**UNITED
      STATES SECURITIES AND EXCHANGE**


**COMMISSION**
 **Washington,
        D.C. 20549**
  
 **FORM
        10-K**
 **ANNUAL
          REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE**
 **SECURITIES
          EXCHANGE ACT OF 1934**
 **For
            the fiscal year ended December 31, 2005**
  **Commission
        File Number 333-119385**
  
 
  **SMART
        ONLINE, INC.**
 (Exact
        name of registrant as specified in its charter)
 
 **Delaware**
              
              **95-4439334**(State
                  or other jurisdiction of
                incorporation
                  or organization
              
              (I.R.S.
                  Employer
                Identification
                  No.)**2530
                  Meridian Parkway, Second Floor Durham, North
                  Carolina**
              
              **27713**(Address
                  of principal executive offices)
              
              (Zip
                  Code)
 
 Registrant's
        telephone number, including area code (919) 765-5000
 
 Securities
        registered pursuant to Section 12(b) of the Act:
 None
 
 Securities
        registered pursuant to Section 12(g) of the Act:
 Common
        stock, $0.001 par value
  
 
 Indicate
          by check mark if the registrant is a well-known seasoned issuer, as defined
          in
          Rule 405 of the Securities Act. Yes  ̈ No x
 
 Indicate
          by check mark if the registrant is not required to file reports pursuant
          to
          Section 13 or Section 15(d) of the Act. Yes  ̈  No x
 
 Indicate
          by check mark whether the registrant: (1) has filed all reports required
          to be
          filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
          the
          preceding 12 months (or for such shorter period that the registrant was
          required
          to file such reports), and (2) has been subject to such filing requirements
          for
          the past 90 days.    Yes o No x
  Indicate
          by check mark if disclosure of delinquent filers pursuant to Item 405 of
          Regulation S-K is not contained herein, and will not be contained, to the
          best
          of registrant's knowledge, in definitive proxy or information statements
          incorporated by reference in Part III of this Form 10-K or any amendment
          to this
          Form 10-K.  o
 
 Indicate
          by check mark whether the registrant is a large accelerated filer, an
          accelerated filer, or a non-accelerated filer. See definition of “accelerated
          filer and large accelerated filer” in Rule 12b-2 of the Exchange Act:
  Large
                      accelerated filer ̈
                  Accelerated
                      filer ̈
                  Non-accelerated
                      filerx
 
 Indicate
          by check mark whether the registrant is a shell company (as defined in
          Rule
          12b-2 of the Act).  Yes  ̈  No x
 
  Aggregate
          market value of voting and non-voting common equity held by non-affiliates
          of
          the registrant as of July 7, 2006 was approximately $15,259,286 million
          based
          upon a closing price of $1.90 on July 6, 2006 and 8,031,203 shares of Common
          Stock outstanding as of July 7, 2006 held by non-affiliates.
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
  None.
  
   **SMART
        ONLINE, INC.**
 
 **FORM
        10-K**
 
 **FOR
        THE FISCAL YEAR ENDED DECEMBER 31, 2004**
 
 **INDEX**
 
 **Page****PART
                    I**Item
                    1.
                Business
                1Item
                    1A.
                Risk
                    Factors
                17Item
                    2.
                Properties
                39Item
                    3.
                Legal
                    Proceedings
                39Item
                    4.
                Submission
                    of Matters to a Vote of Security Holders
                40**PART
                    II**Item
                    5.
                Market
                    for Registrant's Common Equity, Related Stockholder Matters and
                    Issuer
                    Purchases of Equity Securities
                40Item
                    6.
                Selected
                    Financial Data
                42Item
                    7.
                Management's
                    Discussion and Analysis of Financial Condition and Results of
                    Operations
                    of
                    Operations
                42Item
                    7A.
                Quantitative
                    and Qualitative Disclosures About Market Risk
                64Item
                    8.
                Financial
                    Statements and Supplementary Data
                65Item
                    9.
                Changes
                    in and Disagreements with Accountants on Accounting and Financial
                    Disclosure
                65Item
                    9A.
                Controls
                    and Procedures
                65Item
                    9B.
                Other
                    Information
                68**PART
                    III**Item
                    10.
                Directors
                    and Executive Officers of the Registrant
                68Item
                    11.
                Executive
                    Compensation
                74Item
                    12.
                Security
                    Ownership of Certain Beneficial Owners and Management and Related
                    Stockholder Matters
                83Item
                    13.
                Certain
                    Relationships and Related Transactions
                87Item
                    14.
                Principal
                    Accounting Fees and Services
                92**PART
                    IV**Item
                    15.
                Exhibits
                    , Financial Statement Schedules
                94






i









**PART
      I**





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





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





Refer
      to “ITEM 1A. RISK
      FACTORS ”
and
      a
“Special Note Regarding Forward Looking Statements.”





**Special
      Note Regarding**


**FORWARD-LOOKING
      STATEMENTS**





This
      Form
      10-K contains forward-looking statements regarding our plans, objectives,
      expectations, intentions, future financial performance, future financial
      condition, and other statements that are not historical facts. You can identify
      these statements by our use of the future tense, or by forward-looking words
      such as “may,” “will,” “expect,” “anticipate,” “believe,” “intend,” “estimate,”
“continue,” and other similar words and phrases. Examples of sections containing
      forward-looking statements include “ITEM 1. BUSINESS” and “ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.” These
      forward-looking statements involve many risks and uncertainties. Examples of
      such risks and uncertainties are described under “ITEM 1A. RISK
      FACTORS ”
and
      elsewhere in this report, as well as in other filings we may make from time
      to
      time with the United States Securities and Exchange Commission. You should
      be
      aware that the occurrence of any of these risks and uncertainties may cause
      our
      actual results to differ materially from those anticipated in our
      forward-looking statements, which could have a material adverse effect on our
      business, results of operations, and financial condition. All forward-looking
      statements included in this report are based on information available to us
      as
      of the date of this report. We assume no obligation or duty to update any such
      forward-looking statements.





**Overview.** We
      develop and market Internet-delivered Software-as-a-Service (SaaS) software
      applications and data resources for small businesses with one to one hundred
      employees. Our solutions are designed to automate and streamline business
      processes, reduce operating costs and improve internal controls





**History.** Incorporated
      in Delaware in 1993, we focus on the market for small business software
      applications. Our initial offerings were on diskettes and later became
      CD-ROM-based. Since year 2000, our products have been primarily offered through
      an Internet-based platform. Computility, Inc, which we acquired in October
      2005,
      was started in 1999 under the name Harvest Services and changed its name to
      Computility, Inc. in 2003. iMart Incorporated, which we acquired in October
      2005, was incorporated in 1999 and merged with Winsoft, Inc. in
      2001.





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





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





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





On
        January 17, 2006, the Securities and Exchange Commission (the “SEC”) temporarily
        suspended the trading of the securities of the Company. In its “Order of
        Suspension of Trading,” the SEC stated that the reason for the suspension was a
        lack of current and accurate information concerning our securities because
        of
        possible manipulative conduct occurring in the market for the our stock By
        its
        terms, that suspension ended on January 30, 2006 at 11:59 p.m. EST. As a
        result
        of the SEC’s suspension, NASDAQ
        withdrew its acceptance of our application to have our common stock traded
        on
        the NASDAQ Capital Market Simultaneously with the suspension, the SEC advised us that it is conducting
        a
        non-public investigation. While we continue to cooperate with the SEC, w e
        are
        unable to predict at this time whether the SEC will take any adverse action
        against us. See
        Item
        3 of this report and Risk Factors (43) and (50) for additional information
        regarding the SEC action.


1








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


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




In
      our
      Form 10-K for the year ended December 31, 2004, we previously disclosed to
      investors that we planned to (i) introduce to the market new software
      applications, together with a new technology platform called OneBiz SM platform, (ii) acquire additional products by acquiring other companies and
      (iii) change our marketing and sales strategy to focus on generating monthly
      subscription revenue from small business users. Since the beginning of 2005,
      we
      have substantially revamped our product offerings, and we acquired other
      companies with new products and historical revenues that were approximately
      500%
      of our 2004 revenue. These events have also substantially changed our operations
      by increasing our customer base, adding new software applications to our
      previously existing line of software tools, and improving our technology
      platform. We have summarized these recent developments below in three
      categories: “New Software Applications,” “Recent Transactions” and “New
      Marketing and Sales Strategy.”




A substantial
      potion of our 2005 consolidated revenue is attributable to the sales of our
      newly acquired subsidiaries’ standalone products and services. Although both
      subsidiaries were acquired in the fourth quarter of 2005, their sales accounted
      for approximately 50% of our consolidated 2005 annual revenue. We expect our
      2006 consolidated revenue to be heavily reliant on these standalone sales while
      we integrate their technologies into our platform.





We
      derive
      subscription revenue primarily from our stand alone Sales Force
      Automation/Customer Relationship Management application, our stand alone
      e-Commerce application. At the end of 2005, we began to generate a small amount
      of revenue from subscriptions to our main portal, www.SmartOnline.com. Since
      mid-January 2006, the number of subscribers to our software products at our
      main
      portal has declined. Customers have been having some difficulty accessing the
      services offered on our website and product bundling. We do not know whether
      this difficulty is the cause of
      the
      decrease in subscribers, but we have recently redesigned our website. Because
      our market consists almost exclusively of small businesses, ease-of-use is
      always a priority to these customers. We are continuously evaluating whether
      our
      software meets the needs of our customers and what improvements are necessary,
      including upgrades to our accounting software, which we know are needed to
      make
      our accounting application more competitive with other products .





**New
      Software Applications.** Our new
      software applications are described briefly below. Unless indicated otherwise
      below, these applications are being delivered through our OneBiz SM platform
      as a suite of bundled applications and tools, which we believe will become
      part
      of the essential functions of the small business enterprises we are targeting
      as
      customers.





·
            **Unified
                Dashboard Application.**Our customizable dashboards provide a snapshot of real-time business
                information in a single view. Our dashboards allow users to monitor
                key
                business information about their company and employees. Each subscriber
                can customize the dashboard to best suit their own
                company.





·
            **Accounting
                Application.**Our
                Accounting Application is a daily-use web based application that
                allows
                users to create and maintain their accounting books online in a secure
                fashion. This application contains standard accounting features aimed
                at
                the small business user. Since the introduction of this application,
                we
                have received feedback from both customers and an accounting consultant
                that we should improve this application. We are improving our accounting
                application based on this feedback.





2





·
            **Human
                Resource Center Application.**Our
                Human Resource Center Application is a daily-use application designed
                to
                allow companies to manage their employee information online, including
                compensation, attendance records**,**timesheets**,**HR
                documents and beneficiary
                information.





·
            **Sales
                Force Automation (SFA)/Customer Relationship Management (CRM) Application.**Our
                SFA/CRM application is designed to allow companies to manage people
                and
                the sales and marketing processes more effectively by offering the
                capability to collaborate and share information and standardize business
                processes into a single real-time system. In mid-May of 2006, we
                started
                selling a simplified version of the SFA/CRM Software into our application
                suite. We also continue to sell this product as a stand-alone application
                through our wholly-owned subsidiary, Smart CRM,
                Inc.


****


·
            **e-Commerce
                Application.**Our
                e-Commerce applications are designed to provide rapid website design
                and
                launch; inventory query; shopping cart; financial transactions; shipping,
                and; business to business communication. When we acquired this product,
                we
                had targeted to begin selling it on ourOneBizSMplatform during 2006. We are currently evaluating whether we will
                be able
                to integrate some of the features of this applicationinto
                our application suite during 2006. Until we do, we will sell this
                application only as a stand alone
                product.





·
            **Calendar
                Application.**Our
                Calendar Application provides users with an online
                calendar.





·
            **Contacts
                Application.**Our
                Contacts Application provides users with an online business contact
                management system.





**2005
      Acquisitions** .
      In
      August 2005, we acquired rights to an accounting software engine from a software
      development company and co-developed our accounting software application with
      that developer. We have exclusive rights to the accounting application and
      non-exclusive rights to the software engine included in the application. We
      are
      currently working with this developer to complete and improve the accounting
      application.





In
      October 2005, we acquired the business of Computility, Inc., which consisted
      primarily of the Sales Force Automation (SFA) and Customer Relationship
      Management (CRM) Software described above. In 2005, Computility’s revenues,
      which include both hardware and software sales, were approximately $2 million,
      of which approximately $547,000 was generated after we acquired Computility
      on
      October 4, 2005 and are included in our consolidated revenue. See “ITEM 6. SELECTED
      FINANCIAL DATA ” and
      “ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS ”
for
      additional information about the financial impact of this acquisition on our
      business.





In
      October 2005, we acquired the business of iMart Incorporated, which consisted
      primarily of the e-Commerce applications described above. In 2005, revenues
      were
      approximately $3.7 million, of which $800,000 was generated after we acquired
      iMart on October 18, 2005 and are included in our consolidated revenue. See
      “ITEM 6. SELECTED
      FINANCIAL DATA ”
and
      “ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF
      OPERATIONS ”
for
      additional information about the financial impact of this acquisition on our
      business.





**New
      Marketing and Sales Strategy.** We
      believe these recent product releases and transactions described above position
      our business for growth by offering new products and services and the potential
      for cross selling existing products and services to new customers, including
      customers of the companies we acquired. However, we have not yet started our
      cross-selling efforts as we have focused on other aspects of integrating these
      new applications into our suite. We plan to begin implementing this program
      in
      the second half of 2006. We consider strategic opportunities to acquire products
      and technology to advance our business strategy. In addition, we may divest
      ourselves of products or technologies that are not within our continually
      evolving business strategy.





**Goals
      for 2006.** We
      believe we made significant progress during 2005 and the first part of
      2006. **** Our
      primary goals for the remainder of 2006 are as follows:





·
            Continue
                to enhance our products, improve our website design and identify
                acquisitions that allow us to expand the products we offer and to
                grow our
                customer base assuming the company is successful in raising additional
                capital for this purpose, although the SEC investigation and its
                effect on
                trading in our stock may make acquisitions and raising capital
                difficult.





·
              We
                  will be working to increase the total number of subscribers to
                  our
                  platform by executing a marketing strategy which will include efforts
                  to
                  cross sell our products to the customers of Computility and iMart,
                  sell
                  subscriptions in volume to syndication partners for distribution
                  to small
                  businesses, increase the number of our syndication partners and
                  work more
                  closely with our syndication partners to increase the number of
                  small
                  business subscribers who purchase access to our software through
                  the
                  websites of our syndication partners. Implementing this strategy
                  will
                  require both improving our products and adding sales and marketing
                  personnel, including an evaluation of whether our current technology
                  portfolio accurately reflects our business strategy. We will need
                  to raise
                  additional capital to finance our
                  plans.





3








**Channels.** Small
      business users can access our products directly through our portal at www.SmartOnline.com ,
      and the
      websites we acquired from iMart and Computility. We can reach small businesses
      through private label syndication partnering agreements pursuant to which we
      offer our products on the web sites of major companies and financial
      institutions and through barter and other transactions with media companies,
      although our primary products are not yet available on the websites of our
      syndication partners. We have syndication agreements with J.P. Morgan Chase
      as
      successor to BankOne, Union Bank of California, *www.Inc.com*  and *www.FastCompany.com*  web
      sites, and Business Week Online. On May 19, 2006, we entered into an amendment
      to the syndication agreement with Union Bank of California. The amendment renews
      the term of the agreement between the parties for an additional one-year term,
      commencing on June 16, 2006.





We
      plan
      to update the websites of our syndication partners to our OneBiz SM platform
      in the second half of 2006. We have contacted these partners to determine a
      strategy for undertaking this migration process. At this time, all of our
      private label syndication partners have indicated their desire to migrate their
      website to our new OneBiz SM platform
      with the exception of *www.Inc.com* and *www.FastCompany.com* which
      were recently acquired and are currently evaluating this future strategy.





We
      are
      discussing a new pricing model with potential new partners that requires our
      partners to purchase a volume of subscriptions for the small business users
      of
      their websites. This would replace our existing pricing system in which we
      charge an installation and monthly support fees. It is still too early to
      determine whether a syndication partner will decide to make volume purchases
      from us.





**Software-as-a-Service
      (SaaS) Advantages.** We
      believe our Software-as-a-Service (SaaS) model is beneficial to small business
      owners because:




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


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


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


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





**Software
      Applications, Tools and Services**





We
      provide a wide range of Internet-based software applications, content, data
      and
      services to and for small businesses. Applications and products are available
      in
      a bundle, and some are available on a stand alone basis, for a monthly
      subscription fee.





·
            Unified
                Dashboard


·
            Accounting


·
              Human
                  Resource Management ·
              Sales
                  Force Automation/Customer Relationship
                  Management


·
            e-Commerce


·
            Calendars


·
            Contacts


·
            Business
                & Government Forms


·
            Business
                Letters


·
            Business
                Plan


·
            Secured
                Instant Messenger


·
            Additional
                Business Tools (See Complete List
                Below)





**Premium
      Services** .
      Premium
      Services are only offered as a one-time fee and not as part of a monthly
      subscription at this point. Premium Services include the following:





·
            Business
                Plan Writing & Evaluation


·
            Business
                Incorporation


·
            Direct
                Mailing List





4








·
              Press
                  Release Service
 ·
              Domain
                  Name Registration


**Product
      Descriptions**





We
      believe it is useful in understanding our business to divide our software
      products into two broad categories based on how we believe small businesses
      will
      utilize the products: Applications and Tools. Applications are software products
      that we believe will be utilized by small businesses on a regular basis and
      that
      will become key assets of their businesses. Tools are software programs that
      we
      believe will be utilized from time-to-time as specific problems arise. We also
      offer CD-ROM products. Most of our Applications have been released during the
      past year. Most of our Tools and our CD-ROM products are older
      products.





**Applications**





Our
      Software Applications include the following:





**-
      Unified Dashboard Application.** Our
      customizable dashboards provide a snapshot of real-time business information
      in
      a single view, allowing users to monitor key business information about their
      company and employees.





**-
      Accounting Application.** Our
      Accounting Application is an intuitive, easy-to-use, daily-use web based
      application that allows users to create and maintain their accounting books
      online in a secure fashion. This application contains standard accounting
      features aimed at the small business user. Since the introduction of this
      application, we have received feedback from both customers and an accounting
      consultant. As with all of our applications, we are improving our accounting
      application based on this feedback.





**-
      Human Resource Center Application.** Our
      Human
      Resource Center Application is a daily-use application designed to allow
      companies to manage online their employee information, compensation, attendance
      records **,** timesheets **,** HR
      documents and beneficiary information





**-
      Sales Force Automation (SFA)/Customer Relationship Management (CRM) Application.** Our
      SFA/CRM Application is a comprehensive application that is designed to allow
      companies to manage people and the sales and marketing processes more
      effectively by offering the capability to collaborate and share information
      and
      standardize business processes into a single real-time system. We recently
      began the process of integrating our SFA/CRM Software into our application
      suite. We released a simplified version of the SFA/CRM product as part of our
      application suite in May of 2006. ****





**-
      e-Commerce Application.** Our
      e-Commerce **** application provides
      rapid website design and launch; inventory query; shopping cart; financial
      transactions; shipping, and; business to business communication for small
      businesses. We are currently evaluating whether individual features of the
      e-Commerce software will be integrated into
      our
      application suite in 2006.





**-
      Calendar Application.** Calendar
      Application provides users with a full, easy-to-use online
      calendar.





**-
      Contacts Application.** Our
      Contacts Application provides users with an extensive, easy-to-use online
      business contact management system.





**Our
      Software Applications are described in greater detail
      below.**





**Unified
      Dashboard Application.** Our
      customizable dashboards provide a snapshot of real-time business information
      in
      a single view, allowing users to monitor key business information about their
      company and employees. The dashboard will automatically aggregate data from
      multiple sources, regardless of where that source is located, and summarize
      the
      information for the user quickly and efficiently. The dashboard is entirely
      role-based, and will display different types of information to each user based
      upon their role and access levels within the company. These features are
      designed to provide a high level of personalization and focused content relative
      to the needs of the user and their position in the company.





Each
      software application will have its own mini-dashboard that will provide a
      snapshot of real-time business information in a single view for that software
      application.





Users
      are
      also able to customize the look and feel of their dashboard, effectively
      rearranging the content on the dashboard to suit their individual business
      needs.





Users
      are
      also able to access certain information from their dashboard through a mobile
      interface. This will allow users to access data remotely, thereby providing
      the
      user instant access to key information regardless of where they may actually
      be.





5








**Accounting
      Application.** Our
      Accounting Application is a daily-use web based application that allows users
      to
      create and maintain their accounting books online in a secure fashion. This
      application contains standard accounting features aimed at the small business
      user, and will initially allow users to conduct the following
      functions:





Accounting
      Setup Wizard


A
      guided
      process to simplify the initial set-up of accounting files.





Accounts
      Payable


Create,
      update, and inactivate vendors


Create,
      edit, and pay bills


Issue
      Credit Memo


Issue
      Debit Memo


View
      Bill
      History


View/Download
      Checks


Write
      Quick Check


Void
      Check


Import
      Vendor Information


Export
      Vendor Information





Accounts
      Receivable


Create,
      update, and inactivate customers


Create,
      update, and inactivate invoices


Create
      products and prices


Record
      and reverse customer payments


Issue
      Credit Memo


Issue
      Debit Memo


Enter
      and
      List Deferred Revenue


Export
      Customer Information


Import
      Customer Information





Banking


Create,
      view, and edit bank accounts and balances manually


Enter
      bank transactions for the following:


Deposits


Withdrawals


Payments


Interest
      Fees


Bank
      Charges


Bank
      Transfers


Bank
      Reconciliation





General
      Ledger


View
      and
      Edit Chart of Accounts


Maintain
      and adjust GL accounts using journal entries


Amortization
      Schedule


Recurring
      Entries


Export
      Books


View
      Account Audit History





Financial
      Statements/Reports


Balance
      Sheet


Income
      Statement


Trial
      Balance


Cash
      Flow
      Statement


Accounts
      Payable Aging


Accounts
      Receivable Aging


Journal
      Entry Report


Check
      Register Report


Financial
      Ratios





6







Tax
      Forms


Typical
      tax forms that a company may need are made available through the
      system.





Company
      Setup


Access
      Control


View
      Company Info


View/Edit
      employees login information


View/Edit
      employees access control





Our
      Accounting Application is specifically geared towards a small business user
      who
      does not have the time or resources to learn and understand the intricacies
      of
      an accounting application. Users are guided through steps they need to do to
      process invoices, payments, deposits, etc. and the application
      utilizes plain English terminology to make the process simple to
      understand. We will continue to evaluate adding additional functionality to
      our
      Accounting Application to make it more useful to a wider range of customers.
      Since the introduction of this application, we have received feedback from
      both
      customers and an accounting consultant. We are improving our accounting
      application based on this feedback. Until this process is completed, we believe
      our Accounting Application will not be competitive with some competing
      products.





**Human
      Resource Center Application.** Our
      Human
      Resource Center Application is a daily-use application designed to allow
      companies to manage online their:





·
            Employee
                information


·
            Attendance
                records


·
            Compensation


·
              Timesheets


·
            HR
                documents


·
            Beneficiary
                information


·
            Performance
                Reviews - Conduct performance reviews for your employees and file
                them
                online.


·
            Company
                Announcements/News - Quickly and easily send company news and
                announcements to employees.


·
            Company
                Compliance - Incorporate additional company compliance documents
                as part
                of the HR Documents library





Employers
      can also manage the attendance records of each employee by creating and
      assigning vacation, sick leave, civil leave, and other different policies to
      each individual employee. Time-off requests are monitored and approved or
      declined as needed, and the system automatically tracks how much time each
      employee has available on a per policy basis.





Managers
      and administrators can view employees timesheets, and run reports to see a
      detailed break-downs of which employee is working on which project. This helps
      managers keep track of the number of hours spent on projects, and to determine
      what the status of a project is.





Examples
      of HR documents are:





·
            Employee
                insurance forms


·
            W-2s ·
            Employment
              contracts


·
            I-9
                eligibility verification


·
            Company
                policies





The
      Human
      Resource Center Application provides a means by which the HR administrator
      can
      assign documents to employees online. Employees can then login and view or
      download the applicable documents, and hand them back to the
      administrator.





The
      Human
      Resource Center Application comes standard with employee self-service access,
      allowing employees to update their personal information, request time off,
      or
      input their daily timesheet entries.





**Sales
      Force Automation (SFA)/Customer Relationship Management (CRM) Application**





We
      have
      two versions of our SFA/CRM application. The version we acquired from
      Computility is an application that is designed to provide companies with the
      ability to manage people and the sales and marketing processes more effectively,
      by offering the capability to collaborate and share information and standardize
      business processes into a single real-time system. The version that is included
      in our OneBiz SM suite of
      applications is simplified for small business use and contains fewer
      features.





7





SFA
      features included in the OneBiz SM suite of
      applications are:





·
            Account


·
            Contact


·
            Opportunity
                management


·
            Activity
                tracking


·
            Sales
                management


·
            Reporting


·
            Analytics


·
            Mini-dashboard





The
      CRM
      portion of the OneBiz SM suite of
      applications includes:





·
            Customer
                service management


·
            Customer
                support


·
            Marketing
                management


·
            Mini-dashboard





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





Our
      SFA/CRM application is designed to be used by both sales representatives and
      sales managers to assist with sales performance. For example, the application
      can be used to trackwhat their sales people are doing, what progress sales
      people are making, which accounts sales people are spending their time with
      and
      what sales transactions are expected to close in what time periods.





We
      believe our SFA/CRM application offers the following advantages to our
      users:





·
            Improves
                communications and workflow within a user’s organization; allows employees
                to share information and applications and collaborate - from any Internet
                connected location.


·
            Provides
                effective tools to improve the quality of management, by providing
                small
                business with a simplified version of Enterprise Relationship Management
                software used by bigger companies.


·
            Integrated
                package provides users with a “control center” that replaces patchwork of
                single-function applications and allows detailed visualization of
                the
                status of the business.


·
            Provides
                management with flexibility to meet the requirements of changing
                workforce
                levels by enabling management to quickly turn on and turn off employee
                access to different software and
                data.





**e-Commerce
      Application.** Our
      e-Commerce applications and services are designed to give customers the ability
      to conduct their business online. This software provides
      rapid website design and launch; inventory query; shopping cart; financial
      transactions; shipping, and; business to business communication for small
      businesses. These
      applications provide web-based e-commerce, back-end fulfillment, domain
      name and email software primarily to small business customers via a private
      label strategy. The core e-commerce products are web-based e-commerce and
      domain name software which sold under the names iDMA (iMart Direct Marketing
      Architecture), iDSA (iMart Direct Selling Architecture), and
      OneDomain TM .
      These
      software applications allow customers to sell their products online, centralize
      their information and access sales data at anytime and from any location with
      Internet access. Our e-commerce software helps users enhance online sales and
      marketing efforts, increase productivity and generate more revenue. Our Direct
      Marketing Architecture (iDMA) is a technology platform that is designed to
      help
      direct marketers to: increase sales, better leverage corporate resources, and
      deliver superior customer service.  As
      a
      platform for web-enabling the operations of a direct marketing company, the
      iDMA
      delivers value from information technology to a broad audience of customers
      and
      staff. Our Direct
      Selling Architecture (iDSA) is a system available for direct selling and network
      marketing companies. It is built around an open architecture for unmatched
      integration capabilities. The iDSA is completely web based, real-time at all
      stages, and comprised of components that are specifically designed for direct
      selling. Our OneDomainTM
      Domain Name Registration service is designed to provide the tools for small
      business owners to quickly and easily register domain names. When coupled with
      our technical support, ecommerce technology and e-commerce experience, we
      believe the result is a set of services that provide reliable hosting, email
      and
      e-commerce support for small business owners. This application has not yet
      been
      integrated into our suite of applications, and is available only on a stand
      alone basis from our wholly owned subsidiary, Smart Commerce, Inc.





**Calendar
      Application.** Our
      Calendar Application is designed to provide users with a full, easy-to-use
      online calendar. The calendar features daily, weekly, and monthly views,
      together with a mini-calendar that allows the user to quickly browse to any
      other date. Using the calendar, users are able to create, manage, and track
      appointments, group events, meetings, and conferences. Users can set up
      automated email reminders at their convenience, indicating how early they would
      like to be notified of an upcoming event.





8





In
      addition, users have the option to collaborate with their colleagues by sharing
      their calendar and events. When setting up an event, a user has the option
      to
      select whether they would like to share that event with other colleagues. Other
      users can then select whether they would like to view their own calendar, or
      the
      shared calendar of one of their colleagues.





This
      application also includes a To-Do list, allowing users to setup tasks, assign
      priorities and due dates, and mark tasks as complete as they work through them.
      This provides a handy means for users to see, at a glance, what tasks they
      need
      to accomplish.





**Contacts
      Application.** Our
      Contacts Application is designed to provide users with an online business
      contact management system. Contacts are sorted by group and by alphabet,
      providing an organization system that the user can then access from anywhere
      with an Internet browser.





Users
      also have the ability to add, edit, and remove contact groups at their own
      convenience, or they can use the default set of groups that is already provided
      for them as soon as they sign up.





Furthermore,
      users have the option to share their contacts between colleagues. Using the
      intuitive sharing system built into the application, users select whether they
      would like a contact to remain private or shared. The system then automatically
      places shared contacts into an accessible group for other colleagues to view
      at
      their convenience, while leaving all editing rights to the owner of the
      contact.





**Complete
      List of Business Tools**





Our
      Business Tools include the following:  **Secured
      Instant Messenger.** All
      messages are encrypted end-to-end. All access is password protected so only
      authorized users are allowed on the network.  **Business
      Plan.** Designed
      to ease the process of creating business plans to help entrepreneurs obtain
      the
      capital they require for their new or existing businesses.  **Employee
      Policy Manual.** Designed
      to allow employers to quickly and easily build an entire employee policy manual
      or create individual policies.  **Marketing
      Plan.** Designed
      to assist users to establish sales goals and identify the resources and programs
      required to meet those goals.  **Business
      and Legal Forms.** Designed
      to automate and simplify legal communications, address everyday business and
      personal needs, minimize costly legal fees, and reduce the liability associated
      with running a business by providing easy-to-use interactive forms.  **Business
      Letters.** Designed
      to automate and simplify business communications and correspondence.  **Government
      Forms.** Designed
      to make forms processing quick and easy by providing instant access to commonly
      used official forms.  **Job
      Descriptions.** Designed
      to **** assist
      users to create professional job descriptions quickly and effortlessly, by
      providing users with access to a library of more than a thousand job
      descriptions complying with the latest Dictionary of Occupational Titles (DOT).  **Financial
      Calculators.** Our
      suite of over eighteen (18) interactive calculators is designed to allow users
      to manage credit, loan, debt, income, expenses and other critical financial
      matters more effectively to help them make sound decisions.





**Premium
      Services.** Most
      of
      our premium services are provided through us by our integration partners. The
      premium services include the following:  **Business
      Plan Writing & Evaluation.** We
      provide the small business owner the option of engaging a business planning
      expert to guide them through the creation of a business plan.  **Business**  **Incorporation.** We
      assist
      businesses to incorporate quickly and efficiently using the services of our
      partner, Business Filings, a provider of incorporation services to small
      business owners.  **Press
      Releases.** Designed
      to simplify media relations. This professional writing service provided by
      our
      partner crafts a customized press release that is formatted and ready for
      distribution. **Direct
      Mailing Lists.** Designed
      to give users a tool to search for prospective customers by state, city, town,
      zip code, street, and even SIC codes. **Domain
      Name Registration.** Our
      Smart
      Commerce subsidiary offers these services to its existing customer base to
      register domain names and obtain email services.





**Integration
      Partners.** Our
      integration partners supply us with Premium Services described above that are
      integrated into our platform. Accordingly, our integration partners are a source
      of new products and services for us. We generally receive a fee for adding
      the
      partner’s services to our platform and then receive a percentage of revenue from
      sales of the services. Revenues from small businesses using our website and
      the
      websites of our current and former syndication partners and integration partners
      have been insignificant to date. Our contracts with certain integration partners
      terminated earlier than originally contemplated in the contracts with these
      partners following changes in the businesses of our integration partners, which
      made the integration partnership agreements less useful to us and to our
      integration partners. For example, some of our partners were not able to deploy
      the technology required to deliver their products or services through our
      website. In other cases, the partner discontinued Internet based products or
      services to small businesses. Our integration contracts have initial terms
      ranging from one to three years. Most contain automatic renewal provisions,
      which provide for one year renewals, unless notice of non-renewal is provided.
      All of our integration partnership agreements limit our ability to integrate
      products or services onto our website that compete with the products or services
      being provided through our website by our integration partners.








9





**Other
      Products and Services.**





Since
      our
      inception, we have distributed more than two million copies of CD-ROM products
      through a combination of direct sales, distributors and other means. We also
      provide website hosting services. We also act as a systems integrator to some
      of
      our SFA/CRM Software customers and in that capacity provide hardware as well
      as
      software to them. None of these products or services are a substantial revenue
      source for us, and we do not expect these to be a substantial revenue source
      for
      us on a going forward basis.





**Technology**





**Architecture:** In 2004,
      we introduced a new technology architecture for our software products called
      the
      OneBiz SM platform. This architectural platform provides the basis to develop applications
      that are integrated, share data and can be dynamically combined in a modular
      fashion. The OneBiz SM platform
      enables us to develop or license new software applications and to integrate
      third party applications into a common interface.





The
      OneBiz SM platform
      is designed to provide:





·
            A
                centralized dashboard/console that can be customized to show the
                critical
                business operations information a user needs from a single web page.
                This
                information displayed is role centric and is based on the role of
                the
                user.


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


·
            Auditing
                of platform data access and changes to monitor activity by
                users.


·
            Credit
                card billing services for all applications within the platform
                for our for fee or pre-defined package purchases. A platform
                license server integrated with the credit card billing system to
                provide
                authorized access to users within a company. The license server acts
                as a
                gatekeeper to make sure services used are paid for.


·
              Platform
                  Single Sign On. Our platform allows us to distribute our content
                  and
                  third-party partner content seamlessly to small business users
                  using
                  proprietary single sign-on methodology. After the user signs onto
                  our
                  OneBizSMplatform, the user does not have to re-register or login with our
                  integration partners or with other applications interoperating
                  in the
                  platform.


·
            Private
                Label Syndication. The new platform is built using open J2EE standards
                and
                allows us to deploy our products and services to our private label
                syndication partners and the users of their web sites with the look
                and
                feel of their web sites. The syndication technology in the platform
                thereby automates the process by which we integrate our products
                and
                services onto our syndicated partners’ web
                sites.


·
            Collaboration
                capabilities so various users can work together as a group sharing
                information as appropriate, significantly improving workflow efficiency
                and generating higher quality
                output.


·
            User
                Interface Wizards for applications. Our products and services feature
                wizard interfaces that utilize a series of fill-in-the-blank
                questionnaires. In addition, once the user inputs data, it is shared
                as
                appropriate throughout the platform so information need only be input
                once.


·
            The
                platform uses open J2EE standards using the struts application framework.
                The platform follows a logical and physical 3-tier architecture that
                allows for scalability. Due to the open standards employed, the platform
                facilitates plug and play of our developed applications and third
                party
                applications. The OneBizSMplatform’s core consists of the business services that provide common
                platform functionality like e-commerce, authentication, session management
                etc.





Our
      OneBiz SM platform
      is designed to be completely modular, with numerous plug-in connection points
      for existing and new functionality developed in-house or obtained through
      third-party partnerships and acquisitions. The platform uses single sign-on
      and
      web services for data exchange across applications within the
      platform.





The
      OneBiz SM platform
      is designed to provide seamless data exchange to and from each product or
      functional component. In addition, the platform is being designed to allow
      multiple users within the company to share information within a single
      application and across applications within the platform.





**Technology
      Strategy and Implementation:** Our
      technology strategy is to provide software applications to manage the most
      important aspects of small business operations, including: HR, Accounting,
      Contacts, Calendar, Planning, Administration, SFA/CRM, and e-Commerce. These
      applications will be sold directly to small business end-users by us and through
      channel partners, including syndication partners. The technology standards
      and
      modular architecture of the OneBiz SM platform
      allows us to rapidly deploy our new applications with a “private label” look and
      feel for our partners, which means that their end-user small business customers
      will experience the applications with the partner’s branding, color scheme, etc.





Our
      strategy is to develop a suite of applications through a combination of internal
      development, partnering and licensing of software and acquisitions. Our platform
      was developed using industry standard technology and a modular methodology,
      which allows various components to be assembled for rapid new application
      development and enhancement. In addition, all sensitive information is encrypted
      and stored on secured servers. All applications are operated from an environment
      with integrated security to protect against loss, misuse and data tampering.
      Secure Socket Layer technology protects data and provides security during
      transmission of sensitive financial data.





10





We
      are
      evaluating our development priorities in light of our recent acquisitions of
      Computility and iMart. Some features we previously planned to release have
      been
      modified, delayed or eliminated in light of new development priorities.
      Specifically, the following features will be delayed until later years as we
      shift development priorities to, in part, integrate certain products acquired
      from iMart and Computility into our application suite:





·
            Dashboard:
                detailed drill-down views and
                capabilities


·
            Dashboard:
                dynamically updated OneBizSMfunctionality based on the state of
                business


·
              HR:
                  professional training (continuing
                  education)


·
                HR:
                    online interview and applicant
                    screening


·
            Shipping
                (advanced features)


·
            Printing
                and Copying Services





We
      believe we will have a competitive advantage in the market if our small business
      customers can access substantially all their management software applications
      and data online at our web site or the web sites of our syndication partners.
      However, if our software applications are not competitive with the best products
      on the market, then we may not be able to capitalize on this
      advantage.





**Product
      Development**





**Product
      Development Team.** Our
      software engineering organization is responsible for developing our new
      applications and platform, as well as enhancing our existing applications and
      platform. We believe that a technically skilled, quality-oriented, and highly
      productive software engineering organization is important for the success of
      our
      new product offerings. We have increased our development team through the
      acquisitions of iMart and Computility, and may add additional developers to
      meet
      our schedule for developing the future versions of our applications. We have
      used independent development firms or contractors to expand the capacity and
      technical expertise of our internal research and development team. Additionally,
      we have licensed from third parties or otherwise acquired technology that is
      incorporated into our products, and we may do so in the future. Our primary
      development projects during the second half of 2006 will be to improve our
      website design to make it easier for subscribers to access our software
      applications and to improve existing software applications based on feedback
      from users and domain experts. We integrated certain SFA/CRM software
      applications into our application suite during May 2006. We are evaluating
      whether we can integrate certain features of the e-Commerce application in
      2006
      or whether to delay this project until 2007.





**Acquisitions
      from Outside Sources.** Assuming
      we are able to receive financing for potential acquisitions, we plan to continue
      to engage in a targeted and strategically defined plan to acquire additional
      applications or businesses from unrelated third parties within the highly
      fragmented application service provider and software development industries.
      These transactions may include a combination of licenses from other companies,
      joint development and purchases. We expect that some of these licenses will
      be
      for our nonexclusive use. In some cases, we may purchase technology or acquire
      the companies that own the technology. We have had discussions with several
      companies about potential future acquisitions, but we did not reach an agreement
      on terms with any of these companies.





We
      acquired rights to an accounting software engine from a software development
      company and co-developed our accounting software application with that
      developer. We have exclusive rights to the accounting application and
      non-exclusive rights to the software engine included in the application. We
      also
      completed the acquisitions of Computility, Inc. and iMart Incorporated in 2005.
      These acquisitions provided us with SFA/CRM software, e-Commerce software and
      domain registration software, and we are evaluating whether we can integrate
      the
      iMart products into our application suite during 2006 or delay integration
      of
      iMart products until 2007. Factors we are considering in making this evaluation
      include the priorities and demands of our customers. We also plan to add the
      following software applications through transactions with other companies,
      although we expect one effect of the SEC investigation into the trading of
      our
      stock will make such acquisitions difficult:




·
            Payroll


·
            Insurance
                / Benefits


·
            Investment
                / 401(k)


·
            Financial
                Services


·
            Inventory
                / Order Management





Because
      of many factors related to third party transactions that are outside our
      control, we cannot predict whether or when these features will be added to
      the
      application suite.





Following
      license or other acquisition of these applications, we will have to do
      integration work before we can offer these applications as part of our bundled
      suite of applications on our technology platform.





11





**Market
      and Customers**





**Small
      Business Market.** We
      offer
      small businesses a wide range of software applications and other products and
      services that help owners start and grow their small businesses. We define
      small
      businesses as companies with between one and one hundred employees. Small
      businesses often cease operating or are sold. In other cases, their needs
      change. We must constantly recruit new subscribers to replace existing
      subscribers. Since the start of 2006, we have had a net decrease in paying
      subscribers to our main portal. We engage in a variety of marketing activities
      directed to small businesses, including e-mail and direct mail campaigns, and
      co-marketing strategies designed to leverage existing strategic relationships.
      We plan to engage in cross selling customers of the two companies we acquired
      in
      October of 2005 beginning in the second half of 2006.





**Web
      Services Software Applications and Subscription Revenues.** Web
      services software applications and subscription revenues, which includes all
      sales of subscriptions to our software application, whether to partners or
      to
      small businesses, accounted for approximately 6.4%, 6.2%, and 16.5%, of our
      revenue during 2005, 2004, and 2003, respectively. We
      derive
      subscription revenue primarily from our stand alone SFA/CRM application and
      our
      stand alone e-Commerce application, both of which we acquired in October of
      2005. At the end of 2005, we began to generate a small amount of revenue from
      subscriptions to our main portal, www.SmartOnline.com. Subscription
      revenues for the SFA/CRM applications we acquired accounted for approximately
      86.6%, 91.8% and 95.0% of Computility’s revenues for 2005, 2004 and 2003
      respectively. Subscription revenues for the e-Commerce applications we acquired
      accounted for approximately 57.0%, 44.2% and 24.6% of iMart’s revenues for 2005,
      2004 and 2003, respectively. We expect that web services software and
      subscription revenues will account for the majority of revenues in 2006 and
      beyond. Since mid-January 2006, the number of subscribers to our software
      products at our main portal has declined. We do not know why the decline
      occurred, but some users have reported difficulty in accessing our software
      from
      our website. We recently redesigned our website and are currently improving
      our
      accounting application to increase the ease-of-use of our services. We are
      also
      evaluating whether our other software products meets the needs of our customers
      and what improvements may be necessary.





**Product
      Pricing.** Price
      is
      an important factor in the small business market and we seek to adjust our
      pricing to changing market conditions. Our primary pricing strategy is to offer
      a wide range of software applications for a monthly subscription fee that avoids
      large up-front investment costs for small business customers.





We
      offer
      bundled suites of many of our products for a single monthly subscription price.
      Each of our business customers may have multiple users and we count each account
      for each user as a separate subscription. Currently, bundled suites may include
      multiple subscriptions. We also offer our syndication partners discounts for
      large volume purchases of subscriptions which they can distribute to small
      businesses and we share revenue with syndication partners for other
      subscriptions that small businesses purchase through their websites. However,
      as
      of July 7, 2006, no syndication partners have made any volume commitments.
      We
      also offer price promotions, such as free use for 14 days.





**Subscriptions,
        Customers, Orders and Accounts Receivable.** We
        typically do not have a backlog of customer orders as our software applications
        and services are delivered instantaneously over the Internet. Substantially
        all
        of our small business customers pay via credit cards or automatic clearinghouse
        (“ACH”). Our subscribers can cancel their subscriptions at any time without
        penalty. Since mid-January 2006, the number of subscribers to our software
        products at our main portal has declined. Based on feedback we have received
        from customers, we recently redesigned our website in order to address their
        concerns and increase the ease of use of our website. During 2003, integration
        revenues from a related party, Smart IL, Ltd., which is owned by one of our
        affiliates, accounted for 27.2% of total revenue and consulting revenues
        from a
        second related party, Parson & Shearson, Inc., which is co-owned by our
        Chief Executive Officer and one of his brothers, who is also an employee
        of
        Smart Online, accounted for 11.9% of revenue. During 2004, integration revenue
        from Smart IL Ltd., which is owned by one of our affiliates, accounted for
        32.9%
        of total revenue. No other customers or partners accounted for more than
        10% of
        our total revenue during 2004. One related group of customers (Alticor
        affiliated companies) accounted for approximately 50% of iMart’s revenue during
        2004, approximately 89% during 2004, and approximately 96% during 2003. This
        would have been approximately 47.3% of combined company revenue during 2004
        and
        approximately 49.2% of combined company revenue during 2003 had we owned
        the
        e-Commerce and SFA/CRM software we acquired during these periods. In
        the
        first quarter of 2006, we
        learned that one of the e-Commerce customers, Britt WorldWide (“BWW”),
        constituting approximately 59% of iMart’s 2005 revenue, underwent a
        restructuring that could result in a decrease of approximately 30% in their
        business for our e-Commerce applications. BWW accounted for 11.8% of
        consolidated revenues for the fiscal year ended December 31, 2005. We believe
        we
        have a strong working relationship with BWW, and BWW has not indicated any
        desire to terminate this relationship, however, we do not have in place any
        written agreements with BWW. See “ITEM 7. MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
        OPERATIONS ”
and
        Notes to Financial Statements for further discussion of our major
        customers.
  **Marketing
      Strategy**





Our
      plan
      is to increase our revenue through a combination of six factors: (i) introducing
      new applications and products of greater value to small businesses, (ii)
      bundling our software in packages targeted to different types and verticals
      within the small businesses market, (iii) cross selling products to new
      customers we acquired from Computility and iMart, (iv) offering discounts to
      syndication partners who purchase volumes of subscriptions for distribution
      to
      small businesses, (v) soliciting additional syndication partners and (vi)
      actively managing our relationships with channel syndication partners to
      increase sell through to small businesses. We have not yet implemented all
      of
      these marketing strategies, and others have not been implemented until recently.
      We cannot yet determine how successful these strategies will be.





12





**Higher
      Value New Products.** Our
      new
      applications give us a broader and higher value product line. We believe
      Accounting, Human Resource, SFA/CRM, Calendar/Contacts and e-Commerce software
      are critical software applications most small businesses use on a daily basis.
      We believe that these new applications will greatly increase the value
      proposition of our web-based products to small businesses. We believe the value
      for our applications is the ability to access via a web-browser without
      installing and managing traditional software. Also, we believe that by linking
      the data in our applications on our platform so it can be accessed by multiple
      software applications, small businesses can save time by entering, changing
      and
      retrieving data once instead of repeating the process for multiple software
      applications.




**Bundling
      Software.** We have
      identified two broad categories of small businesses to which to target our
      sales
      efforts: new businesses and existing businesses that are outgrowing their
      existing stand alone software packages or paper based systems.  We believe
      that offering a package of software applications and tools to small business
      owners will simplify customer buying decisions, because most customers will
      know
      which type of business they currently have. In addition, some of our e-Commerce,
      SFA/CRM software applications are targeted to specific industries or types
      of
      companies.  We began to offer our initial bundles during the fourth
      quarter of 2005.  We integrated simplified versions of certain of our
      SFA/CRM software applications into our application suite during May 2006, and
      are evaluating whether we will be able to do the same with certain features
      of
      our e-Commerce software in 2006, or wait until 2007. We plan to evaluate the
      extent to which we will continue to target companies in specific
      industries.





**Cross
      Selling to Acquisition Customers.** When we
      acquired Computility and iMart, we acquired new subscribers. We will be
      targeting these new subscribers to sell our other software applications
      in the second half of 2006. We
      cannot
      yet determine how successful these efforts will be.





**Volume
      Discounts to Syndication Partners.**  Before
      we
      acquired new products from Computility and iMart, our largest revenue source
      was
      payments from syndication partners for integrating our software into their
      websites. We are seeking to change the way we do business with
      syndication partners by
      instead  offering
      our syndication partners the opportunity to purchase subscriptions to our
      software applications at a discount based on the volume of
      subscriptio ns
      purchased. These partners would then distribute the subscriptions to small
      businesses. No
      syndication partners have made volume purchases as of July 7, 2006.





**Managing
      Syndication Channel Partners.** We have
      lacked the resources to actively manage our relationships with our syndication
      partners. By entering into syndication relationships, we have gained access
      to
      the users of the websites of our syndication partners. However, having our
      products available on the websites of our syndication partners does not assure
      sales. One challenge we face is properly leveraging the sales power of the
      personnel of our syndication partners. This will require us to devote greater
      resources to managing these relationships by hiring additional personnel, but
      we
      are unable to determine at this time when we will have the resources necessary
      to do this.





**Channel
      Syndication Partners.** We
      private-label and customize our platform for our syndication partners. This
      enables them to provide their own web site users with our resources and
      applications. Companies that private-label most of our products and services
      through their websites include: J.P. Morgan Chase (as successor to BankOne),
      BusinessWeek Online, Union Bank of California, *Inc.com* and *FastCompany.com* .
      We
      recently learned that *Inc.com* and *FastCompany.com* have
      been acquired. As a result, it is unknown at this time whether these
      partners will renew their current agreements with us, or if they will be
      migrating to our OneBiz SM platform, or if they will discontinue using any of our products or
      services.   We In addition, Britt Worldwide is a syndication partner
      for our e-Commerce software application. Our syndication contracts range from
      one to two years in length. Some contain automatic renewal provisions, which
      provide for one year renewals, unless notice of non-renewal is provided. We
      believe the motivation of our syndication partners varies from one partner
      to
      another. In some instances, we believe the primary motivation is to acquire
      and
      retain small business customers, and in some cases to generate new sources
      of
      revenue.





We
      currently rely upon direct marketing to major corporations to establish private
      label syndication and marketing partnerships. Our sales efforts to syndication,
      integration and OEM partners requires us to interact with multiple decision
      makers, frequently including the prospective customer’s officer level personnel.
      While the average sales cycle varies substantially, it has generally ranged
      from
      two to nine months. These partners promote our product line through a variety
      of
      marketing communications vehicles, including advertising and special promotions.
      We have not added a new syndication partner since 2004, and we have lost one
      syndication partner since that time.





We
      believe large companies who desire to acquire and retain small business
      customers represent a significant market opportunity for us. We are working
      on
      expanding our syndication channel to include partners in the financial
      services/banking, media and broadcasting, telecommunications, multi-level
      marketing, franchises, value-added resellers, insurance and real estate markets.
      We expect that our syndication partner relationships will result in substantial
      sales of subscriptions only if we effectively manage these relationships. As
      of July 2006, these agreements have not been a source of substantial
      revenue for either us or our syndication partners. Revenue from our private
      label syndication partners amounted to approximately 9.2% in 2003, 17.6% in
      2004, and 15% in 2005, which percentages do not include pre-acquisition revenue
      from our e-Commerce and SFA/CRM software applications.





13





**Contract
      Terms.** Integration
      and syndication partners typically have the right to terminate their
      contracts for cause if we fail to perform. We generally invoice our
      syndication partners in annual or monthly installments and typical payment
      terms provide that our partners pay us within 30 days of invoice. In
      general, we collect our billings in advance of the service period. Each of
      our
      syndication partnership agreements with *www.Inc.com* and *www.FastCompany.com* ,
      contains a prohibition against our syndicating our platform and applications
      to
      two competitors of *www.Inc.com* and *www.FastCompany.com* .





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





**International
      Plan**





We
      currently generate no revenue from international operations, and we expect
      that
      we will not be generating revenue from international operations in 2006.
      Currently, we are exploring the possibility of expanding into international
      markets.





**Competition**





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





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





Our
      principal direct competition comes from several large vendors of Internet-based
      software for small businesses that sell many products similar to ours. Most
      of
      these competitors also sell other products and services not specifically
      targeted to small businesses, although some of their products have been modified
      for small business use or are marketed as small business products. These
      competitors include, but are not limited to, Microsoft, Oracle, NetSuite,
      Intuit, SAP, Sage and Yahoo! We also expect to face competition from new
      entrants that will market products similar to ours. Among the many companies
      that offer a narrower range of products that compete with us are SalesForce.com,
      Employease and RightNow. As we introduce more software products, we encounter
      more competitors.





For
      our
      accounting software applications, we face different competitors, including
      Netsuite, Intuit, SAP, Sage, and Microsoft. We seek to compete against these
      larger better financed companies primarily by selling a suite of applications
      that are useful to small business. In order to do so, our accounting application
      will have to be acceptable to accountants that provide services to our target
      customer base. We also plan to leverage our financial services private label
      syndication partners to sell this offering to their small business customers.
      We
      are improving our accounting software application to make it more competitive
      with the accounting software products currently offered by our
      competitors.





For
      our
      Human Resource Center software applications, we face different competitors,
      including Employease, Oracle, and Sage. We seek to compete against these larger
      better financed companies primarily by selling a complete suite of applications
      that are useful to small business. We also plan to leverage our private label
      syndication partners to sell this offering to their small business
      customers.





For
      our
      e-Commerce solutions, we face different competitors, including Register.com,
      GoDaddy.com, 1and1 Internet, Yahoo! and others in the domain registration space
      and eBay’s Storefront, Yahoo! Store, Microsoft, NetSuite, Homestead and others
      in the electronic storefront space. We seek to compete against larger better
      financed companies primarily by focusing efforts on direct selling and direct
      marketing of vertical markets.





Various
      modules of our SFA/CRM applications face different competitors. These include:
      software vendors with Enterprise Relationship Management or similar products
      that have been scaled down to the small business market (including Microsoft
      and
      Oracle); software vendors that have niche process or groupware applications
      for
      the small business market (including ACT!, Salesforce.com, and Microsoft);
      and
      providers of various information technology services, particularly remote
      monitoring of computing systems (including CenterBeam and EverDream). We have
      competed against larger, better-financed companies offering similar products
      primarily by directing our SFA/CRM products and marketing efforts at distinct
      market niches such as associations, non-profits, financial services and other
      members of the service-sector of the small business community. To facilitate
      this niche market strategy, our SFA/CRM software has been customized for
      different types of small businesses.





We
      also
      face indirect competition from potential customers’ internal development efforts
      and, at times, we have to overcome their reluctance to move away from existing
      paper-based systems and other computer software. For example, some small
      businesses that have already purchased an accounting software package may be
      reluctant to incur additional expense and take the time to change their
      accounting systems to our software.





14





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





**Competitive
                Factors**
            **Smart
                Online**Customer
                Awareness Access. Most small businesses do not spend substantial
                time
                researching and evaluating solutions. Most purchase what is most
                readily
                available.
            Many
                of our competitors have widely known brand names, large marketing
                budgets,
                and are widely available. Through our syndication, and OEM partnering
                programs, we seek to gain greater customer awareness and access to
                our
                products at relatively moderate cost to us. While we may lack the
                marketing dollars to compete with industry giants, we believe our
                corporate syndication partners will allow us to compete effectively
                if we
                are able to motivate our channel partners to devote resources to
                selling
                subscriptions. This will require us to hire additional personnel
                to manage
                these relationships.Value.
                Most small businesses do not have sufficient cash and do not invest
                in
                information technology, unless they see a tangible value for their
                investment.
            We
                believe one distinctive value our applications offer is the reduction
                of
                the time it takes small businesses to enter, change and retrieve
                important
                data. By integrating data sharing across applications through our
                platform
                small businesses can enter or change data once.Suppliers
                must be able to supply the applications and features customers
                need.
            We
                believe we offer more applications and features specifically targeted
                to
                small businesses than most of our competitors. However, our individual
                applications must also be competitive with the applications offered
                by
                industry leaders in those specific segments. This will require additional
                development work by us.Applications
                must be user friendly and require little training. Small businesses
                generally do not have IT departments to train employees and support
                software.
            We
                continue to improve the ease of use and performance of our applications
                as
                we have received feedback from our customers about difficulties in
                accessing and using our software. We also offer free telephone support
                services. Until recently, our software consisted primarily of simple
                business tools. With the addition of new, more complex applications,
                we
                expect to have additional support services.Compatibility
                with other information technology
            We
                have designed our platform and technology to be compatible with the
                information technology most often used by small businesses, which
                include
                personal computer operating systems, internet access software, email
                and
                instant messaging.





15








Price.
                Most small businesses are price sensitive.
            Our
                pricing structure requires very little initial investment by small
                businesses and is cost competitive with the products of competitors
                over
                the long-term. Our product delivery model also includes automatic
                free
                updates.Obsolescence.
            We
                are always improving our platform and expanding our content and
                applications. We believe the release of our applications demonstrates
                our
                commitment to industry leadership in this
                area.





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





**Intellectual
      Property Rights**





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





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





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





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





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





16





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





**Employees**





As
      of
      July 7, 2006, we had 65 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. We consider our relations with our employees
      to be good, but we face challenges in integrating the employees of the companies
      we acquired in October 2005 into our operations, including challenges arising
      from the terms of the acquisitions, which are discussed elsewhere in this
      report.





**Available
      Information**


We
      maintain a website at the address www.smartonline.com. We are not including
      the
      information contained on our website as a part of, or incorporating it by
      reference into, this annual report on Form 10-K. Although
      we endeavor to keep our Internet website current and accurate, there can be
      no
      guarantees that the information on the Internet website is up to date or
      correct. We
      make
      available free of charge through our website our annual reports on Form 10-K,
      quarterly reports on Form 10-Q and current reports on Form 8-K, amendments
      to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the
      Securities Exchange Act of 1934 and beneficial ownership reports filed by
      officers, directors and principal security holders under Section 16(a) of
      the Securities Exchange Act of 1934 ,
      as soon
      as reasonably practicable after we electronically file such material with,
      or
      furnish such material to, the Securities and Exchange Commission. These reports
      may be accessed by following the link under “About--Investors--SEC Filings” on
      our website.




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




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




We
      operate in a dynamic and rapidly changing business environment that involves
      substantial risk and uncertainty and these risks may change over time. The
      following discussion addresses some of the risks and uncertainties that could
      cause, or contribute to causing, actual results to differ materially from
      expectations. In evaluating our business, readers should pay particular
      attention to the descriptions of risks and uncertainties described below and
      in
      other sections of this document and our other filings with the SEC. These
      risks and uncertainties are not the only ones we face. Additional risks and
      uncertainties not presently known to us, that we currently deem immaterial
      or
      that are similar to those faced by other companies in our industry or business
      in general may also affect our business. If any of the risks described below
      actually occurs, our business, financial condition or results of future
      operations could be materially and adversely affected.




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




·
            Our
                Financial Condition





·
            Our
                Products and Operations





·
            Our
                Market, Customers and Partners





·
            Our
                Officers, Directors, Employees and
                Shareholders





·
            Regulatory
                Matters that Affect Our Business





·
            Matters
                Related to the Market For Our
                Securities










17







**Risks
      Associated with Our Financial Condition**




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




Through
      December 31, 2005, we have lost an aggregate of approximately $52 million since
      inception on August 10, 1993. During the year ended December 31, 2005 and the
      year ended December 31, 2004, we suffered a net loss of approximately $15.5
      million and $8.3 million, respectively. Losses do not include the
      pre-acquisition losses, or profit, of the two companies we acquired during
      2005.
      At December 31, 2005, we had a $2.3 million working capital deficit, which
      increased to approximately $4.2 million on March 31, 2006. Our working capital
      is not sufficient to fund our operations beyond September of 2006, unless
      we substantially increase our revenue, limit expenses or raise substantial
      additional capital. Because we have only nominal tangible assets, you may lose
      your entire investment.




**(2)
      Our Independent Registered Public Accountants Indicate That They Have
      Substantial Doubts That We Can Continue as a Going Concern. Our Independent
      Registered Public Accountants’ Opinion May Negatively Affect Our Ability to
      Raise Additional Funds, Among Other Things. If We Fail to Raise Sufficient
      Capital, We Will Not Be Able to Implement Our Business Plan, We May Have To
      Liquidate Our Business, and You May Lose Your Investment.**




Sherb
      & Co., LLP, our independent registered public accountants, has expressed
      substantial doubt, in their report included with this 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.




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




We
      lack
      sufficient cash to find operations past September of 2006. We will be required
      to seek additional financing to fund our operations both immediately and through
      the remainder of 2006. Factors such as the suspension of trading of shares
      of
      our Common Stock by the SEC and the resulting drop in share price, trading
      volume and liquidity, the commercial success of our existing services and
      products, the timing and success of any new services and products, the progress
      of our research and development efforts, our results of operations, the status
      of competitive services and products, and the timing and success of potential
      strategic alliances or potential opportunities to acquire technologies or assets
      may require us to seek additional funding sooner than we expect. We cannot
      assure you that such funding will be available. If sufficient capital is not
      raised, our ability to achieve or sustain positive cash flows, maintain current
      operations, fund any potential growth, take advantage of unanticipated
      opportunities, develop or enhance services or products, or otherwise respond
      to
      competitive pressures would be significantly limited. If we fail to raise
      sufficient capital, we will not be able to implement our business plan, we
      may
      have to liquidate our business and you may lose your investment. Restrictions
      on
      resale of over nine million shares of our Common Stock terminated on October
      1,
      2005, and the volume of re-sales may adversely affect the market value of our
      Common Stock and may make it more difficult to raise capital. See Risk Factor
      (55) for information about lock-up agreements and other restrictions on resale.




In
      addition, on January 17, 2006, the SEC temporarily suspended trading in our
      securities. As a result, NASDAQ withdrew its acceptance of our application
      to be
      traded on the NASDAQ Capital Market. Following that suspension, the SEC alerted
      brokers and dealers that, pursuant to Rule 15c2-11 promulgated under the
      Securities Exchange Act of 1934, brokers and dealers are prohibited from
      directly or indirectly offering quotations in our Common Stock unless such
      broker or dealer has strictly complied with Rule 15c2-11. As of July 7, 2006,
      no
      broker or dealer has submitted a form that would allow any quotation in our
      Common Stock, and our common stock is only traded on a limited basis without
      any
      broker, dealer or market maker providing quotations. This restriction on the
      market for our securities may also make it more difficult to raise capital.
      See
“ITEM 1, BUSINESS, Recent Developments,” “ITEM 3. LEGAL PROCEEDINGS,” and Risk
      Factor (51) for more information on the effect of the SEC’s suspension of
      trading.




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





18







If
      we
      raise additional funds through the issuance of equity securities or debt
      convertible into equity securities, the percentage of stock ownership by our
      existing stockholders would be reduced. In addition, such securities could
      have
      rights preferences and privileges senior to those of our current stockholders
      and new investors in this offering, which could substantially decrease the
      value
      of our securities owned by them. For example, in March and June 2006, we sold
      an
      aggregate of 800,000 shares of common stock to an existing investor for a price
      of $2.50 per share for total aggregate proceeds of $2 million. Because of the
      share price, we had to sell a significant number of shares to raise the
      necessary amount of capital.




**Risks
      Associated with Our Products and Operations**




**(5)
      We Will Rely Heavily On Successful Development and Market Acceptance of Our
      New
      Applications.**




Internet-based
      products are growing in sophistication and customer expectations are rising
      as
      new products are introduced. Our future financial performance and revenue growth
      will depend upon the successful development, introduction, and customer
      acceptance of new software applications.




**(6)
      We May Not Successfully Develop or Introduce New Products or Enhancements to
      Existing Products, Which Could Harm Our Business.**




Our
      future financial performance and revenue growth will depend, in part, upon
      the
      successful development, integration, introduction, and customer acceptance
      of
      our recently introduced products. Thereafter other new products either developed
      or acquired and enhanced versions of our existing web-native business
      applications will be critically important to our business. Our business could
      be
      harmed if we fail to deliver enhancements to our current and future solutions
      that our customers desire. From time to time, we have experienced delays in
      the
      planned release dates of our applications and technology platform and upgrades,
      and we have discovered software defects in new releases both before and after
      their introduction. New product versions or upgrades may not be released
      according to schedule, or may contain certain defects when released. Either
      situation could result in adverse publicity, loss of sales, delay in market
      acceptance of our services and products, or customer claims against us, any
      of
      which could harm our business. If we do not deliver new product versions,
      upgrades, or other enhancements to existing services and products on a timely
      and cost-effective basis, our business will be harmed. We are also continually
      seeking to develop new offerings. However, we remain subject to all of the
      risks
      inherent in product development, including unanticipated technical or other
      development problems, which could result in material delays in product
      introduction and acceptance or significantly increased costs. There can be
      no
      assurance that we will be able to successfully develop new services or products,
      or to introduce in a timely manner and gain acceptance of such new services
      or
      products in the marketplace. We are evaluating our development priorities in
      light of its recent acquisitions of Computility and iMart (see “Recent
      Developments” in “ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF
      FINANCIAL CONDITION AND RESULTS OF OPERATIONS”) and expect that some previously
      planned features will be modified, delayed or eliminated in light of new
      development priorities. In that regard, the following features contained in
      the
      third version of OneBiz SM ,
      as
      previously disclosed, were not released on or before December 31, 2005:
      Dashboard, detail drill-down views and capabilities; Dashboard, dynamically
      updated OneBiz SM functionality based on state of business; HR, professional training (continuing
      education); HR, online interview and applicant screening; shipping (advanced
      features); printing and copying services




**(7)
      We Have Experienced Delays in Developing Our New Applications and the
      OneBiz** **SM** **Platform. Existing Factors May Result in Further Delays, Which Could Harm Our
      Business.**




We
      have
      experienced delays in developing our new applications and the OneBiz SM platform. For example, the third version of our new applications, including
      enhanced accounting software, and the OneBiz SM platform
      was released at the end of 2005, but with fewer features than we originally
      planned. In addition to the factors that may delay or prevent completion of
      any
      new product development project, some existing factors may further delay or
      prevent development of our next generation products. These factors include
      the
      following: our applications require both enhancing our existing technology
      and
      adding many new software applications; integrating so many new applications
      at
      the same time is difficult; bundling individual applications into an attractive
      subscription package after development is complete takes time. Another factor
      that might delay or prevent development of our applications is that we have
      to
      hire, train and manage new development personnel. In addition, for many of
      the
      most important new applications, such as





19







accounting,
      we rely on third party sources, whether through licensing, joint development
      or
      purchase. The willingness of third parties to enter into agreements with us
      and
      the ability of third parties to perform agreements are totally outside our
      control. For example, our accounting application was integrated into the
      OneBiz SM application suite in December 2005, we did not accept the completion of the
      software application because, in its judgment and based on feedback received
      from both customers and an accounting consultant, certain modifications and
      features were needed to improve the usability of the accounting application.
      As
      a result, we are continuing to work with the software development company to
      complete and improve the accounting application. Our business could be harmed
      if
      we fail to deliver the improved performance that customers want with respect
      to
      our current and future offerings. There can be no assurance that our software
      applications and delivery platform will achieve widespread market penetration
      or
      that we will derive significant revenues from sales of our applications.
      We are evaluating our development priorities in light of its recent
      acquisitions of Computility and iMart and expect that some previously featured
      parts of the third version were modified, delayed or eliminated in light of
      new
      development priorities. In that regard, the following features that were planned
      to be contained in the third version, as previously disclosed, were not released
      on or before December 31, 2005: Dashboard, detail drill-down views and
      capabilities; Dashboard, dynamically updated OneBiz SM functionality based on state of business; HR, professional training (continuing
      education); HR, online interview and applicant screening; shipping (advanced
      features); printing and copying services.




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




**(8)
      Our Products Might Not Keep Pace with Technological Change, Which Could Harm
      Our
      Business.**




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




**(9)
      Our Business Is Difficult To Evaluate Because Our Business Models and Operating
      Plans Have Changed As A Result of Forces Beyond Our Control. Consequently,
      We
      Have Not Yet Demonstrated That We Have a Successful Business Model or Operating
      Plan.**




We
      incorporated in 1993 with a CD-ROM based business model. In 1999, we
      commercially introduced our Internet-based Software-as-a-Service (“SaaS”)
      business model, when it became clear that the developing Internet world offered
      a better delivery platform. We began to enter into syndication partnering
      arrangements during the year 2000 primarily as a result of the need to leverage
      the marketing and sales resources of others. In 2006, we changed our focus
      away
      from deriving up front revenue from integration and syndication agreements
      and
      towards direct sales to small businesses and sales of pre-paid subscriptions
      to
      our syndication partners. Our business models and operating plans have evolved
      as a result of changes in our market, the expectations of customers and the
      behavior of competitors. Today, we anticipate that our future financial
      performance and revenue growth will depend, in large part, upon our
      Internet-based SaaS business model and the results of our direct sales efforts
      to small businesses and pre-paid subscription sales to syndication partners,
      but
      these business models may again become ineffective due to forces beyond our
      control that we do not currently anticipate. Despite
      our sales efforts, the number of small business subscribers to our main portal
      has declined since January 2006 and no syndication partners have purchased
      pre-paid subscriptions. Consequently,
      we have not yet demonstrated that we have a successful business model or
      operating plan. Our evolving business model makes our business operations and
      prospects difficult to evaluate. Investors in our securities should consider
      all
      the risks and uncertainties that are commonly encountered by companies in this
      stage of business operations, particularly companies, such as ours, that are
      in
      emerging and rapidly evolving markets.




**(10)
      It Is Important For Us To Continue To Manage Changing Business Conditions.
      Failure To Do So Could Harm Our Business.**




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




**(11)
      The Success of Our Business Depends on The Continued Growth and Acceptance
      of
      the Internet as a Business Tool. If These Positive Trends Do Not Continue To
      Develop, Our Business Could Be Harmed.**





20







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




**(12)
      We Sell Third-Party Software and Web Services That May be Difficult to Replace.
      If We Are Not Able to Replace Third Party Software And Web Services, Our
      Business May Be Harmed.**




We
      rely
      on software licensed from third parties to offer some of our services and
      software offerings, including merchant services, incorporation services, on-line
      direct mail services and loan referrals. During 2005, approximately 4% of our
      revenue was derived from such third party software and services. During 2003
      and
      2004 approximately 16% and 6%, respectively, of our revenue was derived from
      such sources. These software and services may not continue to be available
      on
      commercially reasonable terms, if at all. The loss or inability to maintain
      any
      of these arrangements could result in delays in the sale of our services or
      software offerings until equivalent technology or services are either developed
      by us, or, if available, are identified, licensed, and integrated. Any such
      delay could harm our business.




**(13)
      We Have Acquired Certain Products, and We Recently Purchased Two Other
      Companies. We May Consider Other Strategic Opportunities in the Future. We
      Face
      Risks Associated with Those Acquisitions. These Risks Include, But Are Not
      Limited to, Difficulty of Integrating, Dilution of Stockholder Value and
      Disruption of Our Business, Which Could Adversely Affect Our Operating
      Results.**




We
      acquired non-exclusive rights to the software engine that is included in our
      accounting application, and then co-developed with the same vendor the remainder
      of the accounting application as to which we have exclusive rights.
      Additionally, as discussed below, we acquired two software companies in October
      2005. In the future, we may acquire other products or technologies or divest
      ourselves of products or technologies that are not within our continually
      evolving business strategy. We may not realize the anticipated benefits of
      our
      current or future acquisitions, divestitures or investments to the extent that
      we anticipate, or at all. We may have to issue debt or issue equity securities
      to pay for future acquisitions or investments, the issuance of which could
      be
      dilutive to our existing stockholders and investors in this offering. If any
      acquisition, divestitures or investment is not perceived as improving our
      earnings per share, our stock price may decline. In addition, we may incur
      non-cash amortization charges from acquisitions, which could harm our operating
      results. Any completed acquisitions or divestitures would also require
      significant integration or separation efforts, diverting our attention from
      our
      business operations and strategy. Our limited acquisition experience is very
      recent, and therefore our ability as an organization to integrate the acquired
      companies into our business is unproven. Acquisitions and investments involve
      numerous risks, including:




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


•
            diversion
                of financial and managerial resources from existing
                operations;


•
                cash
                    requirements for purchase price reduces the cash available for
                    operations;


•
            risk
                of entering new markets;


•
            potential
                write-offs of acquired assets;


•
            potential
                loss of key employees;


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


•
            delays
                in customer purchases due to
                uncertainty.




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




During
      October 2005, we acquired all the assets of Computility, Inc., a distributor
      of
      SFA/CRM software based in Iowa. Also during October of 2005, we acquired iMart
      Incorporated, a distributor of multi-channel e-Commerce systems based in
      Michigan. In addition, we acquired rights to an accounting software engine
      from
      a software development company and co-developed our accounting software
      application with that developer. We have exclusive rights to the accounting
      application and non-exclusive rights to the software engine included in the
      application. In addition to the general risks associated with acquisitions
      outlined above, there are additional risks associated with these three
      transactions including:




•
            risk
                of operating and integrating geographically remote
                offices;


•
                cash
                    requirements for purchase price reduces the cash available for
                    operations





21








•
                risk
                    of integrating technologies and offerings with our current applications;


•
                risk
                    of converting customer data from stand alone product offerings
                    of the
                    acquisition targets to formats utilized by the application bundled
                    offerings;


•
                risk
                    of losing customers of the acquired companies due to actual or
                    perceived
                    changes in operations and customer
                    interfaces;


•
                risk
                    of integrating management, administrative, operational and financial
                    infrastructures;


•
                risks
                    of implementing and monitoring compliance with corporate governance
                    and
                    public company reporting;
                    and


•
                requirements
                    and the ability of management to manage and timely and accurately
                    consolidate the results of
                    operations.




For
        example, approximately 89% of iMart’s revenue during year 2004 was from a group
        of related customers, the loss of which would have a material adverse affect
        on
        our business. In the first quarter of 2006, we
        learned that one of these customers, constituting approximately 59% of iMart’s
        2005 revenue, underwent a restructuring that could result in a decrease of
        approximately 30% in their business with Smart Commerce. At current levels,
        unless offset by other revenues, this could result in a net decrease of up
        to 8%
        of consolidated revenues. Additional
        cash payments of up to $870,000 to iMart and Computility employees over and
        above their normal salaries will also drain our working capital if sales
        of
        iMart and Computility products are less than we expect, or if expenses are
        greater than we expect.


We
      acquired approximately $11.3 million in intangible assets, including $5.2
      million of goodwill, in the two acquisitions during 2005. An independent
      consultant has performed an Allocation of Purchase Price of Intangible Assets
      Acquired in accordance with Statement of Financial Accounting Standards No.
      141.
      See Footnote 6 to the Financial Statements for further discussion of the
      treatment of the intangible assets acquired in these transactions.




Goodwill
      is the excess of the purchase price over the fair value of identifiable net
      assets acquired in business combinations accounted for as purchases. Under
      Financial Accounting Standards Board’s (“FASB”) Statement of Financial
      Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,”
goodwill and other intangible assets with indefinite useful lives are not
      amortized but are tested for impairment annually and whenever events or
      circumstances occur indicating that these intangibles may be impaired. The
      Company performs its review of goodwill for impairment by comparing the carrying
      value of the applicable reporting unit to the fair value of the reporting unit.
      Intangible assets with finite lives are amortized over their estimated useful
      lives.




**(14)
      Our Agreements in the Acquisition of iMart Incorporated Contain Installment
      Payments, Lock Box, License, Noncompetition and Control Provisions That Could
      Have A Material Adverse Effect on Us.**




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




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





22







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




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




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




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




We
      also
      use key systems software from leading open source communities like Sun
      Microsystems, Apache Group, GNU, Suse (Novell) that are free and available
      in
      the public domain. our products will use additional public domain software,
      if
      needed for successful implementation and deployment. In addition, we
      co-developed our accounting software with a development company. This accounting
      software application will be a critical element in selling our suite of software
      applications. However, our integration of this accounting software application
      has not gone according to plan due to usability issues which we are working
      to
      resolve. As a result, there is a possibility that our entire sales campaign
      may
      be substantially damaged. Using such software does not guarantee us support
      and
      upgrades of the software, and therefore could cause disruption in our service,
      if certain critical defects are discovered in the software at a future
      date.




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




Our
      systems software and hardware need periodic upgrades as part of regular
      maintenance. We are in the project planning phase to port the database tier
      of
      our web based applications to use the opensource MySQL database engine, but
      any
      delays in the database porting could harm our business. Similarly we are in
      the
      project planning phase to host and execute our platform and applications to
      run
      on the Linux operating system on Intel hardware. Our goal is to achieve these
      conversions by end of Q2 2007 and until we achieve the Oracle port to MySQL,
      and
      the Sun Solaris port to Linux, we run the risk of using existing system software
      and hardware till Q2 2007 without performing any major upgrades.





23







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




Significant
      portions of our operations depend on our ability to protect our computer
      equipment and the information stored in such equipment, our offices, and our
      hosting facilities against damage from fire, power loss, telecommunications
      failures, unauthorized intrusion, and other events. We back up software and
      related data files regularly and store the backup files at an off-site location.
      However, there can be no assurance that our disaster preparedness will eliminate
      the risk of extended interruption of our operations. In connection with our
      subscription and hosting services, we have engaged third-party hosting facility
      providers to provide the hosting facilities and certain related infrastructure
      for such services. We also retain third-party telecommunications providers
      to
      provide Internet and direct telecommunications connections for our services.
      These providers may fail to perform their obligations adequately. Any damage
      or
      failure that interrupts our operations or destroys some or all of our data
      or
      the data of our customers, whether due to natural disaster or otherwise, could
      expose us to litigation, loss of customers, or other harm to our business.
      We
      are currently developing a project plan in conjunction with the database
      upgrade/porting initiative to achieve partial and then eventually full hot
      failover of our www.smartonline.com portal. This will alleviate to a certain
      extent the risk of interruption of our operations. Until we achieve this hot
      failover strategy, we still have a significant risk regarding interruption
      of
      our business.




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




Because
      our service is complex, it may have errors or defects that users identify after
      they begin using it, which could harm our reputation and our business.
      Internet-based services frequently contain undetected errors when first
      introduced or when new versions or enhancements are released. We have from
      time
      to time found defects in our service and new errors in our existing service
      may
      be detected in the future. Since our customers use our service for important
      aspects of their business, any errors, defects or other performance problems
      with our service could hurt our reputation and may damage our customers’
businesses. In addition to technical defects, our products could have errors
      related to the subject matter they address. For example, our accounting
      applications might cause users to make accounting mistakes due to our software
      not incorporating correct accounting practices or our HR software may have
      mistakes that cause users to have liability to their employees. Even if the
      initial releases of our applications do not contain errors, changes in
      accounting practices or rules related to employers could cause our applications
      to become outdated. If any of the foregoing occurs and customers elect not
      to
      renew, delay or withhold payment to us, we could lose future sales or customers
      may make warranty claims against us, which could result in an increase in our
      provision for doubtful accounts, an increase in collection cycles for accounts
      receivable or the expense and risk of litigation. In addition, the fear that
      any
      of the foregoing could occur may cause customers to choose to purchase the
      products of our larger competitors in the belief that larger companies are
      more
      reliable.




**(18)
      Security and Other Concerns May Discourage Use of Our Internet-Based SaaS Model,
      Which Could Harm Our Business.**




Our
      service involves the storage and transmission of customers’ proprietary
      information, and security breaches could expose us to a risk of loss of this
      information, litigation and possible liability. If our security measures are
      breached as a result of third-party action, employee error, malfeasance or
      otherwise, and, as a result, someone obtains unauthorized access to one of
      our
      customers’ data, our reputation will be damaged, our business may suffer and we
      could incur significant liability. Because techniques used to obtain
      unauthorized access or to sabotage systems change frequently and generally
      are
      not recognized until launched against a target, we may be unable to anticipate
      these techniques or to implement adequate preventative measures. If an actual
      or
      perceived breach of our security occurs, the market perception of the
      effectiveness of our security measures could be harmed and we could lose sales
      and customers. If customers determine that our services offerings do not provide
      adequate security for the dissemination of information over the Internet or
      corporate extranets, or are otherwise inadequate for Internet or extranet use
      or
      if, for any other reason, customers fail to accept our products for use, our
      business will be harmed.




As
      part
      of our operations, we receive credit card, employee, purchasing, supplier,
      and
      other financial and accounting data, through the Internet or extranets. Although
      we have security systems in place, there can be no assurance that this
      information will not be subject to computer break-ins, theft, and other improper
      activity that could jeopardize the security of information for which we are
      responsible. Any such lapse in security could expose us to litigation, loss
      of
      customers, or other harm to our business. In addition, any person who is able
      to
      circumvent our security measures could misappropriate proprietary or
      confidential customer information or cause interruptions in our operations.
      We
      may be required to incur significant costs to protect against security breaches,
      to alleviate problems caused by breaches, or to encrypt additional key sensitive
      data to accommodate privacy laws or security measures. Any general concern
      regarding security in the marketplace could deter customers or prospects from
      using the Internet to conduct transactions that involve transmitting
      confidential information. Our failure to prevent security breaches, or
      well-publicized security breaches affecting the Internet in general, could
      significantly harm our business, operating results, and financial
      condition.




**(19)
      If We Experience Significant Fluctuations In Our Operating Results and Rate
      Of
      Growth And Fail To Balance Our Expenses With Our Revenue and Earnings
      Expectations, Our Results Will Be Harmed and Our Stock Price May Fall Rapidly
      and Without Advance Notice.**





24







Due
      to
      our limited operating history, our evolving business model and the
      unpredictability of our emerging industry, we may not be able to accurately
      forecast our rate of growth. We base our current and future expense levels
      and
      our investment plans on estimates of future revenue and future rate of growth.
      Our expenses and investments are, to a large extent, fixed and we expect that
      these expenses will increase in the future. We may not be able to adjust our
      spending quickly enough if our revenue falls short of our expectations.




As
      a
      result, we expect that our operating results may fluctuate significantly on
      a
      quarterly basis. Revenue growth may not be sustainable and may decrease in
      the
      future. We believe that period-to-period comparisons of our operating results
      may not be meaningful, and you should not rely upon them as an indication of
      future performance.




**(20)
      Because We Recognize Revenue From Our Partners Over The Term Of The Agreement,
      Downturns or Upturns In Sales May Not Be Immediately Reflected in Our Operating
      Results.**




We
      generally recognize revenue from partners ratably over the terms of their
      agreements. As a result, much of the revenue we report in each quarter is
      deferred revenue from partner agreements entered into during previous quarters.
      Consequently, a decline in new or renewed partners in any one quarter will
      not
      necessarily be fully reflected in the revenue in that quarter and will
      negatively affect our revenue in future quarters. In addition, we may be unable
      to adjust our cost structure to reflect these reduced revenues. Accordingly,
      the
      effect of significant downturns in transactions with our partners may not be
      fully reflected in our results of operations until future periods. Our reliance
      on revenue from our partners makes it difficult for us to rapidly increase
      our
      partner revenue through additional sales in any period, as revenue from new
      partners must be recognized over the applicable agreement term.




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




**(21)
      If Our On-Demand Application Service is Not Widely Accepted, Our Operating
      Results Will Be Harmed.**




Historically,
      we have derived a small percentage of our revenue from subscriptions to our
      on-demand application service. However, our business plan contemplates a
      substantial increase in this source of revenue in the future both as a result
      of
      internal growth and subscription customers acquired as part of the iMart and
      Computility acquisitions. As a result, widespread acceptance of our service
      is
      critical to our future success. Factors that may affect market acceptance of
      our
      service include:




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


•
            the
                price and performance of our
                service;


•
            the
                level of customization we can
                offer;


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


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




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




**(22)
      The Market for Our Technology Delivery Model and On-Demand Application Services
      Is Immature And Volatile, and if It Does Not Develop or Develops More Slowly
      Than We Expect, Our Business Will Be Harmed.**




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




**(23)
      We Do Not Have an Adequate History With Our Subscription Model To Predict the
      Rate of Customer Subscription Renewals and the Impact These Renewals Will Have
      on Our Revenue or Operating Results.**




We
      derive
      subscription revenue primarily from our stand alone SFA/CRM application, our
      stand alone e-Commerce application. At the end of 2005, we began to generate
      a
      small amount of revenue from subscriptions to our main portal,
      www.SmartOnline.com. Our
      small
      business customers do not sign long-term contracts. Our customers have no
      obligation to renew their subscriptions for our service after the expiration
      of
      their initial subscription period and in fact, customers have often elected
      not
      to do so. In addition, our customers may renew for a lower-priced edition of
      our
      service or for fewer users. Many of our customers utilize our services without
      charge. We have limited historical data with respect to rates of customer
      subscription renewals for paying customers, so we cannot accurately predict
      customer renewal rates. Our customers’ renewal rates may decline or fluctuate as
      a result of a number of factors, including when we begin charging for our
      services, their dissatisfaction with our service and their ability to continue
      their operations and spending levels. Since the beginning of 2006, the number
      of
      paying subscribers at out main portal has declined. If our customers do not
      renew their subscriptions for our service, our revenue may decline and our
      business will suffer.





25







**(24)
      We Depend on Small Businesses for Our Revenue. Small Businesses are Often
      Financially Unstable, Have High Rates of Attrition and can be Expensive
      Customers to Which to Market Products.**




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




**(25)
      If We Fail to Develop Our Brand Cost-Effectively, Our Business May
      Suffer.**




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




**(26)
      We Depend on Corporate Partners to Market Our Products Through Their Web Sites
      and OEM or Integration Relationships Under Relatively Short Term Agreements.
      Termination of These Agreements Could Cause A Substantial Decline in Our Revenue
      and a Substantial Increase in Customer Acquisition Costs.**




Approximately
      46% of total revenue during year 2005, approximately 93% of total revenue during
      year 2004, and approximately 83% of total revenue during year 2003, was derived
      from syndication, integration and OEM agreements with large companies and
      related parties whereby our content, software applications and technology
      platform are integrated into the web sites of our syndication partners and
      the
      software and services of our integration partners is sold on our website, and
      our CD-ROM products are bundled with the products of others through our OEM
      relationships. Under these agreements we both derive revenue and we utilize
      the
      resources of our partners to reduce our customer acquisition costs. As of July
      7, 2006, we have five (5) syndication agreements, where we currently or will
      have our content and software on the website of large corporate partners.
      However, we have received notice that one contract will not be renewed when
      it
      expires in September of 2006, and we learned in 2006 that a second partner
      is
      involved in a restructuring and it is unknown at this time whether its agreement
      will be renewed. We have not added a new syndication partner since 2004 despite
      our efforts to try and do so, and we have lost one syndication partner in that
      time. As of July 7, 2006, we have four (4) integration partnership agreements
      where we integrate the content or services of our partners into our technology
      platform. Prior to July 7, 2006, a fifth integration partner terminated its
      agreement prior to its scheduled termination date. As of July 7, 2006, we have
      one (1) OEM relationship through our distributor, PC Treasures. Not all these
      agreements generate revenue for us at this time. As of July 7, 2006, no
      syndication partners had agreed to purchase a one-year subscriptions from us
      under our volume discount. These agreements typically have initial terms of
      from
      one to two years. In the event these agreements were to terminate or not be
      renewed, or their terms substantially renegotiated, we expect that our revenues
      would decline and our customer acquisition costs would increase. Although our
      partners are important to our business on a collective basis, no single partner
      is material to our business. The syndication, integration, and OEM agreement
      revenue described above includes revenue from an integration agreement between
      us and Smart IL, a related party owned by one of our stockholders. Smart IL
      accounted for approximately 0% of our total revenues in 2005, approximately
      32.9% of total revenue during 2004 and approximately 27.2% of our total revenue
      during 2003. Smart IL is not expected to contribute to our revenue in the
      future. Our dealings with Smart IL are described under “ ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS -
      Revenue From Related Parties.” One related group of customers (Alticor
      affiliated companies) accounted for approximately 89% and 96% of iMart’s revenue
      during 2004 and 2003, respectively. Approximately 100% of the e-Commerce
      business we acquired from iMart depends upon four partner
      relationships.





26







**(27)
      It is Important for Us to Continue to Develop and Maintain Strategic
      Relationships. We Have Failed to Sign Any New Significant Strategic Partner
      Relationships for the Applications We Sell Via Our OneBiz** **SM** **Platform Since the Beginning of the Second Quarter of 2005. Failure to Do So
      Could Harm Our Business.**




We
      depend
      on syndication and integration partners, OEM relationships and referral
      relationships to offer products and services to a larger customer base than
      we
      can reach through direct sales, and other marketing efforts. Approximately
      83%
      of our total revenue during 2003 and approximately 93% of our total revenue
      during 2004 and approximately 46% of our revenue from 2005 was derived through
      such relationships. We have not signed a new significant strategic partner
      relationship for the applications we sell via our OneBiz SM platform
      since the beginning of the second quarter of 2005. 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. One of the
      integration contracts has been cancelled before the scheduled termination date,
      we have received notice that a syndication contract will not be renewed when
      it
      expires in September of 2006, and we learned in 2006 that another syndication
      partner is involved in a restructuring and it is unknown at this time whether
      its agreement will be renewed. Our success depends in part on the ultimate
      success of our syndication and integration partners, OEM relationships and
      referral partners and their ability to market our products and services
      successfully. Our partners are not obligated to provide potential customers
      to
      us. In addition, some of these third parties have entered, and may continue
      to
      enter, into strategic relationships with our competitors. Further, many of
      our
      strategic partners have multiple strategic relationships, and they may not
      regard us as significant for their businesses. Our strategic partners may
      terminate their respective relationships with us, pursue other partnerships
      or
      relationships, or attempt to develop or acquire products or services that
      compete with our products or services. Our strategic partners also may interfere
      with our ability to enter into other desirable strategic relationships. One
      of
      our syndication partnership agreements with *www.Inc.com* and *www.FastCompany.com* ,
      contains a prohibition against our syndicating our platform and applications
      to
      two competitors. All of our integration partnership agreements limit our ability
      to integrate products or services onto our website that compete with the
      products or services being provided through our website by our integration
      partners.




**(28)
      Our Lengthy Sales Cycle with Syndication, Integration Partners and OEM
      Relationships Could Adversely Affect Our Financial
      Results.**




Our
      syndication and integration partners and OEM relationships typically commit
      significant resources to an evaluation of available solutions and require us
      to
      expend substantial time, effort, and money educating them about the value of
      our
      services and software. Our sales cycle, which is the time between initial
      contact with a potential partner and ultimately signing a contract, is often
      lengthy and unpredictable. As a result, we have limited ability to forecast
      the
      timing and size of new specific partnering and OEM relationships. In addition,
      revenue may not begin to flow from such contracts until long after they are
      signed due to delays in implementing the contracts or the failure of our
      partners to devote the resources required to promote our products to small
      businesses. Any delay in signing or implementing syndication, integration and
      OEM contracts or other strategic agreements could cause our operating results
      to
      vary significantly. We have not added a new syndication partner since 2004
      despite our efforts to try and do so.




**(29)
      We Face Significant Competition, Which Could Adversely Affect Our
      Business.**




The
      market for our solutions is intensely competitive and rapidly changing. The
      direct competition we face depends on the market segment focus and delivery
      model capabilities of our competitors. We also at times have to overcome
      customer reluctance to move away from existing paper-based systems. We have
      two
      primary categories of competitors: companies that offer a broad range of
      software applications for small businesses and companies that offer one or
      two
      applications that compete with our broad range of applications. Our principal
      direct competition primarily comes from large companies, such as Microsoft,
      Oracle, Intuit, SAP and Yahoo!, who provide multiple software products used
      by
      many small businesses. In addition, we face competition from other competitors
      who sell single applications. Salesforce.com is an example of one of the many
      companies that fall within this second category of competitors. Many of our
      competitors have longer operating histories, greater financial, technical,
      marketing, and other resources, greater name recognition, and a larger total
      number of customers for their products and services than we do. Some of our
      competitors sell many products to our current and potential customers, as well
      as to systems integrators and other vendors and service providers. These
      competitors may also be able to respond more quickly to new or emerging
      technologies and changes in customer requirements, or to devote greater
      resources to the development, promotion, and sale of their products, than we
      may
      be able to do. In addition, we anticipate new competitors will enter the market
      in the future. Increased competition may result in price reductions, reduced
      gross margins, and change in market share and could have a material adverse
      effect on our business, financial condition, and results of operations. New
      product announcements by competitors may make it difficult to sell our products
      even before the competitor releases the product. For example, Microsoft has
      announced that it intends to introduce a new small business accounting
      application in 2006, and that it will be working on its own SaaS
      strategy.





27







**(30)
      We Depend on Nonrecurring Revenue, Which May Cause Our Revenue to Fluctuate
      Substantially From One Quarter to Another or to Decline Permanently as Market
      Conditions Change.**




We
      depend
      on nonrecurring revenue. Nonrecurring revenue is primarily derived from
      integration fees and other up-front payments received upon signing syndication
      and integration agreements with corporate partners for which we charge a
      one-time fee. This revenue is recognized on a monthly basis over the initial
      term of the integration and syndication contracts and may fluctuate
      substantially from one quarter to another. All of our integration revenues
      were
      from nonrecurring sources during the years ended December 31, 2003 and December
      31, 2004; and 80% of our integration revenues from 2005 were from nonrecurring
      sources. Approximately 85% of our syndication revenues for 2005, 68% of our
      syndication revenues for 2004, and 48% of our syndication revenues for 2003
      were
      from nonrecurring sources. In addition, such revenue may substantially decrease
      on a permanent basis due to market conditions over which we have little or
      no
      control, including competitors introducing new products to the market or
      reducing the price of competing products.




**(31)
      We Depend on Subscription Revenues; Our Future Growth is Substantially Dependent
      on Customer Demand for Our Subscription Services Delivery Models. Failure to
      Increase This Revenue Could Harm Our Business.**




Revenues
      from small businesses for our subscription revenue, which include subscriptions,
      revenue share, e-Commerce fees, hosting fees, loan origination fees and
      marketing fees, represented approximately 7.7% of our total revenue for 2005,
      6.2% of our total revenue for 2004, and approximately 16.5% of total revenue
      for
      fiscal 2003. For the same periods, the pre-acquisition subscription revenue
      from
      the e-Commerce application, and the SFA/CRM application, constituted
      substantially higher percentages of the revenue of the businesses we acquired
      in
      October of 2005. Consequently, we expect these acquisitions will substantially
      increase our dependence on subscription revenue. We anticipate that with the
      launch of our new applications and the acquisitions of iMart and Computility,
      subscription revenues will represent a significant percentage of our total
      revenues and that our future financial performance and revenue growth will
      depend, in large part, upon the growth in customer demand for our outsourced
      services delivery models. As such, we have invested significantly in
      infrastructure, operations, and strategic relationships to support these models,
      which represent a significant departure from the delivery strategies that other
      software vendors and we have traditionally employed. To maintain positive
      margins for our small business services, our revenues will need to continue
      to
      grow more rapidly than the cost of such revenues. There can be no assurance
      that
      we will be able to maintain positive gross margins in our subscription services
      delivery models in future periods. If our subscription services business does
      not grow sufficiently, we could fail to meet expectations for our results of
      operations, which could harm our business. Since the beginning of 2006, the
      number of paying subscribers at our main portal has declined.




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




**(32)
      There are Risks Associated with International Operations, Which May Become
      a
      Bigger Part of Our Business in the Future.**




We
      currently do not generate substantial revenue from international operations,
      and
      we expect that we will not be generating revenue from international operations
      in 2006. Currently, we are exploring the possibility of expanding into
      international markets. If we do so, our international operations will be subject
      to risks associated with operating abroad. These international operations are
      subject to a number of difficulties and special costs, including:




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


•
            laws
                and business practices favoring local
                competitors;


•
            uncertain
                regulation of electronic commerce;


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


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


•
            import
                and export restrictions and
                tariffs;


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


•
            difficulties
                staffing and managing foreign
                operations;


•
            multiple
                conflicting tax laws and regulations;
                and


•
            political
                and economic instability.





28







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




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




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




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




**(33)
      Historically, Substantial Amounts of Our Revenue Were Derived From Transactions
      with Related Parties, Which Means That Our Revenue May Not Reflect the True
      Commercial Viability of Our Business and That Our Revenue May Decline If We
      Cannot Replace this Revenue With Revenue From Unrelated Third
      Parties.**




During
      2004, $330,050, or 32.9% of total 2004 revenue, was derived from related party
      transactions. During 2003, $513,057, or 40.7% of 2003 total revenue, was derived
      from transactions with parties in which our officers, directors and stockholders
      have a direct or indirect interest. None of our revenues during 2005 was derived
      from related parties.




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




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




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




**(34)
      Any Failure to Adequately Expand Our Direct Sales Force Will Impede Our Growth,
      Which Could Harm Our Business.**




We
      expect
      to be substantially dependent on our direct sales force to obtain new customers.
      In conjunction with the shift in sales focus from integration and syndication
      partners to direct sales to small businesses and sales of pre-paid subscriptions
      to our syndication partners, we recently restructured our sales department,
      which included scaling back the number of sales people we employ. We believe
      that there is significant competition for direct sales personnel with the
      advanced sales skills and technical knowledge we need. Our ability to achieve
      significant growth in revenue in the future will depend, in large part, on
      our
      success in recruiting, training and retaining sufficient direct sales personnel.
      New hires require significant training and may, in some cases, take more than
      a
      year before they achieve full productivity. Our recent hires and planned hires
      may not become as productive as we would like, and we may be unable to hire
      sufficient numbers of qualified individuals in the future in the markets where
      we do business. If we are unable to hire and develop sufficient numbers of
      productive sales personnel, sales of our services will suffer.





29







**(35)
      Because Competition for Our Target Employees Is Intense, We May Not Be Able
      to
      Attract and Retain the Highly Skilled Employees We Need to Support Our Planned
      Growth, Which Could Harm Our Business.**




To
      execute our growth plan, we must attract and retain highly qualified personnel.
      Competition for these personnel is intense, especially for engineers with high
      levels of experience in designing and developing software and Internet-related
      services and senior sales executives. We may not be successful in attracting
      and
      retaining qualified personnel. We have from time to time in the past
      experienced, and we expect to continue to experience in the future, difficulty
      in hiring and retaining highly skilled employees with appropriate
      qualifications. Many of the companies with which we compete for experienced
      personnel have greater resources than we have. In addition, in making employment
      decisions, particularly in the Internet and high-technology industries, job
      candidates often consider the value of the stock options they are to receive
      in
      connection with their employment. Significant volatility in the price of our
      stock, and the recent suspension of trading of the our securities and inability
      for our securities to be traded on a national exchange or quoted on an
      interdealer quotation system described in Risk Factor (51), may adversely affect
      our ability to attract or retain key employees. Furthermore, the new requirement
      to expense stock options may discourage us from granting the size or type of
      stock options awards that job candidates require to join our company. If we
      fail
      to attract new personnel or fail to retain and motivate our current personnel,
      our business and future growth prospects could be severely harmed.




**(36)
      Our Growth Could Strain Our Personnel and Infrastructure Resources, and if
      We
      Are Unable to Implement Appropriate Controls and Procedures To Manage Our
      Growth, We May Not Be Able to Successfully Implement Our Business
      Plan.**




If
      we are
      able to raise additional capital, we plan to have a period of rapid growth
      in
      our headcount and operations, which will place a significant strain on our
      management, administrative, operational and financial infrastructure. We
      anticipate that further growth will be required to address increases in our
      customer base, as well as our expansion into new geographic areas. With the
      Computility acquisition, we added 17 new employees, and with the iMart
      acquisition we added 22 employees, all in October 2005. As of January 1, 2006,
      we had a total of 72 employees in five states, including those employed by
      our
      wholly owned subsidiaries. Since that time, however, we have reduced our
      headcount in a restructuring of our sales department, and the total number
      of
      employees as of July 7, 2006 was 65.




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




**(37)
      Our Executive Management Team is Critical to the Execution of Our Business
      Plan
      and the Loss of Their Services Could Severely Impact Negatively on Our Business;
      We Need to Attract Independent Members to Join Our Board of
      Directors.**




Our
      success depends significantly on the continued services of our management
      personnel, including Michael Nouri, who is P resident
      and Chief Executive Officer, and Henry Nouri, our Executive Vice President.
      Losing any one of our officers could seriously harm our business. Competition
      for executives is intense. If we had to replace any of our officers, we would
      not be able to replace the significant amount of knowledge that they have about
      our operations. All of our executive team work at the same location, which
      could
      make us vulnerable to loss of our entire management team in the event of a
      natural or other disaster. We do not maintain key man insurance policies on
      anyone.


In
        addition, in March 2006, our Board of Directors authorized its Audit Committee
        to conduct an internal investigation of matters relating to the SEC suspension
        and investigation. Final findings of the independent outside legal counsel
        were
        shared with the full Board of Directors on July 7, 2006. As one results of
        these
        findings, Mr.
        Jeffrey LeRose was appointed to the position of non-executive Chairman of
        the
        Board of Directors. Mr. Nouri has stepped down as Chairman of the Board of
        Directors, but will continue to serve as our President, Chief Executive Officer
        and as a member of the Board of Directors. This
        internal investigation has placed considerable time demands upon our independent
        directors. After the end our fiscal year, two of our directors resigned because
        of the time commitments required to adequately perform their duties as a
        directors. We currently have three directors, only one of whom is independent.
        We are conducting a search for additional independent directors with public
        company expertise and financial experience to add to our Board of Directors.
        However, given the unresolved status of the SEC investigation, there can
        be no
        guarantee that we will be able to attract independent directors to join the
        Board of Directors. In addition, effective June 1, 2006, our General Counsel,
        Joan Keston, was no longer an employee, and we are currently considering
        whether
        to hire a new General Counsel or continue to augment our legal department
        with
        the assistance of outside law firms.





30







The
      SEC
      action and the Audit Committee investigation may result in the loss of services
      of one or more of our officers or directors or changes in our additional
      internal controls and procedures. Any such change may have a material adverse
      impact on our business. See “ ITEM 1.
      BUSINESS, Recent Developments” and “ ITEM 3. LEGAL
      PROCEEDINGS” for further discussion of the SEC action and the internal
      investigation; and see “ITEM 9A. CONTROLS AND PROCEDURES.”




**(38)
      Officers, Directors and Principal Stockholders Control Us. This Might Lead
      Them
      to Make Decisions That Do Not Benefit the Stockholder
      Interests.**




At
      July
      7, 2006, our officers, directors and principal stockholders beneficially owned
      approximately 8,647,828 shares
      (approximately 53%) of our outstanding stock, which includes approximately
      870,000 shares which can be acquired upon exercise of options within sixty
      (60)
      days after July 7, 2006. These shares include a total of 3,552,028 shares
      beneficially owned by Michael Nouri and/or Henry Nouri, who are brothers. This
      number does not include 265,631 shares owned by Ronna Loprete, who is the wife
      of Michael Nouri, and who resigned as an officer and director of Smart Online
      in
      September of 2005, and as an employee of the Company in December of 2005. In
      addition, approximately 330,000 shares are subject to issuance upon exercise
      of
      options owned by the officers and directors, which options cannot be exercised
      within sixty (60) days after July 7, 2006, and therefore are not counted as
      being beneficially owned at that date. As a result, these persons, acting
      together, will have the ability to control substantially all matters submitted
      to our stockholders for approval (including the election and removal of
      directors and any merger, consolidation or sale of all or substantially all
      of
      our assets) and to control our management and affairs. Accordingly, this
      concentration of ownership may have the effect of delaying, deferring or
      preventing a 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.




**(39)
      Sales by Officers and Directors, Including Sales Under Rule 10b5-1 Plans, Could
      Adversely Affect Our Stock Price.**




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




Our
      Board
      of Directors has approved a form of Rule 10b5-1 plan for the sale of our shares
      held by officers and key employees. The form of plan approved by the Board
      of
      Directors for use by officers and employees authorizes each person to sell
      650
      shares of our Common Stock each month.




Insiders
      are often prohibited from trading shares of their company, because their duties
      often require them to possess material nonpublic information about their
      companies. Rule 10b5-1 was adopted by the SEC in October 2000 to facilitate
      insiders selling their company stock, if they establish a plan to regularly
      sell
      their shares and the plan satisfies the requirements of Rule 10b5-1, including
      that the insider must not possess material non-public information when the
      plan
      is initiated.




Ten
      of
      our officers and employees, including our Chief Executive Officer, have
      indicated they intend to initiate Rule 10b5-1 plans utilizing the form of plan
      approved by our Board of Directors. As of July 7, 2006, none of these officers
      or employees had instituted a Rule 10b-5 plan. However, we expect these plans
      will be initiated when our officers and key employees do not possess material
      non-public information about us.




Officers
      and key employees are not required to limit their sales of shares of our common
      stock to the number of shares stated in their plans. Consequently, you should
      not interpret the plans as setting any maximum limit on sales by such officers,
      directors or key employees, because officers, directors and key employees may
      sell our shares outside of their plans, whether or not they have executed any
      plans.




**(40)
      Shares of Common Stock Owned by Our Officers, Directors and Consultants Have
      Been Registered in a Registration on Form S-8 and May be Resold by Them, Which
      May Have a Negative Impact on Their Interest in Our
      Future.**




In
      May
      2005, we registered 5,000,000 shares of our Common Stock issuable under our
      2004
      Equity Compensation Plan for our officers, directors and consultants on Form
      S-8. At December 31, 2006, 16,500 shares registered on Form S-8 were outstanding
      and 1,786,750 shares are subject to outstanding stock options. There were an
      additional 941,200 shares subject to outstanding stock options issued under
      prior option plans, or not under any plan, that were not registered. This will
      allow our officers, directors and consultants to more easily sell all of their
      shares of our common stock after their contractual lock-up restrictions expire,
      which may have a negative impact on their interest in our future success .
      Shares owned by officers and directors are deemed to be “control” securities
      and, until we meet certain criteria, resales by officers and directors pursuant
      to a Form S-8 registration statement are subject to the volume limitations
      of
      Rule 144(e), which means that an officer or director would be entitled to sell
      within any three-month period a number of shares that does not exceed (i) 1%
      of
      the number of shares of Common Stock then outstanding, or (ii) the average
      weekly trading volume of the Common Stock during the four calendar weeks
      preceding the filing of a Form 144 with respect to such sale.





31







**Regulatory
      Risks**




**(41)
      Our Revenue Recognition Policy May Change And Affect Our Earnings, Which Could
      Adversely Affect Our Stock Price.**




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




**(42)
      Compliance With New Regulations Governing Public Company Corporate Governance
      and Reporting is Uncertain and Expensive.**




As
      a
      public company, we have incurred and will incur significant legal, accounting
      and other expenses that we did not incur as a private company. We will incur
      costs associated with our public company reporting requirements. We also
      anticipate that we will incur costs associated with recently adopted corporate
      governance requirements, including requirements under the Sarbanes-Oxley Act
      of
      2002, as well as new rules implemented by the Securities and Exchange Commission
      and the NASD. We expect these rules and regulations to increase our legal and
      financial compliance costs and to make some activities more time-consuming
      and
      costly. Any unanticipated difficulties in preparing for and implementing these
      reforms could result in material delays in complying with these new laws and
      regulations or significantly increase our costs. Our ability to fully comply
      with these new laws and regulations is also uncertain. Our failure to timely
      prepare for and implement the reforms required by these new laws and regulations
      could significantly harm our business, operating results, and financial
      condition. We also expect these new rules and regulations may make it more
      difficult and more expensive for us to obtain director and officer liability
      insurance and we may be required to accept reduced policy limits and coverage
      or
      incur substantially higher costs to obtain the same or similar coverage. As
      a
      result, it may be more difficult for us to attract and retain qualified
      individuals to serve on our board of directors or as executive officers. We
      are
      currently evaluating and monitoring developments with respect to these new
      rules. We estimate this will add approximately $1 million to our expenses during
      our first year as a public company, but there can be no assurance that costs
      will not be higher. We have also incurred, and will continue to incur,
      substantial additional professional fees and expenses associated with the SEC’s
      suspension of trading of our securities in January 2006, and with the internal
      investigation authorized by our Board of Directors in March 2006. Although
      our
      insurance carrier has paid a portion of these fees, not all such fees and
      expenses will be covered by our insurance.




**(43)
      The SEC Suspension of Trading of Our Securities Has Damaged Our Business, and
      It
      Could Damage Our Business in the Future.**





On
      January 17, 2006, the Securities and Exchange Commission issued an Order of
      Suspension of Trading in our securities . According to the order, the SEC
      believed that there was a lack of current and accurate information concerning
      our securities because of possible manipulative conduct occurring in the market
      for our stock. By its terms, that suspension ended on January 30, 2006 at 11:59
      p.m. EST. From the beginning, we have cooperated with the SEC’s efforts with
      regard to the suspension. See “Item 3. LEGAL PROCEEDINGS.”.




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





32







**(44)
      We Believe Our Financial Results Will Be Adversely Affected By Changes in
      Accounting Principles Generally Accepted in the United
      States.**




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




For
      example, in December 2004, the FASB announced its decision to require companies
      to expense employee stock options. We will adopt this new accounting
      pronouncement, Statement of Financial Accounting Standards No. 123r (revised
      2004), Share-Based Payment, beginning on January 1, 2006, which is the start
      of
      fiscal 2006. We believe this change in accounting will materially and adversely
      affect our reported results of operations.




**(45)
      Privacy Concerns and Laws or Other Domestic or Foreign Regulations May Reduce
      the Effectiveness of Our Solution and Adversely Affect Our Business.**




Our
      customers can use our service to store contact and other personal or identifying
      information regarding their customers and contacts. Federal, state and foreign
      government bodies and agencies, however, have adopted or are considering
      adopting laws and regulations regarding the collection, use and disclosure
      of
      personal information obtained from consumers and individuals. The costs of
      compliance with, and other burdens imposed by, such laws and regulations that
      are applicable to the businesses of our customers may limit the use and adoption
      of our service and reduce overall demand for it. Furthermore, privacy concerns
      may cause our customers’ customers to resist providing the personal data
      necessary to allow our customers to use our service effectively. Even the
      perception of privacy concerns, whether or not valid, may inhibit market
      adoption of our service in certain industries. For example, regulations such
      as
      the Gramm-Leach-Bliley Act of 1999, which protects and restricts the use of
      consumer credit and financial information, and the Health Insurance Portability
      and Accountability Act of 1996, which regulates the use and disclosure of
      personal health information, impose significant requirements and obligations
      on
      businesses that may affect the use and adoption of our service.




The
      European Union has also adopted a data privacy directive that requires member
      states to impose restrictions on the collection and use of personal data that,
      in some respects, are far more stringent, and impose more significant burdens
      on
      subject businesses, than current privacy standards in the United States. All
      of
      these domestic and international legislative and regulatory initiatives may
      adversely affect our customers’ ability to collect and/or use demographic and
      personal information from their customers, which could reduce demand for our
      service.




In
      addition to government activity, privacy advocacy groups and the technology
      and
      other industries are considering various new, additional or different
      self-regulatory standards that may place additional burdens on us. If the
      gathering of personal information were to be curtailed in this manner, certain
      of our solutions would be less effective, which may reduce demand for our
      service and harm our business.




**(46)
      Our Business is Subject to Changing Regulations Regarding Corporate Governance
      and Public Disclosure That Has Increased Both Our Costs and the Risk of
      Noncompliance.**




We
      are
      subject to rules and regulations by various governing bodies, including the
      SEC,
      NASDAQ and Public Company Accounting Oversight Board, which are charged with
      the
      protection of investors and the oversight of companies whose securities are
      publicly traded. Our efforts to comply with these new regulations, most notably
      the Sarbanes-Oxley Act of 2002(“SOX”), have resulted in, and are likely to
      continue to result in, increased general and administrative expenses and a
      diversion of management time and attention to compliance activities.




By
      the
      end of fiscal 2007, we are required to comply with the SOX requirements
      involving the assessment of our internal control over financial reporting and
      our independent accountant’s audit of that assessment. In March 2006, we
      retained a new Chief Financial Officer. His review of our internal control
      over
      financial reporting to date and the final findings of our Audit Committee
      investigation have identified several deficiencies in our internal control
      over
      financial reporting, which we are working to remediate. See “ITEM 9A. CONTROLS
      AND PROCEDURES” of this report for a more detailed description of this process.
      Although we believe our on-going review and testing of our internal control
      and
      financial reporting will enable us to be compliant with the SOX requirements,
      we
      have identified some deficiencies and may identify others that we may not
      be able to remediate and test by the end of fiscal 2007. If we cannot assess
      our
      internal controls over financial reporting as effective, or our external
      auditors are unable to provide an unqualified attestation report on such
      assessment, our stock price could decline.





33







Moreover,
      because these laws, regulations and standards are subject to varying
      interpretations, their application in practice may evolve over time as new
      guidance becomes available. This evolution may result in continuing uncertainty
      regarding compliance matters and additional costs necessitated by ongoing
      revisions to our disclosure and governance practices. If we fail to address
      and
      comply with these regulations and any subsequent changes, our business may
      be
      harmed.




**(47)
      Evolving Regulation of the Internet May Harm Our Business.**




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




**(48)
      Our Ability to Protect Our Intellectual Property is Limited and Our Products
      May
      be Subject to Infringement Claims by Third Parties.**




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




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




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




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




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




**(49)
      Anti-Takeover Effects of Charter Documents and Delaware Law Could Discourage
      or
      Prevent a Change in Control, Even If a Change of Control Would Be Beneficial
      to
      Shareholders and Investors.**




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





34







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




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




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




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




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




•
            Provisions
                in agreements related to the acquisition of our e-commerce software
                application business which restrict how we operate that business
                and
                installment payment obligations for the purchase price of the e-commerce
                software application business may discourage other companies from
                purchasing our business.




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




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




**(50)
      Our Common Stock is Currently Not Listed on a National Exchange or Quoted in
      an
      Interdealer Quotation System. The Company Cannot Make Any Assurance That Its
      Common Stock Will Be Listed On a National Exchange or Quoted in Any Interdealer
      Quotation System. Therefore, You May Be Unable to Sell Your
      Shares.**





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




Following
      that suspension, the SEC cautioned brokers, dealers, stockholders, and potential
      buyers that they should carefully consider the suspension with our current
      and
      future public information. The SEC also alerted brokers and dealers that,
      pursuant to Rule 15c2-11 promulgated under the Securities Exchange Act of 1934,
      brokers and dealers are prohibited from directly or indirectly offering
      quotations in our Common Stock unless such broker or dealer has strictly
      complied with Rule 15c2-11. The rule provides, in part, that brokers or dealers
      have certain, identified information in their possession and that they have
      a
      reasonable basis for believing that such information is accurate and reliable.
      Prior to the publication of any quotation, such broker or dealer must submit
      a
      form to the interdealer quotation system indicating the broker or dealer has
      the
      information required under Rule 15c2-11. As of July 7, 2006, no broker or dealer
      has submitted such a form that would allow any quotation in our Common Stock,
      and our common stock is only traded on a limited basis in the “grey market,”
without any broker, dealer or market maker providing quotations. We have no
      indication that any such form will be filed, and therefore cannot estimate
      when
      or if our Common Stock will be quoted on an interdealer quotation
      system.




Consequently,
      the market for our Common Stock is greatly reduced, and the lower trading
      volumes (compared to a national exchange or an “Over the Counter” market) may
      make it more difficult to dispose of, or to obtain accurate quotations as to
      the
      price of, our common stock.





35







Since
      our
      securities are not eligible for listing on NASDAQ or quotation in an interdealer
      quotation system, there is currently no significant public trading volume,
      and
      there is no guarantee that our securities will be eligible for listing on an
      exchange or for quotation in an interdealer quotation system, purchasers of
      the
      shares may have difficulty selling their securities should they wish to do
      so. A
      broker-dealer must file a Form 211 and undergo NASD review before it can quote
      securities on either the OTCBB, which is operated by the National Association
      of
      Securities Dealers (“NASD”), or on the “pink sheets,” which are operated by a
      private company and are not affiliated with the NASD. Companies quoted on the
      OTCBB must continue to file reports with the SEC pursuant to Section 13 or
      15(d)
      of the Securities Act of 1933, while companies quoted on the “pink sheets” need
      not do so. Trading volume for securities traded only on the “pink sheets” is
      generally lower than for securities traded on the OTCBB. If our securities
      were
      quoted for trading only on the “pink sheets,” an investor may find it more
      difficult to dispose of, or to obtain accurate quotations as to the price of,
      the securities offered hereby.




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




**(51)
      If Securities Analysts Do Not Publish Research or Reports About Our Business
      or
      If They Downgrade Our Stock, the Price of Our Stock Could
      Decline.**




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




**(52)
      Our Quarterly Revenues and Operating Results may Fluctuate in Future Periods
      and
      We may Fail to Meet Expectations of Investors and Public Market Analysts, Which
      Could Cause the Price of Our Common Stock to Decline.**




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




•
            the
                evolving demand for our services and
                software;


•
            spending
                decisions by our customers and prospective
                customers;


•
            our
                ability to manage expenses;


•
            the
                timing of new product releases;


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


•
            the
                timing of execution of large
                contracts;


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


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


•
            costs
                of developing new products and
                enhancements;


•
            global
                economic and political conditions;


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


•
            the
                renewal rates for our service;


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


•
            the
                length of the sales cycle for our
                service;


•
            new
                product and service introductions by our
                competitors;


•
            technical
                difficulties or interruptions in our
                service;


•
            regulatory
                compliance costs; payment defaults by customers;


•
            integration
                of acquisitions, and


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




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





36







**(53)
      Our Stock Price is Likely to be Highly Volatile and May
      Decline.**




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




•
            variations
                in our actual and anticipated operating
                results;


•
            changes
                in our earnings estimates by
                analysts;


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


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


•
            recruitment
                or departure of key personnel;


•
            changes
                in the estimates of our operating results or changes in recommendations
                by
                any securities analysts that elect to follow our Common
                Stock;


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


•
            the
                recent suspension in the trading of our securities issued by the
                Securities and Exchange Commission;


•
            the
                present inability of brokers and dealers to quote the price of our
                Common
                Stock on the “Over the Counter” markets;
                and


•
            the
                volume of trading in our Common Stock, including sales of substantial
                amounts of Common Stock issued upon the exercise of outstanding options
                and warrants.




In
      addition, NASDAQ, has experienced extreme price and volume fluctuations that
      have affected the trading prices of many technology and computer software
      companies, particularly Internet-related companies. Such fluctuations have
      often
      been unrelated or disproportionate to the operating performance of these
      companies. These broad trading fluctuations could also adversely affect the
      trading price of our Common Stock.




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




**(54)
      Shares Eligible for Public Sale Could Adversely Affect Our Stock Price. Holders
      of Shares of Our Common Stock Signed Agreements That Prohibit Resales of
      Approximately 9,954,624 shares of our Common Stock. The Initial Lock-up Period
      Expired on September 30, 2005. If Substantial Numbers of Shares Are Resold
      as
      Lock-up Periods Expire, the Market Price of Our Common Stock Is Likely to
      Decrease Substantially.**




At
      December 31, 2005, 15,607,231 shares of our common stock were issued and
      outstanding and 2,791,300 shares may be issued pursuant to the exercise of
      warrants and options. 4,145,950
      shares are to be registered on a registration statement on Form S-1; of these
      1,394,758 shares and 36,550 warrants to purchase shares were previously
      registered for resale on registration statement No. 333-119385 and are to be
      reregistered for resale on the registration statement. These 1,394,758 shares
      and 36,550 warrants to purchase shares represent a portion of the 1,942,833
      shares and warrants to purchase shares registered for resale on registration
      statement No. 333-119385. Because
      of fundamental changes to our business, shares cannot be resold under a previous
      registration statement. These shares may be sold pursuant to Rule 144. During
      May 2005, we registered on Form S-8 5,000,000 shares of our Common Stock for
      our
      officers, directors and consultants, of which at December 31, 2005, 16,500
      shares were outstanding and 1,786,750 shares are subject to outstanding stock
      options. There were an additional 941,200 shares subject to outstanding stock
      options issued under prior option plans, or not under any plan, that were not
      registered. The remaining outstanding shares are restricted and may be sold
      in
      the public market only if they qualify for an exemption from registration
      described below under Rules 144, 144(k) or 701 promulgated under the Securities
      Act.




Lock-Up
      and Dribble Out Agreements .
      Most of
      our security holders have signed lock-up agreements (the “Lock-up Agreements”)
      restricting the sale of our securities and/or agreements that limit the number
      of shares sellable during specific time periods (“Dribble Out Agreements”). The
      lock-up period expired on September 30, 2005. At September 30, 2006, all
      contractual restrictions in the Lock Up Agreements on sales terminate. The
      Dribble Out Agreements apply to all the shares sold by us in private placements
      and Regulation S offerings during 2004 and 2005. Until the Dribble Out
      Agreements terminate, the Dribble Out Agreements limit the number of shares
      an
      investor may resell. The three types of Dribble Out Agreements provide that
      certain stockholders may for one year sell up to (1) 8.5% of the formerly locked
      up shares in any calendar month, (2) 25% of such shares during any 30-day
      period, or (3) 33% of such shares during any 30-day period, depending on which
      form of Dribble Out Agreement the investor signed .


The
        purchasers of shares of Common Stock we sold in 2006 also entered into
        agreements restricting the sale of those shares. These contractual restrictions
        are set to expire six (6) months after these shares are registered for resale.
        None of the shares sold in 2006 have been so registered. The Dribble Out
        Agreements with these investors provide that they may for one year sell up
        to
        25% of such shares during any 30-day period.





37







Market
      Price Decline and Low Trading Volume .
      Our
      stock is very thinly traded. The average trading volume for our Common Stock
      during October, November, December 2005, and early January 2006, during which
      time our stock was traded on the OTCBB, was approximately 16,900 thousand shares
      per day. Since the termination of the SEC’s suspension of trading of our
      securities on January 30, 2006 until July 3, 2006, the average trading volume
      for our Common Stock was approximately 1,900 shares per day. The number of
      shares that could be sold during this period was restrained by the lock-up
      agreements described above, while there was no similar contractual restraint
      on
      the number of buyers of our Common Stock. This means that market supply may
      increase more than market demand for our shares when the lock-up period expires.
      Many companies experience a decrease in the market price of their shares when
      a
      lock-up period terminates. For the first three days of October, trading volume
      substantially increased for several days to over 70,000 shares per day and
      our
      stock price declined substantially; for the first three days of November, our
      trading volume was approximately 17,500 shares per day and our stock price
      remained relatively stable; for the first three days of December, our trading
      volume was approximately 6,000 shares per day and our stock price remained
      relatively stable at about $7.60; and for the first three days of January,
      our
      trading volume was approximately 3,600 shares per day and our stock price
      remained relatively stable at about $8.90. Since the termination of the Order
      of
      Suspension of Trading issued by the SEC, our trading volume has ranged from
      0 to
      34,500 shares per day, while our stock price declined from $10.00 per share
      on
      January 13, 2006 to $1.90 per share on July 7, 2006. At the beginning of
      each month, certain people who sold stock during the preceding month are able
      to
      sell additional shares. If the volume of selling increases substantially at
      the
      beginning of each month, or at any other time in the future, the market price
      of
      our Common Stock is likely to decrease substantially.




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




Market
      conditions and market makers may cause your investment in our Common Stock
      to
      significantly diminish and may become very illiquid. Because our Common Stock
      is
      not listed on any national exchange or quoted in an “Over the Counter” market,
      the liquidity of an investment in our Common Stock has been reduced. Further,
      the suspension of trading on our securities may have significantly reduced
      the
      current and future market for buyers in our Common Stock. A reluctance of buyers
      to purchase our securities would limit the number of shares that could be sold
      by selling stockholders, and would significantly reduce the value of the
      stock.




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




**(55)
      Our Securities May Be Subject to “Penny Stock” Rules, Which Could Adversely
      Affect Our Stock Price and Make It More Difficult for You to Resell Our
      Stock.**




The
      SEC
      has adopted rules that regulate broker-dealer practices in connection with
      transactions in penny stocks. Penny stocks are generally equity securities
      with
      a price of less than $5.00 (other than securities registered on certain national
      securities exchanges or quoted on NASDAQ, provided that reports with respect
      to
      transactions in such securities are provided by the exchange or quotation system
      pursuant to an effective transaction reporting plan approved by the Commission.)
      We are subject to these rules because our Common Stock has ceased to be listed
      for trading on NASDAQ or quotation in any “Over the Counter”
markets.




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




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


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


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


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


•
            Defines
                significant terms in the disclosure document or in the conduct of
                trading
                penny stocks; and


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





38







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




•
            bid
                and offer quotations for the penny
                stock;


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


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


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




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





**Special
      Note Regarding**


**FORWARD-LOOKING
      STATEMENTS**




This
      Annual Report on Form 10-K contains forward-looking statements regarding our
      plans, objectives, expectations, intentions, future financial performance,
      future financial condition, and other statements that are not historical facts.
      You can identify these statements by our use of the future tense, or by
      forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,”
“intend,” “estimate,” “continue,” and other similar words and phrases. Examples
      of sections containing forward-looking statements include “Item 1. BUSINESS” and
“Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF OPERATIONS.” These forward-looking statements involve many risks and
      uncertainties. Examples of such risks and uncertainties are described under
      “Item 1A. RISK
      FACTORS ”
and
      elsewhere in this report, as well as in other filings we may make from time
      to
      time with the SEC. You should be aware that the occurrence of any of these
      risks
      and uncertainties may cause our actual results to differ materially from those
      anticipated in our forward-looking statements, which could have a material
      adverse effect on our business, results of operations, and financial condition.
      All forward-looking statements included in this report are based on information
      available to us as of the date of this report. We assume no obligation or duty
      to update any such forward-looking statements.





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





Our
      principal administrative, sales, marketing, and research and development
      facility is located in Durham, North Carolina near Research Triangle Park and
      consists of approximately 5,800 square feet of office space held under a lease
      that expires on October 31, 2006. We also lease approximately 4,800 square
      feet
      of office space in Des Moines, Iowa under a lease that expires on September
      30,
      2006; and approximately 6,800 square feet of office space in Grand Rapids,
      Michigan. The Michigan facility is currently leased on a month-to-month
      basis.





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





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





Smart
      Online, Inc. v. X.C.L. Partners, Inc. On
      November 10, 2005, we instituted a law suit in the General Court of Justice
      Superior Court Division in Wake County, North Carolina against X.C.L. Partners,
      Inc. (“XCL”) seeking a declaratory judgment determining that we did not enter
      into a contract with XCL. The parties settled the case on March 29, 2006 by
      a
“Release of All Claims and Confidentiality Agreement” pursuant to which XCL
      released us from any liability.





39








Suit
      Against Michael Nouri Regarding Smart Online, S.A. Approximately three and a half years ago, we petitioned (as is required under
      French law) a court in France to allow us to liquidate Smart Online S.A., a
      French subsidiary of Smart Online. As a result, we paid $113,056.83 to Smart
      Online S.A. in settlement of all claims against us. Recently, Michael Nouri,
      our
      President and CEO and the former President and CEO of Smart Online S.A., was
      sued personally as the legal representative of Smart Online S.A., which suit
      alleges that Smart Online S.A. suffered unspecified amounts of excess
      liabilities and seeks to hold Mr. Nouri personally responsible. The Liquidateur
      for Smart Online, S.A. has agreed to a proposal for settlement offered by Mr.
      Nouri in the amount of $15,000 Euros (approximately US $18,750 based on an
      exchange rate of US $1.27 per Euro). The case was presented to the court in
      France in early May of 2006 for final resolution, at which time the matter
      was
      scheduled for further hearing in July 2006. On
      June
      13, 2006, the commercial court validated the settlement agreement, but the
      court
      did not register the withdrawal of the claim by the Liquidateur. This matter
      was
      further continued until October 19, 2006. The
      court
      has final approval of the agreement. There can be no assurance this agreement
      will result in a final settlement on these terms. Our Board of Directors has
      authorized us to indemnify Mr. Nouri for the amount of any settlement and all
      legal costs and fees and other expenses associated with the defense of Mr.
      Nouri
      in relation to this matter, because Mr. Nouri was acting on our behalf in the
      liquidation of its French subsidiary.





Order
        of Securities and Exchange Commission Suspending the Trading of Smart Online
        Securities .
        On
        January 17, 2006, the Securities and Exchange Commission (the “SEC”) temporarily
        suspended the trading of the securities of the Company. In its “Order of
        Suspension of Trading,” the SEC stated that the reason for the suspension was a
        lack of current and accurate information concerning our securities because
        of
        possible manipulative conduct occurring in the market for the our stock By
        its
        terms, that suspension ended on January 30, 2006 at 11:59 p.m. EST. As a
        result
        of the SEC’s suspension, NASDAQ
        withdrew its acceptance of our application to have our common stock traded
        on
        the NASDAQ Capital Market Simultaneously with the suspension, the SEC advised us that it is conducting
        a
        non-public investigation. While we continue to cooperate with the SEC, w e
        are
        unable to predict at this time whether the SEC will take any adverse action
        against us. See
        Item
        3 of this report and Risk Factors (43) and (50) for additional information
        regarding the SEC action .
 
 Audit
        Committee Internal Investigation of Matters Related to the SEC Suspension
        and
        Investigation. In March
        2006, our Board of Directors authorized its Audit Committee to conduct an
        internal investigation of matters relating to the SEC suspension and
        investigation. The Audit Committee retained independent outside legal counsel
        to
        assist in conducting the investigation. On July 7, 2006, the independent
        outside
        legal counsel shared final findings with the Audit Committee, which were
        then
        shared with the full Board of Directors. The Audit Committee did not conclude
        that any of our officers or directors have engaged in fraudulent or criminal
        activity. However, it did conclude that we lacked an adequate control
        environment, and has taken action to address certain conduct of management
        that
        was revealed as a result of the investigation. The Audit Committee concluded
        that the control deficiencies primarily resulted from our transition from
        a
        private company to a publicly reporting company and insufficient preparation
        for, focus on and experience with compliance requirements for a publicly
        reporting company. As one of the results of these findings, Mr. Jeffrey LeRose
        was appointed to the position of non-executive Chairman of the Board of
        Directors to separate the leadership of the Board of Directors from the
        management of the Company, which is a recommended best practice for solid
        corporate governance. Mr. Nouri has stepped down as Chairman of the Board
        of
        Directors, but will continue to serve as our president, chief executive officer
        and as a member of the Board of Directors. A discussion of the significant
        deficiencies that were identified by the Audit Committee and related remediation
        efforts can be found in Item 9A of this report.


**ITEM
      4.** **SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS**




During
      the fourth quarter of the year ended December 31, 2005, security holders did
      not
      meet or take any action by written consent.





**PART
      II**





**ITEM
      5.** **MARKET
      FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERS
      MATTERS**





The
      principal United States market in which our shares of Common Stock was quoted
      for trading is the Over-the-Counter Bulletin Board (the “OTC-BB”), which is
      operated by the NASD.





Shares
      of
      our Common Stock were approved for quotation on the OTC-BB on March 15, 2005.
      Trading began in April 2005, and continued through December 31, 2005. The high
      and low quotations for our common stock were as follows:





**Quarter
                Ended**
            **June
                30, 2005**
            **September
                30, 2005**
            **December
                31, 2005**
            **Year**High
            $8.20
            $11.50
            $11.25
            $11.50Low
            $1.50
            $8.00
            $6.30
            $1.50





As
      is
      described in “ITEM 3. LEGAL PROCEEDINGS,” the SEC suspended trading in shares of
      our Common Stock and is conducting an investigation into possible manipulative
      trading in our Common Stock. According to the order, the
      SEC
      believed that there was a lack of current and accurate information concerning
      our securities because of possible manipulative conduct occurring in the market
      for our stock. If
      such
      manipulation occurred, the prices disclosed above may be higher than would
      have
      been the case if manipulation had not occurred. In addition, low trading volume
      and the contractual restrictions on resale of a majority of the shares of our
      Common Stock (which are described in “ITEM 1A. RISK FACTORS,” Risk Factor (54))
      may mean that the prices disclosed above are higher than they would be if
      trading volumes were higher and contractual restrictions on resale did not
      exist.





As
      of
      July 7, 2006, there were approximately 315 record holders of 16,679,031
      shares of our Common Stock. On July 3, 2006, the high and low trading price
      for
      our common stock was $2.75 and $2.00 per share, respectively, on a volume of
      3,850 shares.





We
      have
      never declared or paid any cash dividends on our Common Stock and does not
      intend to declare or pay dividends for the foreseeable future.





40








See
“ITEM
      11. EXECUTIVE
      COMPENSATION - Equity
      Compensation Plans” for a description of our equity compensation
      plans.




During
      the year ended December 31, 2005 and to date in 2006, we made the following
      sales of securities, which were not registered under the Securities Act of
      1933,
      as amended. All proceeds of all sales were used to repay indebtedness and for
      working capital purposes.




(1) From
      February to March of 2005, we sold 605,000 shares of our common stock and
      warrants to purchase 50,000 shares of our common stock for an aggregate gross
      purchase price of $3,275,000 to four (4) investors. Only one investor received
      warrants, and those warrants had an exercise price of $5.00 per share. We
      incurred issuance costs of $290,000 related to these stock sales. See “Note 11”
to “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for information about
      the registration rights penalty payable to these stockholders.





(2) From
      July
      to September of 2005, we sold 786,642 shares of our common stock for an
      aggregate gross purchase price of $4,326,531 to twenty-eight (28) investors
      pursuant to a private offering. We
      incurred issuance costs totaling $340,525 related to these stock sales. See
      “Note 11” to “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for
      information about the registration rights penalty payable to these
      stockholders.




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




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




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


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


41








**ITEM
      6** **.
      5-YEAR SUMMARY OF HISTORICAL SELECTED FINANCIAL DATA FOR SMART ONLINE,
      INC.**





The
      following table sets forth the periods indicated, selected consolidated
      financial data that has been derived from our audited financial statements
      for
      the years ended December 31, 2005, 2004, 2003 and 2002, and unaudited financial
      statements for the year ended December 31, 2001. The following selected
      financial data should be read in conjunction with our financial statements
      and
      related notes thereto, and with “Item 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS .”





**Income
      Statement Data**




2005
                
                2004
                
                2003
                
                2002
                
                2001Revenues
                
                $
                2,701,976
                
                $
                1,002,970
                
                $
                1,261,223
                
                $
                1,391,645
                
                $
                3,193,078Loss
                    from Operations
                
                $
                (16,066,829
                )
                $
                (2,801,935
                )
                $
                (1,865,282
                )
                $
                (999,765
                )
                $
                (1,993,879
                )Net
                    Loss Attributable to Common
                  Stockholders
                
                $
                (15,590,609
                )
                $
                (8,319,049
                )
                $
                (4,375,836
                )
                $
                (1,766,606
                )
                $
                (1,994,203
                )Net
                    Loss per Share - Basic and Diluted
                
                $
                (1.20
                )
                $
                (0.82
                )
                $
                (0.61
                )
                $
                (0.25
                )
                $
                (0.27
                )Number
                    of Shares Used in Per Share
                  Calculation
                
                
                12,960,006
                
                
                10,197,334
                
                
                7,145,047
                
                
                7,181,759
                
                
                7,286,965
  BALANCE
                  SHEET
                  DATA
                
                As
                    of December 31,2005
                
                2004
                
                2003
                
                2002
                
                2001Total
                    Assets
                
                $
                14,558,079
                
                $
                773,701
                
                $
                306,072
                
                $
                252,579
                
                $
                724,349Long-term
                    Obligations
                
                $
                2,963,289
                
                $
                1,091,814
                
                $
                1,193,211
                
                $
                958,925
                
                $
                722,309Redeemable
                    Preferred Stock
                
                $
                -
                
                $
                -
                
                $
                17,509,214
                
                $
                14,692,150
                
                $
                12,128,130Stockholders'
                    Equity (Deficit)
                
                $
                6,672,631
                
                $
                (1,911,090
                )
                $
                (22,014,156
                )
                $
                (19,268,323
                )
                $
                (15,864,201
                )





**ITEM
      7. MANAGEMENT’S DISCUSSION AND ANALYSIS**


**OF
      FINANCIAL CONDITION AND RESULTS OF OPERATIONS**





*The
      following discussion in Management’s Discussion and Analysis of Financial
      Condition as Results of Operations (“MD&A”) and elsewhere in this report
      contains forward-looking statements within the meaning of Section 27A of the
      Securities Act of 1933 and Section 12E of the Securities Exchange Act of 1934.
      Forward-looking statements consist of, among other things, trend analyses,
      statements regarding future events, future financial performance, our plan
      to
      build our business and the related expenses, our anticipated growth, trends
      in
      our business, the effect of interest rate fluctuations on our business, the
      potential impact of current litigation or any future litigation, the potential
      availability of tax assets in the future and related matters, and the
      sufficiency of our capital resources, all of which are based on current
      expectations, estimates, and forecasts, and the beliefs and assumptions of
      our
      management. Words such as “expects,“ “anticipates,” “projects,” “intends,”
“plans,” “estimates,” variations of such words, and similar expressions are also
      intended to identify such forward-looking statements. These forward-looking
      statements are subject to risks, uncertainties and assumptions that are
      difficult to predict. Therefore, actual results may differ materially and
      adversely from those expressed in any forward-looking statements. Readers are
      directed to risks and uncertainties identified above, under “Risk Factors” in
      Item 1A and elsewhere in this report, for factors that may cause actual results
      to be different than those expressed in these forward-looking statements. Except
      as required by law, we undertake no obligation to revise or update publicly
      any
      forward-looking statements for any reason.*





**Overview**





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





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








42





**Recent
      Developments.**





**Financing
      Activities**.  In March 2006, we sold 400,000 shares of its
      common stock to an existing investor for a price of $2.50 per share resulting
      in
      gross proceeds of $1,000,000. We incurred immaterial issuance costs related
      to
      this stock sale. As part of this sale, the existing investor received
      contractual rights to purchase shares at a lower price should we enter into
      a
      Private Placement Agreement in the future with a per share price less than
      $2.50
      per common share. In
      connection with this financing, Berkley Financial Services, Ltd. may claim
      that
      it is entitled to a fee of $100,000 under an investment banking letter agreement
      dated February 23, 2005.





During
        the first half of 2006, we, through our wholly-owned subsidiary Smart CRM,
        Inc.,
        entered into multiple factoring agreements. The factoring arrangements resulting
        in gross aggregate proceeds of approximately $623,000 and a debt payable
        to the
        factor in the total amount of approximately $729,000. The interest rate related
        to these arrangements is fixed at 10.5% and the debt will be paid off over
        the
        lives of the factored contracts which range from 28 to 44 months. These
        factoring agreements provide for a security interest in equipment provided
        to
        customers, if such equipment is provided under the factored contracts. Should
        any customer fail to make their scheduled payments, Smart CRM, Inc. will
        be
        liable to the factor for the full amount of the interest assigned to the
        factor.
        Such factoring agreements are typical and within the normal course of business
        for Smart CRM and its predecessor corporation, Computility. Smart CRM purchased
        the assets of Computility on October 4, 2005. Prior to being purchased by
        Smart
        CRM, Computility factored the majority of their contracts.
  In
      June
      2006, we sold 400,000 shares of its common stock to an existing investor for
      a
      price of $2.50 per share resulting in gross proceeds of $1,000,000. we incurred
      immaterial issuance costs related to this stock sale. In
      connection with this financing, Berkley Financial Services, Ltd. may claim
      that
      it is entitled to a fee under an investment banking letter agreement dated
      February 23, 2005.





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





**Market
      Launch of Bundles of Applications on Our OneBiz** **SM** **Platform.** In
      November of 2005, we began selling our software in bundles of applications
      for
      small business subscribers on our OneBiz SM platform.





We
      derive
      subscription revenue primarily from our stand alone SFA/CRM application, our
      stand alone e-Commerce application. At the end of 2005, we began to generate
      a
      small amount of revenue from subscriptions to our main portal,
      www.SmartOnline.com. As compared to mid-January 2006, the number of subscribers
      to our software products at our main portal www.SmartOnline.com has declined.
      We
      do not know what has caused this decline. Some customers have indicated they
      had
      difficulty accessing our software applications on our website. Consequently,
      we
      recently redesigned our website and product bundling to address this problem.
      We
      are also incorporating feedback from both customers and an outside accounting
      consultant to improve our Accounting application. Since we do not know the
      cause
      for the decline in customers, we have no assurance that the steps we are taking
      will solve this problem. If the decline is not reversed, we may not be able
      to
      survive.





**Acquisition
      of Computility and iMart.** During
      October 2005, we acquired substantially all of the assets of Computility, Inc.,
      a privately held developer and distributor of sales force automation and
      customer relationship management software based in Des Moines, Iowa. We operate
      this SFA/CRM business under the name Smart CRM, Inc. doing business as
      Computility, Inc. Also during October 2005, we acquired all the stock
      of iMart Incorporated, a privately held developer and distributor of
      multi-channel e-commerce systems based in the Great Lakes region of the United
      States. We operate this e-Commerce business under the name Smart Commerce,
      Inc.





iMart
      had
      approximately $3.4 million of revenue during 2004, and $2.9 million (unaudited)
      for the nine months ended September 30, 2005; and Computility had approximately
      $2 million of revenue during 2004, and $1.5 million (unaudited) for the nine
      months ended September 30, 2005. Revenues for both companies increased during
      the past two years.




Both
      companies have customers to whom we will seek to cross-sell our other software
      applications. We expect to begin our cross-selling efforts with these customers
      by the second half of 2006 .
      We have
      to continue selling the e-Commerce and SFA/CRM software applications we acquired
      in a manner similar to how they were sold prior to the acquisition. During
      May
      2006, we integrated simplified versions of certain portions of the SFA/CRM
      software into our application suite, which is now available on our website
      www.smartonline.com. We are currently evaluating whether to integrate our
      e-Commerce application into our application suite during 2006 or
      2007 .




The
      initial effect of these acquisitions on our working capital has been negative
      with approximately $200,000 negative cash flow through December 31, 2005 and
      approximately $340,000 cumulative, net negative cash flow through May 31, 2006.
      Substantial expenses
      were incurred in professional fees in connection with these transactions, and
      substantial amounts will be incurred in integrating the acquired
      companies. Because
      we did not acquire substantial accounts receivables in these
      acquisitions, they have initially resulted in greater working capital needs.
      In
      addition, the obligations to make installment payments during 2006 and 2007
      presents a substantial drain on our capital resources and will require us to
      raise additional capital, which will be difficult because of the effects of
      the
      SEC investigation described above. Because Computilty sold its contracts for
      65%
      of future contract revenues to fund its operations prior to our acquisition,
      and
      we assumed approximately $1.9 million of Computility indebtedness, we will
      receive only 35% of the revenue from the Computility contracts for which we
      are
      required to provide services. The effects of these acquisitions on our liquidity
      and capital resources is described in greater detail under “Liquidity and
      Capital Resources,” below.





43








The
      acquisitions present both opportunities and risks for us. See “ITEM 1A. RISK
      FACTORS ”
Numbers
      (14) and (15) for discussion of certain risks associated with the
      acquisitions. For
      historical and pro forma financial information about Smart Online, iMart and
      Computility, see “ITEM 6. SELECTED
      FINANCIAL DATA ”
and
      “ITEM 8. FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA .”





**Computility
      Acquisition Terms.** In
      consideration for the purchased assets, we issued the seller 484,213 shares
      of
      our Common Stock and assumed certain liabilities of Computility totaling
      approximately $1.9 million.  Of the total shares issued, 84,213 were
      delivered to Computility at the closing of the acquisition and 400,000 are
      being
      held in escrow to cover certain indemnification provisions of Computility.
      In
      addition, two key employees of Computility entered into employment agreements
      with Smart CRM, Inc., a wholly owned subsidiary, pursuant to which the two
      can
      each earn up to a total of $91,800 over and above their base compensation during
      the fifteen months ending December 31, 2006, if certain performance goals are
      achieved. Also as part of these employment agreements, we paid these two key
      employees $45,000 each in October of 2005 in exchange for their covenants not
      to
      compete. These two employees were each granted an option to purchase 75,000
      shares of our common stock. Each of the options vest and become exercisable
      in
      six equal, quarterly increments of 12,500 shares upon the achievement of certain
      quarterly performance milestones.





Historically,
      Computility derived substantially all of its revenue from software and hardware
      subscription agreements which typically have 3-year terms with substantial
      penalties for early termination. Until the date of the acquisition, Computility
      factored substantially all of its subscription agreements and received
      approximately 65% of the expected cash flow from the subscription period upfront
      and used the cash to fund on-going operations. As a result of the factor
      arrangements, we are required to provide services to the customers, but receives
      approximately 35% of the corresponding customer payments to fund ongoing
      operations. The remaining 65% of the monthly customer payments is being used
      to
      offset approximately $1.9 million of the factor liabilities of Computility
      assumed by us. In addition, the shares issued as part of the purchase price
      are
      being held in escrow secure the customer payments used to offset this
      pre-acquisition factoring liability, which was not assumed by us. As a result
      of
      the factoring activity of Computility, the acquisition resulted in an
      approximate $116,000 increase in cash expenditures for us from the date of
      acquisition through December 31, 2005. Smart CRM has continued to factor
      contracts in the ordinary course of business as it deems appropriate. Based
      on
      contracts signed as of December 31, 2005, we have provided approximately
      $50,000 of working capital per month to help fund operations during the first
      quarter of 2006, and management expects that this amount will decrease modestly
      throughout 2006.





**iMart
      Acquisition Terms.** We
      issued
      to iMart’s stockholders 205,767 shares of our Common Stock and agreed to pay
      iMart’s stockholders approximately $3,462,000 in cash installments. This amount
      is payable in four equal payments of $432,886 on the first business day of
      each
      of January 2006, April 2006, July 2006 and October 2006. The remaining
      $1,731,465 is payable in January 2007. In addition, we are to pay $780,000
      for
      non-competition agreements to key personnel of the acquired company in eight
      equal quarterly installments during the period beginning in January 2006 and
      ending October in 2007. The purchase price installment payments are secured
      by
      the net proceeds of customer contracts of iMart, which will limit our ability
      to
      use cash derived from iMart revenue in our business until installment payments
      are paid in full to iMart shareholders and employees. The former CEO of iMart
      has contractual rights to operate Smart Commerce, Inc. within agreed financial
      parameters. See “Note 17 of Notes to Financial Statements” for a summary of the
      iMart acquisition terms.





The
      effect of the Computility acquisition and the iMart acquisition on our cash
      resources and needs is being determined as we develop a history of operating
      the
      acquired entities. However, substantial expenses were incurred in professional
      fees in connection with these transactions, and substantial amounts will be
      incurred in integrating the acquired companies. The acquisitions have initially
      resulted in greater working capital needs as we have not acquired substantial
      accounts receivables. Management believes these acquisitions will eventually
      result in positive cash flow to us, but the initial effect on our working
      capital has been negative. The acquisitions present both opportunities and
      risks
      for us. See “ITEM 1A. RISK
      FACTORS ”
Numbers
      (14) and (15) for discussion of certain risks associated with the
      acquisitions.





For
      historical and pro forma financial information about Smart Online, iMart and
      Computility, see “ ITEM 6. SELECTED
      FINANCIAL DATA ”
and
      “ ITEM 8. FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA .”





**Accounting
      Software Acquisition Terms** . During
      August 2005, we acquired rights to an accounting software engine from a software
      development company and co-developed our accounting software application with
      that developer. We have exclusive rights to the accounting application, and
      non-exclusive rights to the software engine included in the application. In
      connection with this agreement, we agreed to pay the developer up to $512,500
      and issue up to $287,500 worth of our common stock based upon the developer
      attaining certain milestones. As of December 31, 2005 the developer had earned
      and been paid $210,000 ($180,000 in cash and $30,000 of our common stock).
      Although this product was integrated into the OneBiz SM application suite in December 2005, we did not accept the completion of the
      software application because, in our judgment and based on feedback we received
      from both customers and an accounting consultant, certain modifications and
      features were needed to improve the accounting application. As a result, we
      are
      continuing to work with the software development company to complete and improve
      the accounting application. We have deposited $37,500 into escrow, which
      will be released to the software development company upon acceptance of the
      accounting application, with the remaining money and stock to be paid at
      acceptance, 90 days after acceptance and 180 days after acceptance.





44








**SUMMARY**





**Software
      Applications**





During
      2005, we made significant improvements to our applications and the
      OneBiz SM platform, including
      enhancements to its dashboard and adding additional software applications.
      We
      plan to do the same in the first half of 2006, including improving our
      accounting application. We also recently redesigned our website to provide
      greater ease-of-use. These enhancements include a combination of internal
      development, joint development, licensing from other companies, and
      acquisitions. Our new applications and the OneBiz SM platform
      were released in three versions. The first version was released during the
      first
      quarter of 2005. We began offering our primary products as part of the second
      version of our new applications in November 2005.  At present, all of the
      new applications are only offered on our website and most of the new
      applications through one syndication partner, but we plan to migrate all of
      the OneBiz SM applications to our syndication sites when we have completed refining and
      improving these applications. The third version of our new applications and
      the OneBiz SM platform was
      released at the end of the fourth quarter 2005. In May of 2006, we integrated
      a
      simplified version of certain of our SFA/CRM software applications we acquired
      in October of 2005 into our application suite, and we are evaluating whether
      we
      should integrate certain e-Commerce application into our application suite
      during 2006 or 2007.





Since
      2000, our major focus has been on developing and validating our online content,
      applications, services, delivery platform and user interface. To validate the
      platform, services, and products, many customers received access to our products
      and portal free-of-charge. This enabled us to obtain customer evaluation and
      feedback. We terminated this policy in October of 2005, and are developing
      targeted programs to market and sell subscriptions to our software
      applications.





During
      2005, we recognized approximately $2.7 million of revenue. In addition, we
      had
      deferred revenue of approximately $785,000 at December 31, 2005. We recognized
      revenue totaling approximately $1.0 million in 2004 and approximately $1.3
      million in 2003. During 2005, we entered into one new integration agreement
      totaling $320,000. We need to substantially increase our advertising and
      marketing in future years based on our abilities to fund these initiatives,
      but
      any such increase is dependent on our ability to raise capital in 2006. An
      effect of the recent SEC action on our operations has been, and will continue,
      to delay some of these initiatives. In 2004, we started to enter into
      syndication partnerships that target strategic partners for bartering
      arrangements for advertising and joint marketing programs to take advantage
      of
      discounted advertising rates and to provide an opportunity for us to share
      in
      the revenue generated by our syndication partners from use of our platform.
      We
      began targeting small business media companies during the first quarter of
      2004,
      such as Inc. Magazine, FastCompany Magazine, and BusinessWeek, who have
      small-business customer bases. As of July 7, 2006, neither we nor our
      syndication partners have received substantial revenue from the revenue sharing
      arrangements. We will seek to create these arrangements in the future with
      media
      companies who offer the ability to reach small-business customers and assist
      in
      off-setting our cash expenditures for print and online advertising and
      marketing. While we intend to derive a majority of our syndication revenue
      from
      traditional non-barter transactions, we will evaluate barter transactions on
      a
      case-by-case basis when we believe such transactions make economic or strategic
      sense. Pursuant to the requirements of Emerging Issues Task Force (EITF) No.
      93-11, *Accounting
      for Barter Transactions Involving Barter Credits* ,
      and
      EITF 99-17, *Accounting
      for Advertising Barter Transactions* ,
      for the
      year ended December 31, 2005, we recognized approximately $424,000 of barter
      revenue.





To
      increase our revenues and take advantage of our market opportunity, we will
      need
      to add substantial numbers of paying subscribers. However, since the beginning
      of 2006, there has been a decrease in the number of paying subscribers at our
      main portal, www.smartonline.com. The
      planned increase in marketing efforts will depend on us raising additional
      capital, which is more difficult then in the past because of the SEC action’s
      effect on the price and volume of trading of shares of our common
      stock .





If
      we are
      able to raise additional capital, we target sales and marketing costs, which
      included third-party advertising and marketing expenses of approximately
      $404,000, $171,000, and $130,000 for 2005, 2004, and 2003, respectively, to
      increase substantially in dollars and as a percent of total expenses in the
      future as we seek to add and manage more paying subscribers, build brand
      awareness and increase the number of marketing and sales programs implemented.
      Through the first quarter of 2006, we have incurred sales and marketing costs
      of
      approximately $175,000.








45





**Fiscal
      Year**





Our
      fiscal year ends on December 31. References to fiscal 2005, for example, refer
      to the calendar year ended December 31, 2005.





We
      currently derive revenues from the following sources:





·
            Subscription
                fees - Monthly fees charged to customers for access to our suite
                of
                applications, including those applications acquired in the iMart
                and
                Computility acquisitions.





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





·
            Syndication
                Fees - fees consisting of:





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





o
            Barter
                revenue derived from syndication agreements with media
                companies.




·
            Professional
                Service Fees





·
            OEM
                Revenues





Our
      syndication agreements provide that we receive a percentage of the revenue
      generated by our partners from their websites, but neither we nor our
      syndication partners have received any substantial revenue from these revenue
      sharing agreements. These agreements also include bartering arrangements for
      advertising and joint marketing programs to take advantage of discounted
      advertising rates and to provide an opportunity for revenue sharing. These
      partnerships mean that our products could be accessed by small business
      prospects who use the websites of our syndication partners, but we must devise
      ways to more actively sell to these potential users. We embarked on this program
      based on the success of the revenue share strategy, illustrated by Google,
      Overture Services, and CareerBuilder, where media companies provide these
      services to their customers to increase revenue for both companies. We began
      targeting small business media companies during the first quarter of 2004,
      such
      as Inc. Magazine, FastCompany Magazine, and Business Week, who have small
      business customer bases. We expect to create certain types of these arrangements
      in the future with media companies who offer the ability to reach small business
      customers and will assist in off-setting our outlay of cash for more costly
      print and online advertising and marketing. While we intend to derive a majority
      of our syndication revenue from traditional non-barter transactions, we will
      evaluate barter transactions on a case-by-case basis when we believe such
      transactions make economic or strategic sense. In addition, we have embarked
      on
      a telesales effort to up sell current users to additional services and to bring
      former users back to us, but the number of subscribers to our main portal has
      declined since mid-January of 2006. We are planning to engage in cross selling
      our services to customers of the two businesses we acquired in October of 2005
      as part of our integration process. However, this initiative is not in place
      as
      we focus on other aspects of the integration. We expect to start the process
      of
      cross-selling during the second half of 2006.





Subscription
      revenues are comprised of sales of subscriptions directly to end-users, or
      to
      others for distribution to end-users, hosting and maintenance fees, and
      e-commerce website design fees. Subscription sales are made either on a
      subscription or on a “for fee” basis. Subscriptions, which include access to
      most of our offerings are payable in advance on a monthly basis and are targeted
      at small companies or divisions of large companies. Additional time is required
      to leverage existing and new syndication partners and to invest more on
      marketing and sales before significant revenue is generated.  During
      past years, most of our users have been given free use of our products for
      extended time periods. During the fourth quarter of 2005, we changed that policy
      to a limited 30-day free use period, after which we terminate access for users
      who fail to become paid subscribers. We expect lower fees from subscribers
      at
      the private label syndication websites of our partners since our agreements
      call
      for us to share revenue generated on each respective site. We began to offer
      our
      suite of OneBiz SM software
      applications on November 4, 2005 on our own website, and we plan to migrate
      all of the OneBiz SM applications to our syndication sites when we have completed refining and
      improving these applications.  In May of 2006, we released a simplified
      version of our SFA/CRM application as part of the subscription to our suite
      of
      applications available on our core website. We are evaluating whether we can
      integrate certain parts of our new e-Commerce software applications into our
      application suite during 2006. Until then, these applications will be offered
      only on a “for fee” basis.  Customers can also purchase for one-time use of
      a specific software or content service. On our core website, we are in the
      process of phasing out “a la carte” pricing and substituting our
      OneBiz SM suite of
      applications for these services. Eventually, we intend to do the same for our
      syndication partners. At this time, we are still selling certain services on
      a
“for fee” basis, such as the applications we acquired from Computility and
      iMart, and on an “a la carte” basis. Since
      mid-January 2006, the number of subscribers to our software products at our
      main
      portal has declined, but we do not know the precise reasons for this decrease,
      but through customer feedback, we recently learned of a problem accessing our
      services. As a result, we recently redesigned our website to increase its
      ease-of-use and we are considering improving our software applications to make
      them more attractive to customers. This redesigned site was launched on May
      15,
      2006, and it is till too early to determine if these efforts will reverse this
      decline.





46








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





Additionally,
      we receive a portion of third-party sales of products and services by our
      integration partners through revenue sharing arrangements, which involves a
      split of realized revenues. Hosting and maintenance fees are charged for
      supporting and maintaining the private-label portal and providing customer
      and
      technical support directly to our syndication partner’s users and are recognized
      on a monthly basis. E-Commerce website design fees which are charged for
      building and maintaining corporate websites or to add the capability for
      e-Commerce transactions, are recognized over the life of the project. Domain
      name registration fees are recognized over the term of the registration period.





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





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





**Revenue
      From Related Parties**





Approximately
      0%, 32.9%, and 27.2% of total revenues for the years ended December 31, 2005,
      2004, and 2003, respectively, were from a single customer, Smart IL Ltd.
      (“SIL”), formerly known as Smart Revenue Europe Ltd., an Israel based software
      company that specialized in secured instant messaging products. During March
      2004, SIL ceased further development of its technology and laid-off all
      employees after SIL completed development of, and delivered to us, its instant
      messenger product. SIL is currently seeking to license or sell its technology;
      however, we do not expect to receive substantial revenue from SIL in the future.
      SIL is owned by Doron Roethler, one of our stockholders.





On
      August
      13, 2002, we entered into an integration agreement with SIL to incorporate
      its
      products into our platform. As part of this agreement, SIL paid $300,000 for
      such integration, and the parties agreed to share future revenues generated
      from
      the sales of the products. On August 30, 2002, the parties signed
      an amendment to the original agreement, in order for us to provide SIL
      certain co-development services, which includes instant messenger and video
      conferencing. In exchange, SIL paid us an additional $300,000. On April 30,
      2003, we signed a new amendment with SIL and restated the integration program
      agreement. According to this new amendment and restated agreement, we agreed
      to
      fund the future development of the products, and increased SIL’s obligation by
      $200,000 to a total of $800,000. In exchange, SIL agreed to limit future amounts
      payable by us under the original share revenue agreement to $1.7 million. This
      cap on revenue sharing was removed by amendment on October 29,
      2003.





In
      addition to the agreements described above, on August 30, 2002, we also entered
      into a reseller agreement with SIL whereby SIL paid us $200,000 for nonexclusive
      rights to distribute our products in certain foreign territories in exchange
      for
      our marketing support and a twenty percent commission from the gross sales
      generated by SIL. Under the terms of this agreement, we are to collect the
      revenue, if any, from its customers and then make the required payments to
      SIL.
      On May 1, 2003, this reseller agreement was terminated. However, under the
      terms
      of that termination agreement, certain payment obligations of us to SIL survive
      termination with regard to a limited number of prospective business candidates.
      We expect no revenue from SIL, unless SIL hires employees to sell our products.
      We do not know whether SIL intends to hire employees to sell our
      products.





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





47








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





Approximately
      0%, 0% and 11.9% of total revenues for the year ended December 31, 2005, 2004
      and 2003, respectively, were from a third related company, Parson and Shearson,
      Inc., which is owned 50% by our Chief Executive Officer, Michael Nouri, and
      50%
      by his brother, Eric Nouri, who is also one of our employees. This revenue
      related to services performed by us for the development of web-based human
      resources and inventory applications for Parson and Shearson. Parson and
      Shearson has paid in full for all services and has no outstanding amounts
      payable to us.





The
      following is a summary of related party revenues for years ended December 31,
      2005, 2004 and 2003.





**Year
                Ended**
              **DECEMBER
                31, 2005**
            
            **Year
                Ended**
              **DECEMBER
                31, 2004**
            
            **Year
                Ended**
              **DECEMBER
                31, 2003**Smart
                II, Ltd. ("SIL"), formerly known as Smart Revenue Europe
              Ltd.
                - Integration fees
            
            $
            0
            
            $
            330,050
            
            $
            342,857Parson
                and Shearson, Inc. -
              Consulting
                Services
            
            
            0
            
            
            0
            
            
            150,000Small
                Business Lending Institute
              Consulting
                Services
            
            
            0
            
            
            0
            
            
            20,200Total
                Related Party Revenues
            
            $
            0
            
            $
            330,050
            
            $
            513,057




Accordingly,
      approximately 0%, 32.9% and 40.7% of total revenue in 2005, 2004 and 2003 were
      derived from related parties. We expect revenue from related parties will not
      continue to be a significant part of our revenue. If we fail to replace revenue
      from related parties with revenue from unrelated parties, our revenue will
      decrease.





**Cost
      of Revenues**





Historically,
      we have not capitalized any costs associated with the development of our
      products and platform. SFAS No. 86, *Accounting
      for the Costs of Software to be Sold, Leased or Otherwise
      Marketed* ,
      requires capitalization of certain software development costs subsequent to
      the
      establishment of technological feasibility. Based on our product development
      process, technological feasibility is established upon completion of a working
      model. Costs related to software development incurred between completion of
      the
      working model and the point at which the product is ready for general release
      have been insignificant. Cost of revenues is comprised primarily of salaries
      and
      related employee expenses associated with employees who provide maintenance
      and
      support services. Additionally, during 2005, a portion of cost of revenues
      included third-party fees.





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





48





**Operating
      Expenses**





During
      2005, 2004, and 2003 our efforts were primarily focused on product development
      and integration. We employed approximately 13 and 18 full-time equivalent
      development employees during 2003 and 2004, respectively. During 2005, we
      completed two acquisitions and hired additional development and sales staff
      bringing the total to 72 full-time employees at December 31, 2005. As of July
      7,
      2006, we had 65 employees. Most employees performed multiple
      functions.





*Research
      and Development* .
      We have
      historically focused our research and development activities on increasing
      the
      functionality and enhancing the ease of use of our on-demand application
      service. For example, we are working to improve our accounting application
      and
      we are currently re-designing our website to increase the ease of accessing
      our
      services. Because of our proprietary, scalable and secure multi-user
      architecture, we are able to provide all customers with a service based on
      a
      single version of our application. As a result, we do not have to maintain
      multiple versions, which enables us to have relatively low research and
      development expenses as compared to traditional enterprise software business
      models. We expect that in the future, research and development expenses will
      increase substantially in absolute dollars as we upgrade and extend our service
      offerings and develop new technologies. We expect this to be particularly true
      during 2006 as we integrate the products we acquired from recent acquisitions
      into our application suite and continue to enhance the OneBiz SM platform.





*Marketing
      and Sales* .
      During
      2005, 2004, and 2003, we have spent limited funds on marketing, advertising,
      and
      public relations. During the first two quarters of 2005, we incurred marketing
      and selling expenses of approximately $290,000 per quarter. Marketing and
      selling expenses increased to approximately $375,000 and $467,000 in the third
      and fourth quarter of 2005, respectively. We expect these expenditures to
      increase significantly, assuming we are successful in raising capital, in 2006
      as we launch and begin marketing our latest version of the applications. From
      January through March of 2006, we have spent approximately $175,000 on these
      activities. We have also embarked on an effort to develop programs where media
      companies provide our Private Label Syndication services to their small business
      end users. We began targeting small business media companies in the first
      quarter of 2004, such as Inc. Magazine, FastCompany Magazine, and Business
      Week,
      who have small business customer bases. The strategy has been to implement
      Private Label Syndication platforms in exchange for advertising and joint
      marketing programs with these companies. We expect to create certain types
      of
      these arrangements in the future with media companies who offer the ability
      to
      reach small business customers and will assist in off-setting our outlay of
      cash
      for print and online advertising and marketing while providing reduced
      advertising prices. Media companies are requesting such services to assist
      in
      driving additional revenue.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. If we are
      successful in raising additional capital in 2006, we plan to increase
      penetration within our existing customer base, expand our domestic selling
      and
      marketing activities, build brand awareness and participate in additional
      marketing programs. If we are able to raise additional capital, we expect that
      in the future, marketing and sales expenses will increase in absolute dollars
      and will be a significant cost. However, we anticipate that raising such capital
      will be difficult, and we can offer no assurances that we will be successful
      in
      our efforts to do so.





*General
      and Administrative* .
      General
      and administrative expenses consist of salaries and related expenses for
      executive, finance and accounting, legal, human resources, and information
      technology personnel, professional fees, and other corporate expenses, including
      facilities costs. General and administrative expenses have increased and will
      continue to increase as we add personnel and incur additional professional
      fees
      and insurance costs related to the growth of our business and to our operations
      as a public company. Non-recurring general and administrative expenses will
      also
      increase as a result of the SEC’s suspension of trading of our securities, the
      continuing SEC action, and the internal investigation of matters relating to
      that suspension.





*Stock-Based
      Expenses* .
      Our
      operating expenses include stock-based expenses related to options and warrants
      issued to employees and non-employees. These charges have been significant
      and
      are reflected in our historical financial results. In addition, in connection
      with the issuance of 1,273,000 shares of our Common Stock issued pursuant to
      investor relations services contracts, including 1,250,000 of which were
      incurred in the fourth quarter of 2005, we have incurred non-cash expenses
      equal
      to the market value of the shares of approximately $9.9 million. We
      are
      currently negotiating with Berkley to modify the consulting agreement. We are
      seeking a release from Berkley of any and all claims to the shares of common
      stock issued to them as described above. We are also seeking a refund of the
      cash fees, less any out-of-pocket expenses actually incurred and as evidenced
      by
      reasonable documentation. On May 31, 2006, we entered into a Settlement
      Agreement” with GIC with regard to its consulting agreement. Pursuant to the
      Settlement Agreement, GIC released any and all claims to the 625,000 shares
      of
      our common stock that we did not deliver, and released us from any obligation
      to
      make any additional payments under the consulting agreement. We agreed GIC
      can
      retain all of the $250,000 cash fee we previously paid, and released GIC from
      any obligation to provide services pursuant to the terms of the consulting
      agreement.





There
      can
      be no assurance we will be successful in achieving these goals. Also, if we
      are
      successful, we may suffer adverse treatment for this transaction or the
      accounting treatment may be challenged by the SEC or others.





49







**Critical
      Accounting Policies and Estimates**





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





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





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





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





50








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





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





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





Subscription
      revenues are comprised of subscription sales directly to end-users, or to others
      for distribution to end-users, hosting and maintenance fees, e-commerce website
      design fees and online loan origination fees. Subscription sales are made either
      on a monthly subscription or a one-time for fee basis. Subscriptions, which
      include access to most of our offerings, are payable in advance on a monthly
      basis and are targeted at small companies or divisions of large companies.
      Historically, most of our users have been given free use of our products for
      extended time periods. In October of 2005, we changed that policy to a limited
      30-day free use period, after which we terminate access for users who fail
      to
      become paid subscribers. We expect lower fees from subscribers at the private
      label syndication websites of our partners. Currently, most of our syndication
      agreements call for us to receive a percentage of revenue generated. We began
      to
      offer our suite of OneBiz SM software
      applications on November 4, 2005 on our own website, and we plan to
      migrate all of the OneBiz SM applications to our syndication sites when we have completed refining and
      improving these applications. Customers can also purchase for one-time use
      of a
      specific application or content service. On our core website, we are in the
      process of phasing out “a la carte” pricing and substituting our
      OneBiz SM suite of
      applications for these services. Eventually, we will do the same for our
      syndication partners. At this time, we are still selling certain services on
      a
“for fee” basis, such as the applications we acquired from Computility and
      iMart. We also recently began to offer to our syndication partners volume
      discounts for pre-paid subscriptions, which they can either resell or contribute
      to their small business customers, but no volume sales have occurred. The
      changes to our subscription policies are too recent for us to determine how
      they
      will affect our revenues, but the number of subscribers to our main portal
      has
      declined since mid-January 2006.





Additionally,
      we receive a portion of revenue from third-party sales of products and services
      through our website and websites of our syndication partners from revenue
      sharing arrangements, which involves a split of realized revenues. Hosting
      and
      maintenance fees are charged for supporting and maintaining the private-label
      portal and providing customer and technical support directly to our syndication
      partner’s users and are recognized on a monthly basis. E-Commerce website design
      fees, which are charged for building and maintaining corporate websites or
      to
      add the capability for e-Commerce transactions, are recognized over the life
      of
      the project. Domain name registration fees are recognized over the term of
      the
      registration period. Online loan origination fees are charged to provide users
      online financing options. We receive payments for loans or credit provided.





51








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





*Barter
      Transactions* -
      Barter
      revenue relates to syndication and integration services provided by us to
      business customers in exchange for advertising in the customers’ trade magazines
      and on their Web sites. Barter expenses reflect the expense offset to barter
      revenue. The amount of barter revenue and expense is recorded at the estimated
      fair value of the services received or the services provided, whichever is
      more
      objectively determinable, in the month the services and advertising are
      exchanged. We apply APB 29, *Accounting
      for Non-Monetary Transactions* ,
      the
      provisions of EITF 93-11, *Accounting
      for Advertising Barter Transactions Involving Barter Credits* and EITF
      99-17, *Accounting
      for Advertising and Barter Transactions* and,
      accordingly, recognizes barter revenues only to the extent that we have similar
      cash transactions within a period not to exceed six months prior to the date
      of
      the barter transaction. To date the amount of barter revenue to be recognized
      has been more objectively determinable based on integration and syndication
      services provided. For revenue from integration and syndication services
      provided for cash to be considered similar to the integration and syndication
      services provided in barter transactions, the services rendered must have been
      in the same media and similar term as the barter transaction. Further, the
      quantity or volume of integration or syndication revenue recorded in a
      qualifying past cash transaction can only evidence the fair value of an
      equivalent quantity or volume of integration or syndication revenue recorded
      in
      subsequent barter transactions. In other words, a past cash transaction can
      only
      support the recognition of revenue on integration and syndication contracts
      barter transactions up to the dollar amount of the cash transactions. When
      the
      cash transaction has been used to support an equivalent quantity and dollar
      amount of barter revenue, such transaction cannot serve as evidence of fair
      value for any other barter transaction. Once the value of the barter revenue
      has
      been determined, we follow the same revenue recognition principles as it applies
      to cash transactions with unearned revenues being deferred as described more
      fully under the caption “Revenue Recognition” above. At the time the barter
      revenue is recorded, an offsetting pre-paid barter advertising asset is recorded
      on our balance sheet. This pre-paid barter advertising asset is amortized to
      expense as advertising services are received such as when an advertisement
      runs
      in a magazine. Where more than one deliverable exists, such as when the barter
      partner is to provide advertising in four issues of a magazine, the
      expense is recognized pro-rata as the advertising deliverable is provided.
      Barter revenues totaled approximately $424,000 and $113,000, for the years
      ended
      December 31, 2005 and 2004, respectively. We did not have any barter
      transactions for the year ended December 31, 2003.





*Marketable
      Securities* -
      Management determines the appropriate classification of investments in
      marketable securities at the time of purchase in accordance with Statement
      of
      Financial Accounting Standards No. 115, *Accounting
      for Certain Investments in Debt and Equity Securities* and
      reevaluates such determination at each balance sheet date. Securities, which
      are
      classified as available for sale at December 31, 2005, are carried at fair
      value, with the unrealized gains and losses, net of tax, reported as a separate
      component of stockholders’ equity. Fair value is determined based on quoted
      market rates. Realized gains and losses and declines in value judged to be
      other-than-temporary on securities available for sale are included as a
      component of interest income. The cost of securities sold is based on the
      specific-identification method. Interest on securities classified as available
      for sale is also included as a component of interest income.





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





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





52





*Impact
      of Acquisitions -* As
      more
      fully described under “Liquidity and Capital Resources - Recent Developments”,
      during October 2005, we acquired substantially all of the assets of Computility,
      Inc. and acquired all the stock of iMart Incorporated. Below is a summary of
      the
      major sources of income for these entities and a summary of the related revenue
      recognition practices.





Computility’s
      revenues were primarily derived from subscription fees, consulting revenue,
      and
      product sales.





*Computility’s
      Subscription Revenue* - Fees
      for services that are charged to customers monthly, under fixed-length
      subscription contracts. These contracts are typically three-year contracts,
      which provide enumerated services or access to Computility’s web-based products
      in exchange for a monthly subscription payment. The contract and support
      contracts are noncancelable, though they typically provide for early termination
      upon a material breach by either party that is not cured in a timely manner.
      Customers are generally invoiced monthly on the first of the month, and the
      typical payment terms provide that customers pay by automatic ACH withdrawal
      by
      the fifteenth of each month. Revenue is recognized monthly when the customers
      are invoiced for their monthly subscribed services.





*Consulting
      Revenue* - Fees
      for services to customers that are not covered by the subscription contract.
      Customers are billed for these services on an hourly basis, and Computility
      recognizes this consulting revenue at the time the customer is invoiced for
      the
      services.





*Product
      Sales* -
      Represents computer hardware and software that is sold to customers not under
      a
      subscription contract. Revenue is recognized at the time that the product is
      delivered and/or installed and the customer is invoiced for the
      product.





iMart’s
      revenues were primarily derived from subscription fees and professional
      services.





*iMart
      Subscription Fees -* Subscription based domain registration fees charged to end-users for
      registration services are recognized on a straight-line basis over the
      registration term, using a mid-month revenue recognition convention which does
      not materially differ from the use of a daily recognition method. Accordingly,
      domain name registration revenues are deferred at the time of the registration
      and are recognized ratably over the term of the registration period. A majority
      of end-user subscribers pay for services with credit cards for which iMart
      receives remittances from the credit card associations, generally within two
      business days after the sale transaction is processed.





*iMart
      Professional Services -* Professional services and other revenues, when sold with subscription and
      support offerings, are accounted for separately when these services have value
      to the customer on a standalone basis and there is objective and reliable
      evidence of fair value of each deliverable. When accounted for separately,
      consulting revenues are recognized as the services are rendered for time and
      material contracts, and when the milestones are achieved and accepted by the
      customer for fixed price contracts. The majority of iMart’s consulting contracts
      are on a time and material basis. Training revenues are recognized after the
      services are performed.





In
      determining whether the consulting services can be accounted for separately
      from
      subscription and support revenues, we consider the following factors for each
      consulting agreement: availability of the consulting services from other
      vendors, whether objective and reliable evidence for fair value exists of the
      undelivered elements, the nature of the consulting services, the timing of
      when
      the consulting contract was signed in comparison to the subscription service
      start date, and the contractual dependence of the subscription service on the
      customer’s satisfaction with the consulting work.




Except
      as
      indicated in the section titled “Impact of Acquisitions,” the operating results
      reported below for the years ended 2004 and 2003 do not include any operating
      results from Computility or iMart, which acquisitions occurred during October
      2005. Results from operations for iMart (Smart Commerce, Inc.) and Computility
      (Smart CRM, Inc.) are only included in 2005 consolidated amounts from the date
      of acquisition forward (October 18, 2005 and October 4, 2005,
      respectively).





**Overview
      of Results of Operations for the Fiscal Year Ended December 31,
      2005**





Revenues
      for fiscal 2005 totaled approximately $2.7 million as compared to $1.0 million
      for fiscal 2004 representing an increase of $1.7 million. Approximately $1.4
      million of this increase is attributable to the post-acquisition, fourth quarter
      revenues of the newly acquired subsidiaries. We
      derive
      subscription revenue primarily from our stand alone SFA/CRM application, our
      stand alone e-Commerce application. At the end of 2005, we began to generate
      a
      small amount of revenue from subscriptions to our main portal,
      www.SmartOnline.com. The
      additional $300,000 increase is attributable to an increase in integration
      and
      syndication revenue offset by the elimination of related party revenues.
      Operating expenses increased from $3.6 million in 2004 to $18 million in 2005.
      Approximately $10.2 million of this increase is attributable to two investor
      relations contracts of which $9.7 million was paid in stock and $500,000 was
      paid in cash. On eof these investor relations contracts was terminated in May
      2006. As part of this agreement, the contractor released all of its rights
      to
      the 625,000 shares of our common stock. Upon the completion of the return of
      these shares, we will record “Other Income” for the fair market value of these
      shares. Because of the current share price, we anticipate that the income
      recorded will be materially less than the original expense recorded. We have
      not
      yet been able to reach any agreement with the other investor relations
      consultant. If we are able to reach a similar agreement, we anticipate that
      our
      accounting treatment would be similar. Also in 2005, an additional $498,700
      in
      cash and $215,660 in stock was paid to other investor relations consultants.
      The
      net loss attributed to common stock during fiscal 2005 was approximately $15.5
      million compared to a net loss attributed to common stock of $8.3 million for
      fiscal 2004.





53





***Fiscal
      Years Ended December 31, 2005, 2004 and 2003***





**Results
      of Operations**





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





**Revenues**





**Year
                Ended**
              **DECEMBER
                31,**
              **2005**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**REVENUES:Integration
                fees
            
            $
            798,178
            
            $
            374,055
            
            $
            367,617Syndication
                fees
            
            
            402,847
            
            
            176,471
            
            
            115,544OEM
                revenue
            
            
            48,000
            
            
            55,936
            
            
            48,620Web
                services
            
            
            -
            
            
            62,365
            
            
            207,570Subscription
                Fees
            
            
            914,674
            
            
            -
            
            
            -Professional
                Services Fees
            
            
            435,486
            
            
            -
            
            
            -Other
                revenues
            
            
            102,791
            
            
            4,093
            
            
            8,815Related
                party revenues
            
            
            -
            
            
            330,050
            
            
            513,057Total
                revenues
            
            $
            2,701,976
            
            $
            1,002,970
            
            $
            1,261,223





Fiscal
      2005 vs. 2004





Total
        revenues were $2,701,976 in fiscal 2005 compared to $1,002,970 in fiscal
        2004
        representing an increase of $1,699,006, or approximately 170%. Approximately
        50%
        of our consolidated 2005 revenue, or $1,348,869, is attributable to the revenue
        of our newly acquired subsidiaries.
 
 Integration
      revenues in 2005 totaled $798,178 as compared to $374,055 in 2004 representing
      an increase of $424,123 or 113%. This increase was primarily due to two new
      integration contracts which accounted for approximately 43% of the 2005
      integration revenues and each of which accounted for greater than 10% of total
      first half 2005 revenues.





Syndication
        revenues in 2005 totaled $402,847 as compared to $176,471 in 2004 representing
        an increase of $226,376 or 128% due primarily to our entering into new
        syndication agreements. All of the 2005 revenues were from three syndication
        agreements each of which accounted for greater than 10% of total first half
        revenues.
  Included
      in the above noted 2005 and 2004 integration and syndication revenues was
      $424,000 and $113,000, respectively, of revenue derived from barter
      transactions.





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





54





Fiscal
      2004 vs. 2003





Total
      revenues were $1,002,970 in fiscal 2004 compared to $1,261,223 in fiscal 2003
      representing a decrease of $258,253, or 20%.





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





Additionally,
      as a result of the focus on integration and syndication services, web services
      and other revenues decreased by approximately $145,000 and $5,000, respectively.
      Also during 2004, we continued to rely less on relationships with related
      parties resulting in a $183,007 decrease in related party revenues. Management
      does not expect related party revenues to be a significant source of income
      commencing with fiscal 2005.





Impact
      of Acquisitions





As
      more
      fully described below under “Liquidity and Capital Resources - Recent
      Developments,” during October 2005, we acquired substantially all of the assets
      of Computility, Inc. and all of the stock of iMart Incorporated.





Computility
      provided turnkey network computing services on a subscription basis to small
      and
      mid-size organizations. Computility also developed an internet-delivered
      customer resource management (CRM) and sales force automation (SFA) software
      product that it markets on a subscription basis to small and mid-size
      organizations. Computility’s revenues totaled $1,986,522 and $1,452,239 for the
      years ended December 31, 2004 and 2003, respectively. Approximately 87% and
      92%
      of the 2004 and 2003 revenues, respectively, were from subscriptions which
      typically have a 3-year term. Approximately $547,000 is included in consolidated
      revenue which relates to the period Smart CRM was a wholly owned subsidiary
      during 2005 (October 4, 2005 to December 31, 2005). We plan to support the
      existing Computility customer base and to begin integrating Computility’s
      CRM/SFA application into the application suite. Additionally, we believe that
      the acquisition will provide opportunities to cross-sell other applications
      in
      the OneBiz SM application
      suite to Computility’s small and mid-size customers.





iMart
      was
      a privately held developer and distributor of multi-channel e-Commerce systems.
      iMart’s revenues totaled $3,380,609 and $2,871,892 for the years ended December
      31, 2004 and 2003. Approximately 57% and 44% of the 2004, 2003 revenues,
      respectively, were from subscriptions which typically have a term of 12 to
      24
      months. Approximately 40% and 52% of the 2004 and 2003 revenues, respectively,
      were from professional services related to the subscription revenue.
      Approximately $802,000 is included in consolidated revenue which relates to
      the
      period Smart Commerce was a wholly owned subsidiary during 2005 (October 18,
      2005 to December 31, 2005). Approximately 77% of iMart’s revenue for 2005 were
      from three customers. In the first quarter of 2006, we learned that one of
      these
      customers, constituting approximately 40% of iMart’s 2005 revenue, underwent a
      restructuring that could result in a decrease of approximately 30% in their
      business with Smart Commerce. Although this would have a negative effect on
      Smart Commerce, we believe we will be able to offset this potential loss by
      securing several new customers. We plan to support the existing iMart customer
      base and to begin integrating iMart’s e-commerce applications into the
      application suite. Additionally, we believe that the acquisition will provide
      opportunities to cross-sell other applications in the OneBiz SM application
      suite to iMart’s small and mid-size customers.





**Cost
      of Revenues**





**Year
                Ended**
              **DECEMBER
                31,**
              **2005**
            
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**COST
                OF REVENUES
            
            $
            400,822
            
            $
            211,616
            $
            187,064





Fiscal
      2005 vs. 2004





Cost
      of
      revenues is comprised primarily of salaries and wages associated with
      maintaining and supporting integration and syndication partners. Cost of
      revenues increased 89% from $211,616 in 2004 to $400,822 in 2005 primarily
      as a
      result of an increase in costs of revenue related to the operations of the
      acquired subsidiaries. Cost of revenues are expected to continue to grow in
      the
      future commensurate with growth in integration and syndication partners and
      as
      users are added following the 2005 release of the new applications.





55





Fiscal
      2004 vs. 2003





Cost
      of
      revenues increased 13% from $187,064 in 2003 to $211,616 in 2004 primarily
      as a
      result of an increase in the number of integration and syndication partners.





Impact
      of Acquisitions





As
      more
      fully described under “Liquidity and Capital Resources - Recent Developments,”
during October 2005, we acquired substantially all of the assets of Computility,
      Inc. and all the stock of iMart Incorporated.





Computility’s
      cost of revenues totaled $910,605 and $654,835 for the years ended December
      31,
      2004 and 2003, respectively. Cost of revenues represented 46% and 45% of total
      revenues for the years ended December 31, 2004 and 2003, respectively. For
      the
      period from October 4, 2005 to December 31, 2005, costs of revenues was
      $245,930, which is included in 2005 consolidated costs of revenues. This
      represents 45% of Computility’s revenue for the corresponding
      period.





iMart’s
      cost of revenues were primarily comprised of third party domain registration
      fees and personnel costs associated with supporting subscription services.
      iMart’s cost of revenues totaled $410,698 and $313,639 for the years ended
      December 31, 2004 and 2003, respectively. Cost of revenues represented 12%
      and
      11% of total revenues for the years ended December 31, 2004 and 2003,
      respectively. For the period from October 18, 2005 to December 31, 2005, Costs
      of Revenues was $56,449, which is included in 2005 consolidated Costs of
      Revenues. This represents 7% of iMart’s revenue for the corresponding
      period.





**Operating
      Expenses**





**Year
                Ended**
              **DECEMBER
                31,**
              **2005**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**OPERATING
                EXPENSES:General
                and administrative
            
            
            15,208,546
            
            
            2,432,928
            
            
            1,941,920Sales
                and marketing
            
            
            1,422,345
            
            
            596,989
            
            
            321,049Development
            
            
            1,737,092
            
            
            563,372
            
            
            676,472Total
                operating expenses
            
            
            18,367,983
            
            
            3,593,289
            
            
            2,939,441





Fiscal
      2005 vs. 2004





*General
      and Administrative* -
      General
      and administrative expenses increased by approximately $12.8 million from $2.4
      million in 2004 to $15.2 million in 2005. Approximately $10.2 million of this
      increase is attributable to two investor relations contracts of which $9.7
      million was paid in stock and $500,000 was paid in cash. Additionally, we paid
      a
      total of $498,700 in cash and issued 23,000 shares of common stock valued at
      a
      total of $215,660 to other investor relations consultants. Approximately
      $250,000 of this increase is amortization expense related to intangible assets
      acquired from iMart and Computility. The 2004 period included $350,000 of
      expense associated with the conversion of certain warrants to Common Stock
      during September 2004. Additionally, the 2004 period included $66,287 of stock
      based compensation expense. Legal and professional fees, including those
      associated with conducting financial statements audits for 2002 and 2003 and
      one-time expenses associated with preparing to become a public company, totaled
      $1,089,000 in 2005 as compared to $770,000 in 2004 .





Management
      anticipates an increase in legal and professional fees for non-recurring
      expenses related to the costs of compliance with the Sarbanes-Oxley Act and
      other public company-related expenses which will increase general and
      administrative expenses during 2006. The costs associated with the SEC’s
      suspension of trading of our securities, the continuing SEC action, and the
      internal investigation of matters relating thereto are both non-recurring
      expenses, but are expected to be significant expenses in 2006. To date, our
      insurers have only agreed to cover a portion of the fees and expenses related
      to
      the SEC action and the internal investigation.





*Sales
      and Marketing* -
      Sales
      and marketing increased $825,356 to $1,422,345 in 2005 from $596,989 in 2004
      as
      we increased our sales and marketing staff and activities .
      The
      2004 period included approximately $206,000 of barter advertising expense as
      compared to $273,751 for the 2005 period. For the first quarter of 2006, our
      sales and marketing expenses totaled approximately $175,000.





56





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. If we are
      successful in raising funds in 2006, we plan to, among other things, invest
      in
      marketing and sales by increasing the number of direct sales personnel and
      increasing penetration within our existing customer base, expanding our domestic
      selling and marketing activities, building brand awareness and participating
      in
      additional marketing programs (see “Use of Proceeds”). We expect that in the
      future, marketing and sales expenses will increase in absolute dollars and
      will
      be a significant cost. However, we anticipate that raising such capital will
      be
      difficult, and we can offer no assurances that we will be successful in our
      efforts to do so.





*Development* -
      Development expense increased from $563,372 in 2004 to $1,737,092 in 2005.
      This
      increase is primarily the result of our adding additional programming, database
      management, quality assurance, and project management resources to support
      the
      on-going development of the applications.





Fiscal
      2004 vs. 2003





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





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





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





Impact
      of Acquisitions





As
      more
      fully described below under “Liquidity and Capital Resources - Recent
      Developments”, during October 2005, we acquired substantially all of the assets
      of Computility, Inc. and all the stock of iMart Incorporated.





The
      following is a summary of Computility’s operating expenses for the periods
      indicated below:





**Period
                From**
              **OCTOBER
                4,**
              **2005
                to**
              **DECEMBER
                31, 2005**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**OPERATING
                EXPENSES:General
                and administrative
            
            $
            169,484
            
            $
            498,074
            
            $
            443,392Sales
                and marketing
            
            
            36,326
            
            
            547,526
            
            
            324,229Research
                & Development
            
            
            87,135
            
            
            282,359
            
            
            183,779Total
                operating expenses
            
            $
            292,945
            
            $
            1,327,959
            
            $
            951,400





We
      expect
      these operating expenses to increase during the first half of 2006 primarily
      due
      to additional development costs associated with integrating Computility’s
      software applications into our application suite and additional general and
      administrative expenses associated with complying with public company rules
      and
      regulations including Sarbanes-Oxley.





57





The
      following is a summary of iMart’s operating expenses for the periods indicated
      below:





**Period
                From**
              **OCTOBER
                18,**
              **2005
                to**
              **DECEMBER
                31, 2005**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**OPERATING
                EXPENSES:General
                and administrative
            
            $
            166,930
            
            $
            630,502
            
            $
            618,071Sales
                and marketing
            
            
            98,182
            
            
            323,003
            
            
            240,593Development
            
            
            115,936
            
            
            593,746
            
            
            468,986Total
                operating expenses
            
            $
            381,048
            
            $
            1,547,251
            
            $
            1,327,650





We
      expect
      these operating expenses to increase during the first half of 2006 primarily
      due
      to additional development costs associated with integrating iMart’s software
      applications into our application suite and additional general and
      administrative expenses associated with complying with public company rules
      and
      regulations including Sarbanes-Oxley.





**Other
      Income (Expense)**





**Year
                Ended**
              **DECEMBER
                31,**
              **2005**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**OTHER
                INCOME (EXPENSE):Interest
                income (expense), net
            
            $
            (80,414
            )
            $
            (119,389
            )
            
            (186,248
            )Gain
                on debt forgiveness
            
            
            556,215
            
            
            249,395
            
            
            492,757Gain
                on disposal of asset
            
            
            419
            
            
            -
            
            
            -Total
                other income
            
            $
            476,220
            
            $
            130,006
            
            
            306,509





Fiscal
      2005 vs. 2004





We
      incurred net interest expense of $80,414, net of $33,336 of interest income,
      and
      $119,389 during 2005 and 2004, respectively. The 2005 interest expense of
      approximately $113,750 was primarily the result of interest expense on the
      non-compete and purchase price notes related to the October acquisitions, as
      well as interest on the subscription factor payable. We earned approximately
      $33,000 of interest income related to bank deposits during 2005. The 2004
      interest expense amount included $75,000 of interest related to the issuance
      of
      150,000 shares of Common Stock to a relative of one of our officers in
      consideration for extending the term of a loan and loaning additional funds
      to
      the corporation as described in Note 8 to the accompanying audited financial
      statements. The remainder of the 2004 interest expense is primarily attributable
      to interest due on deferred compensation owed to certain of our officers and
      interest related to unpaid payroll tax obligations. Both the deferred
      compensation and income tax obligations were relieved during the first quarter
      of 2005, therefore, management expects that interest expense will be
      significantly lower in 2005.





During
      2005 and 2004, we realized gains totaling $556,215 and $249,395, respectively,
      from negotiated and contractual releases of outstanding liabilities. The gains
      from debt forgiveness resulted from unrelated third parties, primarily trade
      creditors who had performed services for us, agreeing to accept as payment
      in
      full a lesser amount than the stated liability in consideration for timely
      payment of the negotiated settlement.





58





Fiscal
      2004 vs. 2003





We
      incurred net interest expense of $119,389 and $186,248 during 2004 and 2003,
      respectively. The 2004 and 2003 interest expense amounts each included $75,000
      of interest related to the issuance of 150,000 shares of Common Stock to a
      relative of one of our officers in consideration for extending the term of
      a
      loan and loaning additional funds to the corporation as described in Note 8
      to
      the accompanying audited financial statements. The remainder of the 2004 and
      2003 interest expense is primarily attributable to interest due on deferred
      compensation owed to certain of our officers and interest related to unpaid
      payroll tax obligations. Both the deferred compensation and income tax
      obligations were relieved during the first quarter of 2005, therefore,
      management expects that interest expense will be significantly lower in
      2005.





During
      2004 and 2003, we realized gains totaling $249,395 and $492,757, respectively,
      from negotiated and contractual releases of outstanding liabilities. The gains
      from debt forgiveness resulted from unrelated third parties, primarily trade
      creditors who had performed services for us, agreeing to accept as payment
      in
      full a lesser amount than the stated liability in consideration for timely
      payment of the negotiated settlement. With the exception of a negotiated
      settlement with the Internal Revenue Service that resulted in a gain of
      approximately $547,000 in the first quarter of 2005 (see Note 16 to the
      accompanying audited financial statements), we do not expect gains from debt
      forgiveness to be material in future periods.





Impact
      of Acquisitions





As
      more
      fully described below under “Liquidity and Capital Resources - Recent
      Developments,” during October 2005, we acquired substantially all of the assets
      of Computility, Inc. and all the stock of iMart Incorporated.





Computility
      incurred $193,452 and $170,421 of additional net expense, primarily interest
      expense on factored subscription receivables, during the years ended December
      31, 2004 and 2003, respectively.





Other
      income and expense amounts were not significant for iMart during the years
      ended
      December 31, 2004 and 2003, respectively.





**Provision
      for Income Taxes**





We
      have
      not recorded a provision for income tax expense because we have been generating
      net losses. Furthermore, we have not recorded an income tax benefit for fiscal
      2005, 2004, and 2003 primarily due to continued substantial uncertainty
      regarding our ability to realize our deferred tax assets. Based upon available
      objective evidence, there has been sufficient uncertainty regarding the ability
      to realize our deferred tax assets, which warrants a full valuation allowance
      in
      our financial statements. We have approximately $50 million in net operating
      loss carryforwards, which may utilized to offset future taxable
      income.





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





**Liquidity
      and Capital Resources**





At
      December 31, 2005, our principal sources of liquidity were cash and cash
      equivalents totaling $1,434,966 and accounts receivable of $504,979. As of
      July
      6, 2006, our principal sources of liquidity were cash and cash equivalents
      totaling approximately $648,300 and accounts receivable of approximately
      $419,900. However, $79,400 of our cash is restricted and can only be used to
      pay
      the installment of $530,000 due under the iMart acquisition contract at the
      beginning of October 2006. We do not have a bank line of
      credit.





Management
      is actively evaluating additional financing options through existing and
      new shareholders for 2006, signing additional integration partners, and growing
      its base of subscription customers. However, one of our integration
      partners terminated our agreement prior to its scheduled termination, and since
      mid-January 2006, the number of paying subscribers at our main portal has
      decreased. Also, we entered into four factoring arrangements in 2006, whereby
      we
      assigned an interest in certain subsidiary service contracts in exchange for
      a
      cash payment. Our liquidity will also be effected by an approximately $530,000
      payment that is due in early July of 2006, $530,000 due in early October of
      2006, and $1,700,000 due in early January of 2007, under the terms of the
      acquisition and non-compete agreements signed with iMart.








59





Our
      working capital is only sufficient to fund our operations into September 2006,
      unless we substantially increase our revenue, limit expenses or raise
      substantial additional capital, all of which will be difficult to
      achieve.





**Sales
      of Securities.** In
      January of 2006, the SEC suspended trading of our securities. See “ ITEM 3. LEGAL
      PROCEEDINGS” for further details about this matter. One effect of this
      suspension is that our stock cannot currently be quoted by brokers or dealers
      over an interdealer quotation system. As a result, there has been a significant
      decrease in the trading volume for out common stock. This loss of liquidity
      will
      make it more difficult for us to raise revenues to fund its ongoing operations,
      or to raise such revenue on terms favorable to us.





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





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





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





Our
      primary source of liquidity during 2005 and 2004, as well as prior years, was
      from the sale of our securities. Restrictions on resale of over nine million
      shares of our Common Stock began to terminate on October 1, 2005 resulting
      in
      increased volume of resales. The release of additional restrictions may
      adversely affect the market value of our Common Stock and may make it more
      difficult to raise capital. During 2005, we generated net cash from financing
      activities, including the sales of common stock, of approximately $7.7 million.
      During the same period, we consumed approximately $6.4 million of cash in
      operations, including payment of $1.1 million paid related to payment of
      deferred compensation and accrued interest.





During
      2005, we sold 786,642 shares of its common stock to investors for a price of
      $5.50 per share resulting in gross proceeds of $4,326,531. We incurred issuance
      costs totaling $340,525 related to these stock sales. During 2005, we also
      sold
      605,000 shares of common stock to investors at $5.00 per share, resulting in
      gross proceeds of $3,025,000. We incurred issuance costs of $290,000 related
      to
      these stock sales. Additionally, in connection with these offerings, we entered
      into Registration Rights Agreements with these shareholders under which we
      agreed to file with the SEC a registration statement on Form S-1 to register
      the
      shares sold in the offering by a certain date. As of July 7, 2006, we have
      not
      filed such a registration statement and we cannot state when such registration
      statement will be filed. Late filing penalties will continue to accrue under
      these agreements until we can meet our filing obligations. See “Note 11” to
“ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for information about the
      registration rights penalty payable to these stockholders.





Also
      during 2005, we issued 579,717 shares of common stock, including 127,089 shares
      issued as a result of cashless warrant exercises, to holders of warrants to
      purchase common stock, resulting in gross proceeds to us of $1,306,098. The
      warrants had exercise prices that ranged from $1.30 to $5.00 per
      share.





During
      2005, we raised a total of $8.6 million proceeds, net of stock issuance costs
      of
      $630,525, from the sale of additional shares of Common Stock and the exercise
      of
      warrants to purchase shares of Common Stock. Approximately $1.1 million of
      the
      proceeds were used in the first quarter of 2005 to pay deferred compensation
      to
      our officers and related accrued interest amounts. Additionally, during February
      2005, we reached a settlement with the Internal Revenue Service, paid $26,100,
      surrendered all credits and refunds for 2005 or earlier tax periods, and agreed
      to remain in compliance with all federal tax obligations for a term of five
      years to resolve all outstanding federal tax issues.





**Factoring
      of Smart CRM Contracts.** During
      the first half of 2006, our wholly owned subsidiary, Smart CRM, Inc., assigned
      a
      70% interest in twenty (20) separate service contracts, and assigned a 50%
      interest in one (1) service contract, with total payables from customers over
      the lives of the contracts of approximately $1,140,000 to a factor in exchange
      for approximately $668,000. As a result of this arrangement, Smart CRM will
      record a debt payable to the factor in the amount of approximately $727,000,
      which will become due in monthly installments over a period of 36 months. The
      obligations of Smart CRM are secured by a security interest in the equipment
      provided to customers under five of the contracts. This debt will appear on
      our
      consolidated balance sheet and will reduce the amount of future revenue Smart
      CRM derives from these customer contracts. The cash acquired from the factor
      is
      being used primarily to fund current operations. Should any customer fail to
      make their scheduled payments, Smart CRM will be liable to the factor for the
      full amount of the interest assigned to the factor.





60





**Deferred
      Revenue.** At
      December 31, 2005, we had deferred revenue totaling $876,000, net of offsetting
      amounts receivable. Deferred revenue represents amounts collected in advance
      of
      the revenue being recognized. Based upon current conditions, we expect that
      approximately 89% of this amount will be recognized during 2006.





**Investor
      Relations Expenses.** We
      have entered into agreements for investor relations services with certain
      stockholders, including: Mistere, LLC, David Gardner d/b/a Albermarle Fund,
      LLC,
      Ruben Serrano, General Investments Capital (GIC) Ltd. (“GIC”) and Berkley
      Financial Services Ltd. (“Berkley”). Pursuant to their respective agreements,
      GIC and Berkley received $250,000 in cash and the Company issued but did not
      deliver 625,000 shares of our common stock; and as of December 31, 2005,
      Mistere, LLC received $120,000 in cash and 16,000 shares or our common stock,
      Albermarle Fund/David Gardner received $47,500 in cash and 5,000 shares of
      our
      common stock, and Ruben Serrano received $23,200 in cash and 2,000 shares of
      our
      common stock. In 2006, we paid Albermarle Fund/David Gardner an additional
      $7,500. We entered into additional agreements for investor relations services
      with persons who were not issued shares of common stock. Under these agreements,
      we made cash payments totaling $308,000 in 2005 and $5,000 in the first quarter
      of 2006. In sum, these expenses totaled approximately $1 million in cash and
      approximately 1.3 million shares of common stock in 2005, and $12,500 in cash
      in
      2006.





We
      are
      currently negotiating with Berkley to modify the consulting agreement. We are
      seeking a release from Berkley of any and all claims to the shares of common
      stock issued to them as described above. We are also seeking a refund of the
      cash fees, less any out-of-pocket expenses actually incurred and as evidenced
      by
      reasonable documentation. There can be no assurance we will be successful in
      achieving these goals. Also, even if we are successful, we may suffer adverse
      treatment for this transaction or the accounting treatment may be challenged
      by
      the SEC or others. On May 31, 2006, we entered into a Settlement Agreement” with
      GIC with regard to its consulting agreement. In part, GIC agreed to release
      its
      claim to the shares, but retained the entire cash fee as consideration for
      services performed under the consulting agreement and for entering into the
      Settlement Agreement.





In
      addition, it appears that some of the persons that were hired by us as investor
      relations consultants during 2005 may have engaged in trading of our Common
      Stock. Based on our review of certain stockholder lists, it appears five of
      these persons purchased and/or sold shares of our common stock on the open
      market between late August and mid-December of 2005. Based on these reports,
      the
      total number of shares acquired by these persons was approximately 20,000
      shares. According to these same reports, the total number of shares disposed
      of
      by these persons was approximately 14,500 shares. We are not aware of the prices
      paid or received by these persons in these trades. Because it is possible to
      trade in our securities through accounts under different names, we are not
      able
      to verify whether the foregoing constitutes all of the trading in our securities
      by our investor relations consultants.





**Going
      Concern.** Our
      registered public accountants have issued an explanatory paragraph in their
      report included in this Form 10-K for the year ended December 31, 2005 in which
      they express substantial doubt as to our ability to continue as a going concern.
      The financial statements do not include any adjustments relating to the
      recoverability and classification of recorded asset amounts or the amounts
      or
      classification of liabilities that might be necessary should we be unable to
      continue as a going concern. Our continuation as a going concern depends on
      its
      ability to generate sufficient cash flows to meets its 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 17, 2006, the SEC issued an Order of Suspension of Trading in our
      securities. The basis for this suspension was the SEC believed there to be
      a
      lack of current and accurate information concerning our securities because
      of
      possible manipulative conduct occurring in the market for the Company’s stock.
      By its terms, that suspension ended on January 30, 2006 at 11:59 p.m. EST.
      Our
      Audit Committee recently received final findings from independent outside legal
      counsel engaged by it to investigate matters related to the SEC suspension
      and
      investigation. See “Item 3. LEGAL PROCEEDINGS” for further discussion of this
      matter.





During
      August 2005, we acquired rights to an accounting software engine from a software
      development company and co-developed our accounting software application with
      that developer. We have exclusive rights to the accounting application, and
      non-exclusive rights to the software engine included in the application. In
      connection with this agreement, we agreed to pay the developer up to $512,500
      and issue up to $287,500 worth of our Common Stock based upon the developer
      attaining certain milestones. As of December 31, 2005 the developer had earned
      and been paid $210,000 ($180,000 in cash and $30,000 of our Common Stock).
      Although this product was integrated into the OneBiz SM application suite in December 2005, we did not accept the completion of the
      software application because, in its judgment and based on feedback received
      from both customers and an accounting consultant, certain modifications and
      features were needed to improve the usability of the accounting application.
      As
      a result, we are continuing to work with the software development company to
      complete and improve the accounting application. We have deposited $37,500
      into
      escrow, which will be released to the software development company upon
      acceptance of the accounting application, with the remaining money and stock
      to
      be partially payable either at acceptance, 90 days after acceptance and 180
      days
      after acceptance ).
      During
      the third quarter of 2005, approximately $105,000 had been capitalized related
      to this software. During the fourth quarter, management revised its estimate
      as
      to the realizability of this asset. Accordingly, the amount was written-off
      and
      all future costs related to this software will be expensed in the period
      incurred until the criteria of SFAS No. 86 for capitalizing software costs
      are
      met. The remaining portion of the software assignment and development fees
      is
      expected to be earned and payable during the second half of 2006.





61





**Computility.** During
      October of 2005, we acquired substantially all of the assets of Computility,
      Inc. on terms that are summarized above in this Item. Historically, Computility
      derived substantially all of its revenue from software and hardware subscription
      agreements which typically have 3-year terms with substantial penalties for
      early termination. Until the date of the acquisition, Computility factored
      substantially all of its subscription agreements and received approximately
      65%
      of the expected cash flow from the subscription period upfront and used the
      cash
      to fund on-going operations. As a result of the factor arrangements, we are
      required to provide services to the customers, but only receives approximately
      35% of the corresponding customer payments to fund ongoing operations. The
      remaining 65% of the monthly customer payments is being used to offset
      approximately $1.9 million of the factor liabilities of Computility assumed
      by
      us. As a result of the factoring activity of Computility, the acquisition
      resulted in an approximate $116,000 increase in cash expenditures for us from
      the date of acquisition through December 31, 2005. Computility’s operations
      resulted in approximately $30,000 to $50,000 of negative cash flow per month.
      We
      expect lower amounts of negative cash flow from this part of our business for
      the remainder of 2006.





**iMart.** During
      October 2005, we acquired all the stock of iMart Corporation, on terms that
      are
      summarized above in this Item. In addition, the payment terms for the iMart
      acquisition, which are described in greater detail above, have strained our
      limited capital resources, which is expected to continue for the next year
      with
      the greatest drain occurring in January 2007. Approximately 17% of the $530,000
      January 2006 installment payment was funded from the fourth quarter 2005 cash
      flows of the eCommerce business we acquired from iMart. First quarter 2006
      cash
      flows of the eCommerce business we acquired from iMart were sufficient to fund
      84% of the $530,000 April 2006 payment. We expect cash flows during the second
      and third quarters of 2006 from the eCommerce business we acquired from iMart
      will be sufficient to fund in excess of 80% of the $530,000 payments that are
      due at the beginning of July 2006 and October 2006, but our operating history
      of
      this business is so short that these estimates may not be accurate. We will
      have
      to make up the deficiency in cash flows from our limited capital resources,
      which will either cause us to need to reduce expenses in other operations or
      raise additional capital, or both. We
      expect
      the January 2007 payment of $1.7 million will result
      in
      a substantially greater deficiency, which will require us to raise substantially
      greater amounts of additional capital.





**Anticipated
      Increases in Expenses to Fund Growth In Revenue.** With
      the
      release of our new applications and the expenses associated with becoming a
      public company, we believe our capital requirements in 2006 and beyond will
      be
      greater than in past years. Also contributing to our capital needs in 2006
      are
      the non-recurring costs associated with the SEC’s suspension of trading of our
      securities, and the internal investigation of matters relating thereto. As
      such,
      our historical cash flows may not be indicative of future cash flows. The
      following is a discussion of factors that we consider important to our future
      capital requirements and which will affect the amount of additional capital
      we
      need to raise. Our future capital requirements will depend on many factors,
      including the duration of the SEC action and the internal investigation, our
      rate of revenue growth, the expansion of our marketing and sales activities,
      the
      timing and extent of spending to support product development efforts and
      expansion into new territories, the timing of introductions of new services
      and
      enhancements to existing services, the effect of the contemplated acquisitions
      as described above, and the market acceptance of our services.





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





**Integration,
      Syndication and Other Contracts.** Upfront
      payments totaling approximately $100,000, primarily related to new integration
      and syndication contracts, positively impacted operating cash flows for the
      year
      ended December 31, 2005. No new syndication or integration contracts have been
      signed since April 2005. As we release our new applications, we are shifting
      our
      efforts away from up-front integration and syndication fees to utilize our
      syndication arrangements to generate subscription revenue from subscription
      sales to small businesses and sales of volume discounted subscriptions to our
      partners. However, as of this date, none of our syndication partners have made
      such a volume purchase.





**Receivables.** If
      we are
      successful in signing new contracts, we anticipate our receivables and
      collections from integration, syndication, and end-user licensing opportunities
      to increase. Future payments that are not yet receivables from a total
      of twenty-one (21) customer contracts have been assigned to a factor
      for current cash payments. These factoring agreements will reduce receivables
      beyond the first half of 2006. Our receivables are composed of a mixture of
      major companies or banking institutes, as well as end users. Management has
      evaluated the need for an allowance for doubtful accounts and determined that
      no
      provision for uncollectible accounts is required as of December 31, 2005 and
      December 31, 2004.





62





**Facilities.** Our
      principal administrative, sales, marketing, and research and development
      facility is located in Durham, North Carolina and consists of over 5,000 square
      feet of office space. The facility, which is fully furnished, is subject to
      a
      lease agreement that expires on October 31, 2006. During the first half of
      2006,
      we will evaluate our options with regard to extending our current lease or
      relocating to new facilities. Should management determine that it is in our
      best
      interest to relocate, we will likely incur significant additional costs
      associated with relocating its operations and furnishing the new space. In
      addition, we also operate from offices in Iowa and in Michigan occupied by
      the
      two businesses we acquired in October of 2005.




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





**End
      User Customer Revenue.** Until
      the
      fourth quarter of 2005, we allowed most of our web-based products to be used
      without charge. This gained us users, but limited our revenue. In the fourth
      quarter of 2005, we changed our free use policy and began to sell subscriptions.
      However, there can be no assurance that we will be successful in attracting
      new
      customers or that customers will pay for our products, but the number of
      subscribers to our main portal has decreased since mid-January of 2006, We
      do
      not know the reason for this decrease. Failure to reverse this decrease mayl
      substantially harm our business.





**Marketing
      and Sales Expense Increases** .
      Generally, we need to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. If we are able
      to raise additional capital, we plan to invest heavily in marketing and sales
      by
      increasing the number of direct sales personnel, expanding our marketing
      activities, building brand awareness and participating in additional marketing
      programs. However, our ability to do so will depend on our ability to obtain
      sufficient financing in 2006.





**Gains
      From Debt Forgiveness.** During
      2005 and 2004, we realized gains totaling $556,215 and $249,395, respectively,
      resulting from negotiated and contractual releases of outstanding liabilities.
      The 2005 gain was primarily from the settlement with the Internal Revenue
      Service. The 2004 gains were primarily related to unrelated third parties,
      primarily trade creditors who had performed services for us, agreeing to accept
      as payment in full a lesser amount than the stated liability in consideration
      for timely payment of the negotiated settlement. Had we not been able to reach
      agreement with the Internal Revenue Service and these creditors, our liabilities
      and future cash flow requirements would have been higher by the amount of the
      debt forgiven.





**Public
      Company Expenses.** As
      a
      public company, we will incur significant legal, accounting and other expenses
      that we did not incur as a private company. We will incur costs associated
      with
      our public company reporting requirements. We also anticipate that we will
      incur
      costs associated with the SEC suspension of trading described above; recently
      adopted corporate governance requirements, including requirements under the
      Sarbanes-Oxley Act of 2002; as well as new rules implemented by the SEC, the
      NASD, and national securities exchanges. We expect these rules and regulations
      to increase our legal and financial compliance costs and to make some activities
      more time-consuming and costly. Any unanticipated difficulties in preparing
      for
      and implementing these reforms could result in material delays in complying
      with
      these new laws and regulations or significantly increase our costs. We have
      failed to file our SEC periodic reports on time and our ability to fully comply
      with these new laws and regulations is also uncertain. Our failure to timely
      prepare for and implement the reforms required by these new laws and regulations
      could significantly harm our business, operating results, and financial
      condition. We are currently evaluating and monitoring developments with respect
      to these new rules, and we cannot predict or estimate the amount of additional
      costs we may incur or the timing of such costs. We estimate this added
      approximately $1 million to our expenses during 2005, our first year as a public
      company.





**Legal
      Claims.** In
      January 2006, the SEC issued an order temporarily suspending the trading of
      our
      securities. For a more detailed discussion of the effects of this matter, please
      refer to “ITEM 1. BUSINESS, Recent Developments.” We are also subject to other
      claims and suits that arise from time to time in the ordinary course of
      business. In the event an unfavorable final outcome were to occur, there exists
      the possibility of a material adverse impact on our financial position and
      the
      results of operations for the period in which the effect becomes reasonably
      estimable. See “ITEM 3. LEGAL PROCEEDINGS” for a description of current
      litigation, including the SEC action.





63











**ITEM
      7A.** **QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**




***Foreign
      currency exchange risk***




During
      2005, 2004, and 2003, all of our contracts and transactions were U.S. dollar
      denominated. As a result, our results of operations and cash flows are not
      subject to fluctuations due to changes in foreign currency exchange rates.




***Interest
      rate sensitivity***




We
      had
      cash and cash equivalents totaling $1,434,966, $173,339, and $101,486 at
      December 31, 2005, 2004, and 2003, respectively. These amounts were invested
      primarily in demand deposit accounts and money market funds. The cash and cash
      equivalents are held for working capital purposes. We do not enter into
      investments for trading or speculative purposes. Due to the short-term nature
      of
      these investments, we believe that we do not have any material exposure to
      changes in the fair value of our investment portfolio as a result of changes
      in
      interest rates. Declines in interest rates, however, will reduce future
      investment income.





One
      debt
      instrument has a variable interest rate of prime + 4% (See “Floor Plan
      Agreement” in Note 9 to the Consolidated Financial Statements). At December 31,
      2005, the outstanding principal balance on this loan was $150,000. Due to the
      nominal amount of this debt instrument, we do not expect interest rate or market
      volatility to have a material effect on our cash flows.





64





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





INDEX
      TO
      FINANCIAL STATEMENTS





Page
                numberREPORT
                OF INDEPENDENT REGISTEREDPUBLIC
                ACCOUNTING FIRM
            F-2CONSOLIDATED
                BALANCE SHEETS
            F-3CONSOLIDATED
                STATEMENTS OF OPERATIONS
            F-4CONSOLIDATED
                STATEMENTS OFSTOCKHOLDERS’
                (DEFICIT) EQUITY
            F-5CONSOLIDATED
                STATEMENTS OF CASH FLOWS
            F-7NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
            F-8








F-1





REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





Stockholders
      and Directors


Smart
      Online, Inc.


Durham,
      North Carolina





We
      have
      audited the accompanying consolidated balance sheets of Smart Online, Inc.
      as of
      December 31, 2005 and 2004, and the related consolidated statement of
      operations, stockholders’ (deficit) equity, cash flows for each of the years
      then ended December 31, 2005, 2004 and 2003. 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, 2005 and 2004, and the results of its operations and its cash
      flows
      for each of the years then ended December 31, 2005, 2004 and 2003, 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, 2005. These factors raise substantial doubt 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


July
      6,
      2006





F-2








**SMART
      ONLINE, INC.**


**CONSOLIDATED
      BALANCE SHEETS**





**Assets**
            
            **December
                31,**
              **2005**
            
            **December
                31,**
              **2004**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            1,434,966
            
            $
            173,339Restricted
                Cash
            
            
            230,244
            
            
            -Marketable
                securities
            
            
            -
            
            
            395,000Accounts
                receivable, net
            
            
            504,979
            
            
            30,904Other
                accounts receivable
            
            
            74,876
            
            
            43,455Prepaid
                expenses
            
            
            370,225
            
            
            24,850Total
                current assets
            
            
            2,615,290
            
            
            667,548PROPERTY
                AND EQUIPMENT, net
            
            
            664,062
            
            
            75,636INTANGIBLE
                ASSETS, net
            
            
            11,032,129
            
            
            16,623OTHER
                ASSETS
            
            
            246,598
            
            
            13,894TOTAL
                ASSETS
            
            $
            14,558,079
            
            $
            773,701**Liabilities
                and Stockholders’ Equity (Deficit)**CURRENT
                LIABILITIES:Accounts
                payable
            
            $
            855,904
            
            $
            186,382Accrued
                payroll
            
            
            42,559
            
            
            110,079Accrued
                payroll taxes, penalties and interest
            
            
            -
            
            
            574,707Short-Term
                portion of Capital Lease
            
            
            14,707
            
            
            -Short-Term
                Portion of Subscription Financing Payable
            
            
            855,060
            
            
            -Accrued
                Registration Rights Penalty
            
            
            129,945
            
            
            -Current
                Portion of Notes Payable
            
            
            2,189,986
            
            
            -Deferred
                revenue
            
            
            785,324
            
            
            721,689Accrued
                liabilities
            
            
            48,674
            
            
            120Total
                current liabilities
            
            
            4,922,159
            
            
            1,592,977LONG-TERM
                LIABILITIES:Long-Term
                Portion of Notes Payable
            
            
            2,331,152
            
            
            -Long
                Term Portion of Subscription Financing Payable
            
            
            541,110
            
            
            -Unearned
                Revenue
            
            
            91,027
            
            
            -Deferred
                compensation, notes payable and interest
            
            
            -
            
            
            1,091,814Total
                long-term liabilities
            
            
            2,963,289
            
            
            1,091,814Total
                liabilities
            
            
            7,885,448
            
            
            2,684,791STOCKHOLDERS'
                EQUITY (DEFICIT):Common
                stock, $.001 par value, 45,000,000 shares authorized, shares issued
                and
                outstanding:
              December
                31, 2005 -15,607,230, December 31, 2004 —11,631,832
            
            
            15,607
            
            
            11,632Additional
                paid-in capital
            
            
            58,982,617
            
            
            34,809,832Accumulated
                deficit
            
            
            (52,325,593
            )
            
            (36,732,554
            )Total
                stockholders' equity (deficit)
            
            
            6,672,631
            
            
            (1,911,090
            )TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
            
            $
            14,558,079
            
            $
            773,701


See
      notes
      to financial statements.








F-3





**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**









**Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**
            
            **Year
                Ended**
              **December
                31,**
              **2003**REVENUES:Integration
                fees
            
            $
            798,178
            
            $
            374,055
            
            $
            367,617Syndication
                fees
            
            
            402,847
            
            
            176,471
            
            
            115,544Subscription
                fees
            
            
            914,674
            
            
            -
            
            
            -Professional
                Services fees
            
            
            435,486
            
            
            -
            
            
            -OEM
                revenue
            
            
            48,000
            
            
            55,936
            
            
            48,620Web
                services
            
            
            -
            
            
            62,365
            
            
            207,570Other
                revenues
            
            
            102,791
            
            
            4,093
            
            
            8,815Related
                party revenues
            
            
            -
            
            
            330,050
            
            
            513,057Total
                revenues
            
            
            2,701,976
            
            
            1,002,970
            
            
            1,261,223COST
                OF REVENUES
            
            
            400,822
            
            
            211,616
            
            
            187,064GROSS
                PROFIT
            
            
            2,301,154
            
            
            791,354
            
            
            1,074,159OPERATING
                EXPENSES:General
                and administrative
            
            
            15,208,546
            
            
            2,432,928
            
            
            1,941,920Sales
                and marketing
            
            
            1,422,345
            
            
            596,989
            
            
            321,049Development
            
            
            1,737,092
            
            
            563,372
            
            
            676,472Total
                operating expenses
            
            
            18,367,983
            
            
            3,593,289
            
            
            2,939,441LOSS
                FROM OPERATIONS
            
            
            (16,066,829
            )
            
            (2,801,935
            )
            
            (1,865,282
            )OTHER
                INCOME (EXPENSE):Interest
                expense
            
            
            (80,414
            )
            
            (119,389
            )
            
            (186,248
            )Gain
                on debt forgiveness
            
            
            556,215
            
            
            249,395
            
            
            492,757Gain
                on sale of investment
            
            
            419
            
            
            -
            
            
            -Total
                other income
            
            
            476,220
            
            
            130,006
            
            
            306,509NET
                LOSS
            
            
            (15,590,609
            )
            
            (2,671,929
            )
            
            (1,558,773
            )Preferred
                stock dividends and accretion of discount on preferred
                stock
            
            
            -
            
            
            (2,215,625
            )
            
            (2,321,744
            )Deemed
                dividends related to beneficial conversion features of redeemable
                convertible preferred stock
            
            
            -
            
            
            -
            
            
            (495,319
            )Accretive
                dividend issued in connection with registration rights
                agreement
            
            
            -
            
            
            (206,085
            )
            
            -Converted
                preferred stock inducement cost
            
            
            -
            
            
            (3,225,410
            )
            
            -Net
                loss attributed to Common Stockholders
            
            $
            (15,590,609
            )
            $
            (8,319,049
            )
            $
            (4,375,836
            )NET
                LOSS PER SHARE:Net
                loss attributed to Common Stockholders -
              Basic
                and Diluted
            
            $
            (1.20
            )
            $
            (0.82
            )
            $
            (0.61
            )SHARES
                USED IN COMPUTING NET LOSS PER SHARE:Basic
                and Diluted
            
            
            12,960,006
            
            
            10,197,334
            
            
            7,145,047





See
      notes
      to financial statement





F-4








**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





**Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**
            
            **Year
                Ended**
              **December
                31,**
              **2003**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (15,590,609
            )
            $
            (2,671,929
            )
            $
            (1,558,773
            )Adjustments
                to reconcile net loss to netcash
                provided by (used in) operatingactivities:Depreciation
                & Amortization
            
            
            465,800
            
            
            51,531
            
            
            59,852Shares
                ssued for services in lieu of cash payments
            
            
            9,767,500
            
            
            -
            
            
            -Registration
                Rights Penalty Expense
            
            
            129,947
            
            
            -
            
            
            -Loss
                on disposal of property and equipment
            
            
            -
            
            
            8,855
            
            
            -Common
                shares, warrants, or options issued in lieu of
              Compensation
            
            
            826,739
            
            
            168,530
            
            
            1,010,109Common
                shares issued for extension of loan
            
            
            
            
            
            75,000
            
            
            75,000Common
                shares issued in exchange for warrants
            
            
            -
            
            
            350,000
            
            
            -Issuance
                of warrants
            
            
            19,231
            
            
            -
            
            
            -Gain
                on debt forgiveness
            
            
            (556,634
            )
            
            -
            
            
            -Changes
                in assets and liabilities:Accounts
                receivable
            
            
            (76,396
            )
            
            51,672
            
            
            24Related
                party receivable
            
            
            -
            
            
            38,682
            
            
            (38,682
            )Other
                accounts receivable
            
            
            4,687
            
            
            (43,455
            )
            
            -Prepaid
                expenses
            
            
            (194,519
            )
            
            (24,850
            )
            
            -Other
                assets
            
            
            39,964
            
            
            (500
            )
            
            1,447Legal
                settlement obligation
            
            
            -
            
            
            (181,563
            )
            
            (100,937
            )Deferred
                revenue
            
            
            (592,010
            )
            
            (225,951
            )
            
            (267,326
            )Accounts
                payable
            
            
            569,727
            
            
            (321,274
            )
            
            (513,533
            )Accrued
                payroll
            
            
            (110,079
            )
            
            46,946
            
            
            (27,155
            )Accrued
                payroll taxes payable
            
            
            (30,741
            )
            
            (961,196
            )
            
            289,103Accrued
                interest payable
            
            
            -
            
            
            (126,871
            )
            
            97,201Accrued
                expenses
            
            
            68,715
            
            
            -
            
            
            -Accrued
                rent payable
            
            
            -
            
            
            -
            
            
            (50,000
            )Deferred
                compensation payable
            
            
            (1,091,814
            )
            
            80,166
            
            
            335,223Net
                cash (used in) provided by operatingActivities
            
            
            (6,350,492
            )
            
            (3,686,207
            )
            
            (688,447
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchase
                of property and equipment
            
            
            (378,862
            )
            
            (82,710
            )
            
            (1,588
            )Smart
                CRM Non-Compete Agreement
            
            
            (90,000
            )
            
            -
            
            
            -Cash
                acquired from iMart at Acquisition
            
            
            32,028
            
            
            -
            
            
            -Redemption
                (Purchase) of marketable securities
            
            
            395,000
            
            
            (395,000
            )
            
            -Net
                cash used in investing activities
            
            
            (41,834
            )
            
            (477,710
            )
            
            (1,588
            )








F-5








CASH
                FLOWS FROM FINANCING ACTIVITIES:Borrowings
                on notes payable
            
            
            -
            
            
            -
            
            
            190,000Repayments
                on notes payable
            
            
            (326,157
            )
            
            (350,000
            )
            
            (10,000
            )Cash
                reserved for iMart purchase price payment - restricted
                cash
            
            
            (230,244
            )
            
            -
            
            
            -Payments
                on Capital Lease
            
            
            (2,287
            )
            
            -
            
            
            -(Repayments)
                borrowings from stockholder
            
            
            -
            
            
            (86,480
            )
            
            39,686Issuance
                of Common Stock
            
            
            8,212,641
            
            
            4,672,250
            
            
            544,895Net
                cash provided by financing activities
            
            
            7,653,953
            
            
            4,235,770
            
            
            764,581NET
                INCREASE IN CASH
              AND
                CASH EQUIVALENTS
            
            
            1,261,627
            
            
            71,853
            
            
            74,546CASH
                AND CASH EQUIVALENTS,
              BEGINNING
                OF PERIOD
            
            
            173,339
            
            
            101,486
            
            
            26,940CASH
                AND CASH EQUIVALENTS,
              END
                OF PERIOD
            
            $
            1,434,966
            
            $
            173,339
            
            $
            101,486Supplemental
                disclosures:Cash
                payment during the year for interest:
            
            $
            158,232
            
            $
            47,447
            
            $
            89,047Cash
                payment during the year for income taxes:
            
            $
            -
            
            
            -
            
            
            -Non-cash
                financing activities:Notes
                Payables issued related to Acquisitions
            
            $
            3,659,301
            
            
            -
            
            
            -Notes
                Payable for iMart Non-Compete Agreements
            
            $
            715,998
            
            
            -
            
            
            -Assets
                and Liabilities of Computility acquired for stock:Accounts
                Receivable, net
            
            $
            6,894
            
            
            -
            
            
            -Other
                Current Assets
            
            $
            10,742
            
            
            -
            
            
            -P,P&E,
                net
            
            $
            388,128
            
            
            -
            
            
            -Other
                Assets
            
            $
            246,228
            
            
            -
            
            
            -Accounts
                Payable
            
            $
            109,897
            
            
            -
            
            
            -Subscription
                & Notes Payable
            
            $
            1,807,327
            
            
            -
            
            
            -Other
                Liabilities
            
            $
            29,549
            
            
            -
            
            
            -Non-cash
                accretion of preferred
            
            
            
            
            
            -
            
            
            -stock
                redemption value
            
            $
            -
            
            $
            2,215,625
            
            $
            2,321,744Conversion
                of preferred stockinto
                Common Stock
            
            $
            -
            
            $
            19,724,839
            
            $
            -Conversion
                of preferred stockinducement
                cost
            
            $
            -
            
            $
            3,225,410
            
            $
            -





See
      notes
      to financial statements





F-6








**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ DEFICIT**


**FOR
      THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**




**Common**
              **Stock**
              **$.001
                Par**
            
            **Additional**
              **Paid-**
              **In
                Capital**
            
            **Accumulated**
              **Deficit**
            
            **Total**BALANCE,
                JANUARY 1, 2003
            
            $
            7,037
            
            $
            9,299,678
            
            $
            (28,575,038
            )
            $
            (19,268,323
            )Issuance
                of restricted stock
            
            
            75
            
            
            49,500
            
            
            -
            
            
            49,575Interest
                expense associated with notes payable
            
            
            150
            
            
            74,850
            
            
            -
            
            
            75,000Accretion
                of redeemable preferred
            
            
            -
            
            
            (2,321,744
            )
            
            -
            
            
            (2,321,744
            )Issuance
                of stock option to consultant
            
            
            -
            
            
            9,109
            
            
            -
            
            
            9,109Issuance
                of warrant to financial advisor
            
            
            -
            
            
            466,000
            
            
            -
            
            
            466,000Issuance
                of stock options to officers
            
            
            -
            
            
            535,000
            
            
            -
            
            
            535,000Deemed
                dividend related to beneficial conversion features of redeemable
                convertible preferred stock
            
            
            -
            
            
            495,319
            
            
            (495,319
            )
            
            -Net
                loss
            
            
            -
            
            
            -
            
            
            (1,558,773
            )
            
            (1,558,773
            )BALANCE,
                DECEMBER 31, 2003
            
            
            7,262
            
            
            8,607,712
            
            
            (30,629,130
            )
            
            (22,014,156
            )Conversion
                of preferred stock intoCommon
                Stock
            
            
            2,949
            
            
            19,721,890
            
            
            -
            
            
            19,724,839Conversion
                of preferred stockinducement
                cost
            
            
            -
            
            
            3,225,410
            
            
            (3,225,410
            )
            
            -Interest
                expense associated with notesPayable
            
            
            -
            
            
            75,000
            
            
            -
            
            
            75,000Accretion
                of redeemable preferred
            
            
            -
            
            
            (2,215,625
            )
            
            -
            
            
            (2,215,625
            )Issuance
                of Common Stock, net of issuance costs of $183,350
            
            
            1,289
            
            
            4,762,355
            
            
            -
            
            
            4,763,644Issuance
                of Common Stock rescinded
            
            
            (29
            )
            
            (99,973
            )
            
            -
            
            
            (100,002
            )Issuance
                of stock options to officers
            
            
            -
            
            
            161,000
            
            
            -
            
            
            161,000Issuance
                of stock options to members of advisory board
            
            
            -
            
            
            6,034
            
            
            -
            
            
            6,034Issuance
                of Common Stock to former holders of preferred stock pursuant to
                registration rights agreement
            
            
            58
            
            
            206,027
            
            
            (206,085
            )
            
            -Conversion
                of Bank One warrant into Common Stock
            
            
            100
            
            
            349,900
            
            
            -
            
            
            350,000Issuance
                of stock option to consultant
            
            
            -
            
            
            1,495
            
            
            -
            
            
            1,495Exercise
                of warrants
            
            
            3
            
            
            8,607
            
            
            -
            
            
            8,610Net
                loss
            
            
            
            
            
            
            
            
            (2,671,929
            )
            
            (2,671,929
            )BALANCE,
                DECEMBER 31, 2004
            
            
            11,632
            
            
            34,809,832
            
            
            (36,732,554
            )
            
            (1,911,090
            )Issuance
                of Common Stock, net of issuance costs of $630,525
            
            
            1,392
            
            
            6,719,614
            
            
            -
            
            
            6,721,006Exercise
                of warrants
            
            
            580
            
            
            1,305,518
            
            
            -
            
            
            1,306,098Issuance
                of warrants
            
            
            -
            
            
            19,231
            
            
            -
            
            
            19,231Issuance
                of Common Stock for services
            
            
            40
            
            
            343,408
            
            
            -
            
            
            343,448Issuance
                of Common Stock to employees as bonus
            
            
            4
            
            
            40,106
            
            
            -
            
            
            40,110Exercise
                of stock options
            
            
            16
            
            
            57,734
            
            
            -
            
            
            57,750Issuance
                of IR Shares-GIC
            
            
            625
            
            
            5,174,375
            
            
            -
            
            
            5,175,000Issuance
                of IR Shares-Berkley
            
            
            625
            
            
            4,561,875
            
            
            -
            
            
            4,562,500iMart
                Acquisition
            
            
            205
            
            
            1,815,688
            
            
            -
            
            
            1,815,893Computility
                Acquisition
            
            
            484
            
            
            3,534,271
            
            
            -
            
            
            3,534,755Issuance
                of Shares to Spectrum Technologies
            
            
            3
            
            
            22,497
            
            
            -
            
            
            22,500Elimination
                of iMart (Bayberry) Equity not acquired
            
            
            -
            
            
            -
            
            
            (2,430
            )
            
            (2,430
            )Issuance
                of options to consultants
            
            
            -
            
            
            570,014
            
            
            -
            
            
            570,014Issuance
                of Common Stock for technology license
            
            
            1
            
            
            7,499
            
            
            -
            
            
            7,500Gift
                of shares to charitable organization
            
            
            -
            
            
            955
            
            
            -
            
            
            955Net
                Loss
            
            
            
            
            
            
            
            
            (15,590,609
            )
            
            (15,590,609
            )BALANCE
                DECEMBER 31, 2005
            
            $
            15,607
            
            $
            58,982,617
            
            $
            (52,325,593
            )
            $
            6,672,631





See
      notes
      to financial statements.





F-7





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**FOR
      THE YEARS ENDED DECEMBER 31, 2005, 2004 and 2003.**





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





Smart
      Online (or the “Company” as such term is used occasionally) develops and markets
      Internet-delivered Software-as-a-Service (SaaS) software applications and data
      resources to start and grow small businesses with one to one hundred employees.
      Many small business users access our product directly through our portal at www.smartonline.com ,
      and
      small businesses can also access some of our products through the web sites
      of
      major companies, financial institutions and media companies with whom we have
      private label syndication partnering agreements. Expanding this network of
      relationships with large companies is one of our key strategies to generate
      revenue while minimizing our marketing and sales expenses. We also offer the
      services and software of other companies on our websites, through integration
      agreements under which we share revenue from sales of products and services
      of
      our integration partners. Our CD-ROM products are sold primarily through OEM
      arrangements.





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, 2005,
      2004
      and 2003, Smart Online incurred net losses as well as negative cash flows and,
      at December 31, 2005, has deficiencies in working capital. These factors
      indicate that Smart Online may be unable to continue as a going
      concern.





The
      financial statements do not include any adjustments relating to the
      recoverability and classification of recorded asset amounts or the amounts
      or
      classification of liabilities that might be necessary should Smart Online be
      unable to continue as a going concern. As of December 31, 2005, we had a $2.3
      million Working Capital deficiency and recurring losses from operations. Smart
      Online's continuation as a going concern depends upon its ability to generate
      sufficient cash flows to meets its obligations on a timely basis, to obtain
      additional financing as may be required and ultimately to attain profitable
      operations and positive cash flows. Smart Online's future plans include the
      development introduction and maintenance of Smart Online’s OneBiz SM platform, and the introduction of additional new products and enhancing its
      web
      native business applications.




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





**2.** **SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES**




*Principles
      of Consolidation -* The
      accompanying consolidated financial statements include the accounts of Smart
      Online, Inc., Smart CRM, Inc., and Smart Commerce, Inc. All significant
      intercompany accounts and transactions have been eliminated. Minority interests
      in certain subsidiaries are not significant. Subsidiary accounts are included
      only from the date of acquisition forward. See Note 17 -
      Acquisitions.





*Revenue
      Recognition* -
      We
      recognize revenue in accordance with accounting standards for software and
      service companies including United States Securities Exchange Commission
      (“SEC”), Staff Accounting Bulletin No. 104 *Revenue
      Recognition* (“SAB
      104”), the Emerging Issues Task Force Issue No. 00-21 *Revenue
      Arrangements with Multiple Deliverables* (“EITF
      00-21”) *,* Statement of Position 97-2 *Software
      Revenue Recognition* as
      modified by Statement of Position 98-9 and related interpretations including
      American Institute of Certified Public Accountants (“AICPA”) Technical Practice
      Aids. We also utilize interpretative guidance from regulatory and accounting
      bodies, which include, but are not limited to, the SEC, the AICPA, the Financial
      Accounting Standards Board (“FASB”), and various professional
      organizations.





F-8





Syndication
      and Integration Fees





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





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








F-9





Integration
      fees consist primarily of fees charged to partners to integrate their products
      into the Smart Online syndication platform. Integrating third-party content
      and
      products has been one of Smart Online’s strategies to continuously expand and
      enhance its platform offered to syndication partners and its own customer base.
      We generally invoice our customers in advance of the service period in annual
      or
      monthly installments and typical payment terms provide that our customers pay
      us
      within 30 days of invoice. Amounts that have been invoiced are recorded in
      accounts receivable and in deferred revenue and the revenue is recognized
      ratably over the specified lives of the contracts, commencing on the date the
      site goes on-line. We continue to evaluate and adjust the length of these
      amortization periods as we gain more experience with implementation schedules
      and contract cancellations. At present, Smart Online has insufficient historical
      data to determine if the relationship with its existing customers will extend
      beyond the initial term with the customer continuing to benefit from the advance
      fee. If Smart Online determines that existing and/or future contracts are
      expected to extend beyond the initial term whereby the customer continues to
      benefit from the advance fee, Smart Online will extend the revenue recognition
      period accordingly to include the extended term. Our contract and support
      contracts are noncancelable, though they provide for early termination upon
      a
      material breach by either party that is not cured in a timely manner. Should
      the
      contract terminate earlier than its term then we recognize the remaining
      deferred revenue upon termination. Based on that experience, it is possible
      that, in the future, the estimates of customer lives may change and, in such
      event, the period over which such syndication revenues are amortized will
      be adjusted. Any such change in specified contract lives will affect our future
      results of operations. Additionally, integration agreements typically include
      an
      upfront fee and a revenue sharing component. Fees derived from such revenue
      sharing arrangements are recorded when earned. To date such revenue sharing
      fees
      have been negligible. During 2005, 2004, 2003, Smart Online recognized revenues
      from early termination of contracts in the amount of $69,375, $3,158, and
      $76,389, respectively.





Online
      marketing, which consists of marketing services provided to our integration
      and
      syndication partners have in the past generated additional revenue. In addition,
      certain users have requested that Smart Online implement online marketing
      initiatives for them. Online marketing has not been a material source of past
      revenue. We intend to see an increase in the level of online marketing services
      in the future.





Subscription
      Fees





Subscription
      fees are generated by several different product and service offerings including
      (1) e-commerce sales to end-users, (2) web hosting, (3) subscription based
      domain registration fees and (4) monthly service fees under fixed-length
      subscription contracts. In some instances, cash is received in advance of
      services rendered. In such cases, revenue is deferred and recognized monthly
      as
      services are rendered. Most end user subscriptions and contracts are paid for
      using either credit cards for which the Company receives remittances from the
      credit card associations generally within two days after the sale transaction
      is
      processed or by Automated Clearing House (ACH) withdrawl by the 15 th of each
      month.





Professional
      Services





Professional
      services consist of consulting services or other services purchased by customers
      that are billed on a time and material basis. Revenue is recognized at the
      time
      services are rendered, material is received by the customer or at the time
      when
      milestones are achieved and accepted by the customer for fixed price
      contracts.





OEM
      Revenue





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








F-10





Additionally,
      Smart Online receives a portion of third-party sales of products and services
      through revenue sharing arrangements, which involves a split of realized
      revenues. Hosting and maintenance fees are charged for supporting and
      maintaining the private-label portal and providing customer and technical
      support directly to our syndication partner’s users and are recognized on a
      monthly basis. E-commerce website design fees which are charged for building
      and
      maintaining corporate websites or to add the capability for e-commerce
      transactions, are recognized over the life of the project. Online loan
      origination fees are charged to provide users online financing option by which
      Smart Online receives payments for loan or credit provided.







*Barter
      Transactions -* Barter
      revenue relates to syndication and integration services provided by Smart Online
      to business customers in exchange for advertising in the customers’ trade
      magazines and on their Web sites. Barter expenses reflect the expense offset
      to
      barter revenue. The amount of barter revenue and expense is recorded at the
      estimated fair value of the services received or the services provided,
      whichever is more objectively determinable, in the month the services and
      advertising are exchanged. Smart Online applies APB 29, *Accounting
      for Non-Monetary Transactions* ,
      the
      provisions of EITF 93-11, *Accounting
      for Barter Transactions Involving Barter Credits* and EITF
      99-17 *Accounting
      for Advertising Barter Transactions* and,
      accordingly, recognizes barter revenues only to the extent that Smart Online
      has
      similar cash transactions within a period not to exceed six months prior to
      the
      date of the barter transaction. To date the amount of barter revenue to be
      recognized has been more objectively determinable based on integration and
      syndication services provided. For revenue from integration and syndication
      services provided for cash to be considered similar to the integration and
      syndication services provided in barter transactions, the services rendered
      must
      have been in the same media and similar term as the barter transaction. Further,
      the quantity or volume of integration or syndication revenue received in a
      qualifying past cash transaction can only evidence the fair value of an
      equivalent quantity or volume of integration or syndication revenue received
      in
      subsequent barter transactions. In other words, a past cash transaction can
      only
      support the recognition of revenue on integration and syndication contracts
      transactions up to the dollar amount of the cash transactions. When the cash
      transaction has been used to support an equivalent quantity and dollar amount
      of
      barter revenue, that transaction cannot serve as evidence of fair value for
      any
      other barter transaction. Once the value of the barter revenue has been
      determined, Smart Online follows the same revenue recognition principles as
      it
      applies to cash transactions with unearned revenues being deferred as described
      more fully above. At the time the barter revenue is recorded, an offsetting
      pre-paid barter advertising asset is recorded on Smart Online’s balance sheet.
      This pre-paid barter advertising asset is amortized to expense as advertising
      services are received such as when an advertisement runs in a magazine. Barter
      revenues totaled approximately $424,000 and $113,000 in 2005 and 2004,
      respectively. Smart Online did not have any barter transactions for the year
      ended December 31, 2003.




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





*Restricted
      Cash* - Under
      the terms of the purchase agreement between Smart Online and iMart Incorporated,
      cash collected by Smart Commerce is restricted as follows: this cash is used
      to
      fund (1) Smart Commerce operating expenses, then (2) purchase price payments,
      then (3) non-competition payments. Only if any cash remains after making the
      aforementioned payments can Smart Online use the cash for other
      purposes.





*Concentration
      of Credit Risk* -
      Financial instruments which potentially subject us to concentrations of credit
      risk consist principally of cash and accounts receivable. At times, our cash
      balances may exceed the FDIC insurable limits of $100,000.





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





F-11





*Subscription
      Contract Receivables -* Monthly
      subscription fees that Smart CRM is contractually entitled to receive over
      the
      remaining subscription period are netted with the corresponding liability for
      unearned revenue.




*Deferred
      Financing Costs -* Deferred
      financing costs represent cost of obtaining financing and are amortized over
      the
      life of the related financing agreements.





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





*Software
      Development Costs -* SFAS No.
      86, *Accounting
      for the Costs of Software to be Sold, Leased or Otherwise
      Marketed* ,
      requires capitalization of certain software development costs subsequent to
      the
      establishment of technological feasibility. Based on Smart Online’s product
      development process, technological feasibility is established upon completion
      of
      a working model. Costs related to software development incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant. During the third quarter of 2005,
      Smart Online acquired certain rights to an accounting software application
      that
      is currently being integrated with its OneBiz SM platform. During the third quarter of 2005, Smart Online capitalized $105,000
      of
      costs associated with the acquired software. Prior to the third quarter of
      2005,
      Smart Online had not capitalized any direct or allocated overhead associated
      with the development of software products prior to general release. During
      the
      fourth quarter, management revised its estimate as to the realizability of
      this
      asset. Accordingly, the amount was written-off and all future costs related
      to
      this software will be expensed in the period incurred until the criteria of
      SFAS
      No.86 for capitalizing software costs are met. The remaining portion of the
      software assignment and development fees is expected to be earned and payable
      during 2006.





SFAS-2,
      “ *Accounting
      for Research and Development Costs* ”,
      establishes accounting and reporting standards for research and development.
      In
      accordance with SFAS 2, costs we incur to enhance our existing products or
      after
      the general release of the service using the product are expensed in the period
      they are incurred and included in research and development costs on our
      statement of operations.





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





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





Office
                equipment
            5
                yearsComputer
                Software
            3
                yearsComputer
                Hardware
            5
                yearsFurniture
                and fixtures
            7
                yearsAutomobiles
            5
                years





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





F-12





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





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





*Advertising
      Costs -* Smart
      Online expenses all advertising costs as they are incurred. Advertising expense
      during 2005, 2004, and 2003 was $403,669, $170,774 and $3,167, respectively.
      The
      2005 period includes $273,751 of barter advertising expense. The 2004 period
      included $205,833 of barter advertising expenses and a credit of $58,400 related
      to prior advertising activities. Smart Online did not have any barter
      transactions for the year ended December 31, 2003.





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





*Stock-Based
      Compensation -* Smart
      Online accounts for its stock-based compensation plans in accordance with the
      intrinsic value provisions of Accounting Principles Board Opinion (“APB”) No.
      25, *Accounting
      for Stock Issued to Employee.* Stock
      Options are generally granted at prices equal to the fair value of Smart
      Online’s Common Stock on the grant dates (see Note 11). Accordingly, Smart
      Online did not record any compensation expense in the accompanying financial
      statements for its stock-based compensation plans. Had compensation expense
      been
      recognized consistent with the fair value provisions of SFAS No. 123, *Accounting
      for Stock-Based Compensation* ,
      Smart
      Online’s net loss attributed to Common Stockholders and net loss attributed to
      Common Stockholders per share for the years ended December 31, 2005, 2004 and
      2003 would have been changed to the pro forma amounts indicated
      below:





**Year
                ended**
              **December
                31,**
              **2005**
            
            **Year
                ended**
              **December
                31,**
              **2004**
            
            **Year
                ended**
              **December
                31,**
              **2003**Net
                loss attributed toCommon
                Stockholders:As
                reported
            
            $
            (15,590,609
            )
            $
            (8,319,049
            )
            $
            (4,375,836
            )Add:
                Compensation costrecorded
                at intrinsicValue
            
            
            -
            
            
            161,000
            
            
            535,000Less:
                Compensation cost usingthe
                fair value method
            
            
            (581,494
            )
            
            (455,301
            )
            
            (961,234
            )Pro
                forma
            
            $
            (16,172,103
            )
            $
            (8,613,350
            )
            $
            (4,802,070
            )








F-13








**Year
                ended**
              **December
                31,**
              **2005**
            
            **Year
                ended**
              **December
                31,**
              **2004**
            
            **Year
                ended**
              **December
                31,**
              **2003**Reported
                net loss attributed toCommon
                Stockholders:Basic
                and diluted
            
            $
            (1.20
            )
            $
            (0.82
            )
            $
            (0.61
            )Pro
                forma net loss per share:Basic
                and diluted
            
            $
            (1.25
            )
            $
            (0.84
            )
            $
            (0.67
            )





The
      fair
      value of option grants under Smart Online’s plan and other stock option
      issuances during the years ended December 31, 2005, 2004 and 2003 were estimated
      using the Black-Scholes option-pricing model with the following weighted-average
      assumptions:





**Year
                ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**
            
            **Year
                Ended**
              **December
                31,**
              **2003**Dividend
                yield
            
            0.00%
            
            0.00%
            
            0.00%Expected
                volatility
            
            60.20%
            
            0.00%
            
            0.00%Risk
                free interest rate
            
            4.25%
            
            4.23%
            
            4.01%Expected
                lives (years)
            
            9.5
            
            8.9
            
            5.0





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





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





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based
      Payment* (“SFAS
      123(R)”). SFAS 123(R), a revision of SFAS 123, *Accounting
      for Stock-Based Compensation* ,
      which
      supersedes APB Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      and
      amends SFAS No. 95, *Statement
      of Cash Flows* .
      SFAS
      123(R) requires all share-based payments to employees, including grants of
      employee stock options, to be recognized in the financial statements based
      on
      their fair values. SFAS 123(R) is effective for the beginning of the annual
      period beginning after June 15, 2005. Therefore the Company plans to adopt
      SFAS
      123(R) on January 1, 2006. The Company is currently assessing the impact of
      this
      prospective change in accounting and believes that it will have a material
      and
      adverse impact on the Company’s reported results of operations.





**3.** **RECEIVABLES**





Smart
      Online evaluates the need for an allowance for doubtful accounts based on
      specifically identified amounts that management believes to be uncollectible.
      Based upon the aforementioned criteria, management has determined that no
      provision for uncollectible accounts is required as of December 31, 2005, 2004,
      or 2003.








F-14





**4.** **MARKETABLE
      SECURITIES**





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




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





Smart
      Online did not hold any marketable securities as of December 31,
      2005.





**5.** **PROPERTY
      AND EQUIPMENT**





Property
      and equipment consists of the following at:




**December
                31,**
              **2005**
            
            
            **December
                31,**
              **2004**
            
            
            **December
                31,**
              **2003**Office
                equipment
            $
            155,054
            
            $
            16,187
            
            $
            10,026Furniture
                and fixtures
            
            7,125
            
            
            7,125
            
            
            7,125Computer
                software
            
            550,775
            
            
            393,629
            
            
            389,064Computer
                hardware and equipment
            
            1,252,089
            
            
            663,723
            
            
            684,998Automobiles
            
            29,504
            
            
            29,504
            
            
            —1,994,547
            
            
            1,110,168
            
            
            1,091,213Less
                accumulated depreciation
            
            (1,330,485
            )
            
            (1,034,532
            )
            
            (1,042,266
            )Property
                and equipment, net
            $
            664,062
            
            $
            75,636
            
            $
            48,947





Depreciation
      expense for the years ended December 31, 2005, 2004 and 2003 was $150,204,
      $47,167 and $59,852, respectively.





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





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





**Asset
                Category**
            **Value
                Assigned**
            **Residual**
              **Value**
            **Weighted**
              **Avg
                Useful**
              **Life**
            **Accumulated**
              **Amortization**
            **Carrying**
              **Value**Customer
                Base
            $
                2,504,989
            $0
            5.9
            $
                106,744
            $ 
                2,398,245Technology
            $
                1,249,842
            $0
            3
            $
                100,468
            $ 
                1,149,374Non-Compete
            $   
                891,785
            $0
            3.9
            $  
                49,260
            $    
                842,525Copyright
                & Trademark
            $     
                50,339
            $0
            10
            $  
                34,313
            $    
                  16,026Trade
                Name *
            $
                1,180,499
            n/a
            n/a
            n/a
            $ 
                1,180,499Work
                Force &
              Goodwill
                *
            $
                5,489,963
            n/a
            n/a
            n/a
            $   5,489,963**TOTALS**
            **$
                11,367,417**
            
            
            **$290,785**
            **$11,076,632**





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





Intangible
      assets acquired, excluding goodwill, were valued based on the results of an
      independent valuation performed by a certified appraiser. Goodwill was
      calculated as the difference between the purchase price of the acquisition
      (which was negotiated as an arms-length transaction) and the value of the
      identifiable tangible and intangible assets acquired. Trademarks and copyrights
      were capitalized using the costs of all legal and application fees
      incurred.





F-15





For
      the
      years ended December 31, 2005, 2004 and 2003, the aggregate amortization expense
      on the above intangibles was approximately $260,788, $4,365 and $4,128,
      respectively. The estimated aggregate amortization expense for the above assets
      for the years ended December 31, 2006 through 2010 is approximately $1,099,000,
      $1,099,000, $992,000, $578,000 and $285,000 for each respective year. All
      intangible assets are amortized using the straight-line method over their
      estimated useful lives.





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





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





Deferred
      compensation totaling $0, $99,287, and $353,816 is included in salaries and
      wages expense for the years ended December 31, 2005, 2004 and 2003,
      respectively. The following is a summary of deferred compensation and accrued
      interest payable on the deferred compensation as of:




**December
                31,**
              **2005**
            
            **December
                31,**
              **2004**Deferred
                Compensation
            
            $
            0
            
            $
            949,777Accrued
                interest payable on deferred compensation
            
            
            0
            
            
            142,037Total
                deferred compensation
            
            $
            0
            
            $
            1,091,814





**8.** **LOANS**





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





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








F-16





**9.** **NOTES
      PAYABLE**





As
      of
      December 31, 2005, Smart Online had Notes Payable totaling $5,917,308. The
      detail of these notes is as follows:





Note
                Description
            S/T
                Portion
            L/T
                Portion
            Total
            Maturity
            RateiMart
                Purchase Price Note
            $1,559,657
            $1,718,139
            $3,277,796
            Jan
                2007
            8.0%iMart
                Non-Compete Note
            352,041
            375,921
            727,962
            Oct
                2007
            8.0%Acquisition
                Fee - iMart
            118,461
            95,847
            214,308
            Oct
                2007
            8.0%Acquisition
                Fee - Computility
            97,327
            53,745
            151,072
            Mar
                2007
            8.0%Subscription
                Factor Payable
            855,060
            541,110
            1,396,170
            Various
            9%
                - 10.5%Floor
                Plan Agreement
            62,500
            87,500
            150,000
            Feb
                2008
            Prime+4





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




2006:
              
              $
              3,045,0462007:
              
              
              2,775,1672008:
              
              
              97,095TOTAL:
              
              $
              5,917,308
  Smart
      CRM
      borrows money to provide working capital for operations and purchases of
      subscriber equipment by factoring a majority of new subscription contracts
      with
      various financing companies. Smart CRM assigns a percentage of the future
      subscription cash flows on the contract, generally 70%, to the financing
      companies and receives an advance on the discounted present value of the
      assigned cash flows. The lender takes an assignment of the contract and the
      subscriber equipment until the loan is paid. Subscription
      Financing Payable represents the amount of customer contracts that have been
      factored. Terms of the repayments vary from contract to contract based on the
      number of months remaining on the contract at the time it was factored.
      Contracts are typically factored with 30 to 36 months remaining. The amount
      payable is made up of many smaller factoring contracts which have interest
      rates
      ranging from 9.0% to 10.5%. As of December 31, 2005, contracts were being
      factored at 10.5%.





In
      February 2005, Computility entered into a Floor Plan Agreement with a finance
      company that provided additional debt financing of $150,000 for working capital.
      The debt is secured by subscription revenues and is required to be repaid in
      12
      equal monthly installments beginning in March 2006. Interest is at the corporate
      prime rate plus 4%. Smart Online assumed this debt as part of the October 2005
      acquisition (asset purchase) of Computility. As of December 31, 2005, the
      interest rate on this Floor Plan Agreement was 11.5%.





**10.** **LEASES**




*Operating
      Leases* -
      Smart
      Online and Smart CRM lease facilities under renewable operating lease agreements
      which current term expires in October 2006 and September 2006, respectively.
      As
      of December 31, 2005, future annual minimum operating lease payments are as
      follows:




2006
            
            $
            186,400Total
            
            $
            186,400

















Rent
      expense for the years ended December 31, 2005, 2004, and 2003, respectively
      was
      $251,800, $99,606 and $87,146, respectively.








F-17





**11.** **STOCKHOLDERS’
      DEFICIT**





*Corporate
      Reorganization*





During
      the first quarter of 2004, Smart Online completed a corporate reorganization
      of
      its capital stock, which eliminated the Series A Preferred Stock of Smart
      Online. All holders of Series A Preferred Stock who participated in the
      reorganization by signing Reorganization, Lock-up Proxy and Release Agreements
      dated January 1, 2004 (the “Reorganization Agreements”) received 2.22 shares of
      Common Stock (1.22 shares under the conversion rights of the Series A Preferred
      and one share in exchange for contractual commitments) of Smart Online for
      each
      share of Series A Preferred Stock they held prior to the reorganization and
      also
      received the right to receive cash payments from Smart Online equal to a
      percentage of the net proceeds Smart Online raised during calendar year 2004
      from sales of equity securities and convertible debt securities in excess of
      $5
      million of net proceeds. Smart Online received net proceeds of $4,763,644 from
      the sale of equity and convertible debt securities during calendar year 2004
      and
      therefore, had no liability to the former holders of Series A Preferred
      Stock.





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





*Common
      Stock*





Smart
      Online is authorized to issue 45,000,000 shares of Common Stock, $0.001 par
      value per share (the “Common Stock”). As of December 31, 2005, Smart Online has
      15,607,230 shares of Common Stock outstanding. Holders of Common Stock are
      entitled to one vote for each share of Common Stock held by them.





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





On
      August
      6, 2004, Smart Online made a rescission offer to shareholders who purchased
      999,141 shares of Common Stock of Smart Online and warrants to acquire an
      additional 288,638 shares of Common Stock for $3.50 per share in a private
      placement conducted during March through June of 2004, in which Smart Online
      raised a total of $3,496,994. The rescission offer was made because in
      connection with the audit of its financial statements and due diligence review
      of information in connection with the registration of shares sold in the private
      placement described above, Smart Online identified certain inaccuracies and





F-18





omissions
      in the information it provided to investors in the private placement. These
      inaccuracies and omissions included changes to how Smart Online recognized
      revenue, establishing reserves for contingent liabilities, inventory, accounts
      receivable, and equipment write downs and other accounting adjustments, failing
      to disclose the effects of anti-dilution provisions after dilutive issuances
      and
      failure to disclose information about customers, discounting, promotions and
      other product price information. Upon identifying such inaccuracies and
      omissions, Smart Online made the rescission offer and disclosed the inaccuracies
      and omissions to all investors who purchased shares in the private placement.
      In
      the rescission offer, Smart Online offered to repurchase all the shares and
      warrants sold in the private placement for the original purchase price, plus
      interest, and afforded shareholders a thirty-day period in which to accept
      the
      rescission offer. One shareholder accepted the rescission offer and Smart Online
      paid that shareholder $102,610 as payment in full of the purchase price,
      including interest thereon of $2,608 in exchange for 28,572 shares of Common
      Stock and warrants to purchase 7,500 shares of Common Stock. No other
      shareholders accepted the rescission offer and all shareholders to whom the
      offer was made executed and delivered releases for any potential liabilities
      arising out of disclosures made by Smart Online in the private placement.





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





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





During
      February and March 2005, Smart Online sold 500,000 and 80,000 shares of Common
      Stock, respectively, to foreign investors in sales exempt under Regulation
      S.
      The February and March 2005 stock sales resulted in gross proceeds of $2,500,000
      and $400,000, respectively. A portion of those funds were used to repay deferred
      compensation, including interest thereon, as more fully discussed in Note 7.
      In
      connection with this financing, Smart Online incurred stock issuance costs
      of $290,000 to an entity that is an existing shareholder. Concurrent with
      the sale of Common Stock, Smart Online issued warrants to purchase 50,000 shares
      of Common Stock to this investor in consideration for the investor agreeing
      to
      certain restrictions on their ability to sell the shares. These warrants have
      an
      exercise price of $5 per share and terminate on January 1, 2007. During February
      2005, Smart Online raised an additional $125,000 in gross proceeds from the
      sale
      of 25,000 shares of Common Stock at $5.00 per share in a private placement.





F-19








During
      the third quarter, Smart Online sold 786,642 shares of its Common Stock to
      a new
      and existing investors for a price of $5.50 per share resulting in gross
      proceeds of $4,326,531. In connection with this financing, the Smart Online
      incurred stock issuance costs of $340,525 to an entity introduced to Smart
      Online by an existing shareholder, Doron Roethler. Additionally, in connection
      with these offerings, Smart Online entered into Registration Rights Agreements
      with these shareholders under which Smart Online is required to file a
      registration statement with the SEC to register the shares sold in the offering
      no later than September 30, 2005. As of December 31, 2005, Smart Online had
      accrued $129,945 of Registration Rights Penalties which the company expects
      to
      pay in stock. The accrual of this penalty has been treated as a period cost
      as
      part of general and administrative expenses.





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





*Preferred
      Stock*





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





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





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





As
      described above, in March 2004, the outstanding shares of Smart Online’s Series
      A Redeemable Preferred Stock were converted to Common Stock pursuant to a plan
      of reorganization approved by Smart Online’s Board of Directors and
      shareholders. The carrying value of $19,724,839 for redeemable preferred stock
      at date of conversion was reclassed to Common Stock and additional paid-in
      capital. The Series A Redeemable Preferred Stock had a noncumulative dividend
      rate of $0.35 per quarter, a liquidation preference of $15.12 per share, plus
      declared unpaid dividends, was convertible into Common Stock at an initial
      rate
      of one share of Common Stock for each share of Series A Redeemable Preferred
      Stock (but the conversion rate increased to approximately 1.22 shares of Common
      Stock for each share of Series A Redeemable Preferred Stock at the time of
      conversion pursuant to weighted average antidilution provisions), was entitled
      to cast one vote for each share of Common Stock into which it was convertible
      voting as a single class with the Common Stock, had class voting rights with
      respect to certain major corporate events and was redeemable at the option
      of
      its holders after August 31, 2004 for a price equal to $14 per share, plus
      7%
      compounded annually. There were no shares of Preferred Stock outstanding at
      December 31, 2005.





F-20








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





*Restricted
      Stock*





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





Smart
      Online did not issue any restricted stock during 2004.





*Warrants*





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





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





During
      the first half of 2004, Smart Online issued warrants to purchase an aggregate
      of
      288,638 (7,500 of which were cancelled as part of the rescission offer described
      above) shares of Common Stock to shareholders in connection with the 2004 Common
      Stock issuance described above. These warrants have an exercise price of $3.50
      per share and expire in 2014. During November 2004, holders of warrants to
      purchase 2,460 shares of Common Stock at $3.50 per share were exercised
      resulting in proceeds of $8,610.





During
      February 2005, a consulting firm that was issued 350,000 warrants in November
      2003 acquired 50,000 shares of Smart Online’s Common Stock as a result of the
      cashless exercise of warrants. Warrants to purchase 67,568 shares of Common
      Stock were cancelled in this cashless exercise. The fair market value of Smart
      Online’s Common Stock at the time of exercise was $5.00. During May 2005, this
      same consulting firm acquired 48,617 shares of Smart Online’s Common Stock as a
      result of the cashless exercise of warrants. Warrants to purchase 62,432 shares
      of Common Stock were cancelled in this cashless exercise. The fair market value
      of Smart Online’s Common Stock at the time of exercise was $5.875. At December
      31, 2005 ,
      27,000
      of the warrants issued in November 2003 were still outstanding.




During
      the third quarter of 2005, holders of warrants to purchase 355,428 shares of
      Common Stock exercised their warrants resulting in gross proceeds to Smart
      Online of $1,175,998. The warrants had exercise prices that ranged from $1.30
      to
      $5.00 per share.








F-21





All
      the
      foregoing warrants contain cashless exercise provisions.





*Stock
      Option Plans*





*2004
      Equity Compensation Plan*





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





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





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





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





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





During
      April 2005 Smart Online granted options to purchase 180,000 shares of Common
      Stock to a consultant, 34,000 shares of Common Stock to new Board members,
      25,000 shares to an officer, and 2,500 shares to an employee. All options were
      granted under Smart Online’s 2004 Equity Compensation Plan at an exercise price
      of $5.00 per share.





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





At
      December 31, 2005, options to purchase 1,786,750 shares of Common Stock were
      outstanding under the 2004 Plan with a weighted-average exercise price of $6.48
      per share.





*2001
      Equity Compensation Plan*





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





F-22








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





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





At
      December 31, 2005, options to purchase 670,000 shares of Common Stock were
      outstanding under the 2001 Plan. Smart Online cannot make any further grants
      under the 2001 Plan.





*1998
      Stock Option Plan*





Smart
      Online adopted the 1998 Equity Compensation Plan (the “1998 Plan”) as of
      November 12, 1998. The 1998 Plan provides for the grant of options intended
      to
      qualify as “incentive stock options,” and options that are not intended to so
      qualify or “nonstatutory stock options.” As of December 31, 2005, the total
      number of shares of our Common Stock reserved for issuance under the 1998 Plan
      is 288,900 shares, subject to adjustment in the event of stock split, stock
      dividend, recapitalization or similar change. Options to purchase 21,200 shares
      were outstanding under the 1998 Plan at December 31, 2005. Smart Online may
      not
      make any further grants under the 1998 plan.





*Additional
      Options Granted*





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





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





A
      summary
      of the status of the plan and other stock option issuances as of December 31,
      2003, 2004, 2005 and changes during the periods ended on these dates is as
      follows:





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                January 1, 2003
            
            
            771,400
            
            $
            4.69Granted
            
            
            720,000
            
            $
            1.39Forfeited
            
            
            (132,500
            )
            $
            2.27BALANCE,
                December 31, 2003
            
            
            1,358,900
            
            $
            3.18Granted
            
            
            755,000
            
            $
            3.07Forfeited
            
            
            (345,000
            )
            $
            4.12BALANCE,
                December 31, 2004
            
            
            1,768,900
            
            $
            2.78Granted
            
            
            1,535,950
            
            $
            7.98Exercised
            
            
            (16,500
            )
            $
            3.50Forfeited
            
            
            (560,400
            )
            $
            3.61BALANCE,
                December 31, 2005
            
            
            2,727,950
            
            $
            5.34








The
      following table summarizes information about stock options outstanding at
      December 31, 2005:





**Currently
                Exercisable****Exercise**
              **Price**
            **Number
                of**
              **Shares**
              **Outstanding**
            **Average**
              **Remaining**
              **Contractual
                Life**
              **(Years)**
            **Weighted**
              **Average
                Exercise**
              **Price**
            **Number
                of**
              **Shares**
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
                1.30 - $ 1.43
            670,000
            3.0
            $
                1.40
            670,000
            $  
                1.40$
                3.50
            497,500
            8.2
            $
                3.50
            240,748
            $  
                3.50$
                5.00
            286,700
            8.8
            $
                4.88
            50,200
            $  
                4.88$
                7.00 to $ 7.75
            200,500
            9.7
            $
                7.17
            39,250
            $  
                2.76$
                8.20 to $ 8.61
            811,750
            9.5
            $
                8.57
            5,000
            $  
                8.61$
                9.60 to $ 9.82
            261,500
            2.5
            $
                9.82
            52,500
            $
                13.15







F-23




The
        number of options exercisable at December 31, 2005, 2004 and 2003 were
        1,057,698, 1,367,560 and 1,358,900, respectively. The weighted average exercise
        price was $2.71 at December 31, 2005
 
 *Dividends* -
        Smart
        Online has not paid any cash dividends through December 31, 2005.




**12.** **INCOME
      TAXES**





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





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





**December
                31,**
              **2005**
            
            **December
                31,**
              **2004**
            
            **December
                31,**
              **2003**Net
                current deferred income tax
              assets
                relate to:Depreciation
            
            $
            6,000
            
            $
            3,000
            
            $
            18,000Stock
                Based Expenses
            
            
            226,000
            
            
            226,000
            
            
            -Accrued
                liabilities
            
            
            -
            
            
            -
            
            
            390,000Net
                operating loss carryforwards
            
            
            13,111,000
            
            
            11,015,000
            
            
            9,909,000Total
            
            
            13,343,000
            
            
            11,244,000
            
            
            10,317,000Less
                valuation allowance
            
            
            13,343,000
            
            
            11,244,000
            
            
            10,317,000Net
                current deferred income tax
            
            $
            -
            
            $
            -
            
            $
            -





Under
      FAS
      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,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**
            
            **Year
                Ended**
              **December
                31,**
              **2003**Statutory
                federal tax rate
            
            
            34
            %
            
            34
            %
            
            34
            %Tax
                benefit computed at statutory rate
            
            $
            (5,257,000
            )
            $
            (908,000
            )
            $
            (530,000
            )State
                income tax benefit, net of federal effect
            
            
            (704,000
            )
            
            (121,000
            )
            
            (71,000
            )Change
                in valuation allowance
            
            
            2,140,000
            
            
            927,000
            
            
            171,000Stock/Option
              Based Expense
            
            
            3,808,000
            
            
            -
            
            
            386,000Other
                adjustments
            
            
            -
            
            
            77,000
            
            
            -Other
                permanent differences
            
            
            13,000
            
            
            25,000
            
            
            44,000Total
            
            $
            -
            
            $
            -
            
            $
            -




As
      of
      December 31, 2005, Smart Online had US federal net operating loss (“NOL”)
      carryforward of approximately $34 million, which expire between 2009 and 2020.
      For state tax purposes, the NOL’s expire between 2009 and 2020. In accordance
      with Section 382 of the Internal Revenue Code of 1986, as amended, a change
      in
      equity ownership of greater than 50% of Smart Online within a three-year period
      can result in an annual limitation on Smart Online’s liability to utilize its
      NOL carryforwards that were created during tax periods prior to the change
      in
      ownership.







F-24




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





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





Smart
      Online derives a significant portion of its revenues from certain customer
      relationships. The following is a summary of customers that represent greater
      than ten percent of total revenues:





Year
                Ended December 31, 2005Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Subscription
            
            $
            319,874
            
            
            11.8
            %Others
            
            
            Various
            
            
            2,382,102
            
            
            88.2
            %Total
            
            
            
            
            $
            2,701,976
            
            
            100.0
            %





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





Year Ended
                December 30, 2003Revenues
            
            %
                of Total
              RevenuesCustomer
                E
            
            
            Integration
            
            $
            342,847
            
            
            27.2
            %Customer
                F
            
            
            Consulting
            
            
            150,000
            
            
            11.9
            %Others
            
            
            Various
            
            
            768,376
            
            
            60.9
            %Total
            
            
            
            
            $
            1,261,223
            
            
            100.0
            %







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





As
      of
      December 31, 2005, three of Smart Online's customers accounted for 25%, 22%,
      and
      10% of accounts receivable. One customer accounted for substantially all of
      the
      accounts receivable at December 31, 2004.





F-25




**14.** **RELATED
      PARTY TRANSACTIONS**





American
      Investment Holding Group, Inc., which is wholly owned by two officers of Smart
      Online, owns approximately 18.2% of the outstanding Common Stock of Smart Online
      as of December 31, 2005. The same officers also own a controlling interest
      in
      other companies.





In
      February 2005, we entered into an investment banking agreement with Berkley
      Financial Services, Ltd. whereby Berkley served as our nonexclusive agent in
      connection with the negotiations and closing of one or more transactions with
      investors outside the United States. Pursuant to this agreement, we paid Berkley
      approximately $290,000 in
      cash
      in 2005. We sent a notice of termination of this agreement to Berkley on March
      22, 2006. In addition, in October 2005, we entered into an investor relations
      agreement with Berkley, under which Berkley was paid $250,000 and issued 625,000
      shares of our stock. However, the shares have not been delivered to Berkley.
      We
      believe there may be some relationship between Doron Roethler (a shareholder
      who
      beneficially owns more than 10% of our stock) and Berkley, and we are continuing
      to explore the nature of the relationship.





During
      2005, the following loans were made by certain investors, consultants and/or
      shareholders of Smart Online to our Chief Executive Officer: (i) $809,736.49
      was
      borrowed from Leon Sokolic, one of our stockholders, (ii) $77,971.20 was
      borrowed from Atlas Capital, one of our stockholders, (iii) $80,000 was borrowed
      from Pete Coker, the principal of Tryon Capital, which provided financial
      consulting services to us and received a warrant and cash fees, and (iv)
      $296,589 was borrowed from Berkley Financial Services, which was paid
      substantial amounts of cash and stock from us, including during the period
      in
      which Berkley was making loans to our Chief Executive Officer. Our Chief
      Executive Officer has agreed with the Audit Committee that he will repay the
      loans from Berkley by December 31, 2006.





In
      March
      2005, Smart Online entered into a consulting agreement with Hadar, LLC. David
      E.Y. Sarna, a member of Hadar, was appointed as a member of our Board of
      Directors on April 18, 2005, elected Chairman of the Audit Committee of our
      Board of Directors September 13, 2005, and resigned from our Board and all
      Committees of the Board on June 23, 2006. Our understanding is that Mr. Sarna
      and Isaac Nussen were and remain partners of Hadar. Under the terms of that
      agreement, Hadar was to act as a financial advisor to Smart Online regarding
      the
      introduction and evaluation of potential investors. Payment for these services
      was to be 8% of proceeds for investors who invest $5 million or less, and 6%
      of
      proceeds for investors who invest over $5 million. Upon Mr. Sarna’s election to
      the Board of Directors, no further business was conducted between Hadar and
      Smart Online. No monies were ever paid to Hadar by Smart Online, and no monies
      are payable to Smart Online. We do not believe that Hadar provided services
      to
      us under the consulting agreement, but we are reviewing whether Hadar or anyone
      affiliated with Hadar may have received equity in Smart Online from third party
      investors in conjunction with the consulting agreement.





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





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





During
      2003, we provided consulting services totaling $150,000 to Parson and Shearson,
      Inc., an entity owned 50% by our Chief Executive Officer and 50% by our Chief
      Executive Officer’s brother, who is also an employee of Smart Online. The
      consulting income is included in the Statement of Operations under “Related
      Party Revenues.”





On
      August
      13, 2002, we entered into an integration agreement with SIL, a company owned
      by
      Doron Roethler, one of our stockholders, to incorporate its products into our
      platform. As part of this agreement, SIL paid us $300,000 for such integration,
      and the parties agreed to share future revenues generated from the sales of
      the
      products. On August 30, 2002, the parties signed an amendment to the original
      agreement, in order for us to provide SIL certain co-development services,
      which
      includes instant messenger and video conferencing. In exchange, SIL paid us
      an
      additional sum of $300,000. The parties further agreed that the products
      developed as a result of both companies’ efforts will be owned by both parties.
      On April 30, 2003, Smart Online and SIL signed a new amendment and restated
      the
      integration program agreement. Pursuant to this new amendment and restated
      agreement, we agreed to fund the future development of the products and
      increased SIL’s obligation by $200,000 to a total of $800,000. In exchange, SIL
      agreed to limit future amounts payable by us under the original shared revenue
      agreement to $1.7 million. This cap on revenue sharing was removed by amendment
      on October 29, 2003.




In
      addition to the agreements described above, on August 30, 2002, Smart Online
      and
      SIL also entered into a reseller agreement whereby SIL paid us $200,000 for
      nonexclusive rights to distribute our products in certain foreign territories
      in
      exchange for our marketing support and a twenty percent commission from the
      gross sales generated by SIL. Under the terms of this agreement, we are to
      collect the revenue, if any, from our customers and then make the required
      payments to SIL. On May 1, 2003, the Company and SIL terminated this reseller
      agreement. However, under the terms of that termination agreement, certain
      of
      our payment obligations to SIL survive termination with regard to a limited
      number of prospective business candidates. The integration of certain third
      party products could trigger a payment obligation of 80,000 shares of our Common
      Stock to Mr. Roethler. We expect no revenue from SIL, unless SIL hires employees
      to sell our products. We do not know whether SIL intends to hire employees
      to
      sell our products.




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





In
      March
      2004, SIL ceased further development of its technology and laid-off its
      employees. SIL is currently seeking opportunities to license or sell its
      technology. We continue to support this technology on behalf of SIL with the
      current integration agreement running into October 2006. The revenues derived
      from this agreement with SIL were recognized as income on a straight line basis
      over the life of the agreement. We recognized $0, $330,051 and $342,857 of
      revenue related to the aforementioned integration, co-development and reseller
      agreements during 2005, 2004 and 2003, respectively.





F-26








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





As
      of
      December 31, 2001, we owed an officer of Smart Online $40,731 related to loans
      he had made to Smart Online. During 2002, we borrowed an additional $77,980
      from
      and repaid $108,316 to this same officer. During 2003, we borrowed an additional
      $340,776 from and repaid $264,692 to this officer. During the first nine months
      of 2004, we borrowed an additional $4,793 from and repaid the entire remaining
      outstanding balance of $91,273 to this officer. At December 31, 2003 and 2002,
      we owed $86,480 and $10,395, respectively, to this officer. Until October 2003,
      we did not pay any interest on these loans, thereafter the loans accrued
      interest at a rate of 15.0%. Additionally, during 2003, we lent a trust
      established by this officer $494,473, of which $455,792 was repaid in the same
      year. During the first nine months of 2004, we lent the trust an additional
      $142,860, and the trust repaid the entire balance owed, totaling $181,542.
      As of
      December 31, 2005, all borrowings from and loans to the officer and the trust
      were repaid in full. We recorded interest expense of $0, $4,649, and $2,007
      during 2005, 2004, and 2003, respectively, related to these
      loans.





The
      following is a summary of related party revenues for the years ended December
      31, 2005, 2004 and 2003.





**Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**
            
            **Year
                Ended**
              **December
                31,**
              **2003**Smart
                II, Ltd. ("SIL"), formerly
              known
                as Smart Revenue Europe
              Ltd.
                - Integration fees
            
            $
            -
            
            $
            330,050
            
            $
            342,857Parson
                and Shearson, Inc. -
              Consulting
                Services
            
            
            -
            
            
            -
            
            
            150,000Small
                Business Lending Institute
              Consulting
                Services
            
            
            -
            
            
            -
            
            
            20,200Total
                Related Party Revenues
            
            $
            -
            
            $
            330,050
            
            $
            513,057





The
      following is a summary of related party expenses for the years ended December
      31, 2005, 2004 and 2003.







**Year
                Ended**
              **December
                31,**
              **2005**
            
            **Year
                Ended**
              **December
                31,**
              **2004**
            
            **Year
                Ended**
              **December
                31,**
              **2003**Nen,
                Inc. - consulting fees included in sales and marketing expense related
                to
                strategic international sales and marketing services
            
            $
            17,500
            
            $
            70,000
            
            $
            27,083Nen,
                Inc. - consulting fees included in general and administrative expense
                related to assisting Smart Online with obtaining additional equity
                financing
            
            
            -
            
            
            62,000
            
            
            -Small
                Business Loan Institute - consulting fees included in general and
                administrative expense
            
            
            -
            
            
            30,000
            
            
            -Smart
                II, Ltd. - Moving expenses, reseller payment, and technical co-development
                work
            
            
            -
            
            
            75,000
            
            
            43,300Interest
                expense incurred on loans from officer
            
            
            -
            
            
            4,649
            
            
            2,007Total
                Related Party Expenses
            
            $
            17,500
            
            $
            241,649
            
            $
            72,390







F-27




**15.** **EMPLOYEE
      BENEFIT PLANS**





All
      full-time employees who meet certain age and length of service requirements
      are
      eligible to participate in the Smart Online 401(k) Plan. The plan provides
      for
      contributions by Smart Online in such amounts as the Board of Directors may
      annually determine, as well as a 401(k) option under which eligible participants
      may defer a portion of their salary. Smart Online did not make any contributions
      to the plan during 2005, 2004, and 2003.





**16.** **CONTINGENCIES**





**Commitments
      and Contingencies**





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





During
      April 2005 the Company reached a settlement with U.S. News & World Report
      and paid $50,000 to resolve all outstanding claims.





On
      November 10, 2005, Smart Online instituted a lawsuit in the General Court of
      Justice Superior Court Division in Wake County, North Carolina against X.C.L.
      Partners, Inc. (“XCL”) seeking a declaratory judgment determining that Smart
      Online did not enter into a contract with XCL and therefore has no contractual
      relationship with XCL. Smart Online filed such law suit in response to a letter
      dated November 3, 2005 from XCL’s attorneys alleging that the Company is in
      breach of a contract with XCL and demanding, at a minimum, $200,000 plus 121,667
      shares of stock of Smart Online. Management has determined with the advice
      of
      legal counsel that the claim has no merit. On December 12, 2005, XCL filed
      a
      Motion to Dismiss our action alleging lack of personal jurisdiction,
      insufficiency of process and insufficiency of service of process. The hearing
      concerning XCL’s motion is scheduled for February 1, 2006. See Note 18 -
      Subsequent Events





Approximately
      three and a half years ago, Smart Online petitioned (as is required under French
      law) a court in France to allow Smart Online to liquidate Smart Online S.A.,
      a
      French subsidiary of Smart Online. As a result, Smart Online paid $113,056.83
      to
      Smart Online S.A. in settlement of all claims against Smart Online. Recently,
      Michael Nouri, the President and CEO of the Smart Online and the former
      President and CEO of Smart Online S.A., was sued personally as the legal
      representative of Smart Online S.A., which suit alleges that Smart Online S.A.
      suffered unspecified amounts of excess liabilities and seeks to hold Mr. Nouri
      personally responsible. The Liquidateur for Smart Online, S.A. has agreed to
      a
      proposal for settlement offered by Mr. Nouri in the amount of $15,000 Euros
      (approximately US $18,750 based on an exchange rate of US $1.27 per Euro).
      The
      parties are currently negotiating the terms of the settlement agreement. This
      agreement is subject to approval by the French court. On
      June
      13, 2006, the commercial court validated the settlement agreement, but the
      court
      did not register the withdrawal of the claim by the Liquidateur. This matter
      was
      further continued until October 19, 2006. There
      can
      be no assurance this agreement will result in a final settlement on these terms.
      The Board of Directors of Smart Online has authorized Smart Online to indemnify
      Mr. Nouri for the amount of any settlement and all legal costs and fees and
      other expenses associated with the defense of Mr. Nouri in relation to this
      matter, because Mr. Nouri was acting on behalf of Smart Online in the
      liquidation of its French subsidiary. See Note 18 - Subsequent
      Events




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





As
      discussed in Note 1, in August 2005, Smart Online entered into a software
      assignment and development agreement with the developer of a customized
      accounting software application.  In connection with this agreement, Smart
      Online agreed to pay the developer up to $512,500 and issue up to $287,500
      worth
      of Smart Online Common Stock based upon the developer attaining certain
      milestones.  As of December 31, 2005, Smart Online had paid $180,000
      and issued $30,000 worth of Common Stock related to this
      obligation.





F-28




**17.** **ACQUISITIONS**





**Computility
      Acquisition**





On
      October 4, 2005, Smart Online purchased substantially all of the assets of
      Computility, Inc. In consideration for the purchased assets, Smart Online issued
      the seller 484,213 shares of our Common Stock and assumed certain liabilities
      of
      Computility totaling approximately $1.9 million.  The shares were valued at
      $7.30 per share which was the median trading price on the acquisition date.
      The
      total purchase price, including liabilities assumed, was approximately $5.8
      million including approximately $228k of acquisition fees. Of the total shares
      issued, 84,213 were delivered to Computility at the closing of the acquisition
      and 400,000 are being held in escrow to cover certain indemnification provisions
      of Computility. In addition, two key employees of Computility entered into
      employment agreements with Smart CRM, Inc., a wholly owned subsidiary of Smart
      Online, pursuant to which each can earn up to a total of $91,800 over and above
      their base compensation during the fifteen months ending December 31, 2006,
      if
      certain performance goals are achieved. Also as part of these employment
      agreements, we paid these two key employees $45,000 each in October of 2005
      in
      exchange for their covenants not to compete. These two employees were each
      granted an option to purchase 75,000 shares of Smart Online’s common stock. Each
      of the options vest and become exercisable in six equal, quarterly increments
      of
      12,500 shares upon the achievement of certain quarterly performance milestones.





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





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








F-29








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





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





Historically,
      Computility derived substantially all of its revenue from software and hardware
      subscription agreements which typically have 3-year terms with substantial
      penalties for early termination. Until the date of the acquisition, Computility
      factored substantially all of its subscription agreements and received
      approximately 65% of the expected cash flow from the subscription period upfront
      and used the cash to fund on-going operations. As a result of the factor
      arrangements, Smart Online will be required to provide services to the
      customers, but will only receive approximately 35% of the corresponding customer
      payments to fund ongoing operations. The remaining 65% of the monthly customer
      payments will be used to offset approximately $1.7 million of the factor
      liabilities of Computility assumed by Smart Online. In addition, the shares
      issued as part of the purchase price held in escrow secure the customer payments
      used to offset this liability.  As a result of the factoring activity of
      Computility, the acquisition resulted in an approximate $116,000 increase in
      cash expenditures for Smart Online from the date of acquisition through December
      31, 2005. Based on contracts signed as of December 31, 2005, Smart Online will
      have to provide approximately $50,000 of working capital per month to help
      fund
      operations during the first quarter of 2006 and this amount will decrease
      modestly throughout 2006.





The
      results of operations of Computility, Inc. are included in Smart Online’s
      consolidated Statements of Operations for the period October 4, 2005 through
      December 31, 2005.





**iMart
      Incorporated Acquisition**





On
      October 18, 2005, Smart Online completed its purchase of all of the capital
      stock of iMart Incorporated (“iMart”), a Michigan based company providing
      multi-channel electronic commerce systems, pursuant to a Stock Purchase
      Agreement, dated as of October 17, 2005 by and among Smart Online, iMart and
      the
      shareholders of iMart.





Smart
      Online issued to iMart’s stockholders 205,767 shares of our Common Stock and
      agreed to pay iMart’s stockholders approximately $3,462,000 in cash
      installments. This amount is payable in four equal payments of $432,866 on
      the
      first business day of each of January 2006, April 2006, July 2006 and October
      2006. The remaining $1,731,465 is payable in January 2007. The shares were
      valued at $8.825 per share which was the median trading price on the acquisition
      date. The total purchase price for 100% of the outstanding iMart Incorporated
      shares was approximately $5.3 million including approximately $339k of
      acquisition fees.








F-30





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





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





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





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





The
      cash
      flow we received from the business we purchased from iMart during the fourth
      quarter of 2005 was insufficient to cover the first installment payment we
      made
      to iMart’s shareholders and Smart Online had to fund part of this installment
      from its working capital. The remaining $1,731,465 is payable in January 2007.
      In addition, Smart Online is to pay $780,000 for non-competition agreements
      to
      key personnel of the acquired company in eight equal quarterly installments
      during the period beginning in January 2006 and ending October in 2007. The
      purchase price installment payments are secured by the net proceeds of customer
      contracts of iMart, which will limit our ability to use cash derived from iMart
      revenue in our business until installment payments are paid in full to iMart
      shareholders and employees. The former CEO of iMart has contractual rights
      to
      operate Smart Commerce, Inc. within agreed financial parameters. See “Note 15 of
      Notes to Financial Statements” for a summary of the iMart acquisition
      terms.





The
      results of operations of iMart Incorporated are included in Smart Online’s
      consolidated Statements of Operations for the period October 18, 2005 through
      December 31, 2005.





Intangible
      assets were a significant part of the assets acquired through both acquisitions
      detailed above. See Note 6 to the consolidated financial statements for a detail
      of these assets acquired.





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





The
      following pro forma results of operations show the results of operations had
      the
      business combinations been completed at the beginning of each of the periods
      presented below:





For
      the
      Year Ended December 31, 2004





F-31











**Smart
                CRM**
            **Smart**
              **Commerce**
            **Smart**
              **Online**
            **Pro
                forma**
              **Unaudited**Revenue
            $
                1,986,522
            $
                3,380,609
            $
                1,002,970
            $6,370,101Net
                Income / (Loss) (a)
            445,494
            1,423,691
            (2,671,929)
            (802,744)Net
                Income / (Loss) Attributable
              To
                Common Stockholders
            445,494
            1,423,691
            (8,319,049)
            (6,449,864)EPS
            
            
            
            $
                (.59)





For
      the
      Year Ended December 31, 2005





**Smart
                CRM**
            **Smart**
              **Commerce**
            **Smart**
              **Online**
            **Pro
                forma**
              **Unaudited**Revenue
            $
                2,018,379
            $
                3,706,738
            $
                1,353,107
            $
                7,078,224Net
                Income / (Loss) (a)
            (28,026)
            1,487,279
            (15,919,694)
            (14,460,441)Net
                Income / (Loss) Attributable
              To
                Common Stockholders
            (28,026)
            1,487,279
            (15,919,694)
            (14,460,441)EPS
            
            
            
            $
                (1.07)





**18.** **SUBSEQUENT
      EVENTS**





Legal
      Matters





In
      March
      of 2006, a settlement agreement was signed with X.C.L. Partners, Inc. which
      required Smart Online to make an immaterial cash payment (<$10,000) in full
      settlement. Such amount was paid and the case is now fully
      resolved.





In
      March
      2006, Smart Online, S.A. and Michael Nouri agreed to the terms of a settlement
      agreement offered by Mr. Nouri in the amount of $15,000 Euros (approximately
      US
      $18,750 based on an exchange rate of US $1.27 per Euro). The agreement is
      subject to final approval by the French court. There can be no assurance this
      agreement will result in a final settlement on these terms. The French court
      is
      scheduled to render a decision in May 2006. There can be no assurance this
      agreement will result in a final settlement on these terms. The Board of
      Directors of Smart Online has authorized Smart Online to indemnify Mr. Nouri
      for
      the amount of any settlement and all legal costs and fees and other expenses
      associated with the defense of Mr. Nouri in relation to this matter, because
      Mr.
      Nouri was acting on behalf of Smart Online in the liquidation of its French
      subsidiary.





On
        January 17, 2006, the Securities and Exchange Commission (the “SEC”) temporarily
        suspended the trading of the securities of the Company. In its “Order of
        Suspension of Trading,” the SEC stated that the reason for the suspension was a
        lack of current and accurate information concerning our securities because
        of
        possible manipulative conduct occurring in the market for our stock. 
By its terms, that suspension ended on January 30, 2006 at 11:59 p.m. EST.
        As a
        result of the SEC’s suspension, NASDAQ
        withdrew its acceptance of our application to have our common stock traded
        on
        the NASDAQ Capital Market Simultaneously with the suspension, the SEC advised us that it is conducting
        a
        non-public investigation. While we continue to cooperate with the SEC, w e
        are
        unable to predict at this time whether the SEC will take any adverse action
        against us. See
        Item
        3 of this report and Risk Factors (43) and (50) for additional information
        regarding the SEC action. .





F-32







In
        March
        2006, Smart Online’s Board of Directors authorized its Audit Committee to
        conduct an internal investigation of matters relating to the SEC suspension
        and
        investigation. The Audit Committee retained independent outside legal counsel
        to
        assist in conducting the investigation. On July 7, 2006, the independent
        outside
        legal counsel shared final findings with the Audit Committee, which were
        then
        shared with the full Board of Directors. The Audit Committee did not conclude
        that any of Smart Online’s officers or directors have engaged in fraudulent or
        criminal activity. However, it did conclude that Smart Online lacked an adequate
        control environment, and has taken action to address certain conduct of
        management that was revealed as a result of the investigation. A discussion
        of
        the significant deficiencies that were identified by the Audit Committee
        and
        related remediation efforts can be found in Item 9A of this report.
  On
          March
          30, 2006, Smart Online sold 400,000 shares of its common stock to Atlas
          Capital,
          S.A., an existing stockholder, for a price of $2.50 per share resulting
          in gross
          proceeds of $1,000,000. Smart Online incurred immaterial issuance costs
          related
          to this stock sale. As part of this sale, Atlas received contractual rights
          to
          purchase shares at a lower price should Smart Online enter into a private
          placement agreement in the future in which Smart Online sells shares of
          its
          common stock for less than $2.50 per share. In
          connection with this financing, Berkley Financial Services, Ltd. may claim
          that
          it is entitled to a fee of $100,000 under an investment banking letter
          agreement
          dated February 23, 2005.


During
        the first half of 2006, our wholly owned subsidiary, Smart CRM, Inc., assigned
        a
        70% interest in twenty (20) separate service contracts, and assigned a 50%
        interest in one (1) service contract, with total payables from customers
        over
        the lives of the contracts of approximately $1,140,000 to a factor in exchange
        for approximately $668,000. As a result of this arrangement, Smart CRM will
        record a debt payable to the factor in the amount of approximately $727,000,
        which will become due in monthly installments over a period of 36
        months.


On
      May
      31, 2006, Smart Online, Inc. and General Investments Capital, Ltd. (“GIC”)
      entered into a Settlement Agreement which settled certain unresolved matters
      arising out of a Consulting Agreement, dated October 26, 2005. Under the terms
      of the Consulting Agreement, Smart Online agreed to pay GIC a cash fee of
      $250,000 and issue 625,000 shares of Smart Online common stock for the
      performance of investor relations services. Smart Online paid the entire cash
      fee and caused the shares to be issued, but did not deliver any of the 625,000
      shares to GIC. Pursuant to the Settlement Agreement, GIC released any and all
      claims to the 625,000 shares of common stock that Smart Online did not deliver,
      and released Smart Online from any obligation to make any additional payments
      under the Consulting Agreement. Smart Online agreed GIC can retain all of the
      $250,000 cash fee previously paid under the Consulting Agreement, and released
      GIC from any obligation to provide services pursuant to the terms of the
      Consulting Agreement.





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





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








F-33





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





**2005**
              
              **2004**1st
                  Qtr
              
              2nd
                  Qtr
              
              3rd
                  Qtr
              
              4th
                  Qtr
              
              1st
                  Qtr
              
              2nd
                  Qtr
              
              3rd
                  Qtr
              
              
              
              4th
                  QtrRevenues
              
              $
              253,238
              
              $
              406,116
              
              $
              344,692
              
              $
              1,697,930
              
              $
              249,728
              
              $
              235,845
              
              $
              237,545
              
              
              
              $
              279,852Gross
                  Profit
              
              $
              221,511
              
              $
              384,205
              
              $
              318,892
              
              $
              1,376,546
              
              $
              192,709
              
              $
              192,437
              
              $
              178,722
              
              
              
              $
              227,486Loss
                  from Operations
              
              $
              (847,484
              )
              $
              (874,306
              )
              $
              (2,188,462
              )
              $
              (12,156,577
              )
              $
              (519,325
              )
              $
              (707,688
              )
              $
              (1,075,619
              )
              (1
              )
              $
              (499,303
              )
              (2)Net
                    Loss Attributableto
                    Common Stockholders
              
              $
              (294,145
              )
              $
              (860,819
              )
              $
              (2,180,856
              )
              $
              (12,254,789
              )
              $
              (6,040,464
              )
              $
              (692,786
              )
              $
              (1,289,108
              )
              
              
              $
              (296,691
              )Net
                  Loss Per Share-Basic
                  and Diluted
              
              
              (0.02
              )
              
              (0.07
              )
              
              (0.17
              )
              
              (0.84
              )
              
              (0.83
              )
              
              (0.06
              )
              
              (0.12
              )
              
              
              
              (0.03
              )Number
                    of Shares Usedin
                    Per Share Calculation
              
              
              11,829,610
              
              
              12,387,333
              
              
              12,832,365
              
              
              14,667,137
              
              
              7,321,707
              
              
              10,722,507
              
              
              11,089,101
              
              
              
              
              11,630,471
  (1)
                  Includes $350,000 of expense related to the issuance of shares
                  of Common
                  Stock to a company that received warrants for services
                  rendered.(2)
                  Includes $1,009,960 of stock based compensation expense related
                  to options
                  and warrants issued to employees and consultants.









F-34





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





In
      November 2005, the Audit Committee of our Board of Directors approved a change
      in its independent registered public accountant to audit its financial
      statements. The Audit Committee dismissed BDO Seidman, LLP (“BDO”) effective
      November 15, 2005.  The Audit Committee appointed Goldstein Golub
      Kessler LLP (“GGK”) to serve as our independent registered public
      accountants, effective November 15, 2005. GGK replaced BDO. There were no
“disagreements” (as such term is defined in Item 304(a)(1)(iv) of Regulation
      S-K) with BDO at any time during the year ended December 31, 2003 and
      December 31, 2004 and the period January 1, 2005 through November 15,
      2005 regarding any matter of accounting principles or practices, financial
      statement disclosure or auditing scope or procedures that if not resolved to
      the
      satisfaction of BDO would have caused it to make reference to such disagreements
      in its reports. In addition, during the same periods, no “reportable events” (as
      such term is defined in Item 304(a)(1)(v)(A) through (D) of Regulation S-K
      and
      its related instructions) arose in the context of our relationship with
      BDO.





In
      March
      2006, the Audit Committee of our Board of Directors approved a change in its
      independent registered public accountant to audit its financial statements.
      GGK
      resigned as the Company's independent accountant, effective March 16, 2006.
      GGK
      notified us on March 17, 2006. Due to the short duration of GGK's retention
      as
      our outside accounting firm, GGK never provided a report on our financial
      statements. From the time GGK was engaged as our independent auditors on
      November 15, 2005 to the date of the termination of that relationship on March
      16, 2006, there were no "disagreements" (as that term is defined in Item
      304(a)(1)(iv) of Regulation SK) on any matter of accounting principles or
      practices, financial statement disclosure, or auditing scope or procedure,
      which
      would have caused GGK to make reference to the subject matter in connection
      with
      its report, and there have been no "reportable events" (as that term is used
      in
      Item 304(a)(1)(v) of Regulation SK).





On
      April
      3, 2006, the Audit Committee of our Board of Directors engaged Sherb & Co.,
      LLP ("Sherb") as our new independent registered public accountant to be the
      principal independent accountant to audit its financial statements.





**ITEM
      9A.** **CONTROLS
      AND PROCEDURES**





**Evaluation
        of Disclosure Controls and Procedures**
 
 We
        maintain disclosure controls and procedures (as defined in Rules 13a-15(e)
        and
        15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange
        Act”)) that are designed to provide reasonable assurances that information
        required to be disclosed by us in the reports that we file or submit under
        the
        Exchange Act is recorded, processed, summarized and reported, within the
        time
        periods specified in the SEC’s rules and forms, and that such information is
        accumulated and communicated to management, including our Chief Executive
        Officer and new Chief Financial Officer, who joined us in March 2006, as
        appropriate, to allow timely decisions regarding required disclosure. In
        designing and evaluating the disclosure controls and procedures, management
        recognized that disclosure controls and procedures, no matter how well designed
        and operated, can provide only reasonable assurances of achieving the desired
        control objectives, as ours are designed to do, and management necessarily
        was
        required to apply its judgment in evaluating the cost-benefit relationship
        of
        possible controls and procedures
 
 Our
        management, with the participation of our Chief Executive Officer and Chief
        Financial Officer, has evaluated the effectiveness of our disclosure controls
        and procedures as of the end of the period covered by this Form 10-K. Based
        on
        such evaluation, and in particular the final findings of our Audit Committee’s
        investigation, our Chief Executive Officer and Chief Financial Officer concluded
        that, as of the end of the period covered by this Form 10-K, our disclosure
        controls and procedures were not effective as of December 31, 2005 because
        of
        the significant deficiencies described below under “Changes in Internal Control
        Over Financial Reporting,” which we are in the process of
        remediating.








65




**Changes
        to Internal Control over Financial Reporting**
 
 Except
        for the changes in our internal control over financial reporting stated below,
        some of which were implemented after December 31, 2005, there have been no
        significant changes in our internal control over financial reporting that
        occurred during the last fiscal quarter of the fiscal year ended December
        31,
        2005 that have materially affected, or are reasonably likely to materially
        affect, our internal control over financial reporting.
 
 In
        October 2005, we acquired two other companies. Prior to these acquisitions,
        we
        were a single reporting entity for accounting purposes and were not required
        to
        consolidate the financial results of any other entities. In connection with
        these acquisitions, we instituted additional internal controls required to
        facilitate the reporting of consolidated results to include the financial
        results of these two new entities. We have not yet fully integrated these
        companies into our pre-existing operations and expect to institute additional
        internal controls related to such integration.
 
 In
          November 2005, we restated our financial statements for the quarter ended
          June
          30, 2005. In reviewing the reasons for this restatement, we concluded that
          an
          error in interpreting accounting rules was the cause for this restatement.
          Our
          failure to have a sufficient complement of financial personnel to interact
          with
          external accounting consultants and with a level of accounting knowledge,
          experience and training in the application of generally accepted accounting
          principles commensurate with our financing reporting requirements contributed
          to
          the reasons for this restatement. To remediate this deficiency, as well
          as to
          facilitate the transition of some outsourced accounting services to our
          internal
          accounting department, in March 2006, we hired a new Chief Financial Officer
          with experience auditing public companies as a certified public accountant,
          and
          we retained our former Chief Financial Officer as Controller. We believe
          the
          addition of our new Chief Financial Officer has improved and broadened
          our
          internal accounting department. However, we continue to interact with our
          former
          external consultants as they retain significant knowledge of our history
          and
          past transactions. Our Audit Committee currently is comprised of one independent
          director, who is not an audit committee financial expert, and we are continuing
          to search for independent directors with financial expertise to augment
          the
          Audit Committee.
 
 We
        also
        have begun to implement controls in response to the final findings of our
        Audit
        Committee’s investigation. The Audit Committee concluded that: (i) our Chief
        Executive Officer should have disclosed and sought approval from the Board
        of
        Directors before entering into certain transactions and arrangements, including
        personal loans; (ii) there was inadequate diligence by management and the
        Board
        of Directors regarding third parties with which we contracted, including
        outside
        investor relations vendors, some of which were registered brokers; (iii)
        management and our directors lacked sufficient knowledge regarding rules
        and
        regulations with respect to dealings between registered brokers and public
        companies, (iv) we lack clear policies regarding the limits on the Chief
        Executive Officer’s authority to enter into business transactions and agreements
        without Board approval; (v) there has been inadequate legal and accounting
        review of material contracts; (vi) there has been inadequate training and
        understanding of SEC disclosure requirements; (vii) there was an unintentional
        violation of our Securities Trading Policy by one of our directors as previously
        reported in our public filings; (viii) we have inadequate processes for
        determination of independence of Board members; and (ix) there has been a
        failure to communicate and stress the importance of controls and procedures
        throughout our organization. The Audit Committee investigation concluded
        that
        these deficiencies primarily resulted from our transition from a private
        company
        to a publicly reporting company and insufficient preparation for, focus on,
        and
        experience with compliance requirements for a publicly reporting company.
 
 As
        one of
        the results of these findings, Mr.
        Jeffrey LeRose was appointed to the position of non-executive Chairman of
        the
        Board of Directors to separate the leadership of the Board of Directors from
        the
        management of the Company, which is a recommended best practice for solid
        corporate governance. Mr. Nouri has stepped down as Chairman of the Board
        of
        Directors, but will continue to serve as our president, chief executive officer
        and as a member of the Board of Directors. T he
        Audit
        Committee also has been critical of Mr. Nouri in that
        he failed to set and follow proper corporate governance and compliance
        requirements as Smart Online moved from being a private company to being
        a
        public company; required
        Mr. Nouri to repay all amounts outstanding to Berkley Financial Services
        by December 31, 2006 (for a description of Mr. Nouri’s loan
        arrangement with Berkley see Item 13 of this report); required that the Chief
        Financial Officer, at a minimum, be involved in all communications with
        investment professionals, including analysts, brokers and potential
        institutional investors; and provided the Chief Financial Officer with direct
        reporting responsibility to the Audit Committee with respect to any such
        communications. In addition, the Audit Committee has required significant
        strengthening to our system of disclosure controls and procedures to ensure
        that
        all material facts and developments relating to our business and operations
        are
        timely and accurately disclosed.






66




We
        have
        begun the process of reviewing and implementing enhancements to these controls,
        including:
 
 ·
            Commencing
                a search for independent directors with public company experience
                to join
                the Board of Directors. ·
            Joining
                the National Association of Corporate Directors (“NACD”) and requiring
                corporate governance director training through the NACD and/or other
                appropriate professional advisors, including but not limited to mandatory,
                individualized management coaching and education for our Chief Executive
                Officer. This will include training that results in NACD certification
                of
                each Director as a NACD certified public company director, and annual
                education to maintain such certification. ·
            Implementing
                mandatory, periodic educational training for management and directors
                by
                outside legal counsel and other appropriate professional advisors
                regarding: o
            SEC
                and Nasdaq disclosure and corporate governance
                requirements; o
            Our
                Conflicts of Interest Policy; o
            Our
                Securities Trading Policy; and o
            Our
                Code of Ethics and Corporate Conduct
                Policy. ·
            Reviewing,
                revising and clarifying our Securities Trading
                Policy. ·
            Adopting
                a written policy setting forth limits on the Chief Executive Officer’s
                authority to engage in certain business transactions and agreements
                without prior Board approval, including clear guidelines on actions
                requiring Board approval. ·
            Requiring
                our legal department or outside legal counsel to review and approve
                all
                material agreements prior to execution. ·
            Requiring
                that all material agreements be reviewed by our Chief Financial Officer
                prior to execution, including an analysis of proper accounting for
                revenue
                or expense recognition where applicable. ·
            Requiring
                written confirmation of compliance with our Code of Ethics and Conflicts
                of Interest Policy on a quarterly basis from all members of management
                and
                the Board of Directors. ·
            Sending
                quarterly reminders to all employees regarding the location of Code
                of
                Ethics and Conflicts of Interest Policy and our complaint and
                investigation procedures for accounting, internal control, fraud
                or
                auditing matters. ·
            Creating
                checklists of standard closing, cash receipt/disbursement and disclosure
                procedures for material transactions, including entry into material
                agreements, private placements and
                acquisitions. ·
            Creating
                a diligence checklist to be used when entering into any arrangements,
                agreements or other transactions with third parties, designed to
                ensure
                that we are dealing with reputable and established third
                parties. ·
            Retaining
                a law firm that has particular depth and expertise in corporate governance
                and securities matters to augment our legal department, which is
                currently
                without a General Counsel. We are considering whether and when to
                initiate
                a search for a General Counsel. ·
            Creating
                the position of Chief Compliance Officer with primary responsibility
                to
                administer and set compliance policy, monitor and assess control
                deficiency identification and remediation and report to the Audit
                Committee on matters concerning legal, corporate governance and ethical
                compliance. We are currently evaluating whether the responsibilities
                and
                duties of this position can be fulfilled by a current member of management
                or whether it is necessary to seek a qualified outside
                candidate. ·
            Conducting
                a review of our annual directors’ and officers’ questionnaire and using
                the questionnaire in evaluating the independence of any potential
                board
                candidates.




67




**ITEM
        9B.** **OTHER
        INFORMATION**
  There
        is
        no information required to be disclosed on a current report on Form
        8-K during the fourth quarter of 2005 that was not disclosed on a current
        report on Form 8-K.






**PART
      III**





**ITEM
      10.** **DIRECTORS
      AND EXECUTIVE OFFICERS OF THE REGISTRANT**




**Executive
      Officers and Directors**




The
      names
      of our directors and executive officers as of December 31, 2005 are listed
      below. None of the officers and directors of Smart Online named below currently
      serve on the Board of Directors of any other public reporting company. Our
      executive officers are appointed by our board of directors to hold office until
      their successors are appointed the terms of all directors expire at the next
      annual meeting of stockholders and upon election of their successors. The terms
      of all officers expire upon the next annual meeting of the Board of Directors
      and upon the election of the successors to such officers.





68








**Name**
            **Age**
            **Position**Dennis
                Michael Nouri (1)(2)
            52
            President,
                Chief Executive Officer,and
                DirectorHenry
                Nouri (2)
            50
            Executive
                Vice PresidentThomas
                Furr
            39
            Chief
                Operating Officer, DirectorAnil
                Kamath
            39
            Chief
                Technology OfficerJoan
                Keston (4)
            52
            General
                Counsel and SecretaryScott
                Whitaker (3)
            36
            Chief
                Financial Officer and Principal Accounting OfficerGary
                Mahieu
            38
            Chief
                Operating Officer and Vice President of Smart Commerce, Inc., a wholly
                owned subsidiaryDavid
                S. Y. Sarna (5)
            56
            DirectorJeff
                LeRose
            62
            DirectorFrank
                Coll (6)
            47
            Director




(1)
            Michael
                Nouri’s full name is Dennis Michael
                Nouri.


(2)
            Dennis
                Michael Nouri and Henry Nouri are
                brothers.


(3)
            Mr.
                Whitaker was appointed as the Chief Financial officer on an interim
                basis
                on February 24, 2005. On March 21, 2006, Nicholas Sinigaglia was
                appointed
                by the Board of Directors to be the Chief Financial Officer of the
                Company, and his functions include acting as the chief accounting
                officer
                of the Company. Mr. Whitaker continues to serve as the controller
                of the
                Company, but not as an executive
                officer.


(4)
            Effective
                June 1, 2006, Joan Keston is no longer an employee of the
                Company.


(5)
            Effective
                June 23, 2006, David Sarna resigned as a
                director.


(6)
            Effective
                March 5, 2006, Frank Coll resigned as a
                director.




**Michael
      Nouri, President and Chief Executive Officer, Chairman of the Board and
      Director.** Michael
      Nouri’s full name is Dennis Michael Nouri. Mr. Nouri co-founded Smart Online in
      1993 to develop and market business productivity software to provide small
      businesses with cost-effective tools that address critical business issues
      and
      enhance their competitive positioning. He has been our President, Chief
      Executive Officer, Chairman of the Board and a Director since it was started.
      Mr. Nouri stepped down as Chairman of the Board of Directors on July 7,
      2006.  Prior to founding Smart Online, Mr. Nouri was founder and CEO of the
      Nouri Group of Companies from 1980 to 1991. The Nouri Group of Companies
      acquired a number of government-owned manufacturers in Europe and privatized
      them. The Nouri Group was a multi-national conglomerate with diversified
      activities in real estate development, investment, construction, motor yacht
      manufacturing, high-end home design and architecture, marketing and publishing
      and stock trading. More than half of the company’s business was derived from
      real estate development and investment and joint ventures. Another third of
      the
      company’s business was derived from construction and motor yacht
      manufacturing.





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





**Thomas
      Furr, Chief Operating Officer.** Mr.
      Furr
      is responsible for developing and implementing strategies to leverage existing
      direct and indirect distribution channels, and our operational and sales areas.
      He joined as our Vice President, Sales and becameour Chief Operating Officer
      in
      November 2005. In 2002 he also became a Director. He was a co-founder and
      president of Kinetics, Inc., one of the first online commerce providers for
      the
      small business industry, from 1994 until 1995. We purchased Kinetics in 1995.
      After founding Kinetics, Mr. Furr was with the Plurimus Corporation from 1999
      until 2001, where he managed Plurimus’ southeast direct sales efforts.
      Previously, from 1996 until 1999 he managed East Coast direct sales and channel
      efforts in Canada and South Africa for Information Retrieval Corporation (IRC),
      a leading multi-national back-end CRM/help desk company. Mr. Furr holds a
      bachelor’s degree in finance from East Carolina University.





69








**Anil
      Kamath, Chief Technology Officer.** Mr.
      Kamath joined us as Director of Database Implementation in July 1999 and became
      Vice President, Technology in 2000 In November 2005, he became our Chief
      Technology. Mr. Kamath is responsible for the architecture of our web-native
      (SaaS) platform; supervises the development team, and provides architectural
      design direction for new software and hardware implementations. Before joining
      us he was the senior database architect for A 4 Health
      Systems from 1998 to 1999 and senior software architect and technical manager
      of
      BSG Imonics) from 1991 until 1997. He holds a master’s degree in computer and
      information sciences from the University of Florida.





**Joan
      A. Keston, General Counsel and Secretary.** Ms.
      Keston joined us in June 2005 as General Counsel. She was elected as our
      Secretary and an Officer in July 2005. Effective June 1, 2006, Ms. Keston was
      no
      longer an employee of the Company. She was responsible for negotiating
      partnerships and acquisitions strategic to the on-going development our
      applications for small-to-medium size businesses (SMBs), as well as handling
      our
      the legal affairs in general. Before joining Smart Online, Ms. Keston served
      as
      legal counsel to Visage Solutions, LLC beginning in January 2004 and became
      Vice
      President, Business Development, General Counsel and Corporate Secretary of
      the
      firm in January 2005 until June 2005. From September to December 2004 she
      provided services to the World Trade Center in North Carolina as Director of
      Business Development. Prior to that, she acted as a Consultant to Pajet, Inc.
      from 1997 to 2003, representing companies and consulting in international
      business development; was the President and one of the Directors of the Three
      Faiths Forum, a not-for-profit she helped organize in the aftermath of 9/11;
      served as Of Counsel to Santos & Company from 2001 to 2002 and Special
      Counsel to Duane, Morris & Heckscher, LLP / Sacher, Zelman, Stanton, Paul,
      Beiley & Van Sant, P.A. from 1999 to 2000. Ms. Keston holds a B.A. in
      economics and biology from Bucknell University, a J.D. from Villanova University
      School of Law and a LL.M. in International Law from the University of Miami
      School of Law.





**Scott
      Whitaker, Former Principal Financial Officer and Principal Accounting Officer.** Mr.
      Whitaker, 35 years old, has been responsible for supporting the efforts of
      other
      officers of Smart Online with respect to internal controls and our other
      internal accounting functions. He joined us in 1998 as accounting manager,
      was
      promoted to Controller in 2002 and was appointed Principal Financial Officer
      and
      Principal Accounting Officer in February 2005. He was replaced by Nicholas
      Sinigaglia as Chief Financial Officer and Principal Accounting Officer in March
      of 2006.





**Nicholas
      A. Sinigaglia, Chief Financial Officer and Principal Accounting
      Officer.** Mr.
      Sinigaglia, 36 years old, joined us in February 2006. From August 2005 to
      February 2006, he acted as an independent business consultant providing
      accounting and business consulting services as well as interim-CFO services
      to
      New York clients. From February 2004 to June 2005, Mr. Sinigaglia served as
      the
      Center Manager of MedQuest Associates, a leading provider of diagnostic imaging
      services. From 1997 to February 2004, Mr. Sinigaglia was the Vice President
      and
      Managing Partner of Ray-X Medical Management Services, Inc., an organization
      offering management services to various medical specialties. Mr. Sinigaglia
      was
      an Audit Senior Supervisor with Arthur Andersen LLP from 1991 to 1997 and is
      a
      Certified Public Accountant.




**Gary
      Mahieu, Chief Operating Officer and Vice President of Smart Commerce, Inc.,
      a
      wholly owned subsidiary** .
      Mr.
      Mahieu is responsible for the operations of our wholly-owned subsidiary, Smart
      Commerce, Inc., serving as its Chief Operating Officer and Vice-President since
      we acquired iMart Incorporated in October of 2005. Mr. Mahieu founded and served
      as President and Chief Operating Officer of iMart Incorporated from December
      1999 until October 2005. Prior to founding iMart, Mr. Mahieu served as a
      technical manager for Quixtar, Inc. from April 1998 until December 1999. Mr.
      Mahieu received his bachelor’s degree in electrical engineering from Western
      Michigan University, and in 2006 he finished the Owners Presidents Management
      program at Harvard Business School. Mr. Mahieu is also the co-inventor on two
      e-Commerce patents.





**David
      E. Y. Sarna, Director.** Mr.
      Sarna
      became a Director of Smart Online during April 2005, and resigned from that
      position and from all Committees of the Board of Directors on June 23, 2006.
      Since August, 2002, Mr. Sarna has worked through Hendon, Stamford Hill &
Co., and Securities Acquisition New York, LLC (“SANY”), as a merchant banker.
      Mr. Sarna founded ObjectSoft Corporation, a developer and operator of kiosks
      in
      1990. He was the Chairman and a director of ObjectSoft Corporation from





70





December
      1990 to April 2001. ObjectSoft Corporation filed for bankruptcy protection
      in
      July 2001, after Mr. Sarna had left ObjectSoft. The right to the authorized
      but
      unissued stock of ObjectSoft was later acquired by SANY from the bankruptcy
      court through a bidding process. Earlier, Mr. Sarna also founded Image Business
      Systems Corporation (IBS) in 1988, a software company specializing in document
      image. Prior to founding IBS, Mr. Sarna was Executive Vice President and a
      co-founder of International Systems Services Corporation, a consulting and
      software company and, prior to that, he was employed by Price Waterhouse &
Co., IBM and Honeywell.





**Jeffrey
      W. LeRose, Director** .
      Mr.
      LeRose became a Director of Smart Online during September 2005, and was
      appointed Chairman of the Board on July 7, 2006. Mr. LeRose is the CEO and
      President of Research Triangle Software, an information technology company
      that
      he founded in 2001. Mr. LeRose was the Chairman of the Board of Directors of
      the
      business-to-business online e-commerce firm, Internet Commerce Corporation
      (Nasdaq: ICCA) from March 2001 until September 2001. He became
      Chairman of ICCA after selling Research Triangle Commerce, Inc. (“RTCI”) to ICC
      in
      November 2000. Mr. LeRose was the founder and President of RTCI
      from September 1991 until November 2000. He currently sits on the
      Board of Advisors for the Love School of Business at Elon University and is
      a
      founding Board Member for the Research Triangle Chapter of the National
      Association of Corporate Directors. Mr. LeRose also is on the Board of Advisors
      for Southern Capitol Ventures, where he provides advice on the investments
      in
      emerging technology companies in the Triangle. Mr. LeRose received his BA from
      New Jersey City University.





**Frank
      Coll, Director.** Mr.
      Coll
      became a during April 2005 and resigned from this position effective March
      5,
      2006. Mr. Coll has been with AmSurg Corporation, which develops, acquires and
      manages single specialty ambulatory surgery centers in partnership with surgical
      and other group physician practices since February 2005 as Senior Vice
      President, Operations. From November 2001 until joining AmSurge, Mr. Coll served
      as President and Principal of The Bottom Line Solution, a private management
      consulting company. From November 1999 until October 2001, he served as Senior
      Vice President, Operations for WebMD/Envoy Corporation, which primarily provides
      electronic transaction processing services to the healthcare
      industry.





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





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




Michael
      Nouri and Henry Nouri were officers and directors of two companies in Italy
      which were ordered into bankruptcy by Italian courts in 1993. Under Italian
      laws, Michael Nouri and Henry Nouri cannot serve as an officer or director
      of
      any Italian company, because of these bankruptcies. David E. Y. Sarna was
      President and a Director of Object Soft Corporation until April 2001. ObjectSoft
      Corporation filed for bankruptcy protection in July 2001, after Mr. Sarna had
      left ObjectSoft, and its assets were later acquired by SANY, which Mr. Sarna
      owns.





**Board
      of Directors.**





Currently,
      one of our three Directors is “independent” as defined by SEC, stock exchange
      and NASDAQ rules regarding board members, committees and other corporate
      governance standards. During July 2005, our Board of Directors approved charters
      for three new Board committees: (1) Audit, (2) Compensation and (3) Corporate
      Governance and Nominating, and we adopted an Insider Trading Policy. Copies
      of
      these charters and policies are available on our website at www.smartonline.com.





71








During
      2005, one of our independent directors purchased shares of our common stock
      on
      the open market in the following amounts on the following dates: (1) a total
      of
      900 shares at $8.50 on August 12, 2005; (2) 1,000 shares at $8.55 on August
      12,
      2005, and (3) 2,200 shares at $8.55 on August 15, 2005. These purchases were
      in
      violation of ourpany’s Insider Trading Policy, and after discussion, our Board
      of Directors accepted this policy breach as an error, and not as any intention
      of violating the policy or SEC laws.





Our
      Corporate Governance and Nominating Committee identifies and recommends
      candidates to become members of our Board of Directors. To date, the Nominating
      Committee has not adopted any formal procedures for soliciting or evaluating
      nominees who are recommended by our stockholders.





**Number
      of Directors.** Our
      Board
      of Directors currently consists of three persons. Our bylaws provide that the
      whole Board of Directors may consist of that number of directors as determined
      by the Board of Directors from time to time. We are currently conducting a
      search for additional independent directors to join our Board.





**Term
      of Office.** Our
      Directors are currently elected to hold office until the next annual meeting
      of
      our stockholders and until their respective successors have been elected and
      qualified, but our bylaws provide that when the number of directors increases
      to
      six or more members our directors will have staggered terms of three years
      so
      that each year the terms of approximately one third of the entire Board of
      Directors will expire. We
      have
      not held a meeting of our stockholders since we became a public
      company in February 2005.





**Independent
      Directors.** One
      of
      our three Directors is “independent,” as defined in Securities and Exchange
      Commission and NASDAQ rules.





**Committees.** During
      July 2005, our Board of Directors approved charters for three new Board
      committees: (1) Audit, (2) Compensation, (3) and Corporate Governance and
      Nominating, and we adopted an Insider Trading Policy. Copies of these charters
      and policies are available on our website at www.smartonline.com.





The
      members and chairman of each committee of our Board of Directors is set forth
      below:





**Name**
            **Audit
                Committee**
            **Compensation
                Committee**
            **Corporate
                Governance Nominating Committee**Michael
                NouriThomas
                FurrJeff
                LeRose
            Chair
            Chair
            Chair





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







72








During
        2005, the following loans were made by certain investors, consultants and/or
        stockholders to our Chief Executive Officer: (i) $809,736.49 was borrowed
        from
        Leon Sokolic, one of our stockholders, (ii) $77,971.20 was borrowed from
        Atlas
        Capital, one of our stockholders, (iii) $80,000 was borrowed from Pete Coker,
        a
        principal of Tryon Capital, which provided financial consulting services
        to us
        and received a warrant and cash fees, and (iv)$296,589 was borrowed from
        Berkley, which received compensation for services rendered to us for investment
        banking and investor relations services as described above under “Agreements
        with Berkley Financial Services,” including during the period in which Berkley
was making loans to the Chief Executive Officer. Our Chief Executive Officer
        has
        agreed with the Audit Committee that he will repay the loans from Berkley
        by
        December 31, 2006.


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





The
      members of our Board of Directors, our Executive Officers and persons who hold
      more than 10% of our outstanding common stock are subject to the reporting
      requirements of Section 16(a) of the Exchange Act which require them to file
      reports with respect to their ownership of the common stock and their
      transactions in such common stock. Based upon our review of the Section 16(a)
      reports in our records for 2005 fiscal year transactions in the common stock
      and
      their common stock holdings, we believe that, except as noted below, all
      reporting requirements under Section 16(a) for such fiscal year were met in
      a
      timely manner by our directors, executive officers and greater than 10%
      beneficial owners.





Atlas
      Capital, SA was delinquent in the filing of a Form 3 relating to the purchase
      of
      shares of our Common Stock from October 17 through 21, 2005. The Form 3 for
      those purchases was not filed until October 27, 2005.





Frank
      Coll, a former Director, was delinquent in the filing of a Form 3 relating
      to
      the grant of an option to purchase shares of our Common Stock on April 18,
      2005
      in connection with his election to our Board of Directors. The Form 3 for this
      option grant was not filed until August 1, 2005.





David
      E.Y. Sarna, a Former Director, was delinquent in the filing of a Form 3 relating
      to the purchase of shares on August 12 and 15, 2005, and grant of an option
      to
      purchase shares of our Common Stock on April 18, 2005, and a Form 4 relating
      to
      the grant of options to purchase shares of our Common Stock on July 22, 2005.
      Both of these forms were filed on August 12, 2005.





Gary
      Mahieu, the Chief Operating Officer and Vice President of Smart Commerce, Inc.,
      our wholly owned subsidiary, was delinquent in filing of a Form 3 relating
      to
      his appointment to that position and the receipt of shares of our Common Stock
      on October 18, 2005 in connection with the Company’s acquisition of iMart
      Incorporated. The Form 3 for this issuance of Common Stock was filed on February
      14, 2006.





**User
      Advisory Board**





We
      organized a User Advisory Board, consisting of up to 10 professionals
      representing expertise in a broad range of business areas to assist our
      marketing and sales executives with ongoing product development planning,
      pricing, partnerships, new product development and other issues, including
      customer acquisition and retention. User Advisory Board members provide advice
      to our management, but do not have any power to make decisions. User Advisory
      Board members also do not have the same duties and liabilities as members of
      Board of Directors have. Each of our User Advisory Board members has been
      granted nonqualified options to purchase 10,000 shares of Common Stock at an
      exercise price of $3.50 per share, which options vest in equal increments of
      1,250 per meeting attended, provided the member remains on the Advisory Board
      for at least one year. At present, members of the User Advisory Board include
      Mark Self, Rick Bernhardt, Brian Kinahan, and William Eldridge. The last meeting
      of our User Advisory Board was held in June of 2005.





73








**ITEM
      11.** **EXECUTIVE
      COMPENSATION**





**Summary
      Compensation Table**





The
      table
      below summarizes all compensation awarded to, earned by, or paid to our Chief
      Executive Officer and those persons other than the Chief Executive Officer,
      who
      in calendar year 2005 were our four highest-paid executive officers, for all
      services rendered in all capacities to us for the calendar years listed below.




**SUMMARY
                COMPENSATION TABLE****NAME
                AND PRINCIPAL POSITION**
            **YEAR**
            **ANNUAL
                COMPENSATION**
            **LONG-TERM
                COMPENSATION****AWARDS**
            **ALL
                OTHER COMPENSATION****SALARY**
            **BONUS**
            **OTHER
                ANNUAL COMPEN-**
              **SATION**
            **SECURITIES
                UNDERLYING**
              **OPTIONS
                (#)**Dennis
                Michael Nouri(1)
                ,
              President
                and CEO
            2005
            $
            170,000
            $
            0
            $
            0
            100,000
            $
            02004
            $
            170,000
            $
            0
            $
            0
            0
            $
            14,616.702003
            $
            150,000
            $
            0
            $
            0
            250,000
            $
            14,684.00Henry
                Nouri (2) ,
              Executive
                Vice President
            2005
            $
            150,000
            $
            0
            $
            0
            100,000
            $
            02004
            $
            150,000
            $
            0
            $
            0
            0
            $
            9,303.002003
            $
            150,000
            $
            0
            $
            0
            250,000
            $
            9,636.00Ronna
                Loprete (4),
              Secretary
            2005
            $
            120,000
            $
            46,152
            $
            0
            0
            $
            02004
            $
            120,000
            $
            0
            $
            0
            75,000
            $
            02003
            $
            120,000
            $
            0
            $
            0
            0
            $
            0Anil
                Kamath,
              Chief
                Technology Officer
            2005
            $
            125,000
            $
            85,000
            $
            0
            50,000
            $
            02004
            $
            125,000
            $
            0
            $
            0
            75,000
            $
            02003
            $
            100,000
            $
            0
            $
            0
            None
            $
            0Tom
                Furr(3),
              COO
            2005
            $
            136,800
            $
            0
            $
            0
            50,000
            $
            02004
            $
            120,000
            $
            0
            $
            0
            75,000
            $
            02003
            $
            120,000
            $
            0
            $
            0
            0








(1)
            The
                amounts of salary in the table above reflect amounts that accrued
                under an
                employment agreement.  Because Dennis Michael Nouri agreed to allow
                us to defer part of his accrued compensation he received only the
                following amounts of salary: $113,750 in 2004 and $35,000 in 2003.
                These
                deferred amounts, plus $55,950 interest, were paid in March 2005.
                Refer to
                “Item 13.CERTAIN
                RELATIONSHIPS AND INTERESTED TRANSACTIONS”
                for a description of salary deferrals.  “Other Compensation” consists
                of payments for health insurance for family members of Mr. Nouri.
                Until
                December 2005, the wife of Mr. Nouri was also an employee of the
                Company.
                She received the following compensation: $120,000 per year in salary
                for
                each of 2003, 2004 and 2005 (including amounts of deferred salary
                that
                accrued under an employment agreement and was paid with $13,936 in
                interest in 2005); and 75,000 options in 2004. Ms. Loprete also received
                a
                bonus of $46,152 for her service to the Company upon her
                departure.(2)
            The
                amounts of salary in the table above reflect amounts that accrued
                under an
                employment agreement.  Because Henry Nouri agreed to allow us to
                defer part of his accrued compensation he received only the following
                amounts of salary: $102,083 in 2004 and  $35,000 in 2003. These
                deferred amounts, plus $59,582 interest, were paid in March 2005.
                Refer to
                “Item 13.CERTAIN
                RELATIONSHIPS AND INTERESTED TRANSACTIONS”
                for a description of salary deferrals. “Other Compensation” consists of
                payments for health insurance for family members of Mr.
                Nouri.(3)
            The
                amounts of salary in the table above reflect amounts that accrued
                under an
                employment agreement.  Because Tom Furr agreed to allow us to defer
                part of his accrued compensation he received only the following amounts
                of
                salary: $68,305 in 2004 and  $63,998 in 2003. These deferred amounts,
                plus $18,073 interest, were paid in March 2005. Refer to “ITEM 13.CERTAIN
                RELATIONSHIPS AND INTERESTED TRANSACTIONS”
                for a description of salary deferrals.(4)
            Ronna
                Loprete agreed to allow us to defer part of her accrued compensation
                she
                received only the following amounts of salary: $107,500 in 2004,
                and
                $90,000 in 2003. These deferred amounts, plus $13,936 interest, were
                paid
                in March 2005. Refer to “Item 13.CERTAIN
                  RELATIONSHIPS AND INTERESTED TRANSACTIONS”
                for a description of salary deferrals. Ms. Loprete is the wife of
                our
                Chief Executive Officer, Michael Nouri. She resigned as Secretary
                effective July 22, 2005, and as Vice President and Director effective
                September 13, 2005, and was no longer an employee of ours effective
                December 31, 2005. She received a bonus of $46,152 for her service
                to the
                Company upon her departure.







74








**Option
      Grants During 2005**





The
      following options to purchase shares of our Common Stock were granted to
      executive officers during the year ended December 31, 2005:





**Potential
                  Realizable Value At**
                **Assumed
                  Annual Rates of Stock**
                **Price
                  Appreciation For Option**
                **Term****Named**
                **Executive**
                **Officer**
              
              **Number
                  of**
                **Securities**
                **Underlying**
                **Options**
                **Granted**
              
              **%
                  of Total**
                **Options**
                **Granted
                  To**
                **Employees**
                **in
                  Fiscal**
                **Year**
              
              **Exercise**
                **Price**
              
              **Expiration**
                **Date****(1)**
              
              **5%****(2)**
              
              **10%****(2)**Michael
                  Nouri
              
              
              100,000
              
              
              10%
              
              $
              8.61
              
              
              07/22/15
              
              $
              541,478
              
              $
              1,372,212Henry
                  Nouri
              
              
              100,000
              
              
              10%
              
              $
              8.61
              
              
              07/22/15
              
              $
              541,478
              
              $
              1,372,212Thomas
                  Furr
              
              
              50,000
              
              
              5%
              
              $
              8.61
              
              
              07/22/15
              
              $
              270,739
              
              $
              686,106Anil
                  Kamath
              
              
              50,000
              
              
              5%
              
              $
              8.61
              
              
              07/22/15
              
              $
              270,739
              
              $
              686,106





(1)
            The
                options listed were granted under our 2004 Equity Compensation Plan.
                Each
                option expires on the earlier of the expiration date shown or 90
                days
                after termination of the recipient’s employment, except in cases of death
                or disability. The option may be exercised to purchase vested shares
                only.
                Upon termination of employment, the option is forfeited with respect
                to
                any shares not then vested, except in cases of death or disability.
                In the
                event of a change in control, as defined in the option agreements,
                the
                option becomes fully vested and exercisable.(2)
            In
                accordance with SEC rules, these columns show gains that could accrue
                for
                the respective options, assuming that the market price of our common
                stock
                appreciates from the date of grant over the maximum life of the
                option at an annualized rate of 5% and 10%, respectively. If the
                stock price does not increase above the exercise price at the time
                of
                exercise, realized value to the named executives from these options
                will
                be zero. Rules of the SEC permit us to use 5% and 10% in this
                table.  There can be no assurance that the price of our stock will
                increase and this table does not constitute any prediction of the
                future
                value of our stock by us.





**Aggregated
      Option Grants in Year 2005 and Option Values at  December 31,
      2005**





The
      following table provides information concerning unexercised options held as
      of
      December 31, 2005, by each of our executive officers:




**Number
                    of Securities**
                  **Underlying
                    Unexercised**
                  **Options**
                  **at
                    December 31, 2005**
                
                **Value
                    of Unexercised**
                  **In-the-Money
                    Options at**
                  **December
                    31, 2005****(1)****Name**
                
                Shares
                  Acquired
                  Upon
                    Exercise
                
                Value
                    Realized
                
                **Exercisable**
                
                **Unexercisable**
                
                **Exercisable**
                
                **Unexercisable**Michael
                    Nouri
                
                
                0
                
                n/a
                
                
                250,000
                
                
                100,000
                
                $
                1,892,500
                
                $
                39,000Henry
                    Nouri
                
                
                0
                
                n/a
                
                
                250,000
                
                
                100,000
                
                $
                1,892,500
                
                $
                39,000Thomas
                    Furr
                
                
                0
                
                n/a
                
                
                75,000
                
                
                50,000
                
                $
                577,500
                
                $
                19,500Anil
                    Kamath
                
                
                0
                
                n/a
                
                
                75,000
                
                
                50,000
                
                $
                577,500
                
                $
                19,500Ronna
                  Loprete
                
                
                0
                
                n/a
                
                
                75,300
                
                
                0
                
                $
                578,700
                
                $
                0




___________





(1)
            
            Based
                on the closing price of $9.00 per share for our Common Stock on December
                30, 2005, minus the exercise price, multiplied by the number of shares
                issued upon the exercise of, or subject to, the option, without taking
                into account any taxes that may be payable in connection with the
                transaction.(2)
            
            Ronna
              Loprete ceased to be an employee of the Company effective December
              31,
              2005.  The options that have been issued to her have expired and can
              no longer be exercised.





**Options
      Exercised During Year 2005**




No
      executive officers exercised any options during the year ended December 31,
      2005.






76




**Employment
      Agreements**




We
      have
      the following employment agreements with our named executive officers:




**Dennis
      Michael Nouri.** Elsewhere in this document, Mr. Nouri is referred to as Michael Nouri, because
      he uses his middle name instead of his first name in most business
      dealings.  Effective April 1, 2004, covering employment commencing as of
      June 1, 2004 we entered into an employment agreement, which provided for an
      initial base salary of $170,000. The agreement replaced an employment agreement
      dated July 14, 1999 that was about to expire. The new agreement had a
      termination date of December 31, 2005, but it isautomatically extended for
      additional two-year terms, unless either party provided the other with written
      notice of intention not to renew at least 180 days prior to the end of the
      term
      or the end of any renewal period. Since
      neither party gave written notice of termination, the agreement was extended
      for
      an additional two years and thus shall terminate on December 31, 2007. The
      agreement requires us to make a severance payment to Mr. Nouri in an amount
      equal to twelve months of base salary, if either we terminate Mr. Nouri’ s
      employment without “cause” (as defined in the agreement) or Mr. Nouri terminates
      his employment for “good reason” (as defined in the agreement). The agreement
      also contains a retention provision designed to provide incentive for Mr. Nouri
      to remain employed by us following a “change of control” as defined in the
      agreement. Under this retention provision, if Mr. Nouri remains employed by
      the
      surviving entity for a period of time after the change of control occurs
      designated by the Board of Directors of the surviving entity, and either his
      employment is terminated by the surviving entity without cause or by Mr. Nouri
      for good reason, the surviving entity must pay Mr. Nouri an amount equal to
      299%
      of his highest annual salary and bonuses during the preceding five years. This
      retention payment is in addition to other severance payments described above.
      Mr. Nouri’s agreement contains non-competition and non-solicitation provisions.
      Refer to “ITEM 13. CERTAIN
      RELATIONSHIPS AND INTERESTED TRANSACTIONS ”
for
      a
      description of the salary deferral and payments of deferred salary with respect
      to Mr. Nouri.




**Henry
      Nouri.** Effective April 1, 2004, covering employment commencing as of June 1, 2004
      entered into an employment agreement with Mr. Nouri, which provided for an
      initial base salary of $150,000. The agreement replaced an employment agreement
      dated July 14, 1999 that was about to expire. The new agreement had a
      termination date of December 31, 2005, but it would be automatically extended
      for additional two-year terms, unless either party provided the other with
      written notice of intention not to renew at least 180 days prior to the end
      of
      the term or the end of any renewal period. Since
      neither party gave written notice of termination, the agreement was extended
      for
      an additional two years and thus shall terminate on December 31, 2007. The
      agreement requires us to make a severance payment to Mr. Nouri in an amount
      equal to twelve months of base salary, if either we terminate Mr. Nouri’s
      employment without “cause” (as defined in the agreement) or Mr. Nouri terminates
      his employment for “good reason” (as defined in the agreement). The agreement
      also contains a retention provision designed to provide incentive for Mr. Nouri
      to remain employed by us following a “change of control” as defined in the
      agreement. Under this retention provision, if Mr. Nouri remains employed by
      the
      surviving entity for a period of time after the change of control occurs
      designated by the Board of Directors of the surviving entity, and either his
      employment is terminated by the surviving entity without cause or by Mr. Nouri
      for good reason, the surviving entity must pay Mr. Nouri an amount equal to
      299%
      of his highest annual salary and bonuses during the preceding five years. This
      retention payment is in addition to other severance payments described above.
      Mr. Nouri’s agreement contains non-competition and non-solicitation provisions.
      Refer to “Item 13. CERTAIN
      RELATIONSHIPS AND INTERESTED TRANSACTIONS ”
for
      a
      description of the salary deferral and payments of deferred salary with respect
      to Mr. Nouri.





77










**Thomas
      Furr.** Effective April 1, 2004, covering the employment period commencing on June
      1,
      2004, we entered into any employment agreement which was amended effective
      November 9, 2005. This agreement replaced and earlier agreement dated September
      15, 2001 that was about to expire. The agreement provided for an initial base
      salary of $70,000, which was increased to $90,000 effective July 1, 2004 and
      $136,800 effective November 9, 2006. The
      agreement had a termination date of December 31, 2005, but is automatically
      extended for additional one-year terms, unless either party provided the other
      with written notice of intention not to renew at least 30 days prior to the
      end
      of the term or of any renewal period. Since
      neither party gave written notice of termination, the agreement was extended
      for
      an additional year and thus shall terminate on December 31, 2006. The
      agreement requires us to make a severance payment to Mr. Furr in an amount
      equal
      to three months of base salary, if either we terminate Mr. Furr’s employment
      without cause (as defined in the agreement) or Mr. Furr terminates his
      employment for “good reason” (as defined in the agreement). Mr. Furr’s agreement
      contains non-competition and non-solicitation provisions.




**Anil
        Kamath.**  Effective May 1, 2004, covering the employment period
        commencing on May 1, 2004, we entered into an employment agreement which
        was
        amended effective December 20, 2005. The agreement provides for an initial
        base
        salary of $100,000, which was increased to $125,000 effective June 1, 2004. The
        agreement had a termination date of December 31, 2005, but was extended for
        an
        additional one-year term. The terms of the agreement are extended for one
        (1)
        year terms upon written notice by the Company not less than ninety (90) days
        prior to the expiration of the current term. The agreement requires us to
        make a
        severance payment to Mr. Kamath in an amount equal to three months of base
        salary if either we terminate Mr. Kamath’s employment without cause (as defined
        in the agreement) or he terminates his employment for “good reason” (as defined
        in the agreement). Mr. Kamath’s agreement contains non-competition and
        non-solicitation provisions.




**Joan
      A. Keston.** Effective June 1, 2005, covering employment commencing on such date, we entered
      into an employment agreement which provided for an initial base salary of
      $100,000, which was increased to $125,000 effective August 1, 2005 and to
      $150,000 effective October 1, 2005. The agreement has a termination date of
      June
      30, 2006, but it will be automatically extended for additional one-year terms,
      unless either party provides the other with written notice of intention not
      to
      renew at least 30 days prior to the end of the term or of any renewal period.
      Ms. Keston’s agreement contains non-competition and non-solicitation provisions.
      The agreement was accompanied by a grant of incentive stock option for fifty
      thousand (50,000) shares of common stock at an exercise price of eight dollars
      and sixty-one cents ($8.61) vesting over a five (5) year period in five (5)
      equal installments, commencing one year from the date of the grant. Option
      vesting is accelerated upon a change of control or corporate reorganization
      such
      that all options would vest immediately. Ms. Keston’s employment with us ended
      effective June 1, 2006. Under the terms of her option agreements, those options
      expire in ninety (90) days of the end of her employment. Therefore, none of
      the
      shares subject to those grants will vest.





**Gary
      Mahieu.** Effective October 17, 2005, covering employment commencing on such date, we
      entered into an employment agreement which provided for an initial base salary
      of $150,000. The agreement has a termination date of October 17, 2007. Mr.
      Mahieu’s agreement contains non-competition and non-solicitation provisions. As
      consideration for the covenants not compete contained in the agreement, Mr.
      Mahieu is entitled to receive payments totaling $510,000 in equal quarterly
      installments commencing January 2, 2006, with the final payment to be made
      on
      October 1, 2007. Mr. Mahieu did not have any right to receive any stock options
      under his agreement.





**Indemnity
      Agreements.** In addition to those agreements, we have also entered into
      indemnity agreements with the following officers and/or Directors: Michael
      Nouri, Henry Nouri, Tom Furr, Joan Keston, Scott Whitaker, and David E.Y. Sarna.
      These indemnification agreements provide that the officers and directors will
      be
      indemnified, to the fullest extent permitted under the Company’s Bylaws and
      Delaware law, for their expenses incurred in connection with the SEC
      investigation involving us. Each officer or director also agreed to repay these
      amounts to the Company should it ultimately be determined that such indemnity
      was not permissible. As of June 30, 2006, approximately $760,000 in
      expenses, including legal fees, has been incurred on behalf of these
      individuals. Our directors and officer liability insurance carrier has paid
      a
      portion of these fees, while the Company has paid approximately $160,000.
      However, we have no guarantee that all such future fees and expenses will be
      covered by our insurance.






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







78











**Compensation
      Committee Interlocks and Insider Participation**




On
      July
      22, 2005 our Board of Directors adopted the Compensation Committee Charter,
      pursuant to which the Compensation Committee was comprised of two or more
      members of the Board of Directors, each of whom was determined to be
“independent” as
      defined by Securities and Exchange Commission, stock exchange and NASDAQ
      rules. Prior to
      the establishment of this Committee, all of our Directors participated in
      compensation deliberations, including Michael Nouri, Henry Nouri, Ronna Loprete
      and Thomas Furr, all of whom were executive officers. The Compensation
      Committee’s charter requires the Committee to consult with the Chief Executive
      Officer regarding the compensation of all other officers.





**Compensation
      Committee Report on Executive Compensation**





The
      Compensation Committee currently has one member, who is “independent” as defined
      by the SEC, stock exchange and NASDAQ rules. It was comprised of three members,
      all of whom were “independent” as of December 31, 2005 prior to the resignation
      of two independent Board Members.. The Committee operates under a written
      charter adopted by the Board of Directors on July 22, 2005. The Company is
      actively seeking a third Independent Director.





**Overview
      of Compensation Philosophy and Objectives** .
      The
      Compensation Committee is conscious of establishing compensation levels that
      will attract and retain managerial talent desired by us, reward employees for
      past contributions and motivate managerial efforts consistent with corporate
      growth, strategic progress and the creation of stockholder value. Most of our
      executives had employment contracts that were entered into prior to the
      formation of the Compensation Committee, which contracts provide for a base
      salary that can be increased. The Compensation Committee left in place the
      compensation packages previously entered into by the Chief Executive Officer,
      and in general has relied on recommendations made by the Chief Executive Officer
      in awarding compensation packages. Due to the fact that we had immaterial
      revenues until we acquired two other companies during October 2005 and have
      only
      experienced net losses to date, there have been no increases in the compensation
      packages and a bonus plan has not been adopted. All future compensation packages
      will be reviewed and approved by the Compensation Committee.





We
      establish the salaries for our executive officers based on readily available
      public information regarding local market compensation levels, and, considering
      the fact that we have immaterial revenues and has only experienced net
      losses to date, establishes salaries for its executive officers mostly at the
      low end of the market salary ranges. The Human Resources Manager has collected
      relevant market information using various websites. We value the contributions
      of all employees and reward them through stock option awards to purchase shares
      of our common stock. Occasionally, we reward exceptional effort with an
      incentive bonus, but this is not the standard practice since a bonus plan has
      not been implemented. For details of executive compensation please see “ITEM 11.
      EXECUTIVE COMPENSATION.”





**Salary** .
      Factors
      considered in determining salary increases for executive officers include:
      (i)
      length of time the executive has been employed by us, and the last review and
      salary increase; (ii) the nature, scope and level of the executive’s
      responsibilities; (ii) accomplishment of tasks and goals such as the release
      of
      product, attainment of milestones regarding research and development, and
      project completion; (iii) recommendations of the executive’s supervisor; (iv)
      past performance when reviewing employment contract renewals; (v) market
      analysis; (vi) the attitude toward their job and responsibilities, and work
      ethic of the employee; and (vii) the first three months of performance for
      new
      hires in determining whether to maintain or increase the initial salary. Some
      of
      these same factors are considered in determining the salary for new
      hires.





**Stock
      Options** .
      Factors
      considered in determining awards of stock options under our Equity Compensation
      Plan include: (i) the scale of awards based on past practices, (ii) our overall
      practice regarding different managerial levels; and (iii) executive’s past
      performance and incentives for future performance and goals.





79








**Chief
      Executive Officer** .
      The
      Compensation Committee has maintained the salary level of $170,000 for the
      Chief
      Executive Officer that was established in his contract dated April 1, 2004.
      An
      award of 100,000 stock options at an exercise price of $8.61 per share was
      made
      on July 22, 2005, when all other executives and employees were also awarded
      stock options. Based on the local market analysis, the salary of the Chief
      Executive Officer is in the low range. For details of his compensation please
      see “ITEM 11. EXECUTIVE COMPENSATION.”





Since
      the
      beginning of 2005, the following events occurred, which the Committee believes
      are relevant to considering the compensation of the Chief Executive Officer:
      (i)
      we began trading our shares in the public securities market, but trading was
      suspended in January 2006 by order of the SEC and the SEC is conducting an
      investigation of the Company; (ii) two companies were acquired that resulted
      in
      an increase in revenues of 270% and introduced new product lines; (iii)
      substantial strides were made during the fourth quarter of 2005 to integrate
      the
      operations, development and personnel of the two acquired subsidiaries with
      us;
      (iv) we launched key elements of its OneBiz SM platform
      without significant delay; (v) we acquired, developed and launched the
      accounting package on the OneBiz SM platform
      which is currently being modified; (vi) we integrated into its
      OneBiz SM platform
      a simplified version its new CRM/SFA product we acquired in October 2005; (vii)
      we launched our new HR product; (viii) we raised approximately $8 million for
      working capital in 2005; (ix) the fair market value of our stock rose
      progressively higher through 2005 (but fell immediately after the SEC’s
      suspension of trading of our securities); (x) We were approved for trading
      on
      the NASDAQ Capital Market (which approval was withdrawn after the SEC’s
      suspension of trading of our securities); and (xi) the change in the number
      of
      subscriptions to our OneBiz SM platform
      on our core website.





**Goals** .
      As we
      increases our revenues and approaches profitability, the goal and objective
      is
      to establish an incentive bonus plan, and to increase the competitive level
      of
      its executive’s salaries and total compensation.





Jeffrey
      W. LeRose, Chair of the Compensation Committee member





**Stock
      Performance Graph**





The
      graph
      below compares, for the twel ve
      month
      period ended April 2006, the cumulative total return of our Common Stock at
      month end with a market index based on S&P Tech Sector Index and the Russell
      MicroCap Index. The industry index is the S&P Tech Sector Index of the
      Nasdaq Stock Market ****** and
      the
      market index is Russell MicroCap Index. The graph assumes an investment of
      $100
      April 2005 in shares of our Common Stock and in each index and also assumes
      the
      reinvestment of all dividends during the period shown. The indices are
      calculated on a month-end basis.







80








***Comparison
      of Twelve-Month Total Return***


***Among
      Smart Online, Inc., the S&P Tech Sector Index and the Russell MicroCap
      Index***













**Board
      of Directors**




Two
      of
      our three current Directors are officers of Smart Online. We do not pay these
      Directors any additional amounts for serving on our Board of Directors.





Our
      Board
      Compensation Policy provides that each non-management member of the Board of
      Directors (other than the Chair of the Audit Committee) shall be entitled to
      a
      retainer fee of $5000 upon initial election to the Board, and shall be entitled
      to a meeting fee of $1000 per meeting. Each non-management director who is
      a
      member of a Board committee (other than the Chairman of the Audit Committee)
      shall be entitled to an additional meeting fee of $250 per meeting of such
      committee. Each non-management member of the Board of Directors (other than
      the
      Chair of the Audit Committee) shall be entitled to an initial grant of 10,000
      non-qualified stock options, having an exercise price equal to the fair market
      value of our stock on the date of the grant. These options vest quarterly over
      a
      year’s time, provided the optionee remains a member of the Board of Directors.
      In addition, at the time of the annual meeting of our stockholders, each
      non-management member of the Board who is re-elected to the Board (and who
      has
      been serving on the Board for at least six months prior to the date of the
      annual meeting) shall be granted an additional 10,000 non-statutory stock
      options, having an exercise price equal to the fair market value of our stock
      on
      the date of the grant. These options vest quarterly over a year’s time, provided
      the optionee remains a member of the Board of Directors, and shall accelerate
      in
      the event of a change in control.








81





The
      Chairman of the Audit Committee is entitled to a retainer fee of $5000 upon
      initial election to the post of Chairman of the Audit Committee and shall be
      entitled to a meeting fee of $2000 per each meeting of the full Board of
      Directors or the Audit Committee, and $250 for each meeting of other Board
      committees of which such person is a member. The Chairman of the Audit Committee
      shall be entitled to an initial grant of 24,000 non-qualified stock options,
      having an exercise price equal to the fair market value of the our stock on
      the
      date of the grant. These options shall vest quarterly over a year’s time,
      provided that the optionee remains a member of the Board of Directors. In
      addition, at the time of the annual meeting of the Company’s stockholders, the
      Chairman of the Audit Committee (provided he has been serving in such capacity
      for at least six months prior to the date of the annual meeting) shall be
      granted an additional 24,000 non-qualified stock options, having an exercise
      price equal to the fair market value of our stock on the date of the grant.
      These options shall vest quarterly over a year’s time, provided that the
      optionee remains a member of the Board of Directors, and shall accelerate in
      the
      event of a change in control. In the event the Chairman of the Audit Committee
      is elected at any time from among the existing member of the Board, the Chairman
      shall be entitled to the compensation provided both as the Chairman of the
      Audit
      Committee and also as a non-management member of the Board of Directors who
      is
      not the Chairman of the Audit Committee, as set forth in the preceding
      paragraph.





Each
      non-management director is eligible for expense reimbursement for reasonable
      travel and lodging expenses incurred in connection with his or her attendance
      at
      Board and committee meetings.




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




Our
      directors and officers are indemnified as provided by the Delaware Business
      Corporations Act (the “Delaware Corporations Act”) and our Certificate of
      Incorporation. We have been advised that in the opinion of the SEC
      indemnification for liabilities arising under the Securities Act of 1933 is
      against public policy as expressed in the Act, and is, therefore, unenforceable.
      In the event that a claim for indemnification against such liabilities is
      asserted by one of our directors, officers, or controlling persons in connection
      with the securities being registered, we will, unless in the opinion of our
      legal counsel the matter has been settled by controlling precedent, submit
      the
      question of whether such indemnification is against public policy to a court
      of
      appropriate jurisdiction. We will then be governed by the court’s decision.







82








**ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT**





The
      following table sets forth certain information regarding beneficial ownership
      of
      our Common Stock as of July 7, 2006: (i) by each person who is known by us
      to
      beneficially own more than 5% of our Common Stock; (ii) by each of our officers
      and directors; and (iii) by all of our officers and directors as a group. Unless
      otherwise noted, each of the persons listed below is believed to hold sole
      voting and sole investment power with respect to the shares
      indicated.







**Beneficial
                Owner**
              **Name
                and Address**
            **Amount
                and**
              **Nature
                of**
              **Beneficial**
              **Ownership****(1)(2)**
            **Percent
                of Class**Dennis
                Michael Nouri(3)(4)(5)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina 27713
            3,322,028
            20
            %Henry
                Nouri(3)(6)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina 27713
            3,111,985
            19
            %Thomas
                Furr(7)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            420,637
            3
            %Anil
                Kamath(8)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            285,000
            2
            %Atlas
                Capital SA(9)
              116
                Rue du Rhone
              CH-1204
              Geneva,
                Switzerland
            2,257,950
            13
            %Doron
                Roethler(10)
              c/o
                Michal Raviv at
              Granot,
                Strauss, Adar & Co.
              28
                Bezalel Street
              Ramat
                Gan 52521, Israel
            1,754,735
            11
            %Joan
                Keston(11)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            0
            0
            %David
                E. Y. Sarna(12)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            38,050
            0
            %Jeffrey
                W. LeRose(13)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina 27713
            7,500
            0
            %Eric
                Nouri(14)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            35,100
            0
            %Jose
                Collazo(15)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            285,900
            2
            %Gary
                Mahieu(16)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            48,127
            0
            %Nicholas
                A. Sinigaglia(17)
              c/o
                Smart Online, Inc.
              2530
                Meridian Parkway
              Durham,
                North Carolina  27713
            0
            0
            %All
                officers and directors as a group (13 persons)
            8,725,028
            53
            %





(1)
            All
                shares are common stock.(2)
            The
                preceding table was prepared based solely upon the information furnished
                to us by officers, directors and stockholders as of July 7, 2006
                and from
                corporate stock transfer ledgers. The number and percentage of shares
                beneficially owned is determined in accordance with Rule 13d-3 of
                the
                Securities Exchange Act of 1934, and the information is not necessarily
                indicative of beneficial ownership for any other purpose. Under Rule
                13d-3, a beneficial owner of a security includes any person who,
                directly
                or indirectly, through any contract, arrangement, understanding,
                relationship, or otherwise has or shares: (i) voting power, which
                includes
                the power to vote, or to direct the voting of shares; and (ii) investment
                power, which includes the power to dispose or direct the disposition
                of
                shares. Certain shares may be deemed to be beneficially owned by
                more than
                one person (e.g., if persons share the power to vote or the power
                to
                dispose of the shares). In addition, shares are deemed to be beneficially
                owned by a person if the person has the right to acquire the shares
                (for
                example, upon exercise of an option or a warrant) within 60 days
                of the
                date as of which the information is provided. In computing the percentage
                ownership of any person, the number of shares outstanding is deemed
                to
                include the amount of shares beneficially owned by such person (and
                only
                such person) by reason of these acquisition rights. As a result,
                the
                percentage of outstanding shares of any person as shown in this table
                does
                not necessarily reflect the person's actual ownership or voting power
                with
                respect to the number of shares of common stock actually outstanding
                on
                July 7, 2006. As of July 7, 2006, there were 16,679,031 shares issued
                and
                outstanding and our officers and directors beneficially owned
                approximately 870,000 shares which can be acquired upon exercise
                of stock
                options within sixty (60) days after July 7, 2006, which options
                were
                treated the same as outstanding shares in calculating the percentage
                ownership of our officers and directors.









83




(3)
            Includes
                2,841,984 shares owned by American Investment Holding Group, owned
                by
                Michael and Henry Nouri, and as to which they share the power to
                vote and
                the power to dispose of such shares.(4)
            Includes
                87,043 shares owned by Charter Holding, LLC, which is a member-managed
                limited liability company in which Michael Nouri is the sole member.
                Mr.
                Nouri's membership interest in Charter Holding LLC is subject to
                a
                Membership Interest Pledge Agreement dated November 1, 2005 between
                Mr.
                Nouri and Leon Sokolic pursuant to which Mr. Nouri retains all voting
                power with respect to the membership interest unless there is a default
                under the agreement, at which time Mr. Sokolic gains voting and investment
                power with respect to Mr. Nouri's membership interest in Charter
                Holding,
                LLC, and hence beneficial ownership of the 87,043 Smart Online shares
                owned by Charter Holding, LLC. The Membership Interest Pledge Agreement
                was entered into between Mr. Nouri and Mr. Sokolic in order to secure
                payment of the loan from Mr. Sokolic to Mr. Nouri, which is described
                under Item 13 of this report, and a default in repayment of the loan
                is a
                default under the agreement. This amount also includes 23,000 shares
                of
                common stock owned by a trust for which Michael Nouri is the trustee
                and
                is not a beneficiary. This amount does not include 265,631 shares
                owned by
                Ronna Loprete, wife of Michael Nouri.(5)
            Includes
                270,000 shares which can be acquired upon the exercise of options
                which
                can be exercised at any time within the sixty (60) days after July
                7,
                2006. Does not include 80,000 shares subject to options which cannot
                be
                exercised within sixty (60) days after July 7, 2006.(6)
            Includes
                270,000 shares which can be acquired upon the exercise of options
                which
                can be exercised at any time within the sixty (60) days after July
                7,
                2006. Does not include 80,000 shares subject to options which cannot
                be
                exercised within sixty (60) days after July 7, 2006.(7)
            Includes
                85,000 shares which can be acquired upon the exercise of options
                which can
                be exercised at any time within the sixty (60) days after July 7,
                2006.
                Does not include 40,000 shares subject to options which cannot be
                exercised within sixty (60) days after July 7, 2006.(8)
            Includes
                85,000 shares which can be acquired upon exercise of options which
                can be
                exercised at any time within sixty (60) days after July 7, 2006. 
                Does not include 40,000 shares subject to options which cannot be
                exercised within sixty (60) days after July 7, 2006.(9)
            Atlas
                Capital SA had the right to require two other stockholders to purchase
                all
                its Common Stock and warrants under certain circumstances. This right
                was
                terminated by agreement with Atlas Capital SA on March 18, 2005.
                Refer to
                “Certain Relationships and Related Transactions” for a description of this
                put agreement.(10)
            Includes
                (i) 1,323,619 shares owned by Greenleaf Ventures Ltd., a British
                Virgin
                Islands company, owned by Doron Roethler, (ii) 121,116 shares owned
                by
                Crystal Management Ltd., a company registered in Anguilla, owned
                by Doron
                Roethler, and (iii) 310,000 shares of common stock owned directly
                by Doron
                Roethler.(11)
            During
                her employment, Ms. Keston was issued options to purchase up to a
                total of
                100,000 shares. However, since Ms. Keston departed before any shares
                vested, she cannot exercise any of these options.(12)
            Includes
                3,700 shares owned by W-Two, Ltd., 150 shares held in an IRA for
                the
                benefit of David Sarna, and 200 shares owned directly by David E.Y.
                Sarna;
                and 34,000 shares which can be acquired upon exercise of options
                which can
                be exercised within sixty (60) days after July 7, 2006.(13)
            Includes
                7,500 shares subject to options which can be exercised within sixty
                (60)
                days after July 7, 2006. Does not include 2,500 shares subject to
                options
                which cannot be exercised within sixty (60) days after July 7,
                2006.















84


(14)
            Includes
                100 shares owned by Eric Nouri, and 35,000 shares which can be acquired
                upon exercise of options which can be exercised within sixth (60)
                days
                after July 7, 2006. Does not include 90,000 shares subject to options
                which cannot be exercised within sixty (60) days after July 7,
                2006.(15)
            Includes
                85,200 shares which can be acquired upon exercise of options which
                can be
                exercised at any time within sixty (60) days after July 7, 2006.
                Does not
                include 40,000 shares subject to options which cannot be exercised
                within
                sixty (60) days after July 7, 2006.(16)
            Does
                not include 105,365 shares held by Christine Mahieu, wife of Gary
                Maheiu.(17)
            Includes
                50,000 shares subject to options which cannot be exercised within
                sixty
                (60) days after July 7, 2006.





**Equity
      Compensation Plans**





The
      following table sets forth as of December 31, 2005, information related to
      stockholder approval of our equity compensation plans:





**Equity
      Compensation Plan Information**





**Plan
                category**
            **Number
                of securities to be**
              **issued
                upon exercise of**
              **outstanding
                options,**
              **warrants
                and rights****(1)**
              **(a)**
            **Weighted
                average**
              **exercise
                price of**
              **outstanding
                options,**
              **warrants
                and rights**
              **(b)**
            **Number
                of securities**
              **remaining
                available for**
              **future
                issuance under**
              **equity
                compensation**
              **plans
                (excluding securities**
              **reflected
                in column (a))****(1)**
              **(c)**Equity
                Compensation plans approved by security holders
            2,477,950(2)
            $5.09
            3,213,250(3)Equity
                Compensation plans not approved by security holders
            313,550(4)
            $8.35
            N/ATotal
            2,791,500
            
            3,213,250





(1)
      Refers to shares of our Common Stock.





(2)
      Includes shares upon exercise of outstanding options in the amounts indicated:
      2004 Equity Compensation Plan, 2,038,250; 2001 Equity Compensation Plan,
      670,000; and 1998 Equity Compensation Plan, 21,200.





(3)
      The
      foregoing table includes 313,550 shares issuable pursuant to warrants and
      options granted to consultants, advisors, employees, officers or directors
      pursuant to individual compensation arrangements not under any equity
      compensation plan.





(4)
      Includes 3,213,250 shares remaining under the 2004 Equity Compensation Plan.
      No
      shares remain available for grants under either the 2001 Equity Compensation
      Plan or the 1998 Stock Option Plan.





Currently,
      two of our Directors are officers and employees of Smart Online. We do not
      pay
      employee Directors any additional amounts for serving on our Board of Directors.
      Directors who are not officers or employees of Smart Online are compensated
      with
      a combination of cash and stock options with the number of shares and the amount
      of cash based on estimates of the amount of work involved in the expected
      committee assignments for each Director. Non-management Directors receive $5,000
      upon joining the Board, $1,000 per Board meeting attended and $250 per committee
      meeting attended, except that the Chairman of the Audit Committee will be paid
      $2,000 per meeting of the Board of Directors and of the Audit Committee. Frank
      Coll was granted 10,000 options in April 2005 and an additional 10,000 options
      in July 2005. Mr. Coll resigned from the Board in March 2006. David Sarna was
      granted 24,000 options in April 2005 for agreeing to serve as chairman of the
      Audit Committee. Mr. Sarna resigned form our Board and all Committees thereof
      in
      June 2006. Jeff LeRose was granted 10,000 options in September 2005. The options
      vest quarterly over a one-year period if the grantee remains a director of
      Smart
      Online, with the exercise price equal to the value of the stock on the grant
      date.








85





The
      only
      compensation plans or arrangements under which we were authorized to issue
      equity securities are the following (collectively, the “Option Plans”): (1) the
      2004 Equity Compensation Plan; (2) 2001 Equity Compensation Plan; and
      (3) 1998 Stock Option Plan. The only Option Plan under which we remain
      authorized to make future awards is the 2004 Equity Compensation Plan. The
      2004,
      2001, and 1998 Equity Compensation Plans have been approved by the shareholders.
      None of the Plans have not been approved by shareholders. The following
      description of the Company’s Option Plans is merely a summary of some of their
      respective terms and provisions, is not intended to be a complete description
      and is qualified in its entirety by reference to the full text of the applicable
      plan.





**Option
      Plans—General.**





The
      Option Plans are administered under the direction of the Compensation Committee
      of the Board of Directors. The Committee has broad discretion to determine
      the
      terms and conditions of options granted under the Option Plans and must approve,
      among other things, recommendations regarding grants and grant guidelines with
      respect to (1) the individuals to whom option grants are to be made,
      (2) the time or times at which options are granted, (3) the number of
      shares subject to each option, (4) the vesting terms of each option and
      (5) the term of each option.





**2004
      Equity Compensation Plan**





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





We
      adopted our 2004 Equity Compensation Plan as of March 31, 2004. The total number
      of shares of common stock reserved for issuance under the 2004 plan is 5,000,000
      shares, subject to adjustment in the event of stock split, stock dividend,
      recapitalization or similar capital change. At December 31, 2005, 16,500 shares
      were issued and outstanding at an average exercise price of $3.50 per share,
      and
      options to purchase 1,786,750 shares of our common stock were outstanding under
      the 2004 plan.




**2001
      Equity Compensation Plan**




We
      adopted our 2001 Equity Compensation Plan on May 31, 2001. As of
      December 31, 2005, the total number of shares of our common stock reserved
      for issuance under the 2001 plan is 670,000 shares, subject to adjustment in
      the
      event of stock split, stock dividend, recapitalization or similar change.
      Options to purchase 670,000 shares granted under the 2001 plan are outstanding
      at December 31, 2005, and we may not make any further grants under the 2001
      plan.




**1998
      Stock Option Plan**




We
      adopted our 1998 Stock Option Plan on November 12, 1998. As of December 31,
      2005, the total number of shares of our common stock reserved for issuance
      under
      the 1998 plan is 21,200 shares, subject to adjustment in the event of stock
      split, stock dividend, recapitalization or similar change. Options to purchase
      21,200 shares have been granted under the 1998 plan and remain outstanding
      at
      December 31, 2005, and we may not make any further grants under the 1998
      plan.










86





**ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**





Except
      as
      disclosed below, none of the following persons has, since January 1, 2002,
      had
      any material interest, direct or indirect, in any transaction with us or in
      any
      presently proposed transaction that has or will materially affect
      us:





·
            Any
                of our directors or officers;


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


·
            Any
                person who beneficially owns, directly or indirectly, shares carrying
                more
                than 10% of the voting rights attached to our outstanding shares
                of Common
                Stock;


·
            Any
                of our promoters;


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








**Consulting
      Agreement with Hadar, LLC**





In
      March
      2005, we entered into a consulting agreement with Hadar, LLC. David E.Y. Sarna,
      a member of Hadar, was appointed as a member of our Board of Directors on April
      18, 2005, elected Chairman of the Audit Committee of our Board of Directors
      September 13, 2005, and resigned from our Board and all Committees of the Board
      on June 23, 2006. Our understanding is that Mr. Sarna and Isaac Nussen were
      and
      remain partners of Hadar. Under the terms of that agreement, Hadar was to act
      as
      a financial advisor to us regarding the introduction and evaluation of potential
      investors. Payment for these services was to be 8% of proceeds for investors
      who
      invest $5 million or less, and 6% of proceeds for investors who invest over
      $5
      million. Upon Mr. Sarna’s election to the Board of Directors, no further
      business was conducted between Hadar and us. No monies were ever paid to Hadar
      by us, and no monies are payable to us. We do not believe that Hadar provided
      services to us under the consulting agreement, but we are reviewing whether
      Hadar or anyone affiliated with Hadar may have received equity in us from
      third-party investors in conjunction with the consulting agreement. We are
      currently in the process of terminating this agreement.




**Loans
      Made by Certain Parties to the Chief Executive Officer**





During
        2005, the following loans were made by certain investors, consultants and/or
        stockholders to our Chief Executive Officer: (i) $809,736.49 was borrowed
        from
        Leon Sokolic, one of our stockholders, (ii) $77,971.20 was borrowed from
        Atlas
        Capital, one of our stockholders, (iii) $80,000 was borrowed from Pete Coker,
        a
        principal of Tryon Capital, which provided financial consulting services
        to us
        and received a warrant and cash fees, and (iv)$296,589 was borrowed from
        Berkley, which received compensation for services rendered to us for investment
        banking and investor relations services as described above under “Agreements
        with Berkley Financial Services,” including during the period in which Berkley
        was making loans to the Chief Executive Officer. Our Chief Executive Officer
        has
        agreed with the Audit Committee that he will repay the loans from Berkley
        by
        December 31, 2006. Under Section 402 of the Sarbanes-Oxley Act of 2002, issuers
        subject to the Act such as Smart Online are prohibited from making personal
        loans to their directors and executive officers, directly and indirectly.
        We
        believe that the loans to our Chief Executive Officer described above are
        not
        personal loans made directly or indirectly by Smart Online to our Chief
        Executive Officer.


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





**Michael
      Nouri** .
      From
      1999 until September 2003, we deferred salary payments to Mr. Nouri totaling
      $296,667, which were due to him under his employment agreement dated July 14,
      1999, which called for a base salary of $150,000 per year. Loans and deferrals
      earned interest at a rate of 15% compounded annually. In October 2003, Mr.
      Nouri
      agreed to continue to defer $9,583 of salary per month for salary that accrued
      after October 1, 2003. On October 13, 2003, we entered into an agreement with
      Mr. Nouri whereby the salary deferrals through October 1, 2003 were evidenced
      by
      a promissory note in the principal amount of $358,229 for deferrals of salary
      that accrued prior to October 1, 2003. During the fourth quarter of 2003 and
      the
      first quarter of 2004, we deferred an additional $63,437 of Mr. Nouri’s
      compensation. On April 30, 2004, the promissory note dated October 13, 2003
      was
      cancelled and replaced by a successor promissory note in the amount of $418,750
      representing the principal balance of the original note plus the additional
      accrued compensation. Subsequently during 2004, we paid $125,000 of principal
      to
      Mr. Nouri. The outstanding balance due on the successor note bore interest
      of 15% interest compounded annually (reduced to 8% effective June 1, 2004 as
      described above). This note and all of our other obligations to Mr.
      Nouri





87





arising
      out of loans and salary deferrals were secured by all of our assets , which
      lien Mr. Nouri shared with Henry Nouri, Ronna Loprete, Thomas Furr and Eric
      Nouri to secure the obligations to them described below. The security interest
      was originally a second lien on all of our assets, but with repayment of all
      amounts owed to the holder of the first lien, the security interest became
      a first lien on all of our assets . The lien was removed when the notes
      were paid.  The note was due May 31, 2005, but Mr. Nouri entered
      into a standstill agreement not to demand payment on the due date to induce
      holders of outstanding shares of Preferred Stock to convert to shares of Common
      Stock in a reorganization. The standstill agreement, as amended as of December
      22, 2004, continued through the earlier of June 30, 2006 or the closing after
      January 1, 2005 of a financing with gross proceeds to us of $2,000,000 or more.
      After we raised $2,500,000 from a sale of securities to a foreign investor
      in
      February 2005, we paid in full the $296,667 of deferred compensation and accrued
      interest and cancelled the related promissory notes.





**Henry
      Nouri.** From
      1999
      until September 2003, we deferred salary payments to Mr. Nouri totaling
      $398,383, which were due to him under his employment agreement dated July 14,
      1999, which called for a base salary of $150,000 per year. In October 2003,
      Mr.
      Nouri agreed to continue to defer $9,583 of salary per month for salary that
      accrued after October 1, 2003. Deferrals earned interest at a rate of 15%
      compounded annually. On October 13, 2003, we entered into an agreement with
      Mr.
      Nouri whereby all salary deferrals through October 1, 2003 were evidenced by
      a
      promissory note in the principal amount of $346,812 for deferrals of salary
      that
      accrued prior to October 1, 2003. During the fourth quarter of 2003 and the
      first quarter of 2004, we deferred an additional $60,521 of Mr. Nouri’s
      compensation and $8,950 of the original principal was repaid. On April 30,
      2004,
      the promissory note dated October 13, 2003 was cancelled and replaced by a
      successor promissory note in the amount of $398,383 representing the unpaid
      principal balance of the original note plus the additional accrued compensation.
      This note and all deferred salary bore 15% interest compounded annually
      (reduced to 8% effective June 1, 2004, as described above). The note and all
      of
      our other obligations to Mr. Nouri arising out of salary deferrals were
      secured by all of our assets , which lien Mr. Nouri shared with Michael Nouri,
      Ronna Loprete, Thomas Furr and Eric Nouri to secure the obligations to them
      described herein. The security interest was originally a second lien on all
      of
      our assets, but with repayment of all amounts owed to the holder of the first
      lien, the security interest became a first lien on all of our assets . The
      lien was removed when the notes were paid. The notes were due May 31,
      2005, but Mr. Nouri entered into a standstill agreement not to demand
      payment on the due date to induce holders of outstanding shares of Preferred
      Stock to convert to shares of Common Stock in a reorganization. The standstill
      agreement, as amended as of December 22, 2004, continued through the earlier
      of
      June 30, 2006 or the closing after January 1, 2005 of a financing with gross
      proceeds to us of $2,000,000 or more. After we raised $2,500,000 from a sale
      of
      securities to a foreign investor in February 2005, we paid in full the $398,383
      of deferred compensation and accrued interest and cancelled the related
      promissory notes.





**Thomas
      Furr.** From
      2001
      until September 2003, we deferred salary and commission payments to Thomas
      Furr
      totaling $117,810, which were due to him under his employment agreement dated
      September 15, 2001, which called for a base salary of $70,000 per year, plus
      5%
      sales commissions. Deferrals earned interest at a rate of 15% compounded
      annually. In October 2003, Mr. Furr agreed to continue to defer all commissions
      per month for salary or commissions that accrue after October 1, 2003. On
      October 15, 2003, we entered into an agreement with Mr. Furr whereby all the
      loans and salary or commission deferrals through October 1, 2003 were evidenced
      by a promissory note in the principal amount of $114,190 for deferrals of salary
      that accrued prior to October 1, 2003. During the fourth quarter of 2003 and
      the
      first quarter of 2004, we deferred an additional $2,318 of Mr. Furr’s
      compensation. On April 30, 2004, the promissory note dated October 13, 2003
      was
      cancelled and replaced by a successor promissory note in the amount of $116,508
      representing the unpaid principal balance of the original note plus the
      additional accrued compensation. The note, plus $1,302 of compensation
      subsequently deferred during 2004, and all deferred commissions bore 15%
      interest compounded annually (reduced to 8% effective June 1, 2004 as described
      above). The note and all of our other obligations to Mr. Furr arising out of
      salary or commission deferrals were secured by all of our assets , which lien
      Mr. Furr shared with Michael Nouri, Henry Nouri, Ronna Loprete and Eric Nouri
      to
      secure the obligations to them described herein. The security interest was
      originally a second lien on all of our assets, but with repayment of all amounts
      owed to the holder of the first lien, the security interest became a first
      lien on all of our assets . The lien was removed when the notes were
      paid. The note was due May 31, 2005, but Mr. Furr has entered into a
      standstill agreement not to demand payment on the due date to induce holders
      of
      outstanding shares of Preferred Stock to convert to shares of Common Stock
      in a
      reorganization. The standstill agreement, as amended as of December 22, 2004,
      continued through the earlier of June 30, 2006 or the closing after January
      1,
      2005 by Smart Online of a financing with gross proceeds to us of $2,000,000
      or
      more. After we raised $2,500,000 from a sale of securities to a foreign investor
      in February 2005, we paid in full the $92,500 of deferred compensation and
      accrued interest and cancelled the related promissory notes.





88





**Ronna
      Loprete.** From
      2001
      until September 2003, we deferred salary payments to Ms. Loprete totaling
      $92,500, which were due to her under her employment agreement dated June 29,
      1999, which called for a base salary of $80,000 per year. In October 2003,
      Ms.
      Loprete agreed to continue to defer $2,500 of salary per month for salary that
      accrued after October 1, 2003. Deferrals earned interest at a rate of 15%
      compounded annually. On October 15, 2003, we entered into an agreement with
      Ms.
      Loprete whereby all salary deferrals through October 1, 2003 were evidenced
      by a
      promissory note in the principal amount of $92,500 for deferrals of salary
      that
      accrued prior to October 1, 2003. During the fourth quarter of 2003 and the
      first quarter of 2004, we deferred an additional $625 of Ms. Loprete’s
      compensation. On April 30, 2004, the promissory note dated October 15, 2003
      was
      cancelled and replaced by a successor promissory note in the amount of $92,500
      representing the unpaid principal balance of the original note plus the
      additional accrued compensation. This note and all deferred salary bore 15%
      interest compounded annually (reduced to 8% effective June 1, 2004 as described
      above). The note and all of our other obligations to Ms. Loprete arising out
      of
      salary deferrals were secured by all of our assets , which lien Ms. Loprete
      shared with Michael Nouri, Henry Nouri, Thomas Furr and Eric Nouri to secure
      the
      obligations to them described herein. The security interest was originally
      a
      second lien on all of our assets, but with repayment of all amounts owed to
      the
      holder of the first lien, the security interest became a first lien on all
      of our assets.  The lien was removed when the notes were paid. The
      note was due May 31, 2005, but Ms. Loprete entered into a standstill
      agreement not to demand payment to induce holders of outstanding shares of
      Preferred Stock to convert to shares of Common Stock in a reorganization. The
      standstill agreement, as amended as of December 22, 2004, continued through
      the
      earlier of June 30, 2006 or the closing after January 1, 2005 by us of a
      financing with gross proceeds to us of $2,000,000 or more. After we raised
      $2,500,000 from a sale of securities to a foreign investor in February 2005,
      we
      paid in full the $117,800 of deferred compensation and accrued interest and
      cancelled the related promissory notes.





**Eric
      Nouri.** From
      2002
      until September 2003, we deferred salary payments to Eric Nouri totaling
      $44,417, which were due to him under his employment agreement dated April 1,
      2002 which called for a base salary of $60,000 per year. Deferrals earned
      interest at a rate of 15% compounded annually. Eric Nouri is the brother of
      officers and directors of Smart Online, Michael Nouri and Henry Nouri. In
      October 2003, Mr. Nouri agreed to continue to defer $2,500 of salary per month
      for salary that accrued after October 1, 2003. On October 13, 2003, we entered
      into an agreement with Mr. Nouri whereby all salary deferrals through October
      1,
      2003 were evidenced by a promissory note in the principal amount of $54,925
      for
      deferrals of salary that accrued prior to October 1, 2003. During the fourth
      quarter of 2003 and the first quarter of 2004, we deferred an additional $9,000
      of Mr. Nouri’s compensation and $16,185 of principal was paid. On April 30,
      2004, the promissory note dated October 13, 2003 was cancelled and replaced
      by a
      successor promissory note in the amount of $47,740 representing the unpaid
      principal balance of the original note plus the additional accrued compensation.
      Subsequently during 2004, we deferred an additional $3,323 of Mr. Nouri’s
      compensation. This note bore 15% interest compounded annually (reduced to
      8% effective June 1, 2004 as described above). The note and all of our other
      obligations to Mr. Nouri arising out of salary deferrals were secured by
      all of our assets , which lien Mr. Nouri shared with Michael Nouri, Henry Nouri,
      Ronna Loprete and Thomas Furr to secure the obligations to them described
      herein. The security interest was originally a second lien on all of our assets,
      but with repayment of all amounts owed to the holder of the first lien, the
      security interest became a first lien on all of our assets.  The lien
      was removed when the notes were paid. The note was due May 31, 2005,
      but Mr. Nouri entered into a standstill agreement not to demand payment on
      the due date to induce holders of outstanding shares of Preferred Stock to
      convert to shares of Common Stock in a reorganization. The standstill agreement,
      as amended as of December 22, 2004, continues through the earlier of June 30,
      2006 or the closing after January 1, 2005 by Smart Online of a financing with
      gross proceeds to us of $2,000,000 or more. After we raised $2,500,000 from
      a
      sale of securities to a foreign investor in February 2005, we paid in full
      the
      $44,417 of deferred compensation and accrued interest and cancelled the related
      promissory notes.








89





**Tamir
      Sagie.** Tamir
      Sagie was a consultant with and owned Nen, Inc. Nen, Inc. was a consultant
      to us
      and was paid at an annual rate of $70,000 per year in addition to Mr. Tagie's
      salary of $30,000. Nen, Inc. also had an equity interest in Smart IL, Ltd.,
      from
      April 2002 to July 2003. Smart IL became an integration partner with us in
      August 2002 through the efforts of Nen, Inc. Mr. Sagie ended his consulting
      arrangement with Smart IL in August 2003 when he became an employee and officer
      of us. Mr. Sagie’s shares in Smart IL were transferred back to the Smart IL at
      this time. In addition, Mr. Sagie owned 29.5% of Greenleaf Ventures, Ltd.,
      and
      as such had a financial interest in the 1,448,618 shares of our common stock
      owned by Greenleaf Ventures. On January 13, 2005, Mr. Sagie entered into an
      agreement with Greenleaf Ventures, Ltd. and Doron Roethler, one of our
      stockholders and an affiliate of Greenleaf Ventures, Ltd., that provided for
      the
      withdrawal of Mr. Sagie from Greenleaf. In exchange for Mr. Sagie’s release of
      any interest in Greenleaf and Crystal Management Ltd. (another entity owned
      by
      Mr. Roethler), Mr. Sagie received 125,000 shares of our common stock held by
      Greenleaf. He was not an officer or director of Greenleaf Ventures. Mr. Sagie
      resigned from Smart Online in the first quarter of 2005 and has no further
      affiliation with us.





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





Michael
      Nouri and Doron Roethler (“Grantors”) entered into Put Agreements dated
      March 10, 2004 and August 13, 2004 with Atlas Capital, SA (“Atlas”). We were not
      a party to these agreements, but these agreements were entered into at the
      time
      of an investment in us by Atlas to provide comfort to Atlas that we would
      fulfill its promise to cause its Common Stock to become publicly traded. As
      a
      result of publicly registering our Common Stock, this Put Agreement was
      terminated in March 2005. The Put Agreements gave Atlas the right to require
      Mr.
      Nouri and Mr. Roethler to purchase for $2,700,000 all the 728,571 shares of
      Common Stock and warrants to purchase 188,571 shares of Common Stock Atlas
      purchased from us in March 2004 and August 2004.





**Corporate
      Reorganization**





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





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








90





**Shares
      Issued Pursuant to Registration Rights Agreement**





**2004
      Sales of Securities** .
      In
      connection with the private placement conducted during March through June of
      2004, we entered into registration rights agreements with certain investors.
      These registration rights agreements required us to pay investors 2% of their
      investment for each thirty-day period after June 30, 2004 in which we failed
      to
      file a registration statement registering shares sold in the private placement,
      which amount is prorated for partial 30-day periods. The registration rights
      agreements provided that we could choose to pay this by issuing shares of our
      Common Stock in lieu of cash, which we chose to do. On November 1, 2004, we
      issued 58,226 shares of its Common Stock to satisfy amounts that accrued through
      November 1, 2004 at the rate of one share for each $3.50 of accrued liability.
      These shares were registered in a registration statement that became effective
      in February 2005.





**2005
      Sales of Securities.** During
      February and March 2005, we sold 605,000 shares of Common Stock to foreign
      investors in private placements resulting in gross proceeds of $2.7 million.
      In
      connection with this financing, we incurred stock issuance costs of $290,000
      paid to Berkley. In connection with these sales, we entered into registration
      rights agreements with certain investors. These registration rights agreements
      required us to pay investors 0.5% of their investment for each thirty-day period
      after April 30, 2005 for certain investors, or September 30, 2005 for a
      different investor, in which we failed to file a registration statement
      registering the shares sold in the private placement, which amount is prorated
      for partial 30-day periods. The registration rights agreements provide that
      we
      can choose to pay this by issuing shares of our Common Stock in lieu of cash.
      Concurrent with the sale of shares of our Common Stock, we issued warrants
      to
      purchase 50,000 shares of Common Stock to an investor in consideration for
      the
      investor agreeing to certain restrictions on its ability to sell the shares.
      These warrants had an exercise price of $5.00 per share and were to terminate
      on
      January 1, 2007. During February 2005, we raised an additional $125,000 in
      gross
      proceeds from the sale of 25,000 shares of Common Stock at $5.00 per share
      in a
      private placement. These shares have not been registered with the SEC. See
“Note
      11” to “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for information
      about the registration rights penalty payable to these
      stockholders.





During
      July to September 14, 2005, we sold 786,642 shares of Common Stock to new and
      existing investors resulting in gross proceeds of $4,326,531. In connection
      with
      these sales, we entered into registration rights agreements with certain
      investors. These registration rights agreements required us to pay investors
      0.5% of their investment for each thirty-day period after September 30, 2005
      for
      a different investor, in which we failed to file a registration statement
      registering shares sold in the private placement, which amount is prorated
      for
      partial 30-day periods. The registration rights agreements provide that we
      can
      choose to pay this by issuing shares of our Common Stock in lieu of cash.
      Included in the existing investors participating in this private placement
      was
      Atlas Capital, S.A. Atlas purchased a total of 204,409 shares for a total
      purchase price of $1,124,250 in this financing. In connection with this
      financing, we incurred stock issuance costs of $340,525 paid to Berkley. These
      shares have not been registered with the SEC. See “Note 11” to “ITEM 8.
      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for information about the
      registration rights penalty payable to these stockholders.





**2006
      Sales of Securities**





On
      March
      30, 2006, we sold 400,000 shares of Common Stock to Atlas Capital, S.A. At
      the
      time immediately prior to the sale, Atlas held 1,380,750 shares of our Common
      Stock, approximately 9% of all outstanding shares. In
      connection with this sale, we entered into a subscriber rights agreement with
      Atlas. This agreement requires us to pay Atlas 0.5% of its investment for each
      thirty-day period after September 30, 2006, in which we fail to file a
      registration statement registering the shares sold to Atlas, which amount is
      prorated for partial 30-day periods. The subscriber rights agreement provides
      that we can choose to pay this by issuing shares of our Common Stock in lieu
      of
      cash.  The sucscriber rights agreement also provides that, should we offer
      to sell shares of our Common Stock for less than $2.50 per share, then Atlas
      shall have the right to purchase a pro rata share of such offering.  These
      shares have not been registered with the SEC. In
      connection with this financing, Berkley Financial Services, Ltd. may claim
      that
      it is entitled to a fee of $100,000 under an investment banking letter agreement
      dated February 23, 2005.








91





On
      June
      29, 2006, we sold 400,000 shares of Common Stock to Atlas Capital, S.A. At
      the
      time immediately prior to the sale, Atlas held 1,780,750 shares of our Common
      Stock, approximately 11% of all outstanding shares. In
      connection with this sale, we entered into a subscriber rights agreement with
      Atlas. This agreement requires us to pay Atlas 0.5% of its investment for each
      thirty-day period after September 30, 2006, in which we fail to file a
      registration statement registering the shares sold to Atlas, which amount is
      prorated for partial 30-day periods. The subscriber rights agreement provides
      that we can choose to pay this by issuing shares of our Common Stock in lieu
      of
      cash. These shares have not been registered with the SEC. In
      connection with this financing, Berkley Financial Services, Ltd. may claim
      that
      it is entitled to a fee under an investment banking letter agreement dated
      February 23, 2005.





On
      July
      6, 2006, we sold 100,000 shares of Common Stock to BlueLine Fund, Ltd. At
      the time immediately prior to the sale, BlueLine held 550,000 shares of our
      Common Stock, approximately 3% of all outstanding shares. In
      connection with this sale, we entered into a subscriber rights agreement with
      BlueLine. This agreement requires us to BlueLine 0.5% of its investment for
      each
      thirty-day period after September 30, 2006, in which we fail to file a
      registration statement registering the shares sold to BlueLine, which amount
      is
      prorated for partial 30-day periods. The subscriber rights agreement provides
      that we can choose to pay this by issuing shares of our Common Stock in lieu
      of
      cash. These shares have not been registered with the SEC. In
      connection with this financing, Berkley Financial Services, Ltd. may claim
      that
      it is entitled to a fee under an investment banking letter agreement dated
      February 23, 2005.





**Revenue
      and Expense Transactions**





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





**Stock
      Sales to Insiders**





The
      following table summarizes sales by us of shares of our Common Stock since
      January 1, 2005 through June 30, 2006 to our current executive officers,
      directors and persons who currently own five percent or more of our total voting
      securities. These transactions do not include grants of stock options which
      are
      disclosed in “ ITEM
      11.
      EXECUTIVE COMPENSATION .”






**Shares
                of**
              **Common**
              **Stock**
            
            
            **Total**
              **Purchase**
              **Price**
            
            **Date
                of**
              **Purchase**Atlas
            
            
            90,909
            
            
            $
            499,999.50
            
            
            7/22/2005Atlas
            
            
            50,000
            
            
            $
            275,000
            
            
            9/7/2005Atlas
            
            
            237,428
            (1)
            
            $
            830,998
            
            
            9/12/2005Atlas
            
            
            63,500
            
            
            $
            349,250
            
            
            9/13/2005Atlas
            
            
            400,000
            
            
            $
            1,000,000
            
            
            3/30/2006Atlas
            
            
            400,000
            
            
            $
            1,000,000
            
            
            6/29/2006




(1)
      Shares issued upon exercise of warrant by Atlas.





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





**Independent
      Accountant Fees**




During
      2004, we engaged BDO Seidman, LLP to provide services. In November 2005, we
      engaged Goldstein Golub Kessler LLP (“GGK”). We did incur expenses related to
      GGK’s work, although GGK resigned in March 2006 prior to releasing an audit
      opinion. In March 2006, we engaged Sherb & Co., LLP as our principal
      accountant. The amounts billed under the categories referenced below may contain
      a combination of charges from the different firms that served as our independent
      accountant during the referenced year.





92










**Audit
      Fees.** Aggregate
      fees billed for professional services rendered for the audit of our 2004 annual
      financial statements and reviews of financial statements included in our 2004
      Form 10-Q’s and SB-2 Registration statement were $157,983. The audits for
      fiscal years 2002 and 2003 were performed during fiscal 2004.  The audit
      fees also include review of our SB-2 Registration Statement and subsequent
      amendments.





Aggregate
      fees billed for professional services rendered for the audit of our 2005 annual
      financial statements and reviews of financial statements included in our 2005
      Form 10-Q’s were $263,046. This amount represents fees incurred for audits
      of our annual statements for 2005, 2004, and 2003. Under the agreements with
      our
      auditors referenced above, we paid a single price for the audits of the
      financial statements for the three year period. These fees include the current
      independent accountant’s audits of our 2003 and 2004 financial statements and
      the review of an S-1 Registration Statement which has not yet been
      filed.





**Audit-Related
      Fees.** In
      2005,
      we incurred fees of approximately $260,000 related to the audits of Computility,
      Inc. and iMart Incorporated for the years ended December 31, 2002, 2003 and
      2004. Such audits were required for the acquisitions and related Form 8-K
      filings. Fees related to the 2005 audits of these entities are now part of
      the
      consolidated audit and included in “Audit Fees” above.





**Tax
      Fees.** The
      principal accountant did not provide professional services related to tax
      compliance, tax advice, and tax planning during fiscal years 2005 and 2004.




**All
      Other Fees.** None.




93




**PART
          IV**
 
 **ITEM** **15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**
 
 ( a)(1)
          and
          (2) .  The
          financial statements and reports of our independent registered public accounting
          firm are filed as part of this report (see “,” 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.
 
 (b)
          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
                Articles
                    of Incorporation, as restated (incorporated herein by reference
                    to Exhibit
                    3.2 to our Registration Statement on Form SB-2, as filed with
                    the SEC on
                    September 30, 2004))3.2
                Bylaws,
                    as amended (incorporated herein by reference to Exhibit 3.2 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)3.3
                First
                    Amendment to Amended and Restated Bylaws of Smart Online,
                    Inc.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)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
                    Plan10.3*
                Form
                    of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
                    Plan10.4*
                2001
                    Equity Compensation Plan (terminated as to future grants April
                    15, 2004)
                    (incorporated herein by reference to Exhibit 10.2 to our Registration
                    Statement on Form SB-2, as filed with the SEC on September 30,
                    2004)10.5*
                1998
                    Equity Compensation Plan (terminated as to future grants effective
                    April
                    15, 2004) (incorporated herein by reference to Exhibit 10.3 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.6
                Form
                    of Reorganization, Lock-Up Proxy and Release Agreement, dated
                    January 1,
                    2004, and certain stockholders of Smart Online, Inc. (incorporated
                    herein
                    by reference to Exhibit 10.4 to our Registration Statement on
                    Form SB-2,
                    as filed with the SEC on September 30, 2004)10.7
                Form
                    of Lock-up Agreement dated January 1, 2004 between Smart Online
                    and
                    stockholders of Smart Online (incorporated herein by reference
                    to Exhibit
                    10.5 to our Registration Statement on Form SB-2, as filed with
                    the SEC on
                    September 30, 2004)10.8
                Form
                    of Subscription Agreement with lock-up provisions between Smart
                    Online and
                    investors (incorporated herein by reference to Exhibit 10.6 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.9
                Form
                    of Registration Rights Agreement dated as of February 1, 2004
                    between
                    Smart Online (incorporated herein by reference to Exhibit 10.7
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.10*
                Employment
                    Agreement dated April 1, 2004 with Michael Nouri (incorporated
                    herein by
                    reference to Exhibit 10.8 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 30,
                    2004)
  94
  
 10.11*
                Employment
                    Agreement dated April 1, 2004 with Henry Nouri (incorporated
                    herein by
                    reference to Exhibit 10.9 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 30, 2004)10.12*
                Employment
                    Agreement dated April 1, 2004 with Ronna Loprete (incorporated
                    herein by
                    reference to Exhibit 10.10 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 29, 2004)10.13*
                Employment
                    Agreement dated May 1, 2004 with Anil Kamath (incorporated herein
                    by
                    reference to Exhibit 10.12 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 30, 2004)10.14*
                Letter
                    agreement, dated December 20, 2005, with Anil Kamath amending
                    his
                    Employment Agreement10.15*
                Employment
                    Agreement dated June 21, 2005 with Joan Keston10.16*
                Employment
                    Agreement dated March 21, 2006 with Nicholas A. Sinigaglia (incorporated
                    herein by reference to Exhibit 10.1 to our Current Report on
                    Form 8-K, as
                    filed with the SEC on March 27, 2006)10.17*
                Security
                    Agreement dated October 13, 2003 with Smart Online as the Debtor
                    and
                    Michael Henry Nouri, Thomas Furr, Ronna Loprete and Eric Nouri
                    as the
                    Secured Parties (incorporated herein by reference to Exhibit
                    10.13 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.18*
                $418,749.93
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Michael Nouri (incorporated herein by reference to Exhibit 10.14
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.19*
                $64,602.90
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Michael Nouri (incorporated herein by reference to Exhibit 10.15
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.20*
                $398,383.27
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Henry Nouri (incorporated herein by reference to Exhibit 10.16
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.21*
                $116,507.60
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor
                    Thomas Furr (incorporated herein by reference to Exhibit 10.17
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.22*
                $92,500
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Ronna Loprete (incorporated herein by reference to Exhibit 10.18
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.23*
                $47,
                    740.18 Promissory Note dated April 30, 2004 from Smart Online
                    as the
                    Debtor to Eric Nouri (incorporated herein by reference to Exhibit
                    10.19 to
                    our Registration Statement on Form SB-2, as filed with the SEC
                    on
                    September 30, 2004)10.24*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Michael
                    Nouri (incorporated herein by reference to Exhibit 10.20 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.25*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Henry
                    Nouri (incorporated herein by reference to Exhibit 10.21 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.26*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Thomas
                    Furr (incorporated herein by reference to Exhibit 10.22 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.27*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Ronna
                    Loprete (incorporated herein by reference to Exhibit 10.23 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.28*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Eric
                    Nouri (incorporated herein by reference to Exhibit 10.24 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.29
                Asset
                    Purchase Agreement dated as of October 4, 2005 by and among Smart
                    Online,
                    Inc., SmartCRM, Computility, Inc. and certain shareholders of
                    Computility,
                    Inc. (incorporated herein by reference to Exhibit 2.1 to our
                    Current
                    Report on Form 8-K, as filed with the SEC on October 7,
                    2005)
  95
  
 10.30
                Stock
                    Purchase Agreement dated as of October 17, 2005 by and among
                    Smart Online,
                    Inc., iMart Incorporated and the shareholders of iMart Incorporated
                    (incorporated herein by reference to Exhibit 2.1 to our Current
                    Report on
                    Form 8-K, as filed with the SEC on October 24, 2005)10.31*
                Employment
                    Agreement dated as of October 17, 2005 by and among Smart Online,
                    Inc.,
                    iMart Incorporated and Gary Mahieu (incorporated herein by reference
                    to
                    Exhibit 2.2 to our Current Report on Form 8-K, as filed with
                    the SEC on
                    October 24, 2005)10.32
                Letter
                    Agreement dated February 23, 2005 by and between Smart Online,
                    Inc. and
                    Berkley Financial Services (BFS) Ltd. for financial advisory
                    services10.33
                Consulting
                    Agreement, dated October 4, 2005, by and between Smart Online,
                    Inc. and
                    Berkley Financial Services Ltd. (incorporated herein by reference
                    to
                    Exhibit 99.1 to our Current Report on Form 8-K, as filed with
                    the SEC on
                    November 10, 2005)10.34
                Consulting
                    Agreement, dated October 26, 2005, by and between Smart Online,
                    Inc. and
                    General Investments Capital (GIC) Ltd. (incorporated herein by
                    reference
                    to Exhibit 99.2 to our Current Report on Form 8-K, as filed with
                    the SEC
                    on November 10, 2005)10.35
                Settlement
                    Agreement, effective May 31, 2006, by and between Smart Online, Inc.
                    and General Investments Capital (GIC) Ltd. (incorporated herein
                    by
                    reference to Exhibit 99.1 to our Current Report on Form 8-K,
                    as filed with
                    the SEC on June 6, 2006)10.36
                Form
                    of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                    Out
                    Agreement, dated June 29 and July 6, 2006, by and between Smart
                    Online,
                    Inc. and certain investors10.37
                Form
                    of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                    Out
                    Agreement, dated March 30, 2006, by and between Smart Online,
                    Inc. and
                    Atlas Capital, SA10.38
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, dated July 19, September 7 and September 13, 2005,
                    by and
                    between Smart Online, Inc. and Atlas Capital, SA10.39
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, dated September 7, 2005, by and between Smart Online,
                    Inc. and
                    Credit Suisse Zurich10.40
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, and Exhibits thereto, dated February 25, 2005, by
                    and between
                    Smart Online, Inc. and The BlueLine Fund10.41
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, dated August 30, September 10, and September 28, 2004,
                    by and
                    between Smart Online, Inc. and certain investors10.42*
                Indemnification
                    Agreement, dated April ,14 2006, by and between Smart Online,
                    Inc. and
                    David E.Y. Sarna10.43*
                Indemnification
                    Agreement, dated April ,14 2006, by and between Smart Online,
                    Inc. and
                    Joan Keston10.44*
                Indemnification
                    Agreement, dated January 26, 2006, by and between Smart Online,
                    Inc. and
                    Tom Furr10.45*
                Indemnification
                    Agreement, dated January 26, 2006, by and between Smart Online,
                    Inc. and
                    Henry Nouri10.46*
                Indemnification
                    Agreement, dated April 14, 2006, by and between Smart Online,
                    Inc. and
                    Scott Whitaker10.47*
                Indemnification
                    Agreement, dated January 26, 2006, by and between Smart Online,
                    Inc. and
                    Michael Nouri21.1
                Subsidiaries
                    of Smart Online, Inc.23.1
                Consent
                    of Independent Registered Public Accounting Firm31.1
                Certification
                    of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as
                    Adopted
                    Pursuant to Section 302 of the Sarbanes-Oxley Act of
                    200231.2
                Certification
                    of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as
                    Adopted
                    Pursuant to Section 302 of the Sarbanes-Oxley Act of
                    200232.1
                Certification
                    of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350,
                    as Adopted
                    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
                    exhibit
                    is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                    Act of
                    2002 and shall not, except to the extent required by that Act,
                    be deemed
                    to be incorporated by reference into any document or filed herewith
                    for
                    the purposes of liability under the Securities Exchange Act of
                    1934, as
                    amended, or the Securities Act of 1933, as amended, as the case
                    may
                    be.]32.2
                Certification
                    of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350,
                    as
                    Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002 [This
                    exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                    Act of 2002 and shall not, except to the extent required by that
                    Act, be
                    deemed to be incorporated by reference into any document or filed
                    herewith
                    for the purposes of liability under the Securities Exchange Act
                    of 1934,
                    as amended, or the Securities Act of 1933, as amended, as the
                    case may
                    be.]
 
 *
          Management contract or compensatory plan.
 
  96
  **SIGNATURES**
 
 Pursuant
          to the requirements of Section 13 or 15(d) of the Securities Exchange Act
          of
          1934, the Registrant has duly caused this report to be signed on its behalf
          by
          the undersigned, thereunto duly authorized.
 
 SMART
                    ONLINE, INC.
                  RegistrantBy:
                /s/
                    Michael NouriMichael
                    Nouri, Principal Executive Officer
                  July
                    10, 2006
 
 Pursuant
          to the requirements of the Securities Exchange Act of 1934, this report
          has been
          signed below by the following persons on behalf of the Registrant and in
          the
          capacities and on the dates indicated.
 
 
 /s/
          Nicholas A. Sinigaglia
 
 Nicholas
          A. Sinigaglia, Principal Financial Officer and
 Principal
          Accounting Officer
 July
          10,
          2006
 
 
 /s/
          Michael Nouri
 
 Michael
          Nouri
 Principal
          Executive Officer and Director
 July
          10,
          2006
 
 
 /s/
          Jeffrey W. LeRose
 
 Jeffrey
          W. LeRose
 Director
 July
          10,
          2006
 
 
 /s/
          Tom
          Furr
 
 Tom
          Furr
 Director
 July
          10,
          2006
  97
  
 **EXHIBIT
          INDEX**
 
 Exhibit
                    No.
                Description3.1
                Articles
                    of Incorporation, as restated (incorporated herein by reference
                    to Exhibit
                    3.2 to our Registration Statement on Form SB-2, as filed with
                    the SEC on
                    September 30, 2004))3.2
                Bylaws,
                    as amended (incorporated herein by reference to Exhibit 3.2 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)3.3
                First
                    Amendment to Amended and Restated Bylaws of Smart Online,
                    Inc.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)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
                    Plan10.3*
                Form
                    of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
                    Plan10.4*
                2001
                    Equity Compensation Plan (terminated as to future grants April
                    15, 2004)
                    (incorporated herein by reference to Exhibit 10.2 to our Registration
                    Statement on Form SB-2, as filed with the SEC on September 30,
                    2004)10.5*
                1998
                    Equity Compensation Plan (terminated as to future grants effective
                    April
                    15, 2004) (incorporated herein by reference to Exhibit 10.3 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.6
                Form
                    of Reorganization, Lock-Up Proxy and Release Agreement, dated
                    January 1,
                    2004, and certain stockholders of Smart Online, Inc. (incorporated
                    herein
                    by reference to Exhibit 10.4 to our Registration Statement on
                    Form SB-2,
                    as filed with the SEC on September 30, 2004)10.7
                Form
                    of Lock-up Agreement dated January 1, 2004 between Smart Online
                    and
                    stockholders of Smart Online (incorporated herein by reference
                    to Exhibit
                    10.5 to our Registration Statement on Form SB-2, as filed with
                    the SEC on
                    September 30, 2004)10.8
                Form
                    of Subscription Agreement with lock-up provisions between Smart
                    Online and
                    investors (incorporated herein by reference to Exhibit 10.6 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.9
                Form
                    of Registration Rights Agreement dated as of February 1, 2004
                    between
                    Smart Online (incorporated herein by reference to Exhibit 10.7
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.10*
                Employment
                    Agreement dated April 1, 2004 with Michael Nouri (incorporated
                    herein by
                    reference to Exhibit 10.8 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 30, 2004)10.11*
                Employment
                    Agreement dated April 1, 2004 with Henry Nouri (incorporated
                    herein by
                    reference to Exhibit 10.9 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 30, 2004)10.12*
                Employment
                    Agreement dated April 1, 2004 with Ronna Loprete (incorporated
                    herein by
                    reference to Exhibit 10.10 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 29, 2004)10.13*
                Employment
                    Agreement dated May 1, 2004 with Anil Kamath (incorporated herein
                    by
                    reference to Exhibit 10.12 to our Registration Statement on Form
                    SB-2, as
                    filed with the SEC on September 30, 2004)10.14*
                Letter
                    agreement, dated December 20, 2005, with Anil Kamath amending
                    his
                    Employment Agreement10.15*
                Employment
                    Agreement dated June 21, 2005 with Joan
                    Keston
  98
  
 10.16*
                Employment
                    Agreement dated March 21, 2006 with Nicholas A. Sinigaglia (incorporated
                    herein by reference to Exhibit 10.1 to our Current Report on
                    Form 8-K, as
                    filed with the SEC on March 27, 2006)10.17*
                Security
                    Agreement dated October 13, 2003 with Smart Online as the Debtor
                    and
                    Michael Henry Nouri, Thomas Furr, Ronna Loprete and Eric Nouri
                    as the
                    Secured Parties (incorporated herein by reference to Exhibit
                    10.13 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.18*
                $418,749.93
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Michael Nouri (incorporated herein by reference to Exhibit 10.14
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.19*
                $64,602.90
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Michael Nouri (incorporated herein by reference to Exhibit 10.15
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.20*
                $398,383.27
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Henry Nouri (incorporated herein by reference to Exhibit 10.16
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.21*
                $116,507.60
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor
                    Thomas Furr (incorporated herein by reference to Exhibit 10.17
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.22*
                $92,500
                    Promissory Note dated April 30, 2004 from Smart Online as the
                    Debtor to
                    Ronna Loprete (incorporated herein by reference to Exhibit 10.18
                    to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.23*
                $47,
                    740.18 Promissory Note dated April 30, 2004 from Smart Online
                    as the
                    Debtor to Eric Nouri (incorporated herein by reference to Exhibit
                    10.19 to
                    our Registration Statement on Form SB-2, as filed with the SEC
                    on
                    September 30, 2004)10.24*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Michael
                    Nouri (incorporated herein by reference to Exhibit 10.20 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.25*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Henry
                    Nouri (incorporated herein by reference to Exhibit 10.21 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.26*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Thomas
                    Furr (incorporated herein by reference to Exhibit 10.22 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.27*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Ronna
                    Loprete (incorporated herein by reference to Exhibit 10.23 to
                    our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.28*
                Standstill
                    and Interest Modification Agreement dated December 19, 2003 with
                    Eric
                    Nouri (incorporated herein by reference to Exhibit 10.24 to our
                    Registration Statement on Form SB-2, as filed with the SEC on
                    September
                    30, 2004)10.29
                Asset
                    Purchase Agreement dated as of October 4, 2005 by and among Smart
                    Online,
                    Inc., SmartCRM, Computility, Inc. and certain shareholders of
                    Computility,
                    Inc. (incorporated herein by reference to Exhibit 2.1 to our
                    Current
                    Report on Form 8-K, as filed with the SEC on October 7,
                    2005)10.30
                Stock
                    Purchase Agreement dated as of October 17, 2005 by and among
                    Smart Online,
                    Inc., iMart Incorporated and the shareholders of iMart Incorporated
                    (incorporated herein by reference to Exhibit 2.1 to our Current
                    Report on
                    Form 8-K, as filed with the SEC on October 24, 2005)10.31*
                Employment
                    Agreement dated as of October 17, 2005 by and among Smart Online,
                    Inc.,
                    iMart Incorporated and Gary Mahieu (incorporated herein by reference
                    to
                    Exhibit 2.2 to our Current Report on Form 8-K, as filed with
                    the SEC on
                    October 24, 2005)10.32
                Letter
                    Agreement dated February 23, 2005 by and between Smart Online,
                    Inc. and
                    Berkley Financial Services (BFS) Ltd. for financial advisory
                    services10.33
                Consulting
                    Agreement, dated October 4, 2005, by and between Smart Online,
                    Inc. and
                    Berkley Financial Services Ltd. (incorporated herein by reference
                    to
                    Exhibit 99.1 to our Current Report on Form 8-K, as filed with
                    the SEC on
                    November 10, 2005)10.34
                Consulting
                    Agreement, dated October 26, 2005, by and between Smart Online,
                    Inc. and
                    General Investments Capital (GIC) Ltd. (incorporated herein by
                    reference
                    to Exhibit 99.2 to our Current Report on Form 8-K, as filed with
                    the SEC
                    on November 10, 2005)10.35
                Settlement
                    Agreement, effective May 31, 2006, by and between Smart Online, Inc.
                    and General Investments Capital (GIC) Ltd. (incorporated herein
                    by
                    reference to Exhibit 99.1 to our Current Report on Form 8-K,
                    as filed with
                    the SEC on June 6, 2006)10.36
                Form
                    of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                    Out
                    Agreement, dated June 29 and July 6, 2006, by and between Smart
                    Online,
                    Inc. and certain investors10.37
                Form
                    of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                    Out
                    Agreement, dated March 30, 2006, by and between Smart Online,
                    Inc. and
                    Atlas Capital, SA10.38
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, dated July 19, September 7 and September 13, 2005,
                    by and
                    between Smart Online, Inc. and Atlas Capital, SA10.39
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, dated September 7, 2005, by and between Smart Online,
                    Inc. and
                    Credit Suisse Zurich10.40
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, and Exhibits thereto, dated February 25, 2005, by
                    and between
                    Smart Online, Inc. and The BlueLine Fund10.41
                Form
                    of Subscription Agreement, Registration Rights Agreement, and
                    Dribble Out
                    Agreement, dated August 30, September 10, and September 28, 2004,
                    by and
                    between Smart Online, Inc. and certain investors10.42*
                Indemnification
                    Agreement, dated April ,14 2006, by and between Smart Online,
                    Inc. and
                    David E.Y. Sarna10.43*
                Indemnification
                    Agreement, dated April ,14 2006, by and between Smart Online,
                    Inc. and
                    Joan Keston10.44*
                Indemnification
                    Agreement, dated January 26, 2006, by and between Smart Online,
                    Inc. and
                    Tom Furr10.45*
                Indemnification
                    Agreement, dated January 26, 2006, by and between Smart Online,
                    Inc. and
                    Henry Nouri10.46*
                Indemnification
                    Agreement, dated April 14, 2006, by and between Smart Online,
                    Inc. and
                    Scott Whitaker10.47*
                Indemnification
                    Agreement, dated January 26, 2006, by and between Smart Online,
                    Inc. and
                    Michael Nouri21.1
                Subsidiaries
                    of Smart Online, Inc.23.1
                Consent
                    of Independent Registered Public Accounting Firm31.1
                Certification
                    of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as
                    Adopted
                    Pursuant to Section 302 of the Sarbanes-Oxley Act of
                    200231.2
                Certification
                    of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as
                    Adopted
                    Pursuant to Section 302 of the Sarbanes-Oxley Act of
                    200232.1
                Certification
                    of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350,
                    as Adopted
                    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This
                    exhibit
                    is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                    Act of
                    2002 and shall not, except to the extent required by that Act,
                    be deemed
                    to be incorporated by reference into any document or filed herewith
                    for
                    the purposes of liability under the Securities Exchange Act of
                    1934, as
                    amended, or the Securities Act of 1933, as amended, as the case
                    may
                    be.]32.2
                Certification
                    of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350,
                    as
                    Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002 [This
                    exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley
                    Act of 2002 and shall not, except to the extent required by that
                    Act, be
                    deemed to be incorporated by reference into any document or filed
                    herewith
                    for the purposes of liability under the Securities Exchange Act
                    of 1934,
                    as amended, or the Securities Act of 1933, as amended, as the
                    case may
                    be.]
 
 *
          Management contract or compensatory plan.
 99