SaS) Advantages.**  Our
Software-as-Service (SaS) model is beneficial to small business owners
because:




·
    SaS
      is less expensive compared to software distributed by other means and
      offers predictable implementation and management costs. Companies pay a
      monthly or annual per-user subscription fee for access to software
      services and are spared up-front costs of buying hardware and software and
      hiring specialized IT personnel. The price tag of SaS solutions typically
      runs about one-third of the cost of deploying similar software
      in-house.






·
    SaS
      offers customers lower risk and faster return-on-investment. With reduced
      overhead investment and quicker implementation, customers can afford to
      try SaS applications and gain benefits more
quickly.






·
    SaS
      is easier to use, requiring less training. Use of familiar Web interfaces
      makes it easy for customer administrators and end users to use new
      software, resulting in higher end-user adoption and lower training
      costs.






·
    SaS
      enables vendors to provide more responsive service and support. SaS
      vendors know in real-time how their customers use the system and which
      features work and don’t work. Problems need be fixed only once for the
      benefit of all customers.







3







**Small
Business Focus.** Smart Online’s exclusive market focus is small
businesses. We define small businesses as companies that have between one and
fifty employees.  Our solutions are designed to automate and streamline
business processes, reduce operating costs and improve internal controls. 
We believe our new product, OneBiz ConductorSM , may be
attractive to middle size companies when we complete development later this
year.  Accordingly, we intend to begin marketing to middle size companies
of up to 500 employees later this year.





**Market
Channels.** Our
products and services are sold through private label syndication on major
corporation and financial institution web sites (such as Bank One, Union Bank of
California, Gruner +Jahr USA Publishing for its www.Inc.com and www.FastCompany.com web
sites, J.P. Morgan Chase, Business Week, -and through OEM distribution deals by
our distributor, PC Treasures, including Dell and Gateway, and directly to
small business owners at www.smartonline.com .




**Integration
Partners.** Smart
Online distributes the products and services of other companies on its website
and the websites of its syndication partners. These integration partners include
providers of webconference, incorporation services and loans to small
businesses. Integration partners share revenue with Smart Online.




**Value
Proposition.** We
deliver value to small business users and to our syndication, integration and
OEM partners through a combination of three factors. First, like other vendors
we have a wide range of useful business productivity software applications and
content. Unlike most other vendors, however, both our applications and our
content have been designed and redesigned utilizing the experience we have
gained through dealing with large numbers of small businesses over a period of
more than eleven years. With over two million copies of CD-ROM based
products distributed, our Internet-based products incorporate the input we
obtained from CD-ROM customers. In short, trial and error has taught us what
works for small business users and what doesn’t. Finally, our robust,
proprietary technology platform delivers our applications and content in ways
that maximize usefulness and efficiency. We believe this combination of factors
provides our customers with both substantial savings and easy-to-use solutions
for the most common issues faced by small businesses.




**Software
Applications.** We offer
approximately two dozen applications and information resources that assist small
businesses with:




·
    Business
      planning, research and development




·
    Financial
      analysis, planning and reporting




·
    Marketing
      planning, sales and program execution




·
    Legal
      issues, compliance and forms




·
    Human
      resources issues




·
    Business
      communications, internal and external




We
provide extensive **** data
resource offerings that cover a broad range of business, financial, legal, human
resources, operations, and marketing and sales issues, as well as real-time
contact with experts in each of these functional areas.




**Technology
Platform.** Our
proprietary technology platform delivers our products and services in ways that
best suit small business users and our syndication, integration and OEM
partners.




·
    User
      InterfaceWizards. Smart Online products and services feature easy-to-use
      wizard interfaces that utilize a series of fill-in-the-blank
      questionnaires. In addition, once the user inputs data, it is shared as
      appropriate throughout the platform so information need only be input
      once. This important feature of our current platform will be substantially
      more robust in our next generation
platform.




·
    Single
      Sign On For Third Party Content Integration. Our platform allows us to
      distribute third-party partner content seamlessly to small business users
      using proprietary single sign-on methodology. After the user signs onto
      our web site, the user does not have to re-register with our integration
      partners to use applications supplied by our
partners.




·
    Contextual
      Integration Engine (CI Engine). Our CI Engine delivers to small business
      users those products and services of Smart Online and our integration
      partners that we believe is most pertinent to the
user.




·
    Private
      Label Syndication Engine. (SYNGEN) Smart Online’s proprietary SYNGEN
      automatically replicates and delivers the products and services our
      private label syndication partners want delivered to users of their web
      sites and bundles those products and services with the look and feel of
      their web sites. The SYNGEN thereby automates the process by which we
      integrate our products and services onto our partners’ web sites and
      allows each partner to select different groupings of products and
      services.







4







Our
platform was developed using modular methodology, which allows various
components to be assembled for rapid new application development and
enhancement. In addition, all sensitive information is encrypted and stored in
secured servers. All applications are operated from an environment with
integrated security to protect against loss, misuse and data tampering. Secure
Socket Layer technology protects data and provides security during transmission
of sensitive financial data. The platform also integrates e-commerce services
that can be customized based on the partner’s business model.





**Customer
Service.** Smart
Online offers customer and technical support M-F, 8:30 a.m. to 8 p.m. EST.




**Next
Generation Platform — OneBiz Conductor** **SM**




We are
currently developing a next generation platform, called OneBiz
Conductor SM , which
will make significant enhancements to our technology platform and add additional
applications to our product offerings. We plan to accomplish this through a
combination of internal development, joint development, licensing from other
companies and acquisitions. We plan to introduce our next generation platform to
the market in three installments. The first installment, which primarily
consisted of new user interfaces and user planning tools on our new Dashboard,
was released in March 2005. Commercial releases of the other two installments,
both of which will have both enhancements to the Dashboard and new software
applications, are expected by the end of the third quarter of 2005 through the
end of the fourth quarter of 2005. See “Next Generation Product Development —
OneBiz Conductor SM .”




**Current
Products and Services**




We
provide a wide range of Internet-based software applications, content, data and
services to and for small businesses. We also continue to sell a very small
number of CD-ROM products. Our current products are organized in the
following four categories:




·
    Starting
      Business




·
    Protecting
      Business




·
    Growing
      Business




·
    Managing
      Operations




Each of
these categories is described below. We believe this wide range of applications,
content, data and services provide us with a competitive advantage over our
competitors in the small business market for companies with fewer than fifty
employees. These are available to subscribers for a monthly subscription fee
that allows unlimited use by one user at a time, except where noted below. Some
products, identified below, are available to non-subscribers for one-time fees.




**Starting
Business.** Our
Starting Business category of products and services include those related to:




·
    Incorporation




·
    Business
      Plans




·
    Finance




·
    Market
      Research




·
    Self
      Assessment




**Incorporation.** We assist
businesses to incorporate quickly and efficiently using Smart Incorporator and
the services of our partner, Business Filings, a leader in providing
incorporation services to small business owners. We provide information about
the incorporation process and different types of business structures to
allow businesses to determine which structure is best for their business.
Utilizing our services, subscribers can form a corporation, limited
liability company, or nonprofit corporation in any of the 50 states. The process
can take as little as 10 minutes. We provide our subscribers with 24-hour-a-day,
seven days a week access to their accounts and important documents via our
Online Business Center. Our subscribers can also obtain registered
agent







5







services
in the state where their company is formed. We also sell subscribers
personalized corporate or LLC kits, including corporate seal, stock
certificates, stock transfer ledger, and sample forms, bylaws and minutes for
both corporations and limited liability companies. Our subscribers can also
order other services through us, such as Professional Corporation or LLC, S
Corporation Election, Shelf Corporation, Foreign Qualifications, Federal
Tax ID (EIN) and non-profit corporation. We offer this service in connection
with our partner, BizFilings, with which we share revenue.




**Business
Plans.** Our Smart
Business Plan software application is designed to ease the process of creating
business plans to help entrepreneurs obtain the capital they require for their
new or existing businesses. After answering a few simple questions, the user is
ready to begin composing a full business plan — complete with financial tables
and graphs. Smart Business Plan provides an easy-to-use interface and split
screen design with complete guidance, instructions, and organization that
provides even the most basic computer users with advanced functionality and
planning capability. The application was designed for user collaboration as it
allows users to share a plan with other registered users. By collaborating,
users can get the assistance and feedback they need in a quick and timely
fashion. After the user creates a business plan, it can be saved in a secure,
private location for easy access from anywhere, at anytime. This application is
part of our subscription package, but is also available to non-subscribers for a
one-time fee.




**Finance.** Our
subscribers can apply online for loans, lines of credit and SBA loans. Smart
Online’s financing partners provides financing and approve or reject
applications. We may receive a referral fee from our financing partners for
applications that are approved by our financing partners.




**Market
Research - US and Global.** Our **** Smart
Market Research software application is designed to assist users to research
statistical information. Users can research and analyze U.S. or global
demographic statistics. This application enables users to pinpoint statistical
data from multiple markets to assist to target the right customers, in the right
locations. The U.S. database features information for U.S. regions, states,
counties, and cities with populations of 25,000 or more. The Global Statistics
database features demographic information and projections for most countries and
areas of the world. Information included in the databases cover the following
general topics: age, agriculture, ancestry, banking, business, construction,
crime, education, federal government, housing, local government,
Hispanic-origin, households, housing, labor force and employment, land area,
manufactures, money income, personal income and earnings, earnings by industry,
population, poverty, retail trade, service industries, veterans, vital
statistics, and wholesale trade. The information is not owned by Smart Online
and can be researched through sources other than Smart Online. Our value to
users is that we have aggregated these databases in one location and we
facilitate compilation and presentation of the search results. The results of
market research inquiries are displayed in both table and graph formats online
and can be downloaded to a user’s local hard drive for future reference. This
application is part of our subscription package.




**Self-Assessment
of Strengths and Weaknesses.** Our Smart
Entrepreneur tool allows users to determine entrepreneurial strengths and
weaknesses, and provides users with instant feedback to help gauge potential.
After a user answers a series of detailed questions, Smart Entrepreneur provides
an extensive report on the capabilities of the interviewee and provides helpful
suggestions and hints for how to improve entrepreneurial strengths and maximize
performance. Smart Entrepreneur also helps users determine how they will measure
personal and business success, and understand how to overcome the obstacles
between them and their goals. Users are encouraged to match their strengths with
suggested strategies for business growth to increase the probability of
succeeding with their business.




**Protecting
Business.** Our
Protecting Business category includes the following products and services:




·
    Business
      and Legal Forms




·
    Intellectual
      Property Service




·
    Government
      Forms




·
    Corporate
      and Legal Guides




·
    Financial
      Guides




**Business
and Legal Forms.** Our Smart
Legal Forms library is designed to automate and simplify legal communications,
address everyday business and personal needs, minimize costly legal fees, and
reduce the liability associated with running a business by providing easy-to-use
interactive forms. This extensive collection of do-it-yourself legal forms is
fully interactive, enabling users to select, preview, edit, save within our
servers or download over 2,000 forms online
with minimal delay for composition and preparation. Smart Legal Forms’
professionally formatted documents include interactive forms in the following 16
categories: Loan and Credit, Business and Trade, Leasing, Buying and Selling of
Goods, Construction, Human Resources, Corporate/LLC, Partnership/Joint Venture,
Intellectual Property, Real Estate, Agency/Broker, Franchises, Personal and
Family, Bankruptcy, Wills and Trusts, and other General Forms. This library is
part of our monthly subscription package, but non-subscribers can also purchase
forms for a one-time fee.





6





**Intellectual
Property.** We
explain about different kinds of intellectual property and provide links to
search US databases for trademarks, patents and copyrights.




**Government
Forms.** Our Smart
Government Forms application is an electronic library of government statutory
and legal forms, designed to make forms processing quick and easy by providing
instant access to commonly used official forms. Use of forms is easy and fully
automated, enabling users to complete the forms directly from their Web
browsers, and e-mail, download, print, or share with others for collaboration.
The completed documents with user’s input are saved in a secure private location
for future access. This extensive library is continuously updated. Smart
Government Forms includes official forms from the following agencies: Small
Business Administration, Internal Revenue Service, U.S. Bankruptcy Court, Patent
and Trademark Office, U.S. Copyright Office, Department of Housing and Urban
Development, Export-Import Bank of the United States, Immigration and
Naturalization, Customs and Border Protection, Bureau of Consular Affairs, Food
and Drug Administration, Social Security Administration and Federal Emergency
Management Agency. This library is part of our monthly subscription package, but
non-subscribers can also purchase forms for a one-time fee.




**Corporate
Legal Guides.** We
provide information about corporations, partnerships and limited liability
companies.




**Financial
Guides.** We
provide information about: Creating Strategy, Goals and Objectives, Options to
Fund a Business, SBA Financial Assistance Programs, Steps to Funding a Business,
Venture Capital Firms, and Other Financial Resources.




**Growing
the Business.** Our
Growing the Business category includes the following products and services:




·
    Marketing
      Plans




·
    Landlord/Tenant
      Issues




·
    Press
      Releases




·
    Import/Export
      Information




·
    Business
      Letter Forms




**Marketing
Plans.** Our Smart
Marketing Plan software application is designed to assist users to establish
sales goals and identify the resources and programs required to meet those
goals. After answering a small number of questions, the user can begin to
establish marketing and revenue goals. Detailed instructions and examples are
provided at every step to help the user create a clear, concise, well
thought-out document. Users can further customize their plan by adding,
removing, rearranging or changing the names of chapters and sections. The final
product is a professional document that includes tables and colorful 3-D graphs,
which can be used for strategic planning to increase revenue and to meet goals
and objectives. The application was designed for user collaboration as it allows
the user to share a plan with other registered users. By collaborating, users
can get the assistance and feedback they need quickly. After a user creates a
business plan, it will be saved in a secure, private location for easy access
from anywhere, at any time. This application is part of our monthly subscription
package, but is also available to non-subscribers for a one-time fee.




**Landlord
and Tenant Issues.** Our Smart
Rental software application is designed to allow users to protect their legal
rights and increase efficiency when renting, leasing or managing real estate
properties. Information is provided about landlord-tenant laws in each of the
fifty states as well as Washington D.C., Puerto Rico, and the Virgin Islands.
The application provides an overview of some of the highlights of
landlord-tenant laws in each state and a summary of the states’ significant
landlord-tenant codes, as well as the actual state codes. Information provided
in this application enables users to understand and act on pertinent
landlord-tenant issues. The easy-to-use and interactive design of this
application simplifies the process of finding the relevant information. An
extensive library of landlord-tenant forms and useful resources are also
included.




**Press
Releases.** Our Smart
Press Release Writer software application is designed to simplify media
relations. This professional writing service crafts a customized press
release that’s formatted ready for distribution.







7







The Smart
Press Release Writer covers press releases for 14 news categories. Users select
a category and answer questions prompted by our software application.
Professional writers at our partner, Reputations Inc., then write the press
release. Users can review the press release and request changes. Both
subscribers and non-subscribers pay a fee for this service. Fees are shared with
our partner, Reputations, Inc., which performs the press release service for our
customers.




**Import/Export
Information.** Users can
access the current U.S. trade database for over 220 countries, compiled from
tariff and trade data by the U.S. International Trade Commission, including
year-to-date data at all levels for both exports and imports.




**Business
Letter Forms.** Our Smart
Business Letters library is designed to automate and simplify business
communications and correspondence. Smart Business Letters helps users create a
paper trail for their business records, and assists in starting and building
relationships with customers, suppliers, and investors. Smart Business Letters’
professionally formatted, easy-to-use interactive documents enable users to
select, preview, edit, and download over 1,000 quality letters online. Users can
save the completed forms in a secure private location for future reference, and
access them from any web browser. The library of interactive letters includes
localized letters for the United States, United Kingdom, Spain, and Germany,
which take into account the different business practices of each country. This
library is part of our monthly subscription package, but non-subscribers can
also purchase forms for a one-time fee.




**Managing
Operations.** Our
Managing Operations category includes the following products and services:




·
    Employee
      Policies




·
    Research
      Database




·
    Merchant
      Services




·
    Job
      Descriptions




·
    Instant
      Messaging




·
    Webconferencing
 ·
    Healthcare
      Savings Plan & Employee Tax benefit
program


**Employee
Policies.** Our Smart
Policy Manual is designed to allow employers to quickly and easily build an
entire employee policy manual or create individual policies. After an employer
selects a company type and answers some general questions, a completed policy
manual is created and can be downloaded and or published to the Internet.
Complete customization is available for employers who have unique elements to
their businesses or just want to add a more personal touch. This application
will also allow collaboration with other registered users. By collaborating,
employers can get the feedback and assistance they need in a timely fashion.
Publishing the policy manual to the Internet allows employees to access it at
anytime, anywhere, while allowing the employer the flexibility to update and
maintain the manual. This application is part of our monthly subscription
package, but is also available to non-subscribers for a one-time fee.




**Research
Databases** . We
provide users with the following:




·
    Real-time,
      up-to-the-minute information and profiles of over 450,000
      companies




·
    Financial
      data, contact information, product descriptions, industry comparisons,
      rankings, media reports and other valuable
data




·
    Professionally
      formatted reports, ready for online viewing, email, download, and
      printing




·
    Instant
      access to over 3,000 media, industry, research and trade publication
      sources, both on and off the Internet




·
    Time-sensitive,
      in-depth intelligence on companies, people, news and
  more




These
allow our users to monitor key topics and company information with automatic
daily email alerts and update notifications. Users can generate electronic
newsletters and e-mails for their customer bases. Users can also publish
business topics and reports directly on their web sites, complete with their
company’s branding. These services are provided through our partner Net Content,
with whom we share revenue.




**Merchant
Services.** Smart
Online and our partner, Moneris Solutions, provide credit card processing
services. We share fees with Moneris Solutions.







8







**Job
Descriptions.** We assist
users to create professional job descriptions quickly and effortlessly. Our
users can access a library of more than a thousand job descriptions complying
with the latest Dictionary of Occupational Titles (DOT). Users can also preview
job descriptions and postings online in HTML format, download them to their
personal computers, or e-mail them to their colleagues.




**Instant
Messaging Services.** Our Smart
Instant Messenger is private. All messages are encrypted end-to-end. All access
is password protected so only authorized users are allowed on the network.


**Web
Conferencing.** We
provide live collaboration and web conferencing services through our partner,
Convoq, a leader in the web conferencing industry. Using this innovative
application, users can instantly gather the right people at the right time in a
rich-media environment and demonstrate products & services, show PowerPoint
presentations, use live video and audio (Voice over IP) technology, and view,
annotate, or edit documents in real time. The web conferencing application also
automatically integrates with the users existing Instant Messenger (IM)
applications, and furthermore interfaces directly with Outlook so that meeting
invitations can be added directly to Outlook calendars. This application is part
of our subscription package, but is also available to non-subscribers for a
monthly fee.
 
 **Healthcare
Savings Program and Employer/Employee Tax Benefit Programs.** We
provide small businesses and their employees the ability to choose from
innovative non-insurance healthcare savings programs, pre-tax reimbursement
accounts, such as Health Savings Accounts (HSAs) and Flexible Spending Accounts
(FSAs); and employer group sponsored Health Reimbursement Arrangements (HRAs),
through our partnership with Foresight, Inc. This can save both employers and
employees thousands of dollars each year. The healthcare savings program
provides members access to medical providers in national networks at contracted
rates. These reduced fees apply to everything from doctor visits, hospitals, and
specialists for prescription drugs, dental, vision and more. The healthcare
savings program is available to non-subscribers for a monthly fee, and fees vary
for the employer/employee tax benefit programs.


**CD-ROM
Products.** Since our
inception, we have distributed more than two million copies of CD-ROM products
through a combination of direct sales, distributors and other means. Currently,
our Business Plan and Legal Issues products are available online, as CD-ROMs and
are loaded onto computers by some of our OEM partners. Approximately 0.4% of our
2004 revenue, 3.9% of our 2003 revenue, and 1.9% of our 2002 revenue was from
CD-ROM Products.




**Next
Generation Product Development - OneBiz Conductor** **SM**




We are
implementing an aggressive development, partnering and technology acquisition
strategy to introduce the small business industry’s first comprehensive business
resource center portal, to be called, OneBiz Conductor SM . This
will improve our already robust modular platform. We plan to release OneBiz
Conductor SM in three
versions. The first
version was released during the first quarter of 2005. The second and third
versions are expected to be released at the end of the third quarter 2005 and
the end of the fourth quarter 2005, respectively. We believe we will have a
competitive advantage in the market, if our small business customers can access
substantially all their management software applications and data online at the
Smart Online web site and the web sites of our syndication partners. To move us
toward that goal, OneBiz Conductor SM is being
designed to provide users with:




·
    A
      centralized dashboard/console that can be customized to show the critical
      business operations information a user needs from a single web
      page.




·
    Seamless
      data exchange between all appropriate applications so information can be
      input once and automatically accessed as needed in connection with
      multiple applications, providing significant time and cost savings as well
      as reducing input errors.




·
    Collaboration
      capabilities so various employees and/or outside service providers can
      work together on documents and applications as appropriate, significantly
      improving workflow efficiency and generating higher quality output in
      record time.




·
    Personalized
      company profiles that dynamically change as the customer uses OneBiz
      ConductorSM.
      These profiles personalize the way applications work and drive contextual
      advertising so that the same platform serves different customers in
      different ways. We believe this feature will create customer loyalty to
      our platform, because switching to a competitive platform will cause
      subscribers to lose this history.




·
    New
      functionality, primarily in the operations management arena: Financial
      management (accounting,) sales automation, inventory/supplies management
      and human resources.









9





**Architecture.** OneBiz
Conductor’s core consists of the business services that provide common platform
functionality like e-commerce, authentication, session management etc. At the
heart of the core will be the Contextual Dynamic OneBiz Profile. A distinct
profile will be created for every company using our Company Creation wizard when
users signup and register. This feature is an enhancement of the functionality
of our current proprietary technology platform. The profile will continually
update itself based on operations performed and information requested by each
company as it uses OneBiz. Business intelligence accumulated and deduced using
this OneBiz profile will provide the platform with what we call “the *state* ” of each
small business. Various OneBiz attributes are defined and inherited by the small
business based on this “state.” This OneBiz profile also will provide varying
role-based access to the platform based on security privileges assigned to each
user by the business owner.
  The
OneBiz profile will feature our expanded contextual business personalization and
contextual advertising server engines that will change the characteristics of
the OneBiz platform dynamically to meet the needs of each user without any human
intervention. Examples of some behavioral patterns could be an automated GUI
change, added features or an automated background action (for example: sending
automated emails and reminders.)




OneBiz
Conductor’s Business Process rules engine and the corresponding best business
practices process rules and workflows will help users to realize significant
cost reductions and efficiencies by automating business process flows,
eliminating human intervention, and allowing small business applications to
communicate and intelligently share information.




Our
OneBiz Conductor SM platform
is designed to be completely modular, with numerous plug-in connection points
for existing and new functionality developed in-house or obtained through
third-party partnerships and acquisitions.




Data
exchange to and from each product or functional component will be handled
seamlessly by the OneBiz integration platform. In addition, multiple users will
be able to collaborate on the same function, application or document providing
maximized workflow efficiencies. Finally, users will be able to work offline on
various applications and later upload their work to OneBiz Conductor SM for
synchronization.




**New
Functionality.** OneBiz
ConductorSM will focus on the following key categories of services:




·
    Dashboard




·
    Calendaring
      System / Day planner




·
    Business
      Contacts Management




·
    Collaboration
      Services




·
    Accounting
      / Financial Management




·
    Human
      Resources (employee management, payroll, benefits,
etc.)




·
    Sales
      Automation




·
    Shipping




·
    Inventory
      / Order Management




·
    Comprehensive
      Business Resource Center Portal




**Development
Timeline.** To
achieve our goal of completing development of OneBiz Conductor SM before
the end of the fourth quarter of 2005, we plan to release OneBiz
Conductor SM in three
versions.  The first version was commercially released in the first
quarter of 2005. Each release will have improved platform features and
additional software applications.




**OneBiz
Conductor** SM **Version 1** , which
was released to the market during the the first quarter of 2005,
included:




·
    Platform
      Implementation (initial features)




·
    Dashboard
      — Quick Access to Information




·
    Dashboard
      - Role-based Summaries




·
    Dashboard
      - Alerts, Notifications




·
    Dashboard
      - Customized look and feel (initial
features)




·
    Calendaring
      System / Day Planner




·
    Business
      Contact Management




·
    Smart
      Online Business Resource Center




**OneBiz
Conductor** SM **Version 2** , which
we plan to introduce to the market before the end of the third quarter of 2005,
is expected to include:




·
    Platform
      Implementation (additional feature
enhancements)




·
    Dashboard
      - Detailed drill-down views &
capabilities




·
    Dashboard
      - Customized look and feel




·
    Dashboard
      - Mobile interface (WAP, PDA, etc.)




·
    Accounting
      & Financial Management (initial
features)







10







·
    HR
      - Company/Employee Directory




·
    HR
      - Timesheets (Time Tracking and Management)




·
    HR
      - Attendance Records




·
    HR
      - Vacation Tracking




·
    HR
      - Dependant/Beneficiary




·
    HR
      - Compensation Tracking




·
    HR
      - Mini-dashboard




·
    HR
      - Employee Compliance (forms, employment contracts, W-4, benefits,
      etc.)




·
    HR
      - Termination (Exit interview and
compliance)




·
    Shipping
      (advanced features)




·
    Groupware
      services among company users




**OneBiz
Conductor** SM **Version 3** , which
we plan to introduce to the market before the end of the fourth quarter of 2005,
is expected to include:




·
    Platform
      Implementation (advanced feature
enhancements)




·
    Dashboard
      - Detailed drill-down views &
capabilities




·
    Dashboard
      - Dynamically update based on state of business




·
    Dashboard
      - Mobile interface (WAP, PDA, etc.)




·
    Accounting
      and Financial Management (advanced
features)




·
    HR
      - Performance Reviews




·
    HR
      - Company Announcements/News




·
    HR
      - Online Interview & Applicant Screening




·
    HR
      - Company Compliance




·
    HR
      - Professional Training (Continuing
Education)




·
    Shipping
      (advanced features)




·
    Printing
      & Copying Services




**OneBiz
Conductor** **SM** **may also include the following** , if
agreements can be reached with other companies to integrate these services into
OneBiz Conductor **SM** :




·
    Payroll
      partners and deliverable timeline




·
    Insurance
      / Benefits partners and deliverable
timeline




·
    Investment
      / 401(k) partners and deliverable timeline




·
    Sales
      Automation partners and deliverable
timeline




·
    Inventory
      / Order Management partners and deliverable
timeline




·
    Offline
      Capabilities for OneBiz services




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




**Product
Development Team.** Our
software engineering organization is responsible for developing our platform and
new applications, as well as enhancing our existing platform and software. We
believe that a technically skilled, quality-oriented, and highly productive
software engineering organization is important for the success of
new






11





product
offerings. We have increased our development team and may add additional
developers to meet our schedule for developing OneBiz Conductor SM . We may
also use independent development firms or contractors to expand the capacity and
technical expertise of our internal research and development team. Additionally,
we may license from third parties or otherwise acquire technology that is
incorporated into our products. We have a well-defined software development
methodology that we believe allows us to deliver products that satisfy business
needs and meet commercial quality expectations.




**Acquisitions
from Outside Sources.** We plan
to engage in a targeted and strategically defined plan to acquire selected
applications or businesses from unrelated third parties within the highly
fragmented application service provider and software development industries.
These transactions may include a combination of licenses from other companies,
joint development and purchases. We expect that some of these licenses will be
for our nonexclusive use.  In some cases, we may purchase technology or
acquire the companies that own the technology.  We have had discussions
with several companies about potential acquisitions, but we have not reached
agreement on terms with any of these companies.  We do not expect any
acquisitions of companies will occur until after a public market develops for
our securities.




We plan
to add the following software applications through such third party
transactions:




·
    Payroll




·
    Insurance
      / Benefits




·
    Investment
      / 401(k)




·
    Sales
      Automation




·
    Inventory
      / Order Management




·
    Office
      Capabilities for OneBiz Services




Because
of many factors related to third party transactions are outside our control, we
cannot predict whether or when these features will be added to OneBiz
Conductor SM .




Following
license or other acquisition of these applications, we will have to do
integration work before we can offer these applications on our OneBiz
Conductor SM platform.




**Market**




**Small
Business Market.** We offer
small businesses a wide range of software applications and other products and
services that help owners start, run, protect and grow their small businesses.
We define small businesses as companies with between one and fifty
employees.  When we complete development of OneBiz
ConductorSM later
this year, we believe our products may also become attractive to
middle size businesses of up to 500 employees.  At that time, we intend to
begin marketing to such middle size companies.




**Market
Resources.** We spent
$9,766 during 2002 and $3,167 during 2003 on advertising. During 2004, we
incurred advertising and marketing expenses of $170,774 including barter
advertising. Additionally, during 2004, we increased our budget for sales and
marketing, including hiring additional people. Smart Online markets and sells
its products directly to businesses through its www.smartonline.com web site,
through private label syndication partnerships with major corporations and
financial institutions and through OEM relationships. No single customer or
partner accounted for more than 10% of our total revenue during 2002. 
During 2003, integration revenues from a related party, Smart  IL, Ltd.,
accounted for 27.2% of total revenue and consulting revenues from a second
related party, Parson & Shearson, Inc., accounted for 11.9% of
revenue.  During 2004, integration revenue from Smart IL Ltd. accounted for
32.9% of total revenue. No other customers accounted for more than 10% of our
total revenue during 2004. See “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” and Notes to Financial Statements
for discussion of our major customers.




**Web
Services Sales.** Small
businesses often cease operating or are sold. In other cases, their needs
change. We must constantly recruit new subscribers to replace existing
subscribers. **** We engage
in a variety of marketing activities directed to small businesses, including
e-mail and direct mail campaigns, co-marketing strategies designed to leverage
existing strategic relationships, public relations campaigns, speaking
engagements and forums, and industry analyst visibility initiatives. Web
Services sales to small businesses, accounted for approximately 0.3%, 16.5%, and
17% of our revenue during 2004, 2003, and 2002, respectively.




**Subscriptions,
Customer Orders and Accounts Receivable.** We
typically do not have a backlog of customer orders as our services are delivered
instantaneously over the Internet. Substantially all of our small business
customers pay via credit cards. We typically offer new subscribers an initial
period of free subscription service. Our subscribers can cancel their
subscriptions at any time without penalty.







12







**Syndication
Partners.** We
private-label and customize our platform for our syndication partners. This
enables them to provide their own web site users with our resources and
applications. The motivation of our syndication partners is to acquire and
retain small business customers. Companies that utilize private-label Smart
Online products and services include: Bank One, J.P. Morgan Chase, BusinessWeek,
Union Bank of California, Gruner + Jahr USA for *Inc.* and *FastCompany* magazines and Cole Taylor Bank of Chicago. Our syndication partner agreements
have initial terms ranging for periods of up to five years.




We
currently rely upon direct marketing to major corporations to establish private
label syndication and marketing partnerships. Our sales efforts to syndication,
integration and OEM partners involves contact with multiple decision makers,
frequently including the prospective customer’s officer level personnel. While
the average sales cycle varies substantially, it has generally ranged from two
to six months. These partners promote the Smart Online product line through a
variety of marketing communications vehicles, including advertising and special
promotions.




Revenue
from our private label syndication amounted to approximately 14.5% of our total
revenue in 2002, approximately 9.2% in 2003, and 17.6% in 2004.




One of
our syndication partnership agreements with Gruner + Jahr USA Publishing,
pursuant to which we syndicate our platform and applications to the website
www.Inc.com and www.FastCompany.com, contains a prohibition against our
syndicating our platform and applications to two competitors of Gruner +
Jahr.




**Integration
Partners.**  Our
contracts with certain integration partners terminated earlier than originally
contemplated in the contracts with these partners following changes in the
businesses of our integration partners, which made the integration partnership
agreements less useful to us and to our integration partners.  For example,
some of our partners were not able to deploy the technology required to deliver
their products or services through our website.  In other cases, the
partner discontinued Internet based products or services to small businesses.
Revenues from small businesses using our website and the websites of our current
and former syndication partners and integration partners have been insignificant
to date. To maintain existing relationships and attract new relationships, we
must generate substantially greater revenue from small businesses. See
“Marketing Strategy” below for our plan to achieve this.




We
believe large companies, who desire to acquire and retain small business
customers, represent a significant market opportunity  for us.
We intend to expand our syndication channel to include partners in the financial
services/banking, media and broadcasting, telecommunications, insurance and real
estate markets.




All of
our integration partnership agreements limit our ability to integrate products
or services onto our website that compete with the products or services being
provided through our website by our integration partners.




**OEM
Sales.** Our
distributor, PC Treasures, sells some of our CD-ROM products to Dell Computers
and Gateway, which bundle our products with some of their computers on an OEM
basis. We believe the primary value of our OEM relationships is to help develop
our brand name to generate sales of our web-based products.




**Product
Pricing.** Price is
an important factor in the small business market. Currently, most of our small
business users are permitted to access a substantial part of our website without
charge.  Our longer-term pricing model allows customers to purchase use of
substantially all our applications for a monthly subscription fee that provides
unlimited usage for one user at a time. Certain applications, such as business
planning, market research and planning, employment policies and government
forms, are also available to non-subscribers, for a flat fee. After we release
the second version of OneBiz Conductor SM at the
end of the third quarter of 2005, we plan to have monthly subscription rates for
new subscribers direct through www.smartonline.com , for
$29.95 to $49.95 per month after a free trial period. We generally expect to
receive lower fees from subscribers at the private label syndication web sites
of our partners. We share revenue with our syndication partners. We realize
revenue from license fees to syndication partners, which is usually paid in a
lump sum at the beginning of the relationship. By integrating third-party
products onto our web site, such as web conference, loan referral, incorporation
services merchant services and health care service program, we share
revenue from sales of third party services. We also realize revenue from OEM
deals by our distributor, PC Treasures, with manufacturers, such as Dell
Computer and Gateway, for which we receive nominal payments for copies of our
CD-ROM products bundled with computers.




**Future
Possible Revenue Streams.** We plan
to seek to generate additional streams of revenue from international operations,
licensing our technology platform and selling advertising. Of these, we have
invested most in preparing for international operations.







13







**Contract
Terms.** A
significant portion of revenue from syndication contracts is received upfront
with monthly maintenance payments. Customers typically have the right to
terminate their contracts for cause, if we fail to perform. We generally invoice
our syndication customers in annual or monthly installments and typical payment
terms provide that our customers pay us within 30 days of invoice. In general,
we collect our billings in advance of the service period.




**Smart
Online Europe Penetration Plan**




We
currently generate no revenue from international operations . We have
conducted certain test marketing in the United Kingdom and France, but we
have not yet commercially launched in either country. We had previously launched
a French web site, but terminated commercial operations in 2002 as part of our
cost cutting efforts. Smart Online has localized its platform and applications
for the United Kingdom (we estimate it is 80 percent complete) and we are a
licensed provider of U.K. governmental forms. We do not, however, have a
projected launch date for our UK web site, because we are focusing our
development resources on our OneBiz Conductor SM platform
launch. Localizations for Germany, Spain and France are approximately 20-30
percent complete.




As we
have done in the U.S., Smart Online plans to seek syndication and channel
partners in Europe to more quickly and cost-effectively reach the large and
diverse small business market segments in each of the targeted countries.




**Challenges
to Marketing in Europe.** There
are numerous challenges for a U.S.-based company moving into European markets.
These include:




·
    Pricing
      sensitivities that vary from country to
country.




·
    A
      native sales force is necessary to avoid cultural and language
      pitfalls.




·
    Historical
      data shows a slower market adaptation to web-based/SaS business model in
      Europe than in the U.S.




·
    Localization
      must be perfected to ensure easy adoption and
usage.




**Key
Factors to Entering the European Markets.** In
general, our European business development will be focusing on the following
major tasks:




·
    Identify
      and develop relationships with local communities and government entities
      that have established web initiatives.




·
    Gain
      licensing for governmental forms.




·
    Establish
      key strategic channel partners that can represent Smart Online in each
      targeted country.




**Packaging
Smart Online for Different Countries and Partners.** We plan
to offer a modular or slimmed-down version of Smart Online in European countries
with fewer applications than the U.S. web site. The Smart Online platform will
be repackaged as appropriate for each country or channel partner and may include
only a few applications. After we hire sales associates for each country, their
input will assist Smart Online in determining the “package” that will be
promoted and sold in each country.




**Other
International Operations** . Smart
Online currently has a distribution licensing agreement with MYOB Ltd., for
sales of two of its shrink-wrap products in Australia and New Zealand. According
to the three-year contract signed in 2003, MYOB will share 15 percent of gross
sales of these products with Smart Online. If MYOB recruits syndication partners
using the online versions of these two products, MYOB is required to pay us 50
percent of syndication fees.




****










14





**Marketing
Strategy**





Web-based
products are distributed through www.SmartOnline.com and its
companion United Kingdom web site, as well as through the web sites of our
syndication partners discussed below. CD-ROM based products are sold directly to
customers by Smart Online, but most CD-ROM based products are distributed
through OEM relationships. For example, through our distributor PCsTreasures,
Dell Computer packages Smart Online CD-ROM products with some of its computers.




Although
Smart Online has generated revenue from both our web-based and CD-ROM products,
to date Smart Online has focused primarily on developing our web-based products,
distributing a large number of CD-ROMs and free promotional codes to use our
web-based products, testing and validating our technology infrastructure to
prepare to accommodate a high volume of simultaneous users, and evaluating user
feedback.




Our
primary marketing strategy to date has been price-based promotions, which gains
us users, but limits our revenue. For example, CD-ROM products are provided to
OEMs for a nominal charge. In addition, Smart Online has permitted many
customers to use its web-based products for free, either by offering free
initial service or by allowing users that fail to pay our monthly subscription
fees to continue to access our web-based products.




Our
strategy in the past has been to trade revenue opportunities for the opportunity
to learn from our small business customers what features are most important for
their businesses, while at the same time building a leads database consisting of
users of our web-based products and persons to whom CD-ROM products have been
distributed.




We
believe the end of the third quarter of 2005, when we plan to introduce the
second version of our Next Generation Platform, OneBiz Conductor SM , will be
the appropriate time to begin to seek to generate greater revenue from our
technology, content, customer preference knowledge and database of current and
past users.




Our plan
is to generate greater revenue through a combination of two factors: greater
marketing and sales efforts and introducing new products of greater value to
small businesses.




**Higher
Value New Products.** Our next
generation platform, OneBiz Conductor SM , is the
key to adding higher value products. Based on our experience with small
businesses, we believe accounting software is the critical application most
small businesses must have. We plan to add accounting software and sales
automation software to our product offerings as we roll out OneBiz
Conductor SM from the
end of the first quarter of 2005 to the end of the fourth quarter of 2005,
together with the new dashboard features of OneBiz Conductor SM described elsewhere. We believe that when these applications and features are
available, we will greatly increase the value proposition of our web-based
products to small businesses. This additional value will then justify our
allocating greater resources to sales and marketing.




**Greater
Marketing and Sales Efforts.** We plan
to increase our sales force from one person in 2003, to between 15 and 20 people
by the end of 2005. This increase will be timed to coincide with the rollout of
our next generation platform, OneBiz Conductor SM ,
described above. We will utilize these additional resources for a number of
sales and marketing initiatives, but we plan to emphasize contacting people who
currently utilize our internet-based products through our web sites and the web
sites of our syndication partners. We plan to cut off access to OneBiz
Conductor SM for
users who fail to pay for service. At the same time, we will begin to contact
people who have our CD-ROM products to convince them to upgrade to become
subscribers to our OneBiz Conductor SM product.
We expect the success of our sales efforts to people already familiar with our
current web-based and CD-ROM products will depend upon the additional value
provided to businesses by OneBiz Conductor SM ,
particularly the planned new accounting software and sales automation
applications and dash board capabilities.




We
believe these factors will enable us to leverage our current and new assets to
generate greater revenue from existing users and to add new paying customers as
we shift people from whom we currently generate no revenue or nominal revenue to
paying customers.




**Competition**




The
market for small business software applications is highly competitive and
subject to rapid change. The direct competition we face depends on the market
segment focus and delivery model capabilities of our competitors. We also face
indirect competition from potential customers’ internal development efforts and,
at times, we have to overcome their reluctance to move away from existing
paper-based systems.




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







15





Our
principal direct competition comes from several large vendors of Internet-based
software for small businesses that sell many products similar to ours. Most of
these competitors also sell other products and services not specifically
targeted to small businesses. These competitors include, but are not limited to,
Microsoft, Oracle, Intuit, SAP and Yahoo. We also expect to face competition
from new entrants that do not already market products similar to ours. 
Among the many companies that offer a narrower range of products that compete
with us is SalesForce.com.




We have
set forth below the primary competitive factors on which we believe small
businesses of fifty or fewer employees make their information technology
purchasing decisions and our opinion of how we meet each of these competitive
factors compared to most of our competitors.




**Competitive
      Factors**
    **Smart
      Online**Customer
      Awareness Access. Most small businesses do not spend substantial time
      researching and evaluating solutions. Most purchase what is most readily
      available.
    Many
      of our competitors have widely known brand names, large marketing budgets,
      and are widely available. Through our syndication, integration and OEM
      partnering programs, we believe we are able to gain greater customer
      awareness and access to our products at relatively moderate cost to us.
      While Smart Online  may lack the marketing dollars to compete with
      industry giants,  we believe our corporate syndication partners will
      allow us to compete effectively.Suppliers
      must be able to supply the applications and features customers
      need.
    We
      believe we offer more applications and features specifically targeted to
      small businesses than most of our competitors.Applications
      must be user friendly and require little training Customers generally do
      not have IT departments to train employees and support
      software.
    We
      have designed our applications to be highly user friendly and require
      little or no training. We also offer free telephone support
      services.Compatibility
      with other information technology
    We
      have designed our platform and technology to be compatible  with the
      information technology most often used by small businesses, which include
      personal computer operating systems,  internet access software, email
      and instant messaging.Price.
      Most small businesses are price sensitive.
    Our
      pricing structure requires very little initial investment by  small
      businesses and is cost competitive with the products of  competitors
      over the long-term. Our product delivery model also includes automatic
      free updates.Obsolescence
    We
      are always improving our platform and expanding our content and
      applications. We believe the release of our next generation platform,
      OneBiz ConductorSM,
      will demonstrate our commitment to industry leadership in this
      area.




We expect
competitors will seek to offer products with similar features to Smart Online.
Since we have no patents, we are unable to prevent this. We believe the key
barrier competitors will face in trying to develop competing products that
provide small businesses with quality equivalent to our products is that we have
developed products utilizing our more than eleven years of experience
addressing the needs of the many small business users of our CD-







16




ROMs and
Internet based products. During this time, we have learned by trial and error
what works and what doesn’t work for small businesses. We have incorporated into
our products the feedback of our small business customers. We believe this
specialization on small businesses has been a key factor in our ability to
attract syndication partners. One advantage of providing Internet-based services
is that we can monitor customer usage and determine what works and what doesn’t
work by the volume of usage. We do not have to wait for customer complaints to
identify areas for improvements. We believe that competitors who serve personal
users and larger businesses are likely to experience difficulty designing
products that match the utility of our products, which we specifically designed
for small businesses with 50 or fewer employees.   When we complete
development and release the third version of OneBiz ConductorSM later in
2005, we believe our products will become more attractive to middle sized
companies of up to 500 employees.  At that time, we intend to begin
marketing to such middle sized companies where we will face greater competition
from the companies that already serve that market.





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




**Intellectual
Property Rights**




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




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




We have
registered trademarks and registered service marks on more than a dozen products
and data services with other applications for registered trademarks
pending.  Over the past several years, we have made numerous changes in our
product names. Although we own registered trademarks in the United States and
have filed trademark applications in the United States and in certain other
countries, we do not have assurance that our strategy with respect to our
trademark portfolio will be adequate to secure or protect all necessary
intellectual property. There can be no assurance that our means of protecting
these proprietary rights will be adequate, or that our competitors will not
independently develop similar technology.




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




Currently,
we do not own any issued patents nor have any patent applications
pending.




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







17







While we
are not aware that our products, trademarks, copyrights, or other proprietary
rights infringe the proprietary rights of third parties, and no such claim has
been asserted by any third party, third parties may assert infringement claims
against us in the future with respect to current or future products. Further, we
expect that we may become subject to infringement claims as the number of
products and competitors in our industry segment grows and the functionality of
products in different industry segments overlaps. From time to time, we hire
employees and retain consultants who have worked for independent software
vendors or other companies developing products similar to those offered by us.
Such vendors or companies may claim that our products are based on their
products and that we have misappropriated their intellectual property. Any such
claims, with or without merit, could cause a significant diversion of management
attention, result in costly and protracted litigation, cause product shipment
delays or require us to enter into royalty or licensing agreements with third
parties. Such royalty or licensing agreements, if required, may not be available
on terms acceptable to us or at all, which would have a material adverse effect
upon our business and financial position.




**Employees**




As of
December 31, 2004, we had 18 full-time employees, which increased to 22
full-time employees at March 15, 2005. We plan to expand our staff to add
additional employees in software development, sales and marketing and internal
auditing and accounting. 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. We consider our relations with our employees to be good.
As of March 1, 2005, we repaid all indebtedness owed to our employees at
December 31, 2004. See "Note 6 of Notes to Financial Statements."




**Item
2. Properties.**




Our
principal administrative, sales, marketing, and research and development
facility is located in Durham, North Carolina near Research Triangle Park and
consists of over 5,000 square feet of office space held under a lease that
expire on October 31, 2005.




**Item
3. Legal Proceedings.**




U.S.
News & World Report v. Smart Online, Inc. - U.S.
News instituted this action against Smart Online in January 2003 in New York
(Case No. 102959/03) for breach of contract, due to Smart Online’s refusal to
pay the sum of $92,204.17 for an advertising insert, which Smart Online asserts
was faulty. On October 27, 2003, the New York action was dismissed by the
Supreme Court of the State of New York, because the State of New York had no
jurisdiction over this suit. On February 6, 2004, U.S. News filed a similar
claim in the District Court of Durham County, North Carolina (Case No.
04-CVD-00575). On April 9, 2004, Smart Online filed its answer to U.S. News’
claim, together with counterclaims for breach of contract and a motion to
transfer the case to the Superior Court division. Plaintiff filed its reply to
Smart Online’s counterclaims. As a result of the July 12, 2004 hearing, Smart
Online’s motion to transfer the case to Superior Court was granted. 
Mediation in this case is scheduled for April 4, 2005, and trial is scheduled
for April 25, 2005.  In April, an agreement was reached to settle this
matter with Smart Online agreeing to pay $50,000.




Infopia,
Inc. v. Smart Online, Inc. -
Infopia instituted this action against Smart Online on August 6, 2003 in
District Court, Wake County, North Carolina (Case No. 03-CVD-10567) for breach
of contract, unfair and deceptive trade practices, and punitive damages,
alleging that Smart Online improperly refused to refund the $32,500 integration
fee paid by Infopia to Smart Online for Smart Online’s integration of Infopia’s
products into Smart Online’s platform. Smart Online answered the complaint on
October 31, 2003, and denied all claims for relief. Smart Online also filed a
counterclaim for breach of contract against Infopia for Infopia’s failure to pay
Smart Online certain sums it was due under the revenue sharing plan set forth in
the contract between the parties. Smart Online believes plaintiff’s claims for
unfair and deceptive trade practice and punitive damages are without merit. The
case is currently in the fact discovery phase. No trial date has been set.




Smart
Online, Inc. v. Genuity, Inc. - Smart
Online instituted this action against Genuity on May 22, 2001, in the Superior
Court of Wake County, North Carolina, Civil Action No. 01-CVS-06277. Smart
Online brought claims against Genuity for breached of contract, breach of
express warranty, breach of implied warranty of merchantability, breach of
warranty of fitness for a particular purpose, conversion, unfair and deceptive
trade practices, negligent misrepresentation and fraud arising from Genuity’s
failure to perform properly under contracts between the parties, from Genuity’s
failure to return certain property belonging to Smart Online, and from certain
representations made by Genuity with regard to the services needed by Smart
Online under the contracts. On or about July 23, 2001,







18







Genuity
files its answer to the complaint along with counterclaims against Smart Online.
In its counterclaims, Genuity brought claims for breach of contract alleging
that Smart Online failed to pay for the services rendered by Genuity. On October
22, 2002, the court denied Defendant’s request to dismiss Smart Online’s breach
of contract claim, allowed Smart Online to amend its complaint to restate its
claim for breach of contract, and dismissed Smart Online’s claims for breach of
implied warranties. The parties were completing discovery and preparing for
trial when the case was automatically stayed as a result of Genuity’s filing for
bankruptcy. This case is still subject to the automatic stay.




Internal
Revenue Service Claim. - Smart
Online, Inc. has been seeking to resolve a federal employment tax liability of
approximately Five Hundred Sixty Thousand Dollars ($560,000) relating to the
periods beginning December 31, 2000 and continuing through December 31, 2003. On
February 18, 2005, the Internal Revenue Service agreed to accept Smart Online,
Inc.’s offer in compromise (Form 656) in settlement of all of Smart Online’s
outstanding federal tax liabilities. Pursuant to the terms of the agreement,
Smart Online, Inc. agreed to pay Twenty-Six Thousand One Hundred Dollars
($26,100), surrender all credits and refunds for 2005 or earlier tax periods,
and remain in compliance with all federal tax obligations for a term of five
years. Smart Online, Inc. paid Twenty-Six Thousand One Hundred Dollars ($26,100)
to the Internal Revenue Service on February 25, 2005 as required under the
settlement terms.





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





During
the fourth quarter of the year ended December 31, 2004, did not meet or take any
action by written consent.





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





PART
II





**Item
5. Market for Registrant’s Common Equity and Related Stockholders
Matters**





The
principal United States market in which Smart Online’s Common Stock is quoted
for trading is the Over-the-Counter Bulletin Board (the “OTC-BB”), which is
operated by the National Association of Securities Dealers, Inc.





Our
Common Stock was approved for quotation on the OTC-BB on March 15, 2005, but no
trades or bids have occurred to date. Prior to that date there was no
established market for our Common Stock.





As of
March 15, 2005, there were approximately 160 record holders of 12,181,832
shares of Smart Online Common Stock. Smart Online has never declared or paid any
cash dividends on its Common Stock and does not intend to declare or pay
dividends for the foreseeable future.





See Item
11. “Executive Compensation - Stock Option Grants to Senior Executives” for a
description of Smart Online’s equity compensation plans.




During
the year ended December 31, 2004, Smart Online made the following sales of
securities, which were not registered under the Securities Act of 1933, as
amended. All proceeds of all sales were used to repay indebtedness and for
working capital purposes.




(1)
During the first quarter of 2004, Smart Online completed a corporate
reorganization of its capital stock, which eliminated the Series A Preferred
Stock of Smart Online. All holders of Series A Preferred Stock who participated
in the reorganization by signing Reorganization, Lock-up Proxy and Release
agreements dated January 1, 2004 (the “Reorganization Agreements”), received
approximately 2.22 shares of common stock of Smart Online for each share of
Series A Preferred Stock they held prior to the reorganization (of which 1.22
shares were issued pursuant to conversion rights and one share was issued in
consideration for contractual commitments) and also received the right to
receive cash payments from Smart Online equal to a percentage of the net
proceeds Smart Online raised during calendar year 2004 from sales of equity
securities and convertible debt securities in excess of $5 million of net
proceeds. Smart Online received $2,712,063 of net proceeds from sales of equity
securities during calendar year 2004 and, therefore, no payments were due. This
reorganization was ratified by stockholders in August 2004.







19







These
securities were sold under the exemption from registration provided by Section
4(2) of the Securities Act and the rules adopted thereunder. All the investors
are accredited investors. All the investors have prior experience investing in
start-up technology companies. All the investors were provided access to all the
information they deemed relevant to their investment decisions. All the
investors had prior business dealings with one another or with Smart Online.
Neither Smart Online nor any person acting on its behalf offered or sold the
securities by any general solicitation or general advertising. A legend was
placed on the stock certificates stating that the securities have not been
registered under the Securities Act and cannot be sold or otherwise transferred
without an effective registration or exemption from registration.




(2) From
March through June 2004, Smart Online sold 999,141 shares of its common stock
and warrants to purchase 288,638 shares of its common stock for an aggregate
gross purchase price of $3,496,994 to 19 investors pursuant to a private
offering. Different investors received different amounts of warrants depending
on the amount invested. On average, investors received a warrant to purchase
approximately three-tenths of a share of Common Stock for each share they
purchased. The warrants have an exercise price of $3.50 per share.




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




(3) **** On August
6, 2004, Smart Online made a rescission offer to shareholders who purchased
shares of common stock of Smart Online and warrants to acquire an additional
999,141 shares of common stock for $3.50 per share in a private placement
conducted during March through June of 2004, in which Smart Online raised a
total of $3,496,994. The rescission offer was made because in connection with
the audit of its financial statements and due diligence review of information in
connection with the registration statement of shares of Smart Online sold to
investors in the private placement described above, Smart Online identified
certain inaccuracies and omissions in the information it provided to investors
in the private placement. Upon identifying such inaccuracies and omissions,
Smart Online made the rescission offer and disclosed the inaccuracies and
omissions to all investors who purchased shares in the private placement. In the
rescission offer, Smart Online offered to repurchase all the shares and warrants
sold in the private placement for the original purchase price, plus interest,
and afforded shareholders a thirty-day period in which to accept the rescission
offer. One shareholder accepted the rescission offer and Smart Online paid that
shareholder $102,610.27 as payment in full of the purchase price and interest.
No other shareholders accepted the rescission offer and all shareholders to whom
the offer was made executed and delivered releases for any potential liabilities
arising out of disclosures made by Smart Online in the private placement.




This
rescission offer was conducted under the exemption from registration provided by
Section 4(2) of the Securities Act and the rules adopted thereunder. All the
investors are accredited investors. All the investors have prior experience
investing in start-up technology companies. All the investors were provided
access to all the information they deemed relevant to their investment
decisions. All the investors had prior business dealings with one another or
with Smart Online. Neither Smart Online nor any person acting on its behalf
offered or sold the securities by any general solicitation or general
advertising. A legend was placed on the stock certificates stating that the
securities have not been registered under the Securities Act and cannot be sold
or otherwise transferred without an effective registration or exemption from
registration.




(4) In
connection with the private placement conducted during March through June of
2004, Smart Online and the investors executed registration rights agreements.
This registration rights agreement required Smart Online to pay investors 2% of
their investment for each thirty-day period after July 1, 2004 in which Smart
Online failed to file a registration statement registering shares sold in the
private placement, which amount is prorated for partial 30-day periods. The
registration rights agreements provided that Smart Online could choose to pay
this by issuing shares of its common stock in lieu of cash, which Smart Online
chose to do. On November 1, 2004, Smart Online issued 58,226 shares of its
common stock to satisfy amounts that accrued through November 1, 2004.




This
offering was conducted pursuant to Rule 506 under Regulation D. All the
investors are accredited investors. All the investors have prior experience
investing in start-up technology companies. All the investors were provided
access to all the information they deemed relevant to their investment
decisions. All the investors had prior business dealings with one another or
with Smart Online. Neither Smart Online nor any person acting on its behalf
offered or







20







sold the
securities by any general solicitation or general advertising. A legend was
placed on the stock certificates stating that the securities have not been
registered under the Securities Act and cannot be sold or otherwise transferred
without an effective registration or exemption from registration.




(5) In
2001, Smart Online issued to Bank One, a warrant to purchase 619,309 shares of
the common stock of Smart Online for an exercise price of $18.00 per share in
connection with Smart Online and Bank One entering into a syndication partnering
agreement. The warrant contained a weighted average anti-dilution provision,
which caused the exercise price of the warrant to decrease to approximately
$12.04per share and the number of shares issuable upon exercise of the warrant
to increase to approximately 925,789 shares of common stock as of August 1,
2004. To simplify its capital structure, Smart Online offered to issue shares of
common stock of Smart Online to Bank One in exchange for cancellation of the
warrant. On September 3, 2004, Bank One exchanged the warrant for 100,000 shares
of common stock of Smart Online.




This
exchange offer was conducted under the exemption from registration provided by
Section 4(2) of the Securities Act and the rules adopted thereunder. All the
investors are accredited investors. All the investors have prior experience
investing in start-up technology companies. All the investors were provided
access to all the information they deemed relevant to their investment
decisions. All the investors had prior business dealings with one another or
with Smart Online. Neither Smart Online nor any person acting on its behalf
offered or sold the securities by any general solicitation or general
advertising. A legend was placed on the stock certificates stating that the
securities have not been registered under the Securities Act and cannot be sold
or otherwise transferred without an effective registration or exemption from
registration.




(6)
During August through September 27, 2004, Smart Online sold 290,000 shares of
its common stock to investors in a private placement for a price of $5.00 per
share, for an aggregate of $1,450,000.




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




(7)
During the year ended December 31, 2004, Smart Online issued an aggregate of
755,000 shares of its common stock to its directors, officers, employees and
consultants under the stock plans described in Item 11. “Executive
Compensation”. These securities were issued under the exemption from
registration provided by Rule 701 of the Securities Act.




Smart
Online has not received any proceeds from the securities registered pursuant to
Registration Statement on Form SB-2 No. 333-119385 for the resale of securities
by selling security holders. No warrants covered by that registration statement
have been exercised for cash.





**ITEM
6. Selected Financial Data**


**5-Year
Summary of Selected Financial Data**





The following table sets forth the periods indicated,
selected consolidated financial data that has been derived from our audited
financial statements for the years ended December 31, 2004, 2003 and 2002, and
unaudited financial statements for the years ended December 31, 2001 and
2000.  The following selected financial data should be read in conjunction
with our financial statements and related notes thereto, and with Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."





2004
    
    2003
    
    2002
    
    2001
    
    2000STATEMENTS
      OF OPERATIONS DATARevenues
    
    $
    1,002,970
    
    $
    1,261,223
    
    $
    1,391,645
    
    $
    3,193,078
    
    $
    1,549,498Loss
      from Operations
    
    $
    (2,801,935
    )
    $
    (1,865,282
    )
    $
    (999,765
    )
    $
    (1,993,879
    )
    $
    (12,523,510
    )Net
      Loss Attributable to Common Stockholders
    
    $
    (8,319,049
    )
    $
    (4,375,836
    )
    $
    (1,766,606
    )
    $
    (1,994,203
    )
    $
    (12,439,945
    )Net
      Loss per Share - Basic and Diluted
    
    $
    (0.82
    )
    $
    (0.60
    )
    $
    (0.25
    )
    $
    (0.27
    )
    $
    (2.00
    )Number
      of Shares Used in Per Share Calculation
    
    
    10,197,334
    
    
    7,254,978
    
    
    7,181,759
    
    
    7,286,965
    
    
    6,213,526


BALANCE
      SHEET DATATotal
      Assets
    
    $
    773,701
    
    $
    306,072
    
    $
    252,579
    
    $
    724,349
    
    $
    4,679,503Long-term
      Obligations
    
    $
    1,091,814
    
    $
    1,193,211
    
    $
    958,925
    
    $
    722,309
    
    $
    334,155Redeemable
      Preferred Stock
    
    $
    -
    
    $
    17,509,214
    
    $
    14,692,150
    
    $
    12,128,130
    
    $
    12,128,130Stockholders'
      Deficit
    
    $
    (1,911,090
    )
    $
    (22,014,156
    )
    $
    (19,268,323
    )
    $
    (15,864,201
    )
    $
    (13,931,594
    )




21


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




*The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our financial statements and
related notes that appear in this prospectus. In addition to historical
financial information, the following discussion contains forward-looking
statements that reflect our plans, estimates and beliefs. Our actual results
could differ materially from those discussed in the forward-looking statements.
Factors that could cause or contribute to these differences include those
discussed below and elsewhere in this prospectus, particularly in “Risk
Factors.”*




**Overview**




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




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




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





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




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







22






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




During
2004, Smart Online recognized $1.0 million of revenue. In addition, Smart Online
had deferred revenue of approximately $722,000 at December 31, 2004. Smart
Online recognized revenue totaling $1.3 million in 2003 and $1.4 million in
2002. During 2004, Smart Online entered into several new syndication and
integration agreements totaling approximately $1.2 million, including $640,000
of barter transactions. We are planning to substantially increase our
advertising and marketing in future years. We have started to enter into new
syndication partnerships that target strategic partners for bartering
arrangements for advertising and joint marketing programs to take advantage of
discounted advertising rates and to provide an opportunity for us to share in
the revenue generated by our syndication partners from use of our platform. We
began targeting small business media companies during the first quarter of 2004,
such as Inc. Magazine, and FastCompany Magazine, who have small-business
customer bases. Smart Online anticipates the revenue share arrangements with the
media companies will enable it to increase web services revenue for both Smart
Online and its private label syndication partners as we begin to share in the
revenue our partners generate from their websites. We expect to create these
arrangements in the future with media companies who offer the ability to reach
small-business customers and assist in off-setting Smart Online’s cash
expenditures for print and online advertising and marketing. While we intend to
derive a majority of our syndication revenue from traditional non-barter
transactions, we will evaluate barter transactions on a case-by-case basis when
we believe such transactions make economic or strategic sense. Pursuant to the
requirements of Emerging Issues Task Force (EITF) No. 93-11, “Accounting for
Barter Transactions Involving Barter Credits,” and EITF 99-13, “Accounting for
Advertising Barter Transactions,” for the year ended December 31, 2004, Smart
Online recognized approximately $113,000 of barter revenue.




To
increase our revenues and take advantage of our market opportunity, we will need
to add substantial numbers of paying subscribers. We define paying subscriptions
as unique user accounts. We plan to re-invest earnings for the foreseeable
future in the following ways: hiring additional personnel, particularly in
marketing and sales; expanding marketing and sales activities; increasing our
research and development activities to upgrade and extend our service offerings
and to develop new services and technologies; adding to our infrastructure to
support our growth; and formalizing our operational and financial systems to
manage a growing business. Worldwide growth of software subscriptions will
outstrip perpetual licenses, according to IDC, a leading global market
intelligence and advisory firm in the information technology and
telecommunications industries that provides local expertise and insights on
technology markets in the US and 50 other countries, “Subscription licensing
will grow at 16.6%, compounded, from 2004 to 2008 while perpetual licenses will
experience negative growth of three-tenths of one percent in that time frame. By
2008, subscription license revenues will hit $43 billion worldwide, or 34% of
the total software market.”




We expect
sales and marketing costs, which included third-party advertising and marketing
expenses of approximately $16,000, $130,000, and $171,000 for 2002, 2003, and
2004, respectively, to increase substantially in dollars and as a percent of
total expenses in the future as we seek to add and manage more paying
subscribers, build brand awareness and increase the number of marketing and
sales programs implemented.




**Fiscal
Year**




Our
fiscal year ends on December 31. References to fiscal 2004, for example, refer
to the calendar year ended December 31, 2004.




**Sources
of Revenue**




Smart
Online currently derives revenues from the following sources:




·
    Syndication
      Fees - fees consisting of:




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







23






o
    Barter
      revenue derived from syndication agreements with media
      companies.




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




·
    Web
      Services fees - comprised of the following:




o
    E-commerce
      sales directly to end-users:




·
    Subscription




·
    Multiuser
      subscription paid by enterprises for their business
    customers




·
    A
      la carte




·
    E-commerce
      revenue sharing with integration partners




·
    One
      Biz ConductorSMlicensing




·
    Contextual
      integration (“CI”) advertising fee




o
    Hosting
      and maintenance fees




o
    E-commerce
      Website Design and Build




o
    Loan
      origination fees




o
    Online
      marketing to our syndication/integration partners




o
    Marketing
      fee for loan request through the integrated
platform




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




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




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




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




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




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







24







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




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




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




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




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




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




**Revenue
From Related Parties**




Approximately
32.9% and 27.2% of total revenues for the years ended December 31, 2004 and
2003, respectively, were from a single customer, Smart IL Ltd. (“SIL”), formerly
known as Smart Revenue Europe Ltd., an Israeli based software company that
specialized in secured instant messaging products. During March 2004 SIL ceased
further development of its technology and laid-off all employees after SIL
completed development of, and delivered to us, its instant messenger
product.  SIL is currently seeking to license or sell its technology,
however, we do not expect to receive substantial revenue from SIL in the future.
SIL is owned by Doron Roethler, a shareholder of Smart Online.




On August
13, 2002, Smart Online entered into an integration agreement with SIL to
incorporate its products into Smart Online’s platform. As part of this
agreement, SIL paid $300,000 for such integration, and the parties agreed to
share future revenues generated from the sales of the products. On August 30,
2002, the parties signed an







25







amendment
to the original agreement, in order for Smart Online to provide SIL certain
co-development services, which includes instant messenger and video
conferencing. In exchange, SIL paid Smart Online an additional $300,000. The
parties further agreed that the products developed as a result of both
companies’ efforts will be owned by both parties. On April 30, 2003, Smart
Online and SIL signed a new amendment and restated the integration program
agreement. According to this new amendment and restated agreement, Smart Online
agreed to fund the future development of the products. In exchange SIL agreed to
limit future amounts payable by Smart Online under the original share revenue
agreement to $1.7 million. This cap on revenue sharing was removed by amendment
on October 29, 2003.




In
addition to the agreements described above, on August 30, 2002, Smart Online and
SIL also entered into a reseller agreement whereby SIL paid Smart Online
$200,000 for nonexclusive rights to distribute Smart Online’s products in the
territories of Israel, United Kingdom, France, Italy, Netherlands, and Spain, in
exchange for Smart Online’s marketing support and a twenty percent commission
from the gross sales generated by SIL. On March 17 and 27, 2003, the parties
subsequently modified the original re-seller agreement to restrict the territory
to only Israel and Netherlands.  We expect no revenue from SIL, unless SIL
hires employees to sell our products.  We do not know whether SIL intends
to hire employees to sell our products.  Additionally, on December 22,
2003, Smart Online signed a private label syndication agreement with SIL for
Smart Online to provide website development for SIL’s website.




Smart
Online paid $3,300 to SIL for moving expenses with regard to the SIL development
team visiting Smart Online from Israel in January of 2003. Smart Online also
paid SIL $25,000 as a reseller payment for the Moneris Integration contract they
secured pursuant to their re-seller agreement in May of 2003. Smart Online also
paid SIL $90,000 pursuant to their contract dated December 20, 2003 for
technical co-development work, which includes instant messenger and video
conferencing, on a monthly payment of $15,000 starting in December of 2003 and
ending in May of 2004.




During
2003, Smart Online provided $20,200 in consulting services to Small Business
Lending Institute, Inc. (“SBLI”). This constituted approximately 1.6% of Smart
Online’s revenue during 2003. Tamir Sagie, an officer of Smart Online at the
time, is an officer of SBLI. Michael Nouri, the Chief Executive Officer of Smart
Online is a shareholder in SBLI. Smart Online paid $221,517 to SBLI during the
first three months of 2004, because SBLI paid Smart Online’s employees during
the first quarter of 2004 while Smart Online was dealing with a tax matter with
the Internal Revenue Service.  The temporary transfer of Smart Online's
employees to SBLI allowed Smart Online to obtain a clean cut off to determine
the extent of its tax liability.




Approximately
11.9% of total revenues for the year ended December 31, 2003, and 0% for the
year ended December 31, 2004, were from a third related company, Parson and
Shearson, Inc., which is owned 50% by the CEO of Smart Online, Michael Nouri,
and 50% by his brother Eric Nouri. This revenue related to services performed by
Smart Online for the development of web-based human resources and inventory
applications for Parson and Shearson. Parson and Shearson has paid in full for
all services and has no outstanding amounts payable to Smart
Online.




The
following is a summary of related party revenues for the years ended
December 31, 2004, 2003 and 2002:




**Year
      ended**
      **December
      31,**
      **2004**
    
    **Year
      ended**
      **December
      31,**
      **2003**
    
    **Year
      ended**
      **December
      31,**
      **2002**Smart
      II, Ltd. ("SIL"), formerly known as Smart Revenue Europe Ltd.
      -
      Integration fees
    
    $
    330,050
    
    $
    342,857
    
    $
    128,571Parson
      and Shearson, Inc. -
      -  Consulting
      Services
    
    
    -0-
    
    
    150,000
    
    
    11,578Small
      Business Lending Institute -
      - 
      Consulting Services
    
    
    -0-
    
    
    20,200
    
    
    -0-Total
      Related Party Revenues
    
    $
    330,050
    
    $
    513,057
    
    $
    140,149







26







Accordingly,
approximately 32.9% of year 2004 and 40.7% of year 2003 total revenue were
derived from related parties. Smart Online expects revenue from related parties
will not continue to be a significant part of Smart Online’s revenue. If Smart
Online fails to replace revenue from related parties with revenue from unrelated
parties, Smart Online’s revenue will decrease.




**Cost
of Revenues**




*Cost
of Revenues* .    To
date Smart Online has not capitalized any costs associated with the development
of its products and platform. Smart Online has not capitalized any direct or
allocated overhead associated with the development of software products prior to
general release. SFAS No. 86, “Accounting for the Costs of Software to be Sold,
Leased or Otherwise Marketed”, requires capitalization of certain software
development costs subsequent to the establishment of technological feasibility.
Based on the Smart Online’s product development process, technological
feasibility is established upon completion of a working model. Costs related to
software development incurred between completion of the working model and the
point at which the product is ready for general release have been insignificant.
Cost of revenues is comprised primarily of salaries and related employee
expenses associated with employees who provide maintenance and support
services.  Additionally, during 2002 and a portion of 2003 cost of revenues
included third-party website hosting fees.




**Operating
Expenses**




During
2002, 2003, and 2004 our efforts were primarily focused on product development
and integration. During the first quarter of 2002, we substantially reduced the
number of people we employed. Smart Online employed approximately 13
full-time equivalent employees during 2002 and 2003. During 2004, Smart
Online hired additional development and sales staff and had 18 full-time
employees at December 31, 2004.  Most employees performed multiple
functions.




*Research
and Development* .    We
have historically focused our research and development activities on increasing
the functionality and enhancing the ease of use of our on-demand application
service. Because of our proprietary, scalable and secure multi-user
architecture, we are able to provide all customers with a service based on a
single version of our application. As a result, we do not have to maintain
multiple versions, which enables us to have relatively low research and
development expenses as compared to traditional enterprise software business
models. We expect that in the future, research and development expenses will
increase substantially in absolute dollars as we upgrade and extend our service
offerings and develop new technologies. We expect this to be particularly true
during 2004 and 2005 as we incur expenses to develop our next generation
platform One Biz Conductor SM .




*Marketing
and Sales* .   During
2002, 2003, and 2004, Smart Online has spent limited funds on marketing,
advertising, and public relations. We expect these expenditures to increase
significantly starting in 2005 and expect this trend to continue as we strive to
grow our revenue. Smart Online has also embarked on an effort to develop
programs similar to marketing efforts by Google, Overture, and Career Builder
where media companies provide Smart Online’s Private Label Syndication services
to their small business end users. Smart Online began targeting small business
media companies in the first quarter of 2004, such as Inc. Magazine and
FastCompany Magazine, who have small business customer bases. The strategy has
been to implement Private Label Syndication platforms in exchange for
advertising and joint marketing programs with these companies. Smart Online
estimates the revenue capabilities from its back-end revenue share arrangements
with these contracts will enable it to increase web services revenue for both
Smart Online and its partners beginning after we release the second version of
OneBiz Conductor SM , which
is planned to occur before the end of the third quarter of 2005. Smart
Online expects to create certain types of these arrangements in the future with
media companies who offer the ability to reach small business customers and will
assist in off-setting Smart Online’s outlay of cash for print and online
advertising and marketing while providing reduced advertising prices. Media
companies are requesting such services to assist in driving additional
revenue.




As our
revenues increase, we plan to continue to invest heavily in marketing and sales
by increasing the number of direct sales personnel and increase penetration
within our existing customer base, expanding our domestic and international
selling and marketing activities, building brand awareness and participating in
additional marketing programs. We expect that in the future, marketing and sales
expenses will increase in absolute dollars and will be a significant cost.




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







27












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




**Critical
Accounting Policies and Estimates**




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




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




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







28












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




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




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







29









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




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




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




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




Consulting
revenues are recognized over the term of the consulting engagement as services
are performed, which is typically one to three months. Advance payments for
consulting services, if billed and paid prior to completion of the project, are
recorded as deferred revenue when received.  If the fees are not fixed or
determinable, revenue is recognized as payments are received from the
customer.




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







30





is
recognized pro-rata as the advertising deliverable is provided.  Barter
revenues totaled approximately $113,000 during 2004. Smart Online did not have
any barter transactions for the years ended December 31, 2003 and
2002.




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




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




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




**Overview
of Results of Operations for the Fiscal Year Ended December 31,
2004**




Revenues
during fiscal 2004 totaled approximately $1.0 million as compared to $1.3
million for fiscal 2003 representing a decrease of $300,000. Approximately,
$183,000 of this decrease is attributable to a reduction in related party
revenue as Smart Online decreased its dependence on related entities. Operating
expenses increased from $2.9 million in 2003 to $3.6 million in 2004 primarily
as a result of legal and professional costs incurred in preparing to become a
public company. The net loss during fiscal 2004 was approximately $2.7 million
compared to a net loss of $1.6 million for fiscal 2003.




***Fiscal
Years Ended December 31, 2004, 2003 and 2002***




**Results
of Operations**




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







31





**Revenues**




**For
      the years ended December 31:****2004**
    
    **2003**
    
    **2002**Integration
      fees
    
    $
    374,055
    
    $
    367,617
    
    $
    740,561Syndication
      fees
    
    
    176,471
    
    
    115,544
    
    
    202,368OEM
      revenue
    
    
    55,936
    
    
    48,620
    
    
    43,608Web
      services
    
    
    62,365
    
    
    207,570
    
    
    241,420Other
      revenues
    
    
    4,093
    
    
    29,015
    
    
    23,539Related
      party revenues
    
    
    330,050
    
    
    492,857
    
    
    140,149**Total
      Revenues**
    
    $
    1,002,970
    
    $
    1,261,223
    
    $
    1,391,645






Fiscal
2004 vs. 2003




Total
revenues were $1,002,970 in fiscal 2004 compared to $1,261,223 in fiscal 2003
representing a decrease of $258,253, or 20.5 percent.




During
2004 the Company focused on entering into integration and syndication agreements
with third parties who have significant small-business customer bases as it
prepares for the launch of its OneBiz Conductor SM product.
This focus resulted in nine new integration and syndication partners, including
several major business publications such as Inc. Magazine, FastCompany Magazine
and BusinessWeek, and a 7.9 percent increase in integration and syndication
revenue as compared to 2003. The 2004 integration revenues included
approximately $113,000 of revenue from barter transactions as compared to $0 in
2003. Barter revenues are expected to increase in 2005 as a result of new and
existing integration and syndication barter arrangements.




Additionally,
as a result of the focus on integration and syndication services, web services
and other revenues decreased by approximately $145,000 and $25,000,
respectively. Also during 2004, Smart Online continued to rely less on
relationships with related parties resulting in a $162,807 decrease in related
party revenues. Management does not expect related party revenues to be a
significant source of income commencing with fiscal 2005.




Fiscal
2003 vs. 2002




Total
revenues were $1,261,223 in fiscal 2003 compared to $1,391,645 in fiscal 2002, a
decrease of $130,422, or 9.4 percent. The decrease in revenues was primarily due
to the management and officers of Smart Online focusing their efforts during the
last half of 2003 on strategic planning, negotiating and evaluating a potential
sale of the company, and structuring and negotiating a corporate reorganization
in which preferred stock owners converted to common stock. These major efforts
took time and focus away from all employees of Smart Online and resulted in a
significant reduction in the sales effort. This reduction in sales effort was
off-set in part by revenue from performing services for a related party in 2003.
Revenue from related parties accounted for $140,149 or approximately 10.1%, of
the 2002 revenues and $513,057 or approximately 40. 7%, of
the 2003 revenues. See "Revenue from Related Parties" and Note 12 of Notes to
Financial Statements for a description of related party transactions.
Additionally, the 2002 period included $133,979 of non-recurring revenue
recognized upon the early termination of six integration agreements. During the
2003 period $76,389 of revenue was recognized from the early termination of a
single integration contract.




Integration
fees from unrelated parties decreased from $740,561 in fiscal 2002 to $367,617
in fiscal 2003, a decrease of $372,944, or 50.4%. As noted above, Smart Online's
2003 sales and marketing efforts were significantly reduced resulting in a
significant reduction in the signing of new integration partners with the number
of new integration customers decreasing from 7 in 2002 to 3 in 2002. 
Additionally, Smart Online’s integration contracts with related parties resulted
in related party integration revenue of $342,857 in 2003 compared to $128,571 in
2002.




Syndication
fees decreased from $202,368 in fiscal 2002 to $115,544 in fiscal 2003, a
decrease of $86,824, or 42.9%. This decrease in syndication fees is primarily
attributable to the expiration of a large syndication contract that accounted
for approximately $108,000 of syndication revenue in 2002 and $0 in 2003. The
impact of the contract termination was offset in part by the signing of a new
syndication partner in April 2002. 2003 syndication fees from this new partner
were approximately $21,000 higher than in 2002 as the 2003 period covered a full
year whereas the 2002 revenues related to only the last nine months of
2002.







32







2003 and
2002 OEM and ”other revenues” were comparable with web services revenues
decreasing by $33,850 as  Smart Online focused on its syndication and
integration lines of business.




As noted
above, integration revenues from related parties accounted for $128,571 and
$342,857 of related party revenues during 2002 and 2003, respectively.  In
addition, as discussed in Note 12 of Notes to Financial Statements, during 2003
Smart Online performed $150,000 of consulting services to an entity owned by an
officer of Smart Online and by the officer's brother, who is also an employee of
Smart Online.




**Cost
of Revenues**




**For the years ended December
      31:****2004**
    
    **2003**
    
    **2002****Cost
      of Revenues**
    
    $
    211,616
    
    $
    187,064
    
    $
    267,058







Fiscal
2004 vs. 2003




Cost of
revenues is comprised primarily of salaries and wages associated with
maintaining and supporting integration and syndication partners. Cost of
revenues increased 13.1% from $187,064 in 2003 to $211,616 in 2004 primarily as
a result of the increased number of integration and syndication partners. Cost
of revenues are expected to continue to grow in the future commensurate with
growth in integration and syndication partners and as users are added following
the 2005 release of OneBiz Conductor SM .




Fiscal
2003 vs. 2002




Cost of
revenues decreased by approximately $80,000 in 2003 as compared to 2002. 
The 2002 period included approximately $37,000 of third-party website hosting
fees while the 2003 period only included approximately $1,000 as a result of
Smart Online bringing the website hosting function in-house.  The remainder
of the decrease was primarily attributable to a decrease in employee
costs.




Cost of
revenues is comprised primarily of salaries and related employee expenses
associated with employees who provide maintenance and support services. 
Additionally, during 2002 and a portion of 2003 cost of revenues included
third-party website hosting fees.  The 2002 period included approximately
$37,000 of third party website hosting fees as compared to approximately $1,000
in the 2003 period as Smart Online brought website hosting in-house. 
Excluding website hosting fees, cost of revenues represented 17% and 15% of
revenues in 2002 and 2003, respectively.




**Operating
Expenses**




**For
      the years ended December 31:******
    
    ******2004**
    
    ******2003**
    
    ******2002****Operating
      Expenses**General
      and administrative
    
    $
    2,432,928
    
    $
    1,941,920
    
    $
    1,392,658Sales
      and marketing
    
    
    596,989
    
    
    321,049
    
    
    300,653Development
    
    
    563,372
    
    
    676,472
    
    
    431,041**Total
      Operating Expenses**
    
    $
    3,593,289
    
    $
    2,939,441
    
    $
    2,124,352












33







Fiscal
2004 vs. 2003




*General
and Administrative*  - General
and administrative expenses increased by approximately $491,000 from $1.9
million in 2003 to $2.4 million in 2004.  The 2004 period included $350,000
of expense associated with the conversion of certain warrants to common stock
during September 2004. Additionally, the 2004 period included $66,287 of stock
based compensation expense as compared to $733,500 of stock based compensation
expense included in the 2003 period related to stock options issued to the CEO
of Smart Online and warrants issued to a financial advisor.  Legal and
professional fees, including those associated with conducting financial
statements audits for 2002 and 2003 and one-time expenses associated with
preparing to become a public company, totaled $770,000 in 2004 as compared to
$355,000 in 2003. The 2003 legal and professional fees were primarily related to
litigation and settlements obtained regarding outstanding
liabilities.




Smart
Online anticipates hiring additional staff during 2005. Management anticipates
that the incremental cost of these additions will be offset by a reduction in
legal and professional fees for non-recurring expenses incurred in 2004, but
that the costs of compliance with the Sarbanes-Oxley Act and other public
company-related expenses will increase general and administrative expenses
during 2005.




*Sales
and Marketing* - Sales
and marketing increased from $321,049 in 2003 to $596,989 in 2004, an increase
of approximately $276,000.  The 2004 increase was primarily attributable to
barter advertising expense that commenced in 2004 and the hiring of additional
sales staff. The 2004 period included approximately $206,000 of barter
advertising expense as compared to $0 for the 2003 period.




As our
revenues increase, we plan to continue to invest heavily in marketing and sales
by increasing the number of direct sales personnel and increase penetration
within our existing customer base, expanding our domestic and international
selling and marketing activities, building brand awareness and participating in
additional marketing programs. We expect that in the future, marketing and sales
expenses will increase in absolute dollars and will be a significant
cost.




*Development* -
Development expense decreased from $676,472 in 2003 to $563,372 in
2004.   The 2003 period included approximately $268,000 of stock based
compensation expense related to stock options issued to an officer as compared
to approximately $41,000 included in the 2004 year.  Excluding the 2003
stock based compensation expense, development expense increased by approximately
$114,000 as Smart Online added additional programming, database management,
quality assurance, and project management resources to support the on-going
development of the OneBiz Conductor SM product.




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




Fiscal
2003 vs. 2002




*General
and Administrative*  - General
and administrative expenses increased by $549,261 from $1,392,658 in 2002 to
$1,941,920 in 2003.  The 2003 period included approximately $733,500 of
stock based compensation expense related to stock options issued to the CEO of
Smart Online and warrants issued to a financial advisor.  This increase was
offset in part by a $50,000 decrease in salaries and wages which in part
reflected the departure of the company’s full-time chief financial officer and
approximately $183,000 of lower book depreciation expense as assets became fully
depreciated.  Additionally, these decreases were offset by an increase of
approximately $36,000 in accounting and professional fees which included
payments to a contractor that replaced the chief financial officer *.*




*Sales
and Marketing* - 
Sales and marketing increased from $300,653 in 2002 to $321,049 in 2003
primarily as a result of increased use of consultants.  The 2003 period
included $78,333 of consulting expense, including $27,083 paid to a consulting
firm owned by one Smart Online’s officers to provide strategic international
sales and marketing, as compared to $0 for 2002.  This increase in
consulting expense was offset in part by a $22,238 reduction in marketing
expense and a $38,299 reduction in compensation cost primarily attributable to a
reduction in sales and marketing wages.




*Development* -
Development expense increased from $431,041 in 2002 to $676,472 in
2003.   The 2003 period included approximately $267,500 of stock based
compensation expense related to stock options issued to an office.  The
2002 period included approximately $17,000 of contract development expenses for
which there was no comparable 2003 expense.  Additionally, 2003 development
salaries and wages were $27,498 lower than 2002 due to the elimination of one
position.  These decreases were offset in part by $15,000 of consulting
expense incurred during 2003.







34







**Other
Income (Expense)**




**For
      the years ended December 31:**
    ********
    ****
    ****
    **2004**
    ****
    ****
    **2003**
    ****
    ****
    **2002****Other
      Income & Expenses**Interest
      expense, net
    
    $
    (119,389
    )
    $
    (186,248
    )
    $
    (89,912
    )Gain
      from debt forgiveness
    
    
    249,395
    
    
    492,757
    
    
    338,866Loss
      on disposal of assets
    
    
    -
    
    
    -
    
    
    (54,595
    )**Total
      Other Income & Expenses**
    
    $
    130,006
    
    $
    306,509
    
    $
    194,359




Fiscal
2004 vs. 2003




Smart
Online incurred net interest expense of $119,389 and $186,248 during 2004 and
2003, respectively. The 2004 and 2003 interest expense amounts each included
$75,000 of interest related to the issuance of 150,000 shares of common stock to
a relative of one of Smart Online’s officers in consideration for extending the
term of a loan and loaning additional funds to the corporation as describe in
Note 7 to the accompanying audited financial statements. The remainder of the
2004 and 2003 interest expense is primarily attributable to interest due on
deferred compensation owed to officers of Smart Online and interest related to
unpaid payroll tax obligations. Both the deferred compensation and income tax
obligations were relieved during the first quarter of 2005, therefore,
management expects that interest expense will be significantly lower in
2005.




During
2004 and 2003, Smart Online realized gains totaling $249,395 and $492,757,
respectively, from negotiated and contractual releases of outstanding
liabilities. The gains from debt forgiveness resulted from unrelated third
parties, primarily trade creditors who had performed services for Smart Online,
agreeing to accept as payment in full a lesser amount than the stated liability
in consideration for timely payment of the negotiated settlement.  With the
exception of a negotiated settlement with the Internal Revenue Service that
resulted in a gain of approximately $547,000 in the first quarter of 2005 (see
Note 15 to the accompanying audited financial statements), Smart Online does not
expect gains from debt forgiveness to be material in future
periods.




Fiscal
2003 vs. 2002




During
2003 and 2002 Smart Online realized gains totaling $492,757 and $338,866,
respectively, resulting from negotiated and contractual releases of outstanding
liabilities. The gains from debt forgiveness resulted from unrelated third
parties, primarily trade creditors who had performed services for Smart Online,
agreeing to accept as payment in full a lesser amount than the stated liability
in consideration for timely payment of the negotiated settlement. 
Additionally, during 2002 Smart Online realized a loss of $54,595 in connection
with disposing of assets principally related to Smart Online moving to new
office space.




**Provision
for Income Taxes**




We have
not recorded a provision for income tax expense because we have been generating
net losses. Furthermore, we have not recorded an income tax benefit for fiscal
2004, 2003, and 2002 primarily due to continued substantial uncertainty
regarding our ability to realize our deferred tax assets. Based upon available
objective evidence, there has been sufficient uncertainty regarding the ability
to realize our deferred tax assets, which warrants a full valuation allowance in
our financial statements. Smart Online has approximately $29,000,000 in net
operating loss carryforwards, which may utilized to offset future taxable
income.




**Liquidity
and Capital Resources**




At
December 31, 2004, our principal sources of liquidity were cash and cash
equivalents totaling $173,339, marketable securities totaling $395,000, and
accounts receivable of $30,904. We do not have a bank line of
credit.




At
December 31, 2004, we had approximately a $1.3 million deficit in working
capital, which is not sufficient to fund our operations for the next year,
unless we substantially increase our revenue, limit expenses or raise
substantial additional capital.





Smart Online leases its facility under a renewable,
operating lease agreement, which current term expires in October 2005.  As
of December 31, 2004, future minimum operating lease payments total $102,040 all
of which is payable in 2005.







35







Our
primary source of liquidity during 2004 was from sales of our securities. During
the 2004, Smart Online generated net cash from financing activities, including
the sales of common stock, of approximately $4.2 million. During the same period
Smart Online consumed approximately $3.7 million of cash in operations,
including payment of $1,126,485 paid related to outstanding payroll tax
liabilities.




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




**Recent
Developments.** As of
March 31, 2005, Smart Online raised an additional $2,735,000 of proceeds,
net of stock issuance costs of $290,000, through the sale of additional shares
of Common Stock and a warrant to purchase 50,000 shares of Common Stock.
Approximately, $1.1 million of the proceeds were used in the first quarter of
2005 to pay-off the deferred compensation to our officers and related accrued
interest amounts. Additionally, during February 2005, Smart Online reached a
settlement with the Internal Revenue Service, paid $26,100, surrendered all
credits and refunds for 2005 or earlier tax periods, and agreed to remain in
compliance with all federal tax obligations for a term of five years to resolve
all outstanding federal tax issues (see Note 15 to the audited financial
statements). In April 2004, Smart Online settled for $50,000  claims made
by U.S. News & World Reports.





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


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




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




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




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




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







36







**Receivables.** If we
are successful in signing new contracts, we anticipate our receivables and
collections from integration, syndication, and end-user licensing opportunities
to increase significantly starting during the first quarter of 2006. Smart
Online’s receivables are primarily from major companies or banking institutes,
and not end users. Management has evaluated the need for an allowance for
doubtful accounts and determined that no provision for uncollectible accounts is
required as of December 31, 2004, 2003 and 2002.




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




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




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




**Gains
From Debt Foregiveness.** During
2004, 2003, and 2002 Smart Online realized gains totaling $249,395, $492,757,
and $338,866, respectively, resulting from negotiated and contractual releases
of outstanding liabilities. The gains from debt foregiveness resulted from
unrelated third parties, primarily trade creditors who had performed services
for Smart Online, agreeing to accept as payment in full a lesser amount than the
stated liability in consideration for timely payment of the negotiated
settlement.  Had Smart Online been unable to reach agreement with these
creditors, Smart Online’s liabilities and future cash flow requirements would
have been higher by the amount of the debt foregiven.




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




**Legal
Claims.** Smart
Online is subject to other claims and suits that arise from time to time in the
ordinary course of business. While management currently believes that resolving
these matters, individually or in aggregate, will not have a material adverse
impact on Smart Online’s financial position or results of operations, the
litigation and other







37







claims
noted above are subject to inherent uncertainties and management’s view of these
matters may change in the future. Were an unfavorable final outcome to occur,
there exists the possibility of a material adverse impact on Smart Online’s
financial position and the results of operations for the period in which the
effect becomes reasonably estimable. See “Item 3. Legal Proceedings” for a
description of current litigation.




**Risk
Factors**




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




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




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




·
    Our
      Financial Condition




·
    Our
      Products and Operations




·
    Our
      Market, Customers and Partners




·
    Our
      Officers, Directors, Employees and
Shareholders




·
    Regulatory
      Matters that Affect Our Business




·
    Matters
      Related to The Market for Our Securities




**Risks
Associated With Our Financial Condition**




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




We have
lost an aggregate of $36.7 million since inception on August 10, 1993. During
the year ended December 31, 2004, we suffered a net loss of approximately $2.7
million. At December 31, 2004, we had a $1.3 million deficit in working
capital.  Consequently, our working capital is not sufficient to fund our
operations for the next year, unless we substantially increase our revenue,
limit expenses or raise substantial additional capital.  At December 31,
2004, our cash and cash equivalents were only $173,000.  We had $173,000 of
marketable securities, for total lquid assets of $395,000 and we had only
nominal tangible assets. **** If we do
not rectify these deficiencies, we may have to cease operations and liquidate
our business.  Because we have only nominal tangible assets, you may lose
your entire investment.




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




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




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




In the
future, we will be required to seek additional financing to fund our operations
or growth. Factors such as the commercial success of our existing services and
products, the timing and success of any new services and products,







38





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




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




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




**Risks
Associated With Our Products And Operations**




**(5)
Many of our Current Users Do Not Pay For Our Products.  If We Are Not
Successful in Substantially Increasing Paying Customers, Our Business Will
Fail.**




We
currently allow many users of our web-based products to access our products
without charge. Our primary marketing strategy to date has been price-based
promotions, which gains us users, but limits our revenue. For example, CD-ROM
products are provided to OEMs for a nominal charge. In addition, Smart Online
has permitted many customers to use its web-based products for free, either by
offering free initial service or by allowing users that fail to pay our monthly
subscription fees to continue to access our web-based products.




Our
strategy in the past has been to trade revenue opportunities for the opportunity
to learn from our small business customers what features are most important for
their businesses, while at the same time building a leads database consisting of
users of our web-based products and persons to whom CD-ROM products have been
distributed.




We plan
to continue to offer free or discounted pricing on our products until we
commercially release the second version of our Next Generation Platform, OneBiz
Conductor SM , which
is expected to occur before the end of the third quarter of 2005.  There
can be no assurance customers will pay for our products after we release our
Second Generation Platform.  If we are not successful in substantially
increasing our paying customers, our business will fail and you may lose your
entire investment.




**(6)
We Will Rely Heavily On Successful Development and Market Acceptance of Our Next
Generation Platform, OneBiz Conductor** **SM**




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




**(7)
We May Not Successfully Develop or Introduce the Next Two Installments of Our
Next Generation Product, OneBiz Conductor** **SM** **,
and Other New Products or Enhancements to Existing Products, Which Could Harm
Our Business.**




Our
future financial performance and revenue growth will depend, in part, upon the
successful development, introduction, and customer acceptance of our next
generation product, OneBiz Conductor SM .
Thereafter other new products and enhanced versions of our web-native business
applications will be critically important to our business. Our business could be
harmed if we fail to deliver enhancements that customers desire to our current
and future







39







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




**(8)
We Have Experienced Delays in Developing Our Next Generation Platform, OneBiz
Conductor** **SM** **.  
Existing Factors May Result in Further Delays Which Could Harm Our
Business.**




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




**(9)
Our Products Might Not Keep Pace with Technological Change, Which Could Harm Our
Business.**




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




**(10)
Our Business Is Difficult To Evaluate Because Our Business Models and Operating
Plans Have Changed As A Result of Forces Beyond Our Control.  Consequently,
We Have Not Yet Demonstrated That We Have a Successful Business Model or
Operating Plan.**




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




**(11)
It Is Important For Us To Continue To Manage Changing Business Conditions. 
Failure To Do So Could Harm Our Business.**







40





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




**(12)
The Success of Our Business Depends on The Continued Growth and Acceptance of
the Internet as a Business Tool.  If These Positive Trends Do Not Continue
To Develop, Our Business Could Be Harmed.**




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




**(13)
We Sell Third-Party Software and Web Services That May be Difficult to
Replace.  If We Are Not Able to Replace Third Party Software And Web
Services, Our Business May Be Harmed.**




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




**(14)
If We Acquire Companies, Products, or Technologies, We May Face Risks Associated
with Those Acquisitions. These Risks Include, But Are Not Limited to, Difficulty
of Integrating, Dilution of Stockholder Value and Disruption of Our Business,
Which Could Adversely Affect Our Operating Results.**




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




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




·
    diversion
      of financial and managerial resources from existing
      operations;




·
    risk
      of entering new markets;




·
    potential
      write-offs of acquired assets;




·
    potential
      loss of key employees;




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




·
    delays
      in customer purchases due to uncertainty.







41







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




**(15)
We Rely on Third-Party Hardware and Software That May Be Difficult To Replace or
Which Could Cause Errors or Failures of Our Service.  Such Events May Harm
Our Business.**




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




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




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




**(16)
Interruption Of Our Operations Could Significantly Harm Our
Business.**




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




**(17)
Defects in Our Service Could Diminish Demand for Our Service and Subject Us to
Substantial Liability, Damage Our Reputation, Or Otherwise Harm Our
Business.**




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




**(18)
Security and Other Concerns may Discourage Use of Our Internet Based
Software-as-Service (SaS) Model, Which Could Harm Our
Business.**




Our
service involves the storage and transmission of customers’ proprietary
information, and security breaches could expose us to a risk of loss of this
information, litigation and possible liability. If our security measures are
breached as a result of third-party action, employee error, malfeasance or
otherwise, and, as a result, someone obtains unauthorized access to one of our
customers’ data, our reputation will be damaged, our business may suffer and we
could incur significant liability. Because techniques used to obtain
unauthorized access or to sabotage







42







systems
change frequently and generally are not recognized until launched against a
target, we may be unable to anticipate these techniques or to implement adequate
preventative measures. If an actual or perceived breach of our security occurs,
the market perception of the effectiveness of our security measures could be
harmed and we could lose sales and customers. If customers determine that our
services offerings do not provide adequate security for the dissemination of
information over the Internet or corporate extranets, or are otherwise
inadequate for Internet or extranet use or if, for any other reason, customers
fail to accept our products for use, our business will be harmed. As part of our
operations, we receive credit card, employee, purchasing, supplier, and other
financial and accounting data, through the Internet or extranets. Although we
have security systems in place, there can be no assurance that this information
will not be subject to computer break-ins, theft, and other improper activity
that could jeopardize the security of information for which we are responsible.
Any such lapse in security could expose us to litigation, loss of customers, or
other harm to our business. In addition, any person who is able to circumvent
our security measures could misappropriate proprietary or confidential customer
information or cause interruptions in our operations. We may be required to
incur significant costs to protect against security breaches or to alleviate
problems caused by breaches. Any general concern regarding security in the
marketplace could deter customers or prospects from using the Internet to
conduct transactions that involve transmitting confidential information. Our
failure to prevent security breaches, or well-publicized security breaches
affecting the Internet in general, could significantly harm our business,
operating results, and financial condition.




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




**(19)
If Our On-Demand Application Service is Not Widely Accepted, Our Operating
Results Will Be Harmed.**




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




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




·
    the
      price and performance of our service;




·
    the
      level of customization we can offer;




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




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




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




**(20)
The Market for Our Technology Delivery Model and On-Demand Application Services
Is Immature And Volatile, and if It Does Not Develop or Develops More Slowly
Than We Expect, Our Business Will Be Harmed.**




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




**(21)
We Do Not Have an Adequate History With Our Subscription Model To Predict the
Rate of Customer Subscription Renewals and the Impact These Renewals Will Have
on Our Revenue or Operating Results.**







43







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




**(22)
We Depend on Small Businesses for Our Revenue. Small Businesses are Often
Financially Unstable, Have High Rates of Attrition and can be Expensive
Customers to Which to Market Products.**




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




**(23)
If We Fail to Develop Our Brand Cost-Effectively, Our Business May
Suffer.**




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




**(24)
We Depend on Corporate Partners to Market Our Products Through Their Web Sites
and OEM or Integration Relationships Under Relatively Short Term Agreements.
Termination of These Agreements Could Cause A Substantial Decline in Our Revenue
and a Substantial Increase in Customer Acquisition Costs.**




Approximately
93% of total revenue during year 2004 and approximately 83% of total revenue
during year 2003 was derived from syndication, integration and OEM agreements
with large companies whereby our content, software applications and technology
platform are integrated into the web sites of our syndication partners and the
software and services of our integration partners is sold on our website, and
our CD-Rom products are bundled with the products of others through our OEM
relationships. Under these agreements we both derive revenue and we utilize the
resources of our partners to reduce our customer acquisition costs. As of March
15, 2005, we have six syndication agreements, where we currently or will have
our content and software on the website of large corporate partners. We
currently have eleven  integration partnership agreements where we
integrate the content or services of our partners into our technology platform.
We currently have eleven OEM relationship through our distributor, PC Treasures.
Not all these agreements generate revenue for us at this time.  These
agreements typically have terms of from one to five years. In the event these
agreements were to terminate or not be renewed, or their terms substantially
renegotiated, we expect that our revenues would decline and our customer
acquisition costs would increase.   Although our partners are
important to our business on a collective basis, no single partner is material
to our business.  The syndication, integration, and OEM agreement revenue
described above includes revenue from an integration agreement between Smart
Online and Smart IL, a related party owned by a shareholder of Smart Online.
Smart IL accounted for approximately 27.2% of our total revenue in 2003 and
approximately 32.9% of total revenue during 2004. We do not expect to receive
revenue from Smart IL after 2004.  Our dealings with Smart IL are described
under “Item 7. Management Discussion and Analysis of Financial Condition and
Results of Operations - Revenue From Related Parties.”







44







**(25)
It is Important for Us to Continue to Develop and Maintain Strategic
Relationships.  Failure to Do So Could Harm Our
Business.**




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




**(26)
Our Lengthy Sales Cycle with Syndication, Integration Partners and OEM
Relationships Could Adversely Affect Our Financial Results.**




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




**(27)
We Face Significant Competition, Which Could Adversely Affect Our
Business.**




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







45












**(28)
We Depend on Nonrecurring Revenue, Which May Cause Our Revenue to Fluctuate
Substantially From One Quarter to Another or to Decline Permanently as Market
Conditions Change.**




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




**(29)
We Depend on Web Services Revenues; Our Future Growth is Substantially Dependent
on Customer Demand for Our Subscription Services Delivery Models.  Failure
to Increase This Revenue Could Harm Our Business.**




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




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




**(30)
There are Risks Associated with International Operations, Which We Expect Will
Become a Bigger Part of Our Business in the Future.**




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




·
    costs
      of customizing products for foreign
countries;




·
    laws
      and business practices favoring local
competitors;




·
    uncertain
      regulation of electronic commerce;




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




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




·
    import
      and export restrictions and tariffs;




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




·
    difficulties
      staffing and managing foreign operations;




·
    multiple
      conflicting tax laws and regulations; and




·
    political
      and economic instability.







46







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




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




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




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




**(31)
Substantial Amounts of Our Revenue Is Derived From Transactions with Related
Parties, Which Means That Our Revenue May Not Reflect the True Commercial
Viability of Our Business and That Our Revenue May Decline If We Cannot Replace
this Revenue With Revenue From Unrelated Third Parties.**




During
2004, approximately $330,000 of our total revenue, constituting approximately
32.9% of total 2004 revenue, was derived from related party transactions. During
2003, approximately  $513,057 of our total revenue, constituting
approximately 40.7% of 2003 total revenue, was derived from transactions with
parties in which our officers, directors and stockholders have a direct or
indirect interest. For year 2002, related party transactions provided
approximately  $140,149 of our revenue, constituting approximately 10.1% of
2002 total revenue.  These transactions are described in “Note 12 of Notes
to Financial Statements.”




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




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




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




**(32)
Any Failure to Adequately Expand Our Direct Sales Force Will Impede Our Growth,
Which Could Harm Our Business.**




We expect
to be substantially dependent on our direct sales force to obtain new customers.
We believe that there is significant competition for direct sales personnel with
the advanced sales skills and technical knowledge we need. Our ability to
achieve significant growth in revenue in the future will depend, in large part,
on our success in recruiting, training and retaining sufficient direct sales
personnel. New hires require significant training and may, in







47







some
cases, take more than a year before they achieve full productivity. Our recent
hires and planned hires may not become as productive as we would like, and we
may be unable to hire sufficient numbers of qualified individuals in the future
in the markets where we do business. If we are unable to hire and develop
sufficient numbers of productive sales personnel, sales of our services will
suffer.




**(33)
Because Competition for Our Target Employees Is Intense, We May Not Be Able to
Attract and Retain the Highly Skilled Employees We Need to Support Our Planned
Growth, Which Could Harm Our Business.**




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




**(34)
Our Growth Could Strain Our Personnel and Infrastructure Resources, and if We
Are Unable to Implement Appropriate Controls and Procedures To Manage Our
Growth, We May Not Be Able to Successfully Implement Our Business
Plan.**




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




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




**(35)
Our Executive Management Team is Critical to the Execution of Our Business Plan
and the Loss of Their Services Could Severely Impact Negatively on Our
Business.**




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




**(36)
Officers, Directors and Principal Stockholders Control Us. This Might Lead Them
to Make Decisions that do not Benefit the Stockholder
Interests.**




At March
15, 2005, our officers and directors beneficially owned approximately 4,783,995
(approximately 34%) of our outstanding stock, which includes approximately
730,000 shares which can be acquired upon exercise of options within sixty (60)
days after March 15, 2005. These shares included approximately 3,892,658 shares
beneficially owned by Michael Nouri and Henry Nouri, who are brothers and Ronna
Loprete, who is Michael Nouri’s wife. **** In
addition, 95,000 shares are subject to issuance upon exercise of options owned
by the officers and directors, which options cannot be exercised within sixty
days after March 15, 2005, and therefore are not counted as being beneficially
owned at that date. As a result, these persons, acting together, will have the
ability to control substantially all matters submitted to our stockholders for
approval (including the election and removal of directors and any merger,
consolidation or sale of all or substantially all of our assets) and to control
our management and affairs. Accordingly, this concentration of ownership may
have the effect of delaying, deferring or preventing a







48







change in
control of us, impeding a merger, consolidation, takeover or other business
combination involving us or discouraging a potential acquirer from making a
tender offer or otherwise attempting to obtain control of us, which in turn
could materially and adversely affect the market price of the common
stock.




**(37)
Sales by Officers and Directors Could Adversely Affect of Our Stock
Price.**




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




**(38)
All of the Shares of Common Stock Owned by Our Officers, Directors and
Consultants Will be Registered Later in a Registration on Form S-8 and May be
Resold by Them, Which May Have a Negative Impact on Their Interest in Smart
Online’s Future.**




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




**Regulatory
Risks**




**(39)
Our Revenue Recognition Policy May Change And Affect Our Earnings, Which Could
Adversely Affect Our Stock Price.**




We
believe our current revenue recognition policies and practices are consistent
with applicable accounting standards. However, revenue recognition rules for
software and service companies are complex and require significant
interpretations by management. Changes in circumstances, interpretations, or
accounting guidance may require us to modify our revenue recognition policies.
Such modifications could impact the timing of revenue recognition and our
operating results. See “Item 7. Management’s Discussion And Analysis Of
Financial Condition And Results Of Operations” regarding our current revenue
recognition policies.




**(40)
Compliance With New Regulations Governing Public Company Corporate Governance
and Reporting is Uncertain and Expensive. Our Difficulties in Complying with
Public Company Reporting Obligations Are Greater, Because We Do Not Have a Chief
Financial Officer.**




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







49







**(41)
Our Reported Financial Results May Be Adversely Affected By Changes in
Accounting Principles Generally Accepted in the United States, Which Could
Adversely Affect the Price of Our Stock.**




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




For
example, we currently are not required to record stock-based compensation
charges, if the employee’s stock option exercise price is equal to or exceeds
the deemed fair value of our common stock at the date of grant. However, some
companies have recently elected to change their accounting policies and have
begun to record the fair value of stock options as an expense. Although the
standards have not been finalized and the timing of a final statement has not
been established, FASB has announced its support for recording expense for the
fair value of stock options granted. If we were required to change our
accounting policy in accordance with Statement of Financial Accounting Standards
(SFAS) No. 123, *Accounting
for Stock-Based Compensation* and SFAS
No. 148. *Accounting
for Stock-Based Compensation—Transition and Disclosure* , and
retroactively restate prior periods as if we had adopted these standards for all
periods presented, then our cost of revenues and operating expenses would have
increased by approximately $2,142 for the year ended December 31, 2002,
$426,234 for the year ended December 31, 2003, and $294,301 for the year ended
December 31, 2004.




**(42)
Privacy Concerns are Increasing, Which Could Result in Regulatory Changes that
may Harm Our Business.**




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




**(43)
Evolving Regulation of the Internet May Harm Our Business.**




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




**(44)
Our Ability to Protect Our Intellectual Property is Limited and Our Products may
be Subject to Infringement Claims by Third Parties.**




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




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







50







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




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




**(45)
Anti-Takeover Effects of Charter Documents and Delaware Law Could Discourage or
Prevent a Change in Control, Even If a Change of Control Would Be Beneficial to
Shareholders and Investors.**




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




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




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




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




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




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




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




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




**(46)
A Market Maker Has Received Approval to Quote Our Stock for Trading on the
Over-the-Counter Electronic Bulletin, but We Have Only One Market Maker and
There Is No Assurance Volume Trading Will Develop. Therefore You may be Unable
to Sell Your Shares. Even if We Qualify to Have Our Stock Quoted for Trading,
Trading Volume May Not Develop and You May be Unable to Sell Your
Shares.**







51







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




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




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




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




**(47)
If Securities Analysts Do Not Publish Research or Reports About Our Business or
If They Downgrade Our Stock, the Price of Our Stock Could
Decline.**




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




**(48)
Our Quarterly Revenues and Operating Results may Fluctuate in Future Periods and
We may Fail to Meet Expectations of Investors and Public Market Analysts, Which
Could Cause the Price of Our Common Stock to Decline.**




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




·
    the
      evolving demand for our services and
software;




·
    spending
      decisions by our customers and prospective
customers;




·
    our
      ability to manage expenses;




·
    the
      timing of new product releases;




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




·
    the
      timing of execution of large contracts;







52









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




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




·
    costs
      of developing new products and enhancements;
and




·
    global
      economic and political conditions.




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




**(49)
Our Stock Price is Likely to be Highly Volatile and May Decline.**




If it
becomes publicly traded, the trading price of our common stock is expected to
fluctuate widely as a result of a number of factors, many of which are outside
our control, such as:




·
    variations
      in our actual and anticipated operating
results;




·
    changes
      in our earnings estimates by analysts;




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




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




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




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




**(50)
Shares Eligible for Public Sale After this Offering Could Adversely Affect Our
Stock Price.**




At March
15, 2005, 12,181,832 shares of our common stock were issued and outstanding
and 2,015,010 shares may be issued pursuant to the exercise of warrants and
options that are exercisable within 60 days of March 15, 2005. Of these shares,
the 1,925,265 shares registered in this offering will be freely tradable, except
for any shares purchased by our “affiliates” as defined in Rule 144 under the
Securities Act. The remaining shares will be “restricted securities,” subject to
the volume limitations and other conditions of Rule 144 under the Securities
Act.




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




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




**(51)
Our Securities May Be Subject to "Penny Stock" Rules, Which Could Adversely
Affect Our Stock Price and Make It More Difficult for You to Resell Our
Stock.**




The
Securities Exchange Commission has adopted rules that regulate broker-dealer
practices in connection with transactions in penny stocks. Penny stocks are
generally equity securities with a price of less than $5.00 (other than
securities registered on certain national securities exchanges or quoted on
NASDAQ, provided that reports with







53







respect
to transactions in such securities are provided by the exchange or quotation
system pursuant to an effective transaction reporting plan approved by the
Commission.)




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




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




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




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




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




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




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




·
    by
      rule or regulation;




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




·
    with
      bid and offer quotations for the penny
stock;




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




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




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




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




**Special
Note Regarding Forward-Looking Statements**




This
document contains forward-looking statements 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 “Item 1. Business” and “Item 7. Management’s
Discussion And Analysis Of Financial Condition And Results Of Operations.” These
forward-looking statements involve many risks and uncertainties. Examples of
such risks and uncertainties are described under “Risk Factors” and elsewhere in
this report, as well as in other filings we may make from time to time with the
United States Securities and Exchange Commission. You should be aware that the
occurrence of any of these risks and uncertainties may cause our actual results
to differ materially from those anticipated in our forward-looking statements,
which could have a material adverse effect on our business, results of
operations, and financial condition. All forward-looking statements included in
this report are based on information available to us as of the date of this
report. We assume no obligation or duty to update any such forward-looking
statements.




**Item
7A. Quantitative and Qualitative Disclosures about Market
Risk**




***Foreign
currency exchange risk***




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







54







***Interest
rate sensitivity***




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




**Item
8. Financial Data and Supplementary Data.**











55







**SMART
ONLINE, INC.**


**FINANCIAL
STATEMENTS**


**TABLE
OF CONTENTS**





**PAGE**Report
      of Independent Registered Public Accounting Firm
    57Financial
      Statements:Balance
      Sheetsas
      of December 31, 2004 and 2003
    58Statements
      of Operationsfor the years ended December 31, 2004, 2003, and
      2002
    60Statements
      of Cash Flowsfor the years ended December 31, 2004, 2003,
      and 2002
    62Statements
      of Stockholders’ Deficitfor the years ended December 31, 2004, 2003,
      and 2002
    64Notesto
      Financial Statements
    66














56







**Report** **of Independent Registered Public Accounting Firm**






Board
of Directors and Stockholders
Smart
Online, Inc.
Durham,
North Carolina

We
have audited the accompanying balance sheets of Smart Online, Inc. as of
December 31, 2004 and 2003 and the related statements of operations,
stockholders’ deficit, and cash flows for each of the three years in the period
ended December 31, 2004. These financial statements are the responsibility of
the Company’s management. Our responsibility is to express an opinion on these
financial statements based on our audits.

We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. 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 testbasis,
evidence supporting the amounts and disclosures in the 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.

In
our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Smart Online, Inc. at December 31,
2004 and 2003, and the results of its operations and its cash flows for each of
the three years in the period ended December 31, 2004, in conformity with
accounting principles generally accepted in the United States of
America.

The
accompanying 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 at
December 31, 2004 had deficiencies in working capital and equity that raise
substantial doubt about its ability to continue as a going concern. Management’s
plans in regard to these matters are also described in Note 1. The financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.

/s/ BDO Seidman, LLP

High
Point, North Carolina
February
28, 2005









57








**SMART
ONLINE, INC.**


**BALANCE** **SHEETS**


****


**Assets**
      ****
    ****
    ****
    **DECEMBER
      31,**
      **2004**
    ****
    ****
    **DECEMBER
      31**,
      **2003**CURRENT
      ASSETS:Cash
      and cash equivalents
    
    $
    173,339
    
    $
    101,486Marketable securities
    
    
    395,000
    
    
    -Accounts
      receivable, net
    
    
    30,904
    
    
    82,576Receivable
      from related party
    
    
    -
    
    
    38,682Other
      accounts receivable
    
    
    43,455
    
    
    -Prepaid
      expenses
    
    
    24,850
    
    
    -Total
      current assets
    
    
    667,548
    
    
    222,744PROPERTY
      AND EQUIPMENT, net
    
    
    75,636
    
    
    48,947INTANGIBLE
      ASSETS, net
    
    
    16,623
    
    
    20,987OTHER
      ASSETS
    
    
    13,894
    
    
    13,394TOTAL
      ASSETS
    
    $
    773,701
    
    $
    306,072CURRENT
      LIABILITIES:Accounts
      payable
    
    $
    186,382
    
    $
    507,656Accrued
      payroll
    
    
    110,079
    
    
    63,133Notes
      payable to affiliates
    
    
    -
    
    
    350,000Accrued
      payroll taxes, penalties and interest
    
    
    574,827
    
    
    1,622,812Accrued
      interest payable
    
    
    -
    
    
    40,082Loan
      from stockholder
    
    
    -
    
    
    86,480Deferred
      revenue
    
    
    721,689
    
    
    947,640Accrued
      rent payable
    
    
    -
    
    
    -Total current liabilities
    
    
    1,592,977
    
    
    3,617,803LONG-TERM
      LIABILITIES:Legal
      settlement obligation
    
    
    -
    
    
    181,563Deferred
      compensation, notes payable and interest
    
    
    1,091,814
    
    
    1,011,648Total
      long-term liabilities
    
    
    1,091,814
    
    
    1,193,211Total
      liabilities
    
    
    2,684,791
    
    
    4,811,014COMMITMENTS
      AND CONTINGENCIESRedeemable
      Convertible Preferred stock - Series A, $.001 par value, 5,000,000 shares
      authorized, sharesissued and outstanding 2004 — 0 and 2003 — 1,361,614
    
    
    -
    
    
    17,509,214STOCKHOLDERS'
      DEFICIT:Common
      stock, $.001 par value, 45,000,000 shares authorized, shares issued and
      outstanding:
      2004 —
      11,631,832 and,  2003 — 7,261,964
    
    
    11,632
    
    
    7,262Additional
      paid-in capital
    
    
    34,809,832
    
    
    8,607,712Accumulated
      deficit
    
    
    (36,732,554
    )
    
    (30,629,130
    )Total
      stockholders' deficit
    
    
    (1,911,090
    )
    
    (22,014,156
    )TOTAL
      LIABILITIES AND STOCKHOLDERS' DEFICIT
    
    $
    773,701
    
    $
    306,072







See notes
to financial statements.







58





**SMART
ONLINE, INC.**


**STATEMENTS
OF OPERATIONS**


**Year
      Ended**
      **DECEMBER
      31,**
      **2004**
    
    **Year
      Ended**
      **DECEMBER
      31,**
      **2003**
    
    **Year
      Ended**
      **DECEMBER
      31,**
      **2002**REVENUES:Integration fees
    
    $
    374,055
    
    $
    367,617
    
    $
    740,561Syndication fees
    
    
    176,471
    
    
    115,544
    
    
    202,368OEM revenue
    
    
    55,936
    
    
    48,620
    
    
    43,608Web services
    
    
    62,365
    
    
    207,570
    
    
    241,420Other revenues
    
    
    4,093
    
    
    8,815
    
    
    23,539Related party revenues
    
    
    330,050
    
    
    513,057
    
    
    140,149Total revenues
    
    
    1,002,970
    
    
    1,261,223
    
    
    1,391,645COST
      OF REVENUES
    
    
    211,616
    
    
    187,064
    
    
    267,058GROSS
      PROFIT
    
    
    791,354
    
    
    1,074,159
    
    
    1,124,587OPERATING
      EXPENSES:General
      and administrative
    
    
    2,432,928
    
    
    1,941,920
    
    
    1,392,658Sales and marketing
    
    
    596,989
    
    
    321,049
    
    
    300,653Development
    
    
    563,372
    
    
    676,472
    
    
    431,041Total operating expenses
    
    
    3,593,289
    
    
    2,939,441
    
    
    2,124,352LOSS
      FROM OPERATIONS
    
    
    (2,801,935
    )
    
    (1,865,282
    )
    
    (999,765
    )OTHER
      INCOME (EXPENSE):Interest expense
    
    
    (119,389
    )
    
    (186,248
    )
    
    (89,912
    )Gain on debt forgiveness
    
    
    249,395
    
    
    492,757
    
    
    338,866Loss on disposal of asset
    
    
    -
    
    
    -
    
    
    (54,595
    )Total
      other income (expense)
    
    
    130,006
    
    
    306,509
    
    
    194,359NET
      LOSS
    
    
    (2,671,929
    )
    
    (1,558,773
    )
    
    (805,406
    )Preferred
      stock dividends and
      accretion of discount on
      preferred stock
    
    
    (2,215,625
    )
    
    (2,321,744
    )
    
    (961,200
    )Deemed
      dividends related to
      beneficial
      conversion features
      of
      redeemable convertible
      preferred stock
    
    
    -
    
    
    (495,319
    )
    
    -Accretive
      dividend issued
      in
      connection with registration
      rights agreement
    
    
    (206,085
    )
    
    -
    
    
    -Converted
      preferred
      stock inducement cost
    
    
    (3,225,410
    )
    
    -
    
    
    -Net
      loss attributed to
      common stockholders
    
    $
    (8,319,049
    )
    $
    (4,375,836
    )
    $
    (1,766,606
    )NET
      LOSS PER SHARE:Net
      loss attributed to
      common stockholders
      -
      Basic
      and Diluted
    
    $
    (0.82
    )
    $
    (0.60
    )
    $
    (0.25
    )SHARES
      USED IN COMPUTING NET LOSS PER SHARE:Basic
      and Diluted
    
    
    10,197,334
    
    
    7,254,978
    
    
    7,181,759




See notes
to financial statements.














59





**SMART
ONLINE, INC.**


**STATEMENTS
OF CASH FLOWS**


**Year
      Ended**
      **DECEMBER 31,**
      **2004**
    ****
    **Year
      Ended**
      **DECEMBER 31,**
      **2003**
    ****
    **Year
      Ended**
      **DECEMBER 31,**
      **2002**CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
    
    $
    (2,671,929
    )
    $
    (1,558,773
    )
    $
    (805,406
    )Adjustments to reconcile net loss to netcash provided by (used in) operatingactivities:Depreciation
    
    
    51,531
    
    
    59,852
    
    
    242,877Loss on disposal of property and equipment
    
    
    8,855
    
    
    -
    
    
    54,595Common shares or options issued in lieu of
      compensation
    
    
    168,530
    
    
    1,010,109
    
    
    50,159Common shares issued for extension of loan
    
    
    75,000
    
    
    75,000
    
    
    -Common shares issued in exchange for warrants
    
    
    350,000
    
    
    -
    
    
    -Gain on return of common shares
    
    
    -
    
    
    -
    
    
    (105,000
    )Changes in assets and liabilities:Accounts receivable
    
    
    51,672
    
    
    24
    
    
    275,876Related party receivable
    
    
    38,682
    
    
    (38,682
    )
    
    -Other accounts receivable
    
    
    (43,455
    )
    
    -
    
    
    -Prepaid expenses
    
    
    (24,850
    )
    
    -
    
    
    -Other assets
    
    
    (500
    )
    
    1,447
    
    
    (9,265
    )Legal settlement obligation
    
    
    (181,563
    )
    
    (100,937
    )
    
    -Deferred revenue
    
    
    (225,951
    )
    
    (267,326
    )
    
    589,492Cash overdraft
    
    
    -
    
    
    -
    
    
    (152,405
    )Accounts payable
    
    
    (321,274
    )
    
    (513,533
    )
    
    (989,277
    )Accrued payroll
    
    
    46,946
    
    
    (27,155
    )
    
    14,627Accrued payroll taxes payable
    
    
    (961,196
    )
    
    289,103
    
    
    477,567Accrued interest payable
    
    
    (126,871
    )
    
    97,201
    
    
    70,442Accrued rent payable
    
    
    -
    
    
    (50,000
    )
    
    (73,759
    )Deferred compensation payable
    
    
    80,166
    
    
    335,223
    
    
    360,375Net
      cash (used in) provided by operatingActivities
    
    
    (3,686,207
    )
    
    (688,447
    )
    
    898CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
    
    
    (82,710
    )
    
    (1,588
    )
    
    (66,755
    )Purchase
      of marketable securities
    
    
    (395,000
    )
    
    -
    
    
    -Net
      cash used in investing activities
    
    
    (477,710
    )
    
    (1,588
    )
    
    (66,755
    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Borrowings
      on notes payable
    
    
    -
    
    
    190,000
    
    
    270,000Repayments
      on notes payable
    
    
    (350,000
    )
    
    (10,000
    )
    
    (225,000
    )(Repayments)
      borrowings from stockholder
    
    
    (86,480
    )
    
    39,686
    
    
    27,653Issuance
      of common stock
    
    
    4,672,250
    
    
    544,895
    
    
    20,144Net
      cash provided by financing activities
    
    
    4,235,770
    
    
    764,581
    
    
    92,797NET
      INCREASE IN CASH
      AND CASH EQUIVALENTS
    
    
    71,853
    
    
    74,546
    
    
    26,940CASH
      AND CASH EQUIVALENTS,
      BEGINNING OF PERIOD
    
    
    101,486
    
    
    26,940
    
    
    -CASH
      AND CASH EQUIVALENTS,
      END OF PERIOD
    
    $
    173,339
    
    $
    101,486
    
    $
    26,940Supplemental
      disclosures:Cash payment during the year for interest:
    
    $
    47,447
    
    $
    89,047
    
    $
    19,469Non-cash
      financing activities:Non-cash accretion of preferredstock redemption value
    
    $
    2,215,625
    
    $
    2,321,744
    
    $
    961,200Conversion of preferred stockinto common stock
    
    $
    19,724,839
    
    $
    -
    
    $
    -Conversion of preferred stockinducement cost
    
    $
    3,225,410
    
    $
    -
    
    $
    -




See notes
to financial statements.










60





**SMART
ONLINE, INC.**


**STATEMENTS
OF STOCKHOLDERS’ DEFICIT**


**FOR
THE YEARS ENDED**


**DECEMBER
31, 2004, 2003 AND  2002**


**Common**
      **Stock**
      **$.001
      Par**
    ****
    **Additional**
      **Paid-**
      **In
      Capital**
    ****
    **Accumulated**
      **Deficit**
    ****
    **Total**BALANCE,
      JANUARY 1, 2002
    
    $
    7,287
    
    $
    10,295,323
    
    $
    (27,769,632
    )
    $
    (17,467,022
    )Issuance
      of restricted stock
    
    
    100
    
    
    70,205
    
    
    -
    
    
    70,305Recission of shares in connection withlegal
      settlement
    
    
    (350
    )
    
    (104,650
    )
    
    -
    
    
    (105,000
    )Accretion
      of redeemable preferred
    
    
    -
    
    
    (961,200
    )
    
    -
    
    
    (961,200
    )Net
      loss
    
    
    -
    
    
    -
    
    
    (805,406
    )
    
    (805,406
    )BALANCE,
      DECEMBER 31, 2002
    
    
    7,037
    
    
    9,299,678
    
    
    (28,575,038
    )
    
    (19,268,323
    )Issuance
      of restricted stock
    
    
    75
    
    
    49,500
    
    
    -
    
    
    49,575Interest expense associated with notesPayable
    
    
    150
    
    
    74,850
    
    
    -
    
    
    75,000Accretion
      of redeemable preferred
    
    
    -
    
    
    (2,321,744
    )
    
    -
    
    
    (2,321,744
    )Issuance
      of stock option to consultant
    
    
    -
    
    
    9,109
    
    
    -
    
    
    9,109Issuance
      of warrant to financial advisor
    
    
    -
    
    
    466,000
    
    
    -
    
    
    466,000Issuance
      of stock options to officers
    
    
    -
    
    
    535,000
    
    
    -
    
    
    535,000Deemed
      dividend related to beneficial conversion features of
      redeemable
      convertible preferred stock
    
    
    -
    
    
    495,319
    
    
    (495,319
    )
    
    -Net
      loss
    
    
    -
    
    
    -
    
    
    (1,558,773
    )
    
    (1,558,773
    )BALANCE,
      DECEMBER 31, 2003
    
    
    7,262
    
    
    8,607,712
    
    
    (30,629,130
    )
    
    (22,014,156
    )Conversion
      of preferred stock intocommon
      stock
    
    
    2,949
    
    
    19,721,890
    
    
    -
    
    
    19,724,839Conversion
      of preferred stockinducement
      cost
    
    
    -
    
    
    3,225,410
    
    
    (3,225,410
    )
    
    -Interest
      expense associated with notespayable
    
    
    -
    
    
    75,000
    
    
    -
    
    
    75,000Accretion of redeemable preferred
    
    
    -
    
    
    (2,215,625
    )
    
    -
    
    
    (2,215,625
    )Issuance of common stock, net of issuance costs of $183,350
    
    
    1,289
    
    
    4,762,355
    
    
    -
    
    
    4,763,644Issuance of common stock rescinded
    
    
    (29
    )
    
    (99,973
    )
    
    -
    
    
    (100,002
    )Issuance
      of stock options to officers
    
    
    -
    
    
    161,000
    
    
    -
    
    
    161,000Issuance of stock options to members of advisory board
    
    
    -
    
    
    6,034
    
    
    -
    
    
    6,034Issuance of common stock to former holders of preferred stock
      pursuant
      to
      registration rights agreement
    
    
    58
    
    
    206,027
    
    
    (206,085
    )
    
    -Conversion of Bank One warrant into common stock
    
    
    100
    
    
    349,900
    
    
    -
    
    
    350,000Issuance
      of stock option to consultant
    
    
    -
    
    
    1,495
    
    
    -
    
    
    1,495Exercise of warrants
    
    
    3
    
    
    8,607
    
    
    -
    
    
    8,610Net
      loss
    
    
    
    
    
    
    
    
    (2,671,929
    )
    
    (2,671,929
    )BALANCE,
      DECEMBER 31, 2004
    
    $
    11,632
    
    $
    34,809,832
    
    $
    (36,732,554
    )
    $
    (1,911,090
    )







See notes
to financial statements.









61








**SMART
ONLINE, INC.**




**CONSOLIDATED** **NOTES** **TO FINANCIAL STATEMENTS FOR THE YEARS ENDED**


**DECEMBER
31, 2004, 2003 AND 2002.**




**1.** **NATURE
OF BUSINESS AND GOING CONCERN**




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




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, 2004, 2003
and 2002, Smart Online incurred net losses as well as negative cash flows and,
at December 31, 2004, has deficiencies in working capital and equity. These
factors indicate that Smart Online 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 Smart Online be
unable to continue as a going concern. Smart Online's continuation as a going
concern is dependent upon its ability to generate sufficient cash flows to meets
its obligations on a timely basis, to obtain additional financing as may be
required and ultimately to attain profitable operations and positive cash flows.
Smart Online's future plans include the development introduction and maintenance
of Smart Online's next generation product, OneBiz Conductor, and the
introduction of additional new products and enhancing its webnative business
applications.  Additionally, Smart Online is in discussions with several
potential integration, syndications, and technology platform licensing partners
that, if successful, could result in positive cash flow from operations.
However, there can be no assurance that these efforts will be
successful.




Smart
Online continues to incur development expenses to enhance and expand its product
by focusing on establishing its Internet-delivered Software-as-Services (SaS)
software applications and data resources. All allocable expenses to establish
the technical feasibility of the software have been recorded as research
expense. The ability of Smart Online to successfully develop and market its next
generation of products is dependent upon certain factors, including the success
of Smart Online’s existing services and products, the timing and success of any
new services and products, the progress of research and development efforts,
results of operations, the status of competitive services and products, and the
timing and success of potential strategic alliances or potential opportunities
to acquire technologies or assets may require Smart Online to seek additional
funding sooner than expected. There can be no assurance that sufficient
additional capital needed to sustain operations will be obtained by Smart Online
or that the Company’s operations will become profitable.





**2.            
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**




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




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







62







multiple
deliverables including the grant of a non-exclusive license to distribute, use
and access the Smart Online platform, fees for the integration of content into
the Smart Online platform, maintenance and hosting fees, documentation and
training, and technical support and customer support fees.  Smart Online
cannot establish fair value of the individual revenue deliverables based on
objective and reliable evidence because the company does not have a long,
consistent history of standard syndication and integration contractual
arrangements, there have only been a few contracts that have continued past the
initial contractual term, the company does not have any contracts in which these
elements have been sold as stand-alone items, and there is no third-party
evidence of fair value for products or services that are interchangeable and
comparable to Smart Online’s products and services.  As such, Smart Online
can not allocate revenue to the individual deliverables and must record all
revenues received as a single unit of accounting as further described
below.  Additionally, Smart Online has evaluated the timing and substantive
nature of the performance obligations associated with the multiple deliverables
noted above, including the determination that the remaining obligations are
essential to the on-going  usability and functionality of the delivered
products, and determined that revenue should be recognized over the life of the
contracts due to such factors as the length of time over which the remaining
obligations will be performed, the complex nature of integrating and maintaining
customer content with Smart Online’s platform which services are unavailable
from other vendors, and the timing of payment of a portion of the contract price
such as monthly hosting payments.




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




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







63





amortized
will be adjusted.  Any such change in specified contract lives will affect
our future results of operations. Additionally, integration agreements typically
include an upfront fee and a revenue sharing component.  Fees derived from
such revenue sharing arrangements are recorded when earned.  To date such
revenue sharing fees have been negligible.




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




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




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




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




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




Consulting
revenues which are immaterial and only relate to 2003, are recognized over the
term of the consulting engagement as services are performed, typically one to
three months. Advance payments for consulting services, if billed and paid prior
to completion to the project, are recorded as deferred revenue when
received.  If the fees are not fixed or determinable, revenue is recognized
as payments are received from the customer.




*Barter
Transactions*  - Barter
revenue relates to syndication and integration services provided by Smart Online
to business customers in exchange for advertising in the customers’ trade
magazines and on their Web sites. Barter expenses reflect the expense offset to
barter revenue. The amount of barter revenue and expense is recorded at the
estimated fair value of the services received or the services provided,
whichever is more objectively determinable, in the month the services and
advertising are exchanged. Smart Online applies APB 29, Accounting for
Non-Monetary Transactions, the provisions of EITF 93-11, “Accounting for Barter
Transactions Involving Barter Credits” and EITF 99-13 “Accounting for
Advertising Barter Transactions” and, accordingly, recognizes barter revenues
only to the extent that Smart Online has similar cash transactions within a
period not to exceed six months prior to the date of the barter
transaction.    To date the amount of barter revenue to be
recognized has been more objectively







64





determinable
based on integration and syndication services provided.   For revenue
from integration and syndication services provided for cash to be considered
similar to the integration and syndication services provided in barter
transactions, the services rendered must have been in the same media and similar
term as the barter transaction.  Further,
the quantity or volume of integration or syndication revenue received in a
qualifying past cash transaction can only evidence the fair value of an
equivalent quantity or volume of integration or syndication revenue received in
subsequent barter transactions.  In other words, a past cash transaction
can only support the recognition of revenue on integration and syndication
contracts transactions up to the dollar amount of the cash transactions. 
When the cash transaction has been used to support an equivalent quantity and
dollar amount of barter revenue, that transaction cannot serve as evidence of
fair value for any other barter transaction.  Once the value of the barter
revenue has been determined, Smart Online follows the same revenue recognition
principals as it applies to cash transactions with unearned revenues being
deferred as described more fully above . 
At the time the barter revenue is recorded, an offsetting pre-paid barter
advertising asset is recorded on Smart Online’s balance sheet.  This
pre-paid barter advertising asset is amortized to expense as advertising
services are received such as when an advertisement runs in a magazine. 
Where more than one deliverable exists, such as when the barter partner is to
provide advertising in four issues of a magazine, the expense is recognized
pro-rata as the advertising deliverable is provided.  Barter revenues
totaled approximately $113,000 in 2004. Smart Online did not have any barter
transactions for the years ended December 31, 2003 and 2002.




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




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




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




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




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




Office
      equipment
    5 yearsFurniture
      and fixtures
    7 years




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




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







65





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




*Advertising
Costs* - Smart
Online expenses all advertising costs as they are incurred. The amount charged
to expense for 2004, 2003, and 2002 was $170,774, $3,167 and $9,766,
respectively. The 2004 period included $205,833 of barter advertising expenses
and a credit of $58,400 related to prior advertising activities. Smart Online
did not have any barter transactions for the years ended December 31, 2003 and
2002.




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




*Stock-Based
Compensation* - Smart
Online accounts for its stock-based compensation plans in accordance with the
intrinsic value provisions of Accounting Principles Board Opinion (“APB”) No.
25, “Accounting for Stock Issued to Employees.” Stock Options are generally
granted at prices equal to the fair value of Smart Online’s common stock on the
grant dates (see Note 9). Accordingly, Smart Online did not record any
compensation expense in the accompanying financial statements for its
stock-based compensation plans. Had compensation expense been recognized
consistent with the fair value provisions of SFAS No. 123, “Accounting for
Stock-Based Compensation,” Smart Online’s net loss attributed to common
stockholders and net loss attributed to common stockholders per share for the
years ended December 31, 2004, 2003 and 2002 would have been changed to the pro
forma amounts indicated below:




**Year
      ended****December
      31,****2004**
    
    
    **Year
      ended**
      **December
      31,****2003**
    
    
    **Year
      ended****December
      31,****2002**Net
      loss attributed tocommon stockholders:As
      reported
    
    $
    (8,319,049)
    
    $
    (4,375,836)
    
    $
    (1,766,606)Add:
      Compensation costrecorded
      at intrinsicvalue
    
    
    161,000
    
    
    535,000
    
    
    —Less:
      Compensation cost usingthe fair value method
    
    
    (455,301)
    
    
    (961,234)
    
    
    (2,142)Pro
      forma
    
    $
    (8,613,350)
    
    $
    (4,802,010)
    
    $
    (1,768,748)












66












**Year
      ended**
      **December
      31,**
      **2004**
    
    **Year
      ended**
      **December
      31,**
      **2003**
    
    **Year
      ended**
      **December
      31,**
      **2002**Reported
      net loss attributed tocommon stockholders:Basic
      and diluted
    
    $
    (0.82
    )
    $
    (0.60
    )
    $
    (0.25
    )Pro
      forma net loss per share:Basic
      and diluted
    
    $
    (0.84
    )
    $
    (0.66
    )
    $
    (0.25
    )





The fair
value of option grants under Smart Online’s plan and other stock option issuance
during the years ended December 31, 2004, 2003 and 2002 was estimated using the
Black-Scholes option-pricing model with the following weighted-average
assumptions were used:




**Year****Ended**
      **December
      31,**
      **2004**
    
    **Year****Ended**
      **December
      31,**
      **2003**
    ****
    ****
    **Year****Ended**
      **December
      31,**
      **2002**Dividend
      yield
    
    0.
      00
    %
    
    
    0.
      00
    %
    
    
    
    0.00
    %Expected
      volatility
    
    0.00
    %
    
    
    0.00
    %
    
    
    
    0.00
    %Risk
      free interest rate
    
    4.23
    %
    
    
    4.01
    %
    
    
    
    4.61
    %Expected
      lives (years)
    
    8.9
    
    
    
    5.0
    
    
    
    
    5.0




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




As noted
above we recognize revenues from syndication, integration and web business
services each month over the specified lives of the contracts, typically the
contract term. Should the contract terminate earlier than specified, then we
recognize the remaining deferred revenue upon termination. During 2004, 2003,
2002, Smart Online recognized revenues from early termination of contracts in
the amount of $3,158, $76,389, $133,979, respectively.







67










*Reclassifications* -
Certain 2003 and 2002 balances have been reclassified to conform with their 2004
presentation. These reclassifications did not result in a change to total
assets, total liabilities, equity or net loss as previously
reported.




*New
Accounting Standards* — In
January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable
Interest Entities”. This interpretation establishes new guidelines for
consolidating entities in which a parent company may not have majority voting
control, but bears residual economic risks or is entitled to receive a majority
of the entity’s residual returns, or both. As a result, certain subsidiaries
that were previously not consolidated under the provisions of Accounting
Research Bulletin No. 51 may now require consolidation with the parent company.
This interpretation applies in the first year or interim period beginning after
June 15, 2003, to variable interest entities in which an enterprise holds a
variable interest that it acquired before February 1, 2003. Management reviewed
this interpretation and determined that it did not have any variable interest
entities.




In May
2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity” (SFAS 150).
SFAS 150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). Many of those instruments
were previously classified as equity. SFAS 150 is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003.Provisions of this statement did not have a material effect on our
business, results of operations, financial position, or liquidity.





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




**3.            
RECEIVABLES**




Smart
Online evaluates the need an allowance for doubtful accounts based on
specifically identified amounts that management believes to be uncollectible.
Management also records an additional allowance based on certain percentages of
its receivables over 90 days old, which are determined based on historical
experience and management’s assessment of the general financial conditions
affecting its customer base. If actual collections experience changes, revisions
to the allowance may be required. Based upon the aforementioned criteria,
management has determined that no provision for uncollectible accounts is
required as of December 31, 2004 or 2003.







68





**4.            
MARKETABLE SECURITIES**





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





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







**5.            
PROPERTY AND EQUIPMENT**




Property
and equipment consists of the following at:




**December
      31,**
      **2004**
    
    **December
      31,**
      **2003**Office
      equipment
    
    $
    16,187
    
    $
    10,026Furniture
      and fixtures
    
    
    7,125
    
    
    7,125Computer
      software
    
    
    393,629
    
    
    391,063Computer
      equipment
    
    
    663,723
    
    
    682,999Automobiles
    
    
    29,504
    
    
    —1,110,168
    
    
    1,091,213Less
      accumulated depreciation
    
    
    (1,034,532
    )
    
    (1,042,266
    )Property
      and equipment, net
    
    $
    75,636
    
    $
    48,947




Depreciation
expense for the periods ended December 31, 2004, 2003, and 2002 was $47,167,
$59,852, and $242,877, respectively.




**6.            
DEFERRED COMPENSATION**




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







69










Deferred
compensation totaling $99,287, $353,816, and $368,792 is included in salaries
and wages expense for the years ended December 31, 2004, 2003 and 2002,
respectively. The following is a summary of deferred compensation and accrued
interest payable on the deferred compensation as of:





**December
      31,**
      **2004**
    
    **December
      31,**
      **2003**Deferred
      compensation
    
    $
    949,777
    
    $
    979,813Accrued
      interest payable on deferred compensation
    
    
    142,037
    
    
    31,835Total
      deferred compensation payable
    
    $
    1,091,814
    
    $
    1,011,648




See Note
15 - Subsequent Events for details regarding payment of deferred compensation
and accrued interest.




**7.            
LOANS**




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




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




See Note
12 - Related Party Transaction for additional loans from related parties.




**8.            
LEASES**




*Operating
Leases* - Smart
Online leases its facility under a renewable, operating lease agreement which
current term expires in October 2005. As of December 31, 2004, future annual
minimum operating lease payments are as follows:




Total
      - 2005
    
    $
    102,040




Rent
expense for the years ended December 31, 2004, 2003, and 2002 was $99,606,
$87,146, and $87,900 , respectively.




**9.            
STOCKHOLDERS' DEFICIT**




*Corporate
Reorganization*




During
the first quarter of 2004, Smart Online completed a corporate reorganization of
its capital stock, which eliminated the Series A Preferred Stock of Smart
Online. All holders of Series A Preferred Stock who participated in the
reorganization by signing Reorganization, Lock-up Proxy and Release agreements
dated January 1, 2004 (the "Reorganization Agreements") received 2.22 shares of
common stock (1.22 shares under the conversion rights of the Series A Preferred
and one share in exchange for contractual commitments) of Smart Online for each
share of Series A Preferred Stock they held prior to the reorganization and also
received the right to receive cash payments from Smart Online equal to a
percentage of the net proceeds Smart Online raises during calendar year 2004
from sales of equity securities and convertible debt securities in excess of $5
million of net proceeds. Smart Online received net proceeds of $4,712,063 from
the sale of equity and convertible debt securities during calendar year 2004
and, therefore, had no liability to the former holders of Series A Preferred
Stock.







70







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




*Common
Stock*




Smart
Online is authorized to issue 45,000,000 shares of common stock, $0.001 par
value per share (the "Common Stock"). As of December 31, 2004, Smart Online has
11,631,832 shares of Common Stock outstanding. Holders of Common Stock are
entitled to one vote for each share of Common Stock held by them.




During
2002, as partial settlement of a lawsuit, Smart Online received back 350,000
shares of its Common Stock that were previously issued during 1998 in
consideration for the purchase of a French company.  The fair value of the
returned common stock was determined to be approximately $105,000, which was
recorded as a reduction in stockholders' deficit and as income in the year ended
December 31, 2002.




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




On August
6, 2004, Smart Online made a rescission offer to shareholders who purchased
999,141 shares of common stock of Smart Online and warrants to acquire an
additional 288,638 shares of common stock for $3.50 per share in a private
placement conducted during March through June of 2004, in which Smart Online
raised a total of $3,496,994. The rescission offer was made because in
connection with the audit of its financial statements and due diligence review
of information in connection with the registration of shares sold in the private
placement described above, Smart Online identified certain inaccuracies and
omissions in the information it provided to investors in the private placement.
These inaccuracies and omissions included changes to how Smart Online recognized
revenue, establishing reserves for contingent liabilities, inventory, accounts
receivable, and equipment write downs and other accounting adjustments, failing
to disclose the effects of anti-dilution provisions after dilutive issuances and
failure to disclose information about customers, discounting, promotions and
other product price information.  Upon identifying such inaccuracies and
omissions, Smart Online made the rescission offer and disclosed the inaccuracies
and omissions to all investors who purchased shares in the private placement. In
the rescission offer, Smart Online offered to repurchase all the shares and
warrants sold in the private placement for the original purchase price, plus
interest, and afforded shareholders a thirty-day period in which to accept the
rescission offer. One shareholder accepted the rescission offer and Smart Online
paid that shareholder $102,610 as payment in full of the purchase price,
including interest thereon of $2,608 in exchange for 28,572 shares of common
stock and warrants to purchase 7,500 shares of common stock. No other
shareholders accepted the rescission offer and all shareholders to whom the
offer was made executed and delivered releases for any potential liabilities
arising out of disclosures made by Smart Online in the private
placement.




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







71










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




*Preferred
Stock*




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




In
November 2003, Smart Online sold 495,320 shares of Series A Redeemable Preferred
Stock to an existing holder of Smart Online's common stock for a purchase price
of $1.00 per share. An officer of Smart Online is a minority shareholder in the
entity that purchased these shares. Since the Series A Redeemable Preferred
Stock is redeemable at the discretion of the holder, the preferred stock is
characterized as mezzanine capital and the accretive value and accrued dividends
are amortized through the date of redemption noted below.




The
Series A Redeemable Preferred Stock contained a conversion feature which allowed
the holders of the preferred stock to receive 1 share of common stock for each
share of preferred stock held, which conversion ratio was adjusted pursuant to
antidilution provisions of the preferred stock to 1.22 shares of common stock
for each share of preferred stock held at the time of conversion in March
2004.  Holders of preferred stock who signed reorganization agreements also
received one additional share of common stock held for each share of preferred
stock held in March 2004.  In accordance with EITF 98-5, "Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios" the value of such beneficial conversion feature of
approximately $495,000 has been recognized as a deemed dividend in the year
ended December 31, 2003.




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




In
connection with the conversion of the preferred stock the Company offered an
inducement of one (1) share of common stock in exchange for contractual
commitments in addition to the contractual conversion noted in the preceding
paragraph.  In accordance with FAS No. 84, "Induced Conversions of
Convertible Debt", the Company recorded the $3.2 million premium as a charge to
arrive at net loss available to common stockholders.




*Restricted
Stock*




During
2001 Smart Online issued 1,498,500 shares of restricted stock to employees of
Smart Online for no cash consideration, pursuant to agreements which provided
for the cancellation of these shares if certain liquidity events did not occur
by certain dates. In April 2002 Smart Online agreed to release the restriction
on the stock for consideration of $0.02 per share, or a total of $20,396. Smart
Online recorded salary expense of $50,158 in 2002 related to the 2001 issuance
and the 2002 release of the restrictions.







72







In April
2002 Smart Online issued 60,000 shares of restricted stock to an officer of
Smart Online at a purchase price of $0.02 per share.




In
January 2003, Smart Online issued 15,000 shares of restricted stock to an
individual who later became an officer of Smart Online for no cash
consideration. Smart Online recorded $7,500 of consulting expense in 2003
related to this grant of restricted stock. Subsequently, in May 2003, Smart
Online issued an additional 60,000 shares of restricted stock to a consulting
firm owned by this same individual for no cash consideration. Smart Online
recorded $42,000 of consulting expense in 2003 related to this grant of
restricted stock.




Smart
Online did not issue any restricted stock during 2004.




*Warrants*




In 2001,
Smart Online issued to Bank One, a warrant to purchase 619,309 shares of the
common stock of Smart Online for an exercise price of $18.00 per share in
connection with Smart Online and Bank One entering into a syndication partnering
agreement. The warrant contained a weighted average anti-dilution provision,
which caused the exercise price of the warrant at August 1, 2004 to decrease to
approximately $12.04 per share and the number of shares issuable upon exercise
of the warrant to increase to approximately 925,789 shares of common stock. To
simplify its capital structure, Smart Online offered to issue shares of its
common stock to Bank One in exchange for cancellation of the warrant. On
September 3, 2004, Bank One exchanged the warrant for 100,000 shares of common
stock of Smart Online, which were issued to J P Morgan Chase & Co., an
affiliate of Bank One.  The fair value of the shares issued was $350,000
which was recorded as an expense in the accompanying statements of operations.




In
November 2003, Smart Online granted a warrant to purchase 350,000 shares of
Common Stock to a financial consulting firm as partial consideration for
consulting services. This warrant has an exercise price of $1.30 per share, is
subject to anti-dilution adjustment, and expires in 2006.  Smart Online
recorded $466,000 of consulting expense during 2003 related to the issuance of
the warrants.




During
the first half of 2004, Smart Online issued warrants to purchase an aggregate of
288,638 shares of Common Stock to shareholders in connection with the 2004
Common Stock issuance described above. These warrants have an exercise price of
$3.50 per share and expire in 2014. During November 2004, holders of warrants to
purchase 2,460 shares of Common Stock at $3.50 per share were exercised
resulting in proceeds of $8,610.




All the
foregoing warrants contain cashless exercise provisions.




*Stock
Option Plans*




*2004
Equity Compensation Plan*




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




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




On July
1, 2004, Smart Online granted options to purchase 75,000 shares of Common Stock,
including 75,000 options to officers of Smart Online, under the 2004 Equity
Compensation Plan to an officer of Smart Online. These options had an exercise
price of $3.50 per share and a term of ten years.  The fair value of the
options, issued to the consultant, at the grant date was not significant. 
See Note 15 Subsequent Events.




During
the third quarter of 2004, Smart Online granted options to purchase 80,000
shares of Common Stock under the 2004 Equity Compensation Plan to members of
Smart Online’s advisory committee. These options had an exercise price of $3.50
per share, a term of five years, and vest 12.5% per meeting each consultant
attends.  Smart Online recorded consulting expense of $6,034 during 2004
related to these options.




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







73










At
December 31, 2004, options to purchase 520,000 shares of common stock were
outstanding under the 2004 Plan with a weighted-average exercise price of $3.52
per share.




*2001
Equity Compensation Plan*




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




During
2003 Smart Online granted options to purchase 700,000 shares of Common Stock to
employees and officers of Smart Online at exercise prices ranging from $1.30 to
$1.43 per share. Smart Online recorded compensation expense of $535,000 in 2003
related to this issuance.  Additionally, during 2003 Smart Online issued
options to purchase 20,000 shares of Common Stock of Smart Online to a
consultant at an exercise price of $1.30 per share. Smart Online recorded
consulting expense of $8,960 in 2003 related to this issuance.




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




At
December 31, 2004, options to purchase 870,000 shares of common stock were
outstanding under the 2001 Plan. Smart Online cannot make any further grants
under the 2001 plan.




*1998
Stock Option Plan*




Smart
Online adopted the 1998 Equity Compensation Plan (the "1998 Plan") as of
November 12, 1998. The 1998 plan provides for the grant of options intended to
qualify as "incentive stock options," and options that are not intended to so
qualify or "nonstatutory stock options." As of September 30, 2004, the total
number of shares of our common stock reserved for issuance under the 1998 plan
is 288,900 shares, subject to adjustment in the event of stock split, stock
dividend, recapitalization or similar change. Options to purchase 228,900 shares
were outstanding under the 1998 plan at December 31, 2004. Smart Online may not
make any further grants under the 1998 plan.




*Additional
Options Granted*




Additionally,
at September 30, 2004 options to purchase 150,000 shares of Common Stock
originally issued in 2000 were outstanding outside any of the aforementioned
stock option plans.




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







74







A summary
of the status of the plan and other stock option issuances as of December 31,
2002, 2003 and 2004 and changes during the periods ended on these dates is as
follows:




**Shares**
    
    
    **Weighted
      Average****Exercise**
      **Price**BALANCE,
      January 1, 2002
    
    
    1,168,100
    
    $
    4.80Forfeited
    
    
    (396,700
    )
    $
    5.00BALANCE,
      December 31, 2002
    
    
    771,400
    
    $
    4.69Granted
    
    
    720,000
    
    $
    1.39Forfeited
    
    
    (132,500
    )
    $
    2.27BALANCE,
      December 31, 2003
    
    
    1,358,900
    
    $
    3.18Granted
    
    
    755,000
    
    $
    3.07Forfeited
    
    
    (345,000
    )
    $
    4.12BALANCE,
      December 31, 2004
    
    
    1,768,900
    
    $
    2.78





The
following table summarizes information about stock options outstanding at
December 31, 2004:


**Currently
      Exercisable****Exercise**
      **Price**
    **Number
      of**
      **Shares**
      **Outstanding**
    **Average**
      **Remaining**
      **Contractual
      Life**
      **(Years)**
    **Weighted**
      **Average
      Exercise**
      **Price**
    **Number
      of**
      **Shares**
    **Weighted**
      **Average**
      **Exercise**
      **Price**$  1.30  
      -   $  1.43
    870,000
    4.0
    $ 
      1.37
    870,000
    $
      1.37$ 
      3.50
    514,000
    9.3
    $ 
      3.50
    112,750
    $ 
      3.50$ 
      5.00
    384,900
    0.7
    $ 
      5.00
    384,900
    $ 
      5.00$ 
      1.30   -   $  5.00
    1,768,900
    4.9
    $ 
      2.78
    1,367,650
    $ 
      2.57




The
number of options exercisable at December 31, 2003 and 2002 were 1,358,900 and
771,400, respectively.  The weighted average exercise price was $3.18 and
$4.69 at December 31, 2003 and 2002, respectively.





*Dividends* - Smart
Online has not paid any cash dividends through December 31, 2004.




**10.            
INCOME TAXES**




Smart
Online accounts for income taxes under the asset and liability method in
accordance with the requirements of Statement of Financial Accounting Standard
No. 109 ("FAS 109"). Under the asset and liability method, deferred income taxes
are recognized for the tax consequences of “temporary differences” by applying
enacted statutory tax rates applicable to future years to differences between
the financial statement carrying amounts and the tax bases of existing assets
and liabilities.







75







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




**December
      31,****2004**
    
    
    **December
      31,****2003**
    
    
    **December
      31,****2002**Net
      current deferred income tax
      assets
      relate to:Depreciation
    
    $
    3,000
    
    $
    18,000
    
    $
    41,000Stock
      Based Expenses
    
    
    226,000
    
    
    -
    
    
    -Accrued
      liabilities
    
    
    -
    
    
    390,000
    
    
    261,000Net
      operating loss carryforwards
    
    
    11,015,000
    
    
    9,909,000
    
    
    9,844,000Total
    
    
    11,244,000
    
    
    10,317,000
    
    
    10,146,000Less
      valuation allowance
    
    
    11,244,000
    
    
    10,317,000
    
    
    10,146,000Net
      current deferred income tax
    
    $
    -
    
    $
    -
    
    $
    -




Under
SFAS 109, a valuation allowance is provided when it is more likely than not that
the deferred tax asset will not be realized.




Total
income tax expense differs from expected income tax expense (computed by
applying the U.S. federal corporate income tax rate of 34% to profit (loss)
before taxes for the years ended December 31, 2004, 2003 and 2002) as follows:




**December
      31,**
      **2004**
    
    **December
      31,**
      **2003**
    
    **December
      31,**
      **2002**Statutory
      federal tax rate
    
    
    34
    %
    
    34
    %
    
    34
    %Tax
      benefit computed at statutory rate
    
    $
    (908,000
    )
    $
    (190,000
    )
    $
    (310,000
    )State
      income tax benefit, net of federal effect
    
    
    (121,000
    )
    
    (25,000
    )
    
    (41,000
    )Change
      in valuation allowance
    
    
    927,000
    
    
    171,000
    
    
    307,000Other
      adjustments
    
    
    77,000
    
    
    -
    
    
    -Other
      permanent differences
    
    
    25,000
    
    
    44,000
    
    
    44,000Total
    
    $
    -
    
    $
    -
    
    $
    -





As of,
December 31, 2004, Smart Online had US federal net operating loss (“NOL”)
carryforward of approximately $28.6 million, which expire between 2009 and
2019. For state tax purposes, the NOL’s expire between 2009 and 2019. In
accordance with Section 382 of the Internal Revenue Code of 1986, as amended, a
change in equity ownership of greater than 50% of Smart Online within a
three-year period can result in an annual limitation on Smart Online’s liability
to utilize its NOL carryforwards that were created during tax periods prior to
the change in ownership.




**11.          
MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK**




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




A
customer that is owned by a shareholder of Smart Online accounted for
approximately 32.9% and 27.2% of total revenues for the years ended December 31,
2004 and 2003, respectively. A second customer that is 50% owned by an officer
of Smart Online accounted for 11.9% of 2003 revenues.




Smart
Online had one customer that accounted for 100% of receivables at December 31,
2004 and three customers that represented 59.1%, 23.9% and 14.3% of total
receivables at December 31, 2003.







76





**12.          
RELATED PARTY TRANSACTIONS**




American
Investment Holding Group, Inc., which is wholly-owned by two officers of Smart
Online, owns approximately 24% of the outstanding Common Stock of Smart Online
as of December 31, 2004. The same officers also own a controlling interest in
other companies.




An
officer of Smart Online and a trust established by this officer for the benefit
of his children, have from time to time provided loans to Smart Online. As of
January 1, 2002, Smart Online owed these parties $40,731 related to outstanding
loans. During 2002, the Company borrowed an additional $77,980 from and repaid
$108,316 to these same parties leaving an outstanding liability to the officer
and the trust of $10,395 at December 31, 2002. During 2003, the Company borrowed
an additional $796,568 and repaid $759,165 to these same parties leaving an
outstanding liability to the officer and the trust of $47,798 at December 31,
2003. During the first six months of 2004, the Company borrowed an additional
$186,335 and repaid the entire remaining outstanding balance of $186,335. As of
September 30, 2004 all borrowings from and loans to the officer and the trust
were repaid in full. Until October 2003, the Company did not pay any interest on
these loans, thereafter the loans accrued interest at a rate of 15.0%.




During
2003 and 2004, Smart Online has contracted with a consulting firm owned by one
of its officers to provide strategic international sales and marketing services.
Smart Online paid consulting fees of $70,000 and $27,083 during 2004 and 2003,
respectively, related to these services. Additionally, as discussed in Note 9,
Smart Online paid the same consulting firm $31,000 related to the sale of
certain shares of Common Stock during the first half of 2004.   In
addition, during the third quarter of 2004, Smart Online paid this same
consultant an additional $31,000 in consulting fees for assisting the Company
with obtaining additional equity financing during the quarter.




During
2001 Smart Online utilized the services of Parson and Shearson, Inc., an entity
owned 50% by an officer of Smart Online and 50% by the officer’s brother, who is
also an employee of Smart Online, to provide marketing services for a fee of
$11,578. This fee was included in accounts receivable at December 31, 2001 and
was paid during 2002. During 2003 Smart Online provided consulting services
totaling $150,000 to this same related party. The consulting income is included
in the Statement of Operations under “Related Party Revenues”.




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




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




Smart
Online paid SIL $3,300 for moving expenses with regard to SIL’s
development team visiting Smart Online from Israel in January of 2003. Smart
Online also paid SIL $25,000 as a reseller payment for the Moneris
Integration contract they secured pursuant to their re-seller agreement in May
of 2003. Smart Online also paid SIL $90,000 pursuant to their contract dated
December 20, 2003 for technical co-development work on a monthly payment of
$15,000 starting in December of 2003 and ending in May of 2004.







77





In March
2004, SIL ceased further development of its technology and laid-off its
employees.  SIL is currently seeking opportunities to license or sell its
technology.  The Company continues to support this technology on behalf of
SIL with the current integration agreement running through the end of
2004.  The revenues derived from this agreement with SIL were recognized as
income on a straight line basis over the life of the agreement . Smart Online
recognized $330,051, $342,857, and $128,571 of revenue related to the
aforementioned integration, co-development and reseller agreements during 2004,
2003 and 2002, respectively.




Additionally,
during 2003 Smart Online provided $20,200 of consulting services to the
Small Business Lending Institute (SBLI), of which an officer of Smart
Online is also an officer and in which another officer of Smart Online is a
minority shareholder. At December 31, 2003, $20,200 was included in accounts
receivable and subsequently collected in 2004. Smart Online paid $63,133 in 2003
and $158,384 in 2004 to SBLI, because SBLI paid Smart Online’s
employees during the first quarter of 2004 while Smart Online was dealing with a
tax matter with the Internal Revenue Service.




As of
December 31, 2001, Smart Online owed an officer of Smart Online $40,731 related
to loans he had made to Smart Online. During 2002, Smart Online borrowed an
additional $77,980 from and repaid $108,316 to this same officer. During 2003,
Smart Online borrowed an additional $340,776 from and repaid $264,692 to this
officer. During the first nine months of 2004, Smart Online borrowed an
additional $4,793 from and repaid the entire remaining outstanding balance of
$91,273 to this officer. At December 31, 2003 and 2002 Smart Online owed $86,480
and $10,395, respectively, to this officer. Until October 2003, Smart Online did
not pay any interest on these loans, thereafter the loans accrued interest at a
rate of 15.0%. Additionally, during 2003 Smart Online lent a trust established
by this officer $494,473 of which $455,792 was repaid in the same year. During
the first six months of 2004, Smart Online lent the trust an additional $142,860
and the trust repaid the entire balance owed to Smart Online totaling $181,542.
As of December 31, 2004 all borrowings from and loans to the officer and the
trust were repaid in full. Smart Online recorded interest expense of $4,649 and
$2,007 during 2004 and 2003, respectively, related to these loans.




The
following is a summary of related party revenues for the years ended
December 31, 2004, 2003 and 2002.







**Year
      ended**
      **December
      31,**
      **2004**
    
    **Year
      ended**
      **December
      31,**
      **2003**
    
    **Year
      ended**
      **December
      31,**
      **2002**Smart
      II, Ltd. ("SIL"), formerly
      known
      as Smart Revenue Europe Ltd.
      -
      Integration fees
    
    $
    330,050
    
    $
    342,857
    
    $
    128,571Parson
      and Shearson, Inc. -
      Consulting
      Services
    
    
    -
    
    
    150,000
    
    
    11,578Small
      Business Lending Institute
      Consulting Services
    
    
    -
    
    
    20,200
    
    
    -Total
      Related Party Revenues
    
    $
    330,050
    
    $
    513,057
    
    $
    140,149












78







The
following is a summary or related party expenses for the years ended
December 31, 2004, 2003 and 2002.





**Year
      ended**
      **December
      31,**
      **2004**
    
    **Year
      ended**
      **December
      31,**
      **2003**
    
    **Year
      ended**
      **December
      31,**
      **2002**Nen,
      Inc. - consulting fees included
      in
      sales and marketing expense
      related
      to strategic international sales
      and
      marketing services
    
    $
    70,000
    
    $
    27,083
    
    $
    -Nen,
      Inc. - consulting fees included
      in
      general and administrative
      expense
      related to assisting Smart
      Online
      with obtaining additional
      equity
      financing
    
    
    31,000
    
    
    -
    
    
    -Small
      Business Loan Institute -
      consulting
      fees included in general
      and
      administrative expense
    
    
    30,000
    
    
    -
    
    
    -Smart
      II, Ltd. - Moving expenses,
      reseller
      payment, and technical co-
      development
      work
    
    
    75,000
    
    
    43,300
    
    
    -Interest
      expense incurred on
      loans
      from officer
    
    
    4,649
    
    
    2,007
    
    
    -Total
      Related PartyExpenses
    
    $
    210,649
    
    $
    80,390
    
    $
    -







**13.         
EMPLOYEE BENEFIT PLANS**




All
full-time employees who meet certain age and length of service requirements are
eligible to participate in the Smart Online 401(k) Plan. The plan provides for
contributions by Smart Online in such amounts as the Board of Directors may
annually determine, as well as a 401(k) option under which eligible participants
may defer a portion of their salary. Smart Online did not make any contributions
to the plan during 2004, 2003, and 2002.




**14.         
CONTINGENCIES**




Smart
Online is subject to other claims and suits that arise from time to time in the
ordinary course of business including claims asserted by two former commercial
business partners. The first claim asserts that Smart Online owes $92,204 for
advertising which Smart Online asserts was faulty. Smart Online has asserted
counterclaims for breach of contract. Neither party has yet served discovery and
no trial date has been set. In the second claim, Smart
Online is being sued  for
breach of contract, unfair and deceptive trade practices, and punitive damages,
alleging that Smart Online improperly refused to refund a $32,500 integration
fee. Smart Online filed a counterclaim for breach of contract for failure to pay
Smart Online certain sums it was due under the revenue sharing plan set forth in
the contract between the parties. Smart Online believes plaintiff’s claims for
unfair and deceptive trade practice and punitive damages are without merit. The
case is currently in the fact discovery phase. No trial date has been set. While
management currently believes that resolving these matters, individually or in
aggregate, will not have a material adverse impact on Smart Online’s financial
position or results of operations, the litigation and other claims noted above
are subject to inherent uncertainties and management’s view of these matters may
change in the future. Were an unfavorable final outcome to occur, there exists
the possibility of a material adverse impact on Smart Online’s financial
position and the results of operations for the period in which the effect
becomes reasonably estimable.




**15.         
SUBSEQUENT EVENTS**





Sale
of Common Stock





During
February and March 2005, Smart Online sold 580,000 shares of common
stock resulting in gross proceeds of $2.7 million to foreign investors in
sales exempt under Regulation S. A portion of those funds were used to repay
deferred compensation, including interest thereon, as more fully discussed in
Note 6. In connection with this financing, the Smart Online incurred stock
issuance costs of $290,000 to an entity an existing shareholder. Concurrent
with the sale of common stock, Smart Online issued warrants to purchase 50,000
shares of common stock to this investor in consideration for the investor
agreeing to certain restrictions on their ability to sell the shares. 
These warrants have an exercise price of $5 per share and terminate on January
1, 2007.  During March 2005, Smart Online raised an additional $125,000 in
gross proceeds from the sale of 25,000 shares of common stock at $5.00 per
share in a private placement.





79








Settlement
of IRS Liability





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





Payment
of Deferred Compensation and Accrued Interest





Also,
during the first quarter of 2005, Smart Online paid the $949,777 of deferred
compensation plus accrued interest of $154,288 and cancelled the related
promissory notes.





Exercise
of Warrants





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




**16. Summary of
Operations by Quarters (Unaudited)**
 
 2004
    
    20031st
      Qtr
    
    2nd
      Qtr
    
    3rd
      Qtr
    
    4th
      Qtr
    
    1st
      Qtr
    
    2nd
      Qtr
    
    3rd
      Qtr
    
    4th
      QtrRevenues
    
    $
    249,728
    
    $
    235,845
    
    $
    237,545
    
    $
    279,852
    
    $
    322,663
    
    $
    442,571
    
    $
    229,411
    
    $
    266,578Gross
      Profit
    
    $
    192,709
    
    $
    192,437
    
    $
    178,722
    
    $
    227,486
    
    $
    51,619
    
    $
    46,171
    
    $
    43,374
    
    $
    45,900Loss
      from Operations
    
    $
    (519,325
    )
    $
    (707,688
    )
    $
    (1,075,619
    ) 
      (1)
    $
    (499,303
    )
    $
    (159,151
    )
    $
    (96,229
    )
    $
    (294,715
    )
    $
    (1,315,187
    )(2)Net
      Loss Attributable to Common Stockholders
    
    $
    (6,040,464
    )
    $
    (692,786
    )
    $
    (1,289,108
    )
    $
    (296,691
    )
    $
    (402,852
    )
    $
    (186,685
    )
    $
    (599,931
    )
    $
    (3,186,368
    )Net
      Loss per Share - Basic and Diluted
    
    $
    (0.83
    )
    $
    (0.06
    )
    $
    (0.12
    )
    $
    (0.03
    )
    $
    (0.06
    )
    $
    (0.03
    )
    $
    (0.08
    )
    $
    (0.44
    )Number
      of Shares Used in Per Share Calculation
    
    
    7,321,707
    
    
    10,722,507
    
    
    11,089,101
    
    
    11,630,471
    
    
    7,097,798
    
    
    7,111,965
    
    
    7,111,965
    
    
    7,257,073
 
 
 (1)
    Includes
      $350,000 of expense related to the issuance of shares of common stock to a
      company that received warrants for services
rendered.
 (2)
    Includes
      $1,009,960 of stock based compensation expense related to options and
      warrants issued to employees and
consultants.
 
 END OF
NOTES TO FINANCIAL STATEMENTS





80





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





None.





**Item
9A. Controls and Procedures**





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





**Evaluation
of Disclosure Controls and Procedures**





With the
effectiveness of our first registration statement on February 15, 2005, our
Board of Directors approved disclosure controls and procedures (“Disclosure
Controls”) based on the evaluation and recommendations of our Chief Executive
Officer and Chief Financial Officer in connection with preparation of financial
statements for the period covered by this Form 10-K. Disclosure Controls are
controls and procedures designed to reasonably assure that information required
to be disclosed in our reports filed under the Securities and Exchange Act of
1934, as amended (the “Exchange Act”), such as this Form 10-K, is recorded,
processed, summarized and reported within the time periods specified in the U.S.
Securities and Exchange Commission’s (SEC’s) rules and forms. Disclosure
Controls are also designed to reasonably assure that such information is
accumulated and communicated to our management, including the CEO and CFO, as
appropriate to allow timely decisions regarding required disclosure.





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





Based
upon the Disclosure Controls evaluation, our CEO and CFO have concluded that,
subject to the limitations noted below, as of the end of the period covered
by this Form 10-K, our Disclosure Controls were effective to provide reasonable
assurance that information required to be disclosed in our Exchange Act reports
is recorded, processed, summarized and reported within the time periods
specified by the SEC, and that material information relating to Smart Online is
made known to management, including the CEO and CFO, particularly during the
period when our periodic reports are being prepared.





**Internal
Controls**





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





**Inherent
Limitations on Effectiveness of Controls**





Our
management, including the CEO and CFO, does not expect that our Disclosure
Controls or our internal control over financial reporting will prevent or detect
all error and all fraud. A control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the control
system’s objectives will be met. The design of a control system must reflect the
fact that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Further, because of the inherent limitations
in all control systems, no evaluation of controls can provide absolute assurance
that misstatements due to error or fraud will not occur or that all control
issues and instances of fraud, if any, within the company have been detected.
These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Controls can also be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the controls. The design of any system of





81





controls
is based in part on certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Projections of any
evaluation of controls effectiveness to future periods are subject to risks.
Over time, controls may become inadequate because of changes in conditions or
deterioration in the degree of compliance with policies or procedures.





**Item 9B.  Other
Information**





There is
no information required to be disclosed on a report on Form 8-K during the
fourth quarter of 2004 that was not disclosed on a report on Form
8-K.





**PART
III**





**Item
10. Directors and Executive Officers of the Registrant**




**Executive
Officers and Directors**




The names
of our directors and executive officers are listed below. None of the officers
and directors of Smart Online named below serve on the Board of Directors of any
other public reporting company. Our executive officers are appointed by our
board of directors to hold office until their successors are appointed the terms
of all directors expire at the next annual meeting of stockholders and upon
election of their successors. The terms of all officers expire upon the next
annual meeting of the Board of Directors and upon the election of the successors
to such officers.




**Name**
    **Age**
    **Position**Dennis
      Michael Nouri(1)(2)(3)
    51
    President,
      Chief Executive Officer, Chairman of the
      Board
      of Directors and DirectorHenry
      Nouri(2)
    48
    Vice
      President and DirectorRonna
      Loprete(3)
    35
    Vice
      President, Administrator, DirectorThomas
      Furr
    37
    Vice
      President, Sales, DirectorAnil
      Kamath
    38
    Vice
      President TechnologyJose
      Collazo
    32
    Vice
      President, Internet DevelopmentScott
      Whitaker
    34
    Chief
      Financial Officer and Principal Accounting Officer(1) 
      Michael Nouri’s full name is Dennis Michael Nouri.
      (2) 
      Dennis Michael Nouri and Henry Nouri are brothers
      (3) 
      Michael Nouri and Ronna Loprete are married.





**Michael
Nouri, President and Chief Executive Officer, Chairman of the Board and
Director.**  Michael
Nouri’s full name is Dennis Michael Nouri.  Mr. Nouri co-founded Smart
Online in 1993 to develop and market business productivity software to provide
small businesses with cost-effective tools that address critical business issues
and enhance their competitive positioning. He has been President, Chief
Executive Officer, Chairman of the Board and a Director of Smart Online since it
was started. Prior to founding Smart Online, Mr. Nouri was founder and CEO of
the Nouri Group of Companies from 1980 to 1991. The Nouri Group of Companies
acquired a number of government-owned manufacturers in Europe and privatized
them. The Nouri Group was a multi-national conglomerate with diversified
activities in real estate development, investment, construction, motor yacht
manufacturing, high-end home design and architecture, marketing and publishing
and stock trading. More than half of the company’s business was derived from
real estate development and investment and joint ventures. Another third of the
company’s business was derived from construction and motor yacht
manufacturing.




**Henry
Nouri, Executive Vice President, Research and Development, and Director.** Mr. Nouri
co-founded Smart Online in 1993 and has been its Vice President, Research and
Development and a Director since that time. Currently, he manages Smart Online’s
research and development teams. He is responsible for development of the
company’s CD-ROM and Internet-hosted applications, for creating the extensive
research and information management systems required to control the flow of
vital validated business data and the effective delivery of that information to
the business user.




**Ronna
Loprete, Vice President, Administration and Director.** Ms.
Loprete is responsible for all administrative and office operations activities.
In addition, she manages Smart Online’s relationships with legal advisors and
develops and defines all corporate and organizational policies. She joined Smart
Online in 1995. In 1998 she became Vice
President, Administration. In 1996 she became a Director of Smart Online. Prior
to joining Smart Online in 1995, she was a territory supervisor/administrator
for Markel Corporation, a high-risk insurance company.







82










**Thomas
Furr, Vice President, Sales and Director.** Mr. Furr
is responsible for developing and implementing strategies to leverage existing
direct and indirect distribution channels. He has been Vice President, Sales of
Smart Online since 2001. In 2002 he also became a Director. He was a co-founder
and president of Kinetics, Inc., one of the first online commerce providers for
the small business industry, from 1994 until 1995. Smart Online purchased
Kinetics in 1995. After founding Kinetics, Mr. Furr was with the Plurimus
Corporation from 1999 until 2001, where he managed Plurimus’ southeast direct
sales efforts. Previously, from 1996 until 1999 he managed East Coast direct
sales and channel efforts in Canada and South Africa for Information Retrieval
Corporation (IRC), a leading multi-national back-end CRM/help desk company. Mr.
Furr holds a bachelor’s degree in finance from East Carolina University.




**Anil
Kamath, Vice President, Technology.** Mr.
Kamath joined Smart Online as Director of Database Implementation in July 1999
and became Vice President, Technology in 2000. Mr. Kamath is responsible for the
architecture of the web-native (SaS) platform at SmartOnline; supervises the
development team, and provides architectural design direction for new software
and hardware implementations. Before joining Smart Online he was the senior
database architect for A-4 Health Systems from 1998 to 1999 and senior software
architect and technical manager of BSG Imonics) from 1991 until 1997. He holds a
master’s degree in computer and information sciences from the University of
Florida.




**Jose
Collazo, Vice President, Internet Development.** Mr.
Collazo is responsible for overseeing all aspects of software development.
Joining Smart Online in 1995, he has been a major contributor to Smart Online's
extensive suite of offline and online applications. Mr. Collazo is an expert is
using core web technologies, such as Java, HTML, XML / XSL, and was instrumental
in the development of the syndication platform used by Smart Online for its
syndication partners. Mr. Collazo holds a bachelor's degree in computer science
from the University of Georgia.




**Scott
Whitaker, Principal Financial Officer and Principal Accounting
Officer.** Mr.
Whitaker, 34 years old, has been responsible for supporting the efforts of other
officers of Smart Online with respect to internal controls and other internal
accounting functions of Smart Online. He joined Smart Online in 1998 as
accounting manager, was promoted to Controller in 2002 and was appointed
Principal Financial Officer and Principal Accounting Officer in March
2005.




Except as
disclosed below, none of the directors or executive officers has, during the
past five years:




(a)
    
    Had
      any bankruptcy petition filed by or against any business of which such
      person was a general partner or executive officer either at the time of
      the bankruptcy or within two years prior to that time;(b)
    
    Been
      convicted in a criminal proceeding or subject to a pending criminal
      proceeding;(c)
    
    Been
      subject to any order, judgment, or decree, not subsequently reversed,
      suspended or vacated, of any court of competent jurisdiction, permanently
      or temporarily enjoining, barring, suspending or otherwise limiting his
      involvement in any type of business, securities, futures, commodities or
      banking activities; and(d)
    
    Been
      found by a court of competent jurisdiction (in a civil action), the
      Securities and Exchange Commission or the Commodity Futures Trading
      Commission to have violated a federal or state securities or commodities
      law, and the judgment has not been reversed, suspended, or vacated.




Michael
Nouri and Henry Nouri were officers and directors of two companies in Italy,
which were ordered into bankruptcy by Italian courts in 1993. Under Italian
laws, Michael Nouri and Henry Nouri cannot serve as an officer or director of
any Italian company, because of these bankruptcies.







83







**Board
of Directors.**




Currently,
all of our Directors are also officers of Smart Online. Consequently, none of
our Directors are “independent” as defined by Securities and Exchange
Commission, stock exchange and NASDAQ rules regarding board members, committees
and other corporate governance standards. Consequently, we have not yet
established any committees of the Board of Directors. We will seek to change our
board of directors to meet these standards when we identify qualified people who
are willing to serve on our board of directors. We do not currently have in
place any procedures for our shareholders to recommend nominees to serve on our
board of directors.




**Number
of Directors.** Our
Board of Directors currently consists of four persons. Our bylaws provide that
the whole Board of Directors may consist of that number of directors as
determined by the Board of Directors from time to time.




**Term
of Office.** Our
Directors are currently elected to hold office until the next annual meeting of
our stockholders and until their respective successors have been elected and
qualified, but our Bylaws provide that when the number of directors increases to
six or more members our directors will have staggered terms of three years so
that each year the terms of approximately one third of the entire Board of
Directors will expire. The last annual meeting or written consent in lieu of
annual meeting of our stockholders to elect the Board of Directors was held on
January 1, 2005.




**Independent
Directors.** None of
our Directors are “independent,” as defined in Securities and Exchange
Commission or stock exchange or NASDAQ rules. We intend to search for
independent Directors and add them to our Board when we identify suitable
candidates who are willing to serve as directors.




**Committees.** Our Board
of Directors currently does not have any audit committee or any other committee.
None of our current directors have the experience and qualification to meet the
definition of a “financial expert” under Securities and Exchange Commission
rules governing audit committees and we have no independent directors. We are
looking for a suitable candidate, who would meet the definition of “financial
expert” and be independent, to join our board of directors and audit committee.
We intend to form an audit committee and other committees of our Board when we
recruit independent directors, including a financial expert and other directors
with the experience necessary for audit committee membership.




**Code
of Ethics.** We have
adopted a code of ethics applicable to our executives, including our principal
executive officer, principal accounting officer and principal financial officer,
as defined by applicable rules of the SEC. It is publicly available on our web
site at *www.smartonline.com* . If we
make any amendments to our code of ethics other than technical, administrative,
or other non-substantive amendments, or grant any waivers, including implicit
waivers, from a provision of our code of ethics to our chief executive officer,
chief financial officer, or certain other finance executives, we will disclose
the nature of the amendment or waiver, its effective date and to whom it applies
on our web site at *www.smartonline.com* or in a
report on Form 8-K filed with the SEC.




**User
Advisory Board**




We have
organized an User Advisory Board, consisting of up to 10 professionals
representing expertise in a broad range of business areas to assist Smart Online
marketing and sales executives with ongoing product development planning,
pricing, partnerships, new product development and other issues, including
customer acquisition and retention. User Advisory Board members provide advice
to Smart Online’s management, but do not have any power to make decisions. User
Advisory Board members also do not have the same duties and liabilities as
members of Board of Directors have. Each of our User Advisory Board members has
been granted nonqualified options to purchase 10,000 shares of common stock at
an exercise price of $3.50 per share, which options vest in equal increments of
1,250 per meeting attended, provided the member remains on the Advisory Board
for at least one year. At present, members of the User Advisory Board
include Mark Self, Rick Bernhardt, Brian Kinahan, Felix Mulhebach, Thomas
Martignon and William Eldridge.




**Section
16(a) Beneficial Ownership Reporting Compliance**





During
2004, our officers, directors and owners of securities were not subject to the
reporting requirements of Section 16(a) of the Securities and Exchange Act of
1934.





84








**Item
11. Executive Compensation**




**Summary
Compensation Table**




The table
below summarizes all compensation awarded to, earned by, or paid to (i) our
Chief Executive Officer and those persons other than the Chief Executive
Officer, who in calendar year 2004 were our four highest-paid executive
officers, for all services rendered in all capacities to us for the calendar
years listed below. No persons who were not executive officers were among our
five most highly compensated employees.




****
    
    ****
    
    ****
    
    ****
    
    ****
    
    **OTHER**
    
    **RESTRICTED**
    
    ******ANNUAL**
    
    **STOCK**
    
    ****SARS/OPTIONS****
    
    **LTIP**
    
    **ALL
      OTHER****NAME**
    
    ****
    
    **TITLE**
    
    **YEAR**
    
    **SALARY**
    
    **BONUS****(1)**
    
    **COMPENSATION**
    
    **AWARDED**
    
    **GRANT**
    
    **COMPENSATION**
    
    **COMPENSATION**DennisMichael
      Nouri (1)
    CEO
    
    
    2004
    
    $
    170,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    14,616.702003
    
    $
    150,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    250,000
      options
    
    $
    0
    
    $
    14,6842002
    
    $
    150,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    11,226Henry
      Nouri (2)
    
    Vice
      President
    
    
    2004
    
    $
    150,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    9,3032003
    
    $
    150,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    250,000
      options
    
    $
    0
    
    $
    9,6362002
    
    $
    150,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    6,528Ronna
      Loprete (3) (4)
    VP
    
    
    2004
    
    $
    120,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    75,000
      options
    
    $
    0
    
    $
    02003
    
    $
    120,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    02002
    
    $
    120,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    0Jose
      Collazo (4)
    
    
    VP
    
    
    2004
    
    $
    120,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    75,000
      options
    
    $
    0
    
    $
    02003
    
    $
    100,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    02002
    
    $
    100,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    0Anil
      Kamath (4)
    
    
    VP
    
    
    2004
    
    $
    125,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    75,000
      options
    
    $
    0
    
    $
    02003
    
    $
    100,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    02002
    
    $
    100,000
    
    $
    0
    
    $
    0
    
    
    none
    
    
    0
    
    $
    0
    
    $
    0







(1)
    The
      amounts of salary in the table above reflect amounts that accrued under an
      employment agreement.  Because Dennis Michael Nouri agreed to allow
      Smart Online to defer part of his accrued compensation he received only
      the following amounts of salary: $113,750 in 2004; $35,000 in 2003,
      $26,250 in 2002, $37,500 in 2001, $150,000 in 2000 and $150,000 in 1999.
      These amounts, plus $55,950 interest, were paid in March 2005. Refer to
      “Item 13. Certain Relationships and Interested Transactions” for a
      description of salary deferrals.  “Other Compensation” consists of
      payments for health insurance for family members of Mr.
Nouri.(2)
    The
      amounts of salary in the table above reflect amounts that accrued under an
      employment agreement.  Because Henry Nouri agreed to allow Smart
      Online to defer part of his accrued compensation he received only the
      following amounts of salary: $102,083 in 2004.  $35,000 in 2003,
      $26,250 in 2002, $37,500 in 2001, $143,300 in 2000 and $89,300 in 1999.
      These amounts, plus $59,582 interest, were paid in March 2005. Refer to
      “Item 13. Certain Relationships and Interested Transactions” for a
      description of salary deferrals.   “Other Compensation” consists
      of payments for health insurance for family members of Mr.
      Nouri.(3)
    The
      amounts of salary in the table above reflect amounts that accrued under an
      employment agreement.  Because Ronna Loprete agreed to allow Smart
      Online to defer part of her accrued compensation she received only the
      following amounts of salary:  $107,500 in 2004, $90,000 in 2003,
      $90,000 in 2002, $97,500 in 2001, $113,300 in 2000 and $80,000 in 1999.
      These amounts, plus $13,936 interest, were paid in March 2005. Refer to
      “Item 13. Certain Relationships and Interested Transactions” for a
      description of salary deferrals.(4)
    The
      shares of restricted stock in the table above were purchased in 2001 at a
      purchase price of $0.02 per share, which Smart Online determined to be the
      fair market value of the shares at that time.







85







**Aggregated
Option Grants in Year 2004 and Option Values at  December 31,
2004**




The
following table provides information concerning unexercised options held as of
December 31, 2004, by each of our executive officers:




****
    
    **Number
      of Securities**
      **Underlying
      Unexercised Options**
      **at
      December 31, 2004**
    
    ****
    
    **Value
      of Unexercised**
      **In-the-Money
      Options at**
      **December
      31, 2004****(1)****Name**
    
    **Exercisable**
    
    **Unexercisable**
    
    ****
    
    **Exercisable**
    
    **Unexercisable**Michael
      Nouri
    
    
    250,000
    
    
    0
    
    
    
    
    $
    892,500
    
    $
    0Henry
      Nouri
    
    
    250,000
    
    
    0
    
    
    
    
    $
    892,500
    
    $
    0Ronna
      Loprete
    
    
    75,000
    
    
    0
    
    
    
    
    $
    277,500
    
    $
    0Thomas
      Furr
    
    
    75,000
    
    
    0
    
    
    
    
    $
    277,500
    
    $
    0Anil
      Kamath
    
    
    0
    
    
    75,000
    
    
    
    
    $
    0
    
    $
    112,500Tamir
      Sagie
    
    
    200,000
    
    
    0
    
    
    
    
    $
    740,000
    
    $
    0Jose
      Collazo
    
    
    0
    
    
    75,000
    
    
    
    
    $
    0
    
    $
    112,500Deb
      Lovig
    
    
    0
    
    
    75,000
    
    
    
    
    $
    0
    
    $
    112,500Scott
      Whitaker
    
    
    0
    
    
    25,000
    
    
    
    
    $
    0
    
    $
    112,500




___________




(1)
    
    Based
      on the last price at which Smart Online sold shares of Common Stock at
      $5.00 per share in September, 2004, minus the exercise price, multiplied
      by the number of shares issued upon the exercise of, or subject to, the
      option, without taking into account any taxes that may be payable in
      connection with the transaction.




**Option
Grants During Year 2004**




The
following options to purchase shares of our common stock were granted to
executive officers during the year ended December 31, 2004:




**Named
      Executive Officer**
    
    **Number
      of Shares**
      **Subject
      to Options**
    ****
    ****
    **%
      of Total**
      **Options**
      **Granted**
      **to**
      **Employees**
      **During**
      **Period**
    ****
    **Date
      of**
      **Grant**
    ****
    **Exercise**
      **Price**
    ****
    **Expiration**
      **Date**
    **Potential**
      **Realizable
      Value At Assumed Annual Rates of Stock Price Appreciation**
      **For
      Option Term****5%****(1)**
    **10%****(1)**Michael
      Nouri
    0
    
    
    0
    
    --
    
    --
    
    --Henry
      Nouri
    0
    
    
    0
    
    --
    
    --
    
    --Thomas
      Furr
    75,000
    
    
    12.4
      %
    
    02/05/04
    
    $ 1.30
    
    02/05/09
    $141,803
    $204,471Ronna
      Loprete
    75,000
    
    
    12.4
      %
    
    02/05/04
    
    $ 1.30
    
    02/05/09
    $141,803
    $204,471Anil
      Kamath
    75,000
    
    
    12.4
      %
    
    05/01/04
    
    $ 3.50
    
    05/01/14
    $165,085
    $418,357Jose
      Collazo
    75,000
    
    
    12.4
      %
    
    05/01/04
    
    $ 3.50
    
    05/01/14
    $165,085
    $418,357Deb
      Lovig
    75,000
    
    
    12.4%
    
    07/01/04
    
    $
      3.50
    
    07/01/14
    $165,085
    $418,357Scott
      Whitaker
    25,000
    
    
    4.1%
    
    04/01/04
    
    $
      3.50
    
    04/01/14
    $ 
      55,028
    $139,452











86







(1)
    In
      accordance with SEC rules, these columns show gains that could accrue for
      the respective options, assuming that the market price of Smart Online
      common stock appreciates from the date of grant over the maximum life of
      the option at an annualized rate of 5% and 10%, respectively. If the
      stock price does not increase above the exercise price at the time of
      exercise, realized value to the named executives from these options will
      be zero. Rules of the Securities and Exchange Commission permit Smart
      Online to use 5% and 10% in this table.  There can be no assurance
      that the price of Smart Online's stock will increase and this table does
      not constitute any prediction of the future value of its stock by Smart
      Online.







**Options
Exercised During Year 2004**





No
executive officers exercised any options during the year ended December 31,
2004.


****


**Other
Plans and Agreements**





Smart
Online not granted any stock appreciation rights (SARs) to any of its executive
officers. Smart Online made no long-term incentive plan (LTIPs) awards to
executive officers. Smart Online has no defined benefit or actuarial plans.
Smart Online did not reprice stock options during the year ended December 31,
2004.




**Employment
Agreements**




We have
the following employment agreements with the five executive officers named in
the compensation table above.




**Dennis
Michael Nouri.** Elsewhere in this document, Mr. Nouri is referred to as Michael Nouri, because
he uses his middle name instead of his first name in most business
dealings.  Effective April 1, 2004, covering employment commencing as of
June 1, 2004 Smart Online and Michael Nouri entered into an employment
agreement, which provided for an initial base salary of $170,000. The agreement
replaced an employment agreement dated July 14, 1999 that was about to expire.
The new agreement has a termination date of December 31, 2005, but it will be
automatically extended for additional two-year terms, unless either Mr. Nouri or
Smart Online provides the other with written notice of intention not to renew at
least 180 days prior to the end of the term or the end of any renewal period.
The agreement requires Smart Online to make a severance payment to Mr. Nouri in
an amount equal to twelve months of base salary, if either Smart Online
terminates Mr. Nouri’ s employment without “cause” (as defined in the agreement)
or Mr. Nouri terminates his employment for “good reason” (as defined in the
agreement). The agreement also contains a retention provision designed to
incentivise Mr. Nouri to remain employed by Smart Online following a “change of
control” as defined in the agreement. Under this retention provision, if Mr.
Nouri remains employed by the surviving entity for a period of time after the
change of control occurs designated by the Board of Directors of the surviving
entity, and either his employment is terminated by the surviving entity without
cause or by Mr. Nouri for good reason, the surviving entity must pay Mr. Nouri
an amount equal to 299% of his highest annual salary and bonuses during the
preceding five years. This retention payment is in addition to other severance
payments described above. Mr. Nouri’s agreement contains non-competition and
non-solicitation provisions. Refer to “Item 13. Certain Relationships and
Interested Transactions” for a description of the salary deferral and payments
of deferred salary.




**Henry
Nouri.** Effective April 1, 2004, covering employment commencing as of June 1, 2004 Smart
Online and Henry Nouri entered into an employment agreement, which provided for
an initial base salary of $150,000. The agreement replaced an employment
agreement dated July 14, 1999 that was about to expire. The new agreement has a
termination date of December 31, 2005, but it will be automatically extended for
additional two-year terms, unless either Mr. Nouri or Smart Online provides the
other with written notice of intention not to renew at least 180 days prior to
the end of the term or the end of any renewal period. The agreement requires
Smart Online to make a severance payment to Mr. Nouri in an amount equal to
twelve months of base salary, if either Smart Online terminates Mr. Nouri’s
employment without “cause” (as defined in the agreement) or Mr. Nouri terminates
his employment for “good reason” (as defined in the agreement). The agreement
also contains a retention provision designed to incentivise Mr. Nouri to remain
employed by Smart Online following a “change of control” as defined in the
agreement. Under this retention provision, if Mr. Nouri remains employed by the
surviving entity for a period of time after the change of control occurs
designated by the Board of Directors of the surviving entity, and either his
employment is terminated by the surviving entity without cause or by Mr. Nouri
for good reason, the surviving entity must pay Mr. Nouri an amount equal to 299%
of his highest annual salary and bonuses during the preceding five years. This
retention payment is in addition to other severance payments described above.
Mr. Nouri’s agreement contains non-competition and non-solicitation provisions.
Refer to “Item 13. Certain Relationships and Interested Transactions” for a
description of the salary deferral and payments of deferred salary.







87







**Ronna
Loprete** . 
Effective April 1, 2004, covering employment commencing as of June 1, 2004 Smart
Online and Ronna Loprete entered into an employment agreement which provided for
an initial base salary of $120,000. The agreement replaced an employment
agreement dated June 29, 1999 that was about to expire. The new agreement has a
termination date of December 31, 2005, but it will be automatically extended for
additional one-year terms, unless either Ms. Loprete or Smart Online provides
the other with written notice of intention not to renew at least 30 days prior
to the end of the term or the end of any renewal period. The agreement requires
Smart Online to make a severance payment to Ms. Loprete in an amount equal to
three months of base salary, if either Smart Online terminates Ms. Loprete’s
employment without cause (as defined in the agreement) or Ms. Loprete terminates
her employment for “good reason” (as defined in the agreement). Ms. Loprete’s
agreement contains non-competition and non-solicitation provisions. Refer to
“Item 13. Certain Relationships and Interested Transactions” for a description
of the salary deferral and payments of deferred salary.




**Jose
Collazo** . 
Effective May 1, 2004, covering employment commencing as of June 1, 2004 Smart
Online and Jose Collazo entered into an employment agreement, which provided for
an initial base salary of $120,000. The agreement replaced an employment
agreement dated August 1, 2000 that would expire later this year. The new
agreement has a termination date of December 31, 2005, but it will be
automatically extended for additional one-year terms, unless either Mr. Collazo
or Smart Online provides the other with written notice of intention not to renew
at least 30 days prior to the end of the term or of any renewal period. The
agreement requires Smart Online to make a severance payment to Mr. Collazo in an
amount equal to three months of base salary, if either Smart Online terminates
Mr. Collazo’ s employment without cause (as defined in the agreement) or Mr.
Collazo terminates his employment for “good reason” (as defined in the
agreement). Mr. Collazo’s agreement contains non-competition and
non-solicitation provisions. The new agreement was accompanied by a grant of
incentive stock options for seventy-five thousand (75,000) shares of common
stock at an exercise price of three dollars and fifty cents ($3.50) vesting over
a two (2) year period in four (4) equal installments and exercisable for nine
(9) years and eleven (11) months. Option vesting is accelerated upon a change of
control or corporate reorganization such that all options would vest
immediately.




**Anil
Kamath** .
Effective May 1, 2004, covering employment commencing as of June 1, 2004 Smart
Online and Anil Kamath entered into an employment agreement which provided for
an initial base salary of $125,000. The agreement replaced an employment
agreement dated October 16, 2000 that would expire later this year. The new
agreement has a termination date of December 31, 2005, but it will be
automatically extended for additional one-year terms, unless either Mr. Kamath
or Smart Online provides the other with written notice of intention not to renew
at least 30 days prior to the end of the term or of any renewal period. The
agreement requires Smart Online to make a severance payment to Mr. Kamath in an
amount equal to three months of base salary, if either Smart Online terminates
Mr. Kamath’ s employment without cause (as defined in the agreement) or Mr.
Kamath terminates his employment for “good reason” (as defined in the
agreement). Mr. Kamath’s agreement contains non-competition and non-solicitation
provisions. The new agreement was accompanied by a grant of incentive stock
options for seventy-five thousand (75,000) shares of common stock at an exercise
price of three dollars and fifty cents ($3.50) vesting over a two (2) year
period in four (4) equal installments and exercisable for nine (9) years and
eleven (11) months. Option vesting is accelerated upon a change of control or
corporate reorganization such that all options would vest immediately.




**Stock
Option Grants to Senior Executives**




None of
the executive officers named above has exercised options to purchase shares of
Smart Online’s common stock during the year ended December 31,
2004.




The
foregoing option grants are subject to the terms and conditions of the three
plans under which the options were granted. Set forth below is a summary of the
terms of each of these plans. These are only summaries and do not include all
the provisions of these plans, which can only be understood by reading the full
plans.




**2004
Equity Compensation Plan**




We
adopted our 2004 Equity Compensation Plan as of March 31, 2004. The 2004 plan
provides for the grant of options intended to qualify as “incentive stock
options,” options that are not intended to so qualify or “nonstatutory stock
options” and restricted stock and other direct stock awards. The total number of
shares of common stock reserved for issuance under the 2004 plan is 5,000,000
shares, subject to adjustment in the event of stock split, stock dividend,
recapitalization or similar capital change. At December 31, 2004, options to
purchase 520,000 shares of our common stock were outstanding under the 2004
plan.







88







The plan
is administered by our Board of Directors, which selects the eligible persons to
whom options or stock awards shall be granted, determines the number of shares
subject to each option or stock award, the exercise price therefore and the
periods during which options are exercisable, interprets the provisions of the
2004 plan and, subject to certain limitations, may amend the 2004 plan. Each
option or stock award granted under the 2004 plan shall be evidenced by a
written agreement between Smart Online and the grantee. Grants may be made under
the 2004 plan to employees (including officers) and directors of Smart Online as
well as to certain consultants and advisors.




The
exercise price for incentive stock options granted under the 2004 plan is
required to be no less than the fair market value of the common stock on the
date the option is granted, except for options granted to 10% stockholders,
which are required to have an exercise price of not less than 110% of the fair
market value of the common stock on the date the option is granted. Incentive
stock options granted under the 2004 plan have a maximum term of 10 years,
except for option grants to 10% stockholders, which are subject to a maximum
term of 5 years. Nonstatutory stock options granted under the 2004 plan have a
term determined by the Board of Directors. Options granted under the 2004 plan
are not transferable, except by will and the laws of descent and distribution.




**2001
Equity Compensation Plan**




We
adopted our 2001 Equity Compensation Plan on May 31, 2001. The 2001 plan
provides for the grant of options intended to qualify as “incentive stock
options,” options that are not intended to so qualify or “nonstatutory stock
options” and restricted stock. As of December 15, 2004, the total number of
shares of our common stock reserved for issuance under the 2001 plan is 870,000
shares, subject to adjustment in the event of stock split, stock dividend,
recapitalization or similar change. Options to purchase 870,000 shares granted
under the 2001 plan are outstanding at December 31, 2004, and Smart Online may
not make any further grants under the 2001 plan.




The plan
is administered by our Board of Directors, which selected the eligible persons
to whom awards could be made, determined the number of shares subject to each
option or stock award, the exercise price therefore and the periods during which
the options were exercisable. The Board of Directors also interprets the
provisions of the 2001 plan and, subject to certain limitations, may amend the
2001 plan. Each option or grant of restricted stock made under the 2001 plan is
evidenced by a written agreement between Smart Online and the grantee. Grants
could be made under the 2001 plan to employees, directors and certain
consultants and advisors of Smart Online.




The
exercise price for incentive stock options granted under the 2001 plan was
required to be no less than the fair market value of the common stock on the
date the option was granted, except for options granted to 10% stockholders,
which were 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 was granted. Incentive
stock options granted under the 2001 plan have a maximum term of 10 years,
except for option grants to 10% stockholders, which were subject to a maximum
term of 5 years. Nonstatutory stock options granted under the 2001 plan had a
term determined by the Board of Directors. Options granted under the 2001 plan
are not transferable, except by will and the laws of descent and distribution.




**1998
Stock Option Plan**




We
adopted our 1998 Stock Option Plan on November 12, 1998. The 1998 plan provides
for the grant of options intended to qualify as “incentive stock options,” and
options that are not intended to so qualify or “nonstatutory stock options.” As
of December 31, 2004, the total number of shares of our common stock reserved
for issuance under the 1998 plan is 288,900 shares, subject to adjustment in the
event of stock split, stock dividend, recapitalization or similar change.
Options to purchase 228,900 shares have been granted under the 1998 plan and
remain outstanding at December 31, 2004, and Smart Online may not make any
further grants under the 1998 plan.




The plan
is administered by our Board of Directors, which selected the eligible persons
to whom awards could be made, determined the number of shares subject to each
option or stock award, the exercise price therefore and the periods during which
the options were exercisable. The Board of Directors also interprets the
provisions of the 1998 plan and, subject to certain limitations, may amend the
1998 plan. Each option granted under the 1998 plan is evidenced by a written
agreement between Smart Online and the optionee. Grants could be made under the
1998 plan to key employees, directors and independent contractors of Smart
Online.




The
exercise price for incentive stock options granted under the 1998 plan was
required to be no less than the fair market value of the common stock on the
date the option was granted, except for options granted to 10% stockholders,
which were 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 was granted. Stock
options granted under the 1998 plan have a maximum term of 10 years, except for
incentive stock option grants to 10% stockholders, which were subject to a
maximum term of 5 years. Options granted under the 1998 plan are not
transferable, except by will and the laws of descent and distribution.







89





**Participation
in Compensation Deliberations**




Smart
Online has no Compensation Committee. All Directors of Smart Online participate
in compensation deliberations, including Michael Nouri, Henry Nouri, Ronna
Loprete and Thomas Furr, all of whom are executive officers of Smart Online. No
other persons participated in compensation deliberations.




**Board
of Directors**




All our
Directors are officers of Smart Online. We do not pay these Directors any
additional amounts for serving on our Board of Directors. We intend to recruit
new Directors, who are not officers or employees of Smart Online, and when
attractive candidates are identified and agree to become Directors. When we
recruit independent directors for our Board, we will develop a compensation
policy for independent Directors.




**Disclosure
of Commission Position on Indemnification for Securities Act
Liabilities**




Our
directors and officers are indemnified as provided by the Delaware Business
Corporations Act (the “Delaware Corporations Act”) and our Certificate of
Incorporation. We have been advised that in the opinion of the Securities and
Exchange Commission indemnification for liabilities arising under the Securities
Act is against public policy as expressed in the Securities Act, and is,
therefore, unenforceable. In the event that a claim for indemnification against
such liabilities is asserted by one of our directors, officers, or controlling
persons in connection with the securities being registered, we will, unless in
the opinion of our legal counsel the matter has been settled by controlling
precedent, submit the question of whether such indemnification is against public
policy to a court of appropriate jurisdiction. We will then be governed by the
court’s decision.




**Graphic
Comparison of Stock Performance**





Smart
Online’s Common Stock was not publicly traded during the year ended 2004.
Consequently, no graphic comparison about stock performance is included
herein.





90


**Item
12. Security Ownership of Certain Beneficial Owners and
Management**




The
following table sets forth certain information regarding beneficial ownership of
our common stock as of March 15, 2005: (i) by each person who is known by us to
beneficially own more than 5% of our common stock and after completion of this
offering; (ii) by each of our officers and directors; and (iii) by all of our
officers and directors as a group.




**Beneficial
      Owner**
      **Name
      and Address**
    
    **Amount
      and**
      **Nature
      of**
      **Beneficial**
      **Ownership****(1)(2)**
    
    **Percentage****(2)**
      **At
      March 15,**
      **2005**Dennis
      Michael Nouri(4)(5)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina 27713
    
    
    3,302,027
    
    
    27
    %Henry
      Nouri(4)(6)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina 27713
    
    
    3,091,984
    
    
    25
    %Ronna
      Loprete(7)
      C/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina 27713
    
    
    340,631
    
    
    3
    %Thomas
      Furr(8)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina  27713
    
    
    410,637
    
    
    3
    %Anil
      Kamath(9)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina  27713
    
    
    218,750
    
    
    2
    %Tamir
      Sagie(10)(11)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina  27713
    
    
    400,000
    
    
    3
    %Atlas
      Capital SA(12)
      (13)
      116
      Rue du Rhone
      CH-1204
      Geneva,
      Switzerland
    
    
    1,176,341
    
    
    10
    %Doron
      Roethler(14)
      c/o
      Michal Ravivat
      Granot,
      Strauss, Adar & Co.
      28
      Bezalel Street
      Ramat
      Gan 52521, Israel
    
    
    1,754,735
    
    
    15
    %Jose
      Collazo(15)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina  27713
    
    
    219,450
    
    
    2
    %Scott
      Whitaker(16)
      c/o
      Smart Online, Inc.
      2530
      Meridian Parkway
      Durham,
      North Carolina  27713
    
    
    5,000
    
    
    0
    %All
      officers and directors as a group (8 persons)(17)
    
    
    4,783,995
    
    
    37
    %






(1)
    All
      shares are common stock. Unless otherwise indicated by footnotes, all
      beneficial ownership is direct and is not shared with others.(2)
    The
      preceding table was prepared based solely upon the information furnished
      to us by officers, directors and stockholders as of March 15, 2005 and
      from corporate stock transfer ledgers. The number and percentage of shares
      beneficially owned is determined in accordance with Rule 13d-3 of the
      Securities Exchange Act of 1934, and the information is not necessarily
      indicative of beneficial ownership for any other purpose. Under Rule
      13d-3, a beneficial owner of a security includes any person who, directly
      or indirectly, through any contract, arrangement, understanding,
      relationship, or otherwise has or shares: (i) voting power, which includes
      the power to vote, or to direct the voting of shares; and (ii) investment
      power, which includes the power to dispose or direct the disposition of
      shares. Certain shares may be deemed to be beneficially owned by more than
      one person (if, for example, persons share the power to vote or the power
      to dispose of the shares). In addition, shares are deemed to be
      beneficially owned by a person if the person has the right to acquire the
      shares (for example, upon exercise of an option or a warrant) within 60
      days of the date as of which the information is provided. In computing the
      percentage ownership of any person, the number of shares outstanding is
      deemed to include the amount of shares beneficially owned by such person
      (and only such person) by reason of these acquisition rights. As a result,
      the percentage of outstanding shares of any person as shown in this table
      does not necessarily reflect the person’s actual ownership or voting power
      with respect to the number of shares of common stock actually outstanding
      on March 15, 2005. As of March 15, 2005, there were 12,181,832 shares
      issued and outstanding and our officers and directors beneficially owned
      approximately 730,000 shares which can be acquired upon exercise of stock
      options within sixty (60) days after March 15, 2005, which options were
      treated the same as outstanding shares in calculating the percentage
      ownership of our officers and directors.(3)
    Assumes
      that all securities offered hereby will be sold.(4)
    Includes
      2,841,984 shares owned by American Investment Holding Group, owned by
      Michael and Henry Nouri, and as to which they share the power to vote and
      the power to dispose of such shares, and solely with respect to Michael
      Nouri also includes 87,043 shares owned by Charter Holding LLC, owned by
      Michael Nouri, which includes 23,000 shares of common stock owned by a
      trust for which Michael Nouri is the trustee and is not a beneficiary.
      Does not include shares owned by Ronna Loprete, wife of Michael Nouri.(5)
    Includes
      250,000 shares which can be acquired upon the exercise of options which
      can be exercised at any time within the sixty (60) days after March 15,
      2005.(6)
    Includes
      250,000 shares which can be acquired upon the exercise of options which
      can be exercised at any time within the sixty (60) days after March 15,
      2005.(7)
    Includes
      75,000 shares which can be acquired upon the exercise of options which can
      be exercised at any time within the sixty (60) days after March 15, 2005.
      Does not include shares beneficially owned by Michael Nouri, husband of
      Ronna Loprete.(8)
    Includes
      75,000 shares which can be acquired upon the exercise of options which can
      be exercised at any time within the sixty (60) days after March 15, 2005.(9)
    Includes
      37,500 shares which can be acquired upon exercise of options which can be
      exercised at any time within sixty (60) days after March 15, 2005. 
      Does not include 37,500 shares subject to options which cannot be
      exercised within sixty (60) days after March 15, 2005.(10)
    Mr.
      Sagie was an officer at December 31, 2004, but ceased to be an officer in
      January 2005. Includes 200,000 shares which can be acquired upon the
      exercise of options which can be exercised at any time within the sixty
      (60) days after March 15, 2005.(11)
    Includes
      60,000 shares owned by Nen, Inc. as to which Mr. Sagie is sole owner and
      125,000 shares Mr. Sagie received in February 2005 from Greenleaf Ventures
      Ltd. in exchange for his ownership interest in Greenleaf.(12)
    Includes
      237,428 shares which can be acquired upon exercise of warrants which can
      be exercised within sixty (60) days after March 15, 2005.(13)
    Atlas
      Capital SA had the right to require two other stockholders to purchase all
      its common stock and warrants under certain circumstances. This right was
      terminated by agreement with Atlas Capital SA on March 18, 2005. Refer to
      “Certain Relationships and Related Transactions” for a description of this
      put agreement.(14)
    Includes
      (i) 1,323,619 shares owned by Greenleaf Ventures Ltd., a British Virgin
      Islands company, owned by Doron Roethler, (ii) 121,116 shares owned by
      Crystal Management Ltd., a company registered in Anguilla, owned by Doron
      Roethler, and (iii) 310,000 shares of common stock owned directly by Doron
      Roethler.(15)
    Includes
      37,500 shares which can be acquired upon exercise of options which can be
      exercised at any time within sixty (60) days after March 15, 2005. Does
      not include 37,500 shares subject to options which cannot be exercised
      within sixty (60) days after March 15, 2005.(16)
    Includes
      5,000 shares which can be acquired upon exercise of options which can be
      exercised to any time within sixty (60) days after March 15, 2005. Does
      not include 20,000 shares subject to options which cannot be exercised
      within sixty (60) days after March 15, 2005, 2007.(17)
    Includes
      930,000 shares which can be acquired upon the exercise of options at any
      time within sixty (60) days after March 15, 2005 and does not include
      95,000 shares subject to options which cannot be exercised within sixty
      (60) days after March 15, 2005. Includes shares owned by Tamir Sagie who
      ceased to be an officer in January 2005.





91


The
following table sets forth as of December 31, 2004, information related to
stockholder approval of our equity compensation plans:





**Equity
Compensation Plan Information**





**Plan
      category**
    **Number
      of shares of**
      **Common
      Stock to be**
      **issued
      upon exercise of**
      **outstanding
      options,**
      **warrants
      and rights****(1)**
      **(a)**
    **Weighted
      average**
      **exercise
      price of**
      **outstanding
      options,**
      **warrants
      and rights**
      **(b)**
    **Number
      of shares of**
      **Common
      Stock**
      **remaining
      available for**
      **future
      issuance under**
      **equity
      compensation**
      **plans
      (excluding shares**
      **of
      Common Stock**
      **reflected
      in column (a))****(2)**
      **(c)**Equity
      Compensation plans approved by security holders
    1,905,078
    $2.71
    4,480,000Equity
      Compensation plans not approved by security holders
    500,000
    $2.55
    N/ATotal
    2,405,078
    
    4,480,000





( 1 ) The
foregoing table includes 500,000 shares issuable pursuant to warrants and
options granted to consultants, advisors, employees, officers or directors
pursuant to individual compensation arrangements not under any equity
compensation plan.





(2)
Includes 4,480,000 shares remaining under the 2004 Equity Compensation Plan. No
shares remain available for grants under either the 2001 Equity Compensation
Plan or the 1998 Stock Option Plan.





92








**Item
13. Certain Relationships and Related Transactions**





Except as
disclosed below, none of the following persons has, since January 1, 2004, had
any material interest, direct or indirect, in any transaction with us or in any
presently proposed transaction that has or will materially affect us:




·
    Any
      of our directors or officers;




·
    Any
      person proposed as a nominee for election as a
director;




·
    Any
      person who beneficially owns, directly or indirectly, shares carrying more
      than 5% of the voting rights attached to our outstanding shares of common
      stock;




·
    Any
      of our promoters;




·
    Any
      relative or spouse of any of the foregoing persons who lives in the same
      house as such person.




Consulting
Services




During
2004, Smart Online utilized the services of a consulting firm, Nen, Inc., owned
by one of its officers, Tamir Sagie, to provide strategic international sales
and marketing services and paid consulting fees of $70,000 during 2004 related
to these services. Additionally, Smart Online paid the same consulting firm
$31,000 related to the sale of certain shares of Common Stock during the first
half of 2004.   In addition, during the third quarter of 2004, Smart
Online paid this same consultant an additional $31,000 in consulting fees for
assisting the Company with obtaining additional equity financing during the
quarter.




Smart
Online paid $158,384 in 2004 to an entity in which Michael Nouri, the Company’s
CEO, is also an officer, because that company paid Smart Online’s employees
during the first quarter of 2004 while Smart Online was dealing with a tax
matter with the Internal Revenue Service.




**Smart
IL**




Approximately
32.9% of total revenues for the year ended December 31, 2004 was from a single
customer, Smart IL Ltd. (“SIL”), formerly known as Smart Revenue Europe Ltd., an
Israeli based software company that specialized in secured instant messaging
products. During March 2004 SIL ceased further development of its technology and
laid-off all employees after SIL completed development of, and delivered to us,
its instant messenger product.  SIL is currently seeking to license or sell
its technology, however, we do not expect to receive substantial revenue from
SIL in the future. SIL is owned by Doron Roethler, a shareholder of Smart
Online. Also, during 2004, Smart Online paid Smart II, Ltd. $75,000 related to
moving expenses, reseller payments, and technical co- development
work.




**Loans,
Salary Deferrals and Security Interests of Certain Officers, Employees and
Relatives**




As of
December 31, 2003, Smart Online owed Michael Nouri, the Company’s CEO, $86,480
related to loans he had made to Smart Online. During the first nine months of
2004, Smart Online borrowed an additional $4,793 from and repaid the entire
remaining outstanding balance of $91,273 to this officer. Until October 2003,
Smart Online did not pay any interest on these loans, thereafter the loans
accrued interest at a rate of 15.0%. As of December 31, 2003, Smart Online was
owed $38,681 by a trust established by Michael Nouri. During the first six
months of 2004, Smart Online lent the trust an additional $142,860 and the trust
repaid the entire balance owed to Smart Online totaling $181,542. As of December
31, 2004 all borrowings from and loans to the officer and the trust were repaid
in full.




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




During
2002, William Furr (the father of Thomas Furr, who is Vice President Sales and a
Director of Smart Online, and who owned 436,011 shares of Smart Online) lent
Smart Online $270,000.  In consideration for this loan, Smart Online issued
20,000 shares of restricted stock to this individual without additional
consideration by Mr. Furr. Subsequently during 2002, Smart Online repaid
$225,000 of this indebtedness. This loan was evidenced by an unsecured
promissory note bearing interest at a rate of 6%. . In 2003, Smart Online
borrowed an additional $190,000 from this individual and repaid $10,000. In
consideration for extending the term of the 2002 borrowings and for loaning the
additional $190,000, Smart Online issued an additional 150,000 shares of Common
Stock to Mr. Furr. Smart Online recorded interest expense of $75,000 in 2003 and
2004 related to this issuance. In additional, this note accrued interest at a
rate of 15% per annum. At that time, Mr. Furr extended the due date of the first
loan and evidenced the loan extension with a second note in the amount of the
$42,473 unpaid principal and interest from the







93





first
loan. The new note was also due May 13, 2004 and accrued 15% interest compounded
annually. At the time of the second loan, Smart Online granted William Furr, a
security interest in all the assets of Smart Online, which was a first priority
lien to accrue all amounts owed to Mr. Furr. Smart Online repaid all amounts
owed to William Furr on March 24, 2004.




As of
December 31, 2004, the Smart Online owed certain officers (Michael Nouri, Henry
Nour, Ronna Loprete, Thomas Furr and Eric Nouri) deferred compensation of
$949,777 and accrued interest thereon of $142, 037. This deferred compensation
was for nonpayment of a portion of the compensation, including commissions and
interest charges on previously earned but unpaid compensation, from the second
quarter of 2001 until September, 2003. In October 2003, these salary deferrals
plus interest were converted to promissory notes (the “2003 Notes”) in the
aggregate amount of $1,049,765. These 2003 Notes bore 15% interest and were
payable on demand, but on December 19, 2003, the officers agreed not to demand
payment until May 31, 2004. During the fourth quarter of 2003 and the first
quarter of 2004, these officers deferred an additional $141,771 of
compensation.  Additionally, during this period $50,135 of the original
notes payable were repaid.  In April 2004, the holders of the 2003 Notes
agreed to exchange the 2003 Notes for new promissory notes (the “2004 Notes”)
with due dates of December 31, 2004. The principal amount of the 2004 Notes,
$1,141,401, included the unpaid principal from the 2003 Notes, plus the
subsequent deferrals.  Subsequently during 2004, $160,904 was repaid
against the 2004 Notes and an additional $2,302 of compensation was
deferred.  The 2004 Notes bore interest at a rate of 15% per annum through
June 1, 2004 at which time the holders voluntarily reduced the rate to 8% per
annum. On April 30, 2004, the 2004 Notes were extended until May 31, 2005, but
later during 2004 the officers entered into standstill agreements not to demand
payment until June 30, 2006. The standstill agreement was again amended on
December 22, 2004, to provide that demand for payment could be made upon the
earlier of June 30, 2006 or the closing after January 1, 2005 of a financing
with gross proceeds to Smart Online of $2,000,000 or more. After Smart Online
raised $2,500,000 from a sale of securities to a foreign investor in February
2005, Smart Online paid in full the $949,777 of deferred compensation, plus all
accrued interest of $154,288, and cancelled the related promissory notes to
these officers as follows: Michael Nouri $296,667, Henry Nouri $398,383, Ronna
Loprete $92,500, Thomas Furr $117,810, and Eric Nouri $44,417. The 2003 Notes
and 2004 Notes and all other obligations of Smart Online arising out of loans
and salary deferrals were secured by all the assets of Smart Online. The
security interest was originally a second lien on all the assets, but with
repayment of all amounts owed to the holder of the first lien (William Furr),
the security interest became a first lien on all the assets of Smart
Online.




**Put
Agreements In Connection With Private Placement Investor**




Michael
Nouri and Doron Roethler (“Grantors”) entered into a Put Agreements dated March
10, 2004 and August 13, 2004 with Atlas Capital, SA (“Atlas”). Smart Online is
not a party to this agreement, but these agreements were entered into at the
time of an investment in Smart Online by Atlas to provide comfort to Atlas that
Smart Online would fulfill its promise to cause its common stock to become
publicly traded. The Put Agreements give Atlas the right to require Mr. Nouri
and Mr. Roethler to purchase for $2,700,000 all the 728,571 shares of common
stock and warrants to purchase 188,571 shares of common stock Atlas purchased
from Smart Online in March 2004 and August 2004. Atlas also owns 162,857 shares
of common stock and warrants to purchase 48,857 which are not covered by any Put
Agreement.  The Put Agreements can be exercised in the sole discretion of
Atlas during the month of March 2005 or during the month of March 2006, but the
Put Agreements terminate and the put options cannot be exercised after (i) the
common stock of Smart Online is listed or quoted for pubic trading, or (ii) the
stockholders of Smart Online vote to approve any action reasonably necessary to
cause Smart Online stock to be publicly traded, but Atlas votes against the
action, or (iii) Atlas transfers any of its common stock or warrants of Smart
Online.  The Put Agreements are not assignable and terminate if Atlas
transfers the securities covered by the Put Agreements. The Put Agreements
terminated by agreement with Atlas on March 18, 2005.




**Corporate
Reorganization**




During
the first quarter of 2004, Smart Online completed a corporate reorganization
(the “Reorganization”) of its capital stock, which eliminated the Series A
Preferred Stock of Smart Online. All holders of Series A Preferred Stock who
participated in the reorganization by signing Reorganization, Lock-up Proxy and
Release agreements dated January 1, 2004 (the “Reorganization Agreements”)
received approximately 2.22 shares of common stock (of which 1.22 shares were
issued under conversion rights and one share was issued in consideration for
contractual commitments) Smart Online for each share of Series A Preferred Stock
they held prior to the Reorganization and also received the right to receive
cash payments from Smart Online equal to a percentage of the net proceeds Smart
Online raises during calendar year 2004 from sales of equity securities and
convertible debt securities in excess of $5 million of net proceeds. The
percentage payable to participating holders of Series A Preferred Stock is as
follows: (i) 20% of net proceeds between $5 million and $10 million of net
proceeds, (ii) 30% of net proceeds between $10 million and $15 million of net
proceeds, and (iii) 40% of net proceeds between $15 million and $20 million of
net proceeds. As of December 31, 2004, we raised approximately $4.6 million of
net proceeds.  Consequently, no payments have been due or will be due
pursuant to this provision. In August 2004, the former holders of Series A
Preferred Stock ratified their prior approval of the
Reorganization.







94







Participating
holders of Series A Preferred Stock who signed the Reorganization Agreements
also agreed to subject approximately 90% of the common shares they received in
the reorganization to transfer restrictions that include, among other
restrictions, a “lock-up” agreement preventing the sale or transfer of the
shares (other than transfers to certain related parties). The restrictions are
effective through September 30, 2006, but commencing October 1, 2005 each holder
subject to the provisions of the Lock-up Agreements may transfer up to 8.5% of
such holder’s shares that are subject to the restrictions during each calendar
month. The Reorganization Agreements also contained mutual releases by Smart
Online and participating holders of Series A Preferred Stock.




**Private
Placement**




From
March through June 2004, Smart Online sold 999,141 shares of its common stock
and warrants to purchase 288,638 shares of its common stock for an aggregate
gross purchase price of $3,496,994 to 19 investors pursuant to a private
offering. Different investors received different amounts of warrants depending
on the amount invested. On average, investors received a warrant to purchase
approximately three-tenths of a share of Common Stock for each share they
purchased. The warrants have an exercise price of $3.50 per share. These shares
are included in a registration statement that became effective on February 15,
2005.




**Rescission
Offer**




On August
6, 2004, Smart Online made a rescission offer to shareholders who purchased
999,141 shares of common stock of Smart Online and warrants to acquire an
additional 288,638 shares of common stock for $3.50 per share in a private
placement conducted during March through June of 2004, in which Smart Online
raised a total of $3,496,994. The rescission offer was made because in
connection with the audit of its financial statements and due diligence review
of information in connection with preparing the registration statement of which
this Prospectus is a part, Smart Online identified certain inaccuracies and
omissions in the information it provided to investors in the private
placement.  These inaccuracies and omissions included changes to how Smart
Online recognized revenue, establishing reserves for contingent liabilities,
inventory, accounts receivable, and equipment write downs and other accounting
adjustments, failing to disclose the effects of antidilution provisions after
dilutive issuances and failure to disclose information about customers,
discounting, promotions and other product price information.   Upon
identifying such inaccuracies and omissions, Smart Online made the rescission
offer and disclosed the inaccuracies and omissions to all investors who
purchased shares in the private placement. In the rescission offer, Smart Online
offered to repurchase all the shares and warrants sold in the private placement
for the original purchase price, plus interest, and afforded shareholders a
thirty-day period in which to accept the rescission offer. One shareholder
accepted the rescission offer and Smart Online paid that shareholder $102,610 as
payment in full of the purchase price and interest. No other shareholders
accepted the rescission offer and all shareholders to whom the offer was made
executed and delivered releases for any potential liabilities arising out of
disclosures made by Smart Online in the private placement.




**Shares
Issued in Pursuant to Registration Rights Agreement**




In
connection with the private placement conducted during March through June of
2004, Smart Online and the investors executed registration rights agreements.
This registration rights agreement required Smart Online to pay investors 2% of
their investment for each thirty-day period after June 30, 2004 in which Smart
Online failed to file a registration statement registering shares sold in the
private placement, which amount is prorated for partial 30-day periods. The
registration rights agreements provided that Smart Online could choose to pay
this by issuing shares of its common stock in lieu of cash, which Smart Online
chose to do. On November 1, 2004, Smart Online issued 58,226 shares of its
common stock to satisfy amounts that accrued through November 1, 2004 at the
rate of one share for each $3.50 of accrued liability. These shares were
included in a registration statement that became effective on February 15,
2005.




**Exchange
of Bank One Warrant**




In 2001,
Smart Online issued to Bank One, N.A., a warrant to purchase 619,309 shares of
the common stock of Smart Online for an exercise price of $18.00 per share in
connection with Smart Online and Bank One entering into a syndication partnering
agreement. The warrant contained a weighted average anti-dilution provision,
which caused the exercise price of the warrant to decrease to approximately
$12.04 per share and the number of shares issuable upon exercise of the warrant
to increase to approximately 925,789 shares of common stock as of August 1,
2004. To simplify its capital structure, Smart Online offered to issue shares of
common stock of Smart Online to Bank One in exchange for cancellation of the
warrant. On September 3, 2004, Bank One exchanged the warrant for 100,000 shares
of common stock of Smart Online, which shares were issued to J P Morgan Chase
& Co., an affiliate of Bank One. These shares are included in a registration
statement that became effective on February 15, 2005.







95







**Private
Placement**




During
August through September 27, 2004, Smart Online sold 290,000 shares of its
common stock to investors in a private placement for a price of $5.00 per share,
for an aggregate of $1,450,000. These shares were included in a registration
statement that became effective on February 15, 2005.




**Revenue
and Expense Transactions**




Refer to
“Item 7. Management’s Discussion and Analysis of Financial Performance and
Results of Operations - Revenue from Related Parties” and Notes to Financial
Statements for a description of related party transactions with companies that
resulted in Smart Online receiving revenue or incurring expenses.




**Stock
Sales to Insiders**




The
following table summarizes sales by us of our common stock since January 1, 2004
to our executive officers, directors and persons who currently own five percent
or more of our total voting securities. These transactions do not include grants
of stock options which are disclosed in “Executive Compensation.”




**Shares
      of**
      **Common**
      **Stock**
    
    **Total**
      **Purchase**
      **Price**
    
    **Date
      of**
      **Purchase**Atlas
      Capital
    
    
    628,571
    
    $
    2,200,000
    
    
    3/22/2004Atlas
      Capital
    
    
    162,857
    
    $
    570,000
    
    
    5/24/2004Atlas
      Captial
    
    
    100,000
    
    $
    500,000
    
    
    8/30/2004




Greenleaf
Ventures, owned by a shareholder of Smart Online, Doron Roethler, purchased
495,319 shares of our Series A Preferred Stock from us on November 17, 2003 for
$495,320. These shares were exchanged for 1,098,619 shares of our Common Stock
in the reorganization that occurred in the first quarter of 2004.




**Fees
for Sales of Stock**





Smart
Online raised $2,500,000 in a sale of Common Stock under Regulation S during the
first quarter of 2005. A company introduced to Smart Online by Doron
Roethler, a shareholder of Smart Online, was paid a fee in the amount of
$250,000 for introducing the investor to Smart Online.





**Item
14. Principal Accounting Fees and Services**





**Independent
Accountant Fees**





During
2004, the Company engaged BDO Seidman, LLP to provide services in the following
categories and amounts:





**Audit
Fees**





Aggregate
fees billed for professional services rendered for the audit of the Company’s
annual financial statements and reviews of financial statements included in the
Company’s SB-2 Registration statement were $157,983. The audits for fiscal
years 2002 and 2003 were performed during fiscal 2004.  The audit fees also
include review of the Company's SB-2 Registration Statement and subsequent
amendments.





**Audit-Related
Fees**





None.





**Tax
Fees**





The
principal accountant did not provide professional services related to tax
compliance, tax advice, and tax planning during fiscal years 2004 and 2003.





**All
Other Fees**





None.





96














**PART
IV**





**Item
15. Exhibits and Financial Statement Schedules**





(a)
    
    1.
      Financial Statements: See “Index to Consolidated Financial Statements” in
      Part II, Item 8 on page 56 of this Form 10-K.2.
      Financial Statement Schedule: None.(b)
    Exhibits:
      The exhibits listed in the accompanying index to exhibits are filed or
      incorporated by reference as part of this
  Form 10-K.(c)
    Financial
      Statement Schedules omitted by reason of Rule 14a-3(b): 
      None








97








**SIGNATURES**





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





SMART ONLINE, INC.
      RegistrantBy:
    /s/  Michael
  NouriMichael
      Nouri, Principal Executive Officer
      April
      13, 2005


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








/s/ Scott
Whitaker


Scott Whitaker, Principal Financial Officer and


Principal
Accounting Officer


April 13,
2005








/s/
Michael Nouri


Michael
Nouri


Principal
Executive Officer and Director


April 13,
2005








/s/ Ronna
Loprete


Ronna
Loprete


Director


April 13,
2005








/s/ Tom
Furr


Tom
Furr


Director


April 13,
2005








/s/ Henry
Nouri


Henry
Nouri


Director


April 13,
2005














98





**INDEX
TO EXHIBITS**


**Incorporated
by Reference**


________________________________________





**Exhbit
      Number**
    **Exhibit
      Description**
    **Form**
    **File**
      **Number**
    **Exhibit**
    **Filing**
      **Date**
    **Filed**
      **Herewith**3.1
    Amended
      and Restated
      Certification
      of Incorporation
    SB-2
    333-119385
    3.1
    9/30/043.2
    Amended
      and Restated By-Laws
    SB-2
    333-119385
    3.1
    9/30/0410.1
    2004
      Equity Compensation Plan
    SB-2
    333-119385
    10.1
    9/30/0410.2
    2001
      Equity Compensation Plan
    SB-2
    333-119385
    10.2
    9/30/0410.3
    1998
      Stock Option Plan
    SB-2
    333-119385
    10.3
    9/30/0410.4
    Form
      of Reorganization Lock-up Proxy and Release Agreement dated 1/01/04
      between Online and stockholders of Smart Online
    SB-2
    333-119385
    10.4
    9/30/0410.5
    Form
      of Lock-up Agreement dated 01/01/04, between Online and stockholders of
      Smart Online
    SB-2
    333-119385
    10.5
    9/30/0410.6
    Form
      of Subscription Agreement with lock-up provisions between Smart Online and
      investors
    SB-2
    333-119385
    10.6
    9/30/0410.7
    Form
      of Registration Rights Agreement dated as of 02/01/04 between Smart Online
      and investors
    SB-2
    333-119385
    10.7
    9/30/0410.8
    Employment
      Agreement dated 04/01/04 with Michael Nouri
    SB-2
      Amendment
      1
    333-119385
    10.8
    11/24/0410.9
    Employment
      Agreement dated 04/01/04 with
      Henry
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.9
    11/24/0410.10
    Employment
      Agreement dated 04/01/04 with Ronna Loprete
    SB-2
      Amendment
      1
    333-119385
    10.10
    11/24/0410.11
    Employment
      Agreement dated 05/01/04 with Jose Collazo
    SB-2
      Amendment
      1
    333-119385
    10.11
    11/24/0410.12
    Employment
      Agreement dated 05/01/04 with Anil Kamath
    SB-2
      Amendment
      1
    333-119385
    10.12
    11/24/0410.13
    Security
      Agreement dated 10/13/03 with Smart Online as the Debtor and Michael
      Nouri, Henry Nouri, Thomas Furr, Ronna Loprete and Eric Nouri as the
      Secured Parties
    SB-2
      Amendment
      1
    333-119385
    10.13
    11/24/0410.14
    $418,749.93
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Michael
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.14
    11/24/0410.15
    $64,602.90
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Michael
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.15
    11/24/0410.16
    $398,383.27
      Promissory Note dated 04/01/04 from Smart Online as the Debtor to Henry
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.16
    11/24/0410.17
    $116,507.60
      Promissory Note dated 04/30/04 from Smart Online as the Debtor Thomas
      Furr
    SB-2
      Amendment
      1
    333-119385
    10.17
    11/24/0410.18
    $92,500
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Ronna
      Loprete
    SB-2
      Amendment
      1
    333-119385
    10.18
    11/24/0410.19
    $47,740.18
      Promissory Note dated 04/30/04 from Smart Online as the Debtor to Eric
      Nouri
    SB-2
      Amendment
      1
    333-119385
    10.19
    11/24/0410.20
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Michael
      Nouri
    SB-2
      Amendment
      2
    333-119385
    10.20
    12/23/0410.21
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Henry
      Nouri
    SB-2
      Amendment
      2
    333-119385
    10.21
    12/23/0410.22
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Thomas
      Furr
    SB-2
      Amendment
      2
    333-119385
    10.22
    12/23/0410.23
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Ronna
      Loprete
    SB-2
      Amendment
      2
    333-119385
    10.23
    12/23/0410.24
    Standstill
      and Interest Modification Agreement dated 12/22/04 with Eric
      Nouri
    SB-2
      Amendment
      2
    333-119385
    10.24
    12/23/0410.25
    Amended
      and Restated Integration Program Agreement for Vmail and Internet
      Messenger Engine dated 04/30/03 with Smart IL, Ltd.
    SB-2
      Amendment
      1
    333-119385
    10.25
    11/24/0410.26
    Amendment
      to Amended and Restated Integration Program Agreement dated 10/29/03 with
      Smart IL, Ltd.
    SB-2
      Amendment
      1
    333-119385
    10.26
    11/24/04











**Exhibit
      Number**
    **Exhibit
      Description**
    **Form**
    **File**
      **Number**
    **Exhibit**
    **Filing**
      **Date**
    **Filed**
      **Herewith**31.1
    Certification
      of Principal Executive Officer Pursuant to Rule 13a-14(a) of the
      Securities Exchange Act of 1934, as amended (the Exchange
    Act)
    
    
    
    
    X31.2
    Certification
      of Principal Financial Officer and Principal Accounting Officer Pursuant
      to Rule 13a-14(a) of the Exchange Act
    
    
    
    
    X32.1
    Certification
      of the Principal Executive Officer Pursuant to Rule 13a-14(b) of the
      Exchange Act and 18 U.S.C. Section 1350, as Adopted Pursuant to Section
      906 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    X32.2
    Certification
      of the Principal Financial Officer and the Principal Accounting Officer
      Pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350,
      as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002
    
    
    
    
    X