RISK FACTORS

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

We operate in a dynamic and rapidly changing business environment that involves substantial risk and uncertainty and these risks may change over time. The following discussion addresses some of the risks and uncertainties that could cause, or contribute to causing, actual results to differ materially from expectations. In evaluating our business, 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, that we currently deem immaterial, or that are similar to those faced by other companies in our industry or business in general may also affect our business. If any of the risks described below actually occurs, our business, financial condition, or results of operations could be materially and adversely affected.

 

We have organized these factors into the following categories below:

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Our Financial Condition

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Our Products and Operations

 

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Our Market, Customers and Partners

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Our Officers, Directors, Employees and Stockholders

 

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Regulatory Matters that Affect Our Business

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Matters Related to the Market For Our Securities

Risks Associated with Our Financial Condition

(1)    We have had recurring losses from operations since inception, and continue to have negative cash flows. If we do not rectify these deficiencies through additional financing or growth, we may have to cease operations and liquidate our business. Because we have only nominal tangible assets, you may lose your entire investment.

Through March 31, 2007, we have lost an aggregate of approximately $58.7 million since inception on August 10, 1993. During the quarters ended March 31, 2007 and 2006, we incurred a net loss of approximately $1.3 million and $1.6 million, respectively. At March 31, 2007, we had $3.3 million of working capital. Our working capital, including our line of credit and recent financing transaction for $6 million, is not sufficient to fund our operations beyond July 2008, unless we substantially increase our revenue, limit expenses or raise substantial additional financing. Factors such as the commercial success of our existing services and products, the timing and success of any new services and products, the progress of our research and development efforts, our results of operations, the status of competitive services and products, the timing and success of potential strategic alliances or potential opportunities to acquire technologies or assets, and the suspension of trading of shares of our common stock by the U.S. Securities and Exchange Commission, or the SEC, and the resulting drop in share price, trading volume and liquidity, 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, we may have to liquidate our business and you may lose your investment.

(2)    Any issuance of shares of our common stock in the future could have a dilutive effect on your investment.

We may issue shares of our common stock in the future for a variety of reasons. For example, under the terms of the stock purchase warrant and agreement we recently entered into with Atlas Capital, S.A., or 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 Wachovia Bank, NA, or Wachovia. In connection with our recent private financing, 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. In addition, we may raise funds in the future by issuing additional shares of common stock or other securities.

 

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

(3)    In the future, we may enter into certain debt financing transactions with third parties that could adversely affect our financial health.

We currently have a secured loan arrangement from 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 is prime plus 1.5% as periodically determined by Fifth Third Bank. The loan is secured by all of the assets of Smart Commerce and all of Smart Commerce’s intellectual property. The loan is guaranteed by us and such guaranty is secured by all the common stock of Smart Commerce.

We also have a revolving line of credit from Wachovia. This line of credit is $2.5 million, and as of July 24, 2007, we have drawn down approximately $2.1 million. Any advances made on the line of credit must be repaid no later than August 1, 2008, with monthly payments of accrued interest only commencing on December 1, 2006 on any outstanding balance. 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 our deposit account at Wachovia and an irrevocable standby letter of credit in the amount of $2.5 million issued by HSBC Private Bank (Suisse) S.A. with Atlas as account party.

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We are evaluating various equity and debt financing options and in the future may incur indebtedness that could adversely affect our financial health. For example, indebtedness could:

 

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increase our vulnerability to general adverse economic and industry conditions;

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require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes;

 

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limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

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result in the loss of a significant amount of our assets or the assets of our subsidiary if we are unable to meet the obligations of these arrangements;

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place us at a competitive disadvantage compared to our competitors that have less indebtedness or better access to capital by, for example, limiting our ability to enter into new markets; and

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limit our ability to borrow additional funds in the future.

 

Risks Associated with Our Products and Operations

(4)    Our business is dependent upon the development and market acceptance of our applications, including the acceptance of using some of our applications to conduct business. Our business models and operating plans have changed as a result of forces beyond our control. Consequently, we have not yet demonstrated that we have a successful business model or operating plan.

We continually revise our business models and operating plans as a result of changes in our market, the expectations of customers and the behavior of competitors. Today, we anticipate that our future financial performance and revenue growth will depend, in large part, upon our Internet-based SaaS business model and the results of our 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. We recently entered into agreements with four new syndication partners, but we have not yet derived any revenue under these agreements. Consequently, we have not yet demonstrated that we have a successful business model or operating plan. Our evolving business model makes our business operations and prospects difficult to evaluate. There can be no assurance that our revised business model will allow us to capture significant future market potential. Investors in our securities should consider all the risks and uncertainties that are commonly encountered by companies in this stage of operations under our current business model, particularly companies, such as ours, that are in emerging and rapidly evolving markets.

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. There can be no assurance that we will be able to successfully develop new services or products, or to introduce in a timely manner and gain acceptance of our new services or products in the marketplace.

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. We cannot assure you that our products will achieve widespread market penetration or that we will derive significant revenues from the sale of our applications.

 

Certain of our services involve the storage and transmission of customers’ personal and proprietary information (such as credit card, employee, purchasing, supplier, and other financial and accounting data). If customers determine that our services do not provide adequate security for the dissemination of information over the Internet or corporate extranets, or are otherwise inadequate for Internet or extranet use, or if, for any other reason, customers fail to accept our products for use, our business will be harmed. Our failure to prevent security breaches, or well-publicized security breaches affecting the Internet in general, could significantly harm our business, operating results, and financial condition.

(5)    We may consider strategic divestiture, acquisition or investment opportunities in the future. We face risks associated with any such opportunity.

From time to time we evaluate strategic opportunities available to us for product, technology or business acquisitions, investments and divestitures. In the future, we may divest ourselves of products or technologies that are not within our continually evolving business strategy or acquire other products or technologies. We may not realize the anticipated benefits of any such current or future opportunity to the extent that we anticipate, or at all. We may have to issue debt or equity securities to pay for future acquisitions or investments, the issuance of which could be dilutive to our existing stockholders. If any opportunity is not perceived as improving our earnings per share, our stock price may decline. In addition, we may incur non-cash amortization charges from acquisitions, which could harm our operating results. Any completed acquisitions or divestitures would also require significant integration or separation efforts, diverting our attention from our business operations and strategy. We have limited acquisition experience, and therefore our ability as an organization to integrate any acquired companies into our business is unproven. Acquisitions and investments involve numerous risks, including:

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difficulties in integrating operations, technologies, services and personnel;

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diversion of financial and managerial resources from existing operations;

 

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reduction of available cash;

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risk of entering new markets;

 

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potential write-offs of acquired assets;

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potential loss of key employees;

 

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

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delays in customer purchases due to uncertainty.

 

If we fail to properly evaluate and execute acquisitions, divestitures or investments, our business and prospects may be seriously harmed.

(6)    We entered into a debt financing transaction in order to make certain installment payments under our agreement in the iMart acquisition. Failure to comply with the provisions of this loan agreement could have a material adverse effect on us.

When we purchased iMart Incorporated, or iMart, in October 2005, we committed to make installment payments of approximately $3,462,000 and non-competition payments to two key employees of $780,000. Prior to the loan agreement described below, the cash flow we received from the business we purchased from iMart has been insufficient to cover any of the installment payments we have been required to make, and we have had to fund the difference. We recently amended the lock box agreement related to the acquisition, terminating the iMart shareholders’ security interest in the amounts in the lock box account, and agreed to pay the installment payments and noncompetition payments in three non-equal installments by February 2007, which have been paid in full.

In order to make these payments, we entered into a loan agreement with Fifth Third Bank in order to finance a portion of the payments to the iMart shareholders. Under the terms of this agreement, Smart Commerce borrowed $1.8 million to be repaid in 24 monthly installments of $75,000 plus interest. The interest rate is prime plus 1.5% as periodically determined by Fifth Third Bank. Currently and at closing, the prime rate was 8.25%. The loan is secured by all of the assets of Smart Commerce, including a security account of $250,000 and all of Smart Commerce’s intellectual property. The loan is guaranteed by us and such guaranty is secured by all the common stock of Smart Commerce. If an event of default occurs and remains uncured, then the lender could foreclose on the assets securing the loan. If that were to occur, it would have a substantial adverse effect on our business. Making the payments on the loan used to finance part of these payments may drain our financial resources or cause other material harm to our business if the lender forecloses on the secured assets.

(7)    We rely on third-party software that may be difficult to repair should errors or failures occur. Such an error or failure, or the process undertaken by us to correct such an error or failure, could disrupt our services and harm our business.

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

 

We also use key systems software from leading open source communities that are free and available in the public domain. Our products will use additional public domain software, if needed for successful implementation and deployment. We currently do not have support contracts for the open source software that we use. We rely on our own research and development personnel and the open source community to discover and fix any errors and bugs that may exist in the software we use. As a result, if there are errors in such software of which we are unaware or are unable to repair in a timely manner, there could be a disruption in our services if certain critical defects are discovered in the software at a future date.

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Risks Associated with Our Markets, Customers and Partners

(8)    The structure of our subscription model makes it difficult to predict the rate of customer subscription renewals or the impact non-renewals will have on our revenue or operating results.

Our small business customers do not sign long-term contracts. Our customers have no obligation to renew their subscriptions for our services after the expiration of their initial subscription period and, in fact, customers have often elected not to do so. In addition, our customers may renew for a lower-priced edition of our services or for fewer users. Many of our customers 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. Most of our subscribers are in our Smart Commerce segment. Although the number of subscribers to our Smart Online segment has remained relatively constant since September 2006, we have experienced a decline in the number of subscribers to our Smart Commerce segment. This decline is primarily attributable to the restructuring of a major customer and was anticipated when we learned of the restructuring. 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)    We depend on corporate partners to market our products through their web sites under relatively short-term agreements in order to increase subscription fees and grow revenue. Failure of our partners’ marketing efforts or termination of these agreements could harm our business.

 

Subscription fees represented approximately 52%, 22%, 0% of total revenues for 2006, 2005, and 2004, respectively. Subscription fees represented approximately 67% of total revenues in the first quarter of 2007 compared to 40% of total revenues in the first quarter of 2006. With the launch of our new applications and the acquisition of iMart, subscription fees represent a significant percentage of our total revenues and our future financial performance and revenue growth depends, in large part, upon the growth in customer demand for our outsourced services delivery models. We depend on our syndication partners and referral relationships to offer our products and services to a larger customer base than we can reach through direct sales or other marketing efforts. Although we entered into nine new and renewed agreements in the first half of 2007, we have not yet derived any revenue under several of these agreements. 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.

 

(10)    Our future growth is substantially dependent on customer demand for our subscription services delivery models. Failure to increase this revenue could harm our business.

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. There can be no assurance that we will be able to maintain positive gross margins in our subscription services delivery models in future periods. If our subscription services business does not grow sufficiently, we could fail to meet expectations for our results of operations, which could harm our business.

 

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

(11)    There are risks associated with international operations, which may become a bigger part of our business in the future.

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We currently do not generate revenue from international operations. Although we have recently signed an agreement with a company to market our products and services in a foreign country, this agreement has not yet generated any revenue for us. We are currently evaluating whether and how to expand into additional international markets. If we continue to develop our international operations, these operations will be subject to risks associated with operating abroad. These international operations are subject to a number of difficulties and special costs, including:

 

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costs of customization and localization of products for foreign countries;

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laws and business practices favoring local competitors;

 

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uncertain regulation of electronic commerce;

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

 

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longer sales cycles; greater difficulty in collecting accounts receivable;

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import and export restrictions and tariffs;

 

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

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difficulties staffing and managing foreign operations;

 

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multiple conflicting tax laws and regulations; and

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political and economic instability.

 

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

 

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

 

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

Risks Associated with Our Officers, Directors, Employees and Stockholders

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

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

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

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Our officers, directors and principal stockholders beneficially own or control approximately 59% of our outstanding common stock. As a result, these persons, acting together, will have the ability to control substantially all matters submitted to our stockholders for approval (including the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets) and to control our management and affairs. Accordingly, this concentration of ownership may have the effect of delaying, deferring or preventing a change in control of us, impeding a merger, consolidation, takeover or other business combination involving us or discouraging a potential acquiror 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.

Regulatory Risks

(14)    Compliance with new regulations governing public company corporate governance and reporting is uncertain and expensive.

As a public company, we have incurred and will incur significant legal, accounting and other expenses that we did not incur as a private company. We will incur costs associated with our public company reporting requirements. We also anticipate that we will incur costs associated with recently adopted corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, as well as new rules implemented by the SEC and the NASD. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time consuming and costly. Any unanticipated difficulties in preparing for and implementing these reforms could result in material delays in complying with these new laws and regulations or significantly increase our costs. Our ability to fully comply with these new laws and regulations is also uncertain. Our failure to prepare timely for and implement the reforms required by these new laws and regulations could significantly harm our business, operating results, and financial condition. We also expect that these new rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. In the past, we have incurred substantial additional professional fees and expenses associated with the SEC’s suspension of trading of our securities in January 2006 and with the internal investigation authorized by our Board of Directors in March 2006. Although our insurance carrier has paid a portion of these fees, not all such fees and expenses will be covered by our insurance.

(15)    Remediation of deficiencies in our internal control over financial reporting is uncertain and may be expensive.

By the end of fiscal 2007, we are required to comply with Sarbanes-Oxley requirements involving management's assessment of our internal control over financial reporting and our independent accountant's audit of that assessment is required for fiscal 2008. In March 2006, we retained a new Chief Financial Officer. His review of our internal control over financial reporting to date and the final findings of our Audit Committee investigation have identified several deficiencies in our internal control over financial reporting. In July 2006, the Audit Committee concluded that: (i) our Chief Executive Officer should have disclosed and sought approval from the Board of Directors before entering into certain transactions and arrangements, including personal loans; (ii) there was inadequate diligence by management and the Board of Directors regarding third parties with which we contracted, including outside investor relations vendors, some of which were registered brokers; (iii) management and our directors lacked sufficient knowledge regarding rules and regulations with respect to dealings between registered brokers and public companies, (iv) we lack clear policies regarding the limits on the Chief Executive Officer’s authority to enter into business transactions and agreements without Board approval; (v) there has been inadequate legal and accounting review of material contracts; (vi) there has been inadequate training and understanding of SEC disclosure requirements; (vii) there was an unintentional violation of our Securities Trading Policy by one of our directors as previously reported in our public filings; (viii) we have inadequate processes for determination of independence of Board members; and (ix) there has been a failure to communicate and stress the importance of controls and procedures throughout our organization. The Audit Committee investigation concluded that these deficiencies primarily resulted from our transition from a private company to a publicly reporting company and insufficient preparation for, focus on, and experience with compliance requirements for a publicly reporting company. We reported the changes to our internal controls related to the Audit Committee’s findings in our Annual Report on Form 10-K for the fiscal year ending December 31, 2005, filed with the SEC on July 11, 2006, or the 2005 Annual Report, and as updated in our Annual Report on Form 10-K for the fiscal year ending December 31, 2006, filed with the SEC on March 30, 2007.

 

While we have made some progress on this remediation effort, we continue to work on addressing all the issues raised in these findings. Although we believe our on-going review and testing of our internal control over financial reporting will enable us to be compliant with these requirements, we have identified some deficiencies and may identify others that we may not be able to remediate and test by the end of fiscal 2007.

If we cannot assess our internal controls over financial reporting as effective, it may affect our management’s assessment of our internal control environment as it will be disclosed in our Annual Report on Form 10-K for fiscal 2007 and our stock price could decline.

(16)    The SEC suspension of trading of our securities has damaged our business, and it could damage our business in the future.

The suspension of trading by the SEC has harmed our business in many ways, and may cause further harm in the future. Prior to our re-entry onto the OTC-BB for quotation, our ability to raise financing on favorable terms to us and our existing stockholders suffered due to the lack of liquidity of our stock, the questions raised by the SEC’s action, and the resulting drop in the price of our common stock. As a result, we did not raise sufficient financing to make the sales and marketing investments we felt were needed in 2006 to substantially increase revenue. Legal and other fees related to the SEC’s action also reduced our cash flow which jeopardized our ability to make the installment payments required by the agreements to acquire iMart. We recently completed a private placement financing for $6 million; however we make no assurance that we will not continue to experience additional harm as a result of the SEC matter. The time spent by our management team and directors dealing with issues related to the SEC action also detracted from the time they spent on our operations, including strategy development and implementation. Finally, an important part of our business plan is to enter into private label syndication agreements with large companies. The SEC’s action and related matters have caused us to be a less attractive partner for large companies and to lose important opportunities. The SEC’s action and related matters may cause other problems in our operations.

Risks Associated with the Market for Our Securities

(17)    If securities analysts do not publish research or reports about our business or if they downgrade our stock, the price of our stock could decline.

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

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(18)    Our revenues and operating results may fluctuate in future periods and we may fail to meet expectations of investors and public market analysts, which could cause the price of our common stock to decline.

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

 

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the evolving demand for our services and software;

	·	spending decisions by our customers and prospective customers;

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our ability to manage expenses;

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the timing of product releases;

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changes in our pricing policies or those of our competitors;

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the timing of execution of contracts;

 

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changes in the mix of our services and software offerings;

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

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costs of developing product enhancements;

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global economic and political conditions;

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

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subscription renewal rates for our service;

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the rate of expansion and effectiveness of our sales force;

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the length of the sales cycle for our service;

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new product and service introductions by our competitors;

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technical difficulties or interruptions in our service;

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regulatory compliance costs;

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integration of acquisitions; and

 

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

 

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

 

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

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

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variations in our actual and anticipated operating results;

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

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

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recruitment or departure of key personnel;

 

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changes in the estimates of our operating results or changes in recommendations by any securities analysts that elect to follow our common stock;

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

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

In addition, 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. Securities class action litigation could result in substantial costs and a diversion of our management’s attention and resources. If such a suit is brought against us, we may determine, like many defendants in such lawsuits, that it is in our best interests to settle such a lawsuit, even if we believe that the plaintiffs’ claims have no merit, to avoid the cost and distraction of continued litigation. Any liability we incur in connection with any 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.

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

Certain holders of shares of our common stock signed agreements that prohibit resales of our common stock. If substantial numbers of shares are resold as lock-up periods expire, the market price of our common stock is likely to decrease substantially.

 

At July 24, 2007, 17,927,137 shares of our common stock were issued and outstanding and 3,857,715 shares may be issued pursuant to the exercise of warrants and options. During May 2005, we registered on Form S-8 5,000,000 shares of our common stock for issuance to our officers, directors and consultants under our 2004 Equity Compensation Plan, of which at July 24, 2007, 156,000 shares were outstanding and 1,376,200 shares are subject to outstanding stock options of the 5,000,000 shares reserved for issuance under such plan. In June 2007, we limited the issuance of shares of our common stock reserved under our 2004 Equity Compensation Plan to awards of shares of restricted and unrestricted common stock. Also in June 2007, our Board of Directors approved an offer for holders of outstanding options with an exercise price of $2.50 per share or greater to exchange the outstanding options for a certain number of shares of restricted stock. We target that the restriction on these shares of stock would lapse in four equal, quarterly increments over the year following the acceptance of the exchange offer. This proposed tender offer is described more fully in “Shares Eligible for Future Sale - Outstanding Options and Warrants,” below.

 

The remaining outstanding shares of our common stock are restricted and may be sold in the public market only if they qualify for an exemption from registration under Rules 144 or 701 promulgated under the Securities Act. Because we have a material number of options and warrants outstanding, your shares may be significantly diluted if a large number of these outstanding options or warrants are exercised.

 

We entered into agreements that limit the number of shares that may be sold during specific time periods, or Dribble Out Agreements, with all of the investors who purchased shares of our stock from us in private placements during 2005 and 2006, a total of approximately 2,497,000 shares. Under these Dribble Out Agreements, sales of shares are limited to 25% during a rolling 30-day period. Such limitations terminate six months after the effective date of the registration statement registering these shares.

 

Certain of our affiliates have also entered into other Lock-Up Agreements covering a portion of their shares. These agreements restrict the sale of 1,296,623 shares of our common stock. Under the terms of these Lock-Up Agreements, these officers cannot sell, pledge, grant or otherwise transfer the shares subject to the agreement for one year following the effective date of the registration statement of which this prospectus is a part. After one year, 2.5% of these shares per quarter are released from these restrictions on a pro rata basis among these affiliates. All remaining shares will be released from the Lock-Up Agreements on the second anniversary of the effective date of the registration statement of which this prospectus is a part. These Lock-Up Agreements will otherwise terminate at the following times: (A) if the registration statement of which this prospectus is a part is terminated, the earlier of (i) the date of termination if no shares were sold, or (ii) the date any proceeds received from public investors are placed in the mail for return; (B) the date our common stock is listed on a national securities exchange, or (C) thirty (30) days following the date the persons signing these Lock-Up Agreements are no longer affiliates.

Our stock is very thinly traded. The average daily trading volume for our common stock between November 2006 and July 2007 was approximately 14,900 shares per day. The number of shares that could be sold during this period was restrained by Dribble Out Agreements and other contractual limitations imposed on some of our shares, while there was no similar contractual restraint on the number of buyers of our common stock. This means that market supply may increase more than market demand for our shares when lock-up and dribble-out periods expire. 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 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.

 

Market conditions and market makers may cause your investment in our common stock to significantly diminish and become very illiquid.

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

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

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

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

 

·

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

 

·

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

 

·

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

 

·

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

 

·

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

·

contains such other information and is in such form (including language, type, size, and format) as the SEC requires.

 

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

 

·

bid and ask quotations for the penny stock;

·

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

·

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

·

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

 

In addition, the penny stock rules require that, prior to a transaction in a penny stock not otherwise exempt from those rules, the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written acknowledgment of the receipt of a risk disclosure statement, a written agreement 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.

 

SELLING SECURITY HOLDERS

An aggregate of 8,707,051 shares of our common stock may be offered for sale and sold pursuant to this prospectus by the selling security holders. These shares consist of:

·	7,051,136 currently outstanding shares; and

 

·	1,655,915 shares issuable upon exercise of outstanding warrants held by the selling security holders.

These aggregate shares are to be offered by and for the respective accounts of the selling security holders and any pledgees, donees, assignees and transferees or successors-in-interest of the respective selling security holders. We have agreed to register all of such securities under the Securities Act and to pay all of the expenses in connection with such registration and sale of the shares (other than underwriting discounts and selling commissions and the fees and expenses of counsel and other advisors to the selling security holders). Selling security holders who received their shares from our Chief Executive Officer in connection with Note Cancellation Agreements or the sale on October 10, 2006 are obligated to pay their proportionate share of registration expenses. See “Certain Relationships and Related Transactions.”  We will not purchase any of the shares being sold in this offering.

 

These aggregate shares were acquired by the selling security holders in the following transactions:

 

·

From March 2004 through June 2004, we sold 999,140 shares of our common stock to investors in a private placement for a price of $3.50 per share, for an aggregate of $3,496,990. Concurrently, we issued warrants to purchase an aggregate of 288,638 shares of our common stock for an exercise price of $3.50 per share. Of these securities, only 241,628 shares issued upon the exercise of these warrants and 791,428 shares sold in the private placement are being registered in this offering.

 

13

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·

From August 2004 through September 2004, we sold 290,000 shares of our common stock in a private placement for a price of $5.00 per share, for an aggregate of $1,450,000. Only 100,000 shares of common stock issued in this private placement are being registered in this offering.

·

In private placements that took place from March 2004 through June 2004, we entered into registration rights agreements with our investors. Under these rights agreements, the investors accrued a late registration penalty based on a formula using the time between the target registration date and the actual registration date. We failed to file the registration statement by the appropriate date. This amount was paid in shares of our common stock instead of cash. The number of such shares was determined by dividing the penalty amount by the purchase price of the shares under the applicable subscription agreement. A total of 47,485 of these penalty shares are being registered in this offering from this transaction.

·

During February 2005 through April 2005, we sold 605,000 shares of our common stock to investors in a private placement for a price of $5.00 per share, for an aggregate of $3,025,000. Concurrently, we issued a warrant to purchase 50,000 shares of our common stock for an exercise price of $5.00 per share in consideration for an investor agreeing to certain restrictions on the ability to sell the shares. The warrant was exercised on September 15, 2005, and the 50,000 shares issued upon the exercise of the warrant and all 605,000 shares sold in the private placement are being registered in this offering.

·

From July 1, 2005 through September 14, 2005, we sold 786,642 shares of our common stock to investors in a private placement for a price of $5.50 per share, for an aggregate of $4,326,531.  Of these securities, only 750,279 shares sold in the private placement are being registered in this offering.

·

In 2006, we sold an aggregate of 1,000,000 shares of our common stock to investors in private placements for $2.50 per share for an aggregate of $2,500,000.

·

On February 21, 2007, we sold an aggregate of 2,352,941 shares of our common stock at a price of $2.55 per share for aggregate proceeds of $6,000,000 in a private placement with two investors. We also issued these investors warrants for the purchase of a total of 1,176,471 shares of our common stock at an exercise price of $3.00 per share. As part of the compensation paid to our agent in this private placement, we issued the agent a warrant to purchase 35,000 shares of our common stock with an exercise price of $2.55 per share.

·

In connection with the sale of our common stock in private placements that occurred from March to September 2004, we issued a warrant to a third party who assisted us in identifying investors who participated in those private placements. The warrant was for an aggregate of 350,000 shares of our common stock with an exercise price of $1.30 per share. This warrant was subsequently transferred and exercised by various parties. Only 243,617 shares of common stock issued upon exercise of the warrants are being registered in this offering from this transaction.

·

In private placements that took place from February 2005 through August 2006, we entered into registration rights agreements with our investors. We subsequently entered into amendments to certain registration rights agreements with certain existing investors. Under the original rights agreements, the investors accrued a late registration penalty based on a formula using the time between the target registration date, which has passed, and the actual registration date, which occurred on April 3, 2007. Under the terms of the amendment, certain investors received a predetermined payment as we had not registered the subject shares. In both cases, this amount was paid in shares of our common stock instead of cash. The number of such shares was determined by dividing the penalty amount by the purchase price of the shares under the applicable subscription agreement. Of the 83,093 penalty shares issued in these transactions, only 82,003 shares are being registered in this offering.

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·

From August 19, 2005 through September 13, 2005, we issued 1,273,000 shares of our common stock to investor relations firms for investor relations services for an aggregate value of $9,953,160. These and other firms were paid an additional aggregate of $1,011,200 between April 14, 2005 and January 13, 2006 in cash for their services. The aggregate value paid for these services was $10,964,360.  In 2006, we entered into settlement agreements with two of the consultants who received both shares and cash in exchange for their services. Pursuant to these settlement agreements, the consultants released any and all claims to an aggregate of 1,250,000 shares of the common stock that we did not deliver, and released us from any obligation to make any additional payments under their consulting agreements. We agreed that the consultants could retain all of the aggregate $500,000 in cash fees previously paid, and we released them from any obligation to provide services pursuant to the terms of the consulting agreements. Only 18,000 shares issued to investor relations consultants are included in the shares being registered in this offering.

·

On January 19, 2007, our Chief Executive Officer entered into Note Cancellation Agreements with certain lenders, as more fully described in “Certain Relationships and Related Transactions.” Under the terms of these Note Cancellation Agreements, the Chief Executive Officer transferred his personally held shares of our common stock to the lenders as consideration for the cancellation of promissory notes held by the lenders. Under these agreements, the Chief Executive Officer transferred a total of 521,712 shares of common stock for the cancellation of principal and interest totaling $1,306,178.66 as of December 31, 2006. The agreed upon per share value ranged from $1.50 to $4.22 per share.

·

On October 10, 2006, our Chief Executive Officer entered into a stock purchase agreement with Doron Roethler, a current stockholder. Pursuant to this agreement, our Chief Executive Officer sold 247,043 shares of our common stock from his personal holdings at a price of $1.5176 per share.

·

In January 2007, we issued Atlas a warrant to purchase up to 444,444 shares of our common stock at an exercise price of $2.70 per share. The warrant was issued in connection with the increase of an irrevocable standby letter of credit issued by Atlas from $1.3 million to $2.5 million. The letter of credit was issued in connection with our revolving line of credit with Wachovia Bank, NA.

The following table and notes to the table set forth, with respect to each selling security holder:

 

·	the name of the selling security holder and any material relationship the selling security holder has had with us over the past three years;

 

·	the number of shares of our common stock beneficially owned by the selling security holder as of July 24, 2007;

 

·	the number of shares being offered for sale by the selling security holder pursuant to this prospectus; and
·	the number of shares of our common stock and percentage that will be beneficially owned by the selling security holder assuming the selling security holder disposes of all of the shares being offered pursuant to this prospectus.

Name and Material Relationships		Beneficial Ownership Prior to Sale of the Shares		Number of Shares Being Offered for Sale		Beneficial Ownership After the Sale of the Shares
						Number		Percentage
John Smith (1)(4)		70,553		27,929		42,624		*
Juliani Ltd. (1)(4)(12)		217,030		67,030		50,000		*
Chiche Yael (1)(4)		22,343		22,343		0		0
The Blueline Fund (1)(2)(3)(4)(13)		718,750		718,750		0		0
Atlas Capital, SA(1)(3)(4)(5)(6)(9)(14)(24)		2,773,600		2,699,535		74,065		*
Gilbert H. Burnett(1)(4)(5)		20,135		13,479		6,656		*
Sandra Burnett(5)		6,656		600		6,056		*
Edward S. Finley, Jr.(1)(4)		16,356		10,600		5,756		*
Lawrence Zirbel(1)(4)		30,566		30,566		0		0
Credite Suisse Zurich(1)(4)(15)(16)		187,274		187,274		0		0
Eddie G. Hatch, III(1)(4)(16)		7,056		4,240		2,816		*
Candis Boyer Trust(1)(4)		10,916		10,916		0		0
David P. Nichols(1)(4)		23,826		9,540		14,286		*
Judy M. Nichols(1)(4)		23,826		9,540		14,286		*

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C. Richard Vaughn, Jr.(1)(4)		46,500		26,500		20,000		*
William M. Rhyne(1)(4)		9,236		3,180		6,056		*
Horace T. Bone (1)(4)		2,650		2,650		0		0
Ursula Main(1)(4)		2,650		2,650		0		0
Edgar L. Blackley(1)(4)(16)		27,291		27,291		0		0
Martin L. Wachtel, III(1)(4)		2,120		2,120		0		0
Rodney Cantrell(1)(4)(16)		31,800		31,800		0		0
Michael Hensley(1)(4)(5)		22,058		15,900		6,158		*
Steven Andreus(1)(4)		31,200		21,200		10,000		*
William L. Daniels, Jr.(1)(4)		39,805		8,480		31,325		*
Michael Olander(1)(4)		59,550		59,550		0		0
Andrew Tyson(1)(4)		13,100		10,600		2,500		*
C. Richard Vaughn, Sr.(1)(4)		10,600		10,600		0		0
Jeffrey C. Davis(1)(4)(16)		33,347		27,291		6,056		*

Monty K. Venable(1)(4)		13,600		10,600		3,000		*
David & Robin Young(1)(4)(16)		16,972		10,916		6,056		*
Charles Hoffman(1)(4)		5,300		5,300		0		0
Danny Eason(1)(4)		22,096		14,840		7,256		*
Philippe Pouponnot - member of Board of Directors (3)(4)(13)		50,750		50,750		0		0
Berkley Financial Services, Ltd.(6) (25)		216,175		216,175		0		0
Leon Sokolic(6)(7)		389,965		320,000		85,065		*
Pete Coker(6)(23)		155,945		155,945		0		0
Doron Roethler(6)		2,001,778		247,043		1,754,735		9.8%
Daniel Flebotte(5)		29,232		3,000		26,232		*
Richmond Bernhardt, III(7)(16)(18)		16,815		5,015		11,800		*
J. Fielding Miller(7)(16)(18)		16,815		5,015		11,800		*
Perkins Holdings, LLC(7)(16)(17)(18)		16,815		5,015		11,800		*
Wilson Hoyle, III(7)(16)(18)		6,555		1,955		4,600		*
Ruben Serrano(8)		2,000		2,000		0		0
Mistere, LLC(8)(19)		16,000		16,000		0		0
Herald Investment Trust, PLC.(10)(20)		1,176,471		1,176,471		0		0
Magnetar Capital Master Fund, Ltd.(10)(21)		2,352,941		2,352,941		0		0
Canaccord Adams, Inc..(11)		35,000		35,000		0		0
Tryon Capital Ventures, LLC(7)(22)		98,617		98,617		0		0

This table was prepared based solely upon our stock transfer records as of July 24, 2007, and information furnished to us by the selling security holders listed above. The selling security holders identified above may have sold, transferred or otherwise disposed of, in transactions exempt from the registration requirements of the Securities Act, all or a portion of their shares since the date on which the information in the preceding table was provided. The number and percentage of shares beneficially owned before and after the sales was determined in accordance with Rule 13d-3 under the Securities Exchange Act of 1934, or the Exchange Act, and based on 17,927,137 shares outstanding as of July 24, 2007, and the percentage of outstanding shares of any person as shown in this table does not necessarily reflect the person's actual ownership or voting power with respect to the number of shares of common stock actually outstanding on July 24, 2007.

(1)

Acquired these shares being offered pursuant to this prospectus in a private placement conducted during February 2005 through September 2005. Under the terms of registration rights agreements with investors in this transaction, we have filed with the SEC, under the Securities Act, the registration statement of which this prospectus forms a part, with respect to the resales of the shares from time to time in the markets in which shares of our common stock may be traded from time to time, in privately negotiated transactions, or otherwise, and have agreed to prepare and file such amendments and supplements to the registration statement as may be necessary to keep such registration statement effective until the earlier of (i) 270 days after the effective date of this registration statement, (ii) the date on which all the registered securities have been sold by the selling security holders, and (iii) all the shares registered hereunder can be immediately resold by the selling security holders without a registration statement being in effect.

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(2)	Acquired these shares being offered pursuant to this prospectus upon the exercise of common stock purchase warrants having an exercise price of $5.00 per share.
(3)	Acquired these shares being offered pursuant to this prospectus in a private placement conducted in July 2006 through August 2006. Under the terms of registration rights agreements with investors in this transaction, we have filed with the SEC, under the Securities Act, the registration statement of which this prospectus forms a part, with respect to the resales of the shares from time to time in the markets in which shares of our common stock may be traded from time to time, in privately negotiated transactions, or otherwise, and have agreed to prepare and file such amendments and supplements to the registration statement as may be necessary to keep such registration statement effective until the earlier of (i) 270 days after the effective date of this registration statement, (ii) the date on which all the registered securities have been sold by the selling security holders, and (iii) all the shares registered hereunder can be immediately resold by the selling security holders without a registration statement being in effect.
(4)	Acquired these shares being offered pursuant to this prospectus as a penalty for late registration of other shares issued in private placements.
(5)	Acquired these shares being offered pursuant to this prospectus upon the exercise of common stock purchase warrants having an exercise price of $3.50 per share.

(6)		Acquired these shares being offered pursuant to this prospectus upon transfer from our president and CEO pursuant to a note cancellation agreement or stock purchase agreement. Under the terms of registration rights agreements with investors in this transaction, each party receiving shares of our common stock from our president and CEO's personal holdings under these agreements shall be given notice when we file a registration statement under the Securities Act. Each party is then permitted to include the shares received in such registration statement at such party’s own expense.
(7)		Acquired these shares being offered pursuant to this prospectus upon the exercise of common stock purchase warrants having an exercise price of $1.30 per share.
(8)		Acquired these shares being offered pursuant to this prospectus as compensation for investor relations services in 2005.
(9)		Includes 444,444 shares issuable upon the exercise of a common stock purchase warrant having an exercise price of $2.70 per share.
(10)		Acquired these shares being offered pursuant to this prospectus in a private placement conducted in February 2007. Includes shares issuable upon the exercise of common stock purchase warrants having an exercise price of $3.00 per share in the following amounts: Herald Investment Trust, PLC. - 392,157; Magnetar Capital Master Fund, Ltd. - 784,314. Under the terms of registration rights agreements with investors in this transaction, we have an obligation to register the shares sold 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 reviews the registration statement. If a registration statement is not timely filed or declared effective by the SEC by the date set forth in this agreement, we are obligated to pay a cash penalty of 1% of the purchase price on the day after the filing or declaration of effectiveness is due, and 0.5% of the purchase price per every 30 day period thereafter, to be prorated for partial periods, until we fulfill these obligations. Under no circumstances can the aggregate penalty for late registration or effectiveness exceed 10% of the aggregate purchase price. Under the terms of these agreements, we cannot offer for sale or sell any securities until May 22, 2007, subject to certain limited exceptions, unless, in the opinion of our counsel, such offer or sale does not jeopardize the availability of exemptions from the registration and qualification requirements under applicable securities laws with respect to this placement.
(11)		Includes 35,000 shares issuable upon the exercise of a common stock purchase warrant having an exercise price of $2.55 per share. These securities were acquired by Canaccord Adams, Inc. as compensation for acting as our placement agent in a transaction that closed on February 21, 2007. Canaccord Adams, Inc. is a registered broker-dealer and is therefore deemed an underwriter by the SEC.
(12)		The natural person who exercises voting power and investment control over the securities held by Juliani Ltd. is Neil Smollett.

(13)		Philippe Pouponnot, a member of our Board of Directors, was originally recommended for appointment to the Board by the Blueline Fund. The natural persons who exercise voting power and investment control over the securities held by the Blueline Fund are Farid Raphael, Moussa Raphael, Pierre Parodi and Philippe Lette.
(14)		Shlomo Elia, a member of our Board of Directors, was originally recommended for appointment to the Board by Atlas. The natural persons who exercise voting power and investment control over the securities held by Atlas are Avy Lugassy and Moise Dwek.

 

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(15)		The natural person who exercises voting power and investment control over the securities held by Credite Suisse Zurich is Avy Lugassy.
(16)		This selling security holder is an affiliate of a registered broker-dealer and therefore may be deemed an underwriter by the SEC. This selling security holder purchased our common stock in the ordinary course of business and, at the time it purchased the common stock, it had no agreements or understandings, directly or indirectly, with any person to distribute the common stock.
(17)		The natural person who exercises voting power and investment control over the securities held by Perkins Holdings, LLC is David B. Perkins.
(18)		These selling security holders are affiliates of CapFinancial Partners, LLC, or CapFinancial. In December 2004, we entered into a letter agreement with CapFinancial for consulting services. Pursuant to this agreement, we have paid CapFinancial an aggregate of $231,000 and issued 28,230 shares.
(19)		The natural person who exercises voting power and investment control over the securities held by Mistere, LLC is Sol Meyer.
(20)		The natural person who exercises voting power and investment control over the securities held by Herald Investment Trust, PLC. is Katherine Potts.
(21)		The natural person who exercises voting power and investment control over the securities held by Magnetar Capital Master Fund, Ltd. is Alec Litowitz.
(22)		The natural persons who exercise voting power and investment control over the securities held by Tryon Capital Ventures, LLC are Peter L. Coker and Peter Reichard.
(23)		Includes 98,617 shares of common stock held by Tryon Capital Ventures, LLC, of which Mr. Coker is a managing director. Mr. Coker disclaims beneficial ownership over these 98,617 shares, except to the extent of his pecuniary interest therein.
(24)		Includes shares acquired in private placements that occurred between March 2004 and September 2004, and shares issued as a penalty for late registration of those shares.

 

(25)		The natural person who exercises voting power and investment control over the securities held by Berkley Financial Services, Ltd. is David Moskowich.

 

 

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Interest rate sensitivity

 

We had unrestricted cash and cash equivalents totaling $327,000, $1,435,000, and $173,000 at December 31, 2006, 2005, and 2004, respectively. At March 31, 2007, our unrestricted cash was $5,028,000. These amounts were invested primarily in demand deposit accounts and money market funds. The cash and cash equivalents are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income.

Two debt instruments have variable interest rates; one is prime + 1.5% and the other is LIBOR + .9% (See Note 9, “Notes Payable,” to the accompanying audited financial statements). At March 31, 2007, the outstanding principal balance on these loans was $1,500,000 and $2,052,000, respectively. Due to the relatively short term of these debt instruments combined with the relative stability of interest rates, we do not expect interest rate or market volatility will have a material effect on our cash flows.

 

DESCRIPTION OF BUSINESS

OVERVIEW

Smart Online, Inc. develops and markets products and services targeted to small businesses (less than 50 employees) that are delivered via a Software-as-a-Service, or SaaS, model. Our goal is to be the leading provider of on-demand SaaS applications for small businesses. We sell our products and services primarily through private label syndication and original equipment manufacturer, or OEM, distribution channels, although small businesses may purchase products and services directly through our main portal located at www.smartonline.com.

Our primary source of revenue currently comes from sales of our SaaS applications for business management, web marketing, and e-commerce, which represented 63%, 77%, and 55% of our revenue from continuing operations for the fiscal years ended December 31, 2006, 2005, and 2004, respectively. We derive revenue from sales of services that are designed to complement our product offerings and allow us to create custom business solutions that fit our end-users' and our channel partners' needs, which represented 35%, 19%, and 0% of our revenue from continuing operations for the fiscal years ended December 31, 2006, 2005, and 2004, respectively.

 

We offer two technology platforms that communicate via web service and serve as the foundation for delivery of our business solutions: OneBiz^SM and iDirect Architecture^TM, or iDA. Each is described more fully below. Both platforms allow integrated applications to share data with the other products and/or services running on our platforms. Our products and services are primarily offered on a subscription basis using the on-demand SaaS model.

HISTORY

We were incorporated in Delaware in 1993 and initially offered our software applications using traditional distribution methods of diskettes and later CD-ROMs. In 2000, we moved away from the traditional distribution model and began primarily offering on-demand SaaS applications over the Internet. Unlike the traditional distribution method that requires a customer to install, configure, and maintain hardware, software, and network services internally to support the software applications, our proprietary SaaS applications allow small businesses to subscribe to a wide variety of applications that have been developed specifically for delivery over the Internet on an on-demand basis with very little or no installation or maintenance required.

 

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During October 2005, we acquired substantially all of the assets of Computility, a privately held developer and distributor of sales force automation and customer relationship management, or SFA/CRM, software applications based in Des Moines, Iowa. We operated this business under the name Smart CRM. Also during October 2005, we acquired all the stock of iMart, a privately held developer and distributor of multi-channel e-commerce systems based in Grand Rapids, Michigan. We operate this subsidiary as Smart Commerce.

 

Upon our integration of Smart CRM's SFA/CRM application into our OneBiz^SM platform, management 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 about this business closure, see Note 17, “Acquisitions & Dispositions” in the accompanying audited financial statements included in this prospectus.

The Smart CRM assets sold to Alliance included the traditional 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 OneBiz^SM platform.

Consistent with SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, or SFAS No. 131, we have defined two reportable segments based on factors such as geography, products, customers, how operations are managed, and how our chief executive officer, 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.

The Smart Commerce segment's revenues are derived primarily from the development and distribution of multi-channel e-commerce systems including domain name registration and e-mail solutions, e-commerce solutions, website design and website hosting. In 2006, our Smart Commerce segment generated 86% of our total consolidated revenue and 96% 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 2006, our Smart Online segment generated 14% of our total consolidated revenue and 100% of our integration and syndication revenue, and 4% 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.

During the period from 2000 to 2006, we were functioning primarily in a research and development mode as we adapted our products for the SaaS model. We began shifting our focus to the marketing of our most current products in the fourth quarter of 2006. During fiscal 2006, the operations we acquired following the iMart acquisition, which we operate as Smart Commerce, were revenue-generating operations. Accordingly, the majority of current revenues is generated by our Smart Commerce segment.

PRINCIPAL PRODUCTS AND SERVICES

Our principal products and services include:

 

	·	SaaS applications for business management, web marketing, and e-commerce;
	·	software business tools that assist customers in developing written content; and

 

·

services that are designed to complement our product offerings and allow us to create custom business solutions that fit our end-users' and our channel partners' needs.

  

 

Business Management SaaS Applications

Our business management SaaS applications are designed to allow users to access and work on information securely from anywhere with an Internet browser. These applications include:

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. The dashboard automatically aggregates data from multiple sources and summarizes the information for the user quickly and efficiently. Examples of business information that users may view on the dashboard include: a list of key documents for the user, daily events scheduled, FedEx packages shipped by a user, or a list of new employees. The dashboard is entirely role-based, and displays different information to each user based upon their role and access levels within the company.

Accounting: Our Accounting application is targeted for users that want to create and maintain their accounting books online in a secure fashion but do not have the time or resources to learn and understand the intricacies of traditional accounting applications designed for larger businesses. The Accounting application functions allow a user to create invoices, record payments, print checks, produce real-time financial statements and reports, as well as manage accounts receivable and payable.

 

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

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 other different policies to each individual employee. The application can 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 user to quickly browse to any other date. Users can set up automated email reminders at their convenience, indicating how early they would like to be notified of an upcoming event. In addition, users have the option to collaborate with their colleagues by sharing their calendar and events. This application also includes a to-do list, allowing users to setup tasks, assign priorities and due dates, and mark tasks as complete as they work through them.

Contacts: Our Contacts application is designed to provide users with an online business contact management system. Contacts can be sorted by group or alphabetically. Users also have the option to add, edit, and remove contact groups at their own convenience, or they can use the default set of groups that is already provided for them when they sign up. Furthermore, users have the option to share their contacts between colleagues. Using the intuitive sharing system built into the application, users select whether they would like a contact to remain private or shared.

e-Commerce: Our e-commerce applications, OneDomain^TM and OneDomainX^TM, are designed to give customers the ability to conduct their business online and include website design and launch, inventory query, shopping cart, financial transactions, shipping, domain name registration and business to business communication for small businesses. Our e-commerce applications also include our Direct Marketing Architecture, or iDMA, which is a technology platform that is designed to help direct marketers increase sales, better leverage corporate resources, and deliver superior customer service, and our Direct Selling Architecture, or iDSA, which is a system available for direct selling and network marketing companies.

Business Tools

We offer a variety of business tools through our website to aid small businesses. Most of these tools are also available through the private-label sites of our 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.

Additional Services

These services are designed to complement our product offerings and allow us to create custom business solutions that fit our end-users' and 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, and personalized email creation, FedEx tracking, loan center, press release writing, business plan writing & evaluation, 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 customers. The Internet allows for delivery of software in new ways. For example, a company can download a software application instead of buying it from the local retail store. However, software purchased in this fashion still needs to be installed, updated, and the data backed-up, all by the end-user. The on-demand SaaS model eliminates these additional tasks. Instead, end users 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, anywhere by the end-user. Multi-tenant SaaS applications have the additional benefit of allowing functionality to be added to our applications in one place to the benefit of all users. This allows us to have easier maintenance, universal upgrading, and quick deployment of new features.

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Revenue Stream

We charge small businesses who use our SaaS applications a subscriber fee on a monthly subscription basis, rather than the large upfront cost typically charged for traditional software applications.

Platforms

We have designed two technology platforms to serve as the foundation for delivery of our business solutions: OneBiz^SM and iDA.

OneBiz^SM is our business management platform offered though our main portal and through the sites of our private-label partners. This allows us to offer our proprietary products, as well as certain integration partner products, to our partners' small business customers in the “look” and “feel” of the partner's website. iDA is our web marketing and web selling platform offered through Smart Commerce. Both platforms communicate with each other via web services and have the ability to allow integrated applications to share data with the rest of the products and/or services running on our platforms. The platforms also allow users to seamlessly login to multiple SaaS applications/services without having to re-enter a user ID and password or navigate to another site. Both platforms use a modular methodology, which allows various components to be assembled for rapid new application development and enhancement. Our OneBiz^SM platform has a distinct profile feature that is created for every company when users sign up and register. This profile is continually updated based on operations performed and information requested by each company as its users operate on the platform.

Integration and Sharing

Our platforms allow end-users to share information (with selectivity and control options) with other members of their organization. Each user that subscribes to our platform can have multiple members or employees who share information with one another. Information entered by one user can be shared and modified by one or more other users, promoting collaboration within a company.

 

Several of the applications within our platforms are integrated with one another. Integration means that certain applications communicate and share information with other applications.

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. The small business market is diverse, fragmented, yet very large and, we believe, underserved. We define small businesses as those having less than 50 employees. Even within this definition, there exists a large variety of businesses. Therefore, we have focused on offering a wide range of software products that combine simplicity and affordability. We realize that many new small businesses will fail relatively quickly, which forces us to continuously seek out new end-users to replace existing end-user attrition. Another characteristic of small businesses is that they are typically late adopters of technology. Internet adoption is well past critical mass, and we believe the growth rate of small businesses using web-based applications will exceed the growth rate of large enterprises. These businesses may even leapfrog traditional software and go straight from paper-based management to a SaaS solution.

Although our ultimate end-users are small businesses and entrepreneurs who access our software products and services via the web, we use channel partners such as financial institutions, telecommunication companies, direct selling organizations, retailers, technology companies, and small business consultants as channels to reach small business customers. These partnerships can be constructed in a variety of formats - from resellers to co-branded offerings to private label or OEM solutions. We typically seek partnerships with organizations that already have a relationship with small businesses. We have successfully targeted our applications to direct selling organizations, financial companies as well as business media companies.

Our plan for 2007 is to increase our revenue through a combination of four sales and marketing initiatives:

 

	·	soliciting additional syndication partners,
	·	actively managing relationships with our partners to increase sales,
	·	bundling our software in packages targeted to different types of vertical industries within the small business market, and

 

·

partner with companies to introduce new applications and products to enhance our platform for greater value to small businesses.

We have not yet implemented all of these marketing strategies, and others have not been implemented until recently. At this time, we cannot determine how successful these strategies will be.

We also plan to continue to update, enhance, and add to the functionality of our platforms, and add sales and marketing personnel to implement our syndication partner strategy.

 

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PRINCIPAL CUSTOMERS

Currently, two customers are considered major customers the loss of whom 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 45% of our consolidated revenue for the fiscal year ended December 31, 2006. BWW was not a customer of ours in 2004, and was a customer of ours only after we acquired iMart in October 2005. Accordingly, BWW represented 0% and 15% of our revenues in 2004 and 2005, respectively. Although our revenue is derived from the IBO, because BWW can influence the actions of the IBOs, this revenue has been aggregated for purposes of this prospectus.

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 28% of our consolidated revenues for the fiscal year ended December 31, 2006. Vera Bradley was not a customer of ours in either 2004 or 2005, and therefore represented 0% of our revenue in those years.

RESEARCH & DEVELOPMENT

Between 1999 and 2000, we made a strategic decision to shift our focus from traditional software delivery to the SaaS model. From that point until the present, we have devoted substantially all of our development personnel's time and efforts 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 2004, we spent approximately $563,000 on research and development. In 2005, our research and development costs increased to approximately $1.6 million as we increased our efforts to develop our OneBiz^SM applications for new partners. In 2006, our research and development costs were approximately $2.0 million with the increase over 2005 primarily related to development efforts in Smart Commerce.

We have not engaged in any customer sponsored research and development.

COMPETITION

The market for small business software applications is highly competitive and subject to rapid change. 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. Most of these competitors also sell other products and services not specifically targeted to small businesses, although some of their products have been modified for small business use or are marketed as small business products. These competitors include, but are not limited to, Microsoft, Oracle, NetSuite, Intuit, SAP, Sage and Yahoo!.

We also expect to face competition from new entrants that will market SaaS applications similar to ours to small businesses. As we introduce more software products, we expect to encounter more competitors. 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, Oracle, Sage and others.
	·	e-Commerce solutions: Register.com, GoDaddy.com, 1and1 Internet, Yahoo!, eBay's Storefront, Yahoo! Store, Microsoft, NetSuite, Homestead and others.
	·	SFA/CRM applications: Microsoft, Oracle, Sage, Salesforce.com, Netsuite, and others.

 

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

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On each competitive front, we seek to compete against these larger and better financed companies primarily by offering a 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. By integrating data sharing across applications through our platform, small businesses can enter or change data once. However, our individual applications must also be competitive with the applications offered by industry leaders in those specific segments which will require additional development work by us. If we are unable to develop new and enhanced applications that are competitive, our business may be harmed.

We also plan to leverage our private label syndication partners to sell our SaaS applications to their small business customers. We offer these partners and potential partners the ability for large corporations to private-label our products to offer their small business customers value added products and services. While we may lack the marketing budget or resources to compete with industry giants, we believe our corporate syndication partners will allow us to compete effectively if we are able to motivate our partners to devote resources to selling subscriptions. This strategy will require us to hire additional personnel to develop and manage these relationships and to sign additional partners to private label our SaaS applications.

We also believe that our focus on delivering our products and service via the SaaS business model enables us to compete with these companies. This model requires very little initial investment by small businesses and we believe it is cost competitive with the products of many competitors over the long-term. SaaS applications provide our customers with access to their important business data from any location via the Internet and can be updated automatically and without a charge to the customer. This functionality enables us to continually improve the ease of use and performance of our SaaS applications as we receive feedback from our customers. However, this functionality may also make the SaaS model more attractive to competitors that currently offer their products through traditional methods of software delivery. As a result, we expect the number of competitors offering software via the SaaS model to increase in the future.

WORKING CAPITAL PRACTICES

Due to the nature of the model we have adopted for the delivery of our products, our working capital needs are primarily cash and equivalents and accounts receivable, which are necessary to support and sustain our operations. We do not carry any significant inventory nor do we maintain substantial reserves for returns or credit terms.

INTELLECTUAL PROPERTY RIGHTS

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

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

We have registered copyrights, trademarks and registered service marks on more than a dozen 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. We also employ various physical security measures to protect our software source codes, technology, and other proprietary information.

EMPLOYEES

As of July 24, 2007, we had 61 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.

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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, 2007. We also lease approximately 1,500 square feet of office space in Clive, Iowa under a lease that expires on October 31, 2008, and approximately 6,800 square feet of office space in Grand Rapids, Michigan. The Michigan facility is currently leased on a month-to-month basis.

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.

Suit Against Michael Nouri Regarding Smart Online, S.A. On or about March 7, 2002, we petitioned (as is required under French law) a court in France to allow us to liquidate our French subsidiary, Smart Online S.A. As a result, we paid $113,056.83 to Smart Online S.A. in settlement of all claims against us. Michael Nouri, our President and CEO and the former President and CEO of Smart Online S.A., was subsequently sued personally as the legal representative of Smart Online S.A. The Liquidateur for Smart Online S.A. has agreed to a proposal for settlement offered by Mr. Nouri in the amount of €15,000 (approximately US $18,500 based on an exchange rate of approximately US $1.23 per €1.00 on March 7, 2006). On October 19, 2006, the court officially recorded the withdrawal of the claims asserted by the Liquidateur. Our Board of Directors has authorized us to indemnify Mr. Nouri for the amount of any settlement and all legal costs and fees and other expenses associated with the defense of Mr. Nouri in relation to this matter, because Mr. Nouri was acting on our behalf in the liquidation of our French subsidiary.

Order of Securities and Exchange Commission Suspending the Trading of Smart Online Securities. 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 OTC-BB. After the filing of the required paperwork by a market maker, our common stock returned to quotation on the OTC-BB on September 11, 2006. Simultaneously with the suspension, the SEC advised us that it was conducting a non-public investigation. While we continue to cooperate with the SEC, we are unable to predict at this time whether the SEC will take any adverse action against us.

 

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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Review and Approval of Related Person Transactions

The Audit Committee recently adopted the Policy and Procedures with Respect to Related Person Transactions, which is implemented through the Audit Committee and is designed to regularly monitor the appropriateness of any significant transactions with related persons. The policy applies to any transaction required to be disclosed under Item 404(a) of Regulation S-K in which (1) we are a participant, (2) any related person (as defined in Item 404(a) of Regulation S-K) has a direct or indirect material interest and (3) the amount involved exceeds $120,000. Our policy requires notification to our Chief Financial Officer prior to the consummation of any related person transaction regardless of whether the related person has a material interest, describing the related person's interest in the transaction, the material facts of the transaction, the benefits to us of the transaction, the availability of other sources of comparable products or services, and an assessment of whether the transaction is on terms that are comparable to the terms available to an unrelated third party or employees generally. The Chief Financial Officer then evaluates the proposed transaction and, if he determines that it is a related person transaction, submits the transaction to the Audit Committee for approval. The Audit Committee considers all of the relevant facts and circumstances available to it including (if applicable) but not limited to:

 

	·	the benefits to us;
	·	the impact on a director's independence in the event the related person is a director, an immediate family member of a director or an entity in which a director is a partner, stockholder or executive officer;
	·	the availability of other sources for comparable products or services;
	·	the terms of the transaction; and
	·	the terms available to unrelated third parties or to employees generally.

 

No member of the Audit Committee shall participate in any review, consideration or approval of any related person transaction with respect to which such member or any of his or her immediate family members is the related person. Three of our four independent directors currently serve on our Audit Committee. If an Audit Committee member must recuse himself from the consideration and approval of a related person transaction due to his interest in the transaction, then the independent director who does not serve on the Audit Committee will participate in the consideration and approval of such transaction unless he also has an interest in the transaction. If the total number of independent directors falls to two, both independent directors will approve all related person transactions in which they do not have an interest. The Audit Committee approves only those related person transactions that are in, or are not inconsistent with, the best interests of us and our stockholders, as the Audit Committee determines in good faith. If the transaction has already been consummated, the Audit Committee will undergo the same analysis as it does with a proposed transaction, and if it determines that the consummated transaction is a related person transaction, it will evaluate whether the consummated related person transaction should be ratified, amended, terminated or rescinded and whether any disciplinary action is appropriate. The Audit Committee has access, at the Company's expense, to the Company's counsel or independent legal counsel.

 

The Audit Committee has reviewed and approved or ratified all related person transactions that have taken place since the beginning of fiscal 2006.

Related Person Transactions

Except as disclosed below, none of the following persons has, since January 1, 2002, had any material interest, direct or indirect, in any transaction with us or in any presently proposed transaction that has or will materially affect us:

·	Any of our directors or executive officers;
·	Any person proposed as a nominee for election as a director;
·	Any person who beneficially owns, directly or indirectly, shares carrying more than 5% of the voting rights attached to our outstanding shares of common stock; or
·	Any member of the immediate family of any of the foregoing persons.

Non-Compete Payments Made to Chief Operating Officer of Smart Commerce

In October 2005, we purchased all of the stock of iMart. One of the named executive officers, Gary Mahieu, was a founder and shareholder of iMart, and was its principal executive officer. Following the purchase of iMart's stock, Mr. Mahieu entered into an employment agreement with Smart Commerce, our wholly-owned subsidiary. Under the terms of that agreement, we agreed to make non-competition payments to Mr. Mahieu of an aggregate of $510,000 to be made in eight equal quarterly installments of $63,750 through October 1, 2007. In connection with obtaining a loan from Fifth Third Bank, the payment schedule was modified to require all outstanding non-compete payments to be made by February 2007. This amount was paid in full on February 7, 2007, and no additional non-compete payments are owed to Mr. Mahieu. Both the original employment agreement and the modifications of the non-compete payments were unanimously approved by our Board of Directors, including all “independent” directors. This transaction was not generally available from unaffiliated parties.

 

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Loans Made by Certain Parties to the Chief Executive Officer

 

During 2005, the following loans were made by certain investors, consultants and/or stockholders to our Chief Executive Officer: (i) $809,736.49 was borrowed from Leon Sokolic, one of our stockholders, (ii) $77,971.20 was borrowed from Atlas, one of our stockholders, (iii) $80,000 was borrowed from Pete Coker, a principal of Tryon Capital, which provided financial consulting services to us and received a warrant and cash fees, and (iv) $296,589 was borrowed from Berkley Financial Services, Ltd., or Berkley, which received compensation for services rendered to us for investment banking and investor relations services, including during the period in which Berkley was making loans to the Chief Executive Officer, or collectively, the Lenders. Under Section 402 of Sarbanes-Oxley, we are prohibited from making personal loans to our directors and executive officers, directly and indirectly. We believe that the loans to the Chief Executive Officer described above are not personal loans made directly or indirectly by us to the Chief Executive Officer.

 

On January 19, 2007, our Chief Executive Officer entered into Note Cancellation Agreements with each of the Lenders. Under the terms of these Note Cancellation Agreements, the Chief Executive Officer transferred his personally held shares of our common stock to the Lenders as consideration for the cancellation of promissory notes held by the Lenders. Under these agreements, the Chief Executive Officer transferred a total of 521,699 shares of common stock for the cancellation of principal and interest totaling $1,306,178.66 as of December 31, 2006. The agreed upon per share value ranged from $1.50 to $4.22 per share.

 

In connection with the Note Cancellation Agreements, we entered into Registration Rights Agreements with each of the Lenders described in the preceding paragraphs. Under the terms of these Registration Rights Agreements, each Lender must be given notice when we file a registration statement under the Securities Act. Each Lender is then permitted to include its shares received in such registration statement. Under the Registration Rights Agreements, parties electing to include such shares in the registration are to bear their proportionate share of the registration expenses. The terms of this transaction were as favorable as those generally available from unaffiliated parties.

 

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

Michael Nouri. From 1999 until September 2003, we deferred salary payments to Mr. Nouri totaling $296,667, which were due to him under his employment agreement dated July 14, 1999, which called for a base salary of $150,000 per year. Loans and deferrals earned interest at a rate of 15% compounded annually. In October 2003, Mr. Nouri agreed to continue to defer $9,583 of salary per month for salary that accrued after October 1, 2003. On October 13, 2003, we entered into an agreement with Mr. Nouri whereby the salary deferrals through October 1, 2003 were evidenced by a promissory note in the principal amount of $358,229 for deferrals of salary that accrued prior to October 1, 2003. During the fourth quarter of 2003 and the first quarter of 2004, we deferred an additional $63,437 of Mr. Nouri's compensation. On April 30, 2004, the promissory note dated October 13, 2003 was cancelled and replaced by a successor promissory note in the amount of $418,750 representing the principal balance of the original note plus the additional accrued compensation. Subsequently during 2004, we paid $125,000 of principal to Mr. Nouri. The outstanding balance due on the successor note bore interest of 15% interest compounded annually (reduced to 8% effective June 1, 2004). This note and all of our other obligations to Mr. Nouri arising out of loans and salary deferrals were secured by all of our assets, which lien Mr. Nouri shared with Henry Nouri, Ronna Loprete, Thomas Furr and Eric Nouri to secure the obligations to them described below. The security interest was originally a second lien on all of our assets, but with repayment of all amounts owed to the holder of the first lien, the security interest became a first lien on all of our assets. The lien was removed when the notes were paid.  The note was due May 31, 2005, but Mr. Nouri entered into a standstill agreement not to demand payment on the due date to induce holders of outstanding shares of preferred stock to convert to shares of common stock in a reorganization. The standstill agreement, as amended as of December 22, 2004, continued through the earlier of June 30, 2006 or the closing after January 1, 2005 of a financing with gross proceeds to us of $2,000,000 or more. After we raised $2,500,000 from a sale of securities to a foreign investor in February 2005, we paid in full the $296,667 of deferred compensation and accrued interest and cancelled the related promissory note.

Henry Nouri. From 1999 until September 2003, we deferred salary payments to Mr. Nouri totaling $398,383, which were due to him under his employment agreement dated July 14, 1999, which called for a base salary of $150,000 per year. In October 2003, Mr. Nouri agreed to continue to defer $9,583 of salary per month for salary that accrued after October 1, 2003. Deferrals earned interest at a rate of 15% compounded annually. On October 13, 2003, we entered into an agreement with Mr. Nouri whereby all salary deferrals through October 1, 2003 were evidenced by a promissory note in the principal amount of $346,812 for deferrals of salary that accrued prior to October 1, 2003. During the fourth quarter of 2003 and the first quarter of 2004, we deferred an additional $60,521 of Mr. Nouri's compensation and $8,950 of the original principal was repaid. On April 30, 2004, the promissory note dated October 13, 2003 was cancelled and replaced by a successor promissory note in the amount of $398,383 representing the unpaid principal balance of the original note plus the additional accrued compensation. This note and all deferred salary bore 15% interest compounded annually (reduced to 8% effective June 1, 2004). The note and all of our other obligations to Mr. Nouri arising out of salary deferrals were secured by all of our assets, which lien Mr. Nouri shared with Michael Nouri, Ronna Loprete, Thomas Furr and Eric Nouri to secure the obligations to them described herein. The security interest was originally a second lien on all of our assets, but with repayment of all amounts owed to the holder of the first lien, the security interest became a first lien on all of our assets. The lien was removed when the notes were paid. The notes were due May 31, 2005, but Mr. Nouri entered into a standstill agreement not to demand payment on the due date to induce holders of outstanding shares of preferred stock to convert to shares of common stock in a reorganization. The standstill agreement, as amended as of December 22, 2004, continued through the earlier of June 30, 2006 or the closing after January 1, 2005 of a financing with gross proceeds to us of $2,000,000 or more. After we raised $2,500,000 from a sale of securities to a foreign investor in February 2005, we paid in full the $398,383 of deferred compensation and accrued interest and cancelled the related promissory note.

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Thomas Furr. From 2001 until September 2003, we deferred salary and commission payments to Thomas Furr totaling $117,810, which were due to him under his employment agreement dated September 15, 2001, which called for a base salary of $70,000 per year, plus 5% sales commissions. Deferrals earned interest at a rate of 15% compounded annually. In October 2003, Mr. Furr agreed to continue to defer all commissions per month for salary or commissions that accrue after October 1, 2003. On October 15, 2003, we entered into an agreement with Mr. Furr whereby all the loans and salary or commission deferrals through October 1, 2003 were evidenced by a promissory note in the principal amount of $114,190 for deferrals of salary that accrued prior to October 1, 2003. During the fourth quarter of 2003 and the first quarter of 2004, we deferred an additional $2,318 of Mr. Furr's compensation. On April 30, 2004, the promissory note dated October 13, 2003 was cancelled and replaced by a successor promissory note in the amount of $116,508 representing the unpaid principal balance of the original note plus the additional accrued compensation. The note, plus $1,302 of compensation subsequently deferred during 2004, and all deferred commissions bore 15% interest compounded annually (reduced to 8% effective June 1, 2004). The note and all of our other obligations to Mr. Furr arising out of salary or commission deferrals were secured by all of our assets, which lien Mr. Furr shared with Michael Nouri, Henry Nouri, Ronna Loprete and Eric Nouri to secure the obligations to them described herein. The security interest was originally a second lien on all of our assets, but with repayment of all amounts owed to the holder of the first lien, the security interest became a first lien on all of our assets. The lien was removed when the notes were paid. The note was due May 31, 2005, but Mr. Furr entered into a standstill agreement not to demand payment on the due date to induce holders of outstanding shares of preferred stock to convert to shares of common stock in a reorganization. The standstill agreement, as amended as of December 22, 2004, continued through the earlier of June 30, 2006 or the closing after January 1, 2005 of a financing with gross proceeds to us of $2,000,000 or more. After we raised $2,500,000 from a sale of securities to a foreign investor in February 2005, we paid in full the $92,500 of deferred compensation and accrued interest and cancelled the related promissory note.

Ronna Loprete. From 2001 until September 2003, we deferred salary payments to Ms. Loprete totaling $92,500, which were due to her under her employment agreement dated June 29, 1999, which called for a base salary of $80,000 per year. In October 2003, Ms. Loprete agreed to continue to defer $2,500 of salary per month for salary that accrued after October 1, 2003. Deferrals earned interest at a rate of 15% compounded annually. On October 15, 2003, we entered into an agreement with Ms. Loprete whereby all salary deferrals through October 1, 2003 were evidenced by a promissory note in the principal amount of $92,500 for deferrals of salary that accrued prior to October 1, 2003. During the fourth quarter of 2003 and the first quarter of 2004, we deferred an additional $625 of Ms. Loprete's compensation. On April 30, 2004, the promissory note dated October 15, 2003 was cancelled and replaced by a successor promissory note in the amount of $92,500 representing the unpaid principal balance of the original note plus the additional accrued compensation. This note and all deferred salary bore 15% interest compounded annually (reduced to 8% effective June 1, 2004). The note and all of our other obligations to Ms. Loprete arising out of salary deferrals were secured by all of our assets, which lien Ms. Loprete shared with Michael Nouri, Henry Nouri, Thomas Furr and Eric Nouri to secure the obligations to them described herein. The security interest was originally a second lien on all of our assets, but with repayment of all amounts owed to the holder of the first lien, the security interest became a first lien on all of our assets.  The lien was removed when the notes were paid. The note was due May 31, 2005, but Ms. Loprete entered into a standstill agreement not to demand payment to induce holders of outstanding shares of preferred stock to convert to shares of common stock in a reorganization. The standstill agreement, as amended as of December 22, 2004, continued through the earlier of June 30, 2006 or the closing after January 1, 2005 of a financing with gross proceeds to us of $2,000,000 or more. After we raised $2,500,000 from a sale of securities to a foreign investor in February 2005, we paid in full the $117,800 of deferred compensation and accrued interest and cancelled the related promissory note.

Eric Nouri. From 2002 until September 2003, we deferred salary payments to Eric Nouri totaling $44,417, which were due to him under his employment agreement dated April 1, 2002 which called for a base salary of $60,000 per year. Deferrals earned interest at a rate of 15% compounded annually. Eric Nouri is the brother of Michael Nouri and Henry Nouri. In October 2003, Mr. Nouri agreed to continue to defer $2,500 of salary per month for salary that accrued after October 1, 2003. On October 13, 2003, we entered into an agreement with Mr. Nouri whereby all salary deferrals through October 1, 2003 were evidenced by a promissory note in the principal amount of $54,925 for deferrals of salary that accrued prior to October 1, 2003. During the fourth quarter of 2003 and the first quarter of 2004, we deferred an additional $9,000 of Mr. Nouri's compensation and $16,185 of principal was paid. On April 30, 2004, the promissory note dated October 13, 2003 was cancelled and replaced by a successor promissory note in the amount of $47,740 representing the unpaid principal balance of the original note plus the additional accrued compensation. Subsequently during 2004, we deferred an additional $3,323 of Mr. Nouri's compensation. This note bore 15% interest compounded annually (reduced to 8% effective June 1, 2004). The note and all of our other obligations to Mr. Nouri arising out of salary deferrals were secured by all of our assets, which lien Mr. Nouri shared with Michael Nouri, Henry Nouri, Ronna Loprete and Thomas Furr to secure the obligations to them described herein. The security interest was originally a second lien on all of our assets, but with repayment of all amounts owed to the holder of the first lien, the security interest became a first lien on all of our assets.  The lien was removed when the notes were paid. The note was due May 31, 2005, but Mr. Nouri entered into a standstill agreement not to demand payment on the due date to induce holders of outstanding shares of preferred stock to convert to shares of common stock in a reorganization. The standstill agreement, as amended as of December 22, 2004, continued through the earlier of June 30, 2006 or the closing after January 1, 2005 of a financing with gross proceeds to us of $2,000,000 or more. After we raised $2,500,000 from a sale of securities to a foreign investor in February 2005, we paid in full the $44,417 of deferred compensation and accrued interest and cancelled the related promissory note.

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Tamir Sagie. Tamir Sagie was a consultant with and owned Nen, Inc. Nen, Inc. was a consultant to us and was paid at an annual rate of $70,000 per year in addition to Mr. Tagie's salary of $30,000. Nen, Inc. also had an equity interest in Smart IL, Ltd., or Smart IL, from April 2002 to July 2003. Smart IL became an integration partner with us in August 2002 through the efforts of Nen, Inc. Mr. Sagie ended his consulting arrangement with Smart IL in August 2003 when he became an employee and officer of us. Mr. Sagie's shares in Smart IL were transferred back to Smart IL at this time. In addition, Mr. Sagie owned 29.5% of Greenleaf Ventures, Ltd., or Greenleaf, and as such had a financial interest in the 1,448,618 shares of our common stock owned by Greenleaf. On January 13, 2005, Mr. Sagie entered into an agreement with Greenleaf and Doron Roethler, one of our stockholders and an affiliate of Greenleaf, that provided for the withdrawal of Mr. Sagie from Greenleaf. In exchange for Mr. Sagie's release of any interest in Greenleaf and Crystal Management Ltd. (another entity owned by Mr. Roethler), Mr. Sagie received 125,000 shares of our common stock held by Greenleaf. He was not an officer or director of Greenleaf. Mr. Sagie resigned from Smart Online in the first quarter of 2005 and has no further affiliation with us.

 

At the time we entered into each of the transactions described above in this “Loans, Salary Deferrals and Security Interests of Certain Officers, Employees and Relatives” section, none of the members of our Board of Directors were “independent.” The terms of these transactions were not generally available from unaffiliated third parties.

 

Certain Investor Relations Service Provider and Company Stockholder

In February 2005, we entered into an investment banking agreement with Berkley whereby Berkley served as our nonexclusive agent in connection with the negotiation and closing of one or more transactions with investors outside the United States. Pursuant to this agreement, we paid Berkley approximately $290,000 in cash in 2005. We sent a notice of termination of this agreement to Berkley on March 22, 2006. In addition, in October 2005, we entered into an investor relations consulting agreement with Berkley, under which Berkley was paid $250,000 and issued 625,000 shares of our common stock. On August 30, 2006, we entered into a Settlement Agreement with Berkley with regard to its consulting agreement. Pursuant to the Settlement Agreement, Berkley released any and all claims to the 625,000 shares of the common stock that we did not deliver, and released us from any obligation to make any additional payments under the consulting agreement. We agreed that Berkley can retain all of the $250,000 cash fee previously paid, and we released Berkley from any obligation to provide services pursuant to the terms of the consulting agreement. The investment banking agreement, its termination, the consulting agreement and the settlement and release were approved by our Board of Directors, including all “independent” directors. We believe there may be some relationship between Doron Roethler (a stockholder who beneficially owns more than 10% of the outstanding shares of our common stock) and Berkley, although we are unable to determine the nature of the relationship. 

 

Private Placement of Common Stock to Certain Affiliates

In private placement transactions that closed in 2006, Mr. Pouponnot, one of our directors, purchased 50,000 shares of our common stock, and Atlas, which holds more than 10% of our outstanding common stock, purchased 800,000 shares of our common. All of these private placement shares were sold at $2.50 per share pursuant to Subscription Agreements between us and each of Atlas and Mr. Pouponnot. We entered into a Subscriber Rights Agreement with each whereby we are obligated to register these shares for resale by the purchaser by filing a registration statement on or before September 30, 2006. If a registration statement is not filed by that date, we are obligated to pay a penalty obtained by multiplying the total purchase price for the shares by 0.5% by the number of prorated 30 day periods after the target registration date. At our sole discretion, this penalty can be paid in the number of shares obtained by dividing the total penalty amount by the per share purchase price. We filed a registration statement for these shares on April 3, 2007. In January 2007, we entered into an amendment to the Subscriber Rights Agreement with Atlas and Mr. Pouponnot. Under these amendments, the penalty for late registration was set at a fixed amount. We subsequently issued Mr. Pouponnot 750 shares of our common stock, and Atlas 12,000 shares of our common stock, as payment for these late registration penalties with an aggregate value of $35,700 based upon a closing price per share of $2.80 on the OTC-BB on the date of issuance.

Both Atlas and Mr. Pouponnot have entered into a Dribble Out Agreement with us pursuant to which they may sell up to 25% of these shares during any rolling 30 day period, following the effective date of the registration statement.

At the time of the sale to Mr. Pouponnot, he had not been appointed a member of our Board of Directors. Although the Dribble Out Agreement described above still applies, any disposition of the shares sold to Mr. Pouponnot would also have to comply with our Insider Trading Policy. At the time we entered into each of these private placements, only one member of our Board of Directors was “independent.” Although this director approved the terms of these agreements, we lacked a sufficient number of disinterested “independent” directors to ratify these transactions. The terms of these private placements were as favorable as those generally available from unaffiliated parties.

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Private Placement of Common Stock to a Certain Affiliate by Chief Executive Officer

On October 10, 2006, Michael Nouri entered into a stock purchase agreement with Doron Roethler, a current stockholder. Pursuant to this agreement, Mr. Nouri sold 247,043 shares of our common stock from his personal holdings at a price of $1.5176 per share. We entered into a Registration Rights Agreement with Mr. Roethler in connection with this transaction under which we have an obligation to register the shares sold my Mr. Nouri to Mr. Roethler on the first registration statement filed by us following the sale, with Mr. Roethler bearing his proportionate share of the registration expenses. Under the terms of this agreement, the shares were delivered following our execution of such Registration Rights Agreement, which occurred on January 19, 2007. The Company filed a registration statement for these shares on April 3, 2007. At the time Mr. Nouri entered into the stock purchase agreement, only one member of our Board of Directors was “independent.” Although this director approved the terms of the stock purchase agreement, we lacked a sufficient number of disinterested “independent” directors to ratify the transaction. The terms of this private placement were as favorable as those generally available from unaffiliated parties.

DESCRIPTION OF SECURITIES

Our authorized capital stock currently consists of 45,000,000 shares of common stock, par value $0.001 per share, of which 17,927,137 shares are issued and outstanding as of July 24, 2007, and 5,000,000 shares of preferred stock, par value $0.001 per share, of which no shares are issued and outstanding. The rights and preferences of the preferred stock may be established from time to time by our Board of Directors.

The following description highlights material information about our securities. However, this description of our securities is a summary only and may be exclusive of certain information that may be important to you. For more complete information, you should read our Certificate of Incorporation together with our corporate Bylaws.

Common Stock

Holders of our common stock are entitled to one vote for each share held on all matters submitted to a vote of stockholders. A vote of the majority of shares voted on any matter at a meeting of stockholders at which a quorum is present shall be the act of the stockholders on that matter, unless a greater number is otherwise required by law, our Certificate of Incorporation or our Bylaws. A consent to action without a meeting must be signed by not less than the minimum number of votes that would be necessary to take such action at a meeting at which all shares entitled to vote were present and voted. Such holders do not have cumulative voting rights. Subject to preferences that may be applicable to any shares of preferred stock outstanding at the time, holders of our common stock are entitled to receive any dividends, if any, that may be declared from time to time by our Board of Directors out of funds legally available therefor on a pro rata basis. 

 

Upon our liquidation, dissolution or winding up, the holders of our common stock are entitled to receive our net assets ratably, after the payment of:

i.	all secured liabilities, including any then outstanding secured debt securities which we may have issued as of such time;
ii.	all unsecured liabilities, including any then unsecured outstanding debt securities which we have issued as of such time; and
iii.	all liquidation preferences on any then outstanding preferred stock.

Holders of our common stock have no preemptive, subscription, redemption or conversion rights, and there are no redemption or sinking fund provisions applicable to the common stock. The rights, preferences and privileges of holders of common stock are subject to, and may be adversely affected by, the rights of the holders of shares of any series of preferred stock that we may designate and issue in the future.

 

A total of 2,487,282 shares being registered are subject to the following restriction on alienability: beginning on the date the shares were purchased and ending six months after the effective date of the first registration statement registering the shares for resale, the holder cannot sell, transfer, assign, pledge, hypothecate, or loan the shares or enter into an agreement to do any of the foregoing. After the effective date of the registration statement described herein, the holder can sell up to 25% of the shares during any rolling 30 day period.  Certain of our affiliates have also entered into other Lock-Up Agreements covering a portion of their shares. These agreements restrict the sale of 1,296,623 shares of our common stock. Under the terms of these Lock-Up Agreements, these officers cannot sell, pledge, grant or otherwise transfer the shares subject to the agreement for one year following the effective date of the registration statement of which this prospectus is a part. After one year, 2.5% of these shares per quarter are released from these restrictions on a pro rata basis among these affiliates. All remaining shares will be released from the Lock-Up Agreements on the second anniversary of the effective date of the registration statement of which this prospectus is a part. These Lock-Up Agreements will otherwise terminate at the following times: (A) if the registration statement of which this prospectus is a part is terminated, the earlier of (i) the date of termination if no shares were sold, or (ii) the date any proceeds received from public investors are placed in the mail for return; (B) the date our common stock is listed on a national securities exchange, or (C) thirty (30) days following the date the persons signing these Lock-Up Agreements are no longer affiliates.

Preferred Stock

Our Board of Directors is authorized, without further stockholder approval, to issue up to 5,000,000 shares of 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, voting rights, terms of redemption and liquidation preferences, and to fix the number of shares constituting any series and the designations of such series. Such shares may have rights senior to our common stock. The issuance of preferred stock may have the effect of delaying or preventing a change in control of our company. The issuance of preferred stock could decrease the amount of earnings and assets available for distribution to the holders of common stock or could adversely affect the rights and powers, including voting rights, of the holders of our common stock. At present, we have no plans to issue any shares of our preferred stock; however, we may have to issue preferred stock in order to raise additional capital. Any such issuance of preferred stock will be approved by a majority of our independent directors who do not have an interest in the transactions and who have access, at our expense, to our or independent counsel. Refer to “Liquidity and Capital Resources” under “Management's Discussion and Analysis of Financial Condition and Results of Operations.”

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Anti-Takeover Provisions

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

·	Our Board of Directors has the right to elect directors to fill a vacancy created by the expansion of the Board of Directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our Board of Directors.
·	Cumulative voting in the election of directors is not authorized by our Certificate of Incorporation. This limits the ability of minority stockholders to elect director candidates.
·	Stockholders must provide advance notice to nominate individuals for election to the Board of Directors or to propose matters that can be acted upon at a stockholders' meeting. This requirement may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror's own slate of directors or otherwise attempting to obtain control of us.
·	Our Board of Directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to authorize undesignated preferred stock makes it possible for our Board of Directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us.

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

 

Warrants

We have outstanding warrants to purchase up to 1,655,915 shares of our common stock under certain conditions that may occur in 2007. Warrants for the purchase of up to 444,444 shares have an exercise price of $2.70 per share and were issued to an investor as consideration for an increase in a letter of credit supplied by the investor. Warrants to purchase up to an aggregate of 1,176,471 shares at an exercise price of $3.00 per share were issued to investors who participated in the private placement of shares of our common stock on February 21, 2007. In addition, we issued a warrant to purchase 35,000 shares of common stock at an exercise price of $2.55 as part of the compensation paid to our placement agent in such private placement.

The shares issuable upon exercise of such warrants are being registered for resale by the registration statement of which this prospectus is a part.

Options

We also have several stock option and equity compensation plans. Refer to “Executive Compensation” for a description of these plans.

Reports to Stockholders

We intend to furnish our stockholders with annual reports containing audited financial statements as soon as practical after the end of each fiscal year. Our fiscal year ends December 31.

Transfer Agent

Continental Stock Transfer and Trust Company is the transfer agent for our common stock.

MARKET FOR COMMON STOCK

Market Information

Our common stock was approved for quotation on the OTC-BB under the symbol “SOLN” on March 15, 2005, but trading did not begin until mid-April 2005. The following table sets forth the high and low bid prices for our common stock for the quarterly periods since trading began until March 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.

 

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For the Quarter Ending		High			Low
June 30, 2005		$	8.05		$	1.05
September 30, 2005		$	11.50		$	8.05
December 31, 2005		$	11.25		$	6.30
March 31, 2006		$	10.00		$	8.05
June 30, 2006		$	n/a		$	n/a
September 30, 2006		$	2.80		$	1.75
December 31, 2006		$	2.75		$	0.90
March 31, 2007		$	3.00		$	2.00
June 30, 2007		$	2.95		$	1.85

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 OTC-BB 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 OTC-BB 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 OTC-BB. 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 OTC-BB during the period from September 11, 2006 through and including September 30, 2006.

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

At July 24, 2007, there were approximately 320 record holders of our common stock. Record holders do not include owners whose shares are held in street name by a broker or other nominee.

 

We have never declared or paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. 

SHARES ELIGIBLE FOR FUTURE SALE

Effect of Sale of Shares

Our common stock is traded on the OTC-BB. No precise prediction can be made about any effect that market sales of common stock or the availability for sale of the common stock in the public market will have on the market price of the common stock. Nevertheless, sales of substantial amounts of the common stock in the public market could adversely affect the market price for the common stock and could impair our future ability to raise capital through the sale of our securities.

We have 17,927,137 shares of common stock issued and outstanding as of July 24, 2007. We are registering for resale 8,707,051 shares in the registration statement of which this prospectus is a part. Of these, 7,530,710 shares being registered for resale under the registration statement of which this prospectus is a part are being registered for the first time. All of the shares outstanding that we currently have an obligation to register are being included on the registration statement of which this prospectus is a part.

In May 2005, a registration statement on Form S-8 under the Securities Act with respect to the 5,000,000 shares of common stock reserved for issuance under our 2004 Plan became effective. The remaining shares of common stock held by existing stockholders as of July 24, 2007 are restricted and may be sold in the public market only if they qualify for an exemption from registration described below under Rules 144 or 701 promulgated under the Securities Act.

The market price of our common stock could drop significantly if the holders of our shares sell them or are perceived by the market as intending to sell them.

Rule 144. In general, under Rule 144 as currently in effect, but subject to Dribble Out Agreements and certain Lock-Up Agreements described below, if applicable, a person (or persons whose shares are aggregated) who has purchased our common stock from us or any “affiliate” of ours at least one year before the date of resale would be entitled to sell within any three-month period a number of shares that does not exceed the greater of: (i) 1% of the number of shares of our common stock then outstanding; or (ii) the average weekly trading volume of our common stock during the four calendar weeks preceding the filing of a Form 144 with respect to such sale. Sales under Rule 144 are also subject to manner of sale provisions and notice requirements, and to the availability of current public information about us. As of July 24, 2007, there are 8,304,568 shares outstanding eligible for sale under Rule 144, excluding shares that can be sold under Rule 144(k) as set forth below.

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In addition, a person who is not deemed to have been our “affiliate” at any time during the 90 days preceding a sale and who has beneficially owned for at least two years the shares of common stock proposed to be sold is entitled to sell such shares under Rule 144(k) without regard to the volume limitations and other requirements described above. Therefore, unless otherwise restricted, Rule 144(k) shares may be sold at any time. As of July 24, 2007, there are 5,985,058 shares outstanding that can be sold under Rule 144(k).

Rule 701. Our employees, directors, officers and consultants who acquired common stock prior to February 15, 2005 (the date we became subject to the reporting requirements of the Exchange Act) under written compensatory benefit plans or written contracts relating to the compensation of those persons may rely on Rule 701 with respect to the resale of that stock. In general, Rule 701 permits resales of shares issued under compensatory benefit plans and contracts in reliance upon Rule 144, but without compliance with certain restrictions, including the holding period requirements described in Rule 144. Accordingly, subject to the Lock-Up Agreements described below, if applicable, under Rule 701 persons who received compensation shares and who are not our “affiliates” may resell those shares subject only to the manner of sale provisions of Rule 144. Persons who received compensation shares and who are our “affiliates” may resell those shares subject to Rule 144, but without compliance with Rule 144's minimum holding period requirements. As of July 24, 2007, there are 575,600 shares outstanding that may be sold pursuant to Rule 701.

Lock-Up Agreements

Many of our security holders have signed agreements restricting the sale of our securities, or Lock-Up Agreements, and/or agreements that limit the number of shares sellable during specific time periods, or Dribble Out Agreements.

 

Certain of these Lock-Up Agreements restrict the sale of 2,441,642 shares of the 17,927,137 shares of common stock issued and outstanding as of July 24, 2007. The Dribble Out Agreements apply to the same outstanding shares subject to the Lock-Up Agreements. The Dribble Out Agreements apply to all the shares sold by us in private placements in 2005 and 2006, which shares we are under an obligation to register for resale and are included in the shares being registered in this offering. Under the Dribble Out Agreements, the stockholders may sell up to 25% of their shares during any rolling 30 day period.

Certain of our affiliates have also entered into other Lock-Up Agreements covering a portion of their shares. These agreements restrict the sale of 1,296,623 shares of our common stock. Under the terms of these Lock-Up Agreements, these officers cannot sell, pledge, grant or otherwise transfer the shares subject to the agreement for one year following the effective date of the registration statement of which this prospectus is a part. After one year, 2.5% of these shares per quarter are released from these restrictions on a pro rata basis among these affiliates. All remaining shares will be released from the Lock-Up Agreements on the second anniversary of the effective date of the registration statement of which this prospectus is a part. These Lock-Up Agreements will otherwise terminate at the following times: (A) if the registration statement of which this prospectus is a part is terminated, the earlier of (i) the date of termination if no shares were sold, or (ii) the date any proceeds received from public investors are placed in the mail for return; (B) the date our common stock is listed on a national securities exchange, or (C) thirty (30) days following the date the persons signing these Lock-Up Agreements are no longer affiliates.

 

Outstanding Options and Warrants

As of July 24, 2007, options to purchase 2,201,800 shares of common stock were issued and outstanding. Of these, 600 were issued under our 1998 Plan; 575,000 were issued under our 2001 Plan; 1,376,200 were issued under our 2004 Plan; and 250,000 were issued outside of any equity compensation plan. Five million shares have been reserved for issuance under our 2004 Plan (pursuant to which options for 1,376,200 shares of common stock and 156,000 shares of common stock were outstanding as of July 24, 2007) and were registered for resale under a Registration Statement on Form S-8 filed and effective during May 2005. In June 2007, we limited the issuance of shares of our common stock reserved under our 2004 Plan to awards of restricted or unrestricted stock.  Shares registered on Form S-8, other than shares held by officers and directors, may be sold in the public markets without any volume limitations. Shares registered on Form S-8 and held by our officers and directors may only be resold in compliance with the volume limitations of Rule 144, discussed above. As of July 24, 2007, officers and directors held options for 605,000 shares of common stock registered under the Form S-8 and options for 771,200 shares of common stock were held by persons other than officers and directors.

 

In June 2007, the non-interested members of our Board of Directors approved an offer for holders of outstanding options with an exercise price of $2.50 per share or greater to exchange the outstanding options for a certain number of shares of restricted stock. In this offer, we intend to divide the outstanding options into classes based on the exercise price and the remaining expected life of the option and to use the Black-Scholes valuation model in our determination of the exchange ratios for the several classes of eligible options. We target using exchange ratios such that the eligible options surrendered for cancellation would exceed the number of shares of restricted stock that would be received in exchange for such options. The exchange offer has not commenced and will not commence until certain actions are taken by us, including the filing of a tender offer statement and offer to exchange on Schedule TO to be filed with the SEC. This prospectus is not an offer or solicitation of an offer to sell or exchange any outstanding options.

 

As of July 24, 2007, there were warrants to purchase 1,655,915 shares of our common stock outstanding, of which 1,655,915 are being registered for resale under the registration statement of which this prospectus is a part.

Registration Rights Agreements

From March 2004 through August 2004, we sold an aggregate of 1,289,140 shares of our common stock in private placements. Under the terms of registration rights agreements entered into between us and these parties, we were obligated to register these shares with the SEC for resale in the public market and keep registration statement effective until the earlier of 270 days following effectiveness of the registration statement, all shares have been sold by the investor, or when all such shares may be sold without registration or restriction. All but one of these investors may now sell their shares pursuant to Rule 144(k). Because one of these investors is our “affiliate” and the earlier registration statement on which such investor’s shares were registered was not kept effective for 270 days, we are therefore reregistering the 891,428 shares purchased in these placements by such “affiliate.” The registration rights agreements further provided for a penalty if such registration did not occur by a certain date. Under these agreements, this penalty may be paid in shares of our common stock. If the penalty is paid in this manner, we are obligated to register those shares as well. We are registering 47,485 shares for resale under the registration statement of which this prospectus is a part in satisfaction of our obligation to register such shares under the registration rights agreement with our “affiliate.”

From 2005 through July 24, 2007, we sold an aggregate of 4,744,583 shares of our common stock in private placements. As of July 24, 2007, there were outstanding warrants to purchase an additional 1,655,915 shares of our common stock, which shares of common stock we are also obligated to register. Under the terms of registration rights agreements entered into between us and these parties, we are obligated to register these shares and the shares underlying the warrants with the SEC for resale in the public market. The registration rights agreements also provide for a penalty if registration does not occur by a certain date. Under certain of these agreements, this penalty may be paid in shares of our common stock. If the penalty is paid in this manner, we are obligated to register those shares as well. Several of the stockholders who were owed a late registration penalty entered into amendments to the registration rights agreements fixing their penalty at a certain amount, while others accrued penalties until the date the registration statement of which this prospectus is a part was filed with the SEC. We are registering 82,003 shares for resale under the registration statement of which this prospectus is a part in satisfaction of our obligation to register such shares under the registration rights agreements. All shares subject to these registration rights agreements are being registered by this registration statement.

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

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

 

·	a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading;
·	a description of the broker's or dealer's duties to the customer and of the rights and remedies available to the customer with respect to a violation to such duties or other requirements;
·	a brief, clear, narrative description of a dealer market, including “bid” and “ask” prices for penny stocks and the significance of the spread between the bid and ask price;
·	a toll-free telephone number for inquiries on disciplinary actions;
·	definitions of significant terms in the disclosure document or in the conduct of trading penny stocks; and
·	such other information as the SEC requires by rule or regulation.

 

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

 

·	bid and ask quotations for the penny stock;
·	the compensation of the broker-dealer and its salesperson in the transaction;
·	the number of shares to which such bid and ask prices apply, or other comparable information relating to the depth and liquidity of the market for such stock; and
·	monthly account statements showing the market value of each penny stock held in the customer's account.

 

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

 

LEGAL MATTERS

The validity of the shares of common stock offered under this prospectus has been passed upon by James W. Gayton, our Corporate Counsel and Secretary.

 

EXPERTS

The audited financial statements of Smart Online for the years ended December 31, 2006, 2005 and 2004 have been included in this prospectus and in the registration statement in reliance upon the report of Sherb & Co., LLP, independent registered public accountants, appearing elsewhere in this prospectus, and upon the authority of that firm as experts in accounting and auditing.

 

WHERE YOU CAN FIND MORE 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 registration statement. Although we endeavor to keep our Internet website current and accurate, there can be no guarantees that the information on the Internet website is up to date or correct. We make available free of charge through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act and beneficial ownership reports filed by officers, directors and principal security holders under Section 16(a) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the SEC. These reports may be accessed by following the link under “Investors - SEC Filings” on our website. The public may also read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site that contains reports, proxy and information statements, and other information that we file electronically with the SEC at the following site: http://www.sec.gov.

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FINANCIAL STATEMENTS

 

		PAGE
Report of Independent Registered Public Accounting Firm		F-2
Financial Statements of Smart Online, Inc. for Year Ended December 31, 2006
Consolidated Balance Sheets		F-3
Consolidated Statements of Operations		F-4
Consolidated Statements of Stockholders' Deficit for the Years ended		F-5
December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows		F-6
Notes to Financial Statements		F-8
Financial Statements of Smart Online, Inc. for Three Months Ended March 31, 2007
Consolidated Balance Sheets as of March 31, 2007 (unaudited) and
December 31, 2006		F-31
Consolidated Statements of Operations (unaudited) for the three months
ended March 31, 2007 and 2006		F-32
Consolidated Statements of Cash Flows (unaudited) for the three months
ended March 31, 2007 and 2006		F-33
Notes to Consolidated Financial Statements (unaudited)		F-34

 

F-1

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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, 2006 and 2005, and the related consolidated statement of operations, stockholders' (deficit) equity, cash flows for each of the years then ended December 31, 2006, 2005 and 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our 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, 2006 and 2005, and the results of its operations and its cash flows for each of the years then ended December 31, 2006, 2005 and 2004, in conformity with accounting principles generally accepted in the United States.

 

/s/ Sherb & Co., LLP Certified Public Accountants

 

New York, New York

March 28, 2007

 

F-2

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SMART ONLINE, INC.

CONSOLIDATED BALANCE SHEETS

  

		December 31, 2006			December 31, 2005
Assets
CURRENT ASSETS:
Cash and Cash Equivalents		$	326,905		$	1,434,966
Restricted Cash			250,000			230,244
Accounts Receivable, Net			247,618			504,979
Prepaid Expenses			100,967			370,225
Assets Available for Sale			--			74,876
Total current assets			925,490			2,615,290
PROPERTY AND EQUIPMENT, Net			180,360			216,969
INTANGIBLE ASSETS, Net			3,617,477			4,298,358
GOODWILL			2,696,642			5,489,963
OTHER ASSETS			13,040			40,400
ASSETS AVAILABLE FOR SALE			--			1,897,099
TOTAL ASSETS		$	7,433,009		$	14,558,079
Liabilities and Stockholders' Equity
CURRENT LIABILITIES:
Accounts Payable		$	850,730		$	855,904
Accrued Registration Rights Penalty			465,358			129,945
Current Portion of Notes Payable			2,839,631			2,127,486
Deferred Revenue			313,774			687,222
Accrued Liabilities			301,266			91,233
Liabilities Held for Sale			--			1,030,369
Total Current Liabilities			4,770,759			4,922,159
LONG-TERM LIABILITIES:
Long-Term Portion of Notes Payable			825,000			2,243,652
Deferred Revenue			11,252			78,771
Liabilities Held for Sale			--			640,866
Total Long-Term Liabilities			836,252			2,963,289
Total Liabilities			5,607,011			7,885,448
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Common stock, $.001 Par Value, 45,000,000 Shares Authorized, Shares Issued and Outstanding: December 31, 2006 - 15,379,030, December 31, 2005 --15,607,230			15,379			15,607
Additional Paid-in Capital			59,159,919			58,982,617
Accumulated Deficit			(57,349,300	)		(52,325,593	)
Total Stockholders' Equity			1,825,998			6,672,631
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY		$	7,433,009		$	14,558,079

See notes to financial statements.

 

F-3

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Notes to Consolidated Financial Statements - Unaudited

1.  Summary of Business and Significant Accounting Policies

 

Description of Business - Smart Online, Inc. (the “Company”) was incorporated in the State of Delaware in 1993. The Company develops and markets Internet-delivered Software-as-a-Service (“SaaS”) software applications and data resources to help start and run small businesses. The Company’s subscribers access its products through the websites of its private label syndication partners, including major companies and financial institutions, and its main portal at www.smartonline.com.

Basis of Presentation- The accompanying balance sheet as of March 31, 2007 and the statements of operations and cash flows for the three months ended March 31, 2007 and 2006 are unaudited. These statements should be read in conjunction with the audited financial statements and related notes, together with management’s discussion and analysis of financial position and results of operations, 0contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2007 (the “2006 Annual Report”).

The financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). In the opinion of the Company’s management, the unaudited statements in this Quarterly Report on Form 10-Q include all normal and recurring adjustments necessary for the fair presentation of the Company’s statement of financial position as of March 31, 2007, and its results of operations and cash flows for the three months ended March 31, 2007 and 2006. The results for the three months ended March 31, 2007 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2007.

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.

Significant Accounting Policies - In the opinion of the Company’s management, the significant accounting policies used for the three months ended March 31, 2007 are consistent with those used for the years ended December 31, 2006, 2005 and 2004. Accordingly, please refer to the 2006 Annual Report for our significant accounting policies.

Revenue Recognition - 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 Emerging Issues Task Force (“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 Statement of Financial Accounting Standard (“SFAS”) No. 154, Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3. For the three months ended March 31, 2007, this accounting method resulted in approximately $261,000 of additional subscription revenue and a corresponding charge to sales and marketing expense.

Fiscal Year - The Company’s fiscal year ends December 31. References to fiscal 2006, for example, refer to the fiscal year ending December 31, 2006.

 

Use of Estimates - The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions in the Company’s financial statements and notes thereto. Significant estimates and assumptions made by management include the determination of the provision for income taxes, the fair market value of stock awards issued and the period over which revenue is generated. Actual results could differ materially from those estimates.

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

F-34

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

Advertising Costs- The Company expenses all advertising costs as they are incurred. The amounts charged to expense during the first quarter of 2007 and 2006 were $3,574 and $41,920, respectively. The 2006 period included $37,915 of barter advertising expenses. No such expenses are included in the 2007 period.

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

Stock-Based Compensation - In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share Based Payment (“SFAS No. 123R”), which replaces SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), and supersedes Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). SFAS 123R requires all share-based payments, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Under SFAS No. 123R, public companies are required to measure the costs of services received in exchange for stock options and similar awards based on the grant date fair value of the awards and recognize this cost in the income statement over the period during which an award recipient is permitted to provide service in exchange for the award. The pro forma disclosures previously permitted under SFAS No. 123 are no longer an alternative to financial statement recognition.

The Company maintains stock-based compensation arrangements under which employees, consultants and directors may be awarded grants of stock options and restricted stock. Effective January 1, 2006, the Company adopted 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 and (ii) compensation cost for all share-based payments that will be 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 recognizes the stock-based compensation of previously granted share-based options and new share based options under the straight-line method over the requisite service period. Total stock-based compensation expense recognized under SFAS No. 123R was approximately $156,733 for the three months ended March 31, 2007. No stock-based compensation was capitalized in the consolidated financial statements. The fair value of option grants under the Company’s 2004 Equity Compensation Plan and other stock option issuances during the quarters ended March 31, 2007 and 2006 was estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions:

		Three Months Ended March 31, 2007			Three Months Ended March 31, 2006
Dividend yield			0.00%			0. 00%
Expected volatility			150%			150%
Risk free interest rate			4.56%			4.85%
Expected lives (years)			4.6%			4.9%

The expected term of the options represents the estimated period of time until exercise or forfeiture and is based on historical experience of similar awards. Expected volatility is based on the historical volatility of our common stock over a period of time. The risk free interest rate is based on the published yield available on U.S treasury issues with an equivalent term remaining equal to the expected life of the option.

Compensation expense is recognized only for option grants expected to vest. We estimate forfeitures at the date of grant based on historical experience and future expectation.

F-35

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The following is a summary of the stock option activity for the three months ended March 31, 2007:

		Shares			Weighted Average Exercise Price
BALANCE, December 31, 2006			2,360,100		$	5.33
Forfeited			4,000			6.35
Exercised			20,000		$	1.30
BALANCE, March 31, 2007			2,336,100		$	5.36

Recently Issued Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in U.S. GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is a relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new fair value measurements. However, for some entities, the application of SFAS No. 157 will change current practices. SFAS No. 157 is effective for financial statements for fiscal years beginning after November 15, 2007. Earlier application is permitted provided that the reporting entity has not yet issued financial statements for that fiscal year. Management believes SFAS No. 157 will have no impact on the financial statements of the Company once adopted.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 provides companies with an option to measure, at specified election dates, many financial instruments and certain other items at fair value that are not currently measured at fair value. A company that adopts SFAS No. 159 will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Management does not believe that the adoption of SFAS No. 159 will have a material impact on the Company’s results of operations or financial condition.

2.   PRESENTATION OF SUBSIDIARIES

As more fully detailed in the 2006 Annual Report, the Company completed two acquisitions in October 2005. On October 4, 2005, the Company purchased substantially all of the assets of Computility, Inc. (“Computility”). In consideration for the purchased assets, the Company issued the seller 484,213 shares of the Company’s common stock and assumed certain liabilities of Computility totaling approximately $1.9 million.  The shares were valued at $7.30 per share, which was the median trading price on the acquisition date. The total purchase price, including liabilities assumed, was approximately $5.8 million including approximately $228,000 of acquisition fees.

On October 18, 2005, the Company completed its purchase of all of the capital stock of iMart Incorporated (“iMart”), a Michigan based company providing multi-channel electronic commerce systems, pursuant to a Stock Purchase Agreement, dated as of October 17, 2005 by and among the Company, iMart and the shareholders of iMart. The Company issued to iMart’s stockholders 205,767 shares of its common stock and agreed to pay iMart’s stockholders approximately $3,462,000 in cash installments. This amount was payable in four equal payments of $432,866 on the first business day of each of January 2006, April 2006, July 2006 and October 2006. The final installment payment of approximately $1.7 million was payable in January 2007. As of January 2007, the entire purchase price was paid in full. The shares were valued at $8.825 per share, which was the median trading price on the acquisition date. The total purchase price for all of the outstanding iMart shares was approximately $5.3 million including approximately $339,000 of acquisition fees.

Upon the Company’s successful integration of the SFA/CRM application into its OneBiz^SM platform, management deemed the remaining operations of Smart CRM, Inc. (d/b/a Computility) (“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 or Disposal of Long-Lived Assets, the Company has reported the operating results for Smart CRM as discontinued operations. For the three months ended March 31, 2006, the revenue and net loss associated with the discontinued operations were $540,206 and ($39,564), respectively. Because the sale had been completed in a period prior to the three months ended March 31, 2007, that period contains no discontinued operations.

F-36

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3.   INDUSTRY SEGMENT INFORMATION 

SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), 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, described below, based on factors such as geography, how the Company manages its operations and how its chief operating decision maker views results.

Smart Commerce, Inc. (d/b/a iMart) revenue is derived primarily from the development and distribution of multi-channel e-commerce systems including domain name registration and email solutions, e-commerce solutions, website design and website hosting.

Smart Online, Inc. generates revenue 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 three months ended March 31, 2007:

		Smart Online, Inc.			Smart Commerce, Inc.			Consolidated
REVENUES:
Syndication Fees			15,000			-			15,000
Subscription Fees			13,391			619,591			632,982
Professional Services Fees			-			288,579			288,579
Other Revenues			200			5,625			5,825
Total Revenues			28,591			913,795			942,386
COST OF REVENUES			13,027			60,799			73,826
OPERATING EXPENSES			1,463,394			697,675			2,161,069
OPERATING INCOME			(1,447,830	)		155,321			(1,292,509	)
OTHER INCOME (EXPENSE)			21,007			(38,262	)		(17,255	)
NET INCOME/(LOSS) BEFORE INCOME TAXES		$	(1,426,823	)	$	117,059		$	(1,309,764	)
TOTAL ASSETS		$	11,886,023		$	727,157		$	12,613,180

4.   CURRENT ASSETS

Receivables

The Company evaluates the need for an allowance for doubtful accounts based on specifically identified amounts that management believes to be uncollectible. Management also records an additional allowance based on management’s assessment of the general financial conditions affecting its customer base. If actual collections experience changes, revisions to the allowance may be required. Based on these criteria, management has recorded an allowance for doubtful accounts of approximately $65,000 and $65,000 as of March 31, 2007 and December 31, 2006, respectively.

Restricted Cash

Under the terms of a promissory note between Smart Commerce and Fifth Third Bank, $250,000 on deposit at Fifth Third Bank serves as loan collateral and is restricted. Such restricted cash is 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 meets certain debt covenants regarding operating metrics for Smart Commerce.

F-37

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Deferred Financing Costs

In order to secure a modification to a line of credit (see Note 5 - Notes Payable), Atlas Capital, S.A. (“Atlas”) provided the Company with a modified letter of credit. In exchange for the modified letter of credit, the Company issued Atlas a warrant to purchase 444,444 shares of common stock at $2.70 per share (see Note 6 - Stockholders’ Equity). The fair value of that warrant using the Black-Scholes model was $734,303 as measured at the time the warrant was issued. Such amount was recorded as deferred financing costs and will be 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. At March 31, 2007, the deferred financing costs which will be amortized to interest expense over the next twelve months, or $451,879, is classified as a current asset with the remaining $188,283 classified as non-current and included in other assets.

5.    NOTES PAYABLE

As of March 31, 2007, the Company had notes payable totaling $3,860,674. 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 ‘07			8.0	%
Acquisition Fee - Computility			99,497			-			99,497			Mar ‘07			8.0	%
Wachovia Credit Line			-			2,052,000			2,052,000			Aug ‘08			Libor + 0.9	%
Fifth Third Loan			900,000			600,000			1,500,000			Nov ‘08			Prime + 1.5	%
TOTAL		$	1,208,674		$	2,652,000		$	3,860,674

On January 24, 2007, the Company entered into an amendment to its line of credit with Wachovia Bank, NA (“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. Interest accrues 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 $2,500,000 issued by HSBC Private Bank (Suisse) S.A. with Atlas as account party. As of March 31, 2007, the Company has drawn down approximately $2.1 million on the line of credit.

6. STOCKHOLDERS’ EQUITY 

 

Common Stock and Warrants

 

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, of which approximately $530,000 have been incurred as of March 31, 2007. 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.

The Company and each of the Investors also entered into a Registration Rights Agreement (the “Investor RRA”) whereby the Company has 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 reviews the registration statement. If a registration statement is not timely filed or declared effective by the date set forth in the Investor RRA, the Company is obligated to pay a cash penalty of 1% of the purchase price on the day after the filing or declaration of effectiveness is due, and 0.5% of the purchase price per every 30-day period thereafter, to be prorated for partial periods, until the Company fulfills these obligations. Under no circumstances can the aggregate penalty for late registration or effectiveness exceed 10% of the aggregate purchase price. Under the terms of the Investor RRA, the Company cannot 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 does 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 eleven calendar days. On April 3, 2007, the Company filed the registration statement within the extended filing obligation period, thereby avoiding the first potential penalty.

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

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As incentive to modify a letter of credit, 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. If the warrant is exercised in full, it will result in gross proceeds to the Company of approximately $1,200,000.

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 registration rights agreements between such investors and the Company. 

On March 30, 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. 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 it sells shares of its common stock for less than $2.50 per share.

During the first quarter of 2006, warrants to purchase 7,500 shares of the Company’s common stock expired. In March 2006, there was a cashless exercise of a warrant to purchase 10,000 shares of the Company’s common stock, resulting in the issuance of 4,800 shares. Also in March 2006, four warrants to purchase a total of 17,000 shares of the Company’s common stock were exercised on a cash basis, resulting in the issuance of 17,000 shares and gross proceeds of $22,100 to the Company. The Company incurred immaterial costs related to these exercises.

Stock Option Plans

 

The Company maintains three equity compensation plans. During the first quarter of 2006, the Company issued a total of 251,500 options to employees. Of these options, a total of 100,000 were issued to two officers of the Company. A total of 201,500 options were granted on January 6, 2006 with a strike price of $9.00 and the fair market value on the date of grant was also $9.00. The March 21, 2006 grant to purchase 50,000 shares of common stock was granted to a newly appointed officer. The strike price and fair market value on the date of grant was $2.50. All options vest over five years and have a ten -year life.

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

				Currently Exercisable
Exercise Price	Number of Shares Outstanding	Average Remaining Contractual Life (Years)	Weighted Average Exercise Price	Number of Shares	Weighted Average Exercise Price
From $1.30 to $1.43	575,000	1.8	$ 1.41	575,000	$ 1.41
From $2.50 to $3.50	512,500	7.3	$ 3.39	344,665	$ 3.46
$5.00	249,900	8	$ 5.00	169,900	$ 5.00
$7.00	153,000	8.5	$ 7.00	53,000	$ 7.00
From $8.61 to $9.00	584,500	8.4	$ 8.70	122,900	$ 8.72
From $9.60 to $9.82	261,200	1.3	$ 9.82	160,240	$ 9.82

Dividends

The Company has not paid any cash dividends through March 31, 2007.

7. MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK

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

					Three Months Ended March 31, 2007
					Revenues			% of Total Revenues
Customer A			Professional Services		$	182,077			19	%
Customer B			Subscription			311,984			33
Others			Various			448,325			48
Total					$	942,386			100	%

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						Three Months Ended March 31, 2006
						Revenues			% of Total Revenues
Customer A			Professional Services			537,760			40	%
Customer B			Subscription			521,809			38	%
Others			Various			295,894			22	%
Total					$	1,355,463			100.0	%

As of March 31, 2007, two customers accounted for 22% and 64% of accounts receivable, respectively. As of March 31, 2006, the Company had two customers that accounted for 44% and 14% of accounts receivable, respectively.

8. COMMITMENTS AND CONTINGENCIES

In August 2005, the Company entered into a software assignment and development agreement with the developer of a customized accounting software application.  In connection with this agreement, the developer would be paid up to $512,500 and issued up to 32,395 shares of the Company’s common stock based upon the developer attaining certain milestones.  As of March 31, 2007, the Company had paid $262,500 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. Simultaneously with the suspension, the SEC advised the Company that the SEC was conducting a non-public investigation. As of March 31, 2007, the SEC has not provided the Company with any communication indicating that its investigation has concluded or that the Company or any of its officers or directors have engaged in any criminal or fraudulent conduct with respect to the Company.

9. SUBSEQUENT EVENTS

On April 11, 2007, the Company entered into a stock option agreement with C. James Meese, Jr., a member of the Company’s Board of Directors and Chairman of its Audit Committee. Mr. Meese was granted an option to purchase up to 20,000 shares of the Company’s common stock at an exercise price of $2.80 per share. Under the terms of the option agreement, this option vests in equal quarterly increments on February 16, 2007, May 16, 2007, August 16, 2007, and November 16, 2007 if Mr. Meese is serving as a member of the Company’s Board of Directors on such dates. These dates were selected so that all shares will have vested by the first anniversary of Mr. Meese’s appointment to the Board. In the event of a change of control or reorganization of the Company (both as defined in the option agreement), the option vests as to all shares on the date of such event.

On April 18, 2007, the Company entered into restricted stock agreements (the "RSAs") pursuant to the Company's 2004 Equity Compensation Plan with three employees of the Company, including Nicholas A. Sinigaglia, the Company's Chief Financial Officer. Under these RSAs, an aggregate of 49,500 shares of the Company's common stock was granted, which included 30,000 shares to Mr. Sinigaglia. Under the terms of the RSAs, these shares are restricted and cannot be sold prior to the lapse of the restriction. Assuming these employees remain employed by the Company, the restriction is scheduled to lapse as to one-third of the shares on each of the following dates: the date of the agreement, the first anniversary thereof, and the second anniversary thereof. In the event of a change of control or reorganization of the Company (both as defined in the RSAs), the restrictions lapse as to all shares on the date of such event.

On April 27, 2007, the Company entered into Executive Officer Compensation Agreements (the "Compensation Agreements") with the following named executive officers: Michael Nouri, President and Chief Executive Officer; Tom Furr, Chief Operating Officer; and Henry Nouri, Executive Vice President. In January 2007, these officers had agreed to a modification of their compensation (the "Modified Arrangements"), each reducing his annual base salary to $100,000 in consideration for a performance based aggregate quarterly bonus (the "Quarterly Bonus"). Under the terms of the Compensation Agreements, each officer agreed to an increase in his annual base salary, effective the pay period ending April 30, 2007, restoring each to his prior annual base salary as follows: Michael Nouri ($170,000), Tom Furr ($136,800) and Henry Nouri ($150,000). These officers remained entitled to the Quarterly Bonus under the Modified Arrangements earned, if any, for the first quarter of fiscal 2007. No Quarterly Bonus was earned by any of these officers. The Compensation Arrangements also terminate the Quarterly Bonus arrangement as of May 1, 2007.

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PROSPECTUS

 

SMART ONLINE, INC.

8,707,051 SHARES OF COMMON STOCK

 

July 31, 2007