**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-K**


(Mark
      One)


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


For
      the
      fiscal year ended December 31, 2007


or


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


For
      the
      transition period from __________ to __________





**Commission
      file number 001-32634**




**SMART
      ONLINE, INC.**


(Exact
      name of registrant as specified in its charter)


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


**(919)
      765-5000**


(Registrant’s
      telephone number, including area code)





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


Title
                of each class
            
            Name
                of each exchange on which registered**N/A**
            
            **N/A**





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


**Common
      Stock, $0.001 par value**


(Title
      of
      Class)





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes oNo x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or 15(d) of the Act. Yes oNo 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 xNo o





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





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting company.
      See
      definitions of “large accelerated filer,” “accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





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





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). Yes oNo x




The
      aggregate market value of common stock held by non-affiliates of the registrant
      as of June 29, 2007 was approximately $24,932,947.50 (based on the closing
      sale
      price of $2.70 per share).





The
      number of shares of the registrant’s Common Stock, $0.001 par value per share,
      outstanding as of March 19, 2008 was 18,184,628.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





Portions
      of the definitive Proxy Statement to be delivered to shareholders in connection
      with the Annual Meeting of Shareholders to be held June 19, 2008 are
      incorporated by reference into Part III.





**TABLE
      OF CONTENTS**




PART
                I
            
            3Item
                1.
            Business
            3Item
                1A.
            Risk
                Factors
            8Item
                1B.
            Unresolved
                Staff Comments
            14Item
                2.
            Properties
            14Item
                3.
            Legal
                Proceedings
            14Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            16PART
                II
            
            16Item
                5.
            Market
                for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            16Item
                6.
            Selected
                Financial Data
            17Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            17Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk
            30Item
                8.
            Financial
                Statements and Supplementary Data
            31Item
                9.
            Changes
                In and Disagreements with Accountants on Accounting and Financial
                Disclosure
            55Item
                9A.
            Controls
                and Procedures
            55Item
                9A(T).
            Controls
                and Procedures
            56Item
                9B.
            Other
                Information
            58PART
                III
            
            58Item
                10.
            Directors,
                Executive Officers and Corporate Governance
            58Item
                11.
            Executive
                Compensation
            58Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
Stockholder
                Matters
            58Item
                13.
            Certain
                Relationships and Related Transactions, and Director
                Independence
            58Item
                14.
            Principal
                Accounting Fees and Services
            58PART
                IV
            
            58Item
                15.
            Exhibits,
                Financial Statement Schedules
            58SIGNATURES
            
            63EXHIBIT INDEX
            
            64







**PART
      I**





**Special
      Note Regarding Forward-Looking Statements**





This
      Annual Report on Form 10-K contains forward-looking statements, within the
      meaning of Section 27A of the Securities Act of 1933, or the Securities Act,
      and
      Section 12E of the Securities Exchange Act of 1934, or the Exchange Act,
      regarding our plans, objectives, expectations, intentions, future financial
      performance, future financial condition, and other statements that are not
      historical facts. You can identify these statements by our use of the future
      tense, or by forward-looking words such as “may,” “will,” “expect,”
“anticipate,” “believe,” “intend,” “estimate,” “continue,” and other similar
      words and phrases. Examples of sections containing forward-looking statements
      include “Part I - ITEM 1. BUSINESS” and “Part II - ITEM 7. MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.” These
      forward-looking statements are subject to risks, uncertainties, and assumptions
      that are difficult to predict. Therefore, actual results may differ materially
      and adversely from those expressed in any forward-looking statements. Readers
      are directed to risks and uncertainties identified in “Part I - ITEM 1A. RISK
      FACTORS” and elsewhere in this report for factors that may cause actual results
      to be different than those expressed in these forward-looking statements. Except
      as required by law, we undertake no obligation to revise or update publicly
      any
      forward-looking statements for any reason.





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





**General**





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





We
      develop and market software products and services targeted to small businesses
      that have less than 50 employees. Our software products and services are
      delivered via a Software-as-a-Service, or SaaS, model. Our goal is to be the
      leading provider of SaaS applications in specific target market segments. We
      sell our SaaS products and services primarily through private label marketing
      partners. Our SaaS products and services are designed to be a value added
      solution that further strengthens our marketing partners’ existing solutions and
      drives additional revenue from their customer bases.





We
      generate revenue from two sources. Our first and primary revenue source is
      derived from sales of our SaaS applications for business management, web
      marketing, and e-commerce. Our second revenue source is derived from sales
      of
      consulting services that allow us to create custom business solutions that
      meet
      our partners’ marketing and information processing requirements. One of our
      current focuses is to design our consulting services to complement our SaaS
      applications, and we expect to provide complementary products and services
      in
      the future.





**History**





During
      the early stages of our development, we offered application-specific software
      using the “shrink-wrapped” method of distribution of diskettes and CD-ROMs,
      primarily through large office supply retailers such as Staples. In 2000, we
      made a significant change in our business strategy, and moved away from the
      development and sale of shrink-wrapped software products, bypassed the
      Application Service Provider, or ASP, model (where software can be accessed
      from
      the server by only one designated PC), and began developing SaaS applications
      for sale over the Internet.





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


3


A
      portion
      of our early stage SaaS sales and marketing strategy was to sell direct to
      the
      end user as well as through private label marketing partners. However, direct
      sales are no longer part of our marketing plan and we now sell primarily through
      syndication arrangements with our private label partners, who in turn market
      our
      SaaS applications to their customer bases.





In
      October 2005, we acquired substantially all of the assets of Computility, Inc.,
      or Computility, based in Des Moines, Iowa. Computility was a privately held
      developer and distributor of sales force automation and customer relationship
      management, or SFA/CRM, software applications. We operated this business under
      the name Smart CRM, Inc. (d/b/a Computility), or Smart CRM. Upon our integration
      of Smart CRM’s SFA/CRM application into our OneBiz SM platform, we determined that the remaining operations of Smart CRM, specifically
      consulting and network management, were not integral to our ongoing operations
      and business model. On September 29, 2006, we sold these non-integral Smart
      CRM
      assets to Alliance Technologies, Inc., or Alliance, and reclassified Smart
      CRM
      as a discontinued operation. For further information, see Note 14,
“Dispositions,” in our consolidated financial statements included in this Annual
      Report on Form 10-K.





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





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





Consistent
      with Statement of Financial Accounting Standards, or SFAS, No. 131, *Disclosures
      about Segments of an Enterprise and Related Information* ,
      we have
      defined two reportable operating segments based on factors such as geography,
      how we manage our operations, and how the chief operating decision-maker views
      results. Those two segments are our core operations, or the Smart Online
      segment, and the operations of our wholly-owned subsidiary, or the Smart
      Commerce segment. We are currently evaluating the factors that will form the
      basis of our segmentation going forward.





The
      Smart
      Commerce segment’s revenues are derived primarily from subscriptions to our
      multi-channel e-commerce systems, including domain name registration and email
      solutions, e-commerce solutions, website design, and website hosting, as well
      as
      consulting services. During 2007, we began integrating the e-commerce product
      line into our Smart Online segment. In 2007, our Smart Commerce segment
      generated 92% of our total consolidated revenue.





The
      Smart
      Online segment generates revenues from the development and distribution of
      internet-delivered


SaaS
      small business applications through a variety of subscription, integration,
      and
      syndication channels. In 2007, our Smart Online segment generated 8% of our
      total consolidated revenue.





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





**Principal
      Products and Services**





Our
      principal products and services include:


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


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


·
            software
                business tools that assist customers in developing written
                content.





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


4


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





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





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





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





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





*Calendar* –
Our
      Calendar application is a full function, easy-to-use online calendar. The
      Calendar application features daily, weekly, and monthly views, together with
      a
      mini-calendar that allows the end user to quickly browse to any date. Automated
      email reminders can be initiated, indicating notification of an upcoming event.
      In addition, employees may collaborate with their colleagues by sharing their
      calendar and events. This application also includes a to-do list to set up
      tasks, assign priorities and due dates, and mark tasks as complete as they
      are
      finished.





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





In
      addition to our SaaS application, we offer a variety of business tools through
      the private label sites of some of our marketing partners. Our business tools
      include Business Plan Writer, Business Letters, Business and Legal Forms,
      Marketing Plan Writer, Job Description Writer, Employee Policy Manual Writer,
      Government Forms, and Business Guides.





We
      also
      provide services that are designed to complement our product offerings and
      allow
      us to create custom business solutions that fit our channel partners’ needs. The
      services offered to our partners include business consulting, graphics design,
      website content syndication, specialized compensation calculation, inventory
      management, domain name registration, personalized email creation, express
      package tracking, business plan writing, e-commerce tax services, e-mail
      marketing, web analytics, warehouse order fulfillment, and business and personal
      calculators.





**Mode
      of Operations**





*Software-as-a-Service
      Model* –
We
      follow the SaaS model for delivering our products and services to our marketing
      partners’ end users. The on demand SaaS model developed using multi-tenant
      architecture enables end users to visit a website and use the SaaS applications,
      all via a web browser, with no installation, no special information technology
      knowledge, and no maintenance. The SaaS application is transformed into a
      service that can be used anytime and anywhere by the end user. Multi-tenant
      SaaS
      applications also permit us to add needed functionality to our applications
      in
      one location for the benefit of all end users. This capability allows us to
      provide upgrades universally.


5




*Integration
      and Sharing* –
Our
      SaaS applications permit the sharing of information (with selectivity and
      control options) between members of an organization. Each company that
      subscribes to our SaaS applications via our marketing partner can have multiple
      members or employees who share information with one another. Information entered
      by one employee can be shared and modified by one or more other employees who
      have the appropriate access authority. Several of the applications within our
      applications are integrated with one another. Integration means that certain
      applications communicate and share information with other applications and
      are
      updated in real time.





**Target
      Market and Sales Channels**





Our
      consistent focus from the beginning has been to design software products and
      services to help start and run small businesses with 50 or fewer employees
      more
      efficiently. The small business market is diverse, fragmented, yet very large
      and, we believe, underserved. We have focused on offering a wide range of
      software products that combine simplicity and affordability and that meet the
      needs of small businesses with capabilities that typically can be afforded
      only
      by much larger companies. We believe the growth rate of small businesses using
      web-based applications will exceed the growth rate of large enterprises.
      Although our ultimate end users are small businesses and entrepreneurs who
      access our software products and services via the web, we do not market our
      products and services directly to these end users. Instead, we target marketing
      partners that are vertical intermediaries in industries such as agriculture,
      finance, telecommunications, direct selling, retail, and technology as channels
      to reach these small business customers.





During
      2007, we increased our revenue through a combination of the following sales
      and
      marketing initiatives:





·
            soliciting
                and contracting with additional marketing
                partners,


·
            actively
                managing relationships with our partners to increase sales,
                and


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





**Principal
      Customers**





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





Britt
      Worldwide, or BWW, is an entity that indirectly controls a significant number
      of
      independent business owners, or IBOs, who currently subscribe to our services.
      The aggregate of the subscriptions from these IBOs represented approximately
      24%
      of our consolidated revenue for the fiscal year ended December 31, 2007. BWW
      became a customer of ours after we acquired iMart in October 2005 and
      represented 45% of our revenues in 2006. Although our revenue is derived from
      the IBOs, BWW can influence the actions of the IBOs, so this revenue has been
      aggregated for purposes of this Annual Report on Form 10-K.





UR
      Association, or URA, is an entity that indirectly controls a significant number
      of IBOs who currently subscribe to our services. The aggregate of the
      subscriptions from these IBOs represented approximately 11% of our consolidated
      revenue for the fiscal year ended December 31, 2007. URA became our customer
      in
      2007. Although our revenue is derived from the IBOs, URA can influence the
      actions of the IBOs, so this revenue has been aggregated for purposes of this
      Annual Report on Form 10-K.





Vera
      Bradley Designs, Inc., or Vera Bradley, a manufacturer of high quality handbags,
      luggage, and other accessories, is also a major customer. Vera Bradley accounted
      for approximately 22% of our consolidated revenues for fiscal year ended
      December 31, 2007. Vera Bradley became our customer in 2006 and represented
      28%
      of our revenues in 2006.


6




**Research
      & Development**





During
      2006, we devoted a substantial amount of time and effort toward the research
      and
      development of our OneBiz SM platform
      and the associated applications. In the fourth quarter of 2006, we began to
      shift our focus from research and development to the marketing of our latest
      products. In the second half of 2007, as part of a general restructuring, we
      began to conduct an evaluation of our technology, platforms, and applications
      in
      an effort to document and improve upon our current product offerings and
      determine which applications, if any, should be discontinued. We expect this
      process to continue through the third quarter of 2008. We also use offshore
      resources to provide assistance in delivering solutions and enhancing some
      applications for the SaaS marketplace.




Our
      research and development costs were approximately $2.5 million and $2.0 million
      in 2007 and 2006, respectively. We have not engaged in any customer-sponsored
      research and development. ******





**Competition**





The
      market for small business software applications in both the traditional and
      SaaS
      environments is highly competitive and subject to rapid changes in technology
      and delivery. The direct competition we face depends on the software application
      within our platforms and the delivery model capabilities of our
      competitors.





We
      have
      two primary categories of competitors: large companies that offer a wide range
      of products for small to medium-size businesses and other companies that offer
      only one or two software products that compete with our broad range of software
      products. Our principal direct competition comes from several large vendors
      of
      SaaS applications for small businesses that sell many products similar to ours.
      These competitors include, but are not limited to, Microsoft, Oracle, NetSuite,
      Intuit, SAP, Sage, Yahoo!, and Google.





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





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


·
            Human
                resource software applications: ADP, Sage, and
                others.


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


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





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





On
      each
      competitive front, we seek to compete against these larger and better financed
      companies primarily by offering an extensive suite of SaaS applications that
      are
      useful to small businesses. We believe we offer more SaaS applications and
      features specifically targeted to small businesses than most of our competitors.
      We believe one distinctive value our applications offer is the integration
      of
      the applications. To meet our business objectives, we will need to enhance
      our
      current applications and continue to develop high quality and competitively
      priced new applications for our SaaS offerings. If we are unable to do so,
      our
      revenue and profitability targets and timetables could be adversely
      impacted.


7


To
      compete effectively in the SaaS market, we plan to leverage our private label
      marketing partners who sell our SaaS applications to their small business
      customers. We offer existing and potential partners to private label our SaaS
      applications to their small business customers as value added products and
      services. This strategy is designed to enable us to compete effectively in
      the
      SaaS market by leveraging the marketing resources and customer relationships
      of
      our marketing partners.





**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 or design around certain aspects of our SaaS
      offerings or to obtain and use information that we regard as proprietary, and
      third parties may attempt to develop similar technology independently. In
      addition, the laws of some foreign countries do not protect our proprietary
      rights to the same extent as do the laws of the United States, and we expect
      that it will become more difficult to monitor use of our products if we develop
      an international presence.





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





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





**Employees**





As
      of
      December 31, 2007, we had 50 full-time employees. No employees are known by
      us
      to be represented by a collective bargaining agreement, and we have never
      experienced a strike or similar work stoppage.





**Available
      Information**





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





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





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


8





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





We
      have
      had recurring losses from operations and continue to have negative cash flows.
      If we do not become cash flow positive through additional financing or growth,
      we may have to cease operations and liquidate our business. Our
      working capital, including our line of credit with Paragon Commercial Bank,
      or
      Paragon, February 2007 equity financing transaction, and convertible note
      financing, should fund our operations for the next 18 months. As of March 19,
      2007, we have approximately $2.0 million available on our revolving line of
      credit and approximately $5.2 million available through our convertible note
      financing. Factors such as the commercial success of our existing services
      and
      products, the timing and success of any new services and products, the progress
      of our research and development efforts, our results of operations, the status
      of competitive services and products, the timing and success of potential
      strategic alliances or potential opportunities to acquire technologies or
      assets, the charges filed against a former officer and a former employee filed
      by the SEC and the United States Attorney General, and the pending shareholder
      class action lawsuit may require us to seek additional funding sooner than
      we
      expect. If we fail to raise sufficient financing, we will not be able to
      implement our business plan and we may have to liquidate our business.





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




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





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





We
      have
      invested significantly in infrastructure, operations, and strategic
      relationships to support our SaaS delivery model, which represents a significant
      departure from the delivery strategies that 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. We anticipate that our future financial performance and
      revenue growth will depend, in large part, upon our Internet-based SaaS business
      model and the results of our sales efforts to reach agreements with syndication
      partners with small business customer bases, but this business model may become
      ineffective due to forces beyond our control that we do not currently
      anticipate. Although
      we entered into agreements, including a marketing referral agreement, with
      14
      new partners and customers during 2007, our success depends in part on the
      ultimate success of our syndication ****** partners
      and referral partners and their ability to market our products and services
      successfully. Our
      partners are not obligated to provide potential customers to us. In addition,
      some of these third parties have entered, and may continue to enter, into
      strategic relationships with our competitors. Further, many of our strategic
      partners have multiple strategic relationships, and they may not regard us
      as
      significant for their businesses. Our strategic partners may terminate their
      respective relationships with us, pursue other partnerships or relationships,
      or
      attempt to develop or acquire products or services that compete with our
      products or services. Our strategic partners also may interfere with our ability
      to enter into other desirable strategic relationships. If we are unable to
      maintain our existing strategic relationships or enter into additional strategic
      relationships, we will have to devote substantially more resources to the
      distribution, sales, and marketing of our products and services.





In
      addition, our end users currently do not sign long-term contracts. They have
      no
      obligation to renew their subscriptions for our services after the expiration
      of
      their initial subscription period and, in fact, they have often elected not
      to
      do so. Our end users also may renew for a lower-priced edition of our services
      or for fewer users. Many of our end users utilize our services without charge.
      These factors make it difficult to accurately predict customer renewal rates.
      Our customers’ renewal rates may decline or fluctuate as a result of a number of
      factors, including when we begin charging for our services, their
      dissatisfaction with our services, and their capability to continue their
      operations and spending levels. If our customers do not renew their
      subscriptions for our services or we are not able to increase the number of
      subscribers, our revenue may decline and our business will
      suffer.


9




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





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





Legal
      and
      other fees related to these actions have also reduced our cash flow. We make
      no
      assurance that we will not continue to experience additional harm as a result
      of
      these matters. The time spent by our management team and directors dealing
      with
      issues related to these actions detracts from the time they spend on our
      operations, including strategy development and implementation. These actions
      also have harmed our reputation in the business community, jeopardized our
      relationships with vendors and customers, and decreased our ability to attract
      qualified personnel, especially given the media coverage of these
      events.





In
      addition, we face uncertainty regarding amounts that we may have to pay as
      indemnification to certain current and former officers, directors, and employees
      under our Bylaws and Delaware law with respect to these actions, and we may
      not
      recover all of these amounts from our directors and officers liability insurance
      policy carrier. Our
      Bylaws and Delaware law generally require us to indemnify, and in certain
      circumstances advance legal expenses to, current and former officers, directors,
      employees, and agents against claims arising out of such person’s status or
      activities as our officer, director, employee, or agent, unless such person
      (i)
      did not act in good faith and in a manner the person reasonably believed to
      be
      in or not opposed to our best interests or (ii) had reasonable cause to believe
      his conduct was unlawful. As of March 19, 2008, there are SEC and criminal
      actions pending against a former executive officer and a former employee who
      have requested that we indemnify them and advance expenses incurred by them
      in
      the defense of those actions. Also, a stockholder class action lawsuit has
      been
      filed against us and certain of our current ****** and
      former officers, directors, and employees. The SEC, criminal, and stockholder
      actions are more fully described in Part I, Item 3, “Legal Proceedings,” in this
      report.





Generally,
      we are required to advance defense expenses prior to any final adjudication
      of
      an individual’s culpability. The expense of indemnifying our current and former
      directors, officers, and employees for their defense or related expenses in
      connection with the current actions may be significant. Our Bylaws require
      that
      any director, officer, employee, or agent requesting advancement of expenses
      enter into an undertaking with us to repay any amounts advanced unless it is
      ultimately determined that such person is entitled to be indemnified for the
      expenses incurred. This provides us with an opportunity, depending upon the
      final outcome of the matters and the Board’s subsequent determination of such
      person’s right to indemnity, to seek to recover amounts advanced by us. However,
      we may not be able to recover any amounts advanced if the person to whom the
      advancement was made lacks the financial resources to repay the amounts that
      have been advanced. If we are unable to recover the amounts advanced, or can
      do
      so only at great expense, our operations may be substantially harmed as a result
      of loss of capital.





Although
      we have purchased insurance that may cover these obligations, we can offer
      no
      assurances that all of the amounts that may be expended by us will be recovered
      under our insurance policy. It is possible that we may have an obligation to
      indemnify our current and former officers, directors, and employees under the
      terms of our Bylaws and Delaware law, but that there may be insufficient
      coverage for these payments under the terms of our insurance policy. Therefore,
      we face the risk of making substantial payments related to the defense of these
      actions, which could significantly reduce amounts available to fund working
      capital, capital expenditures, and other general corporate
      objectives.


10


In
      addition, our insurance policy provides that, under certain conditions, our
      insurer may have the right to seek recovery of any amounts it paid to the
      individual insureds or us. As of March 19, 2008, we do not know and can offer
      no
      assurances about whether these conditions will apply or whether the insurance
      carrier will change its position regarding coverage related to the current
      actions. Therefore, we can offer no assurances that our insurer will not seek
      to
      recover any amounts paid under its policy from the individual insureds or us.
      If
      such recovery is sought, then we may have to expend considerable financial
      resources in defending and potentially settling or otherwise resolving such
      a
      claim, which could substantially reduce the amount of capital available to
      fund
      our operations.





Finally,
      if our directors and officers liability insurance premiums increase as a result
      of the current actions, our financial results may be materially harmed in future
      periods. If we are unable to obtain coverage due to prohibitively expensive
      premiums, we would have more difficulty in retaining and attracting officers
      and
      directors and would be required to self-fund any potential future liabilities
      ordinarily mitigated by directors and officers liability insurance.





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





Our
      executive management team has undergone significant changes during the last
      half
      of 2007 and first quarter of 2008. Our success depends significantly on the
      continued services of our remaining executive management personnel and
      attracting additional qualified personnel. Losing any of our remaining officers
      could seriously harm our business. Competition for executives is intense.
      Although we have resolved the SEC charges filed against us, we may not be able
      to attract highly qualified candidates to serve on our executive management
      team. If we had to replace any of our other officers, we would not be able
      to
      replace the significant amount of knowledge that they may have about our
      operations. If we cannot attract and retain qualified personnel and integrate
      new members of our executive management team effectively into our business,
      then
      our business and financial results may suffer. In addition, all of our executive
      team work at the same location, which could make us vulnerable to loss of our
      entire management team in the event of a natural or other disaster. We do not
      maintain key man insurance policies on any of our employees.





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





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





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





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





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





For
      fiscal 2007, we are required to comply with the
      requirements of Section 404 of Sarbanes-Oxley involving management’s assessment
      of our internal control over financial reporting, and our independent
      accountant’s audit of our internal control over financial reporting is required
      for fiscal 2008. To comply with these requirements, we are evaluating and
      testing our internal controls, and where necessary, taking remedial actions,
      to
      allow management to report on, and our independent auditors to attest to, our
      internal control over financial reporting. As a result, we have incurred and
      will continue to incur expenses and diversion of management’s time and attention
      from the daily operations of the business, which may increase our operating
      expenses and impair our ability to achieve profitability.


11




In
      the
      past, we have
      identified several significant deficiencies in ourinternal
      controloverfinancial reporting. We believe we have remediated these identified significant
      deficiencies, but we cannot give any assurances that all significant
      deficiencies or material weaknesses have been identified or that additional
      significant deficiencies or material weaknesses will not be identified in the
      future in connection with our compliance with the provisions of Section 404
      of
      Sarbanes-Oxley. The existence of one or more material weaknesses would preclude
      a conclusion by management that we maintained effective internal control over
      financial reporting.





In
      addition, there can be no assurance that we will be able to maintain our
      schedule to complete all assessment and testing of our internal controls in
      a
      timely manner. Further, we cannot be certain that our testing
      of internal controls and
      resulting remediation actions will yield adequate internal
      control over
      financial reporting as required by Section 404 of Sarbanes-Oxley. If we are
      not
      able to implement the requirements of Section 404 in a timely manner or with
      adequate compliance, there could be an adverse reaction in the financial markets
      due to a loss of confidence in the reliability of our financial statements,
      which could adversely affect the market price of our common stock.





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





Our
      officers, directors, and principal stockholders beneficially own or control
      approximately 48% of our outstanding common stock. Certain of these principal
      stockholders hold warrants and convertible notes, which may be exercised or
      converted into additional shares of our common stock under certain conditions.
      The convertible noteholders have designated a bond representative to act as
      their agent. We have agreed that the bond representative shall be granted access
      to our facilities and personnel during normal business hours, shall have the
      right to attend all meetings of our Board of Directors and its committees and
      to
      receive all materials provided to our Board of Directors or any committee of
      our
      Board. In addition, so long as the notes are outstanding, we have agreed that
      we
      will not take certain material corporate actions without approval of the bond
      representative. The Chairman of our Board of Directors currently is serving
      as
      the bond representative.





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





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





We
      may
      issue shares of our common stock in the future for a variety of reasons. For
      example, under the terms of our stock purchase warrant and agreement with Atlas,
      it may elect to purchase up to 444,444 shares of our common stock at $2.70
      per
      share upon termination of, or if we are in breach under the terms of, our line
      of credit with Paragon. In connection with our private financing in February
      2007, we issued warrants to the investors to purchase an additional 1,176,471
      shares of our common stock at $3.00 per share and a warrant to our placement
      agent in that transaction to purchase 35,000 shares of our common stock at
      $2.55
      per share. Upon maturity of their convertible notes, our noteholders may elect
      to convert all, a part of, or none of their notes into shares of our common
      stock at variable conversion prices. In addition, we may raise funds in the
      future by issuing additional shares of common stock or other
      securities.




12


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





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





Future
      sales of substantial amounts of our shares in the public market, or the
      appearance that a large number of our shares are available for sale, could
      adversely affect market prices prevailing from time to time and could impair
      our
      ability to raise capital through the sale of our securities. At March 19, 2008,
      18,184,628  shares
      of
      our common stock were issued and outstanding and a significant number of shares
      may be issued upon the exercise of outstanding options, warrants, and
      convertible notes.





Our
      stock
      is very thinly traded. The average daily trading volume for our common stock
      between January 2007 and February 2008 was approximately 18,200 shares per
      day.
      The number of shares that could be sold during this period was restrained by
      previous contractual and other legal limitations imposed on some of our shares
      that are no longer applicable. This means that market supply may increase more
      than market demand for our shares. Many companies experience a decrease in
      the
      market price of their shares when such events occur.





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





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





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





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





Further,
      securities class action litigation has often been brought against companies
      that
      experience periods of volatility in the market prices of their securities.
      A
      securities class action was filed against us in October 2007 as more fully
      described elsewhere in this report. This securities class action litigation
      could result in substantial costs and a diversion of our management’s attention
      and resources. We may determine, like many defendants in such lawsuits, that
      it
      is in our best interests to settle the lawsuit, even if we believe that the
      plaintiffs’ claims have no merit, to avoid the cost and distraction of continued
      litigation. Any liability we incur in connection with this or any other
      potential lawsuit could materially harm our business and financial position
      and,
      even if we defend ourselves successfully, there is a risk that management’s
      distraction in dealing with this type of lawsuit could harm our results.





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





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


13


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





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





**If
      we fail to evaluate, implement** **,
      and integrate strategic opportunities successfully, our business may suffer.**




From
      time
      to time we evaluate strategic opportunities available to us for product,
      technology, or business acquisitions or dispositions. If we choose to make
      acquisitions or dispositions, we face certain risks, such as failure of an
      acquired business to meet our performance expectations, diversion of management
      attention, retention of existing customers of our current and acquired business,
      and difficulty in integrating or separating a business’s operations, personnel,
      and financial and operating systems. We may not be able to successfully address
      these risks or any other problems that arise from our previous or future
      acquisitions or dispositions. Any failure to successfully evaluate strategic
      opportunities and address risks or other problems that arise related to any
      acquisition or disposition could adversely affect our business, results of
      operations, and financial condition.





**ITEM
      1B.**  **UNRESOLVED
      STAFF COMMENTS**





Not
      applicable.





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





Our
      principal administrative and research and development facility is located in
      Durham, North Carolina near Research Triangle Park and consists of approximately
      5,800 square feet of office space held under a lease that expires on October
      31,
      2008. We also lease approximately 6,800 square feet of office space in Grand
      Rapids, Michigan under a lease that expires on March 31, 2008.




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





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





Securities
      and Exchange Commission Litigation .
      On
      January 17, 2006, the SEC temporarily suspended the trading of our securities.
      In its “Order of Suspension of Trading,” the SEC stated that the reason for the
      suspension was a lack of current and accurate information concerning our
      securities because of possible manipulative conduct occurring in the market
      for
      our stock. By its terms, that suspension ended on January 30, 2006 at 11:59
      p.m.
      EST. As a result of the SEC’s suspension, NASDAQ withdrew its acceptance of our
      application to have our common stock traded on the NASDAQ Capital Market, and
      our securities did not automatically return to quotation on the OTCBB. After
      the
      filing of the required paperwork by a market maker, our common stock returned
      to
      quotation on the OTCBB on September 11, 2006. Simultaneously with the
      suspension, the SEC advised us that it was ****** conducting
      a non-public investigation.


14





On
      September 11, 2007, we were informed that Dennis Michael Nouri, our then serving
      President, Chief Executive Officer, and a director, had been charged in a
      criminal complaint that alleges federal securities fraud and conspiracy to
      commit fraud. We were not named in the criminal complaint. The U.S. government
      filed the complaint under seal on August 1, 2007 in the U.S. District Court
      for
      the Southern District of New York. Also named as defendants in the criminal
      complaint were Reeza Eric Nouri, a former manager of our company, and Ruben
      Serrano, Anthony Martin, James Doolan, and Alain Lustig, brokers alleged to
      have
      participated with the Nouris in the alleged fraud. The criminal complaint
      alleges that the defendants, directly and indirectly, used manipulative and
      deceptive devices in violation of Sections 2 and 371 of Title 18 of the U.S.
      Code, Sections 10(b) and 32 of the Exchange Act, and Rule 10b-5 promulgated
      under the Exchange Act, or Rule 10b-5. On November 8, 2007, as part of this
      ongoing action, the U.S. government filed a grand jury indictment against Dennis
      Michael Nouri, Reeza Nouri, Ruben Serrano, and Alain Lustig in the U.S. District
      Court for the Southern District of New York. The grand jury indictment charges
      these defendants with conspiracy to commit securities fraud in violation of
      Sections 78j(b) and 78 ff of Title 17 of the U.S. Code and Rule 10b-5, wire
      fraud in violation of Sections 1343 and 1346 of Title 18 of the U.S. Code,
      and
      commercial bribery in violation of Section 1952(a)(3) of Title 18 of the U.S.
      Code and Sections 180.00 and 180.03 of the New York State Penal Law. Under
      the
      grand jury indictment, the U.S. government is seeking forfeiture from these
      defendants of all property, real and personal, that constitutes or is derived
      from proceeds traceable to the commission of the alleged securities fraud
      offenses.





On
      September 11, 2007, the SEC filed a civil action against us and the defendants
      named in the criminal complaint in the U.S. District Court for the Southern
      District of New York. The SEC complaint alleged that the defendants in this
      civil action, either directly or indirectly, have engaged in transactions,
      acts,
      practices, and courses of business which constitute violations of Section 17(a)
      of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. The
      SEC complaint sought to permanently enjoin each of the civil defendants from
      committing future violations of the foregoing federal securities laws. The
      SEC
      complaint also requested that each of the defendants, excluding us, be required
      to disgorge any ill-gotten gains and pay civil penalties. The SEC complaint
      further sought an order permanently barring Michael Nouri from serving as an
      officer or director of a public company. The SEC complaint did not seek any
      fines or other monetary penalties against us. On September 28, 2007, we agreed,
      without admission of any liability, to the entry of a consent judgment against
      us which permanently enjoins us from violations of the antifraud provisions
      of
      the federal securities laws, specifically Section 17(a) of the Securities Act,
      Section 10(b) of the Exchange Act, and Rule 10b-5. No fines or other monetary
      sanctions were levied against us. The consent judgment settles the SEC complaint
      against us and was entered by the court on October 2, 2007.





Gooden
      v. Smart Online, Inc. On
      October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in
      the
      United States District Court for the Middle District of North Carolina naming
      us, certain of our current and former officers and directors, Maxim Group,
      LLC,
      and Jesup & Lamont Securities Corp. as defendants. The lawsuit was filed on
      behalf of all persons other than the defendants who purchased our securities
      from May 2, 2005 through September 28, 2007 and were damaged. The complaint
      asserts violations of federal securities laws, including violations of
      Section 10(b) of the Exchange Act and Rule 10b-5. The complaint is based on
      the matters alleged in the SEC complaint described above and asserts that the
      defendants participated in a fraudulent scheme to manipulate trading in our
      stock, allegedly causing plaintiffs to purchase the stock at an inflated price.
      The complaint requests certification of the plaintiff as class representative
      and seeks, among other relief, unspecified compensatory damages, including
      interest, plus reasonable costs and expenses, including counsel fees and expert
      fees.





Nouri
      v. Smart Online, Inc. On
      October 17, 2007, Henry Nouri, our former Executive Vice President, filed a
      civil action against us in the General Court of Justice, Superior Court
      Division, in Orange County, North Carolina. The complaint alleged that we had
      no
“cause” to terminate Mr. Nouri’s employment and that we breached Mr. Nouri’s
      employment agreement by notifying him that his employment was terminated for
      cause, by failing to itemize the cause for the termination, and by failing
      to
      pay him benefits to which he would have been entitled had his employment been
      terminated without “cause.” The complaint sought unspecified compensatory
      damages, including interest, a declaratory judgment that no cause existed for
      the termination of Mr. Nouri’s employment and that Mr. Nouri is entitled to the
      benefits provided under his employment agreement for a termination without
      “cause,” and costs and expenses. On December 17, 2007, Mr. Nouri served his
      First Amended Complaint in which he, among other things, added an allegation
      that he was entitled to additional relief because of an alleged “beneficial
      change of ownership” in our company. On January 23, 2008, the parties settled
      this dispute, and on January 24, 2008, the lawsuit was dismissed with
      prejudice.


15




At
      this
      time, we are not able to determine the likely outcome of the legal matters
      described above, nor can we estimate our potential financial exposure. Our
      management has made an initial estimate based upon its knowledge, experience
      and
      input from legal counsel, and we have accrued approximately $250,000 of
      additional legal reserves. Such reserves will be adjusted in future periods
      as
      more information becomes available. If an unfavorable resolution of any of
      these
      matters occurs, our business, results of operations, and financial condition
      could be materially adversely affected.





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




Not
      applicable.





**PART
      II**




**ITEM 5.**
            **MARKET
                FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
                PURCHASES OF EQUITY
                SECURITIES**





Our
      common stock was approved for quotation on the OTCBB under the symbol “SOLN” on
      March 15, 2005, but trading did not begin until mid-April 2005. We do not
      believe there is an established public trading market for our common stock.
      The
      following table sets forth the high and low bid prices for our common stock
      for
      the quarterly periods since trading began until December 31, 2007. The prices
      set forth below reflect interdealer quotations, without retail mark-up,
      mark-down, or commission and may not necessarily represent actual
      transactions.





**For
                  the Quarter Ending**
              
              **High**
              
              **Low**March
                  31, 2006
              
              $
              10.00
              
              $
              8.05June
                  30, 2006
              
              $
              n/a
              
              $
              n/aSeptember
                  30, 2006
              
              $
              2.80
              
              $
              1.75December
                  31, 2006
              
              $
              2.75
              
              $
              0.90March
                  31, 2007
              
              $
              3.00
              
              $
              1.95June
                  30, 2007
              
              $
              2.95
              
              $
              1.85September
                  30, 2007
              
              $
              2.83
              
              $
              0.55December
                  31, 2007
              
              $
              2.80
              
              $
              1.50





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





At
      December 31, 2007, there were approximately 300 record holders of our common
      stock.


16





We
      have
      never declared or paid any cash dividends on our common stock and do not intend
      to declare or pay dividends for the foreseeable future. As long as our
      convertible notes are outstanding, we must receive approval from the agent
      designated by the noteholders in order to pay any dividend on our capital
      stock.





During
      2007, we sold equity securities that were not registered under the Securities
      Act, as described in our quarterly reports on Form 10-Q and current reports
      on
      Form 8-K filed in connection with such transactions.





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





**ITEM
      6.**  **SELECTED
      FINANCIAL DATA**





Not
      applicable.





**ITEM 7.**
            **MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS**





**Overview**





We
      develop and market software products and services delivered via a SaaS model
      and
      targeted to small businesses that have less than 50 employees. We reach small
      businesses primarily through syndication arrangements with large corporations
      that private-label our software applications through their corporate websites.
      We believe our syndication relationships provide a cost and time efficient
      way
      to market to a diverse, fragmented, yet very large small business sector.





Consistent
      with SFAS No. 131, we have defined two reportable segments based on factors
      such
      as geography, how we manage our operations, and how the chief operating
      decision-maker views results. Those segments are our core operations, or the
      Smart Online segment, and the operations of our wholly-owned subsidiary, or
      the
      Smart Commerce segment. We are currently evaluating the factors that will form
      the basis of our segmentation going forward.





The
      Smart
      Commerce segment derived its revenues primarily from subscriptions to our
      multi-channel e-commerce systems, including domain name registration and e-mail
      solutions, e-commerce solutions, website design, and website hosting, as well
      as
      consulting services. During 2007, we began integrating the e-commerce product
      line into our Smart Online segment. For 2007, our Smart Commerce segment
      generated 92% of our total consolidated revenue, and 98% and 100% of our
      subscription and professional services revenue, respectively.





The
      Smart
      Online segment generates revenues from the development and distribution of
      internet-delivered SaaS small business applications through a variety of
      subscription, integration, and syndication channels. In 2007, the Smart Online
      segment derived revenue primarily from fees charged in connection with the
      licensing of its platform and applications. For 2007, our Smart Online segment
      generated 8% of our total consolidated revenue, 100% of our integration and
      syndication revenue, 48% of our licensing revenue, and 2% of our subscription
      revenue.





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





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





During
      2006 and 2007, we made significant improvements to our applications and
      platforms, including enhancements to the OneBiz SM dashboard, marketing features, and the addition of new software applications
      to
      OneBiz SM ,
      such as
      our SFA/CRM and Accounting applications. In the second half of 2007, as part
      of
      a general restructuring, we began to conduct an evaluation of our technology,
      platforms, and applications in an effort to document and improve upon our
      current product offerings and determine which applications, if any, should
      be
      discontinued. We expect this process to continue through the third quarter
      of
      2008. **** Certain
      bundles of our applications included on our website are offered through the
      websites of all of our ****** private
      label partners.


17




Except
      as
      noted below, all financial information for periods prior to our acquisition
      of
      Computility and iMart contained in this Annual Report on Form 10-K refers to
      the
      financial performance of Smart Online only, and does not include the financial
      performance of either Computility or iMart before the acquisitions occurred
      in
      October of 2005. All financial information for periods after these acquisitions
      contained in this Annual Report on Form 10-K includes the financial performance
      of the businesses we acquired, unless otherwise noted. Due to the sale of
      substantially all of the assets of Smart CRM on September 29, 2006, Smart CRM
      is
      classified throughout this Annual Report on Form 10-K as discontinued operations
      and the assets and liabilities related to Smart CRM are classified as available
      for sale.





**Sources
      of Revenue**





In
      2006
      and 2007, we derived revenues from the following sources:





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


·
            License
                fees – fees charged for licensing of platforms or applications. Licenses
                may be perpetual or for a specific
                term.


·
            Integration
                fees – fees charged to partners to integrate their products into our
                syndication platform.


·
            Syndication
                fees – fees consisting of:


§
            fees
                charged to syndication partners to create a customized private label
                site;
                and


§
            barter
                revenue derived from syndication agreements with media
                companies.


·
            Professional
                service fees – fees related to consulting services that complement our
                other products and applications.


·
            Other
                revenues – revenues generated from non-core activities such as sales of
                shrink-wrapped products, original equipment manufacturer, or OEM,
                contracts, and miscellaneous other
                revenues.





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





Subscription
      revenues primarily consist of sales of subscriptions through private label
      marketing partners to end users, sales of subscriptions directly to end users,
      hosting and maintenance fees, and e-commerce website design fees. We make
      subscription sales either on a subscription or on a “for fee” basis.
      Applications for which subscriptions are available vary from our own portal
      to
      the websites of our partners. Subscriptions are generally payable in advance
      on
      a monthly basis and are typically paid via credit card of the individual end
      user or their aggregating entity. We expect lower net fees from subscribers
      at
      the private label syndication websites of our partners than from our main portal
      since our agreements call for us to share revenue generated on each respective
      site. In 2007, our Smart Commerce segment generated 98% of our subscription
      revenue and our Smart Online segment generated the remaining 2%. Our
      subscription revenue has increased from 2006 to 2007 based on our ability to
      secure new private label partners in the direct selling industry. We are
      focusing our efforts on signing up new channel partners as well as diversifying
      with vertical intermediaries in various industries.





Licensing
      revenue consists of perpetual or term license agreements for the use of the
      Smart Online platform, the Smart Commerce platform, or any of our applications.
      In 2007, our Smart Online segment generated 48% of our licensing revenue and
      our
      Smart Commerce segment generated 52% of our licensing revenue. We are currently
      focused on bundling a license component with our other offerings in future
      transactions.


18


When
      appropriate, we charge our partners a fee for private-labeling our website
      in
      their own customized interface (i.e., in the “look and feel” of our partners’
sites). We base this fee on the extent of the modifications required and the
      revenue sharing ratio that we negotiate with our partner. If we charge a fee
      for
      the production of the website and the modifications, we record the fee as
      syndication revenue.





We
      generally invoice our paying syndication or integration customers in annual
      or
      monthly installments, and typical payment terms provide that our customers
      pay
      us within 30 days of invoice. In general, we collect our billings in advance
      of
      the service period. As we have shifted our focus toward driving subscription
      revenue, which we deem to have the greatest potential for future revenue growth,
      we have seen a decrease in syndication and integration revenue through 2007
      and
      we expect this decrease to continue through 2008. In 2007, our Smart Online
      segment generated 100% of our syndication and integration revenue.





We
      generate professional service fees from our consulting services. For example,
      a
      partner may request that we re-design its website to better accommodate our
      products or to improve its own website traffic. We typically bill professional
      service fees on a time and material basis. In 2007, our Smart Commerce segment
      generated 100% of our professional service revenue.





Other
      revenues primarily consist of non-core revenue sources such as traditional
      shrink-wrap software sales and miscellaneous web services. It also includes
      OEM
      revenue generated through sales of our applications bundled with products
      offered by other manufacturers. In 2007, our Smart Online segment generated
      28%
      of our other revenues and our Smart Commerce segment generated the remaining
      72%.





**Cost
      of Revenues**





Cost
      of
      revenues primarily is composed of salaries associated with maintaining and
      supporting integration and syndication partners, the cost of domain name and
      email registrations, and the cost of external hosting facilities associated
      with
      maintaining and supporting integration and syndication partners.





**Operating
      Expenses**





In
      previous years, we primarily focused our efforts on basic product development
      and integration. In the fourth quarter of 2006, we shifted our focus to
      increasing subscription revenue while concentrating our development efforts
      on
      enhancements and customization of our proprietary platforms and applications.
      In
      the early part of 2007, we also began to focus on licensing our platform
      products and applications.





*Research
      and Development* .
      Historically, we have not capitalized any costs associated with the development
      of our products and platforms. SFAS No. 86, “Accounting for the Costs of
      Computer Software to Be Sold, Leased, or Otherwise Marketed,” requires
      capitalization of certain software development costs subsequent to the
      establishment of technological feasibility. Because any such costs that would
      be
      capitalized following the establishment of technological feasibility would
      immediately be written off due to uncertain realizability, all such costs have
      been recorded as research and development costs and expensed as incurred.
      Because of our proprietary, scalable, and secure multi-user architecture, we
      are
      able to provide all customers with a service based on a single version of our
      application. As a result, we do not have to maintain multiple versions, which
      enables us to have relatively low research and development expenses as compared
      to traditional enterprise software business models. We expect that in the
      future, research and development expenses will increase substantially in
      absolute dollars, but decrease as a percentage of total revenue, as we hire
      additional personnel in both segments, whether internally or by outsourcing,
      to
      enhance and customize our platforms and applications. In addition, we have
      begun
      to conduct an evaluation of our technology, platforms, and applications in
      an
      effort to document and improve upon our current product offerings and determine
      which applications, if any, should be discontinued. We expect this process
      to
      continue through the third quarter of 2008.





*Sales
      and Marketing* .
      Historically, we spent limited funds on marketing, advertising, and public
      relations. Our business model of partnering with established companies with
      extensive small business customer bases allows us to leverage the marketing
      dollars spent by our partners rather than requiring us to incur such costs.
      We
      do not yet conduct any significant direct marketing or advertising programs.
      Our
      sales and marketing costs increased significantly in 2007 due to the addition
      of
      personnel in our Sales and Marketing department and revenue share arrangements
      with two new customers in our Smart Commerce segment. As we begin to grow the
      number of subscribers to our products, we expect sales and marketing expense
      to
      increase due to the various percentages of revenue we may be required to pay
      to
      partners as marketing fees.


19




*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. We anticipate general and administrative expenses will
      increase as we add personnel and incur additional professional fees and
      insurance costs related to the growth of our business and to our operations
      as a
      public company. Non-recurring general and administrative expenses increased
      significantly in 2006 as a result of the suspension of trading of our securities
      by the SEC, the related SEC investigation, and the internal investigation of
      matters relating to that suspension. Our expenses related to these matters
      decreased to an immaterial amount in the fourth quarter of 2006. These costs
      again increased in 2007 following the civil and criminal complaints filed in
      September 2007 described in detail in Part I, Item 3, “Legal Proceedings,” of
      this report. We have also incurred additional material costs in 2007 as we
      take
      the necessary steps to comply with Section 404 of Sarbanes-Oxley. We expect
      to
      continue to incur material costs related to these matters in 2008.





*Stock-Based
      Expenses* .
      Our
      operating expenses include stock-based expenses related to options, restricted
      stock awards, and warrants issued to employees and non-employees. These charges
      have been significant and are reflected in our historical financial results.
      Effective January 1, 2006, we adopted SFAS No. 123  (revised
      2004), “Share-Based Payment,” or SFAS No. 123R, which
      resulted and will continue to result in material costs on a prospective basis
      as
      long as a significant number of options are outstanding. See Note 9,
“Stockholders’ Deficit,” of the Consolidated Financial Statements in Item 8 of
      this report. In June 2007, we limited the issuance of awards under our 2004
      Plan
      to awards of restricted or unrestricted stock and do not anticipate any further
      stock option awards to be granted under the 2004 Plan. In addition, in
      connection with the issuance of 1,273,000 shares of our common stock issued
      pursuant to investor relations services contracts, including 1,250,000 of which
      were issued in the fourth quarter of 2005, we have incurred non-cash expenses
      equal to the market value of the shares of approximately $9.9 million.  In
      2006, we redeemed 1,250,000 shares issued in the fourth quarter of 2005,
      resulting in other income of $3,125,000. This was done in connection with the
      settlement agreements between the parties issued these shares and us. Under
      these agreements, these parties retained the cash fee paid to them, totaling
      $500,000, for their services.





**Financing
      Summary**





As
      of
      March 19, 2008, in addition to our cash on hand and accounts receivable, we
      had
      approximately $7.2 million available to us: approximately $2.0 million through
      our revolving line of credit and approximately $5.2 million through our secured
      subordinated convertible notes, both discussed in greater detail
      below.





In
      November 2006, we established a$1.3 million revolving line of credit with
      Wachovia Bank, NA, or Wachovia, which we subsequently increased to $2.5 million.
      We were required to pay off any advances made on the line of credit no later
      than August 1, 2008 and make monthly payments of accrued interest on any
      outstanding balance commencing on December 1, 2006. The line of credit was
      secured by our deposit account at Wachovia and an irrevocable standby letter
      of
      credit in the amount of $2.5 million issued by HSBC with Atlas, a current
      stockholder, as account party. As of December 31, 2007, we had drawn down $2.1
      million of the $2.5 million Wachovia line of credit. On February 15, 2008,
      we
      paid off the Wachovia line of credit, and on February 20, 2008, we entered
      a new
      line of credit with Paragon. This line of credit is secured by an irrevocable
      standby letter of credit in the amount of $2.5 million issued by HSBC with
      Atlas
      as account party. We must pay off any advances made on the line of credit no
      later than February 19, 2009 and make monthly payments of accrued interest
      on
      any outstanding balance. Interest is payable at the prime rate as periodically
      published by the Wall Street Journal, minus one-half percent.





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


20





Under
      the
      terms of the acquisition agreements entered in connection with the purchase
      of
      all the stock of iMart in October 2005, we were obligated to make certain
      installment payments, including non-compete payments, to the former owners
      of
      iMart. As of February 2007, the previous owners of iMart were paid all
      installment payments required under the acquisition agreements. We were able
      to
      make these payments by refinancing the payments with a loan of approximately
      $1.8 million from Fifth Third Bank, as well as through a drawdown of
      approximately $1.0 million from our revolving line of credit with Wachovia
      described above. The loan from Fifth Third Bank was payable in 24 monthly
      installments. The loan was secured by all of the assets of Smart Commerce,
      all
      of Smart Commerce’s intellectual property. We guaranteed the loan with a
      guaranty secured by all the common stock of Smart Commerce, and a restricted
      cash account. In November 2007, following the convertible note offering
      described below, we repaid all principal and interest owed to Fifth Third Bank
      in connection with this loan. All restricted cash was released and used to
      repay
      part of the principal due.





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





On
      November 14, 2007, in an initial closing, we sold $3.3 million aggregate
      principal amount of secured subordinated convertible notes due November 14,
      2010. In addition, the noteholders have committed to purchase on a pro rata
      basis up to $5.2 million aggregate principal of secured subordinated notes
      upon
      approval and call by our Board of Directors in future closings. We are obligated
      to pay interest on the notes at an annualized rate of 8% payable in quarterly
      installments commencing on February 14, 2008. We do not have the ability to
      prepay the notes without approval of at least a majority of the principal amount
      of the notes then outstanding. (For further discussion of these notes, see
      Note
      7, “Notes Payable,” to the consolidated financial statements in Item 8
      below.)





**Critical
      Accounting Policies and Estimates**





Our
      discussion and analysis of financial condition and results of operations are
      based upon our consolidated financial statements, which we prepared in
      accordance with accounting principles generally accepted in the United States.
      The preparation of these financial statements requires us to make estimates
      and
      judgments that affect the reported amounts of assets, liabilities, revenues,
      and
      expenses, and related disclosures of contingent assets and liabilities.
“Critical accounting policies and estimates” are defined as those most important
      to the financial statement presentation and that require the most difficult,
      subjective, or complex judgments. We base our estimates on historical experience
      and on various other factors that we believe to be reasonable under the
      circumstances, the results of which form the basis for making judgments about
      the carrying value of assets and liabilities that are not readily apparent
      from
      other sources. Under different assumptions and/or conditions, actual results
      of
      operations may materially differ. We periodically 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* –
      W e
      recognize revenue in accordance with accounting standards for software and
      service companies including the SEC’s Staff Accounting Bulletin 104,
“ Revenue
      Recognition *,”* or SAB
      104, American Institute of Certified Public Accountants, or AICPA, Statement
      of
      Position 97-2, “Software Revenue Recognition,” or SOP 97-2, Emerging Issues Task
      Force, or EITF, Issue No. 00-21, “ Revenue
      Arrangements with Multiple ** Deliverables,” or EITF
      00-21 , ** EITF
      Issue No. 99-19, “ Reporting
      Revenue Gross as a Principal or Net as an Agent,” ** or
      EITF
      99-19 , and
      related interpretations, including AICPA Technical Practice Aids. We also
      utilize interpretative guidance from regulatory and accounting bodies, which
      include, but are not limited to, the SEC, the AICPA, the Financial Accounting
      Standards Board, or FASB, and various professional organizations.





Subscription
      revenues consist of subscription sales directly to end users, or to others
      for
      distribution to end users, hosting and maintenance fees, and e-commerce website
      design fees. We make subscription sales either on a monthly subscription or
      a
      one-time “for fee” basis. Subscriptions, which include access to most of our
      offerings, are payable in advance on a monthly basis. Currently, most of our
      syndication agreements call for us to receive a percentage of revenue generated.
      Depending on the criteria of each individual contract and in accordance with
      EITF 99-19, we make a determination as to whether we should recognize the gross
      revenue with a corresponding expense for the portion paid to or retained by
      the
      partner or recognize only our net portion as revenue. At this time, we are
      still
      selling certain products and services on a “for fee” basis. We also recently
      stopped offering to our potential syndication partners volume discounts for
      pre-paid subscriptions, which they could either resell or contribute to their
      small business customers, because no volume sales have occurred. ****** E-commerce website design fees, which we charge for building and maintaining
      corporate websites or to add the capability for e-commerce transactions, are
      recognized over the life of the project. We recognize domain name registration
      fees over the term of the registration period.


21




We
      recognize professional service fees over the term of the consulting engagement
      as services are performed, which is typically one to three months. If we bill
      and collect advance payments for consulting services prior to completion of
      the
      project, we record the payments as deferred revenue when received. If the fees
      are not fixed or determinable, we recognize revenue as work is performed and
      billed. In determining whether we can account for the professional service
      fees
      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,
      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.





Effective
      January 1, 2007, a major customer executed a letter of clarification which
      more
      clearly defined the roles and responsibilities of each party. Individual
      Business Owners, or IBOs, associated with this customer are provided e-commerce,
      domain name, and email services. In exchange for marketing these services to
      its
      IBOs, the customer is paid a marketing fee. At the inception of the business
      relationship, it was agreed that the customer would collect the gross service
      fee from the IBOs, and the customer would retain its marketing fee and remit
      the
      net remaining cash to us. Because the roles and responsibilities of each party
      were vaguely defined in the past, we recorded revenue only on the net cash
      received. Following the execution of the letter of clarification and in
      accordance with EITF 99-19, we now record this revenue as the gross amount
      paid
      by the IBO and a sales and marketing expense for the marketing services rendered
      by the customer. Ultimately, the effect on net income is nil; however,
      subscription revenue and sales and marketing expense are effectively and
      appropriately recognized on a gross basis. Because the new accounting method
      was
      triggered by a clarification to the existing agreement and not by a change
      from
      one accepted accounting method to another, we did not retroactively adjust
      the
      2006 subscription revenue as would be required by SFAS No. 154, ** “Accounting
      Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB
      Statement No. 3 .”
In
      2007, this accounting method resulted in approximately $864,000 of additional
      subscription revenue and a corresponding charge to sales and marketing
      expense.





We
      derive
      revenue from the licensing of software platforms along with the sale of
      associated maintenance, consulting, and application development services. The
      arrangement may include delivery in multiple-element arrangements if the
      customer purchases a combination of products and/or services. We use the
      residual method pursuant to SOP 97-2, which allows us to recognize revenue
      for a
      delivered element when such element has vendor specific objective evidence,
      or
      VSOE, of the fair value of the delivered element. If we cannot determine or
      maintain VSOE for an element, it could impact revenues as all or a portion
      of
      the revenue from the multiple-element arrangement may need to be
      deferred.




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





We
      typically base the amount of revenue to be recognized from development and
      consulting services on the amount of work performed within a given period.
      Revenue recognition is typically based on estimates involving total costs to
      complete and the stage of completion. The assumptions and estimates made to
      determine the total costs and stage of completion may affect the timing of
      revenue recognition. We account for changes in estimates of progress to
      completion and costs to complete as cumulative catch-up
      adjustments.


22




Under
      SOP
      97-2, provided the arrangement does not require significant development,
      modification, or customization, we recognize revenue when all of the following
      criteria have been met:





1.
            persuasive
                evidence of an arrangement exists


2.
            delivery
                has occurred


3.
            the
                fee is fixed or determinable


4.
            collectibility
                is probable





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





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





*Impairment
      of Long Lived Assets* –
We
      review long-lived assets and certain identifiable intangibles for impairment
      whenever events or changes in circumstances indicate that the carrying amount
      of
      an asset may not be recoverable. We measure recoverability of assets to be
      held
      and used by comparing the carrying amount of an asset to future net cash flows
      expected to be generated by the asset. If we consider such assets to be
      impaired, we measure the impairment to be recognized as the amount by which
      the
      carrying amount of the assets exceeds the fair value of the assets. We
      report ****** assets
      to
      be disposed of 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, we would
      make
      an adjustment in the period we make such determination. We recorded no income
      tax expense in any of the periods presented, as we have experienced significant
      operating losses to date. If utilized, we may apply the benefit of our total
      net
      operating loss carryforwards to reduce future tax expense. Since our utilization
      of these deferred tax assets is dependent on future profits, which are not
      assured, we have recorded a valuation allowance equal to the net deferred tax
      assets. These carryforwards would also be subject to limitations, as prescribed
      by applicable tax laws. As a result of prior equity financings and the equity
      issued in conjunction with certain acquisitions, we have incurred ownership
      changes, as defined by applicable tax laws. Accordingly, our use of the acquired
      net operating loss carryforwards may be limited. Further, to the extent that
      any
      single year loss is not utilized to the full amount of the limitation, such
      unused loss is carried over to subsequent years until the earlier of its
      utilization or the expiration of the relevant carryforward period.





**Results
      of Operations**





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


23





**Year
                Ended December 31,**
              **2007**
            
            **Year Ended
                December 31,**
              **2006**REVENUES:Integration
                Fees
            
            $
            5,995
            
            $
            182,660Syndication
                Fees
            
            
            60,000
            
            
            218,386Subscription
                Fees
            
            
            2,829,343
            
            
            1,904,192Professional
                Service Fees
            
            
            1,436,770
            
            
            819,300License
                Fees
            
            
            580,000
            
            
            450,000Other
                Revenue
            
            
            25,546
            
            
            70,352Total
                Revenues
            
            
            4,937,654
            
            
            3,644,890COST
                OF REVENUES
            
            
            511,619
            
            
            329,511GROSS
                PROFIT
            
            
            4,426,035
            
            
            3,315,379OPERATING
                EXPENSES:General
                and Administrative
            
            
            4,896,928
            
            
            5,648,377Sales
                and Marketing
            
            
            2,118,245
            
            
            1,016,107Research
                and Development
            
            
            2,497,408
            
            
            2,016,507Total
                Operating Expenses
            
            
            9,512,581
            
            
            8,680,991LOSS
                FROM CONTINUING OPERATIONS
            
            
            (5,086,546
            )
            
            (5,365,612
            )OTHER
                INCOME (EXPENSE):Interest
                Expense, Net
            
            
            (569,975
            )
            
            (254,381
            )Gain
                (Loss) on Settlements
            
            
            (34,877
            )
            
            144,351Redemption
                of Investor Relations Shares
            
            
            -
            
            
            3,125,000Writeoff
                of Investment
            
            
            -
            
            
            (25,000
            )Other
                Income (Expense)
            
            
            184,772
            
            
            (122,502
            )Total
                Other Income
            
            
            (420,080
            )
            
            2,867,468NET
                LOSS FROM CONTINUING OPERATIONS
            
            
            (5,506,626
            )
            
            (2,498,144
            )DISCONTINUED
                OPERATIONSLoss
                of Operations of Smart CRM (2006 includes gain on sale of assets
                of
                $563,835, write-off of goodwill of $2,793,321, and loss on operations
                of
                $296,077), net of tax ($0)
            
            
            -
            
            
            (2,525,563
            )Loss
                on Discontinued Operations
            
            
            -
            
            
            (2,525,563
            )NET
                LOSSNet
                Loss Attributed to Common Stockholders
            
            $
            (5,506,626
            )
            $
            (5,023,707
            )NET
                LOSS PER SHARE:Continuing
                Operations, Basic and Diluted
            
            $
            (0.32
            )
            $
            (0.17
            )Discontinued
                Operations, Basic and Diluted
            
            
            -
            
            
            (0.17
            )Net
                Loss Attributed to Common Stockholders, Basic and Diluted
            
            
            (0.32
            )
            
            (0.33
            )SHARES
                USED IN COMPUTING NET LOSS PER SHARE:Basic
                and Diluted
            
            
            17,046,608
            
            
            15,011,830





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


24





**Year Ended December 31,****2007**
            
            **2006**REVENUES:Integration
                Fees
            
            
            -
            
            
            5
            %Syndication
                Fees
            
            
            1
            %
            
            6
            %Subscription
                Fees
            
            
            57
            %
            
            52
            %Professional
                Service Fees
            
            
            29
            %
            
            35
            %License
                Fees
            
            
            12
            %
            
            12
            %Other
                Revenue
            
            
            -
            
            
            2
            %Total
                Revenues
            
            
            100
            %
            
            100
            %COST
                OF REVENUES
            
            
            10
            %
            
            9
            %GROSS
                PROFIT
            
            
            90
            %
            
            91
            %OPERATING
                EXPENSES:G&A
            
            
            99
            
            
            155
            %Sales
                & Marketing
            
            
            43
            %
            
            28
            %Development
            
            
            51
            %
            
            55
            %Total
                Operating Expenses
            
            
            193
            %
            
            238
            %Net
                Income (Loss) from Operations
            
            
            -103
            %
            
            -147
            %OTHER
                INCOME (EXPENSE):Interest
                Income (Expense), net
            
            
            -12
            %
            
            -7
            %Gain
                (Loss) on Legal Settlements
            
            
            -1
            %
            
            4
            %Other
                Income
            
            
            4
            %
            
            82
            %Writeoff
                of Investment
            
            
            -
            
            
            -1
            %DISCONTINUED
                OPERATIONSGain
                (Loss) from Operations of Smart CRM (including Loss on Sale of
                $2,140,054)
            
            
            -
            
            
            -69
            %Income
                from Discontinued Operations
            
            
            -
            
            
            -69
            %NET
                INCOME (LOSS)
            
            
            -112
            %
            
            -138
            %Net
                Loss Attributed to Common Stockholders
            
            
            -112
            %
            
            -723
            %





**Overview
      of Results of Operations for the Fiscal Year Ended December 31,
      2007**





Total
      revenues for the year ended December 31, 2007 were $4.9 million, an increase
      of
      $1.3 million or 35% over 2006. Subscription revenue for 2007 was $2.8 million,
      an increase of $925,000, or 49%, over 2006. For 2007, we reported in two
      segments and derived $400,000 and $4.5 million of our consolidated revenue
      from
      our Smart Online segment and Smart Commerce segment, respectively.





Our
      net
      loss for 2007 was $5.5 million, an increase of $483,000 from a net loss of
      $5.0
      million in 2006. Net loss for 2006 included a loss on discontinued operations
      of
      $2.5 million, and $3.1 million of other income from the redemption of investor
      relations shares. Also during 2006, we incurred depreciation and amortization
      expense of $782,000 and compensation costs related to stock options and
      restricted stock of $780,000 as accounted for under SFAS No. 123R. Net loss
      for
      2007 included non-cash charges of $842,000 related to amortization and
      depreciation and $548,000 related to compensation costs for stock options and
      restricted stock as accounted for under SFAS No. 123R.


25


During
      2006, we incurred substantial costs related to the SEC’s suspension of the
      trading of our common stock and the resulting SEC and internal investigations.
      Legal expense related to the SEC and internal investigations was approximately
      $1.0 million for 2006. During the latter half 2007, legal expense related to
      the
      continuation of the SEC action ****** was
      approximately $300,000.





In
      the
      first quarter of 2006, we learned that one of our major customers for the Smart
      Commerce segment underwent a restructuring. During 2006, this restructuring
      resulted in a loss of approximately 45% of the revenue generated by this
      customer. Revenue from this customer decreased in the months following the
      restructuring, then leveled off for the last three months of 2006. Throughout
      2007, revenues from this customer again began to decrease and fell approximately
      10% further for a total reduction from this customer of approximately 55% from
      the 2005 level.





As
      of
      December 31, 2007, our platforms were available through an aggregate of ten
      syndication partners and our main portal. Not all of our syndication partners
      offered all of our applications available through either of our platforms,
      and
      none of our syndication partners offered both platforms, through their
      websites.





**Comparison
      of the Results of Operations for the Years Ended December 31, 2007 and
      2006**





*Revenues* –
Total
      revenues were $4.9 million in 2007 as compared to $3.6 million in 2006, an
      increase of $1.3 million, or 35%. Subscription revenue for 2007 was $2.8
      million, an increase of $925,000, or 49%, over 2006. This
      increase was primarily attributable to a change in accounting method for certain
      subscription revenues that were recorded net in 2006 and recorded as gross
      in
      2007. Because the new accounting method was triggered by a clarification to
      an
      existing agreement and not by a change from one accepted accounting method
      to
      another, the 2006 subscription revenues were not retroactively adjusted as
      would
      be required by SFAS No. 154, “Accounting Changes and Error Corrections - a
      replacement of APB Opinion No. 20 and FASB Statement No. 3.” Therefore,
      subscription revenues for 2007 are not recorded in the same manner as
      subscription revenues for 2006. ****** If
      revenue from this customer had been recognized on a net basis in 2007 (making
      it
      comparable to 2006), subscription revenue for 2007 would have been approximately
      $2.0 million, as compared to approximately $1.9 million in 2006, an increase
      of
      approximately $61,000, or 3.2%, and total revenues would have been approximately
      $4.1 million in 2007 as compared to approximately $3.6 million in 2006, an
      increase of approximately $500,000, or 14%. The
      increase in subscription revenue was also attributable to the subscription
      revenue of Smart Commerce, which launched initiatives for several new customers
      in the latter half of 2007. As discussed above, in the first quarter of 2006,
      we
      learned that one customer of Smart Commerce, constituting approximately 40%
      of
      iMart’s 2005 revenue, underwent a restructuring that resulted in a decrease of
      approximately 55% in its business with Smart Commerce between April 2006 and
      December 2007. Although this customer restructuring has had a negative effect
      on
      revenue for Smart Commerce, we have offset this loss by securing two new
      customers in 2007. Integration revenue decreased $183,000, or 97%, to $6,000
      in
      2007. Syndication revenue decreased $158,000, or 73%, to $60,000 in 2007
      compared to $218,000 in 2006. These decreases were primarily attributable to
      our
      shift away from integration and syndication revenue as we began focusing on
      building subscription revenue. Accordingly, we have allowed the majority of
      our
      integration and syndication contracts to expire. We expect our integration
      and
      syndication revenue to continue to decline as we work to increase our
      subscription revenue. Professional service fees increased $617,000, or 75%,
      to
      $1.4 million in 2007 compared to 2006. This increase was primarily attributable
      to the addition of one new customer and the expansion of professional services
      provided to one existing customer. The Smart Commerce segment accounts for
      100%
      of our professional service fees. License fees increased $130,000, or 29%,
      from
      $450,000 in 2006 to $580,000 in 2007. This increase was attributable to the
      sale
      of two licenses in 2007 (one by each segment) as compared to one license sale
      in
      2006 by the Smart Commerce segment.





*Cost
      of Revenues –* Cost
      of
      revenues were $512,000 in 2007 as compared to $330,000 in 2006, an increase
      of
      $182,000, or 55%. The Smart Commerce segment contributed $337,000 to cost of
      revenues in 2007 as compared to $271,000 in 2006, an increase of $66,000. This
      increase was attributable to increased hosting requirements for two customers,
      one new and one existing. The cost of revenues at the Smart Online segment
      increased $119,000, or 216%, to $174,000 in 2007 from $55,000 in 2006. This
      increase was primarily due to the expansion of our call center, including
      additional personnel and a call center manager. The remaining difference of
      approximately $3,000 was due to the discontinuation of operations of Smart
      CRM.





*General
      and Administrative –* General
      and administrative expenses were $4.9 million in 2007 as compared to $5.6
      million in 2006, a decrease of $751,000, or 8%. This decrease was primarily
      due
      to decreases in legal, accounting, and registration rights expenses as well
      as
      compensation expense related to stock options and restricted stock, which were
      offset by increases in total compensation, Sarbanes-Oxley compliance, outside
      contractor expense, and credit card transaction fee expense.


26




Our
      legal
      expenses decreased by $572,000 to $676,000 in 2007 from $1,248,000 in 2006.
      This
      decrease is the direct result of lower legal expenses in the first three
      quarters of 2007 as compared to 2006, which contained higher than normal legal
      expense due to the SEC and internal investigations. Legal expenses began to
      increase significantly in the last four months of 2007 following the initiation
      of a civil proceeding by the SEC against us and certain former employees and
      certain stock brokers and criminal charges levied against certain former
      employees and certain stock brokers. We have submitted these expenses to be
      paid
      by our directors and officers liability insurance carrier, and we believe we
      will recover these expenses; however, there can be no assurance that we will
      recover all of the expenses we submit for payment by the insurance carrier.
      Accounting fees decreased $155,000 to $109,000 in 2007 from $264,000 in 2006.
      This was the result of lower dependence on third party accounting resources
      following the hiring of a full-time chief financial officer in 2006. We expect
      accounting fees to increase in 2008 as we may need to rely on third party
      accounting resources during our search for a new chief financial officer.
      Registration rights penalties decreased $312,000 to $23,000 in 2007 from
      $335,000 in 2006. This was the result of our filing a Registration Statement
      on
      Form S-1 in April 2007, fulfilling our registration requirements and ending
      the
      accrual of additional penalties. In addition, many of our stockholders eligible
      for registration rights settled with us in the first quarter of 2007, which
      ended the accrual of further penalties for these stockholders. In addition,
      our compensation
      expense related to stock options and restricted stock decreased $232,000 to $548,000 in 2007 from $780,000 in 2006. This decrease
      was
      the result of increased issuances of restricted stock in 2007, which we deemed
      to be necessary to recruit and retain new executive officers and to compensate
      existing employees, as a replacement to more costly stock options. All of these
      decreases were in our Smart Online segment.





Compliance
      expense increased to $72,000 in 2007 from $0 in 2006. This was the result of
      the
      engagement of an outside consulting firm to assist us with our plan for
      compliance with Sarbanes-Oxley Section 404. Board compensation expense increased
      $53,000 to $94,000 in 2007 from $41,000 in 2006. This was the result of the
      addition of one new independent board member as well as a full year of expense
      in 2007 related to other independent directors who joined our board in 2006.
      These increases were incurred at our Smart Online segment.





At
      our
      Smart Commerce segment, wages increased $124,000 to $362,000 in 2007 as compared
      to $238,000 in 2006. This was primarily due to increased allocation of personnel
      efforts to complete the integration of the products and operations of the Smart
      Commerce and Smart Online segments. Bank service charges increased $51,000
      to
      $87,000 in 2007 from $36,000 in 2006. This increase was primarily related to
      the
      merchant fees involved in the operation of websites for two new customers
      launched in 2007. Contractor costs increased $42,000 to $144,000 in 2007 from
      $102,000 in 2006. This is the result of additional workload incurred in
      preparation of launching these new customers. We utilized outside consultants
      to
      increase the speed with which we were able to launch these sites. Health
      insurance and other benefit costs increased by $31,000 to $53,000 in 2007 from
      $22,000 in 2006. This increase was the combined result of a new matching program
      we established in 2007 relating to our employees’ contributions under our 401(k)
      plan and a shift in financial burden related to our employee health insurance
      to
      us and away from our employees. This shift was necessary in order to bring
      our
      health insurance plan on par with other local companies with whom we compete
      for
      talent.





We
      are
      currently disputing our insurance carrier’s refusal to cover certain legal
      expenses related to our securities litigation matters. We contend that these
      legal expenses should be reimbursed by our insurance carrier. Because the
      outcome of this dispute is unclear, we have expensed all legal costs incurred
      with respect to the SEC matters and our internal investigation, and we will
      account for any insurance reimbursement, should there be any, in the period
      such
      amounts are reimbursed.





*Sales
      and Marketing –* Sales
      and
      marketing expense increased by $1.1 million or 108%, to $2.1 million in 2007
      from $1.0 million in 2006. This increase was primarily the result of increased
      revenue share expense ****** stemming
      from the addition of two new Smart Commerce customers and our adoption of gross
      revenue reporting with respect to one Smart Commerce customer following a letter
      of clarification, as described below. This increase was offset by lower revenue
      share expense at the Smart Online segment from the loss of one
      customer.


27


Revenue
      share expense for two new customers that launched in the middle of 2007 resulted
      in $856,000 of expense. As those customers did not exist in the previous year,
      there was no corresponding charge in 2006. In addition, effective January 1,
      2007, a major customer executed a letter of clarification which clarified the
      roles and responsibilities of each party. Because these roles and
      responsibilities were vaguely defined in the past, we recorded revenue only
      on
      the net cash received. Following the execution of the letter of clarification
      and in accordance with EITF 99-19, we now record this revenue as the gross
      amount paid by the IBO and a sales and marketing expense for the marketing
      services rendered by the customer. Ultimately, the effect on net income is
      nil;
      however, subscription revenue and sales and marketing expense are effectively
      and appropriately grossed up. For the year ended December 31, 2007, this
      accounting method resulted in approximately $864,000 of additional sales and
      marketing expense for which there was no corresponding charge in
      2006.





At
      the
      Smart Online segment, one customer contract expired early in 2007. That customer
      contract had resulted in revenue share expense of $100,000 in 2006. As that
      customer was no longer a customer in 2007, there was a $100,000 decrease in
      revenue share expense at the Smart Online segment in 2007.





Sales
      and
      marketing wages decreased $100,000 at the Smart Commerce segment in 2007 as
      compared to 2006, but this decrease was offset by an increase in sales and
      marketing wages of $100,000 at the Smart Online segment in 2007 as compared
      to
      2006. These offset amounts were the result of the re-allocation of sales
      resources from one segment to the other.





*Research
      and Development Expense* –
      Research and development expense increased by $480,000, or 24%, to $2.5 million
      in 2007 from $2.0 million in 2006. This increase was primarily attributable
      to
      an increase in development wages of $381,000 at the Smart Online segment to
      $1.3
      million in 2007 from $897,000 in 2006. This increase was due to our need for
      additional development work resulting from the signing of new contracts in
      2007.
      Expense related to the development of our accounting application increased
      $119,000 to $227,000 in 2007 from $108,000 in 2006. In 2006, the expense related
      to this application stalled as we re-assessed the application needs. The expense
      increased in 2007 as we finalized the application based on the new assessment
      of
      management for the specifications of this application.





*Other
      Income (Expense)* –
In
      2006, we entered into settlement agreements with each of two investor relations
      consultants. Under the terms of the settlement agreements, the consultants
      retained $500,000 in cash fees paid to them, but released any interest in
      1,250,000 shares that were issued. We redeemed these shares in 2006, resulting
      in other income of $3.1 million. There was no corresponding income in
      2007.





We
      incurred interest expense of $254,000 and earned interest income of $11,000
      in
      2006, as compared to interest expense of $738,000 and interest income of
      $143,000 in 2007. This increase in interest expense of $484,000, or 191%, is
      attributable to $433,000 of interest expense resulting from the warrant issued
      to Atlas in connection with the extension of our line of credit with Wachovia,
      as well as $33,000 of interest expense related to the convertible notes issued
      in November 2007. The increase in interest income is primarily due to increased
      cash balances in interest-earning accounts that resulted from our February
      2007
      private placement and November 2007 convertible note offering.





Other
      income (expense) increased to $185,000 of income in 2007 from $123,000 of
      expense in 2006. In 2007, other income (expense) consisted primarily of $86,000
      of other income from the reversal of previously recognized registration rights
      expense and $75,000 of other income related to the reversal of previous accruals
      of expenses to a customer that later allowed its contract to terminate and
      did
      not request payment so as to avoid potential litigation. In 2006, other income
      (expense) consisted of $123,000 of expense related to the writeoff of certain
      prepaid barter amounts that were deemed worthless.





**Provision
      for Income Taxes**





We
      did
      not record a provision for income tax expense in 2007 or 2006 because we have
      been generating net losses. Furthermore, we have not recorded an income tax
      benefit for 2007 or 2006 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 to warrant a full valuation allowance in
      our
      financial statements. As of December 31, 2007, we had approximately $43.4
      million in net operating loss carryforwards, which may be utilized to offset
      future taxable income.


28




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





**Liquidity
      and Capital Resources**





As
      of
      December 31, 2007, our principal sources of liquidity were cash and cash
      equivalents totaling $3.5 million and accounts receivable of $815,000, as
      compared to $577,000 of cash and cash equivalents (of which $250,000 was
      restricted) and $248,000 in accounts receivable as of December 31, 2006.
      Deferred revenue at December 31, 2007 was $577,000 as compared to $325,000
      at
      December 31, 2006.





As
      of
      March 19, 2008, our principal sources of liquidity were cash and cash
      equivalents totaling approximately $563,000, accounts receivable of
      approximately $525,000, approximately $2.0 million available under our revolving
      line of credit, and approximately $5.2 million available through our secured
      subordinated convertible notes.




**Cash
      Flow from Operations** .
      Cash
      flows used in operations in 2007 totaled $4.0 million, up from $3.3 million
      in
      2006. The increase in cash flows used in operations from 2006 to 2007 was
      primarily attributable to increases in accounts receivable and decreases in
      accounts payable and accrued expense, the maintenance of a high balance of
      prepaid expenses, and the lack of positive cash flow from our discontinued
      operations. These uses of cash were offset by our increase in deferred
      revenue.




**Cash
      Flow from Financing Activity** .
      In
      2007, we generated a total of $7.2 million net cash from our financing
      activities through both equity and debt financing, as described
      below.





*Equity
      Financing* .
      Our
      primary source of cash during 2007, 2006, and 2005, as well as prior years,
      was
      from the sale of our securities. In a private placement that closed in February
      2007, we sold an aggregate of 2,352,941 shares of our common stock to two new
      investors. We sold these shares at a price of $2.55 per share, resulting in
      gross proceeds of $6.0 million. In connection with this placement, we incurred
      approximately $700,000 in issuance costs. Between March 2006 and August 2006,
      we
      sold an aggregate of 1.0 million shares of our common stock to four investors,
      three of whom were current stockholders, for a price of $2.50 per share,
      resulting in gross proceeds of $2.5 million. We incurred immaterial issuance
      costs related to these stock sales. During 2005, we generated net cash from
      financing activities, including the sales of shares of our common stock, of
      approximately $7.7 million.





*Debt
      Financing* .
      In
      2006, we entered into two debt financing transactions. On November 9, 2006,
      Smart Commerce entered into a loan agreement with Fifth Third Bank. Under the
      terms of this agreement, Smart Commerce borrowed $1.8 million to be repaid
      in 24
      monthly installments of $75,000 plus interest beginning in December 2006. The
      interest rate was prime plus 1.5% as periodically determined by Fifth Third
      Bank. The loan was secured by all of the assets of Smart Commerce, including
      a
      security account of $250,000 with Fifth Third Bank, and all of Smart Commerce’s
      intellectual property. We guaranteed the loan with a guaranty secured by all
      the
      common stock of Smart Commerce. Under the terms of the loan agreement, Smart
      Commerce established a lock box account with Fifth Third Bank, but had the
      right
      to use the amounts deposited in the account for any purpose not inconsistent
      with the loan agreement and related documents so long as no event of default
      exists and is continuing. Further, the $250,000 in the security account was
      to
      be released in three installments of approximately $83,000 if, on June 30,
      2007,
      December 31, 2007, and June 30, 2008, Smart Commerce met certain debt covenants
      regarding operating metrics for Smart Commerce. In November 2007, following
      our
      convertible note offering, we repaid all principal and interest owed to Fifth
      Third Bank in connection with this loan. All restricted cash was released and
      used to repay part of the principal due.





On
      November 14, 2007, in an initial closing, we sold $3.3 million aggregate
      principal amount of secured subordinated convertible notes due November 14,
      2010. In addition, the noteholders have committed to purchase on a pro rata
      basis up to $5.2 million aggregate principal of secured subordinated notes
      upon
      approval and call by our Board of Directors in future closings. We are obligated
      to pay interest on the notes at an annualized rate of 8% payable in quarterly
      installments commencing on February 14, 2008. We do not have the ability to
      prepay the notes without approval of at least a majority of the principal amount
      of the notes then outstanding.


29




**Deferred
      Revenue.** At
      December 31, 2007, we had deferred revenue totaling $577,000, 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 57% of this amount will be recognized during 2008.





We
      have
      not yet achieved positive cash flows from operations, and our main sources
      of
      funds for our operations have been the sale of securities in private placements
      and our line of credit. We must continue to rely on these sources until we
      are
      able to generate sufficient revenue to fund our operations. We believe that
      anticipated cash flows from operations, funds available from our existing line
      of credit, funds callable under the convertible notes, together with cash on
      hand, will provide sufficient funds to finance our operations at least for
      the
      next 18 ****** months.
      Changes in our operating plans, lower than anticipated sales, increased
      expenses, or other events may cause us to need to seek additional equity or
      debt
      financing in future periods. There can be no assurance that financing will
      be
      available on acceptable terms or at all. Additional equity financing could
      be
      dilutive to the holders of our common stock, and additional debt financing,
      if
      available, could impose greater cash payment obligations and more covenants
      and
      operating restrictions. We have no current plans to seek any such additional
      financing.





**Recent
      Developments**





On
      February 15, 2008, we repaid the full outstanding principal balance of
      $2,052,000 and accrued interest of $2,890 outstanding under our revolving credit
      arrangement with Wachovia. The line of credit advanced by Wachovia was $2.5
      million to be used for general working capital purposes. Any advances made
      on
      the line of credit were to be paid off no later than August 1, 2008. The line
      of
      credit was secured by our deposit account at Wachovia and the irrevocable
      standby letter of credit issued by HSBC with Atlas, both of which were released
      by Wachovia.


On
      February 20, 2008, we entered into a revolving credit arrangement with Paragon.
      The line of credit advanced by Paragon is $2.47 million and can be used for
      general working capital. Any advances made on the line of credit must be paid
      off no later than February 19, 2009, with monthly payments being applied first
      to accrued interest and then to principal. The interest shall accrue on the
      unpaid principal balance at the Wall Street Journal’s published prime rate minus
      one half percent. The line of credit is secured by an irrevocable standby letter
      of credit in the amount of $2.47 million issued by HSBC with Atlas as account
      party. We also have agreed with Atlas that in the event of our default in the
      repayment of the line of credit that results in the letter of credit being
      drawn, we will reimburse Atlas any sums that Atlas is required to pay under
      such
      letter of credit. At our sole discretion, these payments may be made in cash
      or
      by issuing shares of our common stock at a set per share price of $2.50.





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





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





Not
      applicable.




30




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








INDEX
      TO
      FINANCIAL STATEMENTS





Page numberREPORT
                OF INDEPENDENT REGISTEREDPUBLIC
                ACCOUNTING FIRM
            
            32CONSOLIDATED
                BALANCE SHEETS
            
            33CONSOLIDATED
                STATEMENTS OF OPERATIONS
            
            34CONSOLIDATED
                STATEMENTS OF CASH FLOWS
            
            35CONSOLIDATED
                STATEMENTS OF
              STOCKHOLDERS’
                DEFICIT
            
            36NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
            
            37


31


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, 2007 and 2006, and the related consolidated statement of
      operations, stockholders’ (deficit) equity, cash flows for each of the years
      then ended December 31, 2007 and 2006. 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, 2007 and 2006, and the results of its operations and its cash
      flows
      for each of the years then ended December 31, 2007 and 2006, in conformity
      with
      accounting principles generally accepted in the United States.




/s/
                  Sherb & Co., LLPCertified
                  Public AccountantsNew
                  York, New YorkMarch
                  20, 2008


32


**SMART
      ONLINE, INC.**


**CONSOLIDATED
      BALANCE SHEETS**


**December 31,**
                **2007**
              
              **December 31,**
                **2006****Assets**CURRENT
                  ASSETS:Cash
                  and Cash Equivalents
              
              $
              3,473,959
              
              $
              326,905Restricted
                  Cash
              
              
              -
              
              
              250,000Accounts
                  Receivable, Net
              
              
              815,102
              
              
              247,618Current
                  Portion of Note Receivable
              
              
              55,000
              
              
              -Prepaid
                  Expenses
              
              
              90,886
              
              
              100,967Deferred
                  Financing Costs
              
              
              301,249
              
              
              -Total
                  Current Assets
              
              
              4,736,196
              
              
              925,490PROPERTY
                  AND EQUIPMENT, Net
              
              
              174,619
              
              
              180,360LONG
                  TERM PORTION OF NOTE RECEIVABLE
              
              
              225,000
              
              
              -INTANGIBLE
                  ASSETS, Net
              
              
              2,882,055
              
              
              3,617,477GOODWILL
                  (See Note 6)
              
              
              2,696,642
              
              
              2,696,642OTHER
                  ASSETS (See Note 6)
              
              
              60,311
              
              
              13,040TOTAL
                  ASSETS
              
              $
              10,774,823
              
              $
              7,433,009**Liabilities
                  and Stockholders’ Equity,**CURRENT
                  LIABILITIES:Accounts
                  Payable
              
              $
              628,370
              
              $
              850,730Accrued
                  Registration Rights Penalty
              
              
              -
              
              
              465,358Current
                  Portion of Notes Payable (See Note 7)
              
              
              2,287,682
              
              
              2,839,631Deferred
                  Revenue
              
              
              329,805
              
              
              313,774Accrued
                  Liabilities
              
              
              603,338
              
              
              301,266Total
                  Current Liabilities
              
              
              3,849,195
              
              
              4,770,759LONG-TERM
                  LIABILITIES:Long-Term
                  Portion of Notes Payable (See Note 7)
              
              
              3,313,903
              
              
              825,000Deferred
                  Revenue
              
              
              247,312
              
              
              11,252Total
                  Long-Term Liabilities
              
              
              3,561,215
              
              
              836,252Total
                  Liabilities
              
              
              7,410,410
              
              
              5,607,011COMMITMENTS
                  AND CONTINGENCIESSTOCKHOLDERS’
                  EQUITY:Common
                  stock, $.001 Par Value, 45,000,000 Shares Authorized, Shares Issued
                  and
                  Outstanding:
                December
                  31, 2007 – 18,159,768; December 31, 2006 - 15,379,030
              
              
              18,160
              
              
              15,379Additional
                  Paid-in Capital
              
              
              66,202,179
              
              
              59,159,919Accumulated
                  Deficit
              
              
              (62,855,926
              )
              
              (57,349,300
              )Total
                  Stockholders’ Equity
              
              
              3,364,413
              
              
              1,825,998TOTAL
                  LIABILITIES AND STOCKHOLDERS’ EQUITY
              
              $
              10,774,823
              
              $
              7,433,009





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


33


**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**




**Year
                Ended**
              **December 31,**
              **2007**
            
            **Year
                Ended**
              **December 31,**
              **2006**REVENUES:Integration
                Fees
            
            $
            5,995
            
            $
            182,660Syndication
                Fees
            
            
            60,000
            
            
            218,386Subscription
                Fees (See Note 4)
            
            
            2,829,343
            
            
            1,904,192Professional
                Service Fees
            
            
            1,436,770
            
            
            819,300License
                Fees
            
            
            580,000
            
            
            450,000Other
                Revenue
            
            
            25,546
            
            
            70,352Total
                Revenues
            
            
            4,937,654
            
            
            3,644,890COST
                OF REVENUES
            
            
            511,619
            
            
            329,511GROSS
                PROFIT
            
            
            4,426,035
            
            
            3,315,379OPERATING
                EXPENSES:General
                and Administrative
            
            
            4,896,928
            
            
            5,648,377Sales
                and Marketing
            
            
            2,118,245
            
            
            1,016,107Research
                and Development
            
            
            2,497,408
            
            
            2,016,507Total
                Operating Expenses
            
            
            9,512,581
            
            
            8,680,991LOSS
                FROM CONTINUING OPERATIONS
            
            
            (5,086,546
            )
            
            (5,365,612
            )OTHER
                INCOME (EXPENSE):Interest
                Expense, Net
            
            
            (569,975
            )
            
            (254,381
            )Gain
                (Loss) on Settlements
            
            
            (34,877
            )
            
            144,351Redemption
                of Investor Relations Shares
            
            
            -
            
            
            3,125,000Writeoff
                of Investment
            
            
            -
            
            
            (25,000
            )Other
                Income (Expense)
            
            
            184,772
            
            
            (122,502
            )Total
                Other Income
            
            
            (420,080
            )
            
            2,867,468NET
                LOSS FROM CONTINUING OPERATIONS
            
            
            (5,506,626
            )
            
            (2,498,144
            )DISCONTINUED
                OPERATIONSLoss
                of Operations of Smart CRM (2006 includes gain on sale of assets
                of
                $563,835, write-off of goodwill of $2,793,321, and loss on operations
                of
                $296,077), net of tax ($0)
            
            
            -
            
            
            (2,525,563
            )Loss
                on Discontinued Operations
            
            
            -
            
            
            (2,525,563
            )NET
                LOSSNet
                Loss Attributed to Common Stockholders
            
            $
            (5,506,626
            )
            $
            (5,023,707
            )NET
                LOSS PER SHARE:Continuing
                Operations, Basic and Diluted
            
            $
            (0.32
            )
            $
            (0.17
            )Discontinued
                Operations, Basic and Diluted
            
            
            -
            
            
            (0.17
            )Net
                Loss Attributed to Common Stockholders, Basic and Diluted
            
            
            (0.32
            )
            
            (0.33
            )SHARES
                USED IN COMPUTING NET LOSS PER SHARE:Basic
                and Diluted
            
            
            17,046,608
            
            
            15,011,830





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


34


**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**Year
                Ended**
              **December 31, 2007**
            
            **Year
                Ended**
              **December 31, 2006**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss from continuing operations
            
            $
            (5,506,626
            )
            $
            (2,498,144
            )Adjustments
                to reconcile net loss to net cash provided
                by (used in) operating activities:Depreciation
                & amortization
            
            
            841,625
            
            
            727,922Write-off
                of investment
            
            
            -
            
            
            25,000Bad
                debt expense
            
            
            -
            
            
            63,317Redemption
                of investor relations shares
            
            
            -
            
            
            (3,125,000
            )Stock
                option and restricted stock expense
            
            
            548,368
            
            
            779,974Registration
                rights penalty expense
            
            
            (62,376
            )
            
            335,413Amortization
                of deferred financing costs
            
            
            433,054
            
            
            -Accrual
                for loss on legal settlements
            
            
            250,000
            
            
            -Loss
                on debt forgiveness
            
            
            (215,123
            )
            
            (144,351
            )Changes
                in assets and liabilities:Accounts
                receivable
            
            
            (567,483
            )
            
            183,386Prepaid
                expenses
            
            
            10,081
            
            
            264,333Other
                assets
            
            
            (47,271
            )
            
            8,308Deferred
                revenue
            
            
            252,089
            
            
            (440,964
            )Accounts
                payable
            
            
            (8,444
            )
            
            121,699Accrued
                expenses
            
            
            53,596
            
            
            234,601Cash
                flow from operations of discontinuedoperations
            
            
            -
            
            
            212,201Net
                cash (used in) provided by operating activities
            
            
            (4,018,510
            )
            
            (3,252,305
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchase
                of property and equipment
            
            
            (77,520
            )
            
            (8,457
            )Purchase
                of trade name
            
            
            (2,033
            )
            
            -Cash
                flow from investing activities of discontinued operations
            
            
            -
            
            
            432,545Net
                cash (used in) provided by investing activities
            
            
            (79,553
            )
            
            424,088CASH
                FLOWS FROM FINANCING ACTIVITIES:Borrowings
                on notes payable
            
            
            4,750,000
            
            
            2,402,000Repayments
                on notes payable
            
            
            (2,834,272
            )
            
            (3,102,918
            )Restricted
                cash
            
            
            250,000
            
            
            (21,211
            )Advances
                from (to) Smart CRM
            
            
            -
            
            
            570,923Cash
                flow from financing activities of discontinued operations
            
            
            -
            
            
            (650,738
            )Notes
                receivable
            
            
            (280,000
            )
            
            -Issuance
                of common stock, net of costs
            
            
            5,359,389
            
            
            2,522,100Net
                cash provided by financing activities
            
            
            7,245,117
            
            
            1,720,156NET
                INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            3,147,054
            
            
            (1,108,061
            )CASH
                AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            326,905
            
            
            1,434,966CASH
                AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            3,473,959
            
            $
            326,905Supplemental
                disclosures:Cash
                payment during the year for interest
            
            $
            302,627
            
            $
            292,807Cash
                payment during the year for income taxes
            
            
            -
            
            
            -Non-cash
                financing activities:Assets
                acquired under capital lease
            
            
            23,949
            
            
            -Shares
                issued in settlement of notes payable
            
            
            129,311
            
            
            -Debt
                assumed by purchaser of assets of Smart CRM
            
            
            -
            
            
            1,733,190




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


35


**SMART
      ONLINE, INC.**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ DEFICIT**


**FOR
      THE YEARS ENDED DECEMBER 31, 2007 AND 2006**


**Common Stock**
              
              **Additional****Shares**
              
              **$.001
                  Par**
                **Value**
              
              **Paid-
                    In**
                **Capital**
              
              **Accumulated**
                **Deficit**
              
              **Total**BALANCE
                  DECEMBER 31, 2005
              
              
              15,607,230
              
              $
              15,607
              
              $
              58,982,617
              
              $
              (52,325,593
              )
              $
              6,672,631Cashless
                  Exercise of Options
              
              
              4,800
              
              
              5
              
              
              (5
              )
              
              -
              
              
              -Issuance
                  of Warrants
              
              
              17,000
              
              
              17
              
              
              22,083
              
              
              -
              
              
              22,100Cancellation
                  of GIC Shares
              
              
              (625,000
              )
              
              (625
              )
              
              (1,561,875
              )
              
              -
              
              
              (1,562,500
              )Issuance
                  of Common Stock
              
              
              1,000,000
              
              
              1,000
              
              
              2,499,000
              
              
              -
              
              
              2,500,000Cancellation
                  of Berkley Shares
              
              
              (625,000
              )
              
              (625
              )
              
              (1,561,875
              )
              
              -
              
              
              (1,562,500
              )Compensation
                  Expense Related to Stock Options and Restricted Stock
              
              
              -
              
              
              -
              
              
              779,974
              
              
              -
              
              
              779,974Net
                  Loss
              
              
              
              
              
              
              
              
              
              
              
              (5,023,707
              )
              
              (5,023,707
              )BALANCE
                  DECEMBER 31, 2006
              
              
              15,379,030
              
              $
              15,379
              
              $
              59,159,919
              
              $
              (57,349,300
              )
              $
              1,825,998Exercise
                  of Options
              
              
              55,204
              
              
              55
              
              
              25,945
              
              
              -
              
              
              26,000Issuance
                  of Common Stock, Net of Expenses
              
              
              2,352,941
              
              
              2,353
              
              
              5,331,035
              
              
              -
              
              
              5,333,388Registration
                  Rights Share Issuances and Settlements
              
              
              83,093
              
              
              83
              
              
              402,899
              
              
              -
              
              
              402,982Compensation
                  Expense Related to Stock Options and Restricted Stock
              
              
              -
              
              
              -
              
              
              268,908
              
              
              -
              
              
              268,908Issuance
                  of Warrants
              
              
              -
              
              
              -
              
              
              734,303
              
              
              -
              
              
              734,303Restricted
                  Share Issuances and Restriction Lapsing
              
              
              289,500
              
              
              290
              
              
              279,170
              
              
              -
              
              
              279,460Net
                  Loss
              
              
              
              
              
              
              
              
              
              
              
              (5,506,626
              )
              
              (5,506,626
              )BALANCEDECEMBER31, 2007
              
              
              18,159,768
              
              $
              18,160
              
              $
              66,202,179
              
              $
              (62,855,926
              )
              $
              3,364,413







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


36


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**FOR
      THE YEARS ENDED DECEMBER 31, 2007 and 2006**





**1.    NATURE
      OF BUSINESS**







Smart
      Online, Inc. (the “Company”) develops and markets software products and services
      targeted to small businesses that have less than 50 employees. The Company’s
      software products and services are delivered via a Software-as-a-Service
      (“SaaS”) model. The Company sells its SaaS products and services primarily
      through private label marketing partners. The Company maintains a website for
      potential partners containing certain corporate information located at
      www.SmartOnline.com.




The
      Company’s primary source of revenue currently comes from sales of SaaS
      applications for business management, web marketing, and e-commerce, which
      represented 57% and 63% of its revenue from continuing operations for the fiscal
      years ended December 31, 2007 and 2006, respectively. The Company also derives
      revenue from sales of professional services, which represented 29% and 35%
      of
      revenue from continuing operations for the fiscal years ended December 31,
      2007
      and 2006, respectively.





In
      previous years, the Company’s auditors expressed doubt about its ability to
      continue as a going concern. The Company has been able to address these concerns
      such that no similar doubt exists at this time. Actions taken by the Company
      that effect this determination include (1) raising substantial additional
      capital in February 2007; (2) completing the sale of $3.3 million aggregate
      principal amount of secured subordinated convertible notes in November 2007
      with
      an additional $5.2 million available for issuance, and (3) controlling expenses
      and anticipated losses.





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





**2.    SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES**





*Principles
      of Consolidation -* The
      accompanying consolidated financial statements include the accounts of the
      Company and its wholly-owned subsidiaries, Smart CRM, Inc. (“Smart CRM”), and
      Smart Commerce, Inc. (“Smart Commerce”). All significant intercompany accounts
      and transactions have been eliminated. Subsidiary accounts are included only
      from the date of acquisition forward. See Note 14, Dispositions, for further
      discussion.





*Revenue
      Recognition* -
      The
      Company recognizes revenue in accordance with accounting standards for software
      and service companies including the Securities and Exchange Commission’s (the
“SEC”) Staff Accounting Bulletin No. 104, *Revenue
      Recognition* (“SAB
      104”), the American Institute of Certified Public Accountants (the “AICPA”)
      Statement of Position 97-2, *Software
      Revenue Recognition* (“SOP
      97-2”), Emerging Issues Task Force (“EITF”) Issue No. 00-21, *Revenue
      Arrangements with Multiple Deliverables* (“EITF
      00-21”) , EITF
      Issue No. 99-19, *Reporting
      Revenue Gross as a Principal or Net as an Agent* (“EITF
      99-19”) , ** and
      related interpretations, including the AICPA Technical Practice Aids. The
      Company utilizes interpretative guidance from regulatory and accounting bodies,
      which include, but are not limited to, the SEC, the AICPA, the Financial
      Accounting Standards Board (“FASB”), and various professional
      organizations.


37


Revenue
      is recognized when all of the following conditions are satisfied: (1) there
      is
      persuasive evidence of an arrangement; (2) the service has been provided to
      the
      customer; (3) the collection of fees is probable; and (4) the amount of fees
      to
      be paid by the customer is fixed or determinable. EITF 00-21 states that revenue
      arrangements with multiple deliverables should be divided into separate units
      of
      accounting if the deliverables in the arrangement meet the following criteria:
      (1) the delivered item has value to the customer on a stand-alone basis; (2)
      there is objective and reliable evidence of the fair value of the undelivered
      item; and (3) if the arrangement includes a general right of return relative
      to
      the delivered item, delivery or performance of the undelivered item is
      considered probable and substantially in control of the vendor. Syndication
      and
      integration agreements typically include multiple deliverables including the
      grant of a non-exclusive license to distribute, use of and access to the
      Company’s platform, fees for the integration of content into the platform,
      maintenance and hosting fees, documentation and training, and technical support
      and customer support fees. The Company cannot establish fair value of the
      individual deliverables based on objective and reliable evidence due to the
      lack
      of a consistent history of standard syndication and integration contractual
      arrangements, the low number of contracts that have continued past the initial
      contractual term, the lack of contracts in which these elements have been sold
      as stand-alone items, and the lack of third-party evidence of fair value for
      products or services that are interchangeable and comparable to the Company’s
      products and services. As such, revenue is not allocated to the individual
      deliverables and must be recorded as a single unit of accounting as further
      described below. Additionally, the Company has evaluated the timing and
      substantive nature of the performance obligations associated with the multiple
      deliverables noted above, including the determination that the remaining
      obligations are essential to the ongoing usability and functionality of the
      delivered products, and determined that revenue should be recognized over the
      life of the contracts, commencing on the date the site goes online.





Subscription
      revenues primarily consist of subscription sales through private label marketing
      partners to end users, sales of subscriptions directly to end users, hosting
      and
      maintenance fees, and e-commerce website design fees. Subscription sales are
      made either on a monthly subscription or a one-time “for fee” basis.
      Subscriptions are payable in advance on a monthly basis. Currently, most
      syndication agreements call for the Company to receive a percentage of revenue
      generated. Depending on the criteria of each individual contract and in
      accordance with EITF 99-19, a determination is made as to whether revenue should
      be recognized gross with a corresponding expense for the portion paid to or
      retained by the partner, or if only the net portion should be recognized as
      revenue. At this time, the Company is still selling certain products and
      services on a “for fee” basis. The Company also recently stopped offering to its
      potential syndication partners volume discounts for pre-paid subscriptions,
      which they could either market or contribute to their small business customers,
      because no volume sales occurred. E-commerce website design fees, which are
      charged for building and maintaining corporate websites or to add the capability
      for e-commerce transactions, are recognized over the life of the project. Domain
      name registration fees are recognized over the term of the registration period.





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





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





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


38


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





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





*Allowance
      for Doubtful Accounts –* The
      need
      for an allowance for doubtful accounts is evaluated based on specifically
      identified amounts that management believes to be uncollectible. Management
      also
      records an additional allowance based on an assessment of the general financial
      conditions affecting the Company’s customer base. If actual collections
      experience changes, revisions to the allowance may be required. Based upon
      these
      criteria, management has recorded an allowance of approximately $65,000 at
      both
      December 31, 2007 and 2006.





*Concentration
      of Credit Risk* -
      Financial instruments which potentially subject the Company to concentrations
      of
      credit risk principally consist of cash and accounts receivable. At times,
      cash
      balances may exceed the Federal Deposit Insurance Corporation (“FDIC”) insurable
      limits of $100,000. See Note 11, Major Customers and Concentration of Credit
      Risk, for further discussion of risk within accounts receivable.





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





*Software
      Development Costs –* Statement of Financial Accounting Standards (“SFAS”) No. 86, *Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise
      Marketed* ,
      requires capitalization of certain software development costs subsequent to
      the
      establishment of technological feasibility. Based on the Company’s product
      development process, technological feasibility is established upon completion
      of
      a working model. Costs related to software development incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant. During 2005, the Company acquired
      certain rights to an accounting software application that has been integrated
      with its OneBiz SM platform, but is still under development. All amounts related to the development
      and modification of this application have been expensed as research and
      development costs.





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





*Impairment
      of Long-Lived Assets -* Long-lived assets and certain identifiable intangibles are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by comparing 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 as 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:


39





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





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





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





*Advertising
      Costs -* All
      advertising costs are expensed as incurred. Advertising expense during 2007
      and
      2006 was $24,144 and $49,000, respectively. The 2006 period included $38,000
      of
      barter advertising expense.





*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 convertible
      notes, stock options, and warrants that are computed using the treasury stock
      method. Shares issuable upon the exercise of stock options and warrants,
      totaling 3,300,215 and 2,360,100 shares on December 31, 2007 and 2006,
      respectively, are excluded from the calculation of common equivalent shares
      as
      the impact was anti-dilutive.





*Stock-Based
      Compensation –* Effective
      January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), *Share-Based
      Payment* (“SFAS
      No. 123R”), using the Modified Prospective Approach. Under the Modified
      Prospective Approach, the amount of compensation cost recognized includes
      (i) compensation cost for all share-based payments granted prior to, but
      not yet vested as of, January 1, 2006, based on the grant date fair value
      estimated in accordance with the provisions of SFAS No. 123, *Accounting for Stock-Based Compensation* ,
      and
      (ii) compensation cost for all share-based payments that are granted
      subsequent to January 1, 2006, based on the grant date fair value estimated
      in accordance with the provisions of SFAS No. 123R. Upon adoption, the
      Company recognized the stock-based compensation of previously granted options
      and new options ****** under
      the
      straight-line method over the requisite service period. Total stock-based
      compensation expense recognized under SFAS No. 123R was approximately
      $548,368 and $780,000 for the years ended December 31, 2007 and 2006,
      respectively. No stock-based compensation was capitalized in the
      consolidated financial statements.





The
      fair
      value of option grants under the Company’s equity compensation plan and other
      stock option issuances during the years ended December 31, 2007 and 2006 were
      estimated using the Black-Scholes option-pricing model with the following
      weighted-average assumptions:





**Year
                Ended**
              **December 31,**
              **2007**
            
            **Year
                Ended**
              **December 31,**
              **2006**Dividend
                yield
            
            
            0.00
            %
            
            0.00
            %Expected
                volatility
            
            
            63.00
            %
            
            150.00
            %Risk
                free interest rate
            
            
            3.45
            %
            
            4.56
            %Expected
                lives (years)
            
            
            4.6
            
            
            4.7





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


40


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





**3.  
      INDUSTRY SEGMENT INFORMATION**





SFAS
      No.
      131, *Disclosures About Segments of an Enterprise and Related
      Information,* establishes standards for the way in which public companies disclose certain
      information about operating segments in their financial reports. Consistent
      with
      SFAS No. 131, the Company has defined two reportable segments, based on factors
      such as geography, how it manages its operations, and how the chief operating
      decision-maker views results. Those segments are the Company’s core operations
      (the “Smart Online segment”) and the operations of its wholly-owned subsidiary
      (the “Smart Commerce segment”).





The
      Smart
      Commerce segment’s revenues are derived primarily from subscriptions to the
      Company’s multi-channel e-commerce systems, including domain name registration
      and e-mail solutions, e-commerce solutions, website design, and website hosting,
      as well as consulting services.





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





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





The
      following table shows the Company’s financial results by reportable segment for
      the year ended December 31, 2007:





Smart Online
            
            Smart
              Commerce
            
            ConsolidatedREVENUES:Integration
                fees
            
            $
            5,995
            
            $
            -
            
            $
            5,995Syndication
                fees
            
            
            60,000
            
            
            -
            
            
            60,000Subscription
                fees
            
            
            52,167
            
            
            2,777,176
            
            
            2,829,343Professional
                service fees
            
            
            -
            
            
            1,436,770
            
            
            1,436,770License
                fees
            
            
            280,000
            
            
            300,000
            
            
            580,000Other
                revenues
            
            
            7,245
            
            
            18,301
            
            
            25,546Total
                revenues
            
            
            405,407
            
            
            4,532,247
            
            
            4,937,654COST
                OF REVENUES
            
            
            174,348
            
            
            337,271
            
            
            511,619OPERATING
                EXPENSES
            
            
            6,386,743
            
            
            3,125,838
            
            
            9,512,581OPERATING
                INCOME (LOSS)
            
            
            (6,155,684
            )
            
            1,069,138
            
            
            (5,086,546
            )OTHER
                INCOME (EXPENSE)
            
            
            (301,625
            )
            
            (118,455
            )
            
            (420,080
            )NET
                INCOME/(LOSS) BEFORE INCOME TAXES
            
            $
            (6,457,309
            )
            $
            950,683
            
            $
            (5,506,626
            )TOTAL
                ASSETS
            
            $
            7,860,312
            
            $
            2,914,511
            
            $
            10,774,823


41


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





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





**4.**  **SUBSCRIPTION
      REVENUE**





Effective
      January 1, 2007, a major customer executed a letter of clarification which
      more
      definitively defined the roles and responsibilities of each party. Individual
      Business Owners (“IBOs”) associated with this customer are provided e-commerce,
      domain name, and email services. In exchange for marketing these services to
      its
      IBOs, the customer is paid a marketing fee. At the inception of the business
      relationship, it was agreed that the customer would collect the gross service
      fee from the IBO; the customer would retain its marketing fee and remit the
      net
      remaining cash. Because the roles and responsibilities of each party were
      vaguely defined in the past, revenue was recorded only on the net cash received.
      Following the execution of the letter of clarification and in accordance with
      EITF 99-19, this revenue is now recorded as the gross amount paid by the IBO
      and
      a sales and marketing expense for the marketing services rendered by the
      customer. Ultimately, the effect on net income is nil; however, subscription
      revenue and sales and marketing expense are effectively and appropriately
      grossed up. Because the new accounting method was triggered by a clarification
      to the existing agreement and not by a change from one accepted accounting
      method to another, the 2006 subscription revenue was not retroactively adjusted
      as would be required by SFAS No. 154, *Accounting
      Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB
      Statement No. 3* .
      For the
      year ended December 31, 2007, this accounting method resulted in approximately
      $864,000 of additional subscription revenue and a corresponding charge to sales
      and marketing expense.


42


**5.     PROPERTY
      AND EQUIPMENT**





Property
      and equipment consists of the following at:





**December 31,**
              **2007**
            
            **December 31,**
              **2006**Office
                equipment
            
            $
            114,384
            
            $
            88,715Furniture
                and fixtures
            
            
            15,386
            
            
            7,125Computer
                software
            
            
            583,724
            
            
            552,585Computer
                hardware and equipment
            
            
            822,341
            
            
            803,225Automobiles
            
            
            29,504
            
            
            29,5041,565,339
            
            
            1,481,154Less
                accumulated depreciation
            
            
            (1,390,720
            )
            
            (1,300,794
            )Property
                and equipment, net
            
            $
            174,619
            
            $
            180,360





Depreciation
      expense for the years ended December 31, 2007 and 2006 was $104,169 and $79,313,
      respectively.





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





Intangible
      assets primarily consist of intangibles acquired during the Computility and
      iMart acquisitions in October 2005 (See Note 14, Dispositions, for details
      on
      intangible assets sold during 2006). In addition to these assets acquired,
      the
      Company has copyrights and trademarks related to products, names, and logos
      used
      throughout the product lines. The assets acquired through the acquisitions
      include customer bases, technology, non-compete agreements, trade names,
      workforces in place, and goodwill. Trade names, work forces in place, and
      goodwill are not subject to amortization, and for the purpose of presentation,
      work forces in place are combined with goodwill.





**Asset
                Category**
            
            **Value Assigned**
            
            **Residual**
              **Value**
            
            **Weighted**
              **Avg Useful**
              **Life
                in**
              **Years**
            
            **Accumulated**
              **Amortization**
            
            **Carrying**
              **Value**Customer
                Base
            
            $
            1,944,347
            
            $
            0
            
            
            5.9
            
            $
            741,130
            
            $
            1,203,217Technology
            
            
            501,264
            
            
            0
            
            
            3
            
            
            368,986
            
            
            132,278Non-Compete
            
            
            891,785
            
            
            0
            
            
            3.9
            
            
            510,152
            
            
            381,633Copyright
                & Trademark
            
            
            52,372
            
            
            0
            
            
            10
            
            
            42,945
            
            
            9,427Trade
                Name *
            
            
            1,155,500
            
            
            n/a
            
            
            n/a
            
            
            n/a
            
            
            1,155,500Work
                Force &
              Goodwill
                *
            
            
            2,696,642
            
            
            n/a
            
            
            n/a
            
            
            n/a
            
            
            2,696,642**TOTALS**
            
            **$**
            **7,241,910**
            
            $
            **0**
            
            
            
            
            **$**
            **1,663,213**
            
            **$**
            **5,578,697**





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





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





For
      the
      years ended December 31, 2007 and 2006, the aggregate amortization expense
      on
      the above intangibles was approximately $737,458 and $702,886, respectively.
      The
      estimated aggregate amortization expense for the years ended December 31, 2008
      through 2012 will be approximately $696,308, $470,127, $200,639, $200,639,
      and
      $158,839 for each respective year. All intangible assets are amortized using
      the
      straight-line method over their estimated useful lives.


43


**7.    NOTES
      PAYABLE**





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





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





On
      January 24, 2007, the Company entered into an amendment to its line of credit
      with Wachovia. The amendment resulted in an increase in the line of credit
      from
      $1.3 million to $2.5 million. The pay-off date for the line of credit was also
      extended from August 1, 2007 to August 1, 2008. The line of credit is secured
      by
      the Company’s deposit account at Wachovia and an irrevocable standby letter of
      credit in the amount of $2,500,000 issued by HSBC Private Bank (Suisse) S.A.
      with Atlas as account party. As of December 31, 2007, the Company had drawn
      down
      approximately $2.1 million on the line of credit.





On
      November 14, 2007, in an initial closing, the Company sold $3.3 million
      aggregate principal amount of secured subordinated convertible notes due
      November 14, 2010. In addition, the noteholders have committed to purchase
      on a
      pro rata basis up to $5.2 million aggregate principal of secured subordinated
      notes upon approval and call by the Company’s Board of Directors in future
      closings. The Company is obligated to pay interest on the notes at an annualized
      rate of 8% payable in quarterly installments commencing on February 14, 2008.
      The Company does not have the ability to prepay the notes without approval
      of at
      least a majority of the principal amount of the notes then outstanding.





On
      the
      earlier of the maturity date of November 14, 2010 or a merger, acquisition,
      sale
      of all or substantially all of the Company’s assets or capital stock or similar
      transaction, each noteholder in its sole discretion shall have the option
      to:





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





·
            demand
                immediate repayment in cash of the note, including any accrued and
                unpaid
                interest.




If
      a
      noteholder elects to convert its note under these circumstances, the conversion
      price for notes:




·
            issued
                in the initial closing on November 14, 2007 shall be $3.05;
                and




44




·
            issued
                in any additional closings shall be the lesser of a 20% premium above
                the
                average of the closing bid and asked prices of shares of the Company’s
                common stock quoted in the Over-The-Counter Market Summary (or, if
                the
                Company’s shares are traded on the Nasdaq Stock Market or another
                exchange, the closing price of shares of the Company’s common stock quoted
                on such exchange) averaged over five trading days prior to the respective
                additional closing date.





Payment
      of the notes will be automatically accelerated if the Company enters voluntary
      or involuntary bankruptcy or insolvency proceedings.





The
      notes
      and the common stock into which they may be converted have not been registered
      under the Securities Act of 1933, as amended (the “Securities Act”), or the
      securities laws of any other jurisdiction. As a result, offers and sales of
      the
      notes were made pursuant to Regulation D of the Securities Act and only made
      to
      accredited investors that were the Company’s existing stockholders. The
      investors include (i) The Blueline Fund (“Blueline”), which originally
      recommended Philippe Pouponnot, one of the Company’s directors, for appointment
      to the Company’s Board of Directors, (ii) Atlas, which originally recommended
      Shlomo Elia, another one of the Company’s directors, for appointment to the
      Board of Directors, and (iii) Crystal Management Ltd., which is owned by Doron
      Roethler, who subsequently became Chairman of the Company’s Board of Directors,
      and (iv) William Furr, who is the father of Thomas Furr, one of the Company’s
      directors and executive officers.





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





On
      November 6, 2007, Canaccord Adams Inc. agreed to waive any rights it held under
      its January 2007 engagement letter with the Company that it may have with
      respect to the convertible note offering, including the right to receive any
      fees in connection with the offering.





As
      of
      December 31, 2007, the Company had notes payable totaling $5,601,585. The detail
      of these notes is as follows:





**Note
                Description**
            
            **S/T
                Portion**
            
            **L/T
                Portion**
            
            **Total**
            
            **Maturity**
            
            **Rate**Acquisition
                Fee - iMart
            
            $
            209,177
            
            $
            -
            
            $
            209,177
            
            
            Oct
                2007
            
            
            8.0
            %Acquisition
                Fee - Computility
            
            
            19,182
            
            
            -
            
            
            19,182
            
            
            Mar
                2007
            
            
            8.0
            %Wachovia
                Credit Line
            
            
            2,052,000
            
            
            -
            
            
            2,052,000
            
            
            Aug
                2008
            
            
            Libor
                + 0.9
            %Convertible
                Notes
            
            
            -
            
            
            3,300,000
            
            
            3,300,000
            
            
            Nov
                2010
            
            
            8.0
            %Other
            
            
            7,321
            
            
            13,905
            
            
            21,226**TOTALS**
            
            **$**
            **2,287,680**
            
            **$**
            **3,313,905**
            
            **$**
            **5,601,585**





As
      of
      December 31, 2007, the prime rate was 7.25% and LIBOR was 4.75%.





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




2008:
            
            $
            2,287,6802009:
            
            
            13,9052010:
            
            
            3,300,000TOTAL:
            
            $
            5,601,585





**8.    LEASES**




The
      Company leases two facilities, one in Michigan and one in North Carolina, under
      renewable operating lease agreements with current terms expiring in March 2008
      and October 2008, respectively. As of December 31, 2007, future annual minimum
      operating lease payments for 2008 are $203,361.


45


Rent
      expense for the years ended December 31, 2007 and 2006 was $275,683 and
      $258,623, respectively.





**9.    STOCKHOLDERS’
      DEFICIT**





*Common
      Stock*





The
      Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
      value per share. As of December 31, 2007, it had 18,159,768 shares of common
      stock outstanding. Holders of common stock are entitled to one vote for each
      share held.





On
      March
      30, 2006, the Company sold 400,000 shares of its common stock to Atlas, an
      existing stockholder, for a price of $2.50 per share resulting in gross proceeds
      of $1,000,000. The Company incurred immaterial issuance costs related to this
      stock sale. As part of this sale, Atlas received contractual rights to purchase
      shares at a lower price should the Company enter into a private placement
      agreement in the future in which the Company sells shares of common stock for
      less than $2.50 per share.





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





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





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





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





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





In
      a
      transaction that closed on February 21, 2007, the Company sold an aggregate
      of
      2,352,941 shares of its common stock to two new investors (the “Investors”). The
      private placement shares were sold at $2.55 per share pursuant to a Securities
      Purchase Agreement (the “SPA”) between the Company and each of the Investors.
      The aggregate gross proceeds were $6 million and the Company incurred issuance
      costs of approximately $585,000.


46


The
      Company and each of the Investors also entered into a Registration Rights
      Agreement (the “Investor RRA”) whereby the Company had an obligation to register
      the shares for resale by the Investors by filing a registration statement within
      30 days of the closing of the private placement, and to have the registration
      statement declared effective 60 days after actual filing, or 90 days after
      actual filing if the SEC reviewed the registration statement. If a registration
      statement was not timely filed or declared effective by the date set forth
      in
      the Investor RRA, the Company would have been obligated to pay a cash penalty
      of
      1% of the purchase price on the day after the filing or declaration of
      effectiveness was due, and 0.5% of the purchase price per every 30-day period
      thereafter, to be prorated for partial periods, until the Company fulfilled
      these obligations. Under no circumstances could the aggregate penalty for late
      registration or effectiveness exceed 10% of the aggregate purchase price. Under
      the terms of the Investor RRA, the Company could not offer for sale or sell
      any
      securities until May 22, 2007, subject to certain limited exceptions, unless,
      in
      the opinion of the Company’s counsel, such offer or sale did not jeopardize the
      availability of exemptions from the registration and qualification requirements
      under applicable securities laws with respect to this placement. On March 28,
      2007, the Company entered into an amendment to the Investor RRA with each
      Investor to extend the registration filing obligation date by an additional
      11
      calendar days. On April 3, 2007, the Company filed the Registration Statement
      on
      Form S-1 (File No. 333-141853) (the “Registration Statement”) within the
      extended filing obligation period, thereby avoiding the first potential penalty.
      Effective July 2, 2007, the Company entered into another amendment to the
      Investor RRA to extend the registration effectiveness obligation date to July
      31, 2007. On July 31, 2007, the SEC declared the Registration Statement
      effective. Accordingly, the Company met all of its requirements under the
      amended Investor RRA and no penalties were incurred.





On
      March
      29, 2007, the Company issued 55,666 shares of its common stock to certain
      investors as registration penalties for its failure to timely file a
      registration statement covering shares owned by those investors as required
      pursuant to amendments to registration rights agreements between such investors
      and the Company. On July 20, 2007, the Company issued 27,427 additional shares
      as registration penalties to certain investors who did not enter into amendments
      to certain registration rights agreements.





*Preferred
      Stock*





The
      Board
      of Directors is authorized, without further stockholder approval, to issue
      up to
      5,000,000 shares of $0.001 par value preferred stock in one or more series
      and
      to fix the rights, preferences, privileges, and restrictions applicable to
      such
      shares, including dividend rights, conversion rights, terms of redemption,
      and
      liquidation preferences, and to fix the number of shares constituting any series
      and the designations of such series. There were no shares of preferred stock
      outstanding at December 31, 2007.





*Warrants*





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





As
      incentive to modify a letter of credit relating to the Wachovia line of credit
      (see Note 7, Notes Payable), the Company entered into a Stock Purchase Warrant
      and Agreement (the “Warrant Agreement”) with Atlas on January 15, 2007. Under
      the terms of the Warrant Agreement, Atlas received a warrant to purchase up
      to
      444,444 shares of the Company’s common stock at $2.70 per share at the
      termination of the line of credit or if the Company is in default under the
      terms of the line of credit with Wachovia. The fair value of such warrant was
      $734,303 as measured using the Black-Scholes option-pricing model at the time
      the warrant was issued. Such amount was recorded as deferred financing costs
      and
      is being amortized to interest expense in the amount of $37,657 per month over
      the remaining period of the modified line of credit, which is scheduled to
      expire in August 2008. As of December 31, 2007, the deferred financing costs
      that will be amortized to interest expense over the remaining eight months,
      or
      $301,249, were classified as current assets. If the warrant is exercised in
      full, it will result in gross proceeds to the Company of approximately
      $1,200,000.





Under
      the
      SPA, the Investors were issued warrants for the purchase of an aggregate of
      1,176,471 shares of common stock at an exercise price of $3.00 per share. These
      warrants contain a provision for cashless exercise and must be exercised by
      February 21, 2010.


47


As
      part
      of the commission paid to Canaccord Adams, Inc. (“CA”), the Company’s placement
      agent in the transaction that closed in February 2007, CA was issued a warrant
      to purchase 35,000 shares of the Company’s common stock at an exercise price of
      $2.55 per share. This warrant contains a provision for cashless exercise and
      must be exercised by February 21, 2012. CA and the Company also entered into
      a
      Registration Rights Agreement (the “CA RRA”). Under the CA RRA, the shares
      issuable upon exercise of the warrant must be included on the same registration
      statement the Company was obligated to file under the Investor RRA described
      above, but CA was not entitled to any penalties for late registration or
      effectiveness.





All
      of
      the foregoing warrants contain cashless exercise provisions, and as of December
      31, 2007, warrants to purchase up to 1,655,915 shares were
      outstanding.





*Stock
      Option Plans*





*2004
      Equity Compensation Plan*





The
      Company adopted its 2004 Equity Compensation Plan (the “2004 Plan”) as of March
      31, 2004. The 2004 Plan provides for the grant of incentive stock options,
      nonstatutory stock options, restricted stock, and other direct stock awards
      to
      employees (including officers) and directors of the Company as well as to
      certain consultants and advisors. In June 2007, the Company limited the issuance
      of shares of its common stock reserved under the 2004 Plan to awards of
      restricted or unrestricted stock. The total number of shares of common stock
      reserved for issuance under the 2004 plan is 5,000,000 shares, subject to
      adjustment in the event of a stock split, stock dividend, recapitalization,
      or
      similar capital change.





In
      the
      first quarter of 2006, the Company granted options to purchase an aggregate
      of
      251,500 shares of common stock to 16 employees, two of whom were officers.
      The
      non-officer employees were granted options to purchase an aggregate of 151,500
      shares of common stock at an exercise price of $9.00. One officer received
      an
      option to purchase 50,000 shares of common stock at an exercise price of $9.00.
      The other officer received an option to purchase 50,000 shares of common stock
      at an exercise price of $2.50. The exercise price of all options granted was
      equal to the fair market value of the stock on the date of the
      grant.





In
      2007,
      the Company granted options to purchase 20,000 shares of common stock to an
      independent member of the Board of Directors. These options have an exercise
      price of $2.80 per share.





At
      December 31, 2007, options to purchase 818,700 shares of common stock were
      outstanding under the 2004 Plan with a weighted-average exercise price of $6.18
      per share.





During
      2007, a total of 274,500 shares of restricted stock were issued. An aggregate
      of
      70,000 shares of restricted stock were issued to the Company’s independent
      directors in accordance with the Company’s board compensation policy. The
      restrictions on such shares lapse with respect to the number of shares equal
      to
      25% of the restricted stock issued over the subsequent four quarters provided
      that the director remains on the Board of Directors at the time each quarter
      commences. A total of 25,000 shares of restricted stock were issued to the
      newly
      appointed Chief Operating Officer, with the restrictions on such shares lapsing
      with respect to the number of shares equal to 12.5% of the restricted stock
      issued over the subsequent eight quarters, provided that at the time each
      quarter commences, the officer is still employed as an officer of the Company.
      A
      total of 79,500 shares of restricted stock were issued to various employees,
      one
      of whom is an officer. Restrictions lapse as to one-third of these shares upon
      grant, with restrictions lapsing on the remaining shares over the next two
      years
      provided the respective employee remains employed by the Company. Finally,
      100,000 shares of restricted stock were awarded to the Company’s newly appointed
      President and Chief Executive Officer, with restrictions on such shares lapsing
      according to the following schedule: 25,000 shares on January 1, 2008; 37,500
      shares on January 1, 2010; 18,750 shares on January 1, 2011; and 18,750 shares
      on January 1, 2012.





*2001
      Equity Compensation Plan*





The
      Company adopted the 2001 Equity Compensation Plan (the “2001 Plan”) as of May
      31, 2001. The 2001 Plan provides for the grant of incentive stock options,
      nonstatutory stock options, restricted stock, and other direct stock awards
      to
      employees (including officers) and directors of the Company as well as to
      certain consultants and advisors. The total number of shares of common stock
      reserved for issuance under the 2001 Plan is 795,000 shares, subject to
      adjustment in the event of a stock split, stock dividend, recapitalization,
      or
      similar change. As of April 15, 2004, the Company cannot make any further grants
      under the 2001 Plan.


48


In
      April
      2007, a 2001 Plan option holder exercised an option to purchase 20,000 shares.
      The option had an exercise price of $1.30 per share, resulting in proceeds
      to
      the Company of $26,000.





In
      December 2007, a 2001 Plan option holder completed a cashless exercise of her
      option. The option holder surrendered 39,796 shares as payment in the exercise
      of an option to purchase 75,000 shares of the Company’s common
      stock.





At
      December 31, 2007, options to purchase 575,000 shares of common stock were
      outstanding under the 2001 Plan.





*1998
      Stock Option Plan*





The
      Company adopted the 1998 Stock Option Plan (the “1998 Plan”) as of November 12,
      1998. The 1998 Plan provides for the grant of incentive stock options and
      nonstatutory stock options. As of December 31, 2007, the total number of shares
      of common stock reserved for issuance under the 1998 Plan is 288,900 shares,
      subject to adjustment in the event of a stock split, stock dividend,
      recapitalization, or similar change. Options to purchase 600 shares were
      outstanding under the 1998 Plan at December 31, 2007. As of April 15, 2004,
      the
      Company may not make any further grants under the 1998 plan.





*Additional
      Options Granted*





At
      December 31, 2007, 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 ten years, except for option
      grants to 10% stockholders, which are subject to a maximum term of five 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,
      2006 and 2007, and changes during the periods ended on these dates is as
      follows:








**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                December 31, 2005
            
            
            2,727,950
            
            $
            5.34Granted
            
            
            256,500
            
            
            7.61Forfeited
            
            
            (624,350
            )
            
            7.13BALANCE,
                December 31, 2006
            
            
            2,360,100
            
            
            5.33Granted
            
            
            20,000
            
            
            2.80Forfeited
            
            
            (640,800
            )
            
            5.98Exercised
            
            
            (95,000
            )
            
            1.30BALANCE,
                December 31, 2007
            
            
            1,644,300
            
            $
            5.07





The
      following table summarizes information about stock options outstanding at
      December 31, 2007:


49





**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
            
            
            575,000
            
            
            1.0
            
            $
            1.41
            
            
            575,000
            
            $
            1.41$
                2.50 - $ 3.50
            
            
            317,500
            
            
            6.8
            
            $
            3.28
            
            
            254,291
            
            $
            3.39$
                5.00
            
            
            31,600
            
            
            7.0
            
            $
            5.00
            
            
            16,600
            
            $
            5.00$
                7.00
            
            
            150,000
            
            
            7.8
            
            $
            7.00
            
            
            150,000
            
            $
            7.00$
                8.61 - $ 9.00
            
            
            310,000
            
            
            7.7
            
            $
            8.74
            
            
            108,700
            
            $
            8.71$
                9.60 to $ 9.82
            
            
            260,200
            
            
            0.5
            
            $
            9.82
            
            
            260,080
            
            $
            9.82





At
      December 31, 2007, there remains $844,733 of unvested expense yet to be recorded
      related to all options outstanding. The following table sets forth the weighted
      average exercise price and fair value of options granted during the year ended
      December 31, 2007:





**Shares**
            
            **Weighted Average
                Exercise Price**
            
            **Weighted Average**
              **Fair
                Value**Exercise
                price exceeds market price
            
            
            -
            
            
            -
            
            
            -Exercise
                price equals market price
            
            
            20,000
            
            $
            2.80
            
            $
            1.56Exercise
                price is less than market price
            
            
            -
            
            
            -
            
            
            -





The
      number of options exercisable at December 31, 2007 and 2006 were 1,364,671
      and
      1,340,080, respectively. The weighted average exercise price of exercisable
      options was $4.62 at December 31, 2007.





*Dividends* - The
      Company has not paid any cash dividends through December 31, 2007.





**10.    INCOME
      TAXES**





The
      Company accounts for income taxes under the asset and liability method in
      accordance with the requirements of SFAS No. 109, *Accounting
      for Income Taxes* .
      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,**
              **2007**
            
            **December
                31, 2006**Net
                current deferred income taxassets
                relate to:Depreciation
            
            $
            295,000
            
            $
            159,000Stock-based
                expenses
            
            
            226,000
            
            
            226,000Net
                operating loss carryforwards
            
            
            15,936,000
            
            
            14,275,000Total
            
            
            16,457,000
            
            
            14,660,000Less
                valuation allowance
            
            
            16,457,000
            
            
            14,660,000Net
                current deferred income tax
            
            $
            -
            
            $
            -


50


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





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





**Year
                Ended**
              **December 31,**
              **2007**
            
            **Year
                Ended**
              **December 31,**
              **2006**Statutory
                federal tax rate
            
            
            34
            %
            
            34
            %Tax
                benefit computed at statutory rate
            
            $
            (1,872,000
            )
            $
            (1,708,000
            )State
                income tax benefit, net of federal effect
            
            
            (251,000
            )
            
            (229,000
            )Change
                in valuation allowance
            
            
            1,661,000
            
            
            1,317,000Permanent
              differences:SFAS
                No. 123R permanent difference
            
            
            211,000
            
            
            265,000Investor
                relations shares permanent difference
            
            
            -
            
            
            (1,205,000
            )Book
                loss in excess of tax on disposal of assets
            
            
            -
            
            
            1,425,000Other
                permanent differences
            
            
            17,000
            
            
            (18,000
            )Temporary
              differences:Depreciation/amortization
            
            
            126,000
            
            
            153,000Litigation
                accrual
            
            
            108,000
            
            
            -Total
            
            $
            -
            
            $
            -





As
      of
      December 31, 2007, the Company had U.S. federal net operating loss (“NOL”)
      carryforwards of approximately $43.4 million, which expires between 2009 and
      2021. For state tax purposes, the NOL expires between 2009 and 2021. In
      accordance with Section 382 of the Internal Revenue Code of 1986, as amended,
      a
      change in equity ownership of greater than 50% of the Company within a
      three-year period can result in an annual limitation on the Company’s ability to
      utilize its NOL carryforwards that were created during tax periods prior to
      the
      change in ownership.





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





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





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


Year Ended
                  December 31, 2007Revenues
              
              %
                  of Total
                RevenuesCustomer
                  A
              
              
              Professional
                  Services
              
              $
              1,070,695
              
              
              21.7
              %Customer
                  B
              
              
              Subscription
              
              
              1,205,094
              
              
              24.4
              %Customer
                  C
              
              
              Subscription
              
              
              562,578
              
              
              11.4
              %Others
              
              
              Various
              
              
              2,099,287
              
              
              42.5
              %Total
              
              
              
              
              $
              4,937,654
              
              
              100.0
              %


51


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





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


As
      of
      December 31, 2006, three customers accounted for 47%, 26%, and 21% of accounts
      receivable, respectively.





**12.    EMPLOYEE
      BENEFIT PLANS**





All
      full-time employees who meet certain age and length of service requirements
      are
      eligible to participate in the Company’s 401(k) Plan. The plan provides for
      contributions by the Company in such amounts as the Board of Directors may
      annually determine, as well as a 401(k) option under which eligible participants
      may defer a portion of their salary. The Company contributed a total of $30,098
      to the plan during 2007 and did not make any contributions to the plan during
      2006 and 2005.





**13.    COMMITMENTS
      & CONTINGENCIES**





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





In
      August
      2005, the Company entered into a software assignment and development agreement
      with the developer of a customized accounting software application.  In
      connection with this agreement, the developer would be paid up to $512,500
      and
      issued up to 32,395 shares of the Company common stock based upon the developer
      attaining certain milestones.  As of December 31, 2007, the Company had
      paid $387,500 and issued 3,473 shares of common stock related to this
      obligation.





On
      January 17, 2006, the SEC temporarily suspended the trading of the Company’s
      securities. In its “Order of Suspension of Trading,” the SEC stated that the
      reason for the suspension was a lack of current and accurate information
      concerning the Company’s securities because of possible manipulative conduct
      occurring in the market for its stock. By its terms, that suspension ended
      on
      January 30, 2006 at 11:59 p.m. EST. As a result of the SEC’s suspension, NASDAQ
      withdrew its acceptance of the Company’s application to have its common stock
      traded on the NASDAQ Capital Market, and the Company’s securities did not
      automatically return to quotation on the OTC Bulletin Board (“OTCBB”). After the
      filing of the required paperwork by a market maker, the Company’s common stock
      returned to quotation on the OTCBB on September 11, 2006. Simultaneously with
      the suspension, the SEC advised the Company that it was ****** conducting
      a non-public investigation.





On
      September 11, 2007, the Company was informed that Dennis Michael Nouri, its
      then
      serving President, Chief Executive Officer, and a director, had been charged
      in
      a criminal complaint that alleges federal securities fraud and conspiracy to
      commit fraud. The Company was not named in the criminal complaint. The U.S.
      government filed the complaint under seal on August 1, 2007 in the U.S. District
      Court for the Southern District of New York. Also named as defendants in the
      criminal complaint were Reeza Eric Nouri, a former manager of the Company, and
      Ruben Serrano, Anthony Martin, James Doolan, and Alain Lustig, brokers alleged
      to have participated with the Nouris in the alleged fraud. The criminal
      complaint alleges that the defendants, directly and indirectly, used
      manipulative and deceptive devices in violation of Sections 2 and 371 of Title
      18 of the U.S. Code, Sections 10(b) and 32 of the Securities Exchange Act of
      1934, as amended (the “Exchange Act”), and Rule 10b-5 promulgated under the
      Exchange Act (“Rule 10b-5”). On November 8, 2007, as part of this ongoing
      action, the U.S. government filed a grand jury indictment against Dennis Michael
      Nouri, Reeza Nouri, Ruben Serrano, and Alain Lustig in the U.S. District Court
      for the Southern District of New York. The grand jury indictment charges these
      defendants with conspiracy to commit securities fraud in violation of Sections
      78j(b) and 78 ff of Title 17 of the U.S. Code and Rule 10b-5, wire fraud in
      violation of Sections 1343 and 1346 of Title 18 of the U.S. Code, and commercial
      bribery in violation of Section 1952(a)(3) of Title 18 of the U.S. Code and
      Sections 180.00 and 180.03 of the New York State Penal Law. Under the grand
      jury
      indictment, the U.S. government is seeking forfeiture from these defendants
      of
      all property, real and personal, that constitutes or is derived from proceeds
      traceable to the commission of the alleged securities fraud offenses.


52


On
      September 11, 2007, the SEC filed a civil action against the Company and the
      defendants named in the criminal complaint in the U.S. District Court for the
      Southern District of New York. The SEC complaint alleged that the defendants
      in
      this civil action, either directly or indirectly, have engaged in transactions,
      acts, practices, and courses of business which constitute violations of Section
      17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5.
      The SEC complaint sought to permanently enjoin each of the civil defendants
      from
      committing future violations of the foregoing federal securities laws. The
      SEC
      complaint also requested that each of the defendants, excluding the Company,
      be
      required to disgorge any ill-gotten gains and pay civil penalties. The SEC
      complaint further sought an order permanently barring Michael Nouri from serving
      as an officer or director of a public company. The SEC complaint did not seek
      any fines or other monetary penalties against the Company. On September 28,
      2007, the Company agreed, without admission of any liability, to the entry
      of a
      consent judgment against it which permanently enjoins the Company from
      violations of the antifraud provisions of the federal securities laws,
      specifically Section 17(a) of the Securities Act, Section 10(b) of the Exchange
      Act, and Rule 10b-5. No fines or other monetary sanctions were levied against
      the Company. The consent judgment settles the SEC complaint against the Company
      and was entered by the court on October 2, 2007.





On
      October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in
      the
      United States District Court for the Middle District of North Carolina naming
      the Company, certain of its current and former officers and directors, Maxim
      Group, LLC, and Jesup & Lamont Securities Corp. as defendants. The lawsuit
      was filed on behalf of all persons other than the defendants who purchased
      the
      Company’s securities from May 2, 2005 through September 28, 2007 and were
      damaged. The complaint asserts violations of federal securities laws, including
      violations of Section 10(b) of the Exchange Act and Rule 10b-5. The
      complaint is based on the matters alleged in the SEC complaint described above
      and asserts that the defendants participated in a fraudulent scheme to
      manipulate trading in the Company’s stock, allegedly causing plaintiffs to
      purchase the stock at an inflated price. The complaint requests certification
      of
      the plaintiff as class representative and seeks, among other relief, unspecified
      compensatory damages, including interest, plus reasonable costs and expenses,
      including counsel fees and expert fees.





On
      October 17, 2007, Henry Nouri, the Company’s former Executive Vice President,
      filed a civil action against the Company in the General Court of Justice,
      Superior Court Division, in Orange County, North Carolina. The complaint alleged
      that the Company had no “cause” to terminate Mr. Nouri’s employment and that it
      breached Mr. Nouri’s employment agreement by notifying him that his employment
      was terminated for cause, by failing to itemize the cause for the termination,
      and by failing to pay him benefits to which he would have been entitled had
      his
      employment been terminated without “cause.” The complaint sought unspecified
      compensatory damages, including interest, a declaratory judgment that no cause
      existed for the termination of Mr. Nouri’s employment and that Mr. Nouri is
      entitled to the benefits provided under his employment agreement for a
      termination without “cause,” and costs and expenses. On December 17, 2007, Mr.
      Nouri served his First Amended Complaint in which he, among other things, added
      an allegation that he was entitled to additional relief because of an alleged
      “beneficial change of ownership” in the Company. On January 23, 2008, the
      parties settled this dispute, and on January 24, 2008, the lawsuit was dismissed
      with prejudice.





At
      this
      time, the Company is not able to determine the likely outcome of the legal
      matters described above, nor can it estimate its potential financial exposure.
      Management has made an initial estimate based upon its knowledge, experience
      and
      input from legal counsel, and the Company has accrued approximately $300,000
      of
      additional legal reserves. Such reserves will be adjusted in future periods
      as
      more information becomes available. If an unfavorable resolution of any of
      these
      matters occurs, the Company’s business, results of operations, and financial
      condition could be materially adversely affected.





**14.    DISPOSITIONS**





On
      October 4, 2005, the Company purchased substantially all of the assets of
      Computility, Inc. Upon our successful integration of the acquired SFA/CRM
      application into the Company’s OneBiz SM platform, management deemed the remaining operations of Smart CRM, specifically
      consulting and network management, to be non-strategic to ongoing operations.
      On
      September 29, 2006, the Company, Smart CRM, and Alliance Technologies, Inc.
      (“Alliance”) executed and delivered an Asset Purchase Agreement pursuant to
      which Alliance acquired substantially all of the assets of Smart CRM. In
      accordance with SFAS No. 144, *Accounting for the Impairment and Disposal of Long-Lived Assets* ,
      the
      Company has reported the operating results for Smart CRM as discontinued
      operations and the assets and liabilities ultimately sold or disposed as
      available for sale.


53


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





In
      consideration for the transfer of these assets, Alliance paid the Company
      $600,000 in cash and assumed approximately $1.7 million in total liabilities
      related to Smart CRM, including all liabilities associated with the factoring
      activity of Smart CRM, for total consideration of approximately $2.3 million.
      In
      exchange, Alliance received assets valued at approximately $1.7 million,
      resulting in a gain on sale of $653,267. The goodwill associated with the
      disposed assets has been written down to zero resulting in an additional
      non-cash charge to other income (expense) in the amount of $2.8 million. The
      combined effect is a net loss on the sale of substantially all of the assets
      of
      Smart CRM totaling $2.1 million.





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





Carrying
              Value
                at
              September 29, 2006**ASSETS**Accounts
                Receivable, net
            
            $
            82,290Fixed
                Assets, net
            
            
            400,624Identifiable
                Intangibles, net
            
            
            972,566Deferred
                Financing Costs
            
            
            224,443TOTAL
                ASSETS SOLD
            
            
            1,679,923**LIABILITIES**Notes
                & Factor Debt Payable
            
            
            1,610,478Customer
                Prepaid Services
            
            
            122,712TOTAL
                LIABILITIES ASSUMED BY BUYER
            
            
            1,733,190CASH
                PAID BY BUYER
            
            
            600,000TOTAL
                CONSIDERATION
            
            
            2,333,190Gain
                on Sale of Assets and Liabilities before Goodwill
                Write-down
            
            
            653,267Write-down
                of Goodwill Related to Assets Sold
            
            
            (2,793,321
            )Net
                Loss on Sale of Assets
            
            $
            (2,140,054
            )





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





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





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


54


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





The
      following pro forma results of operations show the results of operations had
      the
      disposition of Smart CRM been completed at the beginning of the year ended
      December 31, 2006:





**Smart**
              **Commerce**
            
            **Smart**
              **Online**
            
            **Pro Forma**
              **Unaudited**Revenue
            
            $
            3,131,752
            
            $
            513,138
            
            $
            3,644,556Net
                Income (Loss)
            
            
            1,012,255
            
            
            (3,510,399
            )
            
            (2,498,144
            )Net
                Income (Loss)
              Attributable
                to Common Stockholders
            
            
            1,012,255
            
            
            (3,510,399
            )
            
            (2,498,144
            )Earnings
                Per Share
            
            
            
            
            
            
            
            $
            (0.17
            )





The
      2006
      pro forma results exclude the losses from discontinued operations related to
      Smart CRM of $2,525,563.





**15.    SUBSEQUENT
      EVENTS**





On
      January 23, 2008, the Company settled its legal dispute with Henry Nouri, the
      Company’s former Executive Vice President, as described in detail in Note 13,
      Commitments & Contingencies.




On
      February 15, 2008, the Company repaid the full outstanding principal balance
      of
      $2,052,000 and accrued interest of $2,890 outstanding under its revolving credit
      arrangement with Wachovia.




On
      February 20, 2008, the Company entered into a revolving credit arrangement
      with
      Paragon Commercial Bank (“Paragon”). The line of credit advanced by Paragon is
      $2.47 million and can be used for general working capital. Any advances made
      on
      the line of credit must be paid off no later than February 19, 2009, with
      monthly payments being applied first to accrued interest and then to principal.
      The interest shall accrue on the unpaid principal balance at the Wall Street
      Journal’s published prime rate minus one half percent. The line of credit is
      secured by an irrevocable standby letter of credit in the amount of $2.47
      million issued by HSBC with Atlas, a current stockholder of the Company, as
      account party. The Company also has agreed with Atlas that in the event of
      a
      default by the Company in the repayment of the line of credit that results
      in
      the letter of credit being drawn, the Company shall reimburse Atlas any sums
      that Atlas is required to pay under such letter of credit. At the sole
      discretion of the Company, these payments may be made in cash or by issuing
      shares of the Company’s common stock at a set per share price of $2.50.




In
      consideration for Atlas providing the Paragon letter of credit, the Company
      has
      agreed to amend the Warrant Agreement with Atlas to provide that the warrant
      is
      exercisable within 30 business days of the termination of the Paragon line
      of
      credit or if the Company is in default under the terms of the line of credit
      with Paragon.





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





No  t
      applicable.





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





Not
      applicable.


55


**ITEM
              9A(T).**
            **CONTROLS
                AND PROCEDURES**





**Evaluation
      of Disclosure Controls and Procedures**





We
      maintain disclosure controls and procedures (as defined in Rules 13a-15(e)
      and
      15d-15(e) under the Exchange Act) that are designed to provide reasonable
      assurances that information required to be disclosed by us in the reports that
      we file or submit under the Exchange Act is recorded, processed, summarized
      and
      reported, within the time periods specified in the SEC’s rules and forms, and
      that such information is accumulated and communicated to management, including
      our Chief Executive Officer and Chief Financial Officer, as appropriate, to
      allow timely decisions regarding required disclosure. In designing and
      evaluating the disclosure controls and procedures, management recognized that
      disclosure controls and procedures, no matter how well designed and operated,
      can provide only reasonable assurances of achieving the desired control
      objectives, as ours are designed to do, and management necessarily was required
      to apply its judgment in evaluating the cost-benefit relationship of possible
      controls and procedures.





Our
      management, with the participation of our Chief Executive Officer and Chief
      Financial Officer, has evaluated the effectiveness of our disclosure controls
      and procedures as of the end of the period covered by this Annual Report on
      Form
      10-K. Based on such evaluation, and as discussed in greater detail below, our
      Chief Executive Officer and Chief Financial Officer concluded that, as of the
      end of the period covered by this Annual Report on Form 10-K, our disclosure
      controls and procedures were not effective to insure that information required
      to be disclosed by us in the reports we file under the Exchange Act is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms.





**Changes
      in Internal Control Over Financial Reporting**





During
      the fourth quarter of 2007, a number of internal controls were implemented
      in
      conjunction with our compliance with Section 404 of Sarbanes-Oxley.
      Individually, none of these controls might be considered to have a material
      affect on our internal control over financial reporting; however, collectively,
      we believe it is reasonably likely that these controls will materially improve
      our internal control over financial reporting. The processes to which these
      internal controls apply include, but are not limited to, Equity, General Ledger,
      Procurement, Treasury and Cash Management, and Revenue. The controls primarily
      create additional means of review, approval, and documentation for many
      processes that were previously controlled by a single individual, which is
      an
      inherent risk for small accounting departments such as ours where segregation
      of
      duties is difficult. In addition to these internal controls, we also instituted
      a disclosure control process whereby the Chief Financial Officer receives copies
      of all minutes of all Board of Directors and committee meetings to insure that
      any decisions or actions that have accounting implications are properly recorded
      and disclosed. In situations in which the subject matter of a meeting is deemed
      too sensitive to permit distribution of minutes to the Chief Financial Officer,
      outside legal counsel has such minutes reviewed to determine if there is any
      accounting implication.





**Management’s
      Report on Internal Control Over Financial Reporting**





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





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





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





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





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


56


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




In
      making
      the assessment of internal control over financial reporting, our management
      used
      the criteria issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO) in *Internal
      Control-Integrated Framework* .
      Based
      on that assessment and those criteria, management believes that our internal
      control over financial reporting was not effective as of December 31, 2007.





We
      missed
      filing two Current Reports on Form 8-K during the fourth quarter of 2007. We
      reported the events that triggered these Form 8-K filings in our Quarterly
      Report on Form 10-Q for the quarterly period ended September 30, 2007. We
      believe these missed filings were the result of inadequate training of
      management personnel as to the specific events that trigger a Current Report
      on
      Form 8-K and we are putting in place procedures and training to ensure that
      the
      appropriate personnel recognize events that are reportable on Form 8-K.





We
      believe the controls we have put in place to address the aforementioned
      deficiency, along with our existing and additional controls implemented during
      our implementation of Section 404 of Sarbanes-Oxley, have enabled us to develop
      a sound internal control structure. We believe this is demonstrated by the
      fact
      that we have neither had any restatements nor any material audit adjustments,
      individually or in the aggregate, from the period beginning January 1, 2006
      to
      the present. We believe the missed filings on Form 8-K mentioned above represent
      an internal control weakness only to the level of a significant control
      deficiency.





However,
      due to the fact that we were unable to complete testing of these controls,
      we
      lack the documented evidence that we believe is necessary in order to support
      an
      assessment that our internal control over financial reporting is effective.
      Without such testing, we cannot conclude whether there are any other significant
      deficiencies or material control weaknesses, nor can we appropriately remediate
      any such deficiencies that might have been detected. In addition, during the
      analysis of our internal controls during our implementation of Section 404
      of
      Sarbanes-Oxley, we did identify a number of controls, the adoption of which
      would be critical and material to our internal control environment. While no
      errors occurred in any of these specific areas, we believe the identified
      controls are critical to providing reasonable assurance that any potential
      future errors would be detected. Those identified controls are:





1.
            Accrual
                Analysis – We did not maintain adequate procedures to insure accruals
                are properly identified, recorded, and reversed in appropriate
                periods.





2.
            Journal
                Entries – We did not maintain adequate procedures to insure that journal
                entries are adequately documented and reviewed prior to
                entry.





3.
            Journal
                Entries – We did not maintain an adequate list of recurring closing
                entries which would help insure all required closing entries are
                reviewed
                and recorded properly.





4.
            Period
                Closing – We did not maintain an adequate checklist to insure that all
                period closing procedures are recorded properly and
                completely.





5.
            Stock
                Option and Restricted Stock Expense – We did not maintain adequate
                procedures to insure compensation expense related to stock options
                and
                restricted stock was recorded in the proper amounts and in the proper
                periods.





Because
      we have not completed testing of our internal controls, have not yet fully
      adopted these identified, critical procedures, and due to the known failure
      to
      file two Current Reports on Form 8-K timely, our Chief Executive Officer and
      Chief Financial Officer concluded that, as of the end of the period covered
      by
      this Annual Report on Form 10-K, our internal control over financial reporting
      was not effective.





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


57


**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 2007 that was not disclosed on a current
      report on Form 8-K.





**PART
      III**





Information
      called for in Items 10, 11, 12, 13, and 14 is incorporated by reference from
      our
      definitive proxy statement relating to our Annual Meeting of Stockholders,
      which
      will be filed with the SEC within 120 days after the end of fiscal
      2007.




**ITEM
              10.**
            **DIRECTORS,
                EXECUTIVE OFFICERS AND CORPORATE
                GOVERNANCE**





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




**ITEM
              12.**
            **SECURITY
                OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                STOCKHOLDER MATTERS**




**ITEM
              13.**
            **CERTAIN
                RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
                INDEPENDENCE**




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




**PART
      IV**




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





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





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





**Exhibit
                No.**
            
            **Description**2.1
            
            Asset
                Purchase Agreement, dated as of October 4, 2005, by and among Smart
                Online, Inc., Smart CRM, Inc., 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)2.2
            
            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)2.3
            
            Asset
                Purchase Agreement, dated September 30, 2006, by and between Alliance
                Technologies, Inc., Smart CRM, Inc., and Smart Online, Inc. (incorporated
                herein by reference to Exhibit 2.1 to our Quarterly Report on Form
                10-Q,
                as filed with the SEC on November 14, 2006)3.1
            
            Amended
                and Restated Certificate of Incorporation (incorporated herein by
                reference to Exhibit 3.1 to our Registration Statement on Form SB-2,
                as
                filed with the SEC on September 30,
                2004)





58





3.2
            
            Fourth
                Amended and Restated Bylaws (incorporated herein by reference to
                Exhibit
                3.1 to our Quarterly Report on Form 10-Q, as filed with the SEC on
                November 14, 2007)4.1
            
            Specimen
                Common Stock Certificate (incorporated herein by reference to Exhibit
                4.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)4.2
            
            Convertible
                Secured Subordinated Note Purchase Agreement, dated November 14,
                2007, by
                and among Smart Online, Inc. and certain investors (incorporated
                herein by
                reference to Exhibit 4.1 to our Quarterly Report on Form 10-Q, as
                filed
                with the SEC on November 14, 2007)4.3
            
            Form
                of Convertible Secured Subordinated Promissory Note (incorporated
                herein
                by reference to Exhibit 4.2 to our Quarterly Report on Form 10-Q,
                as filed
                with the SEC on November 14, 2007)10.1*
            
            2004
                Equity Compensation Plan (incorporated herein by reference to Exhibit
                10.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)10.2*
            
            Form
                of Incentive Stock Option Agreement under 2004 Equity Compensation
                Plan
                (incorporated herein by reference to Exhibit 10.2 to our Annual Report
                on
                Form 10-K, as filed with the SEC on July 11, 2006)10.3*
            
            Form
                of Incentive Stock Option Agreement under Smart Online, Inc.’s 2004 Equity
                Compensation Plan (incorporated herein by reference to Exhibit 10.7
                to our
                Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
                2007)10.4*
            
            Form
                of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
                Plan (incorporated herein by reference to Exhibit 10.3 to our Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.5*
            
            Form
                of Non-Qualified Stock Option Agreement under Smart Online, Inc.’s 2004
                Equity Compensation Plan (incorporated herein by reference to Exhibit
                10.8
                to our Quarterly Report on Form 10-Q, as filed with the SEC on May
                15,
                2007)10.6*
            
            Form
                of Restricted Stock Agreement under Smart Online, Inc.’s 2004 Equity
                Compensation Plan (incorporated herein by reference to Exhibit 10.6
                to our
                Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
                2007)10.7*
            
            Form
                of Restricted Stock Award Agreement for Employees (incorporated herein
                by
                reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed
                with
                the SEC on August 21, 2007)10.8*
            
            Form
                Restricted Stock Agreement for Employees (incorporated herein by
                reference
                to Exhibit 10.1 to Amendment No. 1 to our Current Report on Form
                8-K, as
                filed with the SEC on February 11, 2008)10.9*
            
            Form
                of Restricted Stock Agreement (Non-Employee Directors) (incorporated
                herein by reference to Exhibit 10.1 to our Current Report on Form
                8-K, as
                filed with the SEC on May 31, 2007)10.10*
            
            Form
                Restricted Stock Agreement (Non-Employee Directors) (incorporated
                herein
                by reference to Exhibit 10.3 to our Current Report on Form 8-K, as
                filed
                with the SEC on December 3, 2007)10.11*
            
            2001
                Equity Compensation Plan (terminated as to future grants effective
                April
                15, 2004) incorporated herein by reference to Exhibit 10.2 to our
                Registration Statement on Form SB-2, as filed with the SEC on September
                30, 2004)10.12*
            
            1998
                Stock Option Plan (terminated as to future grants effective April
                15,
                2004) (incorporated herein by reference to Exhibit 10.3 to our
                Registration Statement on Form SB-2, as filed with the SEC on September
                30, 2004)


10.13*
            
            Cash
                Bonus Program, November 2007 (incorporated herein by reference to
                Exhibit
                10.4 to our Current Report on Form 8-K, as filed with the SEC on
                December
                3, 2007)




59




10.14*
            
            Equity
                Award Program, November 2007 (incorporated herein by reference to
                Exhibit
                10.5 to Amendment No. 1 to our Current Report on Form 8-K, as filed
                with
                the SEC on February 11, 2008)10.15*
            
            Employment
                Agreement, dated April 1, 2004, with 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)10.16*
            
            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)10.17*
            
            Employment
                Agreement, dated April 1, 2004, with Thomas Furr (incorporated herein
                by
                reference to Exhibit 10.14 to our Annual Report on Form 10-K, as
                filed
                with the SEC on March 30, 2007)10.18*
            
            Amendment,
                dated November 9, 2005, to Employment Agreement, dated April 1, 2004,
                with
                Thomas Furr (incorporated herein by reference to Exhibit 10.15 to
                our
                Annual Report on Form 10-K, as filed with the SEC on March 30,
                2007)10.19*
            
            Amendment,
                dated August 15, 2007, to Employment Agreement, dated April 1, 2004,
                with
                Thomas Furr (incorporated herein by reference to Exhibit 10.5 to
                our
                Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2007)10.20*
            
            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)10.21*
            
            Employment
                Agreement, dated 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)10.22*
            
            Employment
                Agreement, dated November 30, 2007, with David E. Colburn (incorporated
                herein by reference to Exhibit 10.2 to our Current Report on Form
                8-K, as
                filed with the SEC on December 3, 2007)10.23*
            
            Description
                of Salary Reduction Agreements, effective January 1, 2007 (incorporated
                herein by reference to Exhibit 10.17 to our Annual Report on Form
                10-K, as
                filed with the SEC on March 30, 2007)10.24*
            
            Form
                of Executive Officer Compensation Agreement, dated April 25, 2007,
                by and
                between Smart Online, Inc. and certain of its executive officers
                (incorporated herein by reference to Exhibit 10.53 to Amendment No.
                1 to
                our Registration Statement on Form S-1/A, as filed with the SEC on
                June
                15, 2007)10.25*
            
            Smart
                Online, Inc. Revised Board Compensation Policy, effective November
                17,
                2006 (incorporated herein by reference to Exhibit 10.39 to our Annual
                Report on Form 10-K, as filed with the SEC on March 30,
                2007)10.26*
            
            Smart
                Online, Inc. Revised Board Compensation Policy, effective February
                2, 2007
                (incorporated herein by reference to Exhibit 10.45 to our Registration
                Statement on Form S-1, as filed with the SEC on April 3,
                2007)10.27*
            
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and
                Michael Nouri (incorporated herein by reference to Exhibit 10.47
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.28*
            
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and
                Henry Nouri (incorporated herein by reference to Exhibit 10.45 to
                our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)


60





10.29*
            
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and Tom
                Furr (incorporated herein by reference to Exhibit 10.44 to our Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.30
            
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated March 30, 2006, by and between Smart Online, Inc.
                and
                Atlas Capital, SA (incorporated herein by reference to Exhibit 10.37
                to
                our Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.31
            
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated June 29 and July 6, 2006, by and between Smart Online,
                Inc. and certain investors (incorporated herein by reference to Exhibit
                10.36 to our Annual Report on Form 10-K, as filed with the SEC on
                July 11,
                2006)10.32
            
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated August 17 and 21, 2006, by and between Smart Online,
                Inc.
                and certain investors (incorporated herein by reference to Exhibit
                10.2 to
                our Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2006)10.33
            
            Form
                of Amendments to Registration Rights Agreements and Amendments to
                Subscriber Rights Agreements, dated from October 2, 2006 through
                January
                26, 2007, by and between Smart Online, Inc. and certain investors
                (incorporated herein by reference to Exhibit 10.40 to our Annual
                Report on
                Form 10-K, as filed with the SEC on March 30, 2007)10.34
            
            Stock
                Purchase Warrant and Agreement, dated January 15, 2007, by and between
                Smart Online, Inc. and Atlas Capital, SA (incorporated herein by
                reference
                to Exhibit 10.44 to our Registration Statement on Form S-1, as filed
                with
                the SEC on April 3, 2007)10.35
            
            Form
                of Securities Purchase Agreement, Registration Rights Agreement,
                and
                Warrant to Purchase Common Stock of Smart Online, Inc., dated February
                21,
                2007, by and between Smart Online, Inc. and each of Magnetar Capital
                Master Fund, Ltd. and Herald Investment Management Limited on behalf
                of
                Herald Investment Trust PLC (incorporated herein by reference to
                Exhibit
                10.46 to our Registration Statement on Form S-1, as filed with the
                SEC on
                April 3, 2007)10.36
            
            Form
                of Amendment to Registration Rights Agreement, dated March 26, 2007,
                by
                and between Smart Online, Inc. and each of Magnetar Capital Master
                Fund,
                Ltd. and Herald Investment Management Limited on behalf of Herald
                Investment Trust PLC ( incorporated herein by reference to Exhibit
                10.54
                to Amendment No. 3 to our Registration Statement on Form S-1, as
                filed
                with the SEC on July 31, 2007)10.37
            
            Form
                of Amendment to Registration Rights Agreement, dated July 3, 2007,
                by and
                between Smart Online, Inc. and each of Magnetar Capital Master Fund,
                Ltd.
                and Herald Investment Management Limited on behalf of Herald Investment
                Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
                No. 3 to our Registration Statement on Form S-1, as filed with the
                SEC on
                July 31, 2007)10.38
            
            Warrant
                to Purchase Common Stock of Smart Online, Inc., and Registration
                Rights
                Agreement, dated February 27, 2007, by and between Smart Online,
                Inc. and
                Canaccord Adams Inc. (incorporated herein by reference to Exhibit
                10.47 to
                our Registration Statement on Form S-1, as filed with the SEC on
                April 3,
                2007)10.39
            
            Form
                of Registration Rights Agreement, of various dates, by and between
                Smart
                Online, Inc. and certain parties in connection with the sale of shares
                by
                Dennis Michael Nouri (incorporated herein by reference to Exhibit
                10.48 to
                our Registration Statement on Form S-1, as filed with the SEC on
                April 3,
                2007)10.40
            
            Registration
                Rights Agreement, dated November 14, 2007, by and among Smart Online,
                Inc.
                and certain investors (incorporated herein by reference to Exhibit
                10.6 to
                our Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2007)


61





10.41
            
            Security
                Agreement, dated November 14, 2007, among Smart Online, Inc. and
                Doron
                Roethler, as agent for certain investors (incorporated herein by
                reference
                to Exhibit 10.7 to our Quarterly Report on Form 10-Q, as filed with
                the
                SEC on November 14, 2007)10.42
            
            Amendment
                No. 1 to Lock Box Agreement, dated November 8, 2006, by and between
                Smart
                Online, Inc., Smart Commerce, Inc. and certain former shareholders
                of
                iMart Incorporated (incorporated herein by reference to Exhibit 10.41
                to
                our Annual Report on Form 10-K, as filed with the SEC on March 30,
                2007)10.43
            
            Settlement
                Agreement, dated August 25, 2006, by and between Smart Online, Inc.
                and
                Berkley Financial Services Ltd. (incorporated herein by reference
                to
                Exhibit 99.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                August 28, 2006)10.44
            
            Settlement
                Agreement, effective May 31, 2006, by and between Smart Online, Inc.
                and
                General Investments Capital 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)10.45
            
            Business
                Loan Agreement, Promissory Note, Guaranty, Security Agreements, and
                Collateral Assignments, dated October 17, 2006, by and between Smart
                Online, Inc., Smart Commerce, Inc., and Fifth Third Bank (incorporated
                herein by reference to Exhibit 10.42 to our Annual Report on Form
                10-K, as
                filed with the SEC on March 30, 2007)10.46
            
            Promissory
                Note, Loan Agreement, and Security Agreement, dated November 14,
                2006, by
                and between Smart Online, Inc. and Wachovia Bank, NA (incorporated
                herein
                by reference to Exhibit 10.43 to our Annual Report on Form 10-K,
                as filed
                with the SEC on March 30, 2007)10.47
            
            Promissory
                Note, Modification Number One to Loan Agreement, and Security Agreement,
                dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
                Bank, NA (incorporated herein by reference to Exhibit 10.8 to our
                Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2007)10.48
            
            Reimbursement
                Agreement, dated November 10, 2006, by and between Smart Online,
                Inc. and
                Atlas Capital SA21.1
            
            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 906 of the Sarbanes-Oxley
                Act of
                2002 and shall not, except to the extent required by that Act, be
                deemed
                to be incorporated by reference into any document or filed herewith
                for
                the purposes of liability under the Securities Exchange Act of 1934,
                as
                amended, or the Securities Act of 1933, as amended, as the case may
                be.]32.2
            
            Certification
                of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit
                is
                being furnished pursuant to Section 906 of the Sarbanes-Oxley Act
                of 2002
                and shall not, except to the extent required by that Act, be deemed
                to be
                incorporated by reference into any document or filed herewith for
                the
                purposes of liability under the Securities Exchange Act of 1934,
                as
                amended, or the Securities Act of 1933, as amended, as the case may
                be.]





*
      Management contract or compensatory plan.


62


**SIGNATURES**





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





**SMART
                ONLINE, INC.**By:
            /s/
                David E. ColburnMarch
                19, 2008
            
            David
                E. Colburn, Principal Executive
                Officer





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





By:
            /s/
                David E. ColburnMarch
                19, 2008
            
            David
                E. Colburn
              Principal
                Executive Officer and DirectorBy:
            /s/
                Nicholas A. SinigagliaMarch
                19, 2008
            
            Nicholas
                A. Sinigaglia
              Principal
                Financial Officer and
              Principal
                Accounting OfficerBy:
            /s/
                Thomas FurrMarch
                19, 2008
            
            Thomas
                Furr
              Chief
                Strategy Officer and DirectorBy:
            /s/
                Doron RoethlerMarch
                19, 2008
            
            Doron
                Roethler
              Chairman
                of the BoardBy:March
                __, 2008
            
            Shlomo
                Elia
              DirectorBy:
            /s/
                C. James Meese, Jr.March
                19, 2008
            
            C.
                James Meese, Jr.
              DirectorBy:
            /s/
                Philippe PouponnotMarch
                19, 2008
            
            Philippe
                Pouponnot
              Director


63





**EXHIBIT
      INDEX**





**Exhibit
                No.**
            
            **Description**2.1
            
            Asset
                Purchase Agreement, dated as of October 4, 2005, by and among Smart
                Online, Inc., Smart CRM, Inc., 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)2.2
            
            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)2.3
            
            Asset
                Purchase Agreement, dated September 30, 2006, by and between Alliance
                Technologies, Inc., Smart CRM, Inc., and Smart Online, Inc. (incorporated
                herein by reference to Exhibit 2.1 to our Quarterly Report on Form
                10-Q,
                as filed with the SEC on November 14, 2006)3.1
            
            Amended
                and Restated Certificate of Incorporation (incorporated herein by
                reference to Exhibit 3.1 to our Registration Statement on Form SB-2,
                as
                filed with the SEC on September 30, 2004)3.2
            
            Fourth
                Amended and Restated Bylaws (incorporated herein by reference to
                Exhibit
                3.1 to our Quarterly Report on Form 10-Q, as filed with the SEC on
                November 14, 2007)4.1
            
            Specimen
                Common Stock Certificate (incorporated herein by reference to Exhibit
                4.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)4.2
            
            Convertible
                Secured Subordinated Note Purchase Agreement, dated November 14,
                2007, by
                and among Smart Online, Inc. and certain investors (incorporated
                herein by
                reference to Exhibit 4.1 to our Quarterly Report on Form 10-Q, as
                filed
                with the SEC on November 14, 2007)4.3
            
            Form
                of Convertible Secured Subordinated Promissory Note (incorporated
                herein
                by reference to Exhibit 4.2 to our Quarterly Report on Form 10-Q,
                as filed
                with the SEC on November 14, 2007)10.1*
            
            2004
                Equity Compensation Plan (incorporated herein by reference to Exhibit
                10.1
                to our Registration Statement on Form SB-2, as filed with the SEC
                on
                September 30, 2004)10.2*
            
            Form
                of Incentive Stock Option Agreement under 2004 Equity Compensation
                Plan
                (incorporated herein by reference to Exhibit 10.2 to our Annual Report
                on
                Form 10-K, as filed with the SEC on July 11, 2006)10.3*
            
            Form
                of Incentive Stock Option Agreement under Smart Online, Inc.’s 2004 Equity
                Compensation Plan (incorporated herein by reference to Exhibit 10.7
                to our
                Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
                2007)10.4*
            
            Form
                of Non-Qualified Stock Option Agreement under 2004 Equity Compensation
                Plan (incorporated herein by reference to Exhibit 10.3 to our Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.5*
            
            Form
                of Non-Qualified Stock Option Agreement under Smart Online, Inc.’s 2004
                Equity Compensation Plan (incorporated herein by reference to Exhibit
                10.8
                to our Quarterly Report on Form 10-Q, as filed with the SEC on May
                15,
                2007)


64





10.6*
            
            Form
                of Restricted Stock Agreement under Smart Online, Inc.’s 2004 Equity
                Compensation Plan (incorporated herein by reference to Exhibit 10.6
                to our
                Quarterly Report on Form 10-Q, as filed with the SEC on May 15,
                2007)10.7*
            
            Form
                of Restricted Stock Award Agreement for Employees (incorporated herein
                by
                reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed
                with
                the SEC on August 21, 2007)10.8*
            
            Form
                Restricted Stock Agreement for Employees (incorporated herein by
                reference
                to Exhibit 10.1 to Amendment No. 1 to our Current Report on Form
                8-K, as
                filed with the SEC on February 11, 2008)10.9*
            
            Form
                of Restricted Stock Agreement (Non-Employee Directors) (incorporated
                herein by reference to Exhibit 10.1 to our Current Report on Form
                8-K, as
                filed with the SEC on May 31, 2007)10.10*
            
            Form
                Restricted Stock Agreement (Non-Employee Directors) (incorporated
                herein
                by reference to Exhibit 10.3 to our Current Report on Form 8-K, as
                filed
                with the SEC on December 3, 2007)10.11*
            
            2001
                Equity Compensation Plan (terminated as to future grants effective
                April
                15, 2004) incorporated herein by reference to Exhibit 10.2 to our
                Registration Statement on Form SB-2, as filed with the SEC on September
                30, 2004)10.12*
            
            1998
                Stock Option Plan (terminated as to future grants effective April
                15,
                2004) (incorporated herein by reference to Exhibit 10.3 to our
                Registration Statement on Form SB-2, as filed with the SEC on September
                30, 2004)10.13*
            
            Cash
                Bonus Program, November 2007 (incorporated herein by reference to
                Exhibit
                10.4 to our Current Report on Form 8-K, as filed with the SEC on
                December
                3, 2007)10.14*
            
            Equity
                Award Program, November 2007 (incorporated herein by reference to
                Exhibit
                10.5 to Amendment No. 1 to our Current Report on Form 8-K, as filed
                with
                the SEC on February 11, 2008)10.15*
            
            Employment
                Agreement, dated April 1, 2004, with 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)10.16*
            
            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)10.17*
            
            Employment
                Agreement, dated April 1, 2004, with Thomas Furr (incorporated herein
                by
                reference to Exhibit 10.14 to our Annual Report on Form 10-K, as
                filed
                with the SEC on March 30, 2007)10.18*
            
            Amendment,
                dated November 9, 2005, to Employment Agreement, dated April 1, 2004,
                with
                Thomas Furr (incorporated herein by reference to Exhibit 10.15 to
                our
                Annual Report on Form 10-K, as filed with the SEC on March 30,
                2007)10.19*
            
            Amendment,
                dated August 15, 2007, to Employment Agreement, dated April 1, 2004,
                with
                Thomas Furr (incorporated herein by reference to Exhibit 10.5 to
                our
                Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2007)10.20*
            
            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)10.21*
            
            Employment
                Agreement, dated 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)


65





10.22*
            
            Employment
                Agreement, dated November 30, 2007, with David E. Colburn (incorporated
                herein by reference to Exhibit 10.2 to our Current Report on Form
                8-K, as
                filed with the SEC on December 3, 2007)10.23*
            
            Description
                of Salary Reduction Agreements, effective January 1, 2007 (incorporated
                herein by reference to Exhibit 10.17 to our Annual Report on Form
                10-K, as
                filed with the SEC on March 30, 2007)10.24*
            
            Form
                of Executive Officer Compensation Agreement, dated April 25, 2007,
                by and
                between Smart Online, Inc. and certain of its executive officers
                (incorporated herein by reference to Exhibit 10.53 to Amendment No.
                1 to
                our Registration Statement on Form S-1/A, as filed with the SEC on
                June
                15, 2007)10.25*
            
            Smart
                Online, Inc. Revised Board Compensation Policy, effective November
                17,
                2006 (incorporated herein by reference to Exhibit 10.39 to our Annual
                Report on Form 10-K, as filed with the SEC on March 30,
                2007)10.26*
            
            Smart
                Online, Inc. Revised Board Compensation Policy, effective February
                2, 2007
                (incorporated herein by reference to Exhibit 10.45 to our Registration
                Statement on Form S-1, as filed with the SEC on April 3,
                2007)10.27*
            
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and
                Michael Nouri (incorporated herein by reference to Exhibit 10.47
                to our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.28*
            
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and
                Henry Nouri (incorporated herein by reference to Exhibit 10.45 to
                our
                Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.29*
            
            Indemnification
                Agreement, dated April 14, 2006, by and between Smart Online, Inc.
                and Tom
                Furr (incorporated herein by reference to Exhibit 10.44 to our Annual
                Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.30
            
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated March 30, 2006, by and between Smart Online, Inc.
                and
                Atlas Capital, SA (incorporated herein by reference to Exhibit 10.37
                to
                our Annual Report on Form 10-K, as filed with the SEC on July 11,
                2006)10.31
            
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated June 29 and July 6, 2006, by and between Smart Online,
                Inc. and certain investors (incorporated herein by reference to Exhibit
                10.36 to our Annual Report on Form 10-K, as filed with the SEC on
                July 11,
                2006)10.32
            
            Form
                of Subscription Agreement, Subscriber Rights Agreement, and Dribble
                Out
                Agreement, dated August 17 and 21, 2006, by and between Smart Online,
                Inc.
                and certain investors (incorporated herein by reference to Exhibit
                10.2 to
                our Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2006)10.33
            
            Form
                of Amendments to Registration Rights Agreements and Amendments to
                Subscriber Rights Agreements, dated from October 2, 2006 through
                January
                26, 2007, by and between Smart Online, Inc. and certain investors
                (incorporated herein by reference to Exhibit 10.40 to our Annual
                Report on
                Form 10-K, as filed with the SEC on March 30, 2007)10.34
            
            Stock
                Purchase Warrant and Agreement, dated January 15, 2007, by and between
                Smart Online, Inc. and Atlas Capital, SA (incorporated herein by
                reference
                to Exhibit 10.44 to our Registration Statement on Form S-1, as filed
                with
                the SEC on April 3, 2007)


66





10.35
            
            Form
                of Securities Purchase Agreement, Registration Rights Agreement,
                and
                Warrant to Purchase Common Stock of Smart Online, Inc., dated February
                21,
                2007, by and between Smart Online, Inc. and each of Magnetar Capital
                Master Fund, Ltd. and Herald Investment Management Limited on behalf
                of
                Herald Investment Trust PLC (incorporated herein by reference to
                Exhibit
                10.46 to our Registration Statement on Form S-1, as filed with the
                SEC on
                April 3, 2007)10.36
            
            Form
                of Amendment to Registration Rights Agreement, dated March 26, 2007,
                by
                and between Smart Online, Inc. and each of Magnetar Capital Master
                Fund,
                Ltd. and Herald Investment Management Limited on behalf of Herald
                Investment Trust PLC ( incorporated herein by reference to Exhibit
                10.54
                to Amendment No. 3 to our Registration Statement on Form S-1, as
                filed
                with the SEC on July 31, 2007)10.37
            
            Form
                of Amendment to Registration Rights Agreement, dated July 3, 2007,
                by and
                between Smart Online, Inc. and each of Magnetar Capital Master Fund,
                Ltd.
                and Herald Investment Management Limited on behalf of Herald Investment
                Trust PLC (incorporated herein by reference to Exhibit 10.55 to Amendment
                No. 3 to our Registration Statement on Form S-1, as filed with the
                SEC on
                July 31, 2007)10.38
            
            Warrant
                to Purchase Common Stock of Smart Online, Inc., and Registration
                Rights
                Agreement, dated February 27, 2007, by and between Smart Online,
                Inc. and
                Canaccord Adams Inc. (incorporated herein by reference to Exhibit
                10.47 to
                our Registration Statement on Form S-1, as filed with the SEC on
                April 3,
                2007)10.39
            
            Form
                of Registration Rights Agreement, of various dates, by and between
                Smart
                Online, Inc. and certain parties in connection with the sale of shares
                by
                Dennis Michael Nouri (incorporated herein by reference to Exhibit
                10.48 to
                our Registration Statement on Form S-1, as filed with the SEC on
                April 3,
                2007)10.40
            
            Registration
                Rights Agreement, dated November 14, 2007, by and among Smart Online,
                Inc.
                and certain investors (incorporated herein by reference to Exhibit
                10.6 to
                our Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2007)10.41
            
            Security
                Agreement, dated November 14, 2007, among Smart Online, Inc. and
                Doron
                Roethler, as agent for certain investors (incorporated herein by
                reference
                to Exhibit 10.7 to our Quarterly Report on Form 10-Q, as filed with
                the
                SEC on November 14, 2007)10.42
            
            Amendment
                No. 1 to Lock Box Agreement, dated November 8, 2006, by and between
                Smart
                Online, Inc., Smart Commerce, Inc. and certain former shareholders
                of
                iMart Incorporated (incorporated herein by reference to Exhibit 10.41
                to
                our Annual Report on Form 10-K, as filed with the SEC on March 30,
                2007)10.43
            
            Settlement
                Agreement, dated August 25, 2006, by and between Smart Online, Inc.
                and
                Berkley Financial Services Ltd. (incorporated herein by reference
                to
                Exhibit 99.1 to our Current Report on Form 8-K, as filed with the
                SEC on
                August 28, 2006)10.44
            
            Settlement
                Agreement, effective May 31, 2006, by and between Smart Online, Inc.
                and
                General Investments Capital 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)10.45
            
            Business
                Loan Agreement, Promissory Note, Guaranty, Security Agreements, and
                Collateral Assignments, dated October 17, 2006, by and between Smart
                Online, Inc., Smart Commerce, Inc., and Fifth Third Bank (incorporated
                herein by reference to Exhibit 10.42 to our Annual Report on Form
                10-K, as
                filed with the SEC on March 30, 2007)10.46
            
            Promissory
                Note, Loan Agreement, and Security Agreement, dated November 14,
                2006, by
                and between Smart Online, Inc. and Wachovia Bank, NA (incorporated
                herein
                by reference to Exhibit 10.43 to our Annual Report on Form 10-K,
                as filed
                with the SEC on March 30, 2007)


67





10.47
            
            Promissory
                Note, Modification Number One to Loan Agreement, and Security Agreement,
                dated January 24, 2007, by and between Smart Online, Inc. and Wachovia
                Bank, NA (incorporated herein by reference to Exhibit 10.8 to our
                Quarterly Report on Form 10-Q, as filed with the SEC on November
                14,
                2007)10.48
            
            Reimbursement
                Agreement, dated November 10, 2006, by and between Smart Online,
                Inc. and
                Atlas Capital SA21.1
            
            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 906 of the Sarbanes-Oxley
                Act of
                2002 and shall not, except to the extent required by that Act, be
                deemed
                to be incorporated by reference into any document or filed herewith
                for
                the purposes of liability under the Securities Exchange Act of 1934,
                as
                amended, or the Securities Act of 1933, as amended, as the case may
                be.]32.2
            
            Certification
                of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit
                is
                being furnished pursuant to Section 906 of the Sarbanes-Oxley Act
                of 2002
                and shall not, except to the extent required by that Act, be deemed
                to be
                incorporated by reference into any document or filed herewith for
                the
                purposes of liability under the Securities Exchange Act of 1934,
                as
                amended, or the Securities Act of 1933, as amended, as the case may
                be.]





*
      Management contract or compensatory plan.


68