CONSOLIDATED BALANCE SHEETS

 

		September 30, 2007 (unaudited)			December 31, 2006
Assets
CURRENT ASSETS:
Cash and Cash Equivalents		$	2,228,027		$	326,905
Restricted Cash (See Note 5)			250,000			250,000
Accounts Receivable, Net			964,264			247,618
Current Portion of Note Receivable			50,000			-
Prepaid Expenses			119,109			100,967
Deferred Financing Costs (See Note 5)			414,220			-
Total Current Assets		$	4,025,620		$	925,490
PROPERTY AND EQUIPMENT, Net		$	187,195		$	180,360
LONG TERM PORTION OF NOTE RECEIVABLE			230,000			-
INTANGIBLE ASSETS, Net			3,036,419			3,617,477
GOODWILL			2,696,642			2,696,642
OTHER ASSETS			75,311			13,040
TOTAL ASSETS		$	10,251,187		$	7,433,009
Liabilities and Stockholders' Equity
CURRENT LIABILITIES:
Accounts Payable		$	720,845		$	850,730
Accrued Registration Rights Penalty			-			465,358
Current Portion of Notes Payable (See Note 6)			3,187,346			2,839,631
Deferred Revenue (See Note 5)			475,099			313,774
Accrued Liabilities (See Note 5)			629,997			301,266
Total Current Liabilities		$	5,013,287		$	4,770,759
LONG-TERM LIABILITIES:
Long-Term Portion of Notes Payable (See Note 6)		$	165,863		$	825,000
Deferred Revenue			259,534			11,252
Total Long-Term Liabilities			425,397			836,252
Total Liabilities		$	5,438,684		$	5,607,011
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Common Stock, $.001 Par Value, 45,000,000 Shares Authorized, Shares Issued and Outstanding:
September 30, 2007 - 18,009,564; December 31, 2006 - 15,379,030			18,009			15,379
Additional Paid-in Capital			66,231,024			59,159,919
Accumulated Deficit			(61,436,530	)		(57,349,300	)
Total Stockholders' Equity			4,812,503			1,825,998
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY		$	10,251,187		$	7,433,009

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

 

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CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

 

		Three Months Ended						Nine Months Ended
		September			September			September			September
		30, 2007			30, 2006			30, 2007			30, 2006
REVENUES:
Integration Fees		$	-		$	6,250		$	5,000		$	182,660
Syndication Fees			15,000			57,352			45,000			183,619
Subscription Fees (See Note 3)			830,660			429,426			2,040,243			1,476,194
Professional Services Fees			378,068			242,177			984,548			601,200
License Fees			200,000			-			480,000			450,000
Other Revenues			5,467			14,001			20,720			54,312
Total Revenues		$	1,429,195		$	749,206		$	3,575,511		$	2,947,985
COST OF REVENUES		$	168,035		$	31,311		$	355,942		$	212,515
GROSS PROFIT		$	1,261,160		$	717,895		$	3,219,569		$	2,735,470
OPERATING EXPENSES:
General and Administrative			1,398,170			1,208,044			3,567,385			4,844,464
Sales and Marketing			635,201			135,027			1,563,653			666,940
Research and Development			636,780			455,997			1,908,644			1,279,198
Total Operating Expenses		$	2,670,151		$	1,799,068		$	7,039,682		$	6,790,602
LOSS FROM CONTINUING OPERATIONS			(1,408,991	)		(1,081,173	)		(3,820,113	)		(4,055,132	)
OTHER INCOME (EXPENSE):
Interest Expense, Net			(139,124	)		(51,746	)		(400,910	)		(190,802	)
Takeback of Investor Relations Shares			-			1,562,500			-			3,125,000
Legal Reserve and Debt Forgiveness, Net			(39,477	)		-			(34,877	)		144,351
Writeoff of Investment			-			-			-			(25,000	)
Other Income			24,866			-			168,672			-
Total Other Income (Expense)		$	(153,735	)	$	1,510,754			(267,115	)		3,053,549
NET INCOME (LOSS) FROM CONTINUING OPERATIONS			(1,562,726	)		429,581			(4,087,228	)		(1,001,583	)
DISCONTINUED OPERATIONS
Loss of Operations of Smart CRM, net of tax			-			(2,329,429	)		-			(2,525,563	)
NET LOSS attributed to common stockholders		$	(1,562,726	)		(1,899,848	)	$	(4,087,228	)	$	(3,527,146	)
NET LOSS PER SHARE:
Continuing Operations
Basic and Fully Diluted		$	(0.09	)	$	0.03		$	(0.24	)	$	(0.07	)
Discontinued Operations
Basic and Fully Diluted		$	-		$	(0.15	)	$	-		$	(0.17	)
Net Loss Attributed to Common Stockholders
Basic		$	(0.09	)		(0.13	)		(0.24	)		(0.23	)
Fully Diluted			(0.09	)		(0.12	)		(0.24	)		(0.23	)
SHARES USED IN COMPUTING NET LOSS PER SHARE
Basic			17,292,639			15,127,510			17,002,827			15,077,583
Fully Diluted			17,292,639			15,387,110			17,002,827			15,077,583

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

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

		Nine Months Ended September 30, 2007			Nine Months Ended September 30, 2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Loss		$	(4,087,228	)	$	(1,001,583	)
Adjustments to reconcile Net Loss to Net Cash used in Operating Activities:
Depreciation and Amortization			631,267			530,969
Amortization of Deferred Financing Costs			320,083			-
Takeback of Investor Relation Shares			-			(3,125,000	)
Stock Option Related Compensation Expense			574,343			622,442
Writeoff of Investment			-			25,000
Registration Rights Penalty			(320,632	)		345,870
Gain on Debt Forgiveness			(215,123	)		(144,351	)
Changes in Assets and Liabilities:
Accounts Receivable			(716,154	)		215,569
Prepaid Expenses			(18,634	)		97,074
Other Assets			(32,271	)		129
Deferred Revenue			410,179			(309,460	)
Accounts Payable			85,290			379,431
Accrued and Other Expenses			329,643			102,402
Net cash from operations of discontinued operations			-			212,199
Net Cash used in Operating Activities		$	(3,039,237	)	$	(2,049,309	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of Furniture and Equipment			(86,549	)		(7,362	)
Purchase of Tradename			(2,033	)		-
Net cash from investing activities of discontinued operations			-			431,076
Net Cash provided by (used in) Investing Activities		$	(88,582	)	$	423,714
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments on Notes Payable			(1,784,272	)		(1,460,333	)
Debt Borrowings			1,472,850			-
Notes Receivable			(280,000	)		-
Advances to Smart CRM			-			(744,918	)
Advances from Smart CRM			-			1,308,340
Restricted Cash			-			(102,409	)
Issuance of Common Stock			5,748,607			2,522,100
Expenses Related to Form S-1 Filing			(128,244	)		-
Net cash from financing activities of discontinued operations			-			(651,364	)
Net Cash provided by Financing Activities		$	5,028,941		$	871,416
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		$	1,901,122		$	(754,179	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		$	326,905		$	1,427,489
CASH AND CASH EQUIVALENTS OF DISCONTINUED OPERATIONS, BEGINNING OF PERIOD			-			7,477
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	2,228,027		$	680,787
Supplemental Disclosures:
Cash Paid During the Period for Interest:		$	247,400		$	` 154,288
Cash Payment for Interest by Discontinued Operations			-			41,875
Cash Paid for Taxes			-			-
Shares Issued in Settlement of Registration Rights Penalties			144,351			-

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

 

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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. Subscribers access the Company’s products through the websites of its private label syndication partners, and its portal at www.onebiz.com. Corporate information on the Company can be found at www.smartonline.com.

Basis of Presentation- The accompanying balance sheet as of September 30, 2007 and the statements of operations for the three months and nine months ended September 30, 2007 and 2006 and the statements of cash flows for the nine months ended September 30, 2007 and 2006 are unaudited. The balance sheet as of December 31, 2006 is obtained from the audited financial statements as of that date. The accompanying 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, contained 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 September 30, 2007, and its results of operations for the three months and nine months ended September 30, 2007 and September 30, 2006 and the statements of cash flows for the nine months ended September 30, 2007 and 2006. The results for the three months and nine months ended September 30, 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 and development 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.

 

Significant Accounting Policies - In the opinion of the Company's management, the significant accounting policies used for the three months and nine months ended September 30, 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.

Reclassifications - Certain prior year amounts have been reclassified to conform to current year presentation. These reclassifications had no effect on previously reported net income or shareholders’ equity.

Revenue Recognition - The Company derives revenue from the license of software platforms along with the sale of associated maintenance, consulting, and application development services. The arrangement may include delivery in multiple-element arrangements if the customer purchases a combination of products and/or services. The Company uses the residual method pursuant to American Institute of Certified Public Accountants (“AICPA”) Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”), as amended. This method allows the Company to recognize revenue for a delivered element when such element has vendor specific objective evidence (“VSOE”) of the fair value of the delivered element. If VSOE cannot be determined or maintained for an element, it could impact revenues as all or a portion of the revenue from the multiple-element arrangement may need to be deferred.

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

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

 

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

1.

persuasive evidence of an arrangement exists

2.

delivery has occurred

3.

the fee is fixed or determinable

4.

collectability is probable

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

 

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. Statement of Financial Accounting Standard (“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 historically have been insignificant.

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

Advertising Costs - The Company expenses all advertising costs as they are incurred. The amounts charged to sales and marketing expense during the third quarter of 2007 and 2006 were $11,133 and $104, respectively. The amounts charged to sales and marketing expense during the first nine months of 2007 and 2006 were $26,802 and $42,419, respectively. There were no barter advertising expenses for the three months ending September 30, 2007 and September 30, 2006, respectively, and $0 and $37,915 for the nine months ended September 30, 2007 and September 30, 2006, respectively.

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.

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 No. 123R requires all share-based payments, including grants of employee stock options and restricted stock, 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, restricted stock 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.

 

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The Company maintains stock-based compensation arrangements under which employees, consultants and directors may be awarded grants of unrestricted 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 awards and new share-based awards under the straight-line method over the requisite service period. Total stock-based compensation expense recognized under SFAS No. 123R was approximately $194,325 and $574,344 for the three months and nine months ended September 30, 2007, respectively. Total stock-based compensation expense recognized under SFAS No. 123R was approximately $173,428 and $622,442 for the three months and nine months ended September 30, 2006, respectively. 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 (the “2004 Plan”) and other stock options outstanding during the three months and nine months ended September 30, 2007 and September 30, 2006 was estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions:

		Three Months Ended						Nine Months Ended
		September 30, 2007			September 30, 2006			September 30, 2007			September 30, 2006
Dividend yield			0.0	%		0. 00	%		0.0	%		0. 00	%
Expected volatility			150	%		48.6	%		150	%		150	%
Risk free interest rate			4.59	%		4.64	%		4.59	%		4.64	%
Expected lives (years)			5			5			5			5

The expected lives 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 the Company’s 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. The Company estimates forfeitures at the date of grant based on historical experience and future expectation.

The following is a summary of the stock option activity for the nine months ended September 30, 2007:

 

		Shares			Weighted Average Exercise Price
BALANCE, December 31, 2006			2,360,100		$	5.33
Granted			20,000		$	2.80
Forfeited			160,800		$	4.49
Exercised			20,000		$	1.30
BALANCE, September 30, 2007			2,199,300		$	5.40

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 does not believe that the adoption of SFAS No. 157 will have a material impact on the Company's results of operations or financial condition 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 once adopted.

 

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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. The Company operated this business under the name Smart CRM, Inc. (d/b/a Computility) (“Smart CRM”).

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. The Company issued 205,767 shares of its common stock to iMart's stockholders and agreed to pay iMart's stockholders approximately $3,462,000 in cash installments. This cash 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. The Company operates this subsidiary as Smart Commerce, Inc. (d/b/a iMart) (“Smart Commerce”).

Upon the Company's successful integration of the sales force automation and customer relationship management (“SFA/CRM”) application into its OneBiz^SM platform, management deemed the remaining operations of Smart CRM, specifically consulting and network management, to be non-strategic to ongoing operations. On September 29, 2006, the Company, Smart CRM and Alliance Technologies, Inc. ("Alliance") executed and delivered an Asset Purchase Agreement pursuant to which Alliance acquired substantially all of the assets of Smart CRM. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company has reported the operating results for Smart CRM as discontinued operations. For the three months and nine months ended September 30, 2006, the revenues associated with the discontinued operations were $462,468 and $1,497,002, respectively. For the three months and nine months ended September 30, 2006, the net losses associated with the discontinued operations were $(2,329,429) and $(2,525,563), respectively. Because the sale had been completed in 2006, the 2007 periods contain no results of discontinued operations.

3. SUBSCRIPTION REVENUE

Effective January 1, 2007, a major customer executed a letter of clarification which more clearly defined the roles and responsibilities of each party. Individual Business Owners (“IBOs”) associated with this customer are provided e-commerce, domain name and email services. In exchange for marketing these services to its IBOs, the customer is paid a marketing fee. At the inception of the business relationship, it was agreed that the customer would collect the gross service fee from the IBOs, and the customer would retain its marketing fee and remit the net remaining cash to the Company. 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, Reporting Revenue Gross as a Principal versus Net as an Agent, this revenue is now recorded as the gross amount paid by the IBO and a sales and marketing expense is recorded for the marketing services rendered by the customer. Ultimately, the effect on net income is nil; however, subscription revenue and sales and marketing expense are effectively and appropriately grossed up. Because the new accounting method was triggered by a clarification to the existing agreement and not by a change from one accepted accounting method to another, the 2006 subscription revenue was not retroactively adjusted as would be required by SFAS No. 154, Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3. For the three months and nine months ended September 30, 2007, this accounting method resulted in approximately $203,000 and $691,000, respectively, of additional subscription revenue and a corresponding charge to sales and marketing expense.

4.   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 revenue is generally composed of subscription fees, professional services fees and licensing fees related to domain name subscriptions, e-commerce or networking consulting or networking maintenance agreements.

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

 

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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 September 30, 2007:

		Smart  Online, Inc.			Smart  Commerce, Inc.			Consolidated
REVENUES:
Syndication Fees			15,000			-			15,000
Subscription Fees			13,892			816,768			830,660
Professional Services Fees			-			378,068			378,068
License Fees			-			200,000			200,000
Other Revenues			1,117			4,350			5,467
Total Revenues		$	30,009		$	1,399,186		$	1,429,195
COST OF REVENUES		$	60,748		$	107,287		$	168,035
OPERATING EXPENSES		$	1,756,889		$	913,262		$	2,670,151
OPERATING INCOME (LOSS)		$	(1,787,628	)	$	378,637		$	(1,408,991	)
OTHER INCOME (EXPENSE)		$	(126,424	)	$	(27,311	)	$	(153,735	)
NET INCOME/(LOSS) BEFORE INCOME TAXES		$	(1,914,052	)	$	351,326		$	(1,562,726	)
TOTAL ASSETS		$	6,564,696		$	3,686,492		$	10,251,187

The following table shows the Company's financial results by reportable segment for the nine months ended September 30, 2007:

		Smart  Online, Inc.			Smart  Commerce, Inc.			Consolidated
REVENUES:
Integration Fees		$	5,000		$	-		$	5,000
Syndication Fees			45,000			-			45,000
Subscription Fees			41,426			1,998,817			2,040,243
Professional Services Fees			-			984,548			984,548
License Fees			280,000			200,000			480,000
Other Revenues			6,802			13,918			20,720
Total Revenues		$	378,228		$	3,197,283		$	3,575,511
COST OF REVENUES		$	109,522		$	246,420		$	355,942
OPERATING EXPENSES		$	4,743,036		$	2,296,646		$	7,039,682
OPERATING INCOME (LOSS)		$	(4,474,330	)	$	654,217		$	(3,820,113	)
OTHER INCOME (EXPENSE)		$	(168,106	)	$	(99,009	)	$	(267,115	)
NET INCOME/(LOSS) BEFORE INCOME TAXES		$	(4,642,436	)	$	555,208		$	(4,087,228	)
TOTAL ASSETS		$	6,564,696		$	3,686,492		$	10,251,187

 

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5.   ASSETS & LIABILITIES

Accounts Receivable, Net

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 September 30, 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. Those operating metrics relate to Smart Commerce’s actual results of operations as compared to certain projections provided to Fifth Third Bank at the inception of the loan. The metrics for the June 30, 2007 release were not met, and therefore, no cash has yet been released.

Deferred Financing Costs

In order to secure a modification to a line of credit with Wachovia Bank, NA (“Wachovia”) (see Note 6 - 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 7 - Stockholders' Equity). The fair value of that warrant was $734,303 as measured using the Black-Scholes option-pricing model at the time the warrant was issued. Such amount was recorded as deferred financing costs and is being amortized to interest expense in the amount of $37,657 per month over the remaining period of the modified line of credit, which is scheduled to expire in August 2008. As of September 30, 2007, the deferred financing costs that will be amortized to interest expense over the next twelve months, or $414,220, were classified as current assets.

Accrued Liabilities

At December 31, 2006, the Company had accrued liabilities totaling $301,266. This amount consisted primarily of $107,333 of liability accrued related to the development of the Company’s custom accounting application, $56,997 related to its internal investigation conducted during 2006 and $25,000 accrued liability related to a lawsuit against the Company for legal fees incurred by an independent director in connection with the suspension of trading of the Company’s securities. At September 30, 2007, total accrued liabilities increased to $629,997. This amount reflects the addition of $300,000 of additional accrued liability as a reserve for the current litigation involving the Company.

Deferred Revenue

At December 31, 2006, deferred revenue consisted of the short-term and long-term portion of cash received related to one or two year subscriptions for domain names and/or email accounts. At September 30, 2007, deferred revenue consisted of the same domain name and e-mail types of deferred revenue in the amount of $254,633. In addition, at September 30, 2007, the Company had deferred $480,000 of perpetual licensing revenue related to two customers that did not meet all the criteria of SOP 97-2. Such deferred revenue will be recognized as cash is received or collectability becomes probable.

6. NOTES PAYABLE

As of September 30, 2007, the Company had notes payable totaling $3,353,209. The detail of these notes is as follows:

Note Description		Short-Term  Portion			Long-Term  Portion			TOTAL			Maturity			Rate
Wachovia Credit Line		$	2,052,000			-		$	2,052,000			Aug `08			Libor + 0.9%
Fifth Third Loan		$	900,000			150,000			1,050,000			Nov `08			Prime + 1.5%
Ailco Financial			6,987			15,863			22,850			June ‘10			18%
Acquisition Fee (iMart)			209,177			-			209,177			Oct ‘07			8%
Acquisition Fee (Computility)			19,182			-			19,182			Mar ‘07			8%
TOTAL		$	3,187,346		$	165,863		$	3,353,209

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On January 24, 2007, the Company entered into an amendment to its line of credit with Wachovia. The amendment resulted in an increase in the line of credit from $1.3 million to $2.5 million. The pay-off date for the line of credit was also extended from August 1, 2007 to August 1, 2008. 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 September 30, 2007, the Company has drawn down approximately $2.1 million on the line of credit.

7. STOCKHOLDERS' EQUITY 

 

Common Stock and Warrants

 

During the nine months ended September 30, 2007, a total of 159,500 shares of restricted stock were issued. A total of 55,000 shares of restricted stock were issued to the Company’s independent directors in accordance with the Company’s board compensation policy. The restrictions on such shares lapse with respect to the number of shares equal to 25% of the total securities issued over the subsequent four quarters provided that the director remains on the Board of Directors at the time each quarter commences. A total of 25,000 shares of restricted stock were issued to the newly appointed Chief Operating Officer, with the restrictions on such shares lapsing with respect to the number of shares equal to 12.5% of the total securities issued over the subsequent eight quarters, provided that at the time each quarter commences, the officer is still employed as an officer of Company. Finally, a total of 79,500 shares of restricted stock were issued to various employees, one of whom is an officer. Restrictions lapse as to one-third of these shares upon grant, with restrictions lapsing on the remaining shares over the next two years provided the respective employee remains employed by the Company.

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 to the Company were $6 million, and the Company has incurred issuance costs of approximately $637,000 as of September 30, 2007. Under the SPA, the Company issued the Investors warrants for the purchase of an aggregate of 1,176,471 shares of common stock at an exercise price of $3.00 per share. These warrants contain a provision for cashless exercise and must be exercised, if at all, by February 21, 2010.

 

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

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 were required to be included on the same registration statement the Company was obligated to file under the Investor RRA described above, but CA was not entitled to any penalties for late registration or effectiveness.

As incentive to modify a letter of credit relating to the Wachovia line of credit (see Note 6 - Notes Payable), the Company entered into a Stock Purchase Warrant and Agreement (the “Warrant Agreement”) with Atlas on January 15, 2007. Under the terms of the Warrant Agreement, Atlas received a warrant 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 amendments to registration rights agreements between such investors and the Company.  On July 20, 2007, the Company issued 27,427 additional shares as registration penalties to certain investors who did not enter into amendments to certain registration rights agreements.

 

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