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, 2008
 or
 o TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 For the
transition period from __________ to __________
 
 Commission
file number 001-32634
  SMART
ONLINE, INC.
 (Exact
name of registrant as specified in its charter)
 Delaware
                (State
      or other jurisdiction of incorporation
                or
      organization)
              
              95-4439334
                (I.R.S.
      Employer Identification No.)4505
      Emperor Blvd., Ste. 320
                Durham,
      North Carolina
                (Address
      of principal executive offices)
              
              27703
                (Zip
      Code)
 (919)
765-5000
 (Registrant’s
telephone number, including area code)
 
 Securities
registered pursuant to Section 12(b) of the Act:
 Title
      of each class
              
              Name
      of each exchange on which registeredN/A
              
              N/A
 
 Securities
registered pursuant to Section 12(g) of the Act:
 Common Stock, $0.001 par
value
 (Title of
Class)
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes o No x
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act. Yes o No x
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x No o
 
 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. o
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
 Large
      accelerated filer o
              Accelerated
      filer oNon-accelerated
      filer o
                (Do
      not check if a smaller reporting company)
              Smaller
      reporting company x
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act). Yes o No x
  The
aggregate market value of common stock held by non-affiliates of the registrant
as of June 30, 2008 was approximately $47,601,644
(based on the closing sale price of $3.15 per share).
 
 The
number of shares of the registrant’s Common Stock, $0.001 par value per share,
outstanding as of March 24, 2009 was 18,333,455.
 
 DOCUMENTS
INCORPORATED BY REFERENCE
 
 Portions
of the definitive Proxy Statement to be delivered to stockholders in connection
with the Annual Meeting of Stockholders to be held June 16, 2009 are
incorporated by reference into Part III.
  
 
 TABLE OF
CONTENTS
 
 PART
      I
                  3Item
      1.
                  Business
                  3Item
      1A.
                  Risk
      Factors
                  9Item
      1B.
                  Unresolved
      Staff Comments
                  15Item
      2.
                  Properties
                  15Item
      3.
                  Legal
      Proceedings
                  15Item
      4.
                  Submission
      of Matters to a Vote of Security Holders
                  15PART
      II
                  15Item
      5.
                  Market
      for Registrant’s Common Equity, Related Stockholder Matters and
      IssuerPurchases
      of Equity Securities
                  15Item
      6.
                  Selected
      Financial Data
                  16Item
      7.
                  Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                  16Item
      7A.
                  Quantitative
      and Qualitative Disclosures About Market Risk
                  32Item
      8.
                  Financial
      Statements and Supplementary Data
                  33Item
      9.
                  Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                  57Item
      9A.
                  Controls
      and Procedures
                  57Item
      9A(T).
                  Controls
      and Procedures
                  57Item
      9B.
                  Other
      Information
                  59PART
      III
                  59Item
      10.
                  Directors,
      Executive Officers and Corporate Governance
                  59Item
      11.
                  Executive
      Compensation
                  59Item
      12.
                  Security
      Ownership of Certain Beneficial Owners and Management and
      RelatedStockholder
      Matters
                  59Item
      13.
                  Certain
      Relationships and Related Transactions, and Director
      Independence
                  59Item
      14.
                  Principal
      Accounting Fees and Services
                  59PART
      IV
                  60Item
      15.
                  Exhibits,
      Financial Statement Schedules
                  60SIGNATURES
                  64EXHIBIT
      INDEX
                  65
  
  PART I
 
 Special Note Regarding
Forward-Looking Statements
 
 This
Annual Report on Form 10-K contains forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933, or the Securities Act, and
Section 21E of the Securities Exchange Act of 1934, or the Exchange Act,
regarding our plans, objectives, expectations, intentions, future financial
performance, future financial condition, and other statements that are not
historical facts. You can identify these statements by our use of the future
tense, or by forward-looking words such as “may,” “will,” “expect,”
“anticipate,” “believe,” “intend,” “estimate,” “continue,” and other similar
words and phrases. Examples of sections containing forward-looking statements
include Part I, Item 1, “Business” and Part II, Item 7, “Management’s Discussion
and Analysis of Financial Condition and Results of Operations.” These
forward-looking statements are subject to risks, uncertainties, and assumptions
that are difficult to predict. Therefore, actual results may differ materially
and adversely from those expressed in any forward-looking statements. Readers
are directed to risks and uncertainties identified in Part I, Item 1A, “Risk
Factors” and elsewhere in this report for factors that may cause actual results
to be different than those expressed in these forward-looking statements. Except
as required by law, we undertake no obligation to revise or update publicly any
forward-looking statements for any reason.
 
 Item 1.
              Business
 
 General
 
 In this
Annual Report on Form 10-K, we refer to Smart Online, Inc. as “Smart Online,”
the “Company,” “us,” “we,” and “our.” Smart Online was incorporated in Delaware
in August 1993 and became a public company through a self-registration in
February 2005. Smart Online’s common stock trades on the OTC Bulletin Board, or
the OTCBB, under the symbol “SOLN.”
 
 We
develop and market software products and services targeted to small businesses
that are delivered via a Software-as-a-Service, or SaaS, model. We also provide
website consulting services, primarily in the e-commerce retail industry. We
reach small businesses primarily through arrangements with channel partners that
private label our software applications and market them to their customer bases
through their corporate websites. We believe these relationships provide a cost-
and time-efficient way to market to a diverse and fragmented yet very sizeable
small-business sector. We also offer our products directly to end-user small
businesses through our OneBiz® branded
website.
 
 History
 
 During
the early stages of our development, we offered application-specific software
using the “shrink-wrapped” method of distribution of diskettes and CD-ROMs,
primarily through large office supply retailers. In 2000, we undertook a
significant shift in our business strategy by moving away from the development
and sale of shrink-wrapped software products and began developing SaaS
applications for sale over the Internet.
 
 Unlike
the shrink-wrapped distribution method that requires the end user to install,
configure, and maintain hardware, software, and network services internally to
support the software applications, or the ASP model that permits access to the
software resident on a server by a user from one dedicated PC, our proprietary
multi-tenant SaaS applications allow small businesses to subscribe and access
those applications via a browser from any PC on an as-needed basis, with no
installation or maintenance required by the end user.
 
 In
October 2005, we acquired substantially all of the assets of Computility, Inc.,
or Computility, an Iowa-based, privately held developer and distributor of sales
force automation and customer relationship management, or SFA/CRM, software
applications. We operated this business under the name Smart CRM, Inc. (d/b/a
Computility), or Smart CRM. Upon our integration of Smart CRM’s SFA/CRM
application into our OneBiz®
platform, we determined that the remaining operations of Smart CRM, specifically
consulting and network management, were not integral to our ongoing operations
and business model. On September 29, 2006, we sold these non-integral Smart CRM
assets to Alliance Technologies, Inc., or Alliance, and reclassified Smart CRM
as a discontinued operation.
  3
 
 The Smart
CRM assets sold to Alliance included the SFA/CRM software application developed
and sold by Smart CRM and its predecessor-in-interest, Computility. We retained
all rights relating to the derivative SFA/CRM SaaS application developed by us
with Smart CRM and incorporated into our SaaS offerings.
 
 In
October 2005, we purchased all of the capital stock of iMart Incorporated, or
iMart, a Michigan-based company providing multi-channel e-commerce systems.
Subsequently, we operated this business as our wholly owned subsidiary, Smart
Commerce, Inc., or Smart Commerce.
 
 In 2007,
we operated our company as two segments. The two segments were our core
operations, or the Smart Online segment, and the operations of our
wholly owned subsidiary Smart Commerce, or the Smart Commerce segment. The
Smart Online segment generated revenues from the development and distribution of
Internet-delivered SaaS small-business applications through a variety of
channels. The Smart Commerce segment generated revenues primarily from
subscriptions to our multi-channel e-commerce systems, including domain name
registration and e-mail solutions, e-commerce solutions, and website design, as
well as website hosting and consulting services. We included costs that were not
allocated to specific segments, such as corporate general and administrative
expenses and share-based compensation expenses, in the Smart Online
segment. During late 2007 and the first quarter of 2008, we realigned
certain production and development functions and eliminated redundant
administrative functions and now report the consolidated business as a single
business segment.
 
 In the
second half of 2007, we commenced an overall evaluation of our business model as
well as our current technologies, the outcome of which was our decision to
develop a core industry-standard platform for small business with an
architecture designed to integrate with a virtually unlimited number of other
applications, services, and existing infrastructures. These applications would
include not only our own small-business applications, which we are currently
optimizing, but also other applications we expect to arise from collaborative
partnerships with third-party developers and service providers. In addition, we
identified emerging-market opportunities in the small-business segment to
leverage social networking and community building. We are currently refining and
integrating these capabilities into the core platform to be readily available in
a “plug-and-play” fashion to meet any anticipated customer need or desire. We
believe that this platform and associated applications will provide
opportunities for new sources of revenue, including an increase in our
subscription fees. We also believe, because the platform is designed to follow
industry-standard protocol, that the customization efforts and associated
timeline previously necessary to meet a particular customer’s requirements will
diminish significantly, allowing us to shorten the sale-to-revenue cycle.As
we near completion of the development of our industry-standard platform, we
began shifting our focus from development toward the sales and marketing of the
new platform in the fourth quarter of 2008.
 
 In light
of our new operating strategy involving the industry-standard platform, the
consolidation of all operations into our North Carolina headquarters, and other
factors including certain income tax advantages, we concluded in the latter
part of 2008 that it was no longer necessary to operate with the Smart Commerce
and Smart CRM subsidiaries. As a result, an upstream merger was completed as of
December 31, 2008 that merged the subsidiaries with the parent
corporation.
 
 Principal
Products and Services
 
 Our
principal products and services include:
 
 ·
              SaaS
      applications for business management, web marketing, and
      e-commerce;
 ·
              Software
      business tools that assist customers in developing written content;
      and
 ·
              Services
      that are designed to complement our product offerings and allow us to
      create custom business solutions that fit our end users’ and channel
      partners’ needs.
 
 Our SaaS
applications are designed to allow end users to access and work on information
securely from any location where an Internet browser can be accessed. These
applications include:
 
 e-Commerce – Our e-commerce
applications are designed to give customers the capability to conduct
transactions online. These applications also include inventory query, shopping
cart, financial transactions, shipping, domain name registration and
business-to-business communication for small businesses. We provide consulting
services such as website design and launch, among others, in connection with
these applications. Our e-commerce offerings are designed to help direct
marketers increase sales, better leverage corporate resources, and deliver
superior customer service.
  4
 
 SFA/CRM – Our SFA/CRM
application allows end users to create standardized processes to define their
sales approach, create marketing plans, and monitor and guide sales activities.
Users can utilize the customer service management feature to create, monitor,
and track service requests. In addition, users can display and present their
business data with built-in report templates designed to provide information on
sales activity, pipeline activity, revenue, and other relevant business
data.
 
 Business Dashboard – Our
Business Dashboard application provides a snapshot of real-time business data in
a single view, allowing users to monitor key information about their company and
employees. Examples of business information that end users may view on the
dashboard include a list of key documents for the user, daily events scheduled,
product shipments, and a list of new employees. The dashboard displays different
information to each user based upon his or her job function and access levels
within the company.
 
 Accounting – Our Accounting
application is targeted for end users that want to create and maintain their
accounting records online in a secure fashion, but do not have the resources or
desire to utilize traditional accounting applications designed for larger
businesses. The Accounting application enables a user to create invoices, record
payments, print checks, produce real-time financial statements and reports, as
well as manage accounts receivable and payable.
 
 Human Resource Center – Our
Human Resource, or HR, Center application is designed to allow companies to
manage their daily human resources needs, including employee information, HR
documents, performance reviews, and compensation. The HR Center application also
allows employers to manage the attendance records of each employee by creating
and assigning vacation, sick leave, civil leave, and leave under other policies
to each employee. The application allows an end-user manager to monitor and
approve or decline time-off requests and automatically track how much time each
employee has available on a per-policy basis.
 
 Calendar – Our Calendar
application is a full-function, easy-to-use online calendar. The Calendar
application features daily, weekly, and monthly views, together with a mini
calendar that allows the end user to quickly browse to any date. Automated
e-mail reminders can be scheduled, indicating notification of an upcoming event.
In addition, employees may collaborate with their colleagues by sharing their
calendars and events. This application also includes a to-do list to set up
tasks, assign priorities and due dates, and mark tasks as complete.
 
 Contacts – Our Contacts
application is designed to provide users with an online business contact
management system. Contacts can be sorted by group or alphabetically and may be
shared among colleagues. End users can add, edit, and remove contact groups as
needed, or they can use the default set of groups.
 
 In
addition to our SaaS applications, we offer a variety of online tools to assist
users with business processes, such as Business Plan Writer, Business Letters,
Business and Legal Forms, Marketing Plan Writer, Job Description Writer,
Employee Policy Manual Writer, Government Forms, and Business
Guides.
 
 We also
provide services that are designed to complement our product offerings and allow
us to create custom business solutions that fit our channel partners’ needs.
These services include business consulting, graphic design, website content
syndication, specialized compensation calculations, inventory management, domain
name registration, personalized e-mail creation, express package tracking,
business plan writing, e-commerce tax services, e-mail marketing, web analytics,
warehouse order fulfillment, and business and personal calculators.
 
 Mode
of Operations
 
 Software-as-a-Service Model –
We follow the SaaS model for delivering our products and services to end users.
The on-demand SaaS model developed using multi-tenant architecture enables end
users to visit a website and use the SaaS applications, all via a web browser,
with no installation, no special information technology knowledge, and no
maintenance. The SaaS application is transformed into a service that can be used
anytime and anywhere by the end user. Multi-tenant SaaS applications also permit
us to add needed functionality to our applications in one location for the
benefit of all end users. This capability allows us to provide upgrades
universally.
  5
 
 Integration and Sharing– Our
SaaS applications have the capability to allow sharing of information (with
selectivity and control options) among members of an organization. Each company
that subscribes to our SaaS applications can have multiple members or employees
who share information with one another. Information entered by one employee can
be shared and modified by one or more other employees who have the appropriate
access authority.
 
 Target
Market and Sales Channels
 
 Our
consistent focus has been to design software products and services to help start
and run small businesses in a more efficient and cost-effective manner. The
small-business market is diverse and fragmented, yet very large and, we believe,
underserved. We have focused on offering a wide range of software products that
combine simplicity and affordability and that meet the needs of small businesses
with capabilities that typically can be afforded only by much larger companies.
We believe the growth rate of small businesses using web-based applications will
exceed the growth rate of large enterprises. We follow a two-prong approach to
target these small business and entrepreneurial end users that access our
software products and services via the Internet. The first is an indirect
approach via marketing partners that are vertical intermediaries in industries
such as agriculture, finance, telecommunications, direct selling, retail, and
technology as channels to reach these small-business customers. The second is a
direct approach via a website we develop and maintain where our applications and
business tools are marketed and sold via monthly subscription under the
OneBiz®
brand.
 
 Principal
Customers
 
 Currently,
we consider three customers as our major customers, and the loss of any of these
customers could have a material adverse effect on our business.
 
 Britt
Worldwide, or BWW, is an entity that indirectly controls a significant number of
independent business owners, or IBOs, who currently subscribe to our services.
The aggregate of the subscriptions from these IBOs represented approximately 21%
of our consolidated revenues for the year ended December 31, 2008. BWW became a
customer after we acquired iMart in October 2005 and represented 24% of our
revenues in 2007. Although our revenue is derived from the IBOs, BWW can
influence the actions of the IBOs, so this revenue has been aggregated for
purposes of this Annual Report on Form 10-K.
 
 URAssociation,
or URA, is another entity that indirectly controls a significant number of IBOs
who currently subscribe to our services. The aggregate of the subscriptions from
these IBOs represented approximately 28% of our consolidated revenues for the
year ended December 31, 2008. URA became a customer in 2007 and represented 11%
of our revenues in that year. Although our revenue is derived from the IBOs, URA
can influence the actions of the IBOs, so this revenue has been aggregated for
purposes of this Annual Report on Form 10-K.
 
 Vera
Bradley Designs, Inc., or Vera Bradley, is a manufacturer of high quality
handbags, luggage, and other accessories. Vera Bradley accounted for
approximately 28% of our consolidated revenues for the year ended December 31,
2008. Vera Bradley became a customer in 2006 and represented 22% of our revenues
in 2007.
 
 Research
and Development
 
 In the
second half of 2007, as part of a general restructuring, we began to conduct an
evaluation of our technology, platforms, and applications in an effort to
document and improve upon our current product offerings and determine which
applications, if any, should be discontinued. During 2008, we decided to develop
an industry-standard platform that would allow significant technological
flexibility with current and future customers. We devoted a substantial amount
of time and effort in 2008 to developing this platform, updating and migrating
our business applications and tools to the new platform, and enhancing the user
interface of the products.
 
 Our
research and development costs were approximately $3.0 million and $2.5 million
in 2008 and 2007, respectively. We have not engaged in any customer-sponsored
research and development.
  6
  Competition
 
 The
market for small-business software applications in both the traditional and SaaS
environments is highly competitive and subject to rapid changes in technology
and delivery. The direct competition we face depends on the software application
within our platforms and the delivery model capabilities of our
competitors.
 
 We have
two primary categories of competitors: large companies that offer a wide range
of products for small- to medium-size businesses, and companies that offer only
one or two software products that compete with our broad range of software
products. Our principal direct competition is a number of very large vendors of
SaaS applications for small businesses that sell many products similar to ours.
These competitors include, but are not limited to, Microsoft, Oracle, NetSuite,
Intuit, SAP, Sage, Yahoo!, and Google.
 
 Companies
that offer only one or two products that compete with our suite of SaaS
applications include:
 
 ·
              Accounting
      software applications: NetSuite, Intuit, SAP, Sage, Microsoft, and
      others
 ·
              Human
      resource software applications: ADP, Sage, and
  others
 ·
              SFA/CRM
      applications: Microsoft, Sage, salesforce.com, NetSuite, and
      others
 ·
              e-Commerce
      solutions: Register.com, GoDaddy.com, 1and1 Internet, eBay’s Storefront,
      Yahoo! Store, Microsoft, NetSuite, Intuit, and
  others
 
 We also
expect to face competition from new entrants marketing SaaS applications similar
to ours to small businesses.
 
 Although
we believe we offer highly competitive services and software, many of our
competitors do or may have greater resources and a larger number of total
customers for their products and services. In addition, a number of our
competitors already sell certain products to our current and potential
customers, as well as to systems integrators and other vendors and service
providers. These competitors may be able to respond more quickly to new or
emerging technologies and changes in customer requirements, or to devote greater
resources to the development, promotion, and sale of their products, than we
can. It is also possible that new competitors or alliances among competitors or
other third parties may emerge and rapidly acquire market share. Increased
competition may result in price reductions, reduced gross margins, and change in
market share, any of which could adversely impact our revenue and profitability
targets and timetables.
 
 On each
competitive front, we seek to compete against these larger and better-financed
companies primarily by offering an extensive suite of SaaS applications that are
useful to small businesses. We believe we offer more SaaS applications and
features specifically targeted to small businesses than most of our competitors.
We also believe a distinctive value proposition we offer is the integration of
our applications. To meet our business objectives, we will need to continue to
develop high quality and competitively priced new applications for our SaaS
offerings. If we are unable to do so, our revenue and profitability targets and
timetables could be adversely impacted.
 
 To
compete effectively in the SaaS market, we plan to leverage the marketing
resources and small-business customer relationships of our private-label
marketing partners that sell our SaaS applications by offering innovative and
value-added products and services.
 
 Intellectual
Property
 
 Our
success depends, in part, upon our proprietary technology, processes, trade
secrets, and other proprietary information and our ability to protect this
information from unauthorized disclosure and use. We rely on a combination of
copyright, trade secret, and trademark laws, confidentiality procedures,
contractual provisions, and other similar measures to protect our proprietary
information. We do not own any issued patents or have any patent applications
pending. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy or design around certain aspects of our SaaS
offerings or to obtain and use information that we regard as proprietary, and
third parties may attempt to develop similar technology independently. In
addition, the laws of some foreign countries do not protect our proprietary
rights to the same extent as do the laws of the United States, and we expect
that it will become more difficult to monitor use of our products if we develop
an international presence.
  7
  We have
registered copyrights, trademarks, and registered service marks on several
products and data services. These marks include, but are not limited to: Smart
Online®,
OneBiz®, Smart
Attorney®, Smart
Business Plan®, Smart Marketing Plan®,
iMartTM, and
OneDomain®.
 
 As part
of our efforts to protect our proprietary information, we enter into license
agreements with our customers and nondisclosure agreements with certain of our
employees, consultants, and corporate partners. These agreements generally
contain restrictions on disclosure, use, and transfer of our proprietary
information for a period of three years. We also employ various physical and
technological security measures to protect our software source codes,
technology, and other proprietary information.
 
 Employees
 
 As of
December 31, 2008, we had 38 full-time employees. No employees are known by us
to be represented by a collective bargaining agreement, and we have never
experienced a strike or similar work stoppage.
 
 Directors
and Executive Officers of the Company
 
 The
members of our current Board of Directors are the following:
  Doron
      Roethler
                    Chairman
      of the Board and Interim President and Chief Executive Officer; Managing
      Director of TMF Airmarine BV, an independent aviation spare parts
      companyShlomo
      Elia
                    Director
      of 3Pen Ltd., a private holding company focusing on business opportunities
      in Internet infrastructure and telecommunicationsRoberta
      B. Hardy
                    Managing
      partner of Silk Road Partners, LLC, a “Mentor Capital” firm providing
      guidance to early stage companies and exit strategies for later stage
      companies; Chairman of A Million Dreams Across America, a non-profit
      organization that provides intensive training for entrepreneurs; and
      Chairman of Atlantis Group, LLC, an angel investment
  groupC.
      James Meese, Jr.
                    President
      of Business Development Associates, Inc., a strategic advisory firm that
      consults with middle market companies on acquisitions, divestitures,
      valuations and corporate governance.Dror
      Zoreff
                    President
      and CEO of Donor Management Services, Inc., a New York-based company that
      provides major donors, corporations, and foundations a unique set of tools
      and services to ensure their charitable gifts are properly used and
      achieve the desired
impact
 
 Our
current executive officers are the following:
  Doron
      Roethler
                  Interim
      President and Chief Executive OfficerNeile
      King
                  Chief
      Operating Officer and Vice President, Sales and
  MarketingTimothy
      Krist
                  Chief
      Financial Officer
  8
  Available
Information
 
 Our
corporate information is accessible through our main web portal at www.smartonline.com.
We are not including the information contained on our website as a part of, or
incorporating it by reference into, this Annual Report on Form 10-K. Although we
endeavor to keep our website current and accurate, there can be no guarantees
that the information on our website is up to date or correct. We make available,
free of charge, access to all reports filed with the U.S. Securities and
Exchange Commission, or SEC, including our Annual Reports on Form 10-K, our
Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and
amendments to these reports, filed or furnished pursuant to Section 13(a)
or 15(d) of the Exchange Act, as soon as reasonably practicable after we
electronically file such material with, or furnish it to, the SEC. These reports
may be accessed by following the link under “About Us - Investor Relations” on
our website.
 
 ITEM
      1A.
              Risk
      Factors
 
 We
operate in a dynamic and rapidly changing business environment that involves
substantial risk and uncertainty, and these risks may change over time. The
following discussion addresses some of the risks and uncertainties that could
cause, or contribute to causing, actual results to differ materially from
expectations. In evaluating our business, you should pay particular attention to
the descriptions of risks and uncertainties described below. These risks and
uncertainties are not the only ones we face. Additional risks and uncertainties
not presently known to us that we currently deem immaterial, or that are similar
to those faced by other companies in our industry or business in general, may
also affect our business. If any of the risks described below actually occur,
our business, financial condition, or results of operations could be materially
and adversely affected.
 
 Historically,
we have operated at a loss, and we continue to do so.
 
 We have
had recurring losses from operations and continue to have negative cash flows.
If we do not become cash flow positive through additional financing or growth,
we may have to cease operations and liquidate our business. Our working capital,
including our revolving line of credit with Paragon Commercial Bank, or Paragon,
and convertible note financing should fund our operations for the next 12 to 18
months. As of March 24, 2009, we have approximately $200,000 available on our
line of credit and approximately $9 million available through our convertible
note financing. Factors such as the commercial success of our existing services
and products, the timing and success of any new services and products, the
progress of our research and development efforts, our results of operations, the
status of competitive services and products, the timing and success of potential
strategic alliances or potential opportunities to acquire technologies or
assets, the charges filed against a former officer and a former employee by the
SEC and the United States Attorney General, and the pending shareholder class
action lawsuit may require us to seek additional funding sooner than we expect.
If we fail to raise sufficient financing, we will not be able to implement our
business plan and may not be able to sustain our business.
 
 In
addition, our current primary credit facilities consisting of the Paragon line
of credit and the convertible note financing both have maturity dates in 2010.
Should we be unable to repay the principal then due from operations or from new
or renegotiated capital funding sources, we may not be able to sustain our
business. As of March 24, 2009, we have approximately $2.27 million outstanding
on our line of credit and $6.3 million aggregate principal amount of convertible
notes outstanding.
 
 Our
independent registered public accountants indicate that they have substantial
doubts that we can continue as a going concern. Our independent registered
public accountants’ opinion may negatively affect our ability to raise
additional funds, among other things. If we fail to raise sufficient capital, we
will not be able to implement our business plan, we may have to liquidate our
business, and you may lose your investment.
 
 Sherb
& Co., LLP, our independent registered public accountants, has expressed
substantial doubt in their report included with this Annual Report on Form 10-K
about our ability to continue as a going concern given our recurring losses from
operations and deficiencies in working capital and equity, which are described
in the first risk factor above. This opinion could materially limit our ability
to raise additional funds by issuing new debt or equity securities or otherwise.
If we fail to raise sufficient capital, we will not be able to implement our
business plan, we may have to liquidate our business, and you may lose your
investment. You should consider our independent registered public accountants’
comments when determining if an investment in us is suitable.
  9
  Current economic uncertainties in the
global economy could adversely impact our growth, results of operations, and our
ability to forecast future business.
 
 Since
2008, there has been a downturn in the global economy, slower economic activity,
decreased consumer confidence, reduced corporate profits and capital spending,
adverse business conditions, and liquidity concerns. These conditions make it
difficult for our customers and us to accurately forecast and plan future
business activities, and they could cause our customers to slow or defer
spending on our products and services, which would delay and lengthen sales
cycles, or change their willingness to enter into longer-term licensing and
support arrangements with us. Furthermore, during challenging economic times our
customers may face issues gaining timely access to sufficient credit, which
could result in an impairment of their ability to make timely payments to us. If
that were to occur, we may be required to increase our allowance for doubtful
accounts and our results would be negatively impacted.
 
 We may
also face difficulties in obtaining additional credit or renewing existing
credit at favorable terms, or at all, which could impact our ability to fund our
operations or to meet debt repayment requirements as they come due.
 
 We cannot
predict the timing, strength, or duration of any economic slowdown or subsequent
economic recovery. If the downturn in the general economy or markets in which we
operate persists or worsens from present levels, our business, financial
condition, and results of operations could be materially and adversely
affected.
 
 Our
business is dependent upon the development and market acceptance of our
applications.
  Our
future financial performance and revenue growth will depend, in part, upon the
successful development, integration, introduction, and customer acceptance of
our software applications. Thereafter, other new products, whether developed or
acquired, and enhanced versions of our existing applications will be critically
important to our business. Our business could be harmed if we fail to deliver
timely enhancements to our current and future solutions that our customers
desire. We also must continually modify and enhance our services and products to
keep pace with market demands regarding hardware and software platforms,
database technology, information security, and electronic commerce technical
standards. Our business could be harmed if we fail to achieve the improved
performance that customers want with respect to our current and future product
offerings. There can be no assurance that our products will achieve widespread
market penetration or that we will derive significant revenues from the sale or
licensing of our platforms or applications.
 
 We
have not yet demonstrated that we have a successful business model.
 
 We have
invested significantly in infrastructure, operations, and strategic
relationships to support our SaaS delivery model, which represents a significant
departure from the delivery strategies that we and other software vendors have
traditionally employed. To maintain positive margins for our small-business
services, our revenues will need to continue to grow more rapidly than the cost
of such revenues. We anticipate that our future financial performance and
revenue growth will depend, in large part, upon our Internet-based SaaS business
model and the results of our sales efforts to reach agreements with marketing
partners with small-business customer bases, but this business model may become
ineffective due to forces beyond our control that we do not currently
anticipate. Although we currently have various agreements and continue to enter
into new agreements, our success depends in part on the ultimate success of our
marketingpartners
and referral partners and their ability to market our products and services
successfully. Our partners are not obligated to provide potential customers to
us and may have difficulty retaining customers within certain markets that we
serve. In addition, some of these third parties have entered, and may continue
to enter, into strategic relationships with our competitors. Further, many of
our strategic partners have multiple strategic relationships, and they may not
regard us as significant for their businesses. Our strategic partners may
terminate their respective relationships with us, pursue other partnerships or
relationships, or attempt to develop or acquire products or services that
compete with our products or services. Our strategic partners also may interfere
with our ability to enter into other desirable strategic relationships. If we
are unable to maintain our existing strategic relationships or enter into
additional strategic relationships, we will have to devote substantially more
resources to the distribution, sales, and marketing of our products and
services.
  10
 
 In
addition, our end users currently do not sign long-term contracts. They have no
obligation to renew their subscriptions for our services after the expiration of
their initial subscription period and, in fact, they have often elected not to
do so. Our end users also may renew for a lower-priced edition of our services
or for fewer users. These factors make it difficult to accurately predict
customer renewal rates. Our customers’ renewal rates may decline or fluctuate as
a result of a number of factors, including when we begin charging for our
services, their dissatisfaction with our services, and their capability to
continue their operations and spending levels. If our customers do not renew
their subscriptions for our services or we are not able to increase the number
of subscribers, our revenue may decline and our business will
suffer.
 
 Failure
to comply with the provisions of our debt financing arrangements could have a
material adverse effect on us.
 
 Our
revolving line of credit from Paragon is secured by an irrevocable standby
letter of credit issued by HSBC Private Bank (Suisse) SA, or HSBC, with Atlas
Capital SA, or Atlas, as account party. Our secured subordinated convertible
notes are secured by a first priority lien on all of our unencumbered
assets.
 
 If an
event of default occurs under our debt financing arrangements and remains
uncured, then the lender could foreclose on the assets securing the debt. If
that were to occur, it would have a substantial adverse effect on our business.
In addition, making the principal and interest payments on these debt
arrangements may drain our financial resources or cause other material harm to
our business.
 
 If
our security measures are breached and unauthorized access is obtained to our
customers’ data or our data, our service may be perceived as not being secure,
customers may curtail or stop using our service, and we may incur significant
legal and financial exposure and liabilities.
 
 Our
service involves the storage and transmission of customers’ proprietary
information. If our security measures are breached as a result of third-party
action, employee error, malfeasance or otherwise and, as a result, unauthorized
access is obtained to our customers’ data or our data, our reputation could be
damaged, our business may suffer, and we could incur significant liability. In
addition, third parties may attempt to fraudulently induce employees or
customers to disclose sensitive information such as user names, passwords, or
other information in order to gain access to our customers’ data or our data,
which could result in significant legal and financial exposure and a loss of
confidence in the security of our service that would harm our future business
prospects. Because the techniques used to obtain unauthorized access, or to
sabotage systems, change frequently and generally are not recognized until
launched against a target, we may be unable to anticipate these techniques or to
implement adequate preventative measures. If an actual or perceived breach of
our security occurs, the market perception of the effectiveness of our security
measures could be harmed and we could lose sales and customers. In addition, our
new industry-standard platform may allow access by third-party technology
providers to access customer data. Because we do not control the transmissions
between our customers and third-party technology providers, or the processing of
such data by third-party technology providers, we cannot ensure the complete
integrity or security of such transmissions or processing.
 
 The
SEC action against us, the SEC and criminal actions brought against certain
former employees, and related stockholder and other lawsuits have damaged our
business, and they could damage our business in the future.
 
 The
lawsuit filed against us by the SEC, the SEC and criminal actions filed against
a former officer and a former employee, and the class action lawsuit filed
against us and certain current and former officers, directors, and employees
have harmed our business in many ways and may cause further harm in the future.
Since the initiation of these actions, our ability to raise financing from new
investors on favorable terms has suffered due to the lack of liquidity of our
stock, the questions raised by these actions, and the resulting drop in the
price of our common stock. As a result, we may not raise sufficient financing,
if necessary, in the future.
 
 Legal and
other fees related to these actions have also reduced our available cash for
operations. We make no assurance that we will not continue to experience
additional harm as a result of these matters. The time spent by our management
team and directors dealing with issues related to these actions detracts from
the time they spend on our operations, including strategy development and
implementation. These actions also have harmed our reputation in the business
community, jeopardized our relationships with vendors and customers, and
decreased our ability to attract qualified personnel, especially given the media
coverage of these events.
  11
 
 In
addition, we face uncertainty regarding amounts that we may have to pay as
indemnification to certain current and former officers, directors, and employees
under our Bylaws and Delaware law with respect to these actions, and we may not
recover all of these amounts from our directors’ and officers’ liability
insurance policy carrier. Our Bylaws and Delaware law generally require us
to indemnify, and in certain circumstances advance legal expenses to, current
and former officers, directors, and employees against claims arising out of such
person’s status or activities as our officer, director, or employee, unless such
person (i) did not act in good faith and in a manner the person reasonably
believed to be in or not opposed to our best interests; or (ii) had reasonable
cause to believe his conduct was unlawful. As of March 24, 2009, there are SEC
and criminal actions pending against a former executive officer and a former
employee who have requested that we indemnify them and advance expenses incurred
by them in the defense of those actions. Also, a stockholder class action
lawsuit has been filed against us and certain of our currentand
former officers, directors, and employees. The SEC, criminal, and stockholder
actions are more fully described in Part I, Item 3, “Legal Proceedings,” in this
Annual Report on Form 10-K.
 
 Generally,
we are required to advance defense expenses prior to any final adjudication of
an individual’s culpability. The expense of indemnifying our current and former
directors, officers, and employees for their defenses or related expenses in
connection with the current actions may be significant. Our Bylaws require that
any director, officer, employee, or agent requesting advancement of expenses
enter into an undertaking with us to repay any amounts advanced unless it is
ultimately determined that such person is entitled to be indemnified for the
expenses incurred. This provides us with an opportunity, depending upon the
final outcome of the matters and the Board’s subsequent determination of such
person’s right to indemnity, to seek to recover amounts advanced by us. However,
we may not be able to recover any amounts advanced if the person to whom the
advancement was made lacks the financial resources to repay us. If we are unable
to recover the amounts advanced, or can do so only at great expense, our
operations may be substantially harmed as a result of loss of
capital.
 
 Although
we have purchased insurance that may cover these obligations, we can offer no
assurances that all of the amounts that may be expended by us will be recovered
under our insurance policies. It is possible that we may have an obligation to
indemnify our current and former officers, directors, and employees under the
terms of our Bylaws and Delaware law, but that there may be insufficient
coverage for these payments under the terms of our insurance policies.
Therefore, we face the risk of making substantial payments related to the
defense of these actions, which could significantly reduce amounts available to
fund working capital, capital expenditures, and other general corporate
objectives.
 
 In
addition, our insurance policies provide that, under certain conditions, our
insurance carriers may have the right to seek recovery of any amounts they paid
to us or the individual insureds. As of March 24, 2009, we do not know and can
offer no assurances about whether these conditions will apply or whether the
insurance carriers will change their position regarding coverage related to the
current actions. Therefore, we can offer no assurances that our insurance
carriers will not seek to recover any amounts paid under their policies from us
or the individual insureds. If such recovery is sought, then we may have to
expend considerable financial resources in defending and potentially settling or
otherwise resolving such a claim, which could substantially reduce the amount of
capital available to fund our operations.
 
 Compliance
with regulations governing public company corporate governance and reporting is
uncertain and expensive.
 
 As a
public company, we have incurred and will continue to incur significant legal,
accounting, and other expenses that we did not incur as a private company. We
incur costs associated with our public company reporting requirements and with
corporate governance and disclosure requirements, including requirements under
the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and new rules implemented by
the SEC and the Financial Industry Regulatory Authority, or FINRA. We expect
these rules and regulations to increase our legal and financial compliance costs
and to make some activities more time consuming and costly.
 
 We
currently are required to comply with the requirements of Section 404 of
Sarbanes-Oxley involving management’s assessment of our internal control over
financial reporting, and our independent accountant’s audit of our internal
control over financial reporting is required for fiscal 2009. To comply with
these requirements, we are evaluating and testing our internal controls, and
where necessary, taking remedial actions, to allow management to report on,
and our independent auditors to attest to, our internal control over financial
reporting. As a result, we have incurred and will continue to incur expenses and
diversion of management’s time and attention from the daily operations of
the business, which may increase our operating expenses and impair our
ability to achieve profitability.
  12
 
 Officers,
directors, and principal stockholders control us. This might lead them to make
decisions that do not align with interests of minority
stockholders.
 
 Our
officers, directors, and principal stockholders beneficially own or control a
large percentage of our outstanding common stock. Certain of these principal
stockholders hold warrants and convertible notes, which may be exercised or
converted into additional shares of our common stock under certain conditions.
The convertible noteholders have designated a bond representative to act as
their agent. We have agreed that the bond representative shall be granted access
to our facilities and personnel during normal business hours, shall have the
right to attend all meetings of our Board of Directors and its committees, and
shall receive all materials provided to our Board of Directors or any committee
of our Board. In addition, so long as the notes are outstanding, we have agreed
that we will not take certain material corporate actions without approval of the
bond representative. The Chairman of our Board of Directors currently is serving
as the bond representative.
 
 Our
officers, directors, and principal stockholders, acting together, would have the
ability to control substantially all matters submitted to our stockholders for
approval (including the election and removal of directors and any merger,
consolidation, or sale of all or substantially all of our assets) and to control
our management and affairs. Accordingly, this concentration of ownership may
have the effect of delaying, deferring, or preventing a change in control of us;
impeding a merger, consolidation, takeover, or other business combination
involving us; or discouraging a potential acquirer from making a tender offer or
otherwise attempting to obtain control of us, which in turn could materially and
adversely affect the market price of our common stock.
 
 Any
issuance of shares of our common stock in the future could have a dilutive
effect on the value of our existing stockholders’ shares.
 
 We may
issue shares of our common stock in the future for a variety of reasons. For
example, under the terms of our stock purchase warrant and agreement with Atlas,
it may elect to purchase up to 444,444 shares of our common stock at $2.70 per
share upon termination of, or if we are in breach under the terms of, our line
of credit with Paragon. In connection with our private financing in February
2007, we issued warrants to the investors to purchase an additional 1,176,471
shares of our common stock at $3.00 per share and a warrant to our placement
agent in that transaction to purchase 35,000 shares of our common stock at $2.55
per share. Upon maturity of their convertible notes, our noteholders may elect
to convert all, a part of, or none of their notes into shares of our common
stock at a floating conversion price. In addition, we may raise funds in the
future by issuing additional shares of common stock or other
securities.
  If we
raise additional funds through the issuance of equity securities or debt
convertible into equity securities, the percentage of stock ownership by our
existing stockholders would be reduced. In addition, such securities could have
rights, preferences, and privileges senior to those of our current stockholders,
which could substantially decrease the value of our securities owned by them.
Depending on the share price we are able to obtain, we may have to sell a
significant number of shares in order to raise the necessary amount of capital.
Our stockholders may experience dilution in the value of their shares as a
result.
 
 Shares
eligible for public sale could adversely affect our stock price.
 
 Future
sales of substantial amounts of our shares in the public market, or the
appearance that a large number of our shares are available for sale, could
adversely affect market prices prevailing from time to time and could impair our
ability to raise capital through the sale of our securities. At March 24, 2009,
18,333,455 shares of our common stock were issued and outstanding, and a
significant number of shares may be issued upon the exercise of outstanding
options, warrants, and convertible notes.
  13
  In
addition, our stock historically has been very thinly traded. Our stock price
may decline if the resale of shares under Rule 144, in addition to the resale of
registered shares, at any time in the future exceeds the market demand for our
stock.
 
 Our
stock price is likely to be highly volatile and may decline.
 
 The
trading prices of the securities of technology companies have been highly
volatile. Accordingly, the trading price of our common stock has been and is
likely to continue to be subject to wide fluctuations. Further, our common stock
has a limited trading history. Factors affecting the trading price of our common
stock generally include the risk factors described in this report.
 
 In
addition, the stock market from time to time has experienced extreme price and
volume fluctuations that have affected the trading prices of many emerging
growth companies. Such fluctuations have often been unrelated or
disproportionate to the operating performance of these companies. These broad
trading fluctuations could adversely affect the trading price of our common
stock.
 
 Further,
securities class action litigation has often been brought against companies that
experience periods of volatility in the market prices of their securities. A
securities class action was filed against us in October 2007 as more fully
described in Part I, Item 3, “Legal Proceedings,” of this report. This
securities class action litigation could result in substantial costs and
diversion of our management’s attention and resources. We may determine, like
many defendants in such lawsuits, that it is in our best interest to settle the
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 or any other potential lawsuit could materially harm our
business and financial position and, even if we defend ourselves successfully,
there is a risk that management’s distraction in dealing with this type of
lawsuit could harm our results.
 
 Our
securities may be subject to “penny stock” rules, which could adversely affect
our stock price and make it more difficult for our stockholders to resell their
stock.
 
 The SEC
has adopted rules that regulate broker-dealer practices in connection with
transactions in penny stocks. Penny stocks are generally equity securities with
a price of less than $5.00 per share (other than securities registered on
certain national securities exchanges or quotation systems, provided that
reports with respect to transactions in such securities are provided by the
exchange or quotation system pursuant to an effective transaction reporting plan
approved by the SEC).
 
 The penny
stock rules require a broker-dealer, prior to a transaction in a penny stock not
otherwise exempt from those rules, to deliver a standardized risk disclosure
document prescribed by the SEC and certain other information related to the
penny stock, the broker-dealer’s compensation in the transaction, and the other
penny stocks in the customer’s account.
 
 In
addition, the penny stock rules require that, prior to a transaction in a penny
stock not otherwise exempt from those rules, the broker-dealer must make a
special written determination that the penny stock is a suitable investment for
the purchaser and receive the purchaser’s written acknowledgment of the receipt
of a risk disclosure statement, a written agreement related to transactions
involving penny stocks, and a signed and dated copy of a written suitability
statement. These disclosure requirements could have the effect of reducing the
trading activity in the secondary market for our stock because it will be
subject to these penny stock rules. Therefore, stockholders may have difficulty
selling those securities.
 
 Our
executive management team is critical to the execution of our business plan and
the loss of their services could have a severely negative impact on our
business.
 
 Our
executive management team has undergone significant changes during the last half
of 2007 and during 2008, including the resignation of our Chief Executive
Officer in December 2008. Although we have resolved the SEC charges filed
against us, it may be difficult to attract highly qualified candidates to serve
on our executive management team. If we cannot attract and retain qualified
personnel and integrate new members of our executive management team effectively
into our business, then our business and financial results may suffer. In
addition, all of our executive team works at the same location, which could make
us vulnerable to the loss of our entire team in the event of a natural or other
disaster. We do not maintain key man insurance policies on any of our
employees.
  
  Item 1B.
              Unresolved
      Staff Comments
 
 Not
applicable.
  Item 2.
              Properties
 
 Our
corporate headquarters and research and development facility is located in
Durham, North Carolina near Research Triangle Park and consists of approximately
9,837 square feet of office space held under a prepaid sublease that expires in
September 2011.
 
 Item 3.
              Legal
      Proceedings
 
 Gooden v. Smart Online, Inc.
– On October 18, 2007, Robyn L. Gooden filed a purported class action
lawsuit in the United States District Court for the Middle District of North
Carolina naming us, certain of our current and former officers and directors,
Maxim Group, LLC, and Jesup & Lamont Securities Corp. as defendants. The
lawsuit was filed on behalf of all persons other than the defendants who
purchased our securities from May 2, 2005 through September 28, 2007 and were
damaged. The complaint asserts violations of federal securities laws, including
violations of Section 10(b) of the Exchange Act and Rule 10b-5. The
complaint asserts that the defendants made material and misleading statements
with the intent to mislead the investing public and conspired in a fraudulent
scheme to manipulate trading in our stock, allegedly causing plaintiffs to
purchase the stock at an inflated price. The complaint requests certification of
the plaintiff as class representative and seeks, among other relief, unspecified
compensatory damages including interest, plus reasonable costs and expenses
including counsel fees and expert fees. On June 24, 2008, the court entered an
order appointing a lead plaintiff for the class action. On September 8, 2008,
the plaintiff filed an amended complaint that added additional defendants who
had served as our directors or officers during the class period as well as our
independent auditor.
 
 At this
time, we are not able to determine the likely outcome of the legal matters
described above, nor can we estimate our potential financial exposure. Our
management has made an initial estimate based upon its knowledge, experience and
input from legal counsel, and we have accrued approximately $137,500 of
additional legal reserves. Such reserves will be adjusted in future periods as
more information becomes available. If an unfavorable resolution of any of these
matters occurs, our business, results of operations, and financial condition
could be materially adversely affected.
 
 Item 4.
              Submission
      of Matters to a Vote of Security
Holders
 
 Not
applicable.
  PART II
 
 Item
      5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
 
 Our
common stock is quoted on the OTCBB under the symbol “SOLN.” The following table
sets forth the range of high and low sales prices of our common stock quoted on
the OTCBB for the quarterly periods indicated.
  15
 
 High
                    
                    
                    LowYear
      Ended December 31, 2007:First
      Quarter
                    
                    $
                    3.00
                    
                    
                    $
                    1.95Second
      Quarter
                    
                    $
                    2.95
                    
                    
                    $
                    1.85Third
      Quarter
                    
                    $
                    2.83
                    
                    
                    $
                    0.55Fourth
      Quarter
                    
                    $
                    2.80
                    
                    
                    $
                    1.50Year
      Ended December 31, 2008:First
      Quarter
                    
                    $
                    2.60
                    
                    
                    $
                    1.65Second
      Quarter
                    
                    $
                    3.40
                    
                    
                    $
                    1.32Third
      Quarter
                    
                    $
                    3.30
                    
                    
                    $
                    1.95Fourth
      Quarter
                    
                    $
                    3.15
                    
                    
                    $
                    1.50
 
 At March
24, 2009, there were 206 holders of record of our common stock.
 
 We have
never declared or paid any cash dividends on our common stock and do not intend
to declare or pay dividends for the foreseeable future. As long as our
convertible notes are outstanding, we must receive approval from the agent
designated by the noteholders in order to pay any dividend on our capital
stock.
 
 During
2008, we sold equity securities that were not registered under the Securities
Act, as described in our quarterly reports on Form 10-Q and current reports on
Form 8-K filed in connection with such transactions.
 
 The
following table lists all repurchases during the fourth quarter of 2008 of any
of our securities registered under Section 12 of the Exchange Act by or on
behalf of us or any affiliated purchaser.
 
 Issuer
Purchases of Equity Securities
  Period
                                Total
                                  Number of
                                  Shares
                                  Purchased(1)
                                
                                Average
                                  Price
                                  Paid Per
                                  Share
                                
                                Total Number of
                                  Shares Purchased as
                                  Part of Publicly
                                  Announced Plans or
                                  Programs
                                
                                Maximum
                                  Number of
                                  Shares That May
                                  Yet Be Purchased
                                  Under the Plans
                                  or
      ProgramsOctober
      1 – October 31, 2008
                                -
                                
                                $
                                -
                                
                                -
                                
                                -November
      1 – November 30, 2008
                                -
                                
                                $
                                -
                                
                                -
                                
                                -December
      1 – December 31, 2008
                                122
                                
                                $
                                2.55
                                
                                -
                                
                                -Total
                                122
                                
                                $
                                2.55
                                
                                -
                                
                                -
  (1)
                  Represents shares
      repurchased in connection with tax withholding obligations under the
      Company’s 2004 Equity Compensation
Plan.
  Item
      6.
              Selected
      Financial Data
  Not
applicable.
 
 Item
      7.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
 
 Executive
Summary
 
 The
following discussion is designed to provide a better understanding of our
consolidated financial statements, including a brief discussion of our business
and products, key factors that impacted our performance, and a summary of our
operating results. This executive summary should be read in conjunction with the
more detailed discussion and analysis of our financial condition and results of
operations in this Item 7; Item 1A, “Risk Factors”; and our consolidated
financial statements and the notes thereto included in Item 8, “Financial Statements and
Supplementary Data.”
  16
  Overview
 
 We
develop and market software products and services targeted to small businesses
that are delivered via a SaaS model. We also provide website consulting
services, primarily in the e-commerce retail industry. We reach small businesses
primarily through arrangements with channel partners that private label our
software applications and market them to their customer bases through their
corporate websites. We believe these relationships provide a cost- and
time-efficient way to market to a diverse and fragmented yet very sizeable
small-business sector. We also offer our products directly to end-user small
businesses through our OneBiz® branded
website.
 
 In 2007,
we operated our company as two segments. The segments were our core operations,
or the Smart Online segment, and the operations of our wholly owned
subsidiary Smart Commerce, or the Smart Commerce segment. The Smart Online
segment generated revenues from the development and distribution of
Internet-delivered SaaS small-business applications through a variety of
channels. The Smart Commerce segment generated revenues primarily from
subscriptions to our multi-channel e-commerce systems, including registration
and e-mail solutions, e-commerce solutions, and website design, as well as
website hosting and consulting services. We included costs that were not
allocated to specific segments, such as corporate general and administrative
expenses and share-based compensation expenses, in the Smart Online
segment. During late 2007 and the first quarter of 2008, we realigned
certain production and development functions and eliminated redundant
administrative functions and now report the consolidated business as a single
business segment.
 
 In the
second half of 2007, we commenced an overall evaluation of our business model as
well as our current technologies, the outcome of which was our decision to
develop a core industry-standard platform for small business with an
architecture designed to integrate with a virtually unlimited number of other
applications, services, and existing infrastructures. These applications would
include not only our own small-business applications, which we are currently
optimizing, but also other applications we expect to arise from collaborative
partnerships with third-party developers and service providers. In addition, we
identified emerging-market opportunities in the small-business segment to
leverage social networking and community building. We are currently refining and
integrating these capabilities into the core platform to be readily available in
a “plug-and-play” fashion to meet any anticipated customer need or desire. We
believe that this platform and associated applications will provide
opportunities for new sources of revenue, including an increase in our
subscription fees. We also believe, because the platform is designed to follow
industry-standard protocol, that the customization efforts and associated
timeline previously necessary to meet a particular customer’s requirements will
diminish significantly, allowing us to shorten the sale-to-revenue cycle.As
we near completion of the development of our industry-standard platform, we
began shifting our focus from development toward the sales and marketing of the
new platform in the fourth quarter of 2008.
 
 In light
of our new operating strategy involving the industry-standard platform, the
consolidation of all operations into our North Carolina headquarters, and other
factors including certain income tax advantages, we concluded in the latter part
of 2008 that it was no longer necessary to operate with the Smart Commerce and
Smart CRM subsidiaries. As a result, an upstream merger was completed as of
December 31, 2008 that merged the subsidiaries with the parent
corporation.
 
 Sources
of Revenue
 
 We derive
revenues from the following sources:
 
 ·
              Subscription
      fees – monthly fees charged to customers for access to our SaaS
      applications
  ·
              Professional
      service fees – fees related to consulting services, some of which
      complement our other products and
applications
  ·
              License
      fees – fees charged for perpetual or term licensing of platforms or
      applications
  ·
              Other
      revenues – revenues generated from non-core activities such as hosting and
      maintenance fees; syndication and integration fees; original
      equipment manufacturer, or OEM, contracts; and miscellaneous other
      revenues
  17
 
 Our
current primary focus is to target those established companies that have both a
substantial base of small-business customers as well as a recognizable and
trusted brand name in specific market segments. Our goal is to enter into
partnerships with these established companies whereby they private label our
products and offer them to their small-business customers. We believe the
combination of the magnitude of their customer bases and their trusted brand
names and recognition will help drive our subscription volume.
 
 Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. We make subscription sales either on a
subscription or on a “for fee” basis. Applications for which subscriptions are
available vary from our own direct sale website, OneBiz®, to the
websites of our partners. Subscriptions are generally payable on a monthly basis
and are typically paid via credit card of the individual end user. We are
focusing our efforts on enlisting new channel partners as well as diversifying
with vertical intermediaries in various industries.
 
 We
generate professional service fees from our consulting services. For example, a
partner may request that we re-design its website to better accommodate our
products or to improve its own website traffic. We typically bill professional
service fees on a time and material basis.
 
 License
fees consist of perpetual or term license agreements for the use of the Smart
Online platform or any of our applications.
 
 Other
revenues primarily consist of non-core revenue sources such as hosting and
maintenance fees, syndication and integration fees, miscellaneous web services,
and OEM revenue generated through sales of our applications bundled with
products offered by other manufacturers.
 
 Cost
of Revenues
 
 Cost of
revenues primarily is composed of salaries associated with maintaining and
supporting customers, the cost of domain name and e-mail registrations, and the
cost of external facilities where our applications and our customers’ customized
applications are hosted.
 
 Operating
Expenses
 
 In
previous years, we primarily focused our efforts on basic product development
and integration. In the early part of 2007, we also began to focus on licensing
our platform products and applications. During 2008, our primary business
initiatives included increasing subscription fee revenue and professional
services revenue, making organizational improvements, concentrating our
development efforts on enhancements and customization of our platforms and
applications, and shifting our strategic focus to the sales and marketing of our
products. We expect in early 2009 to launch our new industry-standard platform
along with enhanced applications targeted to small businesses and to devote
significant resources to the sale and marketing of these applications through
both channel partners and direct sales efforts.
 
 General and Administrative –
General and administrative expenses are composed primarily of costs associated
with our executive, finance and accounting, legal, human resources, and
information technology personnel and consist of salaries and related
compensation costs; professional services (such as outside legal counsel fees,
audit, and other compliance costs); depreciation and amortization; facilities
and insurance costs; and travel and other costs. We anticipate general and
administrative expenses will decrease slightly in 2009 as the legal expenses and
other professional fees we incurred in 2008 to resolve outstanding matters from
previous years and to assist with the transition between permanent financial
officers are offset in part by an increase in costs related to the growth of our
business and to our operations as a public company. However, we may be obligated
to pay a material amount of indemnification costs in 2009 related to the
previously reported SEC litigation against certain former officers and
directors, which would significantly increase our general and administrative
expenses.
  18
  Sales and Marketing – Sales
and marketing expenses are composed primarily of costs associated with our sales
and marketing activities and consist of salaries and related compensation costs
of our sales and marketing personnel, travel and other costs, and marketing and
advertising expenses. Historically, we spent limited funds on marketing,
advertising, and public relations, particularly due to our business model of
partnering with established companies with extensive small-business customer
bases. In June 2008, we engaged a public relations firm and, as a result, our
public relations expenses increased during the latter part of 2008. As we
continue to execute our sales and marketing strategy to take our enhanced
products to market, we expect associated costs to increase in 2009 due to
targeting new partnerships, development of channel partner enablement programs,
advertising campaigns, additional sales and marketing personnel, and the various
percentages of revenues we may be required to pay to future partners as
marketing fees.
 
 Research and Development –
Research and development expenses include costs associated with the development
of new products, enhancements of existing products, and general technology
research. These costs are composed primarily of salaries and related
compensation costs of our research and development personnel as well as outside
consultant costs.
 
 Statement
of Financial Accounting Standard, or SFAS, No. 86, Accounting for the Costs ofComputerSoftware to Be Sold, Leased, or
Otherwise Marketed, or SFAS No. 86, requires capitalization of certain
software development costs subsequent to the establishment of technological
feasibility, with costs incurred prior to this time expensed as research and
development. Technological feasibility is established when all planning,
designing, coding, and testing activities that are necessary to establish that
the product can be produced to meet its design specifications have been
completed. Historically, we had not developed detailed design plans for our SaaS
applications, and the costs incurred between the completion of a working model
of these applications and the point at which the products were ready for general
release had been insignificant. As a result of these factors, combined with the
historically low revenue generated by the sale of the applications that do not
support the net realizable value of any capitalized costs, we continued the
expensing of underlying costs as research and development.
 
 Beginning
in May 2008, we determined that it was strategically desirable to develop an
industry-standard platform and to enhance our current SaaS applications. A
detailed design plan indicated that the product was technologically feasible. In
July 2008, we commenced development, and from that point in time, we are
capitalizing all related costs in accordance with SFAS No. 86. Because of
our scalable and secure multi-user architecture, we are able to provide all
customers with a service based on a single version of our application. As a
result, we do not have to maintain multiple versions, which enables us to incur
relatively low development costs as compared to traditional enterprise software
business models. As we complete the core development of our new applications
through the first quarter of 2009, we expect that future research and
development expenses will decrease in both absolute and relative dollars as we
continue to capitalize costs associated with the new platform and reduce our
personnel to a core group focused on enhancements and custom development work
for customers.
 
 Stock-Based Expenses – Our
operating expenses include stock-based expenses related to options, restricted
stock awards, and warrants issued to employees and non-employees. These charges
have been significant and are reflected in our historical financial results.
Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), Share-Based Payment, or SFAS
No. 123R, which resulted and will continue to result in material costs on a
prospective basis as long as a significant number of options are outstanding. In
June 2007, we limited the issuance of awards under our 2004 Equity Compensation
Plan, or the 2004 Plan, to awards of restricted or unrestricted stock. In June
2008, we made options available for grant under the 2004 Plan once again,
primarily due to the adversetax
consequences to recipients of restricted stock upon the lapsing of
restrictions.
 
 Critical
Accounting Policies and Estimates
 
 Our
discussion and analysis of financial condition and results of operations are
based upon our consolidated financial statements, which we 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 reevaluate our critical
accounting policies and estimates, including those related to revenue
recognition, provision for doubtful accounts, expected lives of customer
relationships, useful lives of intangible assets and property and equipment,
provision for income taxes, valuation of deferred tax assets and liabilities,
and contingencies and litigation reserves. We believe the following critical
accounting policies involve the most significant judgments and estimates used in
the preparation of our consolidated financial statements.
  19
  Revenue Recognition– We
derive revenue primarily from subscription fees charged to customers accessing
our SaaS applications; professional service fees, consisting primarily of
consulting; the perpetual or term licensing of software platforms or
applications; and hosting and maintenance services. These arrangements may
include delivery in multiple-element arrangements if the customer purchases a
combination of products and/or services. Because we license, sell, lease, or
otherwise market computer software, we use the residual method pursuant to
American Institute of Certified Public Accountants Statement of Position
97-2,Software Revenue
Recognition, or SOP 97-2, as amended. This method allows us to recognize
revenue for a delivered element when such element has vendor specific objective
evidence, or VSOE, of the fair value of the delivered element. If we cannot
determine or maintain VSOE for an element, it could impact revenues, as we may
need to defer all or a portion of the revenue from the multiple-element
arrangement.
 
 If
multiple-element arrangements involve significant development, modification, or
customization, or if we determine that certain elements are essential to the
functionality of other elements within the arrangement, we defer revenue until
we provide to the customer all elements necessary to the functionality. The
determination of whether the arrangement involves significant development,
modification, or customization could be complex and require the use of judgment
by our management.
 
 Under SOP
97-2, provided the arrangement does not require significant development,
modification, or customization, we recognize revenue when all of the following
criteria have been met:
 
 1.     persuasive
evidence of an arrangement exists
 
 2.     delivery
has occurred
 
 3.     the
fee is fixed or determinable
 
 4.     collectibility
is probable
 
 If at the
inception of an arrangement the fee is not fixed or determinable, we defer
revenue until the arrangement fee becomes due and payable. If we deem
collectibility not probable, we defer revenue until we receive payment or
collection becomes probable, whichever is earlier. The determination of whether
fees are collectible requires judgment of our management, and the amount and
timing of revenue recognition may change if different assessments are
made.
 
 Under the
provisions of Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables, we account for consulting, website design fees, and
application development services separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, we recognize revenue as the services are rendered for
time and material contracts, and when milestones are achieved and accepted by
the customer for fixed price or long-term contracts. The majority of our
consulting service contracts are on a time and material basis, and we typically
bill our customers monthly based upon standard professional service
rates.
 
 Application
development services are typically fixed price and of a longer term. As such, we
account for them as long-term construction contracts that require us to
recognize revenue based on estimates involving total costs to complete and the
stage of completion. Our assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, we capitalize the associated costs
of such projects and include them in costs in excess of billings on the balance
sheet until such time that we are permitted to recognize
revenue.
  20
 
 Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue-share arrangement with these
marketing partners in order to encourage them to market our products and
services to their customers. Subscriptions are generally payable on a monthly
basis and are typically paid via credit card of the individual end user. We
accrue any payments received in advance of the subscription period as deferred
revenue and amortize them over the subscription period. We recognize revenue on
a gross basis in accordance with Emerging Issues Task Force Issue No. 99-19,
Reporting Revenue Gross as a
Principal or Net as an Agent, when we provide services directly to end
users and revenue-share arrangements exist with our marketing
partners.
 
 Because
our customers generally do not have the contractual right to take possession of
the software we license or market at any time, we recognize revenue on hosting
and maintenance fees as we provide the services in accordance with Emerging
Issues Task Force Issue No. 00-3, Application of AICPA Statement of
Position 97-2 to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.
 
 Provision for Doubtful Accounts
– We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability, failure, or refusal of our customers to make
required payments. We evaluate the need for an allowance for doubtful accounts
based on specifically identified amounts that we believe to be potentially
uncollectible. Although we believe that our allowances are adequate, if the
financial conditions of our customers deteriorate, resulting in an impairment of
their ability to make payments, or if we underestimate the allowances required,
additional allowances may be necessary, which will result in increased expense
in the period in which such determination is made.
 
 Impairment of Long-Lived Assets– We record our long-lived assets, such as property and equipment, at
cost. We review the carrying value of our long-lived assets for possible
impairment at the earlier of annually in the fourth quarter or whenever events
or changes in circumstances indicate that the carrying amount of assets may not
be recoverable in accordance with the provisions of SFAS No. 144,
Accounting for the Impairment
or Disposal ofLong-Lived Assets. We measure
the recoverability of assets to be held and used by comparing the carrying
amount of the asset to future net undiscounted cash flows expected to be
generated by the asset. If we consider such assets to be impaired, we measure
the impairment as the amount by which the carrying amount exceeds the fair
value, and we recognize it as an operating expense in the period in which the
determination is made. We report assets to be disposed at the lower of the
carrying amount or fair value less costs to sell. Although we believe that the
carrying values of our long-lived assets are appropriately stated, changes in
strategy or market conditions or significant technological developments could
significantly impact these judgments and require adjustments to recorded asset
balances.
 
 In
addition to the recoverability assessment, we also routinely review the
remaining estimated useful lives of our long-lived assets. Any reduction in the
useful-life assumption will result in increased depreciation and amortization
expense in the period when such determinations are made, as well as in
subsequent periods.
 
 Income Taxes– We are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This involves estimating our current tax liabilities in each
jurisdiction, including the impact, if any, of additional taxes resulting from
tax examinations, as well as making judgments regarding our ability to realize
our deferred tax assets. Such judgments can involve complex issues and may
require an extended period to resolve. In the event we determine that we will
not be able to realize all or part of our net deferred tax assets, we would make
an adjustment in the period we make such determination. We recorded no income
tax expense in 2008 and 2007, as we have experienced significant operating
losses to date. If utilized, we may apply the benefit of our total net operating
loss carryforwards to reduce future tax expense. Since our utilization of these
deferred tax assets is dependent on future profits, which are not assured, we
have recorded a valuation allowance equal to the net deferred tax assets. These
carryforwards would also be subject to limitations, as prescribed by applicable
tax laws. As a result of prior equity financings and the equity issued in
conjunction with certain acquisitions, we have incurred ownership changes, as
defined by applicable tax laws. Accordingly, our use of the acquired net
operating loss carryforwards may be limited. Further, to the extent that any
single-year loss is not utilized to the full amount of the limitation, such
unused loss is carried over to subsequent years until the earlier of its
utilization or the expiration of the relevant carryforward
period.
  21
  2008
Summary
 
 The
following is a summary of key financial results and certain non-financial
results achieved for the year ended December 31, 2008:
 
 ·
              Our
      total revenues for the year were $4.9 million, a decrease from 2007 of
      $65,000, or 1%. This overall decrease in revenues was primarily
      attributable to decreases in subscription fees and license fees, offset in
      part by increases in professional service fees and other
      revenue.
 
 ·
              Our
      gross profit for the year was $4.0 million, a decrease from 2007 of
      $391,000, or 9%. This decline was primarily attributable to lower revenue,
      but it was also impacted by higher costs incurred in connection with
      supporting several new customers acquired in the latter part of 2007 and
      first part of 2008 as well as a higher turnover rate of members of
      existing direct-selling organization
customers.
 
 ·
              Operating
      expenses for the year were $13.7 million, an increase over 2007 of $4.1
      million, or 44%. A significant portion of this increase was a loss on
      impairment of intangible assets of $3.5 million that we recognized in
      2008. The remaining increase was in sales and marketing expenses, as a
      result of revenue-share arrangements with new customers and as we began to
      turn our attention towards marketing our new and enhanced products;
      and in research and development expenses, as we worked in 2008 to
      enhance our product offerings.
 
 ·
              Our
      loss from operations for the year was $9.6 million, an increase over 2007
      of $4.5 million, or 89%. This amount includes the effect of the loss on
      impairment of intangible assets of $3.5 million discussed above. Net loss
      per basic and fully diluted share was $0.54 in 2008 compared to $0.32 in
      2007.
 
 ·
              Cash
      and cash equivalents at December 31, 2008 were $19,000 compared to $3.5
      million at December 31, 2007. The primary reason for this decrease is that
      in 2008, we established automated sweeps among our banking accounts
      whereby all available cash at the end of each day is used to pay down our
      line of credit, the purpose of which is to reduce our interest
      expense.
 
 ·
              In
      the third quarter of 2008, we began capitalizing the costs associated with
      our new industry-standard platform and expect to launch the first release
      in the first half of 2009.
 
 ·
              We
      made significant investments in our server infrastructure to support the
      launch of our new industry-standard platform, including the ability to
      host up to 250,000 concurrent
users.
 
 ·
              We
      closed our Grand Rapids, Michigan facility and consolidated all operations
      in our Durham, North Carolina headquarters. We also concluded an upstream
      merger that dissolves our wholly owned subsidiaries, Smart Commerce and
      Smart CRM.
 
 Business
Outlook
 
 We
believe that the current economic recession will spawn a record number of new,
highly fragmented and underserved small businesses seeking low-cost tools and
applications to help them operate. We also believe that trade organizations and
other membership- or subscription-driven agencies and companies will recognize
an increased need for customer retention and will look for new and innovative
ways to achieve this. Both of these events would increase our ability to obtain
new channel partners and end-user businesses in 2009. However, we also believe
that competition for Internet-delivered business solutions will increase. We
anticipate focusing on the following key areas, among others, during 2009 in
response to these opportunities and competitive environment:
 
 ·
              Investment in technology,
      product development, and infrastructure. We plan to
      complete and launch the first release of our new industry-standard
      platform in 2009 along with enhanced versions of our business tools and
      applications. In addition, we expect to continue investing in our
      production server infrastructure to ensure scalability and reliability
      through load balancing and redundancy as users are
  added.
  22
 
 ·
              Investment in
      marketing. In the latter
      part of 2008, we began to shift our focus from development to sales and
      marketing of our products. We expect to increase this effort dramatically
      in 2009 through public relations, attendance at trade shows, print and
      electronic advertisements, e-mail marketing, white-paper placement,
      webcasts, blogging, and paid search, among other
  tactics.
 
 ·
              Expansion of our sales
      channels. We intend to
      expand our sales force and channel partner relationships to reach more
      small-business end users.
 
 ·
              Continuation of operating
      improvements. We continue to
      streamline our operations in an effort to reduce cash burn, reach
      profitability, and improve efficiencies. Some of these successes came near
      the end of 2008, but we will continue to focus on this critical area in
      2009 by questioning current practices, closely scrutinizing
      actual-to-budget variances to identify deviations early, and realigning
      the business as required to meet the needs of our
    operations.
 
 Results
of Operations
 
 The
following table sets forth certain consolidated statements of operations data
for the periods indicated:
 
 2008
                    
                    
                    2007Dollars
                    
                    
                    %
      of
                      Revenue
                    
                    
                    Dollars
                    
                    
                    %
      of
                      RevenueTotal
      revenues
                    
                    $
                    4,872,985
                    
                    
                    
                    100.0
                    %
                    
                    $
                    4,937,654
                    
                    
                    
                    100.0
                    %Cost
      of revenues
                    
                    
                    837,789
                    
                    
                    
                    17.2
                    %
                    
                    
                    511,619
                    
                    
                    
                    10.4
                    %Gross
      profit
                    
                    $
                    4,035,196
                    
                    
                    
                    82.8
                    %
                    
                    $
                    4,426,035
                    
                    
                    
                    89.6
                    %Operating
      expenses
                    
                    
                    13,653,175
                    
                    
                    
                    280.2
                    %
                    
                    
                    9,512,581
                    
                    
                    
                    192.6
                    %Loss
      from operations
                    
                    $
                    (9,617,979
                    )
                    
                    
                    (197.4
                    )%
                    
                    $
                    (5,086,546
                    )
                    
                    
                    (103.0
                    )%Other
      income (expense), net
                    
                    
                    (204,171
                    )
                    
                    
                    (4.2
                    )%
                    
                    
                    (420,080
                    )
                    
                    
                    (8.5
                    )%Net
      loss
                    
                    $
                    (9,822,150
                    )
                    
                    
                    (201.6
                    )%
                    
                    $
                    (5,506,626
                    )
                    
                    
                    (111.5
                    )%Net
      loss per common share
                    
                    $
                    (0.54
                    )
                    
                    
                    
                    
                    
                    $
                    (0.32
                    )
 
 Revenues
 
 Revenues
for 2008 and 2007 comprise the following:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentSubscription
      fees
                    
                    $
                    2,683,770
                    
                    
                    $
                    2,829,343
                    
                    
                    $
                    (145,573
                    )
                    
                    
                    (5
                    )%Professional
      service fees
                    
                    
                    2,045,508
                    
                    
                    
                    1,436,770
                    
                    
                    
                    608,738
                    
                    
                    
                    42
                    %License
      fees
                    
                    
                    26,250
                    
                    
                    
                    580,000
                    
                    
                    
                    (553,750
                    )
                    
                    
                    (95
                    )%Other
      revenue
                    
                    
                    117,457
                    
                    
                    
                    91,541
                    
                    
                    
                    25,916
                    
                    
                    
                    28
                    %Total
      revenues
                    
                    $
                    4,872,985
                    
                    
                    $
                    4,937,654
                    
                    
                    $
                    (64,669
                    )
                    
                    
                    (1
                    )%
 
 Revenues
decreased 1% to $4.87 million in 2008 from $4.94 million in 2007. Our overall
decrease in revenues was driven by growth in our professional service fees that
offset a decrease in subscription fees and license fees. Select items are
discussed in detail below.
  23
  Subscription
Fees
 
 Revenues
from subscription fees for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    
                    2007
                    
                    
                    
                    Dollars
                    
                    
                    
                    PercentSubscription
      fees
                    
                    $
                    2,683,770
                    
                    
                    $
                    2,829,343
                    
                    
                    $
                    (145,573
                    )
                    
                    
                    (5
                    )%Percent
      of total revenues
                    
                    
                    55.1
                    %
                    
                    
                    57.3
                    %
 
 Revenue
from subscription fees decreased 5% to $2.7 million in 2008 from $2.8 million in
2007. This decline is primarily attributable to the ongoing migration of one
direct-selling organization customer to its own technology solution that has
resulted in a month-over-month decline in subscription fees, offset in part by
new partnerships under which we began recognizing revenue in the second half of
2007.
 
 Professional
Service Fees
 
 Revenues
from professional service fees for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    
                    PercentProfessional
      service fees
                    
                    $
                    2,045,508
                    
                    
                    $
                    1,436,770
                    
                    
                    $
                    608,738
                    
                    
                    
                    42
                    %Percent
      of total revenues
                    
                    
                    42.0
                    %
                    
                    
                    29.1
                    %
 
 Revenue
from professional service fees increased 42% to $2.0 million in 2008 from $1.4
million in 2007. This increase was due to existing customers requesting
additional project consulting services for their web initiatives as well as
$345,000 associated with the recognition of consulting revenue from new
customers added in 2008.
 
 License
Fees
 
 Revenues
from license fees for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    
                    2007
                    
                    
                    
                    Dollars
                    
                    
                    
                    PercentLicense
      fees
                    
                    $
                    26,250
                    
                    
                    $
                    580,000
                    
                    
                    $
                    (553,750
                    )
                    
                    
                    (95
                    )%Percent
      of total revenues
                    
                    
                    0.5
                    %
                    
                    
                    11.7
                    %
 
 Revenue
from license fees decreased 95% to $26,000 in 2008 from $580,000 in 2007.
License fee revenue recognized in 2008 comprised the ratable recognition of a
term license that commenced in June 2008. License fee revenue recognized in 2007
comprised two perpetual license agreements. We expect that license fees will
continue to represent a small percentage of our revenues in future years as we
focus on increasing our subscription fees revenue derived from our SaaS
applications.
 
 Other
Revenue
 
 Revenues
from other sources for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentOther
      revenue
                    
                    $
                    117,457
                    
                    
                    $
                    91,541
                    
                    
                    $
                    25,916
                    
                    
                    
                    28
                    %Percent
      of total revenues
                    
                    
                    2.4
                    %
                    
                    
                    1.9
                    %
 
 Revenue
from non-core activities increased 28% to $117,000 in 2008 from $92,000 in 2007.
This increase is primarily attributable to hosting revenue derived from a new
customer added in 2008. We expect these revenue streams to continue to be
insignificant in the future as we focus on the growth of our subscription fees
revenue.
  24
 
 Cost
of Revenues
 
 Cost of
revenues for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentCost
      of revenues
                    
                    $
                    837,789
                    
                    
                    $
                    511,619
                    
                    
                    $
                    326,170
                    
                    
                    
                    64
                    %Percent
      of total revenues
                    
                    
                    17.2
                    %
                    
                    
                    10.4
                    %
 
 Cost of
revenues increased 64% to $838,000 in 2008 from $512,000 in 2007. This increase
is primarily the result of incremental costs incurred in connection with
supporting several new customers acquired in the latter part of 2007 and first
part of 2008 as well as a higher turnover rate of members of existing
direct-selling organization customers. These incremental costs include
additional call center personnel salaries and related payroll expenses of
$107,000, external hosting costs of $102,000, and credit card processing of
$50,000. In addition, we introduced business card printing services to our
direct-selling organization customer members in early 2008 that resulted in
incremental costs of $53,000.
 
 Operating
Expenses
 
 Operating
expenses for 2008 and 2007 comprise the following:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentGeneral
      and administrative
                    
                    $
                    4,815,404
                    
                    
                    $
                    4,896,928
                    
                    
                    $
                    (81,524
                    )
                    
                    
                    (2
                    )%Sales
      and marketing
                    
                    
                    2,739,595
                    
                    
                    
                    2,118,245
                    
                    
                    
                    621,350
                    
                    
                    
                    29
                    %Research
      and development
                    
                    
                    2,626,034
                    
                    
                    
                    2,497,408
                    
                    
                    
                    128,626
                    
                    
                    
                    5
                    %Loss
      on impairment of intangible assets
                    
                    
                    3,472,142
                    
                    
                    
                    -
                    
                    
                    
                    3,472,142
                    
                    
                    
                    -Total
      operating expenses
                    
                    $
                    13,653,175
                    
                    
                    $
                    9,512,581
                    
                    
                    $
                    4,140,595
                    
                    
                    
                    44
                    %
 
 Operating
expenses increased 44% to $13.7 million in 2008 from $9.5 million in 2007. This
increase included the loss on impairment of intangible assets of $3.5 million,
as well as increases in sales and marketing and research and development
expenses.
 
 General
and Administrative
 
 General
and administrative expenses for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentGeneral
      and administrative
                    
                    $
                    4,815,404
                    
                    
                    $
                    4,896,928
                    
                    
                    $
                    (81,524
                    )
                    
                    
                    (2
                    )%Percent
      of total revenues
                    
                    
                    98.8
                    %
                    
                    
                    99.2
                    %
 
 General
and administrative expenses decreased 2% to $4.8 million in 2008 from $4.9
million in 2007. The expenses remained relatively flat between 2008 and 2007 as
significant decreases in personnel costs of $306,000 due to reductions in
headcount and the consolidation of our Grand Rapids facility; office expenses of
$53,000 due to the consolidation of our Grand Rapids facility; bank charges of
$60,000 due to consolidation of banking relationships; and Sarbanes-Oxley
compliance costs of $54,000 due to the conclusion of work by an outside
consulting firm were offset in part by $431,000 in bad debt expense on trade
accounts receivable.
 
 Sales
and Marketing
 
 Sales and
marketing expenses for 2008 and 2007 are as follows:
  25
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentSales
      and marketing
                    
                    $
                    2,739,595
                    
                    
                    $
                    2,118,245
                    
                    
                    $
                    621,350
                    
                    
                    
                    29
                    %Percent
      of total revenues
                    
                    
                    56.2
                    %
                    
                    
                    42.9
                    %
 
 Sales and
marketing expenses increased 29% to $2.7 million in 2008 from $2.1 million in
2007. This increase is primarily attributable to $308,000 in incremental
personnel costs, including commissions; $79,000 in public relations expenses
that we incurred as we began to shift our focus to the sales and marketing of
our enhanced products; and $204,000 associated with revenue-sharing arrangements
with our channel partners.
 
 Research
and Development
 
 Research
and development expenses for 2008 and 2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentResearch
      and development
                    
                    $
                    2,626,034
                    
                    
                    $
                    2,497,408
                    
                    
                    $
                    128,626
                    
                    
                    
                    5
                    %Percent
      of total revenues
                    
                    
                    53.9
                    %
                    
                    
                    50.6
                    %
 
 Research
and development expenses increased 5% to $2.6 million in 2008 from $2.5 million
in 2007. This net increase is primarily attributable to an increase of $406,000
in outside contractor fees as we worked on enhancing our business tools and
applications in 2008 offset in part by a decrease in personnel costs of $321,000
due to a deferral in developer costs associated with a contract not yet
recognized as revenue.
 
 Loss
on Impairment of Intangible Assets
 
 On a
periodic basis, we review our long-lived assets, including intangible assets,
for possible impairment. Loss on impairment of intangible assets for 2008 and
2007 are as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentLoss
      on impairment of intangible assets
                    
                    $
                    3,472,142
                    
                    
                    $
                    -
                    
                    
                    $
                    3,472,142
                    
                    
                    
                    -Percent
      of total revenues
                    
                    
                    71.3
                    %
                    
                    
                    0.0
                    %
 
 In 2008,
we determined that our iMart trade name was impaired because its carrying value
of $1,155,500 exceeded future net undiscounted cash flows of $380,000,
calculated using the relief-from-royalty method. As a result, we recognized a
loss on impairment of intangible assets in the amount of $775,500 as an
operating expense in 2008. We also determined that goodwill of $2,696,642
associated with our acquisition of iMart was fully impaired due to a number of
reasons, including the shutdown in 2008 of iMart’s Grand Rapids, Michigan
facility and the termination of all its employees; the consolidation of our
technology platforms; the deterioration in value of our underlying stock that
contributed to the initial value of goodwill; and general economic and market
conditions. As a result, we also recognized a loss on impairment of intangible
assets for this amount as an operating expense in 2008. There was no
impairment of long-lived assets in 2007.
 
 Other
Income (Expense)
 
 Other
income (expense) for 2008 and 2007 comprise the following:
  26
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentInterest
      expense, net
                    
                    $
                    (633,014
                    )
                    
                    $
                    (569,975
                    )
                    
                    $
                    63,039
                    
                    
                    
                    11
                    %Legal
      reserve and debt forgiveness, net
                    
                    
                    -
                    
                    
                    
                    (34,877
                    )
                    
                    
                    (34,877
                    )
                    
                    
                    (100
                    )%Gain
      on legal settlements, net
                    
                    
                    411,710
                    
                    
                    
                    -
                    
                    
                    
                    411,710
                    
                    
                    
                    -Other
      income
                    
                    
                    17,133
                    
                    
                    
                    184,772
                    
                    
                    
                    (167,639
                    )
                    
                    
                    (91
                    )%Total
      other expense
                    
                    $
                    (204,171
                    )
                    
                    $
                    (420,080
                    )
                    
                    $
                    (215,909
                    )
                    
                    
                    (51
                    )%
 
 Net other
expense decreased 51% to $204,000 in 2008 from $420,000 in 2007. This net
decrease was primarily attributable to a gain on legal settlements in 2008,
offset by an increase in interest expense and a decrease in other income. Select
items are discussed in detail below.
 
 Interest
Expense, Net
 
 Interest
expense, net of interest income, for 2008 and 2007 is as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentInterest
      expense, net
                    
                    $
                    633,014
                    
                    
                    $
                    569,975
                    
                    
                    $
                    63,039
                    
                    
                    
                    11
                    %Percent
      of total revenues
                    
                    
                    13.0
                    %
                    
                    
                    11.5
                    %
 
 Interest
expense decreased 6% to $682,000 in 2008 from $726,000 in 2007 due primarily to
an increase in convertible bond interest of $281,000, offset by decreases in
interest expense of $132,000 associated with the warrant issued to Atlas in
connection with the extension of our line of credit with Wachovia Bank, NA, or
Wachovia; $131,000 associated with a term note held with Fifth Third Bank that
was repaid in November 2007; and $64,000 associated with our Paragon line of
credit due to an average lower balance and declining interest rates in
2008.
 
 Interest
income decreased 69% to $49,000 in 2008 from $156,000 in 2007 due primarily to
lower cash balances in interest bearing accounts in 2008, as the cash proceeds
raised in the February 2007 private placement and November 2007 convertible note
offering as described below under “Liquidity and Capital Resources” were
depleted in operations.
 
 Gain
on Legal Settlements, Net
 
 Gain on
legal settlements, net for 2008 and 2007 is as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentGain
      on legal settlements, net
                    
                    $
                    411,710
                    
                    
                    $
                    -
                    
                    
                    $
                    411,710
                    
                    
                    
                    -Percent
      of total revenues
                    
                    
                    8.4
                    %
                    
                    
                    0.0
                    %
 
 The gain
on legal settlements is primarily attributable to $395,000 in legal expense
reimbursements that we received in 2008 from our directors’ and officers’
insurance carrier related to previously disclosed SEC matters.
 
 Other
Income
 
 Other
income for 2008 and 2007 is as follows:
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentOther
      income
                    
                    $
                    17,133
                    
                    
                    $
                    184,772
                    
                    
                    $
                    (167,639
                    )
                    
                    
                    (91
                    )%Percent
      of total revenues
                    
                    
                    0.4
                    %
                    
                    
                    3.7
                    %
  27
  Other
income decreased 91% to $17,000 in 2008 from $185,000 in 2007. This is primarily
a result of certain accounting adjustments made in 2007, including $86,000 from
the reversal of previously recognized registration rights expense and $75,000
from accruals of potential reimbursement of expenses related to a customer that
did not recur in 2008.
 
 Provision
for Income Taxes
 
 We did
not record a provision for income tax expense in 2008 or 2007 because we have
been generating net losses. Furthermore, we have not recorded an income tax
benefit for 2008 or 2007 primarily due to continued substantial uncertainty
regarding our ability to realize our deferred tax assets. Based upon available
objective evidence, there has been sufficient uncertainty regarding our ability
to realize deferred tax assets to warrant a full valuation allowance in our
financial statements. As of December 31, 2008, we had approximately $47.3
million in net operating loss carryforwards, which may be utilized to offset
future taxable income.
 
 Utilization
of our net operating loss carryforwards may be subject to substantial annual
limitation due to the ownership change limitations provided by the Internal
Revenue Code of 1986, as amended, and similar state provisions. Such an annual
limitation could result in the expiration of the net operating loss
carryforwards before utilization.
 
 Liquidity
and Capital Resources
 
 Overview
 
 We
require cash to fund our operating expenses and working capital requirements,
including outlays for capital expenditures and debt service. As of December 31,
2008, our principal sources of liquidity were cash and cash equivalents totaling
$19,000 and current accounts receivable of $185,000, as compared to $3.5 million
of cash and cash equivalents and $815,000 in accounts receivable as of December
31, 2007. A primary reason for the decline in cash balances is that during the
third quarter of 2008, we established automated sweeps among our accounts at
Paragon whereby all available cash at the end of each day is used to pay down
our line of credit with Paragon, the purpose of which is to reduce our interest
expense. As of December 31, 2008, we had drawn approximately $2.27 million on
the $2.47 million line of credit, leaving approximately $200,000 available under
the line of credit for our operations. Deferred revenue at December 31, 2008 was
$391,000 as compared to $577,000 at December 31, 2007.
 
 As of
March 24, 2009, our principal sources of liquidity were cash and cash
equivalents totaling approximately $22,000 and accounts receivable of
approximately $325,000. In addition, we had drawn approximately $2.27 million on
the Paragon line of credit, leaving approximately $200,000 available under the
line of credit for operations. As of March 24, 2009, we also have the ability to
call up to approximately $9 million of additional funding from our convertible
noteholders.
 
 Cash
Flows
 
 During
the year ended December 31, 2008, our working capital deficit increased by
approximately $3,876,000 to $2,989,000 from a working capital surplus of
$887,000 at December 31, 2007. As described more fully below, the working
capital deficit at December 31, 2008 is primarily attributable to negative cash
flows from operations, offset in part by net debt borrowings.
 
 Cash
Flows from Operating Activities
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentNet
      cash used in operating activities
                    
                    $
                    5,041,255
                    
                    
                    $
                    4,298,510
                    
                    
                    $
                    742,745
                    
                    
                    
                    17
                    %
 
 Net cash
used in operating activities increased 17% to $5.0 million in 2008 from $4.3
million in 2007. This increase is primarily attributable to an increase in
prepaid expenses due to the prepayment of 36 months of rent at our new
headquarters facility, an increase in notes receivable, and decreases in
outstanding accounts receivable, other assets, accounts payable, and deferred
revenue.
  28
 
 Cash
Flows from Investing Activities
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentNet
      cash used in investing activities
                    
                    $
                    578,405
                    
                    
                    $
                    79,553
                    
                    
                    $
                    498,852
                    
                    
                    
                    627
                    %
 
 Net cash
used in investing activities increased 627% to $578,000 in 2008 from $80,000 in
2007. This increase is attributable to the acquisition of $331,000 of furniture
and computer equipment in connection with the relocation to our new headquarters
facility, as well as the capitalization of software costs of $261,000 related to
our new industry-standard platform.
 
 Cash
Flows from Financing Activities
 
 Years
      Ended December 31,
                    
                    
                    Year-Over-Year
      Change2008
                    
                    
                    2007
                    
                    
                    Dollars
                    
                    
                    PercentNet
      cash provided by financing activities
                    
                    $
                    2,164,301
                    
                    
                    $
                    7,525,117
                    
                    
                    $
                    (5,360,816
                    )
                    
                    
                    (71
                    )%
 
 Net cash
provided by financing activities decreased 71% to $2.2 million in 2008 from $7.5
million in 2007. This decrease is primarily due to cash raised in 2007 from the
issuance of common stock as described below.
 
 The net
cash in 2008 from our financing activities was generated through both equity and
debt financing, as described below.
 
 Equity Financing. In a
transaction that closed on February 21, 2007, we sold an aggregate of 2,352,941
shares of our common stock to two new investors, or the investors. The private
placement shares were sold at $2.55 per share pursuant to a Securities Purchase
Agreement, or the SPA, between us and each of the investors. The aggregate gross
proceeds to us were $6 million, and we incurred issuance costs of approximately
$667,000.Under
the SPA, the investors were issued warrants for the purchase of an aggregate of
1,176,471 shares of common stock at an exercise price of $3.00 per share. These
warrants contain a provision for cashless exercise and must be exercised, if at
all, by February 21, 2010.
 
 Debt Financing. In
November 2006, we established a $1.3 million revolving credit arrangement with
Wachovia to be used for general working capital purposes, which we increased to
$2.5 million in January 2007. The line of credit was secured by our deposit
account at Wachovia and an irrevocable standby letter of credit issued by HSBC
with Atlas, a current stockholder and affiliate, as account party. Any advances
made on the line of credit were to be paid off no later than August 1,
2008. On February 15, 2008, we repaid the full outstanding principal
balance of $2,052,000 and accrued interest of $2,890 outstanding under the line
of credit, and our deposit account and the irrevocable standby letter of credit
were both released by Wachovia.
 
 On
February 20, 2008, we entered into a revolving credit arrangement with Paragon
that is renewable on an annual basis subject to mutual approval. The line of
credit advanced by Paragon is $2.47 million and can be used for general working
capital. Any advances made on the line of credit must be paid off no later than
February 19, 2009, subject to extension due to renewal, with monthly
payments being applied first to accrued interest and then to principal. The
interest shall accrue on the unpaid principal balance at the Wall Street
Journal’s published Prime Rate minus one half percent. As of December 31, 2008,
the line of credit was secured by an irrevocable standby letter of credit in the
amount of $2.5 million issued by HSBC with Atlas as account party, expiring
February 18, 2010. We also have agreed with Atlas that in the event of our
default in the repayment of the line of credit that results in the letter of
credit being drawn, we will reimburse Atlas any sums that Atlas is required to
pay under such letter of credit. At our sole discretion, these payments may be
made in cash or by issuing shares of our common stock at a set per-share price
of $2.50.
 
 This line
of credit replaces our line of credit with Wachovia. As an incentive for the
letter of credit from Atlas to secure the Wachovia line of credit, we had
entered into a stock purchase warrant and agreement with Atlas. Under the terms
of the agreement, Atlas received a warrant to purchase up to 444,444 shares of
our common stock at $2.70 per share within 30 business days of the termination
of the Wachovia line of credit or if we are in default under the terms of the
line of credit with Wachovia. In consideration for Atlas providing the letter of
credit, we agreed to amend the agreement to provide that the warrant is
exercisable within 30 business days of the termination of the Paragon line of
credit or if we are in default under the terms of the line of credit with
Paragon.
  29
 
 On
November 14, 2007, in an initial closing, we sold $3.3 million aggregate
principal amount of convertible secured subordinated notes due November 14,
2010, or the initial notes. In addition, the noteholders committed to purchase
on a pro rata basis up to $5.2 million aggregate principal of convertible
secured subordinated notes in future closings upon approval and call by our
Board of Directors. On August 12, 2008, we exercised our option to sell $1.5
million aggregate principal of additional convertible secured subordinated notes
due November 14, 2010 with substantially the same terms and conditions as the
initials notes, or the additional notes. In connection with the sale of the
additional notes, the noteholders holding a majority of the aggregate principal
amount of the convertible secured subordinated notes then outstanding agreed to
increase the aggregate principal amount of convertible secured subordinated
notes that they are committed to purchase from $8.5 million to $15.3 million. On
November 21, 2008, we sold $500,000 aggregate principal amount of additional
convertible secured subordinated notes due November 14, 2010, or the new notes,
and together with the initial notes and the additional notes, the notes, to two
new investors with substantially the same terms and conditions as the initial
notes and the additional notes. At December 31, 2008, $5.3 million aggregate
principal amount of notes were outstanding.
 
 We are
obligated to pay interest on the notes at an annualized rate of 8% payable in
quarterly installments commencing three months after the purchase date of the
notes. We are not permitted to prepay the notes without approval of the holders
of at least a majority of the principal amount of the notes then
outstanding.
 
 On the
earlier of the maturity date of November 14, 2010 or a merger or acquisition or
other transaction pursuant to which our existing stockholders hold less than 50%
of the surviving entity, or the sale of all or substantially all of our assets,
or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:
 
 ·
              convert
      the principal then outstanding on its notes into shares of our common
      stock, or
 
 ·
              receive
      immediate repayment in cash of the notes, including any accrued and unpaid
      interest.
 
 If a
noteholder elects to convert its notes under these circumstances, the conversion
price of notes:
 
 ·
              issued
      in the initial closing on November 14, 2007 shall be $3.05;
      and
 
 ·
              issued
      on August 12, 2008 and November 21, 2008 shall be the lower of $3.05 or
      120% multiplied by the average of the closing bid and asked prices of
      shares of our common stock quoted in the Over-The-Counter Market Summary
      (or, if our shares are traded on the Nasdaq Stock Market or another
      exchange, the closing price of shares of our common stock quoted on such
      exchange) averaged over five trading days prior to the closing date of the
      sale of such notes.
 
 Payment
of the notes will be automatically accelerated if we enter voluntary or
involuntary bankruptcy or insolvency proceedings.
 
 The notes
and the common stock into which they may be converted have not been registered
under the Securities Act or the securities laws of any other jurisdiction. As a
result, offers and sales of the notes were made pursuant to Regulation D of the
Securities Act and only made to accredited investors. The investors in the
initial notes include (i) The Blueline Fund, or Blueline, which originally
recommended Philippe Pouponnot, one of our former directors, for appointment to
the Board of Directors; (ii) Atlas, an affiliate that originally recommended
Shlomo Elia, one of our current directors, for appointment to the Board of
Directors; (iii) Crystal Management Ltd., which is owned by Doron Roethler, who
subsequently became Chairman of our Board of Directors and Interim Chief
Executive Officer and serves as the noteholders’ bond representative; and (iv)
William Furr, who is the father of Thomas Furr, who, at the time, was one of our
directors and executive officers. The investors in the additional notes are
Atlas and Crystal Management Ltd. The investors in the new notes are not
affiliated with the Company.
  30
  If we
propose to file a registration statement to register any of its common stock
under the Securities Act in connection with the public offering of such
securities solely for cash, subject to certain limitations, we must give each
noteholder who has converted its notes into common stock the opportunity to
include such shares of converted common stock in the registration. We have
agreed to bear the expenses for any of these registrations, exclusive of any
stock transfer taxes, underwriting discounts, and commissions.
 
 On
November 6, 2007, Canaccord Adams Inc. agreed to waive any rights it held under
its January 2007 engagement letter with us that it may have with respect to the
convertible note offering, including the right to receive any fees in connection
with the offering.
 
 We have
not yet achieved positive cash flows from operations, and our main sources of
funds for our operations are the sale of securities in private placements, the
sale of additional convertible notes, and bank lines of credit. We must continue
to rely on these sources until we are able to generate sufficient cash from
revenues to fund our operations. We believe that anticipated cash flows from
operations, funds available from our existing line of credit, and additional
issuances of notes, together with cash on hand, will provide sufficient funds to
finance our operations at least for the next 12 to 18 months, depending on our
ability to achieve strategic goals outlined in our annual operating budget
approved by our Board of Directors. Changes in our operating plans, lower than
anticipated sales, increased expenses, or other events may cause us to seek
additional equity or debt financing in future periods. There can be no guarantee
that financing will be available on acceptable terms or at all. Additional
equity financing could be dilutive to the holders of our common stock, and
additional debt financing, if available, could impose greater cash payment
obligations and more covenants and operating restrictions.
 
 Going
Concern
 
 Our
independent registered public accountants have issued an explanatory paragraph
in their report included in this Annual Report on Form 10-K for the year ended
December 31, 2008 in which they express substantial doubt as to our ability to
continue as a going concern. The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amounts or classification of liabilities that might be necessary
should we be unable to continue as a going concern. Our continuation as a going
concern depends on our ability to generate sufficient cash flows to meet our
obligations on a timely basis, to obtain additional financing that is currently
required, and ultimately to attain profitable operations and positive cash
flows. There can be no assurance that our efforts to raise capital or increase
revenue will be successful. If our efforts are unsuccessful, we may have to
cease operations and liquidate our business.
 
 Recent
Developments
 
 On
January 6, 2009, we sold $500,000 aggregate principal amount of additional
convertible secured subordinated notes due November 14, 2010 to a current
noteholder with substantially the same terms and conditions as the previously
outstanding notes.
 
 On
February 19, 2009, we renewed our revolving credit arrangement with Paragon. The
line of credit advanced by Paragon is $2.47 million and can be used for general
working capital. Any advances made on the line of credit must be paid off no
later than February 11, 2010, with monthly payments being applied first to
accrued interest and then to principal. The interest shall accrue on the unpaid
principal balance at the Wall Street Journal's published Prime Rate, but at no
time shall the interest rate be less than 5.5%. The line of credit is secured by
an irrevocable standby letter of credit in the amount of $2.50 million issued by
HSBC with Atlas as account party.
 
 On
February 24, 2009, we sold $500,000 aggregate principal amount of additional
convertible secured subordinated notes due November 14, 2010 to a current
noteholder with substantially the same terms and conditions as the previously
outstanding notes.
 
 Also on
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that we may sell up to $6 million
aggregate principal amount of additional convertible secured subordinated notes
to new investors or existing noteholders at any time on or before December 31,
2009 with a maturity date of November 14, 2010 or later. In addition, the
maturity date definition for each of the notes was changed from November 14,
2010 to the date upon which the note is due and payable, which is the earlier of (1)
November 14, 2010, (2) a change of control, or (3) if an event of default
occurs, the date upon which noteholders accelerate the indebtedness evidenced by
the notes.
  31
 
 The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and will be the lowest “applicable conversion
price” determined for each note. The “applicable conversion price” for each note
shall be calculated by multiplying 120% by the lowest of:
 
 ·
              the
      average of the high and low prices of our common stock on the OTCBB
      averaged over the five trading days prior to the closing date of the
      issuance of such note;
 
 ·
              if
      our common stock is not traded on the Over-The-Counter market, the closing
      price of the common stock reported on the Nasdaq National Market or the
      principal exchange on which the common stock is listed, averaged over the
      five trading days prior to the closing date of the issuance of such note;
      or
 
 ·
              the
      closing price of our common stock on the OTCBB, the Nasdaq National Market
      or the principal exchange on which the common stock is listed, as
      applicable, on the trading day immediately preceding the date such note is
      converted, in each case as adjusted for stock splits, dividends or
      combinations, recapitalizations or similar
  events.
 
 Item
      7A.
              Quantitative
      and Qualitative Disclosures about Market
Risk
 
 Not
applicable.
  32


Item
      8.
              Financial
      Statements and Supplementary Data
 
 INDEX TO
FINANCIAL STATEMENTS
 
 PageREPORT
      OF INDEPENDENT REGISTEREDPUBLIC
      ACCOUNTING FIRM
                  34CONSOLIDATED
      BALANCE SHEETS
                  35CONSOLIDATED
      STATEMENTS OF OPERATIONS
                  36CONSOLIDATED
      STATEMENTS OF CASH FLOWS
                  37CONSOLIDATED
      STATEMENTS OFSTOCKHOLDERS’
      EQUITY (DEFICIT)
                  38NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS
                  39
  33
  REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
 
 Stockholders
and Directors
 Smart
Online, Inc.
 Durham,
North Carolina
 
 We have
audited the accompanying consolidated balance sheets of Smart Online, Inc. as of
December 31, 2008 and 2007, and the related consolidated statements of
operations, stockholders’ equity (deficit), and cash flows for each of the years
ended December 31, 2008 and 2007. These financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these financial statements based on our audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Smart Online, Inc. as of
December 31, 2008 and 2007, and the results of its operations and its cash flows
for each of the years ended December 31, 2008 and 2007, in conformity with
accounting principles generally accepted in the United States.
 
 The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 1, the Company has
suffered recurring losses from operations and has a working capital deficiency
as of December 31, 2008. These factors raise substantial doubt about the
Company’s ability to continue as a going concern. The financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.
 
 /s/ Sherb
& Co., LLP
 Certified
Public Accountants
 New York,
New York
 March 27,
2009
  34
  SMART
ONLINE, INC.
 CONSOLIDATED
BALANCE SHEETS
  December 31,
                    2008
                  
                  
                  December 31,
                    2007ASSETSCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  18,602
                  
                  
                  $
                  3,473,959Accounts
      receivable, net
                  
                  
                  184,930
                  
                  
                  
                  815,102Note
      receivable
                  
                  
                  60,000
                  
                  
                  
                  55,000Prepaid
      expenses
                  
                  
                  289,372
                  
                  
                  
                  90,886Deferred
      financing costs
                  
                  
                  -
                  
                  
                  
                  301,249Total
      current assets
                  
                  
                  552,904
                  
                  
                  
                  4,736,196Property
      and equipment, net
                  
                  
                  365,993
                  
                  
                  
                  174,619Capitalized
      software, net
                  
                  
                  261,221
                  
                  
                  
                  -Note
      receivable, non-current
                  
                  
                  372,317
                  
                  
                  
                  225,000Prepaid
      expenses, non-current
                  
                  
                  258,301
                  
                  
                  
                  -Intangible
      assets, net
                  
                  
                  1,410,245
                  
                  
                  
                  2,882,055Goodwill
                  
                  
                  -
                  
                  
                  
                  2,696,642Other
      assets
                  
                  
                  1,736
                  
                  
                  
                  60,311TOTAL
      ASSETS
                  
                  $
                  3,222,717
                  
                  
                  $
                  10,774,823LIABILITIES
      AND STOCKHOLDERS’ EQUITY (DEFICIT)Current
      liabilities:Accounts
      payable
                  
                  $
                  398,237
                  
                  
                  $
                  628,370Notes
      payable
                  
                  
                  2,341,177
                  
                  
                  
                  2,287,682Deferred
      revenue
                  
                  
                  323,976
                  
                  
                  
                  329,805Accrued
      liabilities
                  
                  
                  478,917
                  
                  
                  
                  603,338Total
      current liabilities
                  
                  
                  3,542,307
                  
                  
                  
                  3,849,195Long-term
      liabilities:Notes
      payable
                  
                  
                  5,327,211
                  
                  
                  
                  3,313,903Deferred
      revenue
                  
                  
                  67,353
                  
                  
                  
                  247,312Total
      long-term liabilities
                  
                  
                  5,394,564
                  
                  
                  
                  3,561,215Total
      liabilities
                  
                  
                  8,936,871
                  
                  
                  
                  7,410,410Commitments
      and contingenciesStockholders’
      equity (deficit):Common
      stock, $0.001 par value, 45,000,000 shares authorized, 18,333,601 and
      18,159,768 shares issued and outstanding at December 31, 2008 and December
      31, 2007, respectively
                  
                  
                  18,334
                  
                  
                  
                  18,160Additional
      paid-in capital
                  
                  
                  66,945,588
                  
                  
                  
                  66,202,179Accumulated
      deficit
                  
                  
                  (72,678,076
                  )
                  
                  
                  (62,855,926
                  )Total
      stockholders’ equity (deficit)
                  
                  
                  (5,714,154
                  )
                  
                  
                  3,364,413TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                  
                  $
                  3,222,717
                  
                  
                  $
                  10,774,823
 
 The
accompanying notes are an integral part of these financial
statements.
  35
  SMART
ONLINE, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 
 Year Ended
                                December 31,
                                2008
                              
                              
                              Year Ended
                                December 31,
                                2007REVENUES:Subscription
      fees
                              
                              $
                              2,683,770
                              
                              
                              $
                              2,829,343Professional
      service fees
                              
                              
                              2,045,508
                              
                              
                              
                              1,436,770License
      fees
                              
                              
                              26,250
                              
                              
                              
                              580,000Other
      revenue
                              
                              
                              117,457
                              
                              
                              
                              91,541Total
      revenues
                              
                              
                              4,872,985
                              
                              
                              
                              4,937,654COST
      OF REVENUES
                              
                              
                              837,789
                              
                              
                              
                              511,619GROSS
      PROFIT
                              
                              
                              4,035,196
                              
                              
                              
                              4,426,035OPERATING
      EXPENSES:General
      and administrative
                              
                              
                              4,815,405
                              
                              
                              
                              4,896,928Sales
      and marketing
                              
                              
                              2,739,595
                              
                              
                              
                              2,118,245Research
      and development
                              
                              
                              2,626,034
                              
                              
                              
                              2,497,408Loss
      on impairment of intangible assets
                              
                              
                              3,472,141
                              
                              
                              
                              -Total
      operating expenses
                              
                              
                              13,653,175
                              
                              
                              
                              9,512,581LOSS
      FROM OPERATIONS
                              
                              
                              (9,617,979
                              )
                              
                              
                              (5,086,546
                              )OTHER
      INCOME (EXPENSE):Interest
      expense, net
                              
                              
                              (633,014
                              )
                              
                              
                              (569,975
                              )Legal
      reserve and debt forgiveness, net
                              
                              
                              -
                              
                              
                              
                              (34,877
                              )Gain
      on legal settlements, net
                              
                              
                              411,710
                              
                              
                              
                              -Other
      income
                              
                              
                              17,133
                              
                              
                              
                              184,772Total
      other expense
                              
                              
                              (204,171
                              )
                              
                              
                              (420,080
                              )NET
      LOSS
                              
                              $
                              (9,822,150
                              )
                              
                              $
                              (5,506,626
                              )NET
      LOSS PER COMMON SHARE:Basic
      and fully diluted
                              
                              $
                              (0.54
                              )
                              
                              $
                              (0.32
                              )WEIGHTED-AVERAGE
      NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
    SHARE:Basic
      and fully diluted
                              
                              
                              18,309,771
                              
                              
                              
                              17,046,608
 
 The
accompanying notes are an integral part of these financial
statements.
  36
  SMART
ONLINE, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
  Year Ended
                    December 31,
                    2008
                  
                  
                  Year Ended
                    December 31,
                    2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                  
                  $
                  (9,822,150
                  )
                  
                  $
                  (5,506,626
                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                  
                  
                  825,846
                  
                  
                  
                  841,625Amortization
      of deferred financing costs
                  
                  
                  301,249
                  
                  
                  
                  433,054Provision
      for accounts and contract receivable allowances
                  
                  
                  430,505
                  
                  
                  
                  -Equity-based
      compensation
                  
                  
                  424,513
                  
                  
                  
                  548,368Registration
      rights penalty
                  
                  
                  -
                  
                  
                  
                  (62,376
                  )Accrual
      for loss on legal settlements
                  
                  
                  -
                  
                  
                  
                  250,000Gain
      on debt forgiveness
                  
                  
                  -
                  
                  
                  
                  (215,123
                  )Gain
      on disposal of assets
                  
                  
                  (3,729
                  )
                  
                  
                  -Loss
      on impairment of intangible assets
                  
                  
                  3,472,142
                  
                  
                  
                  -Changes
      in assets and liabilities:Accounts
      receivable
                  
                  
                  199,667
                  
                  
                  
                  (567,483
                  )Notes
      receivable
                  
                  
                  (152,317
                  )
                  
                  
                  (280,000
                  )Prepaid
      expenses
                  
                  
                  (456,787
                  )
                  
                  
                  10,081Other
      assets
                  
                  
                  58,575
                  
                  
                  
                  (47,271
                  )Accounts
      payable
                  
                  
                  (230,133
                  )
                  
                  
                  (8,444
                  )Deferred
      revenue
                  
                  
                  (185,788
                  )
                  
                  
                  252,089Accrued
      and other expenses
                  
                  
                  97,152
                  
                  
                  
                  53,596Net
      cash used in operating activities
                  
                  
                  (5,041,255
                  )
                  
                  
                  (4,298,510
                  )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of property and equipment
                  
                  
                  (330,748
                  )
                  
                  
                  (77,520
                  )Purchase
      of trade name
                  
                  
                  -
                  
                  
                  
                  (2,033
                  )Proceeds
      from sale of furniture and equipment
                  
                  
                  13,564
                  
                  
                  
                  -Capitalized
      software
                  
                  
                  (261,221
                  )
                  
                  
                  -Net
      cash used in investing activities
                  
                  
                  (578,405
                  )
                  
                  
                  (79,553
                  )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from debt borrowings
                  
                  
                  8,780,303
                  
                  
                  
                  4,750,000Repayments
      of debt borrowings
                  
                  
                  (6,713,500
                  )
                  
                  
                  (2,834,272
                  )Restricted
      cash
                  
                  
                  -
                  
                  
                  
                  250,000Issuance
      of common stock, net of costs
                  
                  
                  97,500
                  
                  
                  
                  5,359,389Net
      cash provided by financing activities
                  
                  
                  2,164,303
                  
                  
                  
                  7,525,117NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                  
                  
                  (3,455,357
                  )
                  
                  
                  3,147,054CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
                  
                  
                  3,473,959
                  
                  
                  
                  326,905CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                  
                  $
                  18,602
                  
                  
                  $
                  3,473,959Supplemental
      disclosures of cash flow information:Cash
      paid during the year for:Interest
                  
                  $
                  360,692
                  
                  
                  $
                  302,627Taxes
                  
                  $
                  40,367
                  
                  
                  $
                  -Supplemental
      schedule of non-cash financing activities:Conversion
      of debt to equity
                  
                  $
                  228,546
                  
                  
                  $
                  -Assets
      acquired under capital lease
                  
                  $
                  48,214
                  
                  
                  $
                  23,949Shares
      issued in settlement of notes payable
                  
                  $
                  -
                  
                  
                  $
                  129,311
 
 The
accompanying notes are an integral part of these financial statements.
  37
  SMART
ONLINE, INC.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
 FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007
  Common
      Stock
                  
                  
                  AdditionalShares
                  
                  
                  $0.001
      Par Value
                  
                  
                  Paid-In
                    Capital
                  
                  
                  Accumulated
                    Deficit
                  
                  
                  TotalsBALANCES,DECEMBER
      31, 2006
                  
                  $
                  15,379,030
                  
                  
                  
                  15,379
                  
                  
                  $
                  59,159,919
                  
                  
                  $
                  (57,349,300
                  )
                  
                  $
                  1,825,998Exercise
      of options
                  
                  
                  55,204
                  
                  
                  
                  55
                  
                  
                  
                  25,945
                  
                  
                  
                  -
                  
                  
                  
                  26,000Issuance
      of common stock, net of expenses
                  
                  
                  2,352,941
                  
                  
                  
                  2,353
                  
                  
                  
                  5,331,035
                  
                  
                  
                  -
                  
                  
                  
                  5,333,388Registration
      rights share issuances and settlements
                  
                  
                  83,093
                  
                  
                  
                  83
                  
                  
                  
                  402,899
                  
                  
                  
                  -
                  
                  
                  
                  402,982Equity-based
      compensation
                  
                  
                  289,500
                  
                  
                  
                  290
                  
                  
                  
                  548,078
                  
                  
                  
                  -
                  
                  
                  
                  548,368Issuance
      of warrants
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  734,303
                  
                  
                  
                  -
                  
                  
                  
                  734,303Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (5,506,626
                  )
                  
                  
                  (5,506,626
                  )BALANCES,DECEMBER
      31, 2007
                  
                  $
                  18,159,768
                  
                  
                  
                  18,160
                  
                  
                  $
                  66,202,179
                  
                  
                  $
                  (62,855,926
                  )
                  
                  $
                  3,364,413Exercise
      of options
                  
                  
                  206,069
                  
                  
                  
                  206
                  
                  
                  
                  97,294
                  
                  
                  
                  -
                  
                  
                  
                  97,500Issuance
      of common stock, net of expenses
                  
                  
                  19,608
                  
                  
                  
                  20
                  
                  
                  
                  228,527
                  
                  
                  
                  -
                  
                  
                  
                  228,547Equity-based
      compensation
                  
                  
                  70,000
                  
                  
                  
                  70
                  
                  
                  
                  424,443
                  
                  
                  
                  -
                  
                  
                  
                  424,513Cancellations
      of unvested restricted share issuances and forfeitures for payment of tax
      obligations
                  
                  
                  (121,844
                  )
                  
                  
                  (122
                  )
                  
                  
                  (6,855
                  )
                  
                  
                  -
                  
                  
                  
                  (6,977
                  )Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (9,822,150
                  )
                  
                  
                  (9,822,150
                  )BALANCES,DECEMBER
      31, 2008
                  
                  $
                  18,333,601
                  
                  
                  
                  18,334
                  
                  
                  $
                  66,945,588
                  
                  
                  $
                  (72,678,076
                  )
                  
                  $
                  (5,714,154
                  )
  The
accompanying notes are an integral part of these financial
statements.
  38
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007
 
 1.
              SUMMARY
      OF BUSINESS AND SIGNIFICANT ACCOUNTING
POLICIES
 
 Description ofBusiness and
Going Concern- Smart
Online, Inc. (the “Company”) was incorporated in the State of Delaware in 1993.
The Company develops and markets software products and services targeted to
small businesses that are delivered via a Software-as-a-Service (“SaaS”) model.
The Company sells its SaaS products and services primarily through private-label
marketing partners. In addition, the Company provides website consulting
services, primarily in the e-commerce retail industry. The Company maintains a
website for potential partners containing certain corporate information located
at www.smartonline.com.
 
 The
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. During the years ended December 31, 2008 and
2007, the Company incurred net losses as well as negative cash flows, is
involved in a class action lawsuit (See Note 7, “Commitments and Contingencies”)
and, at December 31, 2008, had deficiencies in working capital. These factors
indicate that the Company may be unable to continue as a going
concern.
 
 The
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts or
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The Company’s continuation as a going
concern depends upon its ability to generate sufficient cash flows to meet its
obligations on a timely basis, to obtain additional financing as may be
required, and ultimately to attain profitable operations and positive cash
flows. At December 31, 2008, the Company does have a commitment from its secured
subordinated noteholders to purchase up to an additional $9 million in
convertible notes, which if funded would enable the Company to continue as a
going concern. The Company’s future plans include the introduction of its new
industry-standard platform, the development of additional new products and
applications, and further enhancement of its existing small-business
applications and tools.
 
 Fiscal Year- The
Company’s fiscal year ends December 31. References to fiscal 2008, for example,
refer to the fiscal year ending December 31, 2008.
 
 Use of Estimates- The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States (“U.S. GAAP”) requires management to
make estimates and assumptions in the Company’s financial statements and notes
thereto. Significant estimates and assumptions made by management include the
determination of the provision for income taxes, the fair market value of stock
awards issued, and the period over which revenue is generated. Actual results
could differ materially from those estimates.
 
 Fair Value of
Financial Instruments-Statement
of Financial Accounting Standards (“SFAS”) No. 107, Disclosures about Fair Value of
Financial Instruments, requires disclosures of fair value
information about financial instruments, whether or not recognized in the
balance sheet, for which it is practicable to estimate that value. Due to the
short period of time to maturity, the carrying amounts of cash equivalents,
accounts receivable, accounts payable, accrued liabilities, and notes payable
reported in the consolidated financial statements approximate the fair
value.
 
 Reclassifications- Certain
prior year and comparative period amounts have been reclassified to conform
to current year presentation. These reclassifications had no effect on
previously reported net income or stockholders’ equity.
 
 Principles of
Consolidation - The accompanying consolidated financial statements
include the accounts of the Company and its wholly owned subsidiaries, Smart
CRM, Inc. (“Smart CRM”) and Smart Commerce, Inc. (“Smart Commerce”). All
significant intercompany accounts and transactions have been eliminated.
Subsidiary accounts are included only from the date of acquisition forward. On
December 31, 2008, each of Smart CRM and Smart Commerce were merged into the
Company.
 
 Cash and Cash
Equivalents - All highly liquid investments with an original
maturity of three months or less are considered to be cash
equivalents.
  39
  Restricted Cash
- Under the terms of a promissory note between Smart Commerce and Fifth
Third Bank, $250,000 on deposit at Fifth Third Bank served as loan collateral
and was restricted. Such restricted cash was scheduled to be released from the
restrictions in three equal installments of approximately $83,000 on June 30,
2007, December 31, 2007, and June 30, 2008 if the Company met certain debt
covenants regarding operating metrics for Smart Commerce. All such cash was
released in November 2007 when the Company prepaid the entire outstanding loan
balance.
 
 Concentration of
Credit Risk - Financial instruments which potentially subject the Company
to concentrations of credit risk consist primarily of cash and accounts
receivable. At times, cash balances may exceed the Federal Deposit Insurance
Corporation (“FDIC”) insurable limits. See Note 10, “Major Customers and
Concentration of Credit Risk,” for further discussion of risk within accounts
receivable.
 
 Allowance for
Doubtful Accounts - The Company maintains an allowance for doubtful
accounts for estimated losses resulting from the inability, failure, or refusal
of its customers to make required payments. The need for an allowance for
doubtful accounts is evaluated based on specifically identified amounts that
management believes to be potentially uncollectible. If actual collections
experience changes, revisions to the allowance may be required.
 
 In
addition, from time to time the Company, as part of its negotiated contracts,
has granted extended payment terms to its strategic partners. As payments become
due under the terms of the contract, they are invoiced and reclassified as
accounts receivable. During the second quarter of 2008, the Company entered into
a web services agreement with a new customer that provided for extended payment
terms related to both professional services and the grant of a software license.
During the third quarter of 2008, this customer began experiencing cash flow
difficulties and significantly slowed its payments to the Company in the fourth
quarter of 2008.
 
 Based on
these criteria, management determined that at December 31, 2008, an allowance
for doubtful accounts of $428,158 was required, comprising the full outstanding
balance of this customer’s accounts and contract receivable. Management
determined that at December 31, 2007, no allowance for doubtful accounts was
required.
 
 Prepaid Expenses
- Prepaid expenses consist primarily of a lump-sum rent payment on the
Company’s headquarters office space, advance payments to registries for domain
name registrations, and miscellaneous payments made in advance of the period to
which they relate. Prepaid expenses are amortized to expense on a straight-line
basis over the period covered by the expenses. In the case of prepaid registry
fees, the amortization period is consistent with the revenue recognition of the
related domain name registration.
 
 Property and
Equipment - Property and equipment are stated at cost and are depreciated
over their estimated useful lives using the straight-line method as
follows:
 
 Computer
      hardware
                3
      yearsComputer
      software
                3
      yearsFurniture
      and fixtures
                7
      yearsOffice
      equipment
                5
      yearsLeasehold
      improvements
                Shorter
      of the estimated useful life or the lease termAutomobiles
                5
      years
 
 Intangible Assets
and Goodwill - Intangible assets consist primarily of assets
obtained through the acquisitions of Computility, Inc. (“Computility”) and iMart
Incorporated (“iMart”) and include customer bases, acquired technology,
non-compete agreements, trademarks, trade names, workforces in place, and
goodwill. The Company also owns several copyrights and trademarks related to
products, names, and logos used throughout its non-acquired product
lines. All assets are amortized on a straight-line basis over their
estimated useful lives with the exception of the iMart trade name, workforces in
place, and goodwill, which are deemed by management to have indefinite lives and
are not amortized.
  40
  Impairment of
Long-LivedAssets -
The Company evaluates the recoverability of its long-lived assets in accordance
with SFAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. Long-lived assets
are reviewed for possible impairment at the earlier of annually in the fourth
quarter or whenever events or changes in circumstances indicate that the
carrying amount of such assets may not be recoverable. Recoverability of assets
to be held and used is measured by comparing the carrying amount of the asset to
future net undiscounted cash flows expected to be generated by the asset. If
such assets are considered to be impaired, the impairment is measured as the
amount by which the carrying amount exceeds the fair value and is recognized as
an operating expense in the period in which the determination is made. Assets to
be disposed are reported at the lower of the carrying amount or fair value less
costs to sell.
 
 In
addition to the recoverability assessment, the Company routinely reviews the
remaining estimated useful lives of its long-lived assets. Any reduction in the
useful-life assumption will result in increased depreciation and amortization
expense in the period when such determinations are made, as well as in
subsequent periods.
 
 In 2008,
management determined that its iMart trade name was impaired because its
carrying value of $1,155,500 exceeded future net undiscounted cash flows of
$380,000, calculated using the relief-from-royalty method. As a result, a loss
on impairment of intangible assets in the amount of $775,500 was recognized as
an operating expense in 2008. However, because the Company intends to continue
to use the iMart trade name and branding in sales and marketing activities
indefinitely, management concluded that an indefinite life was still
appropriate. There was no impairment of long-lived assets in 2007.
 
 The
Company evaluates the recoverability of goodwill in accordance with SFAS No.
142, Goodwill and Other
Intangible Assets, at the earlier of annually in the fourth quarter or
whenever events or changes in circumstances indicate that the balance may not be
recoverable. Impairment may result from, among other things, deterioration in
the performance of the acquired business, adverse market conditions, adverse
changes in applicable laws or regulations including changes that restrict the
activities of the acquired business, a change in the strategic direction of the
Company, and a variety of other circumstances.
 
 In 2008,
management determined that goodwill of $2,696,642 associated with its
acquisition of iMart was fully impaired due to a number of reasons, including
the shutdown in 2008 of iMart’s Grand Rapids, Michigan facility and the
termination of all its employees; the consolidation of its technology platforms;
the deterioration in value of the Company’s underlying stock that contributed to
the initial value of goodwill; and general economic and market conditions. As a
result, a loss on impairment of intangible assets for this amount was recognized
as an operating expense in 2008.
 
 Revenue
Recognition- The
Company derives revenue primarily from subscription fees charged to customers
accessing its SaaS applications; professional service fees, consisting primarily
of consulting; the perpetual or term licensing of software platforms or
applications; and hosting and maintenance services. These arrangements may
include delivery in multiple-element arrangements if the customer purchases a
combination of products and/or services. Because the Company licenses, sells,
leases, or otherwise markets computer software, it uses the residual method
pursuant to American Institute of Certified Public Accountants (“AICPA”)
Statement of Position 97-2,Software Revenue Recognition (“SOP 97-2”), as amended. This method allows
the Company to recognize revenue for a delivered element when such element has
vendor specific objective evidence (“VSOE”) of the fair value of the delivered
element. If VSOE cannot be determined or maintained for an element, it could
impact revenues as all or a portion of the revenue from the multiple-element
arrangement may need to be deferred.
 
 If
multiple-element arrangements involve significant development, modification, or
customization or if it is determined that certain elements are essential to the
functionality of other elements within the arrangement, revenue is deferred
until all elements necessary to the functionality are provided by the Company to
a customer. The determination of whether the arrangement involves significant
development, modification, or customization could be complex and require the use
of judgment by management.
 
 Under SOP
97-2, provided the arrangement does not require significant development,
modification, or customization, revenue is recognized when all of the following
criteria have been met:
  41
 
 1.     persuasive
evidence of an arrangement exists
 
 2.     delivery
has occurred
 
 3.     the
fee is fixed or determinable
 
 4.     collectibility
is probable
 
 If at the
inception of an arrangement the fee is not fixed or determinable, revenue is
deferred until the arrangement fee becomes due and payable. If collectibility is
deemed not probable, revenue is deferred until payment is received or collection
becomes probable, whichever is earlier. The determination of whether fees are
collectible requires judgment of management, and the amount and timing of
revenue recognition may change if different assessments are made.
 
 Under the
provisions of Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables, consulting, website design fees, and application
development services are accounted for separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, revenues are recognized as the services are rendered
for time and material contracts, and when milestones are achieved and accepted
by the customer for fixed price or long-term contracts. The majority of the
Company’s consulting service contracts are on a time and material basis and are
typically billed monthly based upon standard professional service
rates.
 
 Application
development services are typically fixed price and of a longer term. As such,
they are accounted for as long-term construction contracts that require revenue
recognition to be based on estimates involving total costs to complete and the
stage of completion. The assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, the associated costs of such
projects are capitalized and included in costs in excess of billings on the
balance sheet until such time that revenue recognition is
permitted.
 
 Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. The Company typically has a revenue-share arrangement
with these marketing partners in order to encourage them to market the Company’s
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user. Any payments received in advance of the subscription period are accrued as
deferred revenue and amortized over the subscription period. The Company
recognizes revenue on a gross basis in accordance with Emerging Issues Task
Force Issue No. 99-19, Reporting Revenue Gross as a
Principal or Net as an Agent, when services are provided directly by the
Company to end users and revenue-share arrangements exist with its marketing
partners.
 
 Because
its customers generally do not have the contractual right to take possession of
the software it licenses or markets at any time, the Company recognizes revenue
on hosting and maintenance fees as the services are provided in accordance with
Emerging Issues Task Force Issue No. 00-3, Application of AICPA Statement of
Position 97-2 to Arrangements That Include the Right to Use Software Stored on
Another Entity’s Hardware.
 
 DeferredRevenue-Deferred
revenue consists of billings or payments received in advance of revenue
recognition, and it is recognized as the revenue recognition criteria are met.
Deferred revenue also includes certain professional services fees and licensing
revenues where all the criteria of SOP 97-2 were not met. Deferred revenue that
will be recognized over the succeeding 12-month period is recorded as current
and the remaining portion is recorded as noncurrent.
 
 Cost of
Revenues-Cost of
revenues primarily is composed of salaries associated with maintaining and
supporting customers, the cost of domain name and e-mail registrations, and the
cost of external facilities where the Company’s and its customers’ customized
applications are hosted.
  42
  Software
Development Costs-The
Company capitalizes certain costs of software developed in accordance with SFAS
No. 86, Accounting for the
Costs ofComputerSoftware to Be Sold,
Leased, or Otherwise Marketed(“SFAS No. 86”), which
requires capitalization of certain software development costs subsequent to the
establishment of technological feasibility, with costs incurred prior to this
time expensed as research and development. Technological feasibility is
established when all planning, designing, coding, and testing activities that
are necessary to establish that the product can be produced to meet its design
specifications have been completed. The Company’s policy provides for the
capitalization of certain outside contractors’ fees and payroll and
payroll-related costs for employees who are directly associated with the
development of the Company’s software. Capitalized costs are ratably amortized
using the straight-line method over the estimated useful life of the software,
generally three years. Management evaluates the recoverability of its
capitalized software at the earlier of annually in the fourth quarter or
whenever events or changes in circumstances indicate that the carrying amount of
such assets may not be recoverable by comparing the amount capitalized to the
estimated net realizable value of the software. If such evaluations indicate
that the unamortized software development costs exceed the net realizable value,
the Company writes down the carrying cost to net realizable value.
 
 Historically,
the Company had not developed detailed design plans for its SaaS applications,
and the costs incurred between the completion of a working model of these
applications and the point at which the products were ready for general release
had been insignificant. These factors, combined with the historically low
revenue generated by the sale of the applications that do not support the net
realizable value of any capitalized costs, resulted in the continued expensing
of underlying costs as research and development.
 
 Beginning
in May 2008, the Company determined that it was strategically desirable to
develop an industry-standard platform and to enhance the current SaaS
applications. A detailed design plan indicated that the product was
technologically feasible. In July 2008, development commenced, and as of
December 31, 2008, $261,221 in associated costs were capitalized in accordance
with SFAS No. 86. As this platform is still under development, the Company
recognized no amortization expense during the year ended December 31,
2008.
 
 SFAS No.
2, Accounting for Research and
Development Costs, establishes accounting and reporting standards for
research and development. Costs incurred to search for new revenue producing
products or services, to significantly improve an existing product, and to
formulate design plans in an effort to establish technological feasibility are
expensed in the period they are incurred.
 
 Advertising
Costs - The Company expenses all advertising costs as they are incurred.
The amounts charged to sales and marketing expense during 2008 and 2007 were
$37,202 and $24,144, respectively.
 
 Stock-Based
Compensation - Effective January 1, 2006, the Company adopted SFAS
No. 123 (revised 2004), Share-Based Payment (“SFAS
No. 123R”), using the Modified Prospective Approach. Under the Modified
Prospective Approach, the amount of compensation cost recognized includes (i)
compensation cost for all share-based payments granted prior to, but not yet
vested as of, January 1, 2006, based on the grant date fair value estimated
in accordance with the provisions of SFAS No. 123,Accounting for Stock-Based
Compensation; and (ii) compensation cost for all share-based
payments that are granted subsequent to January 1, 2006, based on the grant
date fair value estimated in accordance with the provisions of SFAS
No. 123R. Upon adoption, the Company recognized the stock-based
compensation of previously granted options and new optionsunder
the straight-line method over the requisite service period. Total stock-based
compensation expense recognized under SFAS No. 123R was approximately
$424,513 and $548,368 for the years ended December 31, 2008 and 2007,
respectively. No stock-based compensation was capitalized in the
consolidated financial statements.
 
 In
computing the impact of stock-based compensation expense, the fair value of each
award is estimated on the date of grant based on the Black-Scholes option
pricing model utilizing certain assumptions for a risk-free interest rate,
volatility, and expected remaining lives of the awards. The assumptions used in
calculating the fair value of share-based payment awards represent management’s
best estimates, but these estimates involve inherent uncertainties and the
application of management’s judgment. As a result, if factors change and the
Company uses different assumptions, the Company’s stock-based compensation
expense could be materially different in the future. In addition, the Company is
required to estimate the expected forfeiture rate and only recognize expense for
those shares expected to vest. In estimating the Company’s forfeiture rate, the
Company analyzed its historical forfeiture rate, the remaining lives of unvested
options, and the amount of vested options as a percentage of total options
outstanding. If the Company’s actual forfeiture rate is materially different
from its estimate, or if the Company reevaluates the forfeiture rate in the
future, the stock-based compensation expense could be significantly different
from what the Company has recorded in the current period.
  43
  The fair
value of option grants under the Company’s equity compensation plan during the
years ended December 31, 2008 and 2007 were estimated using the following
weighted average assumptions:
 
 Year Ended December 31,2008
                    
                    
                    2007Dividend
      yield
                    
                    
                    0.0
                    %
                    
                    
                    0.0
                    %Expected
      volatility
                    
                    
                    46
                    %
                    
                    
                    63
                    %Risk-free
      interest rate
                    
                    
                    4.41
                    %
                    
                    
                    3.45
                    %Expected
      lives (years)
                    
                    
                    4.3
                    
                    
                    
                    4.6
 
 Dividend yield – The Company
has never declared or paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.
 
 Expected volatility –
Volatility is a measure of the amount by which a financial variable such as
share price has fluctuated (historical volatility) or is expected to fluctuate
(expected volatility) during a period. Expected volatility is partially based on
the historical volatility of the Company’s common stock since the end of the
prior fiscal year as well as management’s expectations for future
volatility.
 
 Risk-free interest rate – The
risk-free interest rate is based on the published yield available on U.S.
Treasury issues with an equivalent term remaining equal to the expected life of
the option.
 
 Expected lives – The expected
lives of the options represent the estimated period of time until exercise or
forfeiture and are based on historical experience of similar
awards.
 
 Net Loss
PerShare-Basic
net loss per share is computed by dividing net loss by the weighted average
number of common shares outstanding during the periods. Diluted net loss per
share is computed using the weighted average number of common and dilutive
common equivalent shares outstanding during the periods. Common equivalent
shares consist of convertible notes, stock options, and warrants that are
computed using the treasury stock method. Shares issuable upon the exercise of
stock options, totaling 1,927,165 and 3,300,215 shares on December 31, 2008 and
2007, respectively, were excluded from the calculation of common equivalent
shares as the impact was anti-dilutive.
 
 Recently Issued
Accounting Pronouncements-In April
2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff
Position No. 142-3, Determination of the Useful Life of
Intangible Assets (“FSP 142-3”). The standard requires entities to
consider their own historical experience in renewing or extending similar
arrangements when developing assumptions regarding the useful lives of
intangible assets and also mandates certain related disclosure requirements. FSP
142-3 is effective for fiscal years beginning after December 15, 2008, with
early adoption prohibited. The Company is currently evaluating the impact of the
pending adoption of FSP 142-3 on its consolidated financial
statements.
 
 All other
new and recently issued, but not yet effective, accounting pronouncements have
been deemed to be not relevant to the Company and therefore are not expected to
have any impact once adopted.
 
 2.
              SEGMENT
      INFORMATION
 
 In 2007,
the Company operated as two segments. The segments were the Company’s core
operations (the “Smart Online segment”) and the operations of the Company’s
wholly owned subsidiary Smart Commerce (the “Smart Commerce segment”). The
Smart Online segment generated revenues from the development and distribution of
Internet-delivered SaaS small-business applications through a variety of
channels. The Smart Commerce segment generated revenues primarily from
subscriptions to the Company’s multi-channel e-commerce systems, including
domain name registration and e-mail solutions, e-commerce solutions, and
website design, as well as website hosting and consulting services. The
Company included costs that were not allocated to specific segments, such as
corporate general and administrative expenses and share-based compensation
expenses, in the Smart Online segment.
  44
  During
late 2007 and the first quarter of 2008, management realigned certain production
and development functions and eliminated redundant administrative functions and
now reports the consolidated business as a single business segment. The
Company’s chief operating decision maker is its Chief Executive Officer, who
reviews financial information presented on a consolidated basis. Accordingly, in
accordance with SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, the Company has determined that it
has a single reporting segment and operating unit structure, specifically the
provision of an on-demand suite of integrated business management software
services.
 
 3.
              BALANCE
      SHEET ACCOUNTS
 
 Prepaid
Expenses
 
 In July
2008, the Company entered into a 36-month sublease agreement for approximately
9,837 square feet of office space in Durham, North Carolina near Research
Triangle Park, into which the Company relocated its headquarters in September
2008. The agreement included the conveyance of certain furniture to the Company
without a stated value and required a lump-sum, upfront payment of $500,000 that
was made in September 2008. Management has assessed the fair market value of the
furniture to be approximately $50,000, and this amount was capitalized and is
subject to depreciation in accordance with the Company’s fixed asset policies.
The remainder of the payment was recorded as prepaid expense, with the portion
relating to rent for periods beyond the next 12 months classified as
non-current, and is being amortized to rent expense over the term of the
lease.
 
 Deferred
Financing Costs
 
 To assist
the Company in securing a modification to its line of credit with
Wachovia Bank, NA (“Wachovia”), Atlas Capital SA (“Atlas”) provided Wachovia
with a modified standby letter of credit. In exchange for Atlas providing
Wachovia with the modified letter of credit, on January 15, 2007 the Company
issued Atlas a warrant containing a provision for cashless exercise to purchase
up to 444,444 shares of the Company’s common stock at $2.70 per share. The fair
value of the warrant was $734,303 as measured using the Black-Scholes
option pricing model at the time the warrant was issued. This amount was
recorded as deferred financing costs and was amortized to interest expense in
the amount of $37,657 per month over the remaining period of the modified line
of credit, which was scheduled to expire in August 2008. In February 2008, the
Wachovia line of credit was replaced by a new line of credit with Paragon
Commercial Bank (“Paragon”) as described in Note 6, “Notes Payable.” Atlas
agreed to provide Paragon a new standby letter of credit and the Company agreed
to amend the Atlas warrant agreement to provide that the warrant is exercisable
within 30 business days of the termination of the Paragon line of credit or if
the Company is in default under the terms of the line of credit with
Paragon. As of December 31, 2008, the deferred financing costs were fully
amortized to interest expense.
 
 Accrued
Liabilities
 
 At
December 31, 2008, the Company had accrued liabilities totaling $478,917. This
amount consisted primarily of $117,102 of liability related to the development
of the Company’s custom accounting application; $137,500 related to legal
reserves; $30,198 for tax-related liabilities associated with the vesting of
restricted stock; $30,903 of estimated loss on a long-term customer contract;
$79,300 of cash collected through the Company's merchant account on behalf of a
customer; and $54,467 of convertible note interest payable.
 
 At
December 31, 2007, the Company had accrued liabilities totaling $603,338. This
amount consisted primarily of $204,000 of liability accrued related to the
development of the Company’s custom accounting application; $250,000 related to
legal reserves; $45,308 due a customer for overpayment of its account; $30,040
of accrued sales commissions; and $33,733 of convertible note interest
payable.
 
 Deferred
Revenue
 
 Deferred
revenue comprises the following items:
  45
  ·
              Subscription fees– Short-term and
      long-term portions of cash received related to one- or two-year
      subscriptions for domain names and/or e-mail
  accounts.
 
 ·
              License fees– Licensing revenue
      where customers did not meet all the criteria of SOP 97-2. Such deferred
      revenue will be recognized when delivery has occurred or collectibility
      becomes probable.
 
 ·
              Professional
      servicefees– A
      customer that purchased a license and paid professional service fees
      during 2008 and 2007 to develop a customized application decided in the
      latter part of 2008 to move the application to the Company’s new
      technology platform. In connection with this new arrangement, the customer
      desires customization beyond the original scope of the project and will
      also be responsible for a monthly fee to maintain the application starting
      in the second quarter of 2009. This deferred revenue represents the
      difference between earned fees and unearned license and professional
      service fees that will be recognized as professional service fees revenue
      in 2009.
 
 The
components of deferred revenue for the periods indicated were as
follows:
 
 December 31,
                      2008
                    
                    
                    December 31,
                      2007Subscription
      fees
                    
                    $
                    89,852
                    
                    
                    $
                    197,117License
      fees
                    
                    
                    108,750
                    
                    
                    
                    380,000Professional
      service fees
                    
                    
                    192,727
                    
                    
                    
                    -Totals
                    
                    $
                    391,329
                    
                    
                    $
                    577,117Current
      portion
                    
                    $
                    323,976
                    
                    
                    $
                    329,805Non-current
      portion
                    
                    
                    67,353
                    
                    
                    
                    247,312Totals
                    
                    $
                    391,329
                    
                    
                    $
                    577,117
 
 4.
              PROPERTY
      AND EQUIPMENT AND CAPITALIZED
SOFTWARE
 
 Property
and equipment consists of the following:
 
 December 31,
                      2008
                    
                    
                    December 31,
                      2007Computer
      hardware
                    
                    $
                    1,182,513
                    
                    
                    $
                    822,341Computer
      software
                    
                    
                    480,262
                    
                    
                    
                    583,724Furniture
      and fixtures
                    
                    
                    115,167
                    
                    
                    
                    15,386Office
      equipment
                    
                    
                    68,850
                    
                    
                    
                    114,384Leasehold
      improvements
                    
                    
                    52,994
                    
                    
                    
                    -Automobiles
                    
                    
                    -
                    
                    
                    
                    29,5041,899,786
                    
                    
                    
                    1,565,339Less
      accumulated depreciation
                    
                    
                    (1,533,793
                    )
                    
                    
                    (1,390,720
                    )Property
      and equipment, net
                    
                    $
                    365,993
                    
                    
                    $
                    174,619
 
 Capitalized
software consists of the following:
 
 December 31,
                      2008
                    
                    
                    December 31,
                      2007Capitalized
      software
                    
                    $
                    261,221
                    
                    
                    $
                    -Less
      accumulated amortization
                    
                    
                    -
                    
                    
                    
                    -Capitalized
      software, net
                    
                    $
                    261,221
                    
                    
                    $
                    -
 
 Depreciation
expense for the years ended December 31, 2008 and 2007 was $129,539 and
$104,169, respectively.
  46
  As the
Company’s new technology platform was still under development at December 31,
2008, no amortization expense relating to capitalized software has been
recognized.
 
 5.
              INTANGIBLE
      ASSETS
 
 The
following table summarizes information about intangible assets at December 31,
2008:
 
 Asset Category
                  
                  Value
                    Assigned
                  
                  
                  Residual
                    Value
                  
                  
                  Weighted
                    Average
                    Amortization
                    Period
                    (in Years)
                  
                  
                  Impairments
                  
                  
                  Accumulated
                    Amortization
                  
                  
                  Carrying
                    Value (Net of
                    Impairments)Customer
      bases
                  
                  $
                  1,944,347
                  
                  
                  $
                  -
                  
                  
                  
                  6.2
                  
                  
                  $
                  -
                  
                  
                  $
                  1,076,740
                  
                  
                  $
                  867,607Acquired
      technology
                  
                  
                  501,264
                  
                  
                  
                  -
                  
                  
                  
                  3
                  
                  
                  
                  -
                  
                  
                  
                  501,264
                  
                  
                  
                  -Non-compete
      agreement
                  
                  
                  801,785
                  
                  
                  
                  -
                  
                  
                  
                  4
                  
                  
                  
                  -
                  
                  
                  
                  643,098
                  
                  
                  
                  158,687Trademarks
      and copyrights
                  
                  
                  52,372
                  
                  
                  
                  -
                  
                  
                  
                  9.7
                  
                  
                  
                  -
                  
                  
                  
                  48,421
                  
                  
                  
                  3,951Trade
      name
                  
                  
                  1,155,500
                  
                  
                  
                  N/A
                  
                  
                  
                  N/A
                  
                  
                  
                  (775,500
                  )
                  
                  
                  N/A
                  
                  
                  
                  380,000Goodwill
      and workforce
                  
                  
                  2,696,642
                  
                  
                  
                  N/A
                  
                  
                  
                  N/A
                  
                  
                  
                  (2,696,642
                  )
                  
                  
                  N/A
                  
                  
                  
                  -Totals
                  
                  $
                  7,151,910
                  
                  
                  $
                  -
                  
                  
                  
                  
                  
                  
                  $
                  (3,472,142
                  )
                  
                  $
                  2,269,523
                  
                  
                  $
                  1,410,245
 
 The
following table summarizes information about intangible assets at December 31,
2007:
 
 Asset Category
                  
                  Value
                    Assigned
                  
                  
                  Residual
                    Value
                  
                  
                  Weighted
                    Average
                    Amortization
                    Period
                    (in Years)
                  
                  
                  Impairments
                  
                  
                  Accumulated
                    Amortization
                  
                  
                  Carrying
                    Value (Net of
                    Impairments)Customer
      bases
                  
                  $
                  1,944,347
                  
                  
                  $
                  -
                  
                  
                  
                  6.2
                  
                  
                  $
                  -
                  
                  
                  $
                  741,130
                  
                  
                  $
                  1,203,217Acquired
      technology
                  
                  
                  501,264
                  
                  
                  
                  -
                  
                  
                  
                  3
                  
                  
                  
                  -
                  
                  
                  
                  368,986
                  
                  
                  
                  132,278Non-compete
      agreements
                  
                  
                  891,785
                  
                  
                  
                  -
                  
                  
                  
                  4
                  
                  
                  
                  -
                  
                  
                  
                  510,152
                  
                  
                  
                  381,633Trademarks
      and copyrights
                  
                  
                  52,372
                  
                  
                  
                  -
                  
                  
                  
                  9.7
                  
                  
                  
                  -
                  
                  
                  
                  42,945
                  
                  
                  
                  9,427Trade
      name
                  
                  
                  1,155,500
                  
                  
                  
                  N/A
                  
                  
                  
                  N/A
                  
                  
                  
                  -
                  
                  
                  
                  N/A
                  
                  
                  
                  1,155,500Goodwill
      and workforce
                  
                  
                  2,696,642
                  
                  
                  
                  N/A
                  
                  
                  
                  N/A
                  
                  
                  
                  -
                  
                  
                  
                  N/A
                  
                  
                  
                  2,696,642Totals
                  
                  $
                  7,241,910
                  
                  
                  $
                  -
                  
                  
                  
                  
                  
                  
                  $
                  -
                  
                  
                  $
                  1,663,213
                  
                  
                  $
                  5,578,697
 
 Intangible
assets acquired were valued using the standard of “fair value,” defined in SFAS
No. 141, Business
Combinations, as “the amount at which an asset (or liability) could be
bought (or incurred) or sold (or settled) in a current transaction between
willing parties, that is, other than in a forced or liquidation sale.” Goodwill
was initially calculated as the difference between the purchase price of the
acquisition (which was negotiated in an arm’s-length transaction) and the value
of the identifiable tangible and intangible assets acquired. Copyrights and
trademarks were capitalized using the costs of all legal and application fees
incurred.
 
 For the
years ended December 31, 2008 and 2007, the aggregate amortization expense on
the above intangibles was approximately $696,307 and $737,458, respectively. The
aggregate amortization expense for the years ended December 31, 2009 through
2013 is expected to be approximately $470,127, $200,639, $200,639, $158,839, and
$0 for each respective year.
 
 6.
              NOTES
      PAYABLE
 
 Convertible
Notes
 
 On
November 14, 2007, in an initial closing, the Company sold $3.3 million
aggregate principal amount of convertible secured subordinated notes due
November 14, 2010 (the “Initial Notes”). In addition, the noteholders committed
to purchase on a pro rata basis up to $5.2 million aggregate principal of
secured subordinated notes in future closings upon approval and call by the
Company’s Board of Directors. On August 12, 2008, the Company exercised its
option to sell $1.5 million aggregate principal of additional convertible
secured subordinated notes due November 14, 2010, with substantially the same
terms and conditions as the Initial Notes (the “Additional Notes”). In
connection with the sale of the Additional Notes, the noteholders holding a
majority of the aggregate principal amount of the convertible secured
subordinated notes then outstanding agreed to increase the aggregate principal
amount of secured subordinated convertible notes that they are committed to
purchase from $8.5 million to $15.3 million.
  47
  On
November 21, 2008, the Company sold $500,000 aggregate principal amount of
additional convertible secured subordinated notes due November 14, 2010 (the
“New Notes”) to two new investors with substantially the same terms and
conditions as the Initial Notes and the Additional Notes (collectively with the
New Notes, the “notes”).
 
 The
Company is obligated to pay interest on the notes at an annualized rate of 8%
payable in quarterly installments commencing three months after the purchase
date of the notes. The Company is not permitted to prepay the notes without
approval of the holders of at least a majority of the principal amount of the
notes then outstanding.
 
 On the
earlier of the maturity date of November 14, 2010 or a merger or acquisition or
other transaction pursuant to which existing stockholders of the Company hold
less than 50% of the surviving entity, or the sale of all or substantially all
of the Company’s assets, or similar transaction, or event of default, each
noteholder in its sole discretion shall have the option to:
 
 ·
              convert
      the principal then outstanding on its notes into shares of the Company’s
      common stock, or
 
 ·
              receive
      immediate repayment in cash of the notes, including any accrued and unpaid
      interest.
 
 If a
noteholder elects to convert its notes under these circumstances, the conversion
price of notes:
 
 ·
              issued
      in the initial closing on November 14, 2007 shall be $3.05;
      and
 
 ·
              issued
      on August 12, 2008 and November 21, 2008 shall be the lower of $3.05 or
      120% multiplied by the average of the closing bid and asked prices of
      shares of the Company’s common stock quoted in the Over-The-Counter Market
      Summary (or, if the Company’s shares are traded on the Nasdaq Stock Market
      or another exchange, the closing price of shares of the Company’s common
      stock quoted on such exchange) averaged over five trading days prior to
      the closing date of the sale of such
notes.
 
 Payment
of the notes will be automatically accelerated if the Company enters voluntary
or involuntary bankruptcy or insolvency proceedings.
 
 The notes
and the common stock into which they may be converted have not been registered
under the Securities Act of 1933, as amended (the “Securities Act”), or the
securities laws of any other jurisdiction. As a result, offers and sales of the
notes were made pursuant to Regulation D of the Securities Act and only made to
accredited investors. The investors in the Initial Notes include (i) The
Blueline Fund, which originally recommended Philippe Pouponnot, a former
director of the Company, for appointment to the Company’s Board of Directors;
(ii) Atlas, an affiliate of the Company that originally recommended Shlomo Elia,
one of the Company’s current directors, for appointment to the Board of
Directors; (iii) Crystal Management Ltd. (“Crystal”), which is owned by Doron
Roethler, who subsequently became Chairman of the Company’s Board of Directors
and Interim Chief Executive Officer and serves as the noteholders’ bond
representative; and (iv) William Furr, who is the father of Thomas Furr, who, at
the time, was one of the Company’s directors and executive officers. The
investors in the Additional Notes are Atlas and Crystal. The investors in the
New Notes are not affiliated with the Company.
 
 If the
Company proposes to file a registration statement to register any of its common
stock under the Securities Act in connection with the public offering of such
securities solely for cash, subject to certain limitations, the Company shall
give each noteholder who has converted its notes into common stock the
opportunity to include such shares of converted common stock in the
registration. The Company has agreed to bear the expenses for any of these
registrations, exclusive of any stock transfer taxes, underwriting discounts,
and commissions.
  48
  On
November 6, 2007, Canaccord Adams, Inc. (“CA”) agreed to waive any rights it
held under its January 2007 engagement letter with the Company that it may have
with respect to the convertible note offering, including the right to receive
any fees in connection with the offering.
 
 Lines
of Credit
 
 On
November 9, 2006, Smart Commerce entered into a loan agreement with Fifth Third
Bank. Under the terms of this agreement, Smart Commerce borrowed $1.8 million to
be repaid in 24 monthly installments of $75,000 plus interest beginning in
December 2006. The interest rate was Prime plus 1.5% as periodically determined
by Fifth Third Bank. The loan was secured by all of the assets of Smart
Commerce, including a cash security account of $250,000 and all of Smart
Commerce’s intellectual property. The loan was guaranteed by the Company, and
such guaranty was secured by all of the common stock of Smart Commerce. Under
the terms of the loan agreement, Smart Commerce established a lockbox account
with Fifth Third Bank but had the right to use the amounts deposited in the
account for any purpose not inconsistent with the loan agreement and related
documents so long as no event of default existed and was continuing. Such
restricted cash was scheduled to be released from the restrictions in three
equal installments of approximately $83,000, on June 30, 2007, December 31,
2007, and June 30, 2008, if the Company met certain debt covenants regarding
operating metrics for Smart Commerce. In November 2007, following the
convertible note offering described above, the Company repaid all principal and
interest owed to Fifth Third Bank in connection with this loan. All restricted
cash was released and used to repay part of the principal due.
 
 On
November 14, 2006, the Company entered into a revolving credit arrangement with
Wachovia for $1.3 million to be used for general working capital. Any advances
made on the line of credit were to be paid off no later than August 1, 2007,
with monthly payments of accrued interest on any outstanding balance commencing
on December 1, 2006. The interest accrued on the unpaid principal balance at the
LIBOR Market Index Rate plus 0.9%. The line of credit was secured by the
Company’s deposit account at Wachovia and an irrevocable standby letter of
credit in the amount of $1.3 million issued by HSBC Private Bank (Suisse) SA
(“HSBC”) with Atlas, a current stockholder, as account party.
 
 On
January 24, 2007, the Company entered into an amendment to its line of credit
with Wachovia to increase the available principal from $1.3 million to $2.5
million and to extend the maturity date from August 1, 2007 to August 1, 2008.
The amended line of credit was secured by the Company’s deposit account at
Wachovia and a modified irrevocable standby letter of credit in the amount of
$2,500,000 issued by HSBC with Atlas as account party. As of December 31, 2007,
the Company owed $2,052,000 under the line of credit. On February 15, 2008, the
Company repaid the full outstanding principal balance of $2,052,000 and accrued
interest of $2,890.
 
 On
February 20, 2008, the Company entered into a revolving credit arrangement with
Paragon that is renewable on an annual basis subject to mutual approval. The
line of credit advanced by Paragon is $2.47 million and can be used for general
working capital. Any advances made on the line of credit must be paid off no
later than February 19, 2009, subject to extension due to renewal, with monthly
payments being applied first to accrued interest and then to principal. The
interest shall accrue on the unpaid principal balance at the Wall Street
Journal’s published Prime Rate minus one half percent. The line of credit
is secured by an irrevocable standby letter of credit in the amount of $2.5
million issued by HSBC with Atlas as account party that expires on February 18,
2010. The Company also has agreed with Atlas that in the event of a default by
the Company in the repayment of the line of credit that results in the letter of
credit being drawn, the Company shall reimburse Atlas any sums that Atlas is
required to pay under such letter of credit. At the sole discretion of the
Company, these payments may be made in cash or by issuing shares of the
Company’s common stock at a set per-share price of $2.50.
 
 As of
December 31, 2008, the Company had notes payable totaling $7,668,388. The detail
of these notes is as follows:
  49
 
 Note Description
                      
                      Short-Term
                        Portion
                      
                      
                      Long-Term
                        Portion
                      
                      
                      Total
                      
                      Maturity
                      
                      RateParagon
      Commercial Bank credit line
                      
                      $
                      2,272,118
                      
                      
                      $
                      -
                      
                      
                      $
                      2,272,118
                      
                      Feb
      2009
                      
                      Prime less 0.5%Insurance
      premium note
                      
                      
                      42,753
                      
                      
                      
                      -
                      
                      
                      
                      42,753
                      
                      Jul
      2009
                      
                      
                      6.1
                      %Various
      capital leases
                      
                      
                      26,306
                      
                      
                      
                      27,211
                      
                      
                      
                      53,517
                      
                      Various
                      
                      
                      10.7-18.9
                      %Convertible
      notes
                      
                      
                      -
                      
                      
                      
                      5,300,000
                      
                      
                      
                      5,300,000
                      
                      Nov
      2010
                      
                      
                      8.0
                      %Totals
                      
                      $
                      2,341,177
                      
                      
                      $
                      5,327,211
                      
                      
                      $
                      7,668,388
 
 As of
December 31, 2008, the Prime Rate was 3.25%.
 
 As of
December 31, 2007, the Company had notes payable totaling $5,601,585. The detail
of these notes is as follows:
 
 Note Description
                      
                      Short-Term
                        Portion
                      
                      
                      Long-Term
                        Portion
                      
                      
                      Total
                      
                      Maturity
                      
                      RateWachovia
      Bank credit line
                      
                      $
                      2,052,000
                      
                      
                      $
                      -
                      
                      
                      $
                      2,052,000
                      
                      Aug 2008
                      
                      LIBOR plus 0.9%Acquisition
      fee-iMart
                      
                      
                      209,179
                      
                      
                      
                      -
                      
                      
                      
                      209,179
                      
                      Oct
      2007
                      
                      
                      8.0
                      %Acquisition
      fee-Computility
                      
                      
                      19,182
                      
                      
                      
                      -
                      
                      
                      
                      19,182
                      
                      Mar
      2007
                      
                      
                      8.0
                      %Capital
      lease
                      
                      
                      7,321
                      
                      
                      
                      13,903
                      
                      
                      
                      21,224
                      
                      Jun
      2010
                      
                      
                      18.9
                      %Convertible
      notes
                      
                      
                      -
                      
                      
                      
                      3,300,000
                      
                      
                      
                      3,300,000
                      
                      Nov
      2010
                      
                      
                      8.0
                      %Totals
                      
                      $
                      2,287,682
                      
                      
                      $
                      3,313,903
                      
                      
                      $
                      5,601,585
 
 As of
December 31, 2007, LIBOR was 4.75%.
 
 7.
              COMMITMENTS
      AND CONTINGENCIES
 
 Lease
Commitments
 
 The
Company leases computer and office equipment under capital lease agreements that
expire through July 2011. Total amounts financed under these capital leases were
$53,517 and $21,226 at December 31, 2008 and 2007, respectively, net of
accumulated amortization of $18,647 and $2,723, respectively. The current and
non-current portions of the capital leases have been recorded in current and
long-term portions of notes payable on the consolidated balance sheets as of
December 31, 2008 and 2007. See also Note 6, “Notes Payable.”
 
 In 2008,
the Company entered into a non-cancelable sublease with a remaining term of 36
months to relocate its North Carolina headquarters to another facility near
Research Triangle Park. As described in Note 3, “Balance Sheet Accounts,” the
Company prepaid the lease and purchased existing furniture and fixtures for a
lump-sum payment of $500,000, of which $450,080 was allocated to rent and is
being amortized monthly over the remaining term of the lease. The Company also
has a non-cancelable lease through October 2009 for an apartment near its
headquarters that is utilized by its out of town executives and members of its
Board of Directors. As of December 31, 2008, future annual minimum operating
lease payments for 2009 are $19,950.
 
 Rent
expense for the years ended December 31, 2008 and 2007 was $320,421 and
$275,683, respectively.
 
 Development
Agreement
 
 In August
2005, the Company entered into a software assignment and development agreement
with the developer of a customized accounting software application. In
connection with this agreement, the developer would be paid up to $512,500 and
issued up to 32,395 shares of the Company’s common stock based upon the
developer attaining certain milestones. This agreement was modified on
March 26, 2008 to adjust the total number of shares issuable under the agreement
to 29,014. As of December 31, 2008, the Company had paid $470,834 and issued
3,473 shares of common stock related to this obligation.
  50
  Legal
Proceedings
 
 The
Company is subject to claims and suits that arise from time to time in the
ordinary course of business.
 
 On
October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in the
United States District Court for the Middle District of North Carolina naming
the Company, certain of its current and former officers and directors, Maxim
Group, LLC, and Jesup & Lamont Securities Corp. as defendants. The lawsuit
was filed on behalf of all persons other than the defendants who purchased the
Company’s securities from May 2, 2005 through September 28, 2007 and were
damaged. The complaint asserts violations of federal securities laws, including
violations of Section 10(b) of the Securities Exchange Act of 1934, as
amended, and Rule 10b-5. The complaint asserts that the defendants made material
and misleading statements with the intent to mislead the investing public and
conspired in a fraudulent scheme to manipulate trading in the Company’s stock,
allegedly causing plaintiffs to purchase the stock at an inflated price. The
complaint requests certification of the plaintiff as class representative and
seeks, among other relief, unspecified compensatory damages including interest,
plus reasonable costs and expenses including counsel fees and expert fees. On
June 24, 2008, the court entered an order appointing a lead plaintiff for the
class action. On September 8, 2008, the plaintiff filed an amended complaint
that added additional defendants who had served as directors or officers of the
Company during the class period as well as the Company’s independent
auditor.
 
 During
April 2008, the Company received approximately $95,000 in insurance
reimbursement for previously disputed legal expenses primarily related to
previously disclosed SEC matters. During August 2008, the Company and the
insurance carrier agreed that the carrier would reimburse it $300,000 for
previously disputed legal expenses primarily related to its previously disclosed
SEC matters. The reimbursement covered all disputed Company expenses prior to
September 11, 2007 as well as certain enumerated invoices in dispute for the
balance of 2007, and it was received by the Company. Because the outcome of the
dispute was unclear, the Company expensed as incurred all legal costs with
respect to the SEC matters and the Company’s 2006 internal investigation. For
the year ended December 31, 2008, both reimbursements have been recorded in the
consolidated statements of operations as a gain on legal
settlements.
 
 At this
time, the Company is not able to determine the likely outcome of the legal
matters described above, nor can it estimate its potential financial exposure.
Management has made an initial estimate based upon its knowledge, experience and
input from legal counsel, and the Company has accrued approximately $137,500 and
$250,000 of additional legal reserves at December 31, 2008 and 2007,
respectively. Such reserves will be adjusted in future periods as more
information becomes available. If an unfavorable resolution of any of these
matters occurs, the Company’s business, results of operations, and financial
condition could be materially adversely affected.
 
 8.
              STOCKHOLDERS’
      EQUITY
 
 Common
Stock
 
 The
Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
value per share. As of December 31, 2008, it had 18,333,601 shares of common
stock outstanding. Holders of common stock are entitled to one vote for each
share held.
 
 In a
transaction that closed on February 21, 2007, the Company sold an aggregate of
2,352,941 shares of its common stock to two new investors (the “Investors”). The
private placement shares were sold at $2.55 per share pursuant to a Securities
Purchase Agreement (the “SPA”) between the Company and each of the Investors.
The aggregate gross proceeds were $6 million and the Company incurred issuance
costs of approximately $667,000.
  51
  The
Company and each of the Investors also entered into a Registration Rights
Agreement (the “Investor RRA”) whereby the Company had an obligation to register
the shares for resale by the Investors by filing a registration statement within
30 days of the closing of the private placement, and to have the registration
statement declared effective 60 days after actual filing, or 90 days after
actual filing if the SEC reviewed the registration statement. If a registration
statement was not timely filed or declared effective by the date set forth in
the Investor RRA, the Company would have been obligated to pay a cash penalty of
1% of the purchase price on the day after the filing or declaration of
effectiveness was due, and 0.5% of the purchase price per every 30-day period
thereafter, to be prorated for partial periods, until the Company fulfilled
these obligations. Under no circumstances could the aggregate penalty for late
registration or effectiveness exceed 10% of the aggregate purchase price. Under
the terms of the Investor RRA, the Company could not offer for sale or sell any
securities until May 22, 2007, subject to certain limited exceptions, unless, in
the opinion of the Company’s counsel, such offer or sale did not jeopardize the
availability of exemptions from the registration and qualification requirements
under applicable securities laws with respect to this placement. On March 28,
2007, the Company entered into an amendment to the Investor RRA with each
Investor to extend the registration filing obligation date by an additional 11
calendar days. On April 3, 2007, the Company filed the Registration Statement on
Form S-1 (File No. 333-141853) (the “Registration Statement”) within the
extended filing obligation period, thereby avoiding the first potential penalty.
Effective July 2, 2007, the Company entered into another amendment to the
Investor RRA to extend the registration effectiveness obligation date to July
31, 2007. On July 31, 2007, the SEC declared the Registration Statement
effective. Accordingly, the Company met all of its requirements under the
amended Investor RRA and no penalties were incurred.
 
 On March
29, 2007, the Company issued 55,666 shares of its common stock to certain
investors as registration penalties for its failure to timely file a
registration statement covering shares owned by those investors as required
pursuant to amendments to registration rights agreements between such investors
and the Company. On July 20, 2007, the Company issued 27,427 additional shares
as registration penalties to certain investors who did not enter into amendments
to certain registration rights agreements.
 
 In
January 2008, the Company issued 19,608 shares of common stock to a consulting
firm as full payment of the outstanding obligation related to fees accrued for
services rendered in conjunction with the 2005 acquisitions of iMart and
Computility. At December 31, 2007, these obligations were included in the
current portion of notes payable and in accrued liabilities in the amounts of
$228,361 and $187, respectively.
 
 Preferred
Stock
 
 The Board
of Directors is authorized, without further stockholder approval, to issue up to
5,000,000 shares of $0.001 par value preferred stock in one or more series and
to fix the rights, preferences, privileges, and restrictions applicable to such
shares, including dividend rights, conversion rights, terms of redemption, and
liquidation preferences, and to fix the number of shares constituting any series
and the designations of such series. There were no shares of preferred stock
outstanding at December 31, 2008.
 
 Warrants
 
 As
incentive to modify a letter of credit relating to the Wachovia line of credit
(see Note 6, “Notes Payable”), the Company entered into a Stock Purchase Warrant
and Agreement (the “Warrant Agreement”) with Atlas on January 15, 2007. Under
the terms of the Warrant Agreement, Atlas received a warrant containing a
provision for cashless exercise to purchase up to 444,444 shares of the
Company’s common stock at $2.70 per share at the termination of the line of
credit or if the Company is in default under the terms of the line of credit
with Wachovia. The fair value of the warrant was $734,303 as measured using the
Black-Scholes option pricing model at the time the warrant was issued. This
amount was recorded as deferred financing costs and was amortized to interest
expense in the amount of $37,657 per month over the remaining period of the
modified line of credit, which was scheduled to expire in August 2008. As of
December 31, 2007, the deferred financing costs to be amortized to interest
expense over the remaining eight months, or $301,249, were classified as current
assets. In consideration for Atlas providing the Paragon line of credit (see
Note 6, “Notes Payable”), the Company agreed to amend the Warrant Agreement to
provide that the warrant is exercisable within 30 business days of the
termination of the Paragon line of credit or if the Company is in default under
the terms of the line of credit. If the warrant is exercised in full, it will
result in gross proceeds to the Company of approximately
$1,200,000.
 
 Under the
SPA, the Investors were issued warrants for the purchase of an aggregate of
1,176,471 shares of common stock at an exercise price of $3.00 per share. These
warrants contain a provision for cashless exercise and must be exercised by
February 21, 2010.
 
 As part
of the commission paid to Canaccord Adams, Inc. (“CA”), the Company’s placement
agent in the transaction that closed in February 2007, CA was issued a warrant
to purchase 35,000 shares of the Company’s common stock at an exercise price of
$2.55 per share. This warrant contains a provision for cashless exercise and
must be exercised by February 21, 2012. CA and the Company also entered into a
Registration Rights Agreement (the “CA RRA”). Under the CA RRA, the shares
issuable upon exercise of the warrant must be included on the same registration
statement the Company was obligated to file under the Investor RRA described
above, but CA was not entitled to any penalties for late registration or
effectiveness.
  52
  As of
December 31, 2008, warrants to purchase up to 1,655,915 shares were
outstanding.
 
 Equity
Compensation Plans
 
 2004
Equity Compensation Plan
 
 The
Company adopted its 2004 Equity Compensation Plan (the “2004 Plan”) as of March
31, 2004. The 2004 Plan provides for the grant of incentive stock options,
non-statutory stock options, restricted stock, and other direct stock awards to
employees (including officers) and directors of the Company as well as to
certain consultants and advisors. In June 2007, the Company temporarily limited
the issuance of shares of its common stock reserved under the 2004 Plan to
awards of restricted or unrestricted stock and in June 2008 again made options
available for grant under the 2004 Plan. The total number of shares of common
stock reserved for issuance under the 2004 plan is 5,000,000 shares, subject to
adjustment in the event of a stock split, stock dividend, recapitalization, or
similar capital change.
 
 During
2008, a total of 70,000 shares of restricted stock were issued at a price equal
to the fair market value of the stock on the date of grant. An aggregate of
35,000 shares of restricted stock were issued to the Company’s independent
directors in accordance with the Company’s board compensation policy with
restrictions that lapse ratably over a one-year period. A total of 35,000 shares
were issued to the newly appointed Chief Operating Officer with restrictions
that lapse in varying increments over a four-year period. Additionally, a
total of 121,844 shares of restricted stock were canceled during the year ended
December 31, 2008 due to resignations, terminations, payment of employee tax
obligations resulting from share vesting, and exchange for stock options. At
December 31, 2008, there remains $90,055 of unvested expense yet to be recorded
related to all restricted stock outstanding.
 
 During
2007, a total of 274,500 shares of restricted stock were issued at a price equal
to the fair market value of the stock on the date of grant. An aggregate of
70,000 shares of restricted stock were issued to the Company’s independent
directors in accordance with the Company’s board compensation policy with
restrictions that lapse ratably over a one-year period. A total of 25,000 shares
were issued to the newly appointed Chief Operating Officer with restrictions
that lapse ratably over a two-year period, and 100,000 shares were issued to the
Company’s then President and Chief Executive Officer upon appointment with
restrictions that lapse in varying increments over a four-year period. The
remaining shares were issued to officers and employees with restrictions that
lapse ratably over a two-year period.
 
 2001
Equity Compensation Plan
 
 The
Company adopted the 2001 Equity Compensation Plan (the “2001 Plan”) as of May
31, 2001. The 2001 Plan provided for the grant of incentive stock options,
non-statutory stock options, restricted stock, and other direct stock awards to
employees (including officers) and directors of the Company as well as to
certain consultants and advisors. The total number of shares of common stock
reserved for issuance under the 2001 Plan is 795,000 shares, subject to
adjustment in the event of a stock split, stock dividend, recapitalization, or
similar change. As of April 15, 2004, the Company cannot make any further grants
under the 2001 Plan.
 
 At
December 31, 2008, no options to purchase shares of common stock were
outstanding under the 2001 Plan.
 
 1998
Stock Option Plan
 
 The
Company adopted the 1998 Stock Option Plan (the “1998 Plan”) as of November 12,
1998. The 1998 Plan provided for the grant of incentive stock options and
non-statutory stock options. The total number of shares of common stock reserved
for issuance under the 1998 Plan is 288,900 shares, subject to adjustment in the
event of a stock split, stock dividend, recapitalization, or similar change. As
of April 15, 2004, the Company cannot make any further grants under the 1998
Plan.
  53
  At
December 31, 2008, no options to purchase shares of common stock were
outstanding under the 1998 Plan.
 
 The
exercise price for incentive stock options granted under the above plans is
required to be no less than the fair market value of the common stock on the
date the option is granted, except for options granted to 10% stockholders,
which are required to have an exercise price of not less than 110% of the fair
market value of the common stock on the date the option is granted. Incentive
stock options typically have a maximum term of ten years, except for option
grants to 10% stockholders, which are subject to a maximum term of five years.
Non-statutory stock options have a term determined by either the Board of
Directors or the Compensation Committee. Options granted under the plans are not
transferable, except by will and the laws of descent and
distribution.
 
 A summary
of the status of the stock option issuances as of December 31, 2008 and 2007,
and changes during the periods ended on these dates is as follows:
 
 Shares
                    
                    
                    Weighted
                      Average
                      Exercise PriceBALANCE,
      December 31, 2006
                    
                    
                    2,360,100
                    
                    
                    $
                    5.33Granted
                    
                    
                    20,000
                    
                    
                    
                    2.80Exercised
                    
                    
                    (95,000
                    )
                    
                    
                    1.30Canceled
                    
                    
                    (640,800
                    )
                    
                    
                    5.98BALANCE,
      December 31, 2007
                    
                    
                    1,644,300
                    
                    
                    
                    5.07Granted
                    
                    
                    35,000
                    
                    
                    
                    3.19Exercised
                    
                    
                    (325,000
                    )
                    
                    
                    1.40Canceled
                    
                    
                    (1,083,050
                    )
                    
                    
                    5.90BALANCE,
      December 31, 2008
                    
                    
                    271,250
                    
                    
                    $
                    5.89
 
 The
following table summarizes information about stock options outstanding at
December 31, 2008:
 
 Currently ExercisableExercise Price
                  
                  Number of
                    Options
                    Outstanding
                  
                  
                  Average
                    Remaining
                    Contractual
                    Life (Years)
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Number of
                    Shares
                  
                  
                  Weighted
                    Average
                    Exercise
                    PriceFrom
      $2.50 to $3.50
                  
                  
                  98,750
                  
                  
                  
                  5.6
                  
                  
                  $
                  3.20
                  
                  
                  
                  77,500
                  
                  
                  $
                  3.19$5.00
                  
                  
                  25,000
                  
                  
                  
                  6.3
                  
                  
                  $
                  5.00
                  
                  
                  
                  15,000
                  
                  
                  $
                  5.00$7.00
                  
                  
                  75,000
                  
                  
                  
                  6.8
                  
                  
                  $
                  7.00
                  
                  
                  
                  75,000
                  
                  
                  $
                  7.00From
      $8.61 to $9.00
                  
                  
                  72,300
                  
                  
                  
                  3.1
                  
                  
                  $
                  8.71
                  
                  
                  
                  57,300
                  
                  
                  $
                  8.69$9.60
                  
                  
                  200
                  
                  
                  
                  6.7
                  
                  
                  $
                  9.60
                  
                  
                  
                  120
                  
                  
                  $
                  9.60Totals
                  
                  
                  271,250
                  
                  
                  
                  5.3
                  
                  
                  $
                  5.89
                  
                  
                  
                  224,920
                  
                  
                  $
                  5.99
 
 At
December 31, 2008, there remains $290,586 of unvested expense yet to be recorded
related to all options outstanding. The following table sets forth the weighted
average exercise price and fair value of options granted during the year ended
December 31, 2008:
 
 Shares
                    
                    
                    Weighted
                      Average
                      Exercise Price
                    
                    
                    Weighted
                      Average Fair
                      ValueExercise
      price exceeds market price
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Exercise
      price equals market price
                    
                    
                    35,000
                    
                    
                    $
                    3.19
                    
                    
                    $
                    0.63Exercise
      price is less than market price
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
 
 Dividends - The Company has
not paid any cash dividends through December 31, 2008.
  54
  9.
              INCOME
      TAXES
 
 The
Company accounts for income taxes under the asset and liability method in
accordance with the requirements of SFAS No. 109, Accounting for Income Taxes
(“SFAS No. 109”). Under the asset and liability method, deferred income taxes
are recognized for the tax consequences of “temporary differences” by applying
enacted statutory tax rates applicable to future years to differences between
the financial statement carrying amounts and the tax bases of existing assets
and liabilities.
 
 The
balances of deferred tax assets and liabilities are as follows:
 
 December 31,
                      2008
                    
                    
                    December 31,
                      2007Net
      current deferred income tax assets related to:Depreciation
                    
                    $
                    319,000
                    
                    
                    $
                    295,000Stock-based
      expenses
                    
                    
                    226,000
                    
                    
                    
                    226,000Net
      operating loss carryforwards
                    
                    
                    18,385,000
                    
                    
                    
                    15,936,000Total
                    
                    
                    18,930,000
                    
                    
                    
                    16,457,000Less
      valuation allowance
                    
                    
                    (18,930,000
                    )
                    
                    
                    (16,457,000
                    )Net
      current deferred income tax
                    
                    $
                    -
                    
                    
                    $
                    -
 
 Under
SFAS No. 109, a valuation allowance is provided when it is more likely than not
that the deferred tax asset will not be realized.
 
 Total
income tax expense differs from expected income tax expense (computed by
applying the U.S. federal corporate income tax rate of 34% to profit (loss)
before taxes) as follows:
  Year Ended
                        December 31,
                        2008
                      
                      
                      Year Ended
                        December 31,
                        2007Statutory
      federal tax rate
                      
                      
                      34
                      %
                      
                      
                      34
                      %Tax
      benefit computed at statutory rate
                      
                      $
                      (3,340,000
                      )
                      
                      $
                      (1,872,000
                      )State
      income tax benefit, net of federal effect
                      
                      
                      (447,000
                      )
                      
                      
                      (251,000
                      )Change
      in valuation allowance
                      
                      
                      2,449,000
                      
                      
                      
                      1,661,000Permanent
      differences:SFAS
      No. 123R
                      
                      
                      (63,000
                      )
                      
                      
                      211,000Intangible
      impairment
                      
                      
                      1,339,000
                      
                      
                      
                      -Other
      permanent differences
                      
                      
                      9,000
                      
                      
                      
                      17,000Temporary
      differences:Depreciation
      and amortization
                      
                      
                      110,000
                      
                      
                      
                      126,000Accrued
      liabilities
                      
                      
                      (57,000
                      )
                      
                      
                      108,000Totals
                      
                      $
                      -
                      
                      
                      $
                      -
 
 As of
December 31, 2008, the Company had U.S. federal net operating loss (“NOL”)
carryforwards of approximately $47.3 million, which expire between 2009 and
2028. For state tax purposes, the NOL carryforwards expire between 2009 and
2021. In accordance with Section 382 of the Internal Revenue Code of 1986, as
amended, a change in equity ownership of greater than 50% of the Company within
a three-year period can result in an annual limitation on the Company’s ability
to utilize its NOL carryforwards that were created during tax periods prior to
the change in ownership.
  55




10.
              MAJOR
      CUSTOMERS AND CONCENTRATION OF CREDIT
RISK





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





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





Year Ended December 31, 2008Revenue Type
                          
                          Revenues
                          
                          % of Total
                            RevenuesCustomer
      A
                          
                          Professional
      services
                          
                          $
                          1,347,806
                          
                          28
                          %Customer
      B
                          
                          Subscription
      fees
                          
                          
                          1,347,134
                          
                          28
                          %Customer
      C
                          
                          Subscription
      fees
                          
                          
                          1,036,870
                          
                          21
                          %Others
                          
                          Various
                          
                          
                          1,141,175
                          
                          23
                          %Total
                          
                          
                          
                          $
                          4,872,985
                          
                          100
                          %





Year Ended December 31, 2007Revenue Type
                          
                          Revenues
                          
                          % of Total
                            RevenuesCustomer
      A
                          
                          Professional
      services
                          
                          $
                          1,070,695
                          
                          22
                          %Customer
      B
                          
                          Subscription
      fees
                          
                          
                          562,578
                          
                          11
                          %Customer
      C
                          
                          Subscription
      fees
                          
                          
                          1,205,094
                          
                          24
                          %Others
                          
                          Various
                          
                          
                          2,099,287
                          
                          43
                          %Total
                          
                          
                          
                          $
                          4,937,654
                          
                          100
                          %





As of
December 31, 2008, one customer accounted for 93% of accounts receivable. As of
December 31, 2007, three customers accounted for 42%, 28%, and 17% of accounts
receivable, respectively.





11.
            EMPLOYEE
      BENEFIT PLAN





All full
time employees who meet certain age and length of service requirements are
eligible to participate in the Company’s 401(k) Plan. The plan provides for
contributions by the Company in such amounts as the Board of Directors may
annually determine, as well as a 401(k) option under which eligible participants
may defer a portion of their salaries. The Company contributed a total of
$38,943 and $30,098 to the plan during 2008 and 2007, respectively.





12.
            SUBSEQUENT
      EVENTS





On
January 6, 2009, the Company sold $500,000 aggregate principal amount of
additional convertible secured subordinated notes due November 14, 2010 to a
current noteholder with substantially the same terms and conditions as the
previously outstanding notes as described in Note 6, “Notes
Payable.”





On
February 19, 2009, the Company renewed its revolving credit arrangement with
Paragon. The line of credit advanced by Paragon is $2.47 million and can be used
for general working capital. Any advances made on the line of credit must be
paid off no later than February 11, 2010, with monthly payments being applied
first to accrued interest and then to principal. The interest shall accrue on
the unpaid principal balance at the Wall Street Journal's published Prime Rate,
but at no time shall the interest rate be less than 5.5%. The line of credit is
secured by an irrevocable standby letter of credit in the amount of $2.50
million issued by HSBC with Atlas as account party. As of March 24, 2009, the
Company had an outstanding balance of $2.27 million under the line of
credit.




56




On
February 24, 2009, the Company sold $500,000 aggregate principal amount of
additional convertible secured subordinated notes due November 14, 2010 to a
current noteholder with substantially the same terms and conditions as the
previously outstanding notes.





Also on
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that the Company may sell up to $6
million aggregate principal amount of additional convertible secured
subordinated notes to new investors or existing noteholders at any time on or
before December 31, 2009 with a maturity date of November 14, 2010 or later. In
addition, the maturity date definition for each of the notes was changed from
November 14, 2010 to the date upon which the note is due and payable, which is
the earlier of (1)
November 14, 2010, (2) a change of control, or (3) if an event of default
occurs, the date upon which noteholders accelerate the indebtedness evidenced by
the notes.





The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and will be the lowest “applicable conversion
price” determined for each note. The “applicable conversion price” for each note
shall be calculated by multiplying 120% by the lowest of:





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





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





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





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





Not applicable.





Item
      9A.
            Controls
      and Procedures





Not
applicable.


Item
      9A(T).
              Controls
      and Procedures




Evaluation
of Disclosure Controls and Procedures





Our
management, with the participation of our Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness of our disclosure controls and
procedures as of December 31, 2008. The term “disclosure controls and
procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange
Act, means controls and other procedures of a company that are designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the SEC’s rules
and forms. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by a company in the reports that it files or submits under the
Exchange Act is accumulated and communicated to the company’s management,
including its principal executive and principal financial officers, as
appropriate to allow timely decisions regarding required disclosure. Management
recognizes that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives, as ours are designed to do, and management necessarily applies its
judgment in evaluating the cost-benefit relationship of possible controls and
procedures. Based on the evaluation of our disclosure controls and procedures as
of December 31, 2008, our Chief Executive Officer and Chief Financial
Officer concluded that, as of such date, our disclosure controls and procedures
were effective at the reasonable assurance level.




57




Changes
in Internal Control Over Financial Reporting





We have
made the following changes to our internal controls over financial reporting
during the fourth quarter of 2008 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting:





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





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





·
            to
      reduce the possibility of fraud, implemented Positive Pay service with our
      bank to ensure all checks or other debits that are presented for payment
      are approved by us in advance;





·
            with
      respect to our previously identified controls regarding accrual analysis,
      implemented a process by which the Controller prepares all accruals on a
      rollforward basis, and the Chief Financial Officer reviews and approves
      monthly financial statements prior to release to internal users; and where
      applicable, entries to be reversed in the following period are notated as
      such in the supporting accounting records;
and





·
            with
      respect to our previously identified controls regarding journal entries,
      implemented a preparation and review process in which all journal entries
      must be entered into the accounting system by the Chief Financial Officer
      subsequent to his review and
approval.





Management’s
Report on Internal Control Over Financial Reporting





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





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





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





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





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




58




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





In making
the assessment of internal control over financial reporting, our management used
the criteria issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) in Internal
Control-Integrated Framework. Based on that assessment and those
criteria, management believes that our internal control over financial reporting
was effective as of December 31, 2008.





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





Item
      9B.
            Other
      Information





On March
25, 2009, Neile King was appointed as the Company’s Chief Operating Officer in
addition to his current position as Vice President, Sales and Marketing. Mr.
King’s compensation arrangements will not change as a result of his
appointment.








Mr. King,
age 38, was appointed as the Company’s Vice President, Sales and Marketing on
November 10, 2008 after serving as the Company’s Chief Operating Officer between
February 2008 and his appointment as Vice President, Sales and Marketing. Mr.
King served as the Company’s Director of Operations and Vice President of
Business Services from September 2007 to February 2008. Prior to joining the
Company, from March 2006 to September 2007, Mr. King was the Director of
Operations at DataFlux Corporation, a SAS company and data quality vendor. From
April 1999 to July 2005, Mr. King held several management positions within the
IT Solutions group in the Operations, Marketing, Contracts Management, and Sales
Operations organizations with Hill-Rom Company, Inc., a healthcare information
technology services provider.





PART III





Information
called for in Items 10, 11, 12, 13, and 14 is incorporated by reference from our
definitive proxy statement relating to our Annual Meeting of Stockholders, which
will be filed with the SEC within 120 days after the end of fiscal
2008.





Item
      10.
            Directors,
      Executive Officers and Corporate
Governance





Item
      11.
            Executive
      Compensation





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





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





Item
      14.
            Principal
      Accounting Fees and Services


59


PART IV





Item
      15.
            Exhibits,
      Financial Statement Schedules





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





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





Exhibit No.
                
                Description3.1
                
                Amended
      and Restated Certificate of Incorporation (incorporated herein by
      reference to Exhibit 3.1 to our Registration Statement on Form SB-2, as
      filed with the SEC on September 30, 2004)3.2
                
                Fifth
      Amended and Restated Bylaws (incorporated herein by reference to Exhibit
      3.1 to our Current Report on Form 8-K, as filed with the SEC on March 25,
      2008)4.1
                
                Specimen
      Common Stock Certificate (incorporated herein by reference to Exhibit 4.1
      to our Registration Statement on Form SB-2, as filed with the SEC on
      September 30, 2004)4.2
                
                Convertible
      Secured Subordinated Note Purchase Agreement, dated November 14, 2007, by
      and among Smart Online, Inc. and certain investors (incorporated herein by
      reference to Exhibit 4.1 to our Quarterly Report on Form 10-Q, as filed
      with the SEC on November 14, 2007)4.3
                
                Form
      of Convertible Secured Subordinated Promissory Note (incorporated herein
      by reference to Exhibit 4.2 to our Quarterly Report on Form 10-Q, as filed
      with the SEC on November 14, 2007)4.4
                
                First
      Amendment to Convertible Secured Subordinated Note Purchase Agreement,
      dated August 12, 2008, by and among Smart Online, Inc. and certain
      investors (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 12,
      2008)4.5
                
                Second
      Amendment and Agreement to Join as a Party to Convertible Secured
      Subordinated Note Purchase Agreement and Registration Rights Agreement,
      dated November 21, 2008, by and among Smart Online, Inc. and certain
      investors4.6
                
                Third
      Amendment to Convertible Secured Subordinated Note Purchase Agreement and
      Registration Rights Agreement and Amendment to Convertible Secured
      Subordinated Promissory Notes, dated February 24, 2009, by and among Smart
      Online, Inc. and certain investors4.7
                
                Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      January 20094.8
                
                Commercial
      Note dated February 20, 2008, payable by Smart Online, Inc. to Paragon
      Commercial Bank (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 13,
      2008)10.1*
                
                2004
      Equity Compensation Plan (incorporated herein by reference to Exhibit 10.1
      to our Registration Statement on Form SB-2, as filed with the SEC on
      September 30, 2004)10.2*
                
                Form
      of Incentive Stock Option Agreement under 2004 Equity Compensation Plan
      (incorporated herein by reference to Exhibit 10.2 to our Annual Report on
      Form 10-K, as filed with the SEC on July 11,
  2006)
  60
  10.3*
                
                Form
      of Incentive Stock Option Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.7 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.4*
                
                Form
      of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
      Plan (incorporated herein by reference to Exhibit 10.3 to our Annual
      Report on Form 10-K, as filed with the SEC on July 11,
    2006)10.5*
                
                Form
      of Non-Qualified Stock Option Agreement under Smart Online, Inc.’s 2004
      Equity Compensation Plan (incorporated herein by reference to Exhibit 10.8
      to our Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.6*
                
                Form
      of Restricted Stock Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.6 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.7*
                
                Form
      of Restricted Stock Award Agreement for Employees (incorporated herein by
      reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed with
      the SEC on August 21, 2007)10.8*
                
                Form
      Restricted Stock Agreement for Employees (incorporated herein by reference
      to Exhibit 10.1 to Amendment No. 1 to our Current Report on Form 8-K, as
      filed with the SEC on February 11, 2008)10.9*
                
                Form
      of Restricted Stock Agreement (Non-Employee Directors) (incorporated
      herein by reference to Exhibit 10.1 to our Current Report on Form 8-K, as
      filed with the SEC on May 31, 2007)10.10*
                
                Form
      Restricted Stock Agreement (Non-Employee Directors) (incorporated herein
      by reference to Exhibit 10.3 to our Current Report on Form 8-K, as filed
      with the SEC on December 3, 2007)10.11*
                
                2001
      Equity Compensation Plan (terminated as to future grants effective April
      15, 2004) incorporated herein by reference to Exhibit 10.2 to our
      Registration Statement on Form SB-2, as filed with the SEC on September
      30, 2004)10.12*
                
                1998
      Stock Option Plan (terminated as to future grants effective April 15,
      2004) (incorporated herein by reference to Exhibit 10.3 to our
      Registration Statement on Form SB-2, as filed with the SEC on September
      30, 2004)10.13*
                
                Cash
      Bonus Program (incorporated herein by reference to Exhibit 10.4 to our
      Current Report on Form 8-K, as filed with the SEC on December 3,
      2007)10.14*
                
                Equity
      Award Program (incorporated herein by reference to Exhibit 10.5 to
      Amendment No. 1 to our Current Report on Form 8-K, as filed with the SEC
      on February 11, 2008)10.15*
                
                Employment
      Agreement, dated April 1, 2004, with Thomas Furr (incorporated herein by
      reference to Exhibit 10.14 to our Annual Report on Form 10-K, as filed
      with the SEC on March 30, 2007)10.16*
                
                Amendment,
      dated November 9, 2005, to Employment Agreement, dated April 1, 2004, with
      Thomas Furr (incorporated herein by reference to Exhibit 10.15 to our
      Annual Report on Form 10-K, as filed with the SEC on March 30,
      2007)10.17*
                
                Amendment,
      dated August 15, 2007, to Employment Agreement, dated April 1, 2004, with
      Thomas Furr (incorporated herein by reference to Exhibit 10.5 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.18*
                
                Employment
      Agreement, dated November 30, 2007, with David E. Colburn (incorporated
      herein by reference to Exhibit 10.2 to our Current Report on Form 8-K, as
      filed with the SEC on December 3,
2007)
  61
  10.19*
                
                Separation
      and General Release Agreement, dated December 9, 2008, with David E.
      Colburn (incorporated herein by reference to Exhibit 10.1 to our Current
      Report Form 8-K, as filed with the SEC on December 10,
    2008)10.20*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective February 2, 2007
      (incorporated herein by reference to Exhibit 10.45 to our Registration
      Statement on Form S-1, as filed with the SEC on April 3,
    2007)10.21*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective April 1,
      200910.22*
                
                Indemnification
      Agreement, dated April 14, 2006, by and between Smart Online, Inc. and Tom
      Furr (incorporated herein by reference to Exhibit 10.44 to our Annual
      Report on Form 10-K, as filed with the SEC on July 11,
    2006)10.23
                
                Stock
      Purchase Warrant and Agreement, dated January 15, 2007, by and between
      Smart Online, Inc. and Atlas Capital, SA (incorporated herein by reference
      to Exhibit 10.44 to our Registration Statement on Form S-1, as filed with
      the SEC on April 3, 2007)10.24
                
                Amendment
      No. 1 to Stock Purchase Warrant and Agreement, effective February 20,
      2008, by and between Smart Online, Inc. and Atlas Capital SA (incorporated
      herein by reference to Exhibit 10.6 to our Quarterly Report on Form 10-Q,
      as filed with the SEC on May 13, 2008)10.25
                
                Form
      of Securities Purchase Agreement, Registration Rights Agreement, and
      Warrant to Purchase Common Stock of Smart Online, Inc., dated February 21,
      2007, by and between Smart Online, Inc. and each of Magnetar Capital
      Master Fund, Ltd. and Herald Investment Management Limited on behalf of
      Herald Investment Trust PLC (incorporated herein by reference to Exhibit
      10.46 to our Registration Statement on Form S-1, as filed with the SEC on
      April 3, 2007)10.26
                
                Form
      of Amendment to Registration Rights Agreement, dated March 26, 2007, by
      and between Smart Online, Inc. and each of Magnetar Capital Master Fund,
      Ltd. and Herald Investment Management Limited on behalf of Herald
      Investment Trust PLC ( incorporated herein by reference to Exhibit 10.54
      to Amendment No. 3 to our Registration Statement on Form S-1, as filed
      with the SEC on July 31, 2007)10.27
                
                Form
      of Amendment to Registration Rights Agreement, dated July 2, 2007, by and
      between Smart Online, Inc. and each of Magnetar Capital Master Fund, Ltd.
      and Herald Investment Management Limited on behalf of Herald Investment
      Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
      No. 3 to our Registration Statement on Form S-1, as filed with the SEC on
      July 31, 2007)10.28
                
                Warrant
      to Purchase Common Stock of Smart Online, Inc., and Registration Rights
      Agreement, dated February 27, 2007, by and between Smart Online, Inc. and
      Canaccord Adams Inc. (incorporated herein by reference to Exhibit 10.47 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.29
                
                Form
      of Registration Rights Agreement, of various dates, by and between Smart
      Online, Inc. and certain parties in connection with the sale of shares by
      Dennis Michael Nouri (incorporated herein by reference to Exhibit 10.48 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.30
                
                Registration
      Rights Agreement, dated November 14, 2007, by and among Smart Online, Inc.
      and certain investors (incorporated herein by reference to Exhibit 10.6 to
      our Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.31
                
                Security
      Agreement, dated November 14, 2007, among Smart Online, Inc. and Doron
      Roethler, as agent for certain investors (incorporated herein by reference
      to Exhibit 10.7 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on November 14, 2007)10.32
                
                Promissory
      Note, Loan Agreement, and Security Agreement, dated November 14, 2006, by
      and between Smart Online, Inc. and Wachovia Bank, NA (incorporated herein
      by reference to Exhibit 10.43 to our Annual Report on Form 10-K, as filed
      with the SEC on March 30, 2007)
  62
  10.33
              
              Promissory
      Note, Modification Number One to Loan Agreement, and Security Agreement,
      dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
      Bank, NA (incorporated herein by reference to Exhibit 10.8 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.34
              
              Reimbursement
      Agreement, dated November 10, 2006, by and between Smart Online, Inc. and
      Atlas Capital SA (incorporated herein by reference to Exhibit 10.48 to our
      Annual Report on Form 10-K, as filed with the SEC on March 25,
      2008)10.35
              
              Amendment
      to Reimbursement Agreement, effective February 20, 2008, by and between
      Smart Online, Inc. and Atlas Capital SA (incorporated herein by reference
      to Exhibit 10.5 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on May 13, 2008)10.36
              
              Sublease
      Agreement, dated July 30, 2008, between Smart Online, Inc. and Advantis
      Real Estate Services Company (incorporated herein by reference to Exhibit
      10.1 to our Quarterly Report on Form 10-Q, as filed with the SEC on
      November 12, 2008) (asterisks located within the exhibit denote
      information which has been deleted pursuant to a request for confidential
      treatment filed with the Securities and Exchange
    Commission)21.1
              
              Subsidiaries
      of Smart Online, Inc.23.1
              
              Consent
      of Independent Registered Public Accounting Firm31.1
              
              Certification
      of Principal Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200231.2
              
              Certification
      of Principal Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200232.1
              
              Certification
      of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]32.2
              
              Certification
      of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]





*
Management contract or compensatory plan.




63




SIGNATURES





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





SMART
      ONLINE, INC.By:
                  /s/ Doron RoethlerMarch
      30, 2009
                  Doron
      Roethler, Principal Executive
Officer





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





March
      30, 2009
                  
                  By:
                  /s/ Doron RoethlerDoron
      RoethlerPrincipal
      Executive Officer and Chairman of the BoardMarch
      30, 2009
                  
                  By:
                  /s/ Timothy L. KristTimothy
      L. KristPrincipal
      Financial Officer and Principal Accounting OfficerMarch
      30, 2009
                  
                  By:
                  /s/ Shlomo EliaShlomo
      EliaDirectorMarch
      30, 2009
                  
                  By:
                  /s/ Roberta B. HardyRoberta
      B. HardyDirectorMarch
      30, 2009
                  
                  By:
                  /s/ C. James Meese, Jr.C.
      James Meese, Jr.DirectorMarch
      30, 2009
                  
                  By:
                  /s/ Dror ZoreffDror
      ZoreffDirector




64





EXHIBIT
INDEX





Exhibit No.
                
                Description3.1
                
                Amended
      and Restated Certificate of Incorporation (incorporated herein by
      reference to Exhibit 3.1 to our Registration Statement on Form SB-2, as
      filed with the SEC on September 30, 2004)3.2
                
                Fifth
      Amended and Restated Bylaws (incorporated herein by reference to Exhibit
      3.1 to our Current Report on Form 8-K, as filed with the SEC on March 25,
      2008)4.1
                
                Specimen
      Common Stock Certificate (incorporated herein by reference to Exhibit 4.1
      to our Registration Statement on Form SB-2, as filed with the SEC on
      September 30, 2004)4.2
                
                Convertible
      Secured Subordinated Note Purchase Agreement, dated November 14, 2007, by
      and among Smart Online, Inc. and certain investors (incorporated herein by
      reference to Exhibit 4.1 to our Quarterly Report on Form 10-Q, as filed
      with the SEC on November 14, 2007)4.3
                
                Form
      of Convertible Secured Subordinated Promissory Note (incorporated herein
      by reference to Exhibit 4.2 to our Quarterly Report on Form 10-Q, as filed
      with the SEC on November 14, 2007)4.4
                
                First
      Amendment to Convertible Secured Subordinated Note Purchase Agreement,
      dated August 12, 2008, by and among Smart Online, Inc. and certain
      investors (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 12,
      2008)4.5
                
                Second
      Amendment and Agreement to Join as a Party to Convertible Secured
      Subordinated Note Purchase Agreement and Registration Rights Agreement,
      dated November 21, 2008, by and among Smart Online, Inc. and certain
      investors4.6
                
                Third
      Amendment to Convertible Secured Subordinated Note Purchase Agreement and
      Registration Rights Agreement and Amendment to Convertible Secured
      Subordinated Promissory Notes, dated February 24, 2009, by and among Smart
      Online, Inc. and certain investors4.7
                
                Form
      of Convertible Secured Subordinated Promissory Note to be issued post
      January 20094.8
                
                Commercial
      Note dated February 20, 2008, payable by Smart Online, Inc. to Paragon
      Commercial Bank (incorporated herein by reference to Exhibit 4.1 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 13,
      2008)10.1*
                
                2004
      Equity Compensation Plan (incorporated herein by reference to Exhibit 10.1
      to our Registration Statement on Form SB-2, as filed with the SEC on
      September 30, 2004)10.2*
                
                Form
      of Incentive Stock Option Agreement under 2004 Equity Compensation Plan
      (incorporated herein by reference to Exhibit 10.2 to our Annual Report on
      Form 10-K, as filed with the SEC on July 11, 2006)10.3*
                
                Form
      of Incentive Stock Option Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.7 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.4*
                
                Form
      of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
      Plan (incorporated herein by reference to Exhibit 10.3 to our Annual
      Report on Form 10-K, as filed with the SEC on July 11,
    2006)10.5*
                
                Form
      of Non-Qualified Stock Option Agreement under Smart Online, Inc.’s 2004
      Equity Compensation Plan (incorporated herein by reference to Exhibit 10.8
      to our Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)
  65
  10.6*
                
                Form
      of Restricted Stock Agreement under Smart Online, Inc.’s 2004 Equity
      Compensation Plan (incorporated herein by reference to Exhibit 10.6 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
      2007)10.7*
                
                Form
      of Restricted Stock Award Agreement for Employees (incorporated herein by
      reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed with
      the SEC on August 21, 2007)10.8*
                
                Form
      Restricted Stock Agreement for Employees (incorporated herein by reference
      to Exhibit 10.1 to Amendment No. 1 to our Current Report on Form 8-K, as
      filed with the SEC on February 11, 2008)10.9*
                
                Form
      of Restricted Stock Agreement (Non-Employee Directors) (incorporated
      herein by reference to Exhibit 10.1 to our Current Report on Form 8-K, as
      filed with the SEC on May 31, 2007)10.10*
                
                Form
      Restricted Stock Agreement (Non-Employee Directors) (incorporated herein
      by reference to Exhibit 10.3 to our Current Report on Form 8-K, as filed
      with the SEC on December 3, 2007)10.11*
                
                2001
      Equity Compensation Plan (terminated as to future grants effective April
      15, 2004) incorporated herein by reference to Exhibit 10.2 to our
      Registration Statement on Form SB-2, as filed with the SEC on September
      30, 2004)10.12*
                
                1998
      Stock Option Plan (terminated as to future grants effective April 15,
      2004) (incorporated herein by reference to Exhibit 10.3 to our
      Registration Statement on Form SB-2, as filed with the SEC on September
      30, 2004)10.13*
                
                Cash
      Bonus Program (incorporated herein by reference to Exhibit 10.4 to our
      Current Report on Form 8-K, as filed with the SEC on December 3,
      2007)10.14*
                
                Equity
      Award Program (incorporated herein by reference to Exhibit 10.5 to
      Amendment No. 1 to our Current Report on Form 8-K, as filed with the SEC
      on February 11, 2008)10.15*
                
                Employment
      Agreement, dated April 1, 2004, with Thomas Furr (incorporated herein by
      reference to Exhibit 10.14 to our Annual Report on Form 10-K, as filed
      with the SEC on March 30, 2007)10.16*
                
                Amendment,
      dated November 9, 2005, to Employment Agreement, dated April 1, 2004, with
      Thomas Furr (incorporated herein by reference to Exhibit 10.15 to our
      Annual Report on Form 10-K, as filed with the SEC on March 30,
      2007)10.17*
                
                Amendment,
      dated August 15, 2007, to Employment Agreement, dated April 1, 2004, with
      Thomas Furr (incorporated herein by reference to Exhibit 10.5 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.18*
                
                Employment
      Agreement, dated November 30, 2007, with David E. Colburn (incorporated
      herein by reference to Exhibit 10.2 to our Current Report on Form 8-K, as
      filed with the SEC on December 3, 2007)10.19*
                
                Separation
      and General Release Agreement, dated December 9, 2008, with David E.
      Colburn (incorporated herein by reference to Exhibit 10.1 to our Current
      Report Form 8-K, as filed with the SEC on December 10,
    2008)10.20*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective February 2, 2007
      (incorporated herein by reference to Exhibit 10.45 to our Registration
      Statement on Form S-1, as filed with the SEC on April 3,
    2007)10.21*
                
                Smart
      Online, Inc. Revised Board Compensation Policy, effective April 1,
      200910.22*
                
                Indemnification
      Agreement, dated April 14, 2006, by and between Smart Online, Inc. and Tom
      Furr (incorporated herein by reference to Exhibit 10.44 to our Annual
      Report on Form 10-K, as filed with the SEC on July 11,
    2006)
  66
  10.23
                
                Stock
      Purchase Warrant and Agreement, dated January 15, 2007, by and between
      Smart Online, Inc. and Atlas Capital SA (incorporated herein by reference
      to Exhibit 10.44 to our Registration Statement on Form S-1, as filed with
      the SEC on April 3, 2007)10.24
                
                Amendment
      No. 1 to Stock Purchase Warrant and Agreement, effective February 20,
      2008, by and between Smart Online, Inc. and Atlas Capital SA (incorporated
      herein by reference to Exhibit 10.6 to our Quarterly Report on Form 10-Q,
      as filed with the SEC on May 13, 2008)10.25
                
                Form
      of Securities Purchase Agreement, Registration Rights Agreement, and
      Warrant to Purchase Common Stock of Smart Online, Inc., dated February 21,
      2007, by and between Smart Online, Inc. and each of Magnetar Capital
      Master Fund, Ltd. and Herald Investment Management Limited on behalf of
      Herald Investment Trust PLC (incorporated herein by reference to Exhibit
      10.46 to our Registration Statement on Form S-1, as filed with the SEC on
      April 3, 2007)10.26
                
                Form
      of Amendment to Registration Rights Agreement, dated March 26, 2007, by
      and between Smart Online, Inc. and each of Magnetar Capital Master Fund,
      Ltd. and Herald Investment Management Limited on behalf of Herald
      Investment Trust PLC ( incorporated herein by reference to Exhibit 10.54
      to Amendment No. 3 to our Registration Statement on Form S-1, as filed
      with the SEC on July 31, 2007)10.27
                
                Form
      of Amendment to Registration Rights Agreement, dated July 2, 2007, by and
      between Smart Online, Inc. and each of Magnetar Capital Master Fund, Ltd.
      and Herald Investment Management Limited on behalf of Herald Investment
      Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
      No. 3 to our Registration Statement on Form S-1, as filed with the SEC on
      July 31, 2007)10.28
                
                Warrant
      to Purchase Common Stock of Smart Online, Inc., and Registration Rights
      Agreement, dated February 27, 2007, by and between Smart Online, Inc. and
      Canaccord Adams Inc. (incorporated herein by reference to Exhibit 10.47 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.29
                
                Form
      of Registration Rights Agreement, of various dates, by and between Smart
      Online, Inc. and certain parties in connection with the sale of shares by
      Dennis Michael Nouri (incorporated herein by reference to Exhibit 10.48 to
      our Registration Statement on Form S-1, as filed with the SEC on April 3,
      2007)10.30
                
                Registration
      Rights Agreement, dated November 14, 2007, by and among Smart Online, Inc.
      and certain investors (incorporated herein by reference to Exhibit 10.6 to
      our Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.31
                
                Security
      Agreement, dated November 14, 2007, among Smart Online, Inc. and Doron
      Roethler, as agent for certain investors (incorporated herein by reference
      to Exhibit 10.7 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on November 14, 2007)10.32
                
                Promissory
      Note, Loan Agreement, and Security Agreement, dated November 14, 2006, by
      and between Smart Online, Inc. and Wachovia Bank, NA (incorporated herein
      by reference to Exhibit 10.43 to our Annual Report on Form 10-K, as filed
      with the SEC on March 30, 2007)10.33
                
                Promissory
      Note, Modification Number One to Loan Agreement, and Security Agreement,
      dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
      Bank, NA (incorporated herein by reference to Exhibit 10.8 to our
      Quarterly Report on Form 10-Q, as filed with the SEC on November 14,
      2007)10.34
                
                Reimbursement
      Agreement, dated November 10, 2006, by and between Smart Online, Inc. and
      Atlas Capital SA (incorporated herein by reference to Exhibit 10.48 to our
      Annual Report on Form 10-K, as filed with the SEC on March 25,
      2008)10.35
                
                Amendment
      to Reimbursement Agreement, effective February 20, 2008, by and between
      Smart Online, Inc. and Atlas Capital SA (incorporated herein by reference
      to Exhibit 10.5 to our Quarterly Report on Form 10-Q, as filed with the
      SEC on May 13, 2008)
  67
  10.36
              
              Sublease
      Agreement, dated July 30, 2008, between Smart Online, Inc. and Advantis
      Real Estate Services Company (incorporated herein by reference to Exhibit
      10.1 to our Quarterly Report on Form 10-Q, as filed with the SEC on
      November 12, 2008) (asterisks located within the exhibit denote
      information which has been deleted pursuant to a request for confidential
      treatment filed with the Securities and Exchange
    Commission)21.1
              
              Subsidiaries
      of Smart Online, Inc.23.1
              
              Consent
      of Independent Registered Public Accounting Firm31.1
              
              Certification
      of Principal Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200231.2
              
              Certification
      of Principal Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200232.1
              
              Certification
      of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]32.2
              
              Certification
      of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This
      exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and shall not, except to the extent required by that Act, be
      deemed to be incorporated by reference into any document or filed herewith
      for the purposes of liability under the Securities Exchange Act of 1934,
      as amended, or the Securities Act of 1933, as amended, as the case may
      be.]





*
Management contract or compensatory plan.




68