LOOKSMART LTD - FORM 10-Q - November 3, 2009

Attached files

file	filename
EX-10.66 - COVENANTS RIDER TO THE MASTER LEASE AGREEMENT - LOOKSMART LTD	dex1066.htm
EX-32.1 - SECTION 906 CEO AND CFO CERTIFICATION - LOOKSMART LTD	dex321.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - LOOKSMART LTD	dex312.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - LOOKSMART LTD	dex311.htm
EX-10.68 - FIRST AMENDMENT TO SUPPLEMENTAL TERMS AND CONDITIONS LETTER - LOOKSMART LTD	dex1068.htm
EX-10.63 - SUBLEASE AGREEMENT WITH KPMG, LLP - LOOKSMART LTD	dex1063.htm
EX-10.67 - IRREVOCABLE STANDBY LETTER OF CREDIT APPLICATION AND LETTER OF CREDIT AGREEMENT - LOOKSMART LTD	dex1067.htm

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2009

¨	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition Period from to .

Commission File Number: 000-26357

LOOKSMART, LTD.

(Exact Name of Registrant as Specified in its Charter)

Delaware

13-3904355

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

625 Second Street

San Francisco, California 94107

(415) 348-7000

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

NASDAQ Stock Market LLC

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

Common Stock, par value $0.001 per share

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

None

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

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


Large accelerated filer ¨		Accelerated filer x		Non-accelerated filer ¨		Smaller reporting company x

Indicate by check mark whether the registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act. Yes ¨ No x

As of October 30, 2009, there were 17,131,638 shares of the registrant’s common stock outstanding, par value $0.001 per share.

TABLE OF CONTENTS


PART I		3

ITEM 1.	FINANCIAL STATEMENTS	3

	CONDENSED CONSOLIDATED BALANCE SHEETS	3

	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS	4

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	5

	NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	6

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	24

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	35

ITEM 4.	CONTROLS AND PROCEDURES	36

PART II OTHER INFORMATION		36

ITEM 1.	LEGAL PROCEEDINGS	36

ITEM 1A.	RISK FACTORS	36

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	44

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	44

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	44

ITEM 5.	OTHER INFORMATION	44

ITEM 6.	EXHIBITS	44

SIGNATURE		45

EXHIBIT INDEX		46

PART I

ITEM 1.

FINANCIAL INFORMATION

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)


	September 30, 2009			December 31, 2008
ASSETS
Current assets:
Cash and cash equivalents	$	15,217		$	22,393
Short-term investments		11,859			10,185

Total cash, cash equivalents and short-term investments		27,076			32,578
Trade accounts receivable, net		5,869			7,017
Prepaid expenses and other current assets		1,070			1,563

Total current assets		34,015			41,158
Property and equipment, net		2,930			3,371
Capitalized software and other assets, net		2,266			2,235

Total assets	$	39,211		$	46,764


LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable	$	3,549		$	4,357
Accrued liabilities		4,291			6,690
Deferred revenue and customer deposits		1,405			1,593
Current portion of long term obligations		1,694			2,275

Total current liabilities		10,939			14,915
Long-term obligations, net of current portion		1,644			1,438

Total liabilities		12,583			16,353

Commitment and contingencies
Stockholders’ equity:
Convertible preferred stock, $0.001 par value; Authorized: 5,000 shares at September 30, 2009 and December 31, 2008; Issued and Outstanding: none at September 30, 2009 and December 31, 2008		—			—
Common stock, $0.001 par value; Authorized: 200,000 shares at September 30, 2009 and December 31, 2008; Issued and Outstanding: 17,132 shares and 17,075 shares at September 30, 2009 and December 31, 2008, respectively		17			17
Additional paid-in capital		260,741			259,276
Accumulated other comprehensive gain (loss)		15			(4	)
Accumulated deficit		(234,145	)		(228,878	)

Total stockholders’ equity		26,628			30,411

Total liabilities and stockholders’ equity	$	39,211		$	46,764

The accompanying Notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Revenue	$	12,543		$	15,423		$	39,020		$	50,059
Cost of revenue		8,654			9,239			24,746			29,715

Gross profit		3,889			6,184			14,274			20,344

Operating expenses:
Sales and marketing		1,474			2,471			4,313			6,681
Product development		2,419			2,865			7,517			8,603
General and administrative		1,772			2,599			7,444			7,833
Restructuring charge		307			211			536			76
Impairment charge		—			—			180			—

Total operating expenses		5,972			8,146			19,990			23,193

Loss from operations		(2,083	)		(1,962	)		(5,716	)		(2,849	)
Non-operating income, net		10			239			86			919

Loss from continuing operations before income taxes		(2,073	)		(1,723	)		(5,630	)		(1,930	)
Income tax expense (benefit)		—			(7	)		8			7

Loss from continuing operations		(2,073	)		(1,716	)		(5,638	)		(1,937	)
Income (loss) from discontinued operations, net of tax		132			(5	)		371			(448	)

Net loss	$	(1,941	)	$	(1,721	)	$	(5,267	)	$	(2,385	)

Net loss per share - Basic and Diluted
Loss from continuing operations	$	(0.12	)	$	(0.10	)	$	(0.33	)	$	(0.11	)
Income (loss) from discontinued operations, net of tax		0.01			—			0.02			(0.02	)

Net loss per share	$	(0.11	)	$	(0.10	)	$	(0.31	)	$	(0.13	)

Weighted average shares outstanding used in computing basic and diluted net loss per share		17,120			17,038			17,100			18,190

The accompanying Notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Nine Months Ended September 30,
	2009			2008
Cash flows from operating activities:
Net loss	$	(5,267	)	$	(2,385	)
Adjustment to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		2,191			2,467
Share-based compensation		1,391			2,290
Restructuring benefit		—			(135	)
Impairment charge		180			381
Gain from sale of assets and other non-cash charges		(375	)		(594	)
Changes in operating assets and liabilities:
Trade accounts receivable, net		1,106			(4,625	)
Prepaid expenses and other current assets		506			36
Trade accounts payable		(808	)		508
Accrued liabilities		(2,047	)		(2,309	)
Deferred revenue and customer deposits		(188	)		61
Other long-term liabilities		(882	)		(935	)

Net cash used in operating activities		(4,193	)		(5,240	)

Cash flows from investing activities:
Purchase of short-term investments		(12,628	)		(29,171	)
Proceeds from sale of short-term investments		10,944			32,359
Purchase of long-term investments		—			(1,017	)
Payments for property and equipment and capitalized software development		(915	)		(1,233	)
Purchase of intangible assets		—			(280	)
Proceeds from sale of certain consumer assets		—			1,245
Proceeds from contingent purchase consideration of certain consumer assets		399			415

Net cash provided by (used in) investing activities		(2,200	)		2,318

Cash flows from financing activities:
Principal payments of notes		(51	)		(47	)
Principal payments of capital lease obligations		(746	)		(358	)
Proceeds from issuance of common stock		14			184
Payments for repurchase of common stock		—			(20,776	)

Net cash used in financing activities		(783	)		(20,997	)

Decrease in cash and cash equivalents		(7,176	)		(23,919	)
Cash and cash equivalents, beginning of period		22,393			35,743

Cash and cash equivalents, end of period	$	15,217		$	11,824

Supplemental disclosure of noncash activities
Assets acquired through capital lease obligations	$	1,351		$	1,463
Property and equipment received and liability accrued	$	5		$	7
Increase (decrease) in other assets associated with the contingent purchase consideration of certain consumer assets	$	5		$	(38	)
Reclass of property and equipment, capitalized software, and intangible assets related to certain consumer assets held for sale, net	$	—		$	1,010

The accompanying Notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

Nature of Business

LookSmart, Ltd. (“LookSmart”) is a search advertising network solutions company that provides relevant solutions for search advertisers and publishers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.

LookSmart offers search advertisers targeted, pay-per-click (PPC) search, and contextual search advertising via a monitored search advertising distribution network (referred to as the “AdCenter” platform). The Company’s search advertising distribution network (“Advertising Networks”) includes publishers and search partners in the United States and certain other countries. The Company’s application programming interface (API) allows search advertisers and their advertising agencies to connect any type of marketing or reporting software with minimal effort, for easier access, management, and optimization of search advertising campaigns.

In 2007, the Company’s management made the decision to exit certain consumer products activities and to sell or otherwise dispose of the various consumer related websites and assets associated with those activities. In the first quarter of 2008, the Company’s management made the decision to exit its remaining consumer products activities and to sell or otherwise dispose of the remaining consumer assets. During 2008, the Company sold the intellectual property rights to the “Wisenut” trademark and related domain names and decided to wind down the Furl operations. In the first quarter of 2009, the Furl assets were sold. The results of operations of consumer product activities, including related gains (losses), have been classified as discontinued operations for all periods presented in the accompanying Unaudited Condensed Consolidated Statements of Operations (see Note 3). At September 30, 2009, the Company continues to own the Wisenut search engine technology, intellectual property rights in such technology and other assets.

Principles of Consolidation

The Unaudited Condensed Consolidated Financial Statements as of September 30, 2009 and December 31, 2008, and for the three and nine months ended September 30, 2009 and 2008, include the accounts of the Company and its subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.

Unaudited Interim Financial Information

The accompanying Unaudited Condensed Consolidated Financial Statements as of September 30, 2009, and for the three and nine months ended September 30, 2009 and 2008, reflect all adjustments that are normal and recurring in nature and, in the opinion of management, are necessary for a fair representation of the Company’s financial position as of September 30, 2009 and the results of operations for the periods shown. These Unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (“Annual Report”). The Unaudited Condensed Consolidated Balance Sheet as of December 31, 2008 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The results of operations for the interim periods ended September 30, 2009 are not necessarily indicative of results to be expected for the full year.

Use of Estimates and Assumptions

The Unaudited Condensed Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”). This requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenue, expenses, and contingent assets and liabilities during the reporting period. The Company bases its estimates on various factors and information which may include, but are not limited to, history and prior experience, experience of other enterprises in the same industry, new related events, and current economic conditions, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. In management’s opinion, all adjustments necessary for a fair statement are reflected in the interim periods presented.

Reclassifications

Certain amounts in the financial statements for the prior periods have been reclassified to conform to the current presentation. These reclassifications did not change the previously reported net loss, net change in cash and cash equivalents or stockholders’ equity.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Subsequent Events

The Company evaluated subsequent events through November 3, 2009, the date on which this Quarterly Report on Form 10-Q was filed with the Securities and Exchange Commission (“SEC”).

Investments

The Company invests its excess cash primarily in debt instruments of high-quality corporate and government issuers. All highly liquid instruments with maturities at the date of purchase greater than ninety days are considered investments. All instruments with maturities greater than one year from the balance sheet date are considered long-term investments unless management intends to liquidate such securities in the current operating cycle. Such securities are classified as short-term investments. These securities are classified as available-for-sale and carried at fair value.

Changes in the value of these investments are primarily related to changes in interest rates and are considered to be temporary in nature. Except for declines in fair value that are not considered temporary, net unrealized gains or losses on these investments are reported as a component of other comprehensive income (loss) in stockholders’ equity. The Company recognizes realized gains and losses upon sale of investments using the specific identification method.

Concentrations, Credit Risk and Credit Risk Evaluation

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, investments, and accounts receivable. As of September 30, 2009 and December 31, 2008, the Company placed its cash equivalents and investments primarily through one financial institution, City National Bank (“CNB”), and mitigated the concentration of credit risk by placing percentage limits on the maximum portion of the investment portfolio which may be invested in any one investment instrument. These amounts at times may exceed federally insured limits. The Company has not experienced any credit losses on these cash equivalents and investment accounts and does not believe it is exposed to any significant credit risk on these funds. The fair value of these accounts is subject to fluctuation based on market prices.

Credit Risk, Customer and Vendor Evaluation

Accounts receivable are typically unsecured and are derived from sales to customers. The Company performs ongoing credit evaluations of its customers and maintains allowances for estimated credit losses. The Company applies judgment as to its ability to collect outstanding receivables based primarily on management’s evaluation of the customer’s financial condition and past collection history and records a specific allowance. In addition, the Company records an allowance based on the length of time the receivables are past due. Historically, such losses have been within management’s expectations.

The following table reflects customers that accounted for more than 10% of gross accounts receivable:


	September 30, 2009		December 31, 2008
Company 1	18	%	26	%
Company 2	13	%	**
Company 3	12	%	**
Company 4	**		18	%
** Less than 10%

Revenue Concentrations

The following table reflects countries that accounted for more than 10% of net revenue:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
United States	86	%	85	%	87	%	87	%
Canada	11	%	10	%	10	%	**
** Less than 10%

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

LookSmart derives its revenue from two service offerings, or “products”: Advertising Networks and Publisher Solutions. The percentage distributions between the two service offerings are as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Advertising Networks	94	%	90	%	92	%	91	%
Publisher Solutions	6	%	10	%	8	%	9	%

The following table reflects the percentage of revenue attributed to customers who accounted for 10% or more of net revenue:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Company 1	15	%	19	%	17	%	14	%
Company 2	10	%	*	*	10	%	12	%
Company 3	**		13	%	**		**
** Less than 10%

For the three and nine months ended September 30, 2009, IAC Search and Media (“IAC” or “Company 1”) accounted for 15% and 17%, respectively, of net revenue, and 74% and 82%, respectively, of Publisher Solutions revenue. On May 19, 2009, Ask Sponsored Listings, a division of IAC, notified the Company that it did not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services (the “Agreement”) upon its expiration. The Agreement, as amended, expires by its terms on December 31, 2009.

The Company derives its revenue primarily from its relationships with significant distribution network partners. The following table reflects the distribution partners that accounted for more than 10% of the total traffic acquisition costs (“TAC”):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Distribution Partner 1	**		11	%	13	%	**
Distribution Partner 2	**		12	%	11	%	10	%
Distribution Partner 3	11	%	11	%	10	%	12	%
Distribution Partner 4	11	%	11	%	**		13	%
Distribution Partner 5	**		11	%	**		11	%
Distribution Partner 6	**		11	%	**		**
** Less than 10%

Internal Use Software Development Costs

The Company capitalizes external direct costs of materials and services consumed in developing and obtaining internal-use computer software and the payroll and payroll-related costs for employees who are directly associated with and who devote time to developing the internal-use computer software.

Management exercises judgment in determining when costs related to a project may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the amortization period for the capitalized costs. The Company expects to continue to invest in internally developed software and to capitalize such costs.

The Company’s capitalized software development costs were $8.3 million and $7.4 million with related accumulated amortization of $6.2 million and $5.5 million at September 30, 2009 and December 31, 2008, respectively. Amortization expense was $0.2 million and $0.7 million for the three and nine months ended September 30, 2009, respectively, and $0.2 million and $0.6 million for the three and nine months ended September 30, 2008, respectively. Capitalized software development costs are included in capitalized software and other assets and are amortized over three years.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Intangible Assets

The Company amortizes acquired intangible assets with definite lives over periods from two to seven years and the amortization expense is primarily classified as cost of revenues in the Company’s Unaudited Condensed Consolidated Statements of Operations.

Impairment of Long-Lived Assets

The Company reviews long-lived assets held or used in operations, including property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. Subject assets are tested for impairment at the lowest level of operations that generates cash flows that is largely independent of the cash flows from those of other groups of asset and liabilities. Management has determined that the equity of its single reporting unit is the lowest level of operation at which independent cash flows can be identified. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. Assets to be disposed of are reported at the lower of carrying amount or fair value less cost to dispose.

In the second quarter of 2009, purchased technology of $0.3 million was impaired by approximately $0.2 million because an associated initiative was discontinued. Any adjustment to the estimated impairment based on additional information providing a more accurate measurement will be recognized in subsequent reporting periods.

The Company tested its long-lived assets used in operations for impairment as of December 31, 2008 and determined they were not impaired.

Revenue Recognition

Online search advertising revenue is primarily composed of per-click fees that the Company charges customers. The per-click fee charged for keyword-targeted listings is calculated based on the results of online bidding for keywords or page content, up to a maximum cost per keyword or page content set by the customer. Revenue also includes revenue share from licensing of private-labeled versions of the Company’s products.

Revenues associated with online advertising products, including Advertiser Networks, are generally recognized once collectability is established, delivery of services has occurred, all performance obligations have been satisfied, and no refund obligations exist. The Company pays distribution network partners based on clicks on the advertiser’s ad that are displayed on the websites of these distribution network partners. These payments are called traffic acquisition costs (“TAC”) and are included in cost of revenues. The revenue derived from these arrangements that involve traffic supplied by distribution network partners is reported gross of the payment to the distribution network partners. This revenue is reported gross due to the fact that the Company is the primary obligor to the advertisers who are the customers of the advertising service.

The Company also enters into agreements to provide private-labeled versions of its products, including licenses to the AdCenter. These license arrangements include multiple elements: revenue-sharing based on the publisher’s customer’s monthly revenue generated through the AdCenter application; upfront fees; and other license fees. The Company recognizes upfront fees over the term of the arrangement or the expected period of performance, other license fees over the term of the license, and revenue-sharing portions over the period in which such revenue is earned. In all cases, revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed, and collectability of the resulting receivable is reasonably assured.

The Company provides a provision against revenue for estimated reductions resulting from billing adjustments and customer refunds. The amounts of these provisions are evaluated periodically based upon customer experience and historical trends. The allowance for returns included in trade receivables, net is insignificant and $0.3 million at September 30, 2009 and December 31, 2008, respectively.

Deferred revenue is recorded when payments are received in advance of performance in underlying agreements. Customer deposits are recorded when customers make prepayments for online advertising.

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from customers failing to make required payments. This valuation allowance is reviewed on a periodic basis to determine whether a provision or reversal is required. The review is based on factors including the application of historical collection rates to current receivables and economic conditions. The Company will record an increase or reduction of its allowance for doubtful accounts if collection rates or economic conditions are more or less favorable than it anticipated. Additional allowances for doubtful accounts may be required if there is deterioration in past due balances, if economic conditions are less favorable than the Company anticipated or for customer-specific circumstances, such as bankruptcy. The allowance for doubtful accounts included in trade accounts receivable, net is $0.2 million and $0.3 million at September 30, 2009 and December 31, 2008, respectively. Bad debt (recovery) expense included in sales and marketing expense is ($0.1) million and $0.1 million for the three and nine months ended September 30, 2009, respectively, and $0.1 million and $0.3 million for the three and nine months ended September 30, 2008, respectively.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Traffic Acquisition Costs

The Company enters into agreements of varying durations with its distribution network partners that display the Company’s listings ads on their sites in return for a percentage of the revenue-per-click that the Company receives when the ads are clicked on those partners’ sites.

The Company also enters into agreements of varying durations with third party affiliates. There are generally three economic structures of the affiliate agreements: guaranteed fixed payments which often carry reciprocal performance guarantees from the affiliate, variable payments based on a percentage of the Company’s revenue or based on a certain metric, such as number of searches or paid clicks, or a combination of the two.

The Company expenses, as cost of revenues, TAC under two methods; agreements with fixed payments are expensed pro-rata over the term the fixed payment covers, and agreements based on a percentage of revenue, number of paid introductions, number of searches, or other metrics are expensed based on the volume of the underlying activity or revenue, multiplied by the agreed-upon price or rate.

Share-Based Compensation

The Company recognizes share-based compensation costs for all share-based payment transactions with employees, including grants of employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, over the requisite service period based on their relative fair values. The Company estimates the fair value of share-based payment awards on the grant date using the Black-Scholes method. The value of the portion of the award that is ultimately expected to vest is recognized as expense in the Company’s Unaudited Condensed Consolidated Statement of Operations over the requisite service periods. Share-based compensation expense recognized for the three and nine months ended September 30, 2009 was $0.4 million and $1.5 million, respectively, and $0.7 million and $2.4 million for the three and nine months ended September 30, 2008, respectively, which was related to stock grants, options and employee stock purchases.

Forfeitures are estimated at the time of grant in order to estimate the amount of share-based awards that will ultimately vest. The forfeiture rate is determined at the end of each fiscal quarter, based on historical rates. Share-based compensation expense recognized in the Company’s Unaudited Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2009 and 2008 includes (i) compensation expense for share-based payment awards granted prior to, but not yet fully vested as of December 31, 2005, based on the grant-date fair value estimates and (ii) compensation expense for the share-based payment awards granted subsequent to December 31, 2005, based on the grant-date fair value.

The Company elected to adopt the alternative transition method for calculating the tax effects of share-based compensation to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee share-based compensation awards.

Income Taxes

The Company accounts for income taxes using the liability method. Under the liability method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. The Company records liabilities, where appropriate, for all uncertain income tax positions. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits within operations as income tax expense.

Comprehensive Gain (Loss)

Other comprehensive gain (loss) as of September 30, 2009 and December 31, 2008 consists of unrealized gains and losses on marketable securities categorized as available-for-sale.

Net Income (Loss) per Common Share

Basic net income (loss) and diluted net loss per share is calculated using the weighted average shares of common stock outstanding. Diluted net income per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the treasury stock method for stock options and warrants.

Recent Accounting Pronouncements

With the exception of those stated below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the nine months ended September 30, 2009, as compared to the recent accounting pronouncements described in the Company’s Annual Report that are of material significance, or have potential material significance, to the Company.

Effective July 1, 2009, the Company adopted the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 105-10, Generally Accepted Accounting Principles – Overall (“ASC 105-10”). ASC 105-10 establishes the FASB Accounting Standards Codification (the “Codification”) as the source of authoritative accounting principles recognized by the FASB to be applied

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

by nongovernmental entities in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority. The Codification superseded all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification is non-authoritative. The FASB will not issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates (“ASUs”). The FASB will not consider ASUs as authoritative in their own right. ASUs will serve only to update the Codification, provide background information about the guidance and provide the bases for conclusions on the change(s) in the Codification. References made to FASB guidance throughout this document have been updated for the Codification.

Effective January 1, 2008, the Company adopted FASB ASC 820-10, Fair Value Measurements and Disclosures – Overall (“ASC 820-10”) with respect to its financial assets and liabilities. In February 2008, the FASB issued updated guidance related to fair value measurements, which is included in the Codification in ASC 820-10-55, Fair Value Measurements and Disclosures – Overall – Implementation Guidance and Illustrations. The updated guidance provided a one year deferral of the effective date of ASC 820-10 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, the Company adopted the provisions of ASC 820-10 for non-financial assets and non-financial liabilities effective January 1, 2009, and such adoption did not have a material impact on the Company’s consolidated results of operations, financial condition or liquidity.

Effective January 1, 2009, the Company adopted FASB ASC 805, Business Combinations (“ASC 805”). ASC 805 establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. ASC 805 changes the previous treatment of acquisition related costs, restructuring costs related to an acquisition that the acquirer expects but is not obligated to incur, contingent consideration associated with the purchase price and pre-acquisition contingencies associated with acquired assets and liabilities. Under ASC 805, acquisition costs associated with business combinations will generally be expensed as incurred, whereas, prior to the adoption of ASC 805, similar costs associated with a successful acquisition were capitalized. ASC 805 applies to business combinations for which the acquisition date is on or after the adoption date, thus the adoption of ASC 805 will have no effect on prior acquisitions. The effect of the adoption of ASC 805 will depend upon the nature of any future business combinations.

In April 2009, the FASB issued updated guidance relating to intangible asset valuation, which is included in the Codification in ASC 350-30-55, General Intangibles Other Than Goodwill – Implementation (“ASC 350-30-55”). ASC 350-30-55 amends ASC 350-30, Intangibles – Goodwill and Other, to identify the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. ASC 350-30-55 is effective for fiscal years beginning after December 31, 2008. The Company adopted the amendment to ASC 350-30 effective January 1, 2009, and such amendment did not have a material effect on the Company’s results of operations, financial position or liquidity.

Effective April 1, 2009, the Company adopted FASB ASC 825-10-65, Financial Instruments – Overall – Transition and Open Effective Date Information (“ASC 825-10-65”). ASC 825-10-65 amends ASC 825-10 to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements and also amends ASC 270-10, Presentation – Interim Reporting – Overall, to require those disclosures in all interim financial statements. The adoption of ASC 825-10-65 did not have a material impact on the Company’s results of operations, financial position or liquidity.

Effective April 1, 2009, the Company adopted FASB ASC 320-10-65, Investments – Debt and Equity Securities – Overall – Transition and Open Effective Date Information (“ASC 320-10-65”). ASC 320-10-65 amends the other-than-temporary impairment guidance in U.S. GAAP to make the guidance more operational and to improve the presentation of other-than-temporary impairments in the financial statements. The adoption ASC 320-10-65 did not have a material impact on the Company’s results of operations, financial position or liquidity.

Effective April 1, 2009, the Company adopted FASB ASC 855-10, Subsequent Events – Overall (“ASC 855-10”). ASC 855-10 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date – that is, whether that date represents the date the financial statements were issued or were available to be issued. This disclosure should alert all users of financial statements that an entity has not evaluated subsequent events after that date in the set of financial statements being presented. Adoption of ASC 855-10 did not have a material impact on the Company’s results of operations, financial position or liquidity. See the “Subsequent Events” section in Note 1 for the related disclosures.

Effective July 1, 2009, the Company adopted FASB ASU No. 2009-05, Fair Value Measurements and Disclosures (Topic 820) (“ASU 2009-05”). ASU 2009-05 provided amendments to ASC 820-10, Fair Value Measurements and Disclosures – Overall, for the fair value measurement of liabilities. ASU 2009-05 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using certain techniques. ASU 2009-05 also clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of a liability. ASU 2009-05 also clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. Adoption of ASU 2009-05 did not have a material impact on the Company’s results of operations, financial position or liquidity.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2. Discontinued Operations

Foreign Operations

In 2004, the Company’s management made the decision to cease operating and liquidate its then existing foreign legal entities, and reclassified its consolidated financial statements to reflect these foreign entity expenses as discontinued. During the three and nine months ended September 30, 2009 and 2008, the loss related to the liquidation of the Company’s foreign legal entities was not significant. The Company expects to complete the dissolution of these entities in 2009. As of September 30, 2009 and December 31, 2008, there were no net assets related to the discontinued foreign legal entities.

Consumer Products

In 2007, the Company’s management made the decision to exit certain consumer products activities and to sell or otherwise dispose of the various related websites and assets associated with those activities and has reclassified its consolidated financial statements to reflect these consumer activities as discontinued. During 2007, the Company sold FindArticles, the assets relating to Grub, the websites and trademark associated with Zeal, and completed the shutdown of the Wisenut website and search functionality.

In the first quarter of 2008, the Company’s management made the decision to exit the remaining consumer products activities and to sell or otherwise dispose of the remaining consumer assets. The various related websites and assets associated with the consumer products activities previously disposed of, and the foreign operations previously disposed of, met the criteria to be classified as discontinued operations. The results of operations related to assets to be disposed of, and of previously disposed assets, including any related gains and losses are classified as discontinued operations in the accompanying Unaudited Condensed Consolidated Statements of Operations.

As of September 30, 2009 and December 31, 2008, the Company owns the Wisenut search engine technology, intellectual property rights in such technology and other assets.

The following table reflects revenue, gross profit, operating expenses, gain on disposal and net income (loss) of discontinued operations for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,					Nine Months Ended September 30,
	2009		2008			2009		2008
Revenue	$	—	$	26		$	8	$	78

Gross profit	$	—	$	18		$	8	$	49
Product development expenses		2		162			41		682
General and administrative expenses		—		5			—		40
Impairment charges		—		—			—		381

Total operating expenses		2		167			41		1,103
Gain on disposal		134		144			404		597
Non-operating income, net		—		—			—		9

Net income (loss) from discontinued operations	$	132	$	(5	)	$	371	$	(448	)

Furl

In the first quarter of 2008, the Company’s management made the decision to exit the remaining consumer products activities and to sell or otherwise dispose of the remaining consumer assets. As a result, beginning in the first quarter of 2008, Furl assets, consisting of property and equipment, capitalized software, goodwill and intangibles, were accounted for as “assets held for sale.” In the fourth quarter of 2008, the Company determined that the Furl assets were impaired due to the lack of marketability and the decision to wind down the Furl operations. As a result, the Company recognized an impairment charge of $1.4 million during 2008. On February 26, 2009, the Company sold the Furl assets and received a warrant to purchase 1.3 million shares of the acquirer’s non-marketable common stock at an exercise price of $0.30 per share (in each case, subject to certain adjustments in certain circumstances). The warrant expires in February 2010. The Company determined the warrants received had no significant value and did not record a gain on the disposal. The Furl assets had no net book value.

Net Nanny

On January 22, 2007, the Company completed the sale of Net Nanny to Content Watch, Inc. (“Content Watch”). The sale proceeds were comprised of contingent purchase consideration that may be realized at future dates based on the amount of revenue received by Content Watch. The Company recorded contingent purchase consideration of $0.1 million for the three month periods ended September 30, 2009 and 2008, and $0.4 million for the nine month periods ended September 30, 2009 and 2008. Under the terms of the Content Watch agreement, the contingent purchase consideration will end in 2010. Contingent purchase consideration has been classified as gain on disposal.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. Cash, Cash Equivalents and Short-Term Investments

The following table summarizes the Company’s cash and available-for-sale securities’ amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value by significant investment category as of September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009									December 31, 2008
	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value		Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Cash and cash equivalents:
Cash	$	3,856	$	—	$	—		$	3,856	$	4,614	$	—	$	—		$	4,614

Cash equivalents
Money market mutual funds		5,216		—		—			5,216		17,279		—		—			17,279
Certificates of deposit		245		—		—			245		500		—		—			500
Commercial paper		5,900		—		—			5,900		—		—		—			—

Total cash equivalents		11,361		—		—			11,361		17,779		—		—			17,779

Total cash and cash equivalents		15,217		—		—			15,217		22,393		—		—			22,393

Short-term investments:
Corporate bonds		2,205		13		(2	)		2,216		5,204		—		(9	)		5,195
Certificates of deposit		3,930		2					3,932		2,000							2,000
United States government debt securities		2,000		—		—			2,000		2,004		28		—			2,032
Municipal bonds - California		1,011		2					1,013		981				(23	)		958
Commercial paper		2,698		—		—			2,698		—		—		—			—

Total short-term investments		11,844		17		(2	)		11,859		10,189		28		(32	)		10,185

Total cash, cash equivalents and short-term investments	$	27,061	$	17	$	(2	)	$	27,076	$	32,582	$	28	$	(32	)	$	32,578

There were no realized gains or realized losses for the three and nine months ended September 30, 2009. Realized gains and realized losses were not significant for the three and nine months ended September 30, 2008. The cost of all securities sold is based on the specific identification method.

The contractual maturities of cash equivalents and short-term investments at September 30, 2009 were less than one year.

The Company’s gross unrealized loss on investments in corporate bonds at September 30, 2009 relates to a single security with an amortized cost of $0.7 million. The Company considers the decline in market value of this security to be temporary in nature and caused by changes in market interest rates. The Company typically invests in highly-rated securities, and its policy generally limits the amount of credit exposure to any one issuer. When evaluating the investments for other-than-temporary impairment, the Company reviews such factors as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s amortized cost basis. During the three and nine months ended September 30, 2009 and 2008, the Company did not recognize any impairment charges on outstanding investments. As of September 30, 2009, the Company does not consider any of its investments to be other-than-temporarily impaired.

4. Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consisted of the following at September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009		December 31, 2008
Investment bank retainer fees	$	—	$	325
Other prepaid expenses		606		688
Other current assets		464		550

Total	$	1,070	$	1,563

Effective upon the adoption of the revised business combination guidance on January 1, 2009, the prepaid investment bank retainer fees at December 31, 2008 relating to evaluating strategic growth alternatives were expensed and reflected in general and administrative expenses. Fees paid in the future of a similar nature will be expensed as incurred.

5. Property and Equipment

Property and equipment consisted of the following at September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009							December 31, 2008
	Cost		Accumulated Depreciation			Net Book Value		Cost		Accumulated Depreciation			Net Book Value
Computer equipment	$	17,032	$	(14,196	)	$	2,836	$	16,362	$	(13,393	)	$	2,969
Furniture and fixtures		1,151		(1,118	)		33		1,151		(1,105	)		46
Software		3,768		(3,763	)		5		3,765		(3,746	)		19
Leasehold improvements		2,901		(2,845	)		56		2,901		(2,564	)		337

Total	$	24,852	$	(21,922	)	$	2,930	$	24,179	$	(20,808	)	$	3,371

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Depreciation expense on property and equipment for the three and nine months ended September 30, 2009, including property and equipment under capital lease, was approximately $0.5 million and $1.5 million, respectively. Depreciation expense on property and equipment for the three and nine months ended September 30, 2008, including property and equipment under capital lease, was approximately $0.6 million and $1.7 million, respectively. Equipment under capital lease totaled $4.2 million as of September 30, 2009 and $3.1 million as of December 31, 2008. Depreciation expense on equipment under capital lease was $0.3 million and $0.8 million for the three and nine months ended September 30, 2009, respectively, and was $0.2 million and $0.4 million for the three and nine months ended September 30, 2008, respectively. Additionally, accumulated depreciation on equipment under capital lease was $1.5 million as of September 30, 2009 and $0.7 million as of December 31, 2008.

6. Intangible Assets

The Company’s intangible assets are classified in capitalized software and other assets on the Company’s Unaudited Condensed Consolidated Balance Sheet and consist of purchased technology that have estimated useful lives of three years and are as follows (in thousands):


	September 30, 2009							December 31, 2008
	Gross Amount		Accumulated Amortization			Net Book Value		Gross Amount		Accumulated Amortization			Net Book Value
Amortizable purchased technology	$	178	$	(78	)	$	100	$	358	$	(65	)	$	293

Intangible asset amortization expense was not significant for the three and nine months ended September 30, 2009 and three months ended September 30, 2008, and was $0.1 million for the nine months ended September 30, 2008, and has been classified as discontinued operations.

7. Accrued Liabilities

Accrued liabilities consisted of the following as of September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009		December 31, 2008
Accrued distribution and partner costs	$	2,652	$	3,173
Accrued compensation and related expenses		585		722
Accrued legal costs and other professional service fees		352		499
Accrued legal proceedings liability		339		339
Accrued restructuring		266		—
Accrued indemnification liability		—		1,019
Accrued equipment purchases		5		370
Other		92		568

Total accrued liabilities	$	4,291	$	6,690

See Note 11, Commitments and Contingencies, for complete discussion of the accrued legal proceedings and indemnification liabilities.

8. Restructuring Charge

In May 2009, the Company recorded $0.2 million in pre-tax restructuring charges associated with the termination of eight employees. Payments associated with the May 2009 restructuring liability were fully paid in the third quarter of 2009. In September 2009, the Company recorded an additional $0.3 million in pre-tax restructuring charges associated with the termination of five employees. The balance of the remaining payments associated with the September 2009 restructuring liability will be paid in the fourth quarter of 2009. The restructuring liability activity was as follows for the three and nine months ended September 30, 2009 (in thousands).

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


	Employee Severance Costs
	Three Months Ended September 30, 2009			Nine Months Ended September 30, 2009
Balance at beginning of period	$	18		$	—
Restructuring charge		308			537
Cash payments		(60	)		(271	)

Balance at September 30, 2009	$	266		$	266

The restructuring liability is classified in accrued liabilities on the Company’s Unaudited Condensed Consolidated Balance Sheet (see Note 7).

9. Lease Restructuring and Other Liabilities

Between 2003 and 2006, the Company vacated portions of its leased headquarter office facilities, and incurred lease restructuring costs related to closing these facilities. Additionally, the Company entered into various subleases.

Lease restructuring and other liabilities consist of the following at September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009		December 31, 2008
Lease restructuring	$	278	$	1,160
Sublease deposits		196		243

Total lease restructuring and other liabilities	$	474	$	1,403

As of September 30, 2009 and December 31, 2008, the lease restructuring and other liabilities was approximately $0.5 million and $1.4 million, respectively, and is included in the current portion of long-term obligations.

The following table sets forth lease restructuring activity during the three and nine months ended September 30, 2009, and year ended December 31, 2008 (in thousands):


	Lease Restructuring Costs
	Three Months Ended September 30, 2009			Nine Months Ended September 30, 2009			Year Ended December 31, 2008
Balance at beginning of period	$	572		$	1,160		$	2,498
Amortization of lease restructuring costs		(294	)		(882	)		(1,203	)
Lease restructuring credit		—			—			(135	)

Balance at end of period	$	278		$	278		$	1,160

In the second quarter of 2008, the Company subleased approximately 6,500 square feet for which the Company previously recognized a restructuring charge. The additional sublease resulted in a reduction of $0.1 million in the lease restructuring liability with the offset being a lease restructuring credit.

10. Long-Term Obligations

Long-term obligations consist of the following at September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009			December 31, 2008
Note payable	$	12		$	63
Capital lease obligations		2,852			2,247

Total long-term obligations		2,864			2,310
Less: current portion		(1,220	)		(872	)

Long-term obligations, net of current portion	$	1,644		$	1,438

Note Payable

In January 2000, the Company issued an unsecured promissory note in the principal amount of approximately $0.5 million to its landlord to finance tenant improvements. The note bears interest at 9% per annum and is payable in equal monthly installments over a term of 10 years that ends November 2009.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Capital Lease Obligations

On April 6, 2007, the Company entered into a master equipment lease agreement with CNB for an original amount of up to $5.0 million for the purchase of computer equipment. On April 30, 2009, the lease line was extended through April 30, 2010. As of September 30, 2009, the Company had drawn down approximately $4.2 million of the available lease line of credit. Interest on the capital leases was calculated using interest rates ranging from 4.32% to 7.95% per annum. As of September 30, 2009, there is $0.7 million available for new capital leases. Interest on new capital leases will be calculated using an interest rate of 5.60% per annum. Effective as of September 30, 2009, the master equipment lease agreement was amended to modify two financial covenants, with which the Company was in compliance as of such date.

The agreements with CNB, consisting of the outstanding standby letters of credit (each an “SBLC”) and the master equipment lease agreement, contain cross-default provisions, whereby a default under one is deemed a default for the other. As of September 30, 2009 and December 31, 2008, the Company was not in default on either agreement with CNB (see Note 11).

11. Commitments and Contingencies

As of September 30, 2009, future minimum payments under the note payable, all capital and operating leases and minimum sublease rental income are as follows (in thousands):


	Note Payable			Capital Leases			Operating Leases		Minimum Sublease Rental Income			Total
Three months ended December 31, 2009	$	12		$	335		$	822	$	(304	)	$	865
Fiscal years ending December 31,
2010		—			1,310			400		—			1,710
2011		—			980			496		—			1,476
2012		—			411			517		—			928
2013		—			27			536		—			563
2014		—			—			557		—			557

Total minimum payments		12			3,063		$	3,328	$	(304	)	$	6,099

Less: amount representing interest		—			(211	)

Present value of net minimum payments		12			2,852
Less: current portion		(12	)		(1,208	)

Long-term portion of note payable and capital lease obligations	$	—		$	1,644

Operating Leases

The Company leases office space under a non-terminable operating lease that expires on November 30, 2009, of which certain space is sublet under cancellable and noncancellable subleases.

On August 31, 2009, the Company entered into an agreement to sublease office space under an operating lease commencing in November 2009, and expiring on December 30, 2014. In addition to scheduled base rent payments, the Company will also be responsible for varying amounts of operating and tax expenses.

Letters of Credit

The Company has outstanding SBLCs related to security of two building leases totaling $1.1 million at September 30, 2009. At December 31, 2008, the Company had outstanding SBLCs related to the security of a building lease and payroll processing services totaling $1.1 million. Each of the SBLCs contains two financial covenants, which were amended as of September 30, 2009. As of September 30, 2009 and December 31, 2008, the Company was in compliance with all required covenants. The SBLC for one of the building leases in the amount of $0.8 million should be released by the landlord and terminated within a reasonable period of time following the lease expiration on November 30, 2009.

The agreements with CNB, consisting of the SBLCs and master equipment lease agreement, contain cross-default provisions, whereby a default under one is deemed a default for the other. As of September 30, 2009 and December 31, 3008 the Company was not in default on either agreement with CNB (see Note 10).

Guarantees and Indemnities

During its normal course of business, the Company has made certain guarantees, indemnities and commitments under which it may be required to make payments in relation to certain transactions. These indemnities include intellectual property and other indemnities to the Company’s customers and distribution network partners in connection with the sales of its products, and indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

On September 4, 2008, the Company agreed to indemnify one of its Publisher Solutions customers, IAC, pursuant to an indemnification agreement contained in an AdCenter for Publishers’ contract. The obligation arose from a Complaint, which was filed on October 16, 2007 in the United States District Court for the Eastern Division of Texas against IAC and others, alleging that the Company’s AdCenter for Publisher violates the plaintiff’s patent and seeks injunctive relief and unspecified damages. See Performance Pricing v. Google, Inc. et. al., Civil Action No. 2:07 cv 00432-LED, United States District Court for the Eastern District of Texas (the “Action”). On or about February 18, 2009, the Company entered into a Settlement Agreement with the plaintiffs, whereby the Company agreed to pay the plaintiffs $0.6 million in exchange for a dismissal of the Action against IAC, release of IAC and the Company for any past damages for infringement and a future license for the Company and its customers. On or about February 12, 2009, the Company also agreed to pay IAC’s defense costs in the Action which totaled $0.4 million. On or about March 4, 2009, the Court dismissed the Action against IAC. During the six months ended June 30, 2009, the Company paid the $0.6 million required by the Settlement Agreement, the $0.4 million IAC defense cost reimbursement and $0.1 million of legal expenses associated with the Action.

Further, the Company has agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was, serving, at the Company’s request, in such capacity, to the maximum extent permitted under the laws of the State of Delaware. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. However, the Company maintains directors and officers insurance coverage that may contribute, up to certain limits, a portion of any future amounts paid, for indemnification of directors and officers. The Company believes the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal. Historically, the Company has not incurred any losses or recorded any liabilities related to performance under these types of indemnities.

The following table sets forth the indemnification liability activity, including the Settlement Agreement payment, IAC defense costs and the Company’s defense costs, during the three and nine months ended September 30, 2009 and the year ended December 31, 2008 (in thousands):


	Indemnification Liability
	Three Months Ended September 30, 2009		Nine Months Ended September 30, 2009			Year Ended December 31, 2008
Balance at beginning of period	$	—	$	1,019		$	—
Indemnification costs included in general and administrative expense		—		51			1,076
Cash payments		—		(1,070	)		(57	)

Balance at end of period	$	—	$	—		$	1,019

The indemnification liability at December 31, 2008 is classified in trade accounts payable and accrued liabilities on the Company’s Unaudited Condensed Consolidated Balance Sheet (see Note 7).

Legal Proceedings

The Company is involved, from time to time, in various legal proceedings arising from the normal course of business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company does not expect resolution of these matters to have a material adverse impact on its consolidated results of operations, cash flows or financial position unless stated otherwise. However, an unfavorable resolution of a matter could, depending on its amount and timing, materially affect its future results of operations, cash flows or financial position in a future period. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense costs, diversion of management resources and other factors.

Lane’s Gifts and Collectibles, L.L.C., v. Yahoo! Inc

On March 14, 2005, the Company was served with the second amended complaint in a class action lawsuit in the Circuit Court of Miller County, Arkansas. The complaint names eleven search engines and web publishers as defendants, including the Company, and alleges breach of contract, restitution/unjust enrichment/money had and received, and civil conspiracy claims in connection with contracts allegedly entered into with plaintiffs for Internet pay-per-click advertising. The named plaintiffs on the second amended complaint are Lane’s Gifts and Collectibles, L.L.C., U.S. Citizens for Fair Credit Card Terms, Inc., Savings 4 Merchants, Inc., and Max Caulfield d/b/a Caulfield Investigations.

On March 30, 2005, the case was removed to United States District Court for the Western District of Arkansas. On April 4, 2005, plaintiffs U.S. Citizens for Fair Credit Card Terms, Inc. and Savings 4 Merchants, Inc. filed a motion of voluntary dismissal without prejudice. The motion was granted on April 7, 2005. Plaintiffs Lane’s Gifts and Collectibles, L.L.C. and Max Caulfield d/b/a Caulfield Investigations filed a motion to remand the case to state court on April 13, 2005, which was granted in September 2005. In July 2005, defendants, including the Company, petitioned the Eighth Circuit Court of Appeals for an appeal of the remand order, and moved to stay the proceedings while the appeal was pending. The petition was denied on September 8, 2005 and the case was remanded to the Circuit

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Court of Miller County, Arkansas. The Company was served with discovery requests on October 7, 2005. The Company has filed and/or joined motions to dismiss on the basis of failure to state a claim upon which relief can be granted, lack of personal jurisdiction, and improper venue. Pursuant to the court’s initial scheduling order, plaintiffs had until January 27, 2006 to respond to the motions to dismiss for lack of personal jurisdiction and improper venue; and until September 9, 2006 to respond to the motion to dismiss on the basis of failure to state a claim upon which relief can be granted. However the court entered an order staying all proceedings for a period of 60 days on January 9, 2006. On April 20, 2006 the Court preliminarily approved a class settlement among plaintiffs, defendant Google, Inc., and certain defendants who display Google advertisements on their networks (the “Google Settlement”). The Google Settlement purports to release Google of all claims and also purports to release certain defendants, including the Company, for any claims associated with the display of Google advertisements on their networks. On July 24 and 25, 2006, the Court had a final settlement hearing on the Google Settlement, and on July 26, 2006, the Court approved the settlement. On April 21, 2006, the Court ordered the remaining defendants, including the Company, to mediation and further stayed the proceedings to September 21, 2006. The Court further extended the stay as to LookSmart until August 16, 2006. The parties thereafter stipulated that the stay would remain in effect while the parties continue to comply with the Court’s order regarding mediation. On January 10, 2007, the Court further extended the stay until May 1, 2007. On or about November 20, 2007, the Plaintiffs and the Company entered into a Stipulation and Settlement Agreement (the “Settlement Agreement”) to settle the matter in its entirety. On or about November 29, 2007, the Court preliminarily approved the Settlement Agreement and on February 29, 2008, the court entered an order to approve as final the Settlement Agreement. Pursuant to the Settlement Agreement, the Company has agreed to establish a Settlement Fund in the amount of up to approximately $2.5 million to be allocated as follows: (a) the Class Member Fund which should not exceed approximately $2.0 million in advertising credits, (b) the Fees Award to Class Counsel, which shall not exceed the amount of approximately $0.6 million; and (c) the Incentive Award (as hereinafter defined) to the three Class Representatives, which shall not exceed a collective immaterial amount. In the event that the total of the credit claims paid is less than approximately $0.8 million, the difference between the total amount of the credit claims paid and approximately $0.8 million will be paid to charities in the form of advertising credits. Should the total of the credit claims paid to the Settlement Class Members as a group plus any amounts allocated to charities be more than approximately $0.8 million but less than approximately $2.5 million, then the amount if any shall be retained by the Company. Settlement payments from the Class Member Fund will be paid out in advertising credits to members of the Class who file timely claims to participate in the settlement. On December 28, 2007, the Company provided the notices to class members required by the Settlement Agreement who had until February 11, 2008 to file claims. On April 8, 2008, the Company made the Fee Award to Counsel and the Incentive Award payments to plaintiffs’ counsel. On April 29, 2008, the Company began to issue advertising credits to the Class Members who filed timely claims. The deadline for submitting redemption credits expired on April 29, 2009. No charitable organization has submitted a claim for advertising credits to date. The Company recorded an estimate in accrued liabilities of the amount of the loss on settlement which management determined was probable and estimable during the year ended December 31, 2007. This estimate may change as a result of the cost of the final settlement arrangement. In addition, during 2007 the Company recovered settlement proceeds from the insurance carrier, which exceeded the recorded estimate of the amount of loss on settlement. Due to the uncertainty relating to the ultimate settlement amount, the excess settlement proceeds have been recorded as an accrued liability at September 30, 2009 and December 31, 2008.

Upon the completion of the thirty day appeals period, which ended on March 30, 2008, the Company on April 7, 2008 paid approximately $0.6 million of legal fees to the plaintiff’s counsel representing the Fees Award to Class Counsel and the Incentive Award as is stipulated in the Settlement Agreement. As of September 30, 2009, the Company has provided approximately $0.1 million of advertising credits to Class Members.

The following table sets forth the legal proceedings liability activity during nine months ended September 30, 2009 and the year ended December 31, 2008 (in thousands):


	Legal Proceedings
	Three Months Ended September 30, 2009		Nine Months Ended September 30, 2009		Year Ended December 31, 2008
Balance at beginning of period	$	339	$	339	$	1,000
Amounts paid to plaintiff’s counsel		—		—		(602	)
Advertising credits provided to Class Members		—		—		(59	)

Balance at September 30, 2009	$	339	$	339	$	339

The legal proceedings liability is classified in accrued liabilities on the Company’s Unaudited Condensed Consolidated Balance Sheet (see Note 7).

12. Stockholders’ Equity

Share-Based Compensation

Stock Option Plans

In December 1997, the Company approved the 1998 Stock Option Plan (the “Plan”). In October 2000, the Company acquired Zeal

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Media, Inc. and assumed all the stock options outstanding under the 1999 Zeal Media, Inc. Stock Plan (the “Zeal Plan”). In April 2002, the Company acquired Wisenut, Inc. and assumed all the stock options outstanding under the Wisenut, Inc. 1999 Stock Incentive Plan (the “Wisenut Plan”). On June 19, 2007, the stockholders approved the LookSmart 2007 Equity Incentive Plan (the “2007 Plan”). Under the 2007 Plan, the Company may grant incentive stock options, nonqualified stock options, stock appreciation rights and stock rights to employees, directors and consultants. Share-based incentive awards are provided under the terms of these four plans (collectively, the “Plans”).

The Company’s Plans are administered by the Compensation Committee of the Board of Directors. Awards under the Plans principally include at-the-money options and fully vested restricted stock. Except for the one time share grants to certain executive officers that become exercisable over a two year period, outstanding stock options generally become exercisable over a three or four year period from the grant date and have a term of ten years. Beginning in 2008, the Company issued fully vested restricted stock to certain directors and executive officers. The number of shares reserved for issuance under the Plans was approximately 5.0 million and 5.2 million shares of common stock at September 30, 2009 and December 31, 2008, respectively. There were 1.5 million shares available to be granted under the Plans at September 30, 2009.

Share-based compensation expense recorded during the three and nine months ended September 30, 2009 and 2008 was included in the Company’s Condensed Consolidated Statement of Operations as follows for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Sales and marketing	$	16		$	106		$	119		$	322
Product development		143			197			458			546
General and administrative		216			420			874			1,469
Loss from discontinued operations		—			12			—			35

Total share-based compensation		375			735			1,451			2,372
Less amounts capitalized as software development costs		(16	)		(28	)		(60	)		(82	)

Total share-based compensation expense	$	359		$	707		$	1,391		$	2,290

Total unrecognized share-based compensation expense related to share-based compensation arrangements at September 30, 2009 was $1.5 million and is expected to be recognized over a weighted-average period of approximately 2.1 years. The total fair value of equity awards vested during the three and nine months ended September 30, 2009 was $0.4 million and $1.4 million, respectively, and $0.7 million and $2.3 million during the three and nine months ended September 30, 2008, respectively.

The Company recorded share-based compensation of $0.4 million and $1.5 million for the three and nine months ended September 30, 2009, respectively, and $0.7 million and $2.4 million for the three and nine months ended September 30, 2008, respectively. Of these amounts, insignificant amounts were capitalized related to the development of internal-use software for the both the three months ended September 30, 2009 and 2008, and $0.1 million was capitalized for both the nine months ended September 30, 2009 and 2008.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Option Awards

Stock option activity under the Plans during the periods indicated is as follows for the nine months ended September 30, 2009:


	Shares		Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Term	Aggregate Intrinsic Value
	(in thousands)				(in years)	(in thousands)
Options outstanding at December 31, 2008	3,818		$	4.05
Granted	78			1.08
Expired/forfeited	(117	)		3.80

Options outstanding at March 31, 2009	3,779			3.99
Granted	142			1.33
Expired/forfeited	(229	)		3.74

Options outstanding at June 30, 2009	3,692			3.91
Granted	90			1.22
Expired/forfeited	(269	)		3.33

Options outstanding at September 30, 2009	3,513		$	3.88	7.56	$	9

Vested and expected to vest at September 30, 2009	3,308		$	3.94	7.51	$	5

Exercisable at September 30, 2009	2,716		$	4.14	7.34	$	5

The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value (the difference between the market price of the Company’s stock on the last trading day of the period and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holder had all option holders exercised their options at year-end. The intrinsic value amount changes with changes in the fair market value of the Company’s stock.

The following table summarizes information about stock options outstanding at September 30, 2009:


	Options Outstanding				Options Exercisable
Price Ranges	Shares	Weighted-Average Remaining Contractual Term	Weighted-Average Exercise Price Per Share		Shares	Weighted-Average Exercise Price Per Share
	(in thousands)	(in years)			(in thousands)
$1.02 - $3.19	915	8.00	$	2.33	629	$	2.46
3.20 - 3.67	1,079	8.08		3.28	693		3.31
3.68 - 3.68	450	8.35		3.68	450		3.68
3.70 - 4.44	390	7.44		4.14	315		4.10
4.45 - 20.55	679	6.91		5.66	629		5.57

1.02 - 20.55	3,513	7.56		3.88	2,716		4.14

Stock Awards

During the three and nine months ended September 30, 2009, the Company issued 11 thousand and 45 thousand shares, respectively, of fully vested restricted stock, with a weighted average grant date fair value of $1.16 and $1.12 per share, respectively, under the Plans. During the three and nine months ended September 30, 2008, the Company issued 5 thousand shares of fully vested restricted stock with a weighted average grant date fair value of $4.05 per share.

Employee Stock Purchase Plan

Under the 1999 Employee Stock Purchase Plan (the “1999 ESPP”), which was approved by the shareholders in July 1999, the Company was authorized to issue up to 520 thousand shares of Common Stock to Employees of the Company. Under the 1999 ESPP, substantially all employees could purchase the Company’s common stock through payroll deductions at a price equal to 85 percent of the lower of the fair market value at the beginning of the offering period or at the end of each applicable purchase period. An offering period was 24 months, composed of four six-month purchase periods. ESPP contributions were limited to a maximum of 15 percent of an employee’s eligible compensation, and ESPP participants were limited to purchasing a maximum of 500 shares per purchase period. ESPP share-based compensation expense under the 1999 ESPP was not significant for each of the three and nine months ended September 30, 2009 and 2008. As of June 8, 2009, when the 1999 ESPP expired, 490 thousand shares had been issued under the plan.

On July 14, 2009, the 2009 Employee Stock Purchase Plan (the “2009 ESPP”) was approved by the shareholders. Under the 2009 ESPP, the Company is authorized to issue up to 500 thousand shares of Common Stock to employees of the Company. Under the 2009 ESPP,

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85 percent of the lower of the fair market value at the beginning of the offering period or at the end of each applicable purchase period. Each offering period is 6 months and consists of one purchase period. ESPP contributions are limited to a maximum of 15 percent of an employee’s eligible compensation, and ESPP participants are limited to purchasing a maximum of 5,000 shares per purchase period. As of September 30, 2009, there have been no shares issued under the plan.

Share-Based Compensation Valuation Assumptions

The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option valuation model with the following assumptions:

•

Volatility: The volatility factor was based on the Company’s historical stock prices over the most recent period commensurate with the estimated expected term of the stock options.

•

Risk-Free Interest Rate: The Company bases the risk-free interest rate used in the Black-Scholes valuation method on the implied yield currently available on U.S. Treasury issues with an equivalent remaining term of the share-based awards.

•

Expected Term: The Company’s expected term represents the period that the Company’s share-based awards are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the share-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its share-based awards.

•

Expected Dividend: The Black-Scholes valuation model calls for a single expected dividend yield as an input. The Company has not issued any dividends, and does not expect to issue dividends in the foreseeable future.

•

Annual Forfeiture Rate: When estimating pre-vesting forfeitures, the Company considers voluntary termination behavior as well as potential future workforce reduction programs.

As share-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The weighted average grant-date fair value of options granted in the three and nine months ended September 30, 2009 was $0.64 and $0.70 per share, respectively, and $1.93 and $2.20 per share, respectively, for the three and nine months ended September 30, 2008.

Exercise of Employee Stock Options and Purchase Plans

There were no options exercised in the three and nine months ended September 30, 2009. The total cash received as a result of exercises under all share-based compensation arrangement was not significant for the three months ended September 30, 2008 and $0.1 million for the nine months ended September 30, 2008. The aggregate intrinsic value of options exercised for the three and nine months ended September 30, 2008 was insignificant and $53 thousand, respectively. The Company issues new shares of common stock upon exercise of stock options. No income tax benefits have been realized from exercised stock options.

13. Fair Value Measurements

The fair value for assets and liabilities is based on a framework that establishes a hierarchy of the inputs used in valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:


Level 1:		Unadjusted quoted market prices for identical assets or liabilities in active markets that the Company has the ability to access.

Level 2:		Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, default rates, etc.) or can be corroborated by observable market data.

Level 3:		Valuations based on models where significant inputs are not observable. The unobservable inputs reflect the Company’s own assumptions about the assumptions that market participants would use.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Fair Value of Financial Assets

The Company’s financial assets measured at fair value on a recurring basis subject to disclosure requirements at September 30, 2009 and December 31, 2008, were as follows (in thousands):


	Balance at September 30, 2009		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)
Cash equivalents:
Money market mutual funds	$	5,216	$	5,216	$	—
Certificates of deposit		245		—		245
Commercial paper		5,900		—		5,900

		11,361		5,216		6,145
Short-term investments:
Corporate bonds		2,216		—		2,216
Municipal bonds - California		1,013				1,013
United States government debt securities		2,000		—		2,000
Certificates of deposit		3,932		—		3,932
Commercial paper		2,698				2,698

		11,859		—		11,859

Total financial assets measured at fair value	$	23,220	$	5,216	$	18,004


	Balance at December 31, 2008		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)
Cash equivalents:
Money market mutual funds	$	17,279	$	17,279	$	—
Certificates of deposit		500		—		500

		17,779		17,279		500
Short-term investments:
Corporate bonds		5,195		—		5,195
Zero Coupon Municipal Bonds - California		958		—		958
United States government debt securities		2,032		—		2,032
Certificates of deposit		2,000		—		2,000

		10,185		—		10,185

Total financial assets measured at fair value	$	27,964	$	17,279	$	10,685

The Company had an insignificant level 3 investment at September 30, 2009 and did not hold any investments categorized as level 3 at December 31, 2008.

The Company used the following methods and assumptions in estimating financial asset fair value:

Investments

For investments that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. The Company receives the quoted market prices from a third party, nationally recognized pricing service (“pricing service”). When quoted market prices are unavailable, the Company utilizes a pricing service to determine a single estimate of fair value, which is mainly for its fixed maturity investments. The fair value estimates provided from this pricing service are included in the amount disclosed in Level 2 of the hierarchy. The Company bases all of its estimates of fair value for assets on the bid price as it represents what a third party market participant would be willing to pay in an arm’s length transaction.

The Company utilizes a pricing service to estimate fair value measurements of its fixed maturities investments. The pricing service utilizes market quotations for fixed maturity securities that have quoted prices in active markets. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Additionally, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.

The pricing service evaluates each asset class based on relevant market information, relevant credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation, listed in the approximate order of priority, include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data and industry and economic events. The extent of the use of each market input depends on the asset class and the market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities additional inputs may be necessary.

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The pricing service utilized by the Company has indicated that they will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Company would be required to produce an estimate of fair value using some of the same methodologies as the pricing service, but would have to make assumptions for market based inputs that are unavailable due to market conditions.

The fair value estimates of the Company’s fixed maturity investments are based on observable market information rather than market quotes. Accordingly, the estimates of fair value for such fixed maturities, other than money market securities, provided by the pricing service are included in the amount disclosed in Level 2 of the hierarchy. The estimated fair value of money market securities are included in the amount disclosed in Level 1 as the estimates are based on unadjusted market prices.

The Company validates the prices received from the pricing service using various methods including, applicability of FDIC or other national government insurance or guarantees, comparison of proceeds received on individual investments subsequent to reporting date, prices received from publically available sources, and review of transaction volume data to confirm presence of active markets. The Company does not adjust the prices received from the pricing service unless such prices are determined to be inconsistent. At September 30, 2009 and December 31, 2008, the Company did not adjust prices received from the pricing service.

Trade accounts receivable, net: The carrying value reported in the Unaudited Condensed Consolidated Balance Sheets is net of allowances for doubtful accounts and returns which estimate customer non-performance risk.

Trade accounts payable and accrued liabilities: The carrying value reported in the Unaudited Condensed Consolidated Balance Sheets for these items approximates their fair value, which is the likely amount which the liability with short settlement periods would be transferred to a market participant with a similar credit standing as the Company.

Fair Value of Non-Financial Assets

The Company’s non-financial assets measured at fair value on a non-recurring basis subject to disclosure requirements at September 30, 2009 were as follows (in thousands):


	Balance at September 30, 2009		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobserved Inputs (Level 3)		Non-Financial Asset Loss
Intangle Assets
Amortizable purchased technology	$	100	$	—	$	—	$	100	$	180

14. Related Party Transactions

The Company paid one of its board members, Jean-Yves Dexmier, fees totaling $122 thousand and $325 thousand during the three and nine months ended September 30, 2009, respectively, in connection with Mr. Dexmier providing additional board services to the Company as Chair of its Strategic Direction committee. In addition, the Company paid Mr. Dexmier $99 thousand and $137 thousand during the three and nine months ended September 30, 2008, respectively, in connection with additional board services under a Board Services Agreement with the Company.

15. Subsequent Events

On October 28, 2009, the Company appointed Jean-Yves Dexmier as Executive Chairman of the Board of Directors. Dr. Dexmier has served on the Company’s Board of Directors since 2007 and has served as the Chair of both the Audit and Strategic Direction committees. Dr. Dexmier succeeds Mark Sanders, who will remain on the Company’s Board of Directors and serve on the Audit Committee and as Chair of the Compensation Committee.

On October 30, 2009, the Company and RagingWire Enterprise Solutions, Inc. entered into a Master Services Agreement and related Service Level Agreement for IT data center services for a two year term. Prior to the expiration on March 28, 2010 of the Company’s existing data center services agreement, the Company will move its data center to the new facility. During the first 3 months of service, the amount to be paid by the Company to RagingWire under the agreement will vary based on power usage. After the first three months, the minimum annual cost is approximately $0.9 million and will be reflected in cost of revenue.

As a result of this change in data center services, the Company expects its data center related expenses to be approximately $0.5 million less annually once the data center is fully transitioned to the new facility. The Company expects to complete the transition by the end of the first quarter of 2010. Because factors other than these data center services related expenses affect the Company’s cost of revenue and results of operations, the Company’s expectations regarding its cost savings related to data center services should not be construed to provide guidance as to the Company’s overall level of cost of revenue.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

The following discussion should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and the Notes to those statements which appear elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We use words such as “believes,” “intends,” “expects,” “anticipates,” “plans,” “may,” “will” and similar expressions to identify forward-looking statements. Discussions containing forward-looking statements may be found in the material set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other sections of this report. All forward-looking statements, including, but not limited to, projections, expectations or estimates concerning our business, including demand for our products and services, mix of revenue sources, ability to control and/or reduce operating expenses, anticipated gross margins and operating results, cost savings, product development efforts, general outlook of our business and industry, future profits or losses, competitive position, share-based compensation, and adequate liquidity to fund our operations and meet our other cash requirements, are inherently uncertain as they are based on our expectations and assumptions concerning future events. These forward-looking statements are subject to numerous known and unknown risks and uncertainties. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including but not limited to, the possibility that we may fail to maintain or grow our listings advertiser base and/or distribution network, that existing and potential distribution partners may opt to work with, or favor the products of, competitors if our competitors offer more favorable products or pricing terms, that we may be unable to grow our online search advertising revenue and/or find alternative sources of revenue, that we may be unable to attain or maintain customer acceptance of our publisher solutions products, that changes in the distribution network composition may lead to decreases in query volumes, that we may be unable to maintain or improve our query volume, match rate, number of paid clicks, average revenue per click, conversion rate or other ad network metrics, that we may be unable to achieve or maintain profitability, that we may be unable to retain our existing credit facilities or obtain new credit facilities, that we may be unable to attract and retain key personnel, that we may have unexpected increases in costs and expenses, or that one or more of the other risks described below in the section entitled “Risk Factors” and elsewhere in this report may occur.

All forward-looking statements in this report are made as of the date hereof, based on information available to us as of the date hereof, and except as required by applicable law, we assume no obligation to update any forward-looking statements.

Business Overview

LookSmart is a search advertising network solutions company that provides relevant solutions for search advertisers and publishers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.

LookSmart offers search advertisers targeted, pay-per-click (PPC) search, and contextual search advertising via a monitored search advertising distribution network (referred to as the “AdCenter” platform). The Company’s extensive search advertising distribution network includes publishers and search partners within certain vertical market segments in the United States and certain other countries. The Company’s application programming interface (API) allows search advertisers and their advertising agencies to connect any type of marketing or reporting software with minimal effort, for easier access, management, and optimization of search advertising campaigns. The advertiser network service offering provided 94% and 90% of total revenues in the quarters ended September 30, 2009 and 2008, respectively, and 92% and 91% of total revenues for the nine months ended September 30, 2009 and 2008, respectively.

LookSmart also offers publishers licensed private-label search advertiser network solutions based on its AdCenter platform technology (“Publisher Solutions”). Publisher Solutions consist of hosted auction-based ad serving with an ad backfill capability that allows search engines, networks, media companies, social networking sites, retail sites, directories, Internet Service Providers (“ISPs”) and portals to manage their advertiser relationships, distribution channels and accounts. The publisher solutions service offering has provided 6%, and 10% of total revenues in the quarters ended September 30, 2009 and 2008, respectively, and 8% and 9% of total revenues for the nine months ended September 30, 2009 and 2008, respectively. Publisher Solutions revenue decreases for the three and nine months ended September 30, 2009 as compared to the same periods in 2008 is attributed to reduced revenue from one major publisher client, resulting from significantly lower transaction volume on their advertising network, combined with a contractual reduction of the revenue share percentage in the final year of the contract.

In 2007, our management made the decision to exit certain consumer products activities and to sell or otherwise dispose of the various consumer related websites and assets associated with those activities. In the first quarter of 2008, our management made the decision to exit its remaining consumer products activities and to sell or otherwise dispose of the remaining consumer assets. During 2008, we sold the intellectual property rights to the “Wisenut” trademark and related domain names and decided to wind down the Furl operations. In the first quarter of 2009, the Furl assets were sold for an insignificant amount. The results of operations of consumer product activities, including related gains (losses), have been classified as discontinued operations for all periods presented in the accompanying Unaudited Condensed Consolidated Statements of Operations (see Note 3). At September 30, 2009, the Company continues to own the Wisenut search engine technology, intellectual property rights in such technology and other assets.

Critical Accounting Policies and Estimates

Our financial condition and results of operations are based upon certain critical accounting policies, which include estimates, assumptions, and judgments on the part of management. We base our estimates on various factors and information which may include, but are not limited to, history and prior experience, experience of other enterprises in the same industry, new related events, current economic conditions and information from third party professionals that is believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenue and expenses during the period presented. Actual results may differ from those estimates. In management’s opinion, all adjustments necessary for a fair statement are reflected in the interim periods presented. All adjustments are of a normal or recurring nature.

The following discussion highlights those policies and the underlying estimates and assumptions, which we consider critical to an understanding of the financial information in this report.

Fair Value Measurements

Our estimates of fair value for assets and liabilities is based on a framework that establishes a hierarchy of the inputs used in valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect our significant market assumptions. The three levels of the hierarchy are as follows:


Level 1:		Unadjusted quoted market prices for identical assets or liabilities in active markets that we have the ability to access.

Level 2:		Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, default rates, etc.) or can be corroborated by observable market data.

Level 3:		Valuations based on models where significant inputs are not observable. The unobservable inputs reflect our assumptions about the assumptions that market participants would use.

Investments

We invest our excess cash primarily in debt instruments of high-quality corporate and government issuers. All highly liquid instruments with maturities at the date of purchase greater than ninety days are considered investments. All instruments with maturities greater than one year from the balance sheet date are considered long-term investments unless management intends to liquidate such securities in the current operating cycle. Such securities are classified as short-term investments. These securities are classified as available-for-sale and carried at fair value.

Changes in value of these investments are primarily related to changes in interest rates and are considered to be temporary in nature. Except for declines in fair value that are not considered temporary, net unrealized gains or losses on these investments are reported as a component of accumulated other comprehensive income (loss) in stockholders’ equity. We recognize realized gains and losses upon sale of investments using the specific identification method.

Revenue Recognition

Our online search advertising revenue is primarily composed of per-click fees that we charge customers. The per-click fee charged for keyword-targeted listings is calculated based on the results of online bidding for keywords or page content, up to a maximum cost per keyword or page content set by the customer. Revenue also includes revenue share from licensing of private-labeled versions of our products.

Revenues associated with online advertising products, including Advertiser Networks, are generally recognized once collectability is established, delivery of services has occurred, all performance obligations have been satisfied, and no refund obligations exist. We pay distribution network partners based on clicks on the advertiser’s ad that are displayed on the websites of these distribution network partners. These payments are called traffic acquisition costs (“TAC”) and are included in cost of revenues. The revenue derived from these arrangements that involve traffic supplied by distribution network partners is reported gross of the payment to the distribution network partners. This revenue is reported gross due to the fact that we are the primary obligor to the advertisers who are the customers of the advertising service.

We also enter into agreements to provide private-labeled versions of our products, including licenses to the AdCenter. These license arrangements include multiple elements: revenue-sharing based on the publisher’s customer’s monthly revenue generated through the AdCenter application; upfront fees; and other license fees. We recognize upfront fees over the term of the arrangement or the expected period of performance, other license fees over the term of the license, and revenue-sharing portions over the period in which such revenue is earned. In all cases, revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed, and collectability of the resulting receivable is reasonably assured.

We provide a provision against revenue for estimated reductions resulting from billing adjustments and customer refunds. The amounts of these provisions are evaluated periodically based upon customer experience and historical trends.

Deferred revenue is recorded when payments are received in advance of performance in underlying agreements. Customer deposits are recorded when customers make prepayments for online advertising.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from customers failing to make required payments. This valuation allowance is reviewed on a periodic basis to determine whether an additional provision or reversal is required. The review is based on factors including the application of historical collection rates to current receivables and whether economic conditions are more or less favorable than we anticipated. We will record a reduction of our allowance for doubtful accounts if there is a significant improvement in collection rates or economic conditions are more favorable than we anticipated. Additional allowances for doubtful accounts may be required if there is deterioration in past due balances, if economic conditions are less favorable than we anticipated or for customer-specific circumstances, such as bankruptcy. Management’s judgment is required in the periodic review of whether a provision or reversal is warranted.

Valuation of Goodwill and Intangible Assets

Goodwill and other intangibles with indefinite useful lives are not amortized but tested for impairment annually or more frequently when events or circumstances indicates that the carrying value of a reporting unit more likely than not exceeds its fair value. Our annual goodwill impairment testing date is December 31 of each year. In addition, we periodically re-assess the valuation and asset lives of intangible assets with definite lives to conform to changes in management’s estimates of future performance.

We have recorded goodwill and intangible assets in connection with our business acquisitions. Management exercises judgment in the assessment of the related useful lives, fair value and recoverability of these assets. As of September 30, 2009 and December 31, 2008, we have no recorded goodwill. The majority of intangible assets are amortized over two to seven years, the period of expected benefit.

Intangible assets with definite lives are amortized over their estimated useful life and reviewed for impairment annually or more frequently when events or circumstances indicates that the carrying value of a reporting unit more likely than not exceeds its fair value. We amortize acquired intangible assets with definite lives over periods from two to seven years and the amortization expense is primarily classified as cost of revenue in our Unaudited Condensed Consolidated Statements of Operations.

Impairment of Long-Lived Assets

We review long-lived assets held or used in operations, including property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. Subject assets are tested for impairment at the lowest level of operations that generates cash flows that are largely independent of the cash flows from those of other groups of asset and liabilities. We have determined that the equity of our single reporting unit to be the lowest level of operation at which independent cash flows could be identified. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. Assets to be disposed of are reported at the lower of carrying amount or fair value less cost to dispose.

The Company tested its long-lived assets used in operations for impairment as of December 31, 2008 and determined they were not impaired.

Income Taxes

We account for income taxes using the liability method. Under the liability method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Due to our history of losses and the uncertainty of net operating loss utilization, we have established a valuation allowance for the full amount of our deferred tax assets. We record liabilities, where appropriate, for all uncertain income tax positions. We recognize potential accrued interest and penalties related to unrecognized tax benefits within operations as income tax expense.

Internal Use Software Development Costs

We capitalize external direct costs of materials and services consumed in developing and obtaining internal-use computer software and the payroll and payroll-related costs of employees who devote time to developing internal-use computer software.

Management exercises judgment in determining when costs related to a project may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the amortization period for the capitalized costs. We expect to continue to invest in internally developed software and to capitalize such costs.

Restructuring Charges

We have recorded restructuring accruals related to closing of certain leased facilities, as well as severance costs related to workforce reductions. Management’s judgment is required when estimating when the redundant facilities will be subleased and at what rate they will be subleased.

Share-Based Compensation

We recognize share-based compensation costs for all share-based payment transactions with employees, including grants of employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, over the requisite service period based on their relative fair values. We estimate the fair value of share-based payment awards on the grant date using the Black-Scholes method. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods.

We elected to adopt the alternative transition method for calculating the tax effects of share-based compensation to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and cash flows of the tax effects of employee share-based compensation awards.

Recent Accounting Pronouncements

For a description of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) in the Notes to the Unaudited Condensed Consolidated Financial Statements.

Results of Operations

Overview of the Three and Nine months Ended September 30, 2009

The following table sets forth selected information concerning our results of operations as a percentage of consolidated net revenue for the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Revenue	100.0	%	100.0	%	100.0	%	100.0	%
Cost of revenue	69.0	%	59.9	%	63.4	%	59.4	%

Gross profit	31.0	%	40.1	%	36.6	%	40.6	%
Operating expenses:
Sales and marketing	11.8	%	16.0	%	11.1	%	13.3	%
Product development	19.3	%	18.6	%	19.3	%	17.2	%
General and administrative	14.1	%	16.9	%	19.1	%	15.6	%
Restructuring charge	2.4	%	1.4	%	1.3	%	0.2	%
Impairment charge	0.0	%	0.0	%	0.5	%	0.0	%

Total operating expenses	47.6	%	52.9	%	51.3	%	46.3	%

Loss from operations	(16.6	)%	(12.8	)%	(14.7	)%	(5.7	)%
Non-operating income, net	0.1	%	1.6	%	0.2	%	1.8	%

Loss from continuing operations before income taxes	(16.5	)%	(11.2	)%	(14.5	)%	(3.9	)%
Income tax expense (benefit)	0.0	%	0.0	%	0.0	%	0.0	%

Loss from continuing operations	(16.5	)%	(11.2	)%	(14.5	)%	(3.9	)%
Income (loss) from discontinued operations, net of tax	1.1	%	0.0	%	1.0	%	(0.9	)%

Net loss	(15.4	)%	(11.2	)%	(13.5	)%	(4.8	)%

Revenues

Revenue is derived from the Company’s two service offerings or “products”: Advertiser Networks and Publisher Solutions. Total revenue and revenue from Advertiser Networks and Publisher Solutions for each of the three and nine months ended September 30, 2009 and 2008 were as follows (in thousands):


	Three Months Ended September 30,
	2009		% of Revenue		2008		% of Revenue		Dollar Change			% Change
Advertiser Networks	$	11,799	94	%	$	13,901	90	%	$	(2,102	)	(15	)%
Publisher Solutions		744	6	%		1,522	10	%		(778	)	(51	)%

Total revenue	$	12,543	100	%	$	15,423	100	%	$	(2,880	)	(19	)%


	Nine Months Ended September 30,
	2009		% of Revenue		2008		% of Revenue		Dollar Change			% Change
Advertiser Networks	$	35,825	92	%	$	45,441	91	%	$	(9,616	)	(21	)%
Publisher Solutions		3,195	8	%		4,618	9	%		(1,423	)	(31	)%

Total revenue	$	39,020	100	%	$	50,059	100	%	$	(11,039	)	(22	)%

We recognized $12.5 and $39.0 million of total revenue during the three and nine months ended September 30, 2009, respectively. Total revenue for the three and nine months ended September 30, 2009 was down 19% and 22%, respectively, from the $15.4 million and $50.1 million recognized during the comparable three and nine months ended September 30, 2008. We attribute the $2.9 million decrease in the three months ended September 30, 2009 primarily to a 29% decrease in average revenue-per-click (RPC), partially offset by a 19% increase in paid clicks, combined with lower Publisher Solutions revenue from a single significant customer compared to the same period in 2008. For the nine months ended September 30, 2009, revenues were lower by $11.0 million compared to the nine months ended September 30, 2008, due mostly to a 31% decrease in RPC, partially offset by a 15% increase in paid clicks, and lower Publisher Solutions revenue from a single significant customer. Our RPC has decreased as a result of continued pressure on search advertising demand and pricing.

We continue to be dependent upon a few customers for a significant percentage of our revenue. For each of the three months ended September 30, 2009 and 2008, two customers combined to account for 25% and 32% of revenue, respectively. For each of the nine months ended September 30, 2009 and 2008, two customers accounted for a combined 27% and 26%, respectively.

One of these two customers, IAC Search and Media (“IAC”), notified us in May 2009 that it does not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services when it expires on December 31, 2009. The decrease in Publisher Solutions revenue from IAC has accelerated since the May 2009 notification from $1.4 million and $4.0 million, respectively, for the three and nine months ended September 30, 2008, to $0.6 million and $2.6 million, respectively, for the three and nine months ended September 30, 2009. Advertiser Network revenue derived from IAC, which is covered under separate distribution agreements, was $1.3 million and $4.1 million, respectively, for the three and nine months ended September 30, 2009, and $1.5 million and $3.3 million for the three and nine months ended September 30, 2008. IAC has not indicated to us an intent to terminate these separate distribution agreements.

We recognized Advertiser Networks revenue of $11.8 million and $35.8 million, respectively, during the three and nine months ended September 30, 2009, down 15% and 21%, respectively, from the $13.9 million and $45.4 million, respectively, recognized during the three and nine months ended September 30, 2008. Revenue from Advertiser Networks decreased in the third quarter of 2009 by $2.1 million and $9.6 million in the first nine months of 2009 compared to the same respective periods in 2008.

The Advertiser Network saw growth in total paid clicks for both the three and the nine months ended September 30, 2009. Total paid clicks for the three months ending September 30, 2009 increased 19% to 219 million, compared to 184 million for the third quarter of 2008. During the same period, average RPC decreased from $0.076 to $0.054 compared to the previous year’s quarter. Paid clicks totaled 610 million for the nine months ended September 30, 2009, compared to 531 million for the same period of 2008. The 15% increase in paid clicks was offset by a decrease in revenue per click from $0.086 to $0.059 over the same time period.

We recognized Publisher Solutions revenue of $0.7 million during the three months ended September 30, 2009, a 51% decrease from the $1.5 million recognized during the three months ended September 30, 2008. IAC represented $0.6 million, or 74%, of Publisher Solutions revenue during the three months ended September 30, 2009. For the nine months ended September 30, 2009, we recognized $3.2 million of Publisher Solutions revenue, a decrease of 31%, or approximately $1.4 million, from the $4.6 million recognized in the same period of the prior year. IAC represented $2.6 million, or 82%, of Publisher Solutions revenue for the nine months ended September 30, 2009. The decrease in Publisher Solutions revenue for the three and nine months ended September 30, 2009 as compared to the same periods in 2008 is attributed to reduced revenue from IAC, a portion of which relates to a contractual reduction of the revenue share percentage in the final year of the contract.

Cost of Revenue and Gross Margin

Cost of revenue, consisting of traffic acquisition costs (“TAC”), costs paid to our distribution network partners, connectivity costs, hosting expenses, commissions paid to advertising agencies, and credit card fees were as follows for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,
	2009		% of Revenue		2008		% of Revenue		Dollar Change			% Change
Traffic acquisition costs	$	8,117	65	%	$	8,688	56	%	$	(571	)	(7	)%
Other costs		537	4	%		551	4	%		(14	)	(3	)%

Total cost of revenue	$	8,654	69	%	$	9,239	60	%	$	(585	)	(6	)%

Traffic acquisition costs as percentage of Advertiser Network revenue			68.8	%			62.5	%

	Nine Months Ended September 30,
	2009		% of Revenue		2008		% of Revenue		Dollar Change			% Change
Traffic acquisition costs	$	23,162	59	%	$	28,143	56	%	$	(4,981	)	(18	)%
Other costs		1,584	4	%		1,572	3	%		12		1	%

Total cost of revenue	$	24,746	63	%	$	29,715	59	%	$	(4,969	)	(17	)%

Traffic acquisition costs as percentage of Advertiser Network revenue			64.7	%			61.9	%

Our total cost of revenue during the three months ended September 30, 2009 was $8.7 million, down $0.6 million, or 6% from the $9.2 million in the three months ended September 30, 2008. Total cost of revenue for the nine months ended September 30, 2009 was $24.7 million, down $5.0 million, or 17% from the $29.7 million in the nine months ended September 30, 2008.

Our TAC during the three months ended September 30, 2009 was $8.1 million, down $0.6 million, or 7% from the $8.7 million in the three months ended September 30, 2008. TAC for the first nine months of 2009 was $23.2 million, down 18%, or $5.0 million, from the $28.1 million in first nine months of 2008. As a percentage of Advertising Network revenue, TAC for the third quarter 2009 was 69% compared to TAC in the third quarter of 2008 of 63%. For the nine months ended September 30, 2009, TAC was 65% compared to TAC of 62% for the same period in 2008. We increased TAC during the nine months ended September 30, 2009 to attract more high quality traffic to better serve certain advertisers on our Advertiser Network, which resulted in a material adverse affect on gross margin. The Company exited the third quarter with moderate improvement in the average TAC rate on the Advertiser Network, as compared to the TAC rate reported for the third quarter of 2009. While this recent improvement is expected to benefit the Company’s gross margin in future quarters, gross margins are not expected to return to historic levels.

There is no TAC associated with Publisher Solutions revenue and, therefore, Publisher Solutions gross margin percentage is significantly greater than that of Advertiser Network.

Our other costs of revenue during the three and nine months ended September 30, 2009 and 2008 were generally flat period over period as the majority of these costs tend to be more fixed in nature.

Gross profit for the three months ended September 30, 2009 declined 9 percentage points to 31% from 40% for the three months ended September 30, 2008. The gross profit of 37% for the nine months ended September 30, 2009 declined 4 percentage points from the 41% achieved in the nine months ended September 30, 2008. The unfavorable gross profit trends are primarily the result of the Publisher Solutions revenue decreases combined with increasing TAC.

Operating Expenses

Operating expenses consist of sales and marketing, product development, general and administrative, restructuring charges, and impairment charges as follows for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,
	2009		% of Revenue		2008		% of Revenue		Dollar Change			% Change
Sales and marketing	$	1,474	12	%	$	2,471	16	%	$	(997	)	(40	)%
Product development		2,419	19	%		2,865	19	%		(446	)	(16	)%
General and administrative		1,772	14	%		2,599	17	%		(827	)	(32	)%
Restructuring charge		307	3	%		211	1	%		96		45	%
Impairment charge		—	0	%		—	0	%		—		0	%

Total operating expenses	$	5,972	48	%	$	8,146	53	%	$	(2,174	)	(27	)%


	Nine Months Ended September 30,
	2009		% of Revenue		2008		% of Revenue		Dollar Change			% Change
Sales and marketing	$	4,313	11	%	$	6,681	13	%	$	(2,368	)	(35	)%
Product development		7,517	19	%		8,603	17	%		(1,086	)	(13	)%
General and administrative		7,444	19	%		7,833	16	%		(389	)	(5	)%
Restructuring charge		536	1	%		76	0	%		460		605	%
Impairment charge		180	1	%		—	0	%		180		0	%

Total operating expenses	$	19,990	51	%	$	23,193	46	%	$	(3,203	)	(14	)%

Share-based compensation expense, which is included in operating expenses above, was as follows for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Sales and marketing	$	16		$	106		$	119		$	322
Product development		143			197			458			546
General and administrative		216			420			874			1,469
Loss from discontinued operations		—			12			—			35

Total share-based compensation		375			735			1,451			2,372
Less amounts capitalized as software development costs		(16	)		(28	)		(60	)		(82	)

Total share-based compensation expense	$	359		$	707		$	1,391		$	2,290

Sales and Marketing

Sales and marketing expenses include salaries, commissions, share-based compensation and other costs of employment for our sales force, sales administration and customer service staff and marketing personnel, overhead, facilities, allocation of depreciation and the provision for and reductions of the allowance for doubtful trade receivables. Sales and marketing expenses also include the costs of advertising, trade shows, public relations activities and various other activities supporting our customer acquisition efforts.

Our sales and marketing expenses during the three months ended September 30, 2009 were $1.5 million, down 40% from the $2.5 million for the three months ended September 30, 2008. Sales and marketing expenses in the third quarter of 2009 decreased $1.0 million compared to the third quarter of 2008 primarily due to lower staffing costs of $0.5 million and decreased marketing and event expenses.

Our sales and marketing expenses during the nine months ended September 30, 2009 were $4.3 million, down 35% from $6.7 million for the same period in 2008. Sales and marketing expenses for the nine months ended September 30, 2009 decreased $2.4 million compared to the same period in 2008 primarily due to lower staffing costs of $1.5 million, decreased marketing and event expenses, and reduced bad debt expense resulting from successful collection efforts.

Product Development

Product development costs include all costs related to the continued development, enhancement and technical operating expenses relating to our core technology product, the AdCenter platform. The AdCenter is used to operate both our own Advertiser Network and other publishers’ client networks, and is licensed to publishers to operate their own network. These costs include salaries and associated costs of employment, including share-based compensation, overhead, and facilities. Costs related to the development of software for internal use in the business, including salaries and associated costs of employment, are capitalized after certain milestones have been achieved and amortized over a three year period once the project is placed in service. Software licensing and computer equipment depreciation related to supporting product development functions are also included in product development expenses.

Capitalized software development costs include the costs to develop software for internal use, excluding costs associated with research and development, training and testing.

Product development and capitalized software development costs were as follows for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,
	2009			% of Revenue		2008			% of Revenue		Dollar Change			% Change
Product development costs	$	2,689		21	%	$	3,174		21	%	$	(485	)	(15	)%
Capitalized software development costs		(270	)	(2	)%		(309	)	(2	)%		39		(13	)%

Total product development expenses	$	2,419		19	%	$	2,865		19	%	$	(446	)	(16	)%


	Nine Months Ended September 30,
	2009			% of Revenue		2008			% of Revenue		Dollar Change			% Change
Product development costs	$	8,470		22	%	$	9,562		19	%	$	(1,092	)	(11	)%
Capitalized software development costs		(953	)	(3	)%		(959	)	(2	)%		6		(1	)%

Total product development expenses	$	7,517		19	%	$	8,603		17	%	$	(1,086	)	(13	)%

Our product development expenses, net of capitalized software development costs, during the three months ended September 30, 2009 were approximately $2.4 million, down 16% from $2.9 million for the three months ended September 30, 2008. Product development expenses, net of capitalized software development costs, for the third quarter of 2009 decreased $0.4 million compared to the comparable 2008 quarter primarily due to lower staffing costs of $0.4 million.

Our product development expenses, net of capitalized software development costs, during the nine months ended September 30, 2009 were $7.5 million, down 13% from $8.6 million for the nine months ended September 30, 2008. Product development expenses, net of capitalized software development costs, for the nine months ended September 30, 2009 decreased $1.1 million compared to the comparable period in 2008 primarily due to lower staffing costs of $0.9 million.

General and Administrative

General and administrative expenses include costs of executive management, human resources, finance, legal and facilities personnel. These costs include salaries and associated costs of employment, including share-based compensation, overhead, facilities and allocation of depreciation. General and administrative expenses also include legal, insurance, tax and accounting, consulting and professional services fees.

Our general and administrative expenses during the three months ended September 30, 2009 were $1.8 million, down 32% from $2.6 million for the three months ended September 30, 2008. General and administrative expenses in the third quarter of 2009 decreased $0.8 million compared to the third quarter of 2008 due to lower staffing costs of $0.5 million, which includes decreased share-based compensation of $0.2 million, and decreased legal expenses, partially offset by expenses associated with our evaluation of strategic alternatives.

Our general and administrative expenses during the nine months ended September 30, 2009 were $7.4 million, down 5% from $7.8 million for the nine months ended September 30, 2008. General and administrative expenses for the nine months ended September 30, 2009 decreased $0.4 million compared to the comparable 2008 period primarily due to lower staffing costs of $1.0 million, which includes decreased share-based compensation of $0.6 million, reduced audit expense of $0.4 million resulting from our change of audit firms, and decreased legal expenses, partially offset by $1.1 million of expenses associated with our evaluation of strategic growth alternatives. Of the amounts related to the evaluation of strategic growth alternatives, $0.3 million is related to the expensing of investment banker retainer fees that were classified as prepaid expenses at December 31, 2008 as required by the revised business combination guidance that was adopted in 2009 which requires the immediate expensing of costs related to business combinations. In the first quarter of 2008, share-based compensation expense included $0.3 million of accelerated expense resulting from options granted to the President and Chief Executive Officer.

Restructuring Charge

During the three and nine months ended September 30, 2009, we recorded $0.3 million and $0.5 million, respectively, in pre-tax restructuring charges associated with the termination of five and thirteen employees, respectively, to better align the Company’s resources and to improve efficiencies. Three of the employees terminated in the three months ended September 30, 2009 were in conjunction with the Company outsourcing its legal department. All liabilities associated with the restructuring are expected to be paid during the fourth quarter of 2009.

In the third quarter of 2008, we recognized $0.2 million of reorganization charges associated with the termination of five employees. In the second quarter of 2008, we subleased approximately 6,500 square feet of our leased headquarter office facilities for which we had previously recognized a restructuring charge. The additional sublease resulted in a restructuring benefit of $0.1 million.

Impairment Charge

In June 2009, management made the decision to not incorporate previously undeployed technology purchased in January 2008 for $0.3 million into our Advertising Networks’ core technology. As a result, the Company recognized an impairment charge of $0.2 million in the second quarter of 2009 to write the asset down to its estimated fair value of $0.1 million.

Loss from Operations

Our loss from operations for the three and nine months ended September 30, 2009 was $2.1 million and $5.7 million, respectively, which represented increases of $0.1 million and $2.9 million from the respective losses of $2.0 million and $2.8 million for the three and nine months ended September 30, 2008. The losses from operations increased primarily due to the factors discussed above, including but not limited to our decreased revenue and gross profit in the 2009 periods as compared to the 2008 periods, which were partially offset by lower operating expenses, despite incurring $1.1 million of costs associated with the evaluation of strategic growth alternatives.

Other Continuing Operations Items

The table below sets forth other continuing operations data for the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,
	2009			% of Revenue		2008			% of Revenue		Dollar Change			% Change
Non-operating income, net
Interest income	$	49		0	%	$	234		2	%	$	(185	)	(79	)%
Interest expense		(39	)	0	%		(27	)	0	%		(12	)	44	%
Other income, net		—		0	%		32		0	%		(32	)	(100	)%

Total non-operating income, net	$	10		0	%	$	239		2	%	$	(229	)	(96	)%

Income tax expense	$	—		0	%	$	(7	)	0	%	$	7		(100	)%


	Nine Months Ended September 30,
	2009			% of Revenue		2008			% of Revenue		Dollar Change			% Change
Non-operating income, net
Interest income	$	204		1	%	$	942		2	%	$	(738	)	(78	)%
Interest expense		(118	)	0	%		(81	)	0	%		(37	)	46	%
Other income, net		—		0	%		58		0	%		(58	)	(100	)%

Total non-operating income, net	$	86		1	%	$	919		2	%	$	(833	)	(91	)%

Income tax expense	$	8		0	%	$	7		0	%	$	1		14	%

Interest Income and Expense

Interest income includes income from our cash, cash equivalents and investments, and decreased $0.2 million and $0.7 million from the three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2009, respectively. The decreases were primarily driven by a sharp decrease in average yields earned on cash and investment balances in the 2009 periods compared to 2008 periods, combined with a 12% and 22%, respectively, decrease in average cash and investment balances for the comparable three and nine months periods.

Interest expense primarily consists of interest paid on capital leases and our note payable.

Income (Loss) from Discontinued Operations, Net of Tax

In 2007, our management decided to exit certain consumer products activities and to sell the related websites and assets associated with those activities. In the first quarter of 2008, our management further decided to exit our remaining consumer products activities, primarily Furl and Wisenut. This decision, combined with the assets previously disposed of, met the criteria of discontinued operations, and the results of operations to be disposed of and previously disposed assets, including related gains, have been classified as discontinued operations for the three and nine months ended September 30, 2009 and 2008.

Income (loss) from discontinued operations, net of tax, was as follows for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,
	2009		% of Revenue		2008			% of Revenue		Dollar Change		% Change
Income (loss) from discontinued operations, net of tax	$	132	1	%	$	(5	)	0	%	$	137	(2740	)%

	Nine Months Ended September 30,
	2009		% of Revenue		2008			% of Revenue		Dollar Change		% Change
Income (loss) from discontinued operations, net of tax	$	371	1	%	$	(448	)	(1	)%	$	819	(183	)%

The following table reflects revenue, gross profit, operating expenses, non operating income, gain on disposal, income tax expense and net income (loss) from discontinued operations for each of the three and nine months ended September 30, 2009 and 2008 (in thousands):


	Three Months Ended September 30,					Nine Months Ended September 30,
	2009		2008			2009		2008
Revenue	$	—	$	26		$	8	$	78

Gross profit	$	—	$	18		$	8	$	49
Product development expenses		2		162			41		682
General and administrative expenses		—		5			—		40
Impairment charges		—		—			—		381

Total operating expenses		2		167			41		1,103
Gain on disposal		134		144			404		597
Non-operating income, net		—		—			—		9

Net income (loss) from discontinued operations	$	132	$	(5	)	$	371	$	(448	)

In the fourth quarter of 2008, our management determined that the Furl assets were impaired due to lack of marketability and decided to wind down the Furl operations. As a result, the Furl assets were fully impaired as of December 31, 2008. In the first quarter of 2009, the Furl assets were sold for an insignificant amount.

The gain on disposal consists of contingent purchase consideration resulting from the sale of Net Nanny to Content Watch, Inc. in 2007. Under the terms of the 2007 agreement, the contingent purchase consideration will end in 2010.

As of September 30, 2009, we continue to own the Wisenut search engine technology, intellectual property rights in such technology and other assets.

Liquidity and Capital Resources

Cash flows were as follows (in thousands):


	Nine Months Ended September 30,
	2009			2008			Change
Net cash used in operating activities	$	(4,193	)	$	(5,240	)	$	1,047
Net cash provided by (used in) investing activities		(2,200	)		2,318			(4,518	)
Net cash used in financing activities		(783	)		(20,997	)		20,214

Increase (decrease) in cash and cash equivalents	$	(7,176	)	$	(23,919	)	$	16,743

Cash, cash equivalent and short-term investment balances were as follows as of September 30, 2009 and December 31, 2008 (in thousands):


	September 30, 2009			December 31, 2008			Change
Cash and cash equivalents	$	15,217		$	22,393		$	(7,176	)
Short-term investments		11,859			10,185			1,674

Total	$	27,076		$	32,578		$	(5,502	)

% of total assets		69	%		70	%

Total Assets	$	39,211		$	46,764

At September 30, 2009, we had $27.1 million of cash, cash equivalents and short-term investments. Cash equivalents and short-term investments are comprised of highly liquid debt instruments of the U.S. government, commercial paper, time deposits, money market mutual funds and U.S. corporate securities. See Note 3 to the Unaudited Condensed Consolidated Financial Statements, “Cash, Cash Equivalents and Short-Term Investments,” which describes further the composition of our cash, cash equivalents and short-term investments.

Cash, cash equivalents and short-term investments decreased $5.5 million to $27.1 million at September 30, 2009 from $32.6 million at December 31, 2008, primarily due to our operating loss and the use of capital to reduce accounts payable and accrued liabilities, including the payment of an indemnification settlement and its related legal costs of $1.1 million, acquisition of property and equipment, development of capitalized software and payment of capital lease obligations, which were partially offset by accounts receivable collections.

Our primary sources of liquidity are our cash, cash equivalents and short-term investments, as well as our capital lease line and the cash flow that we generate from our operations. We believe that our existing cash, cash equivalents, short-term investments, capital lease line and cash generated from operations will be sufficient to satisfy our current anticipated cash requirements through at least the next 12 months, if not longer. Our liquidity could be negatively affected by an additional decrease in demand for our services beyond the impact of the loss of the IAC AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services, and changes in customer buying behavior that may result from the continued general economic downturn. In addition, our liquidity could be negatively affected if we are in default under our credit facilities and are required to pay the lenders in cash in an amount equal to the capital lease balance, or are required to identify restricted cash equal to the capital lease balance, plus outstanding standby letters of credit. Also, if the banking system or the financial markets continue to remain volatile, our investment portfolio may be impacted and the values and liquidity of our investments could be adversely affected. In addition, we may seek to raise additional capital through public or private debt or equity financings in order to fund our operations and capital expenditures, take advantage of favorable business opportunities, develop and upgrade our technology infrastructure, develop new product and service offerings, take advantage of favorable conditions in capital markets or respond to competitive pressures. In addition, unanticipated developments in the short term requiring cash payments, including the acquisition of businesses with negative cash flows, may necessitate additional financing. We cannot be assured that additional financing will be available on terms favorable to us, or at all. If we issue additional equity or convertible debt securities, our existing stockholders may experience substantial dilution.

In the third quarter of 2009, we launched post-pay whereby self service customers, which have historically represented approximately 20% of Advertiser Networks revenue for the periods presented, will pay for clicks after they occur rather than the prior practice of being billed in advance. The customer’s credit card is charged based on its history of activity and creditworthiness. As of September 30, 2009, this change resulted in a decrease in deferred revenue as those customers with prepaid balances have used those funds in their account. We expect that this decrease in deferred revenue will continue through the fourth quarter, and possibly later, as customers continue to utilize their prepaid balances. After all the prepaid funds have been used, customers will be billed after their account reaches their billing threshold or in 30 days, whichever comes first. As a result of the launch of post-pay, our cash flow was adversely affected by $0.4 million as customer deferred balances were used up and new unpaid charges accumulated. We expect the adverse affect to continue in the fourth quarter of 2009, but we do not expect this change to have a significant impact on the liquidity and capital resources of the Company.

Operating Activities

Cash used in operating activities in the nine months ended September 30, 2009 consisted of our net loss adjusted for certain non-cash items, including depreciation, amortization, share-based compensation expense, impairment charge, gains on sale of assets, as well as the effect of changes in working capital and other activities. Cash used in operations in the nine months ended September 30, 2009 was $4.2 million and consisted of a net loss of $5.3 million, adjustments for non-cash items of $3.4 million and cash used by working capital and other activities of $2.3 million. Adjustments for non-cash items primarily consisted of $2.2 million of depreciation and amortization expense on property and equipment, intangible assets and internally developed software, $1.4 million of share-based compensation expense and a $0.2 impairment charge, partially offset by a $0.4 million gain on sale of assets. In addition, changes in working capital activities primarily consisted of a net decrease of $2.9 million in accounts payable and accrued liabilities and a $0.6 million net increase in prepaid expenses, other assets, deferred revenue, customer deposits and other long term liabilities, partially offset by a $1.1 million decrease in accounts receivable. The decrease in accounts payable and accrued liabilities is due to the timing of vendor payments combined with the payment of an indemnification settlement and its related legal costs of $1.1 million that were accrued in 2008 but paid in 2009. The decrease in accounts receivable is attributed to less revenue from invoiced customers as compared to the previous quarter and successful collection efforts.

Cash used in operating activities in the nine months ended September 30, 2008 consisted of our net loss adjusted for certain non-cash items, including depreciation, amortization, share-based compensation expense, restructuring benefit, impairment charges, gains on sale of assets, as well as the effect of changes in working capital and other activities. Cash used in operations in the nine months ended September 30, 2008 was $5.2 million and consisted of net loss of $2.4 million, adjustments for non-cash items of $4.4 million and cash used by working capital and other activities of $7.3 million. Adjustments for non-cash items primarily consisted of $2.5 million of depreciation and amortization expense on property and equipment, intangible assets and internally developed software and $2.3 million of share-based compensation expense, and a $0.4 million impairment charge, partially offset by $0.6 million net gain on sale of assets. In addition, changes in working capital activities were primarily attributed to the business volume growth and consisted of a $4.6 million net increase in accounts receivable, a $1.8 million decrease in accounts payable and accrued liabilities and a $0.8 million net increase in

prepaid expenses, other assets, deferred revenue, customer deposits and other long term liabilities. The increase in accounts receivable was primarily due to an expected increase resulting from increased invoiced customer revenue and an unanticipated delay in payments from three customers. The payment from one customer, totaling $2.0 million, was received the first day after the end of the quarter. The decrease in accounts payable and accrued liabilities was primarily due to changing the payment of employee bonuses from annual to quarterly and the payment of legal fees associated with the Lane’s Gifts settlement.

Investing Activities

Cash used in investing activities during the nine months ended September 30, 2009 of $2.2 million is attributed to net purchases of investments of $1.7 million, partially offset by $0.9 million for capital expenditures and $0.4 million of proceeds related to the sale of certain consumer assets. Our capital expenditures for the nine months ended September 30, 2009 consisted of an investment of $0.9 million in internally developed software related to our core service offering. During the nine months ended September 30, 2009, most of our $1.0 million investment in computer equipment was financed with capital leases.

Cash provided by investing activities during the nine months ended September 30, 2008 of $2.3 million was primarily provided by net proceeds from investments of $2.2 million and $1.7 million of proceeds related to the sale of certain consumer assets, partially offset by $1.5 million used for capital expenditures. Our capital expenditures during the nine months ended September 30, 2008 consisted of an investment of $0.9 million in internally developed software related to our core service offering, $0.3 million to acquire an intangible asset and $0.3 million for property and equipment. During the nine months ended September 30, 2008, an additional $1.3 million of computer equipment was acquired and financed with capital leases. In addition, during the nine months ended September 30, 2008 we received $1.0 million from the sale of certain consumer assets that were held in escrow at December 31, 2007.

Financing Activities

Cash used by financing activities in the first nine months of 2009 of $0.8 million is attributed to scheduled capital lease and note payable payments.

Cash used by financing activities in the first nine months of 2008 of $21.0 million was due to the repurchase of our common stock via a combination of a modified Dutch Auction tender offer and stock repurchase program in the amount of $20.8 million, and $0.4 million used to make scheduled capital lease and note payable payments, partially offset by $0.2 million of proceeds from the issuance of common stock.

Credit Arrangements

We have outstanding standby letters of credit (“SBLC”) issued by City National Bank (“CNB”) of an aggregate of $1.1 million at September 30, 2009 related to security of two building leases. Each of the SBLCs contains two financial covenants. The SBLCs were amended as of September 30, 2009 to modify such financial covenants, and we were in compliance with such covenants as of such date. The SBLC for one of the building leases in the amount of $0.8 million should be released by the landlord and terminated within a reasonable period of time following the lease expiration on November 30, 2009.

On April 30, 2009, we renewed our master equipment lease agreement with CNB for an amount of up to $1.7 million for the purchase of technical equipment. The lease line expires April 30, 2010. As of September 30, 2009, there is $0.7 million available for new capital leases. Interest on new capital leases will be calculated using an interest rate of 5.6% per annum. Effective as of September 30, 2009, the master equipment lease agreement was amended to modify two financial covenants, with which we were in compliance as of such date.

Our agreements with CNB, consisting of the SBLC and master equipment lease agreement, contain cross-default provisions, whereby a default under one is deemed a default for the other. As of September 30, 2009, we were not in default on either agreement with CNB.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4), investments in special-purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.

Contractual Obligations and Commercial Commitments

On August 31, 2009, we entered into an agreement to sublease office space under an operating lease commencing in November 2009 and expiring on December 30, 2014. Under the agreement, we are obligated to pay $2.5 million in base rent payments over the term of the sublease. In addition to scheduled base rent payments, we will also be responsible for varying amounts of operating and tax expenses.

With the exception of item stated above, in comparison with our Annual Report on Form 10-K for the year ended December 31, 2008, we believe that there have been no significant changes in contractual obligations or commercial commitments.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We believe that our market risk exposure is primarily related to interest rate risk and the market value of certain investments that we hold. We manage these market risks through our normal investing and operating activities. We do not enter into derivatives for trading or other speculative purposes, nor do we use leveraged financial instruments.

Uncertainties in Credit Markets

Interest Rate Risk

We invest our excess cash primarily in highly liquid debt instruments of the U.S. government and its agencies, municipalities in the U.S., commercial paper, time deposits, money market mutual funds and corporate securities. By policy, we limit the amount of credit exposure to any one issuer.

Investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Due in part to these factors, our income from investments may decrease in the future.

We considered the historical volatility of short term interest rates and determined that it was reasonably possible that an adverse change of 100 basis points could be experienced in the near term. A hypothetical 1.00% (100 basis-points) increase in interest rates would have resulted in a decrease in the fair values of our marketable securities that is not significant at September 30, 2009.

ITEM 4.

CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining “disclosure controls and procedures” (as defined in rules promulgated under the Securities Exchange Act of 1934, as amended) for our Company. Based on their evaluation as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective to ensure that the information required to be disclosed by us in this Quarterly Report on Form 10-Q is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (“SEC”) rules and Form 10-Q, and (ii) is accumulated and communicated to the Company’s management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Controls

During the period covered by this report, there were no changes in the Company’s internal control over financial reporting that have materially affected, or could be reasonably likely to materially affect, the registrant’s internal control over financial reporting. During the course of our general evaluation of internal controls for the quarter ended September 30, 2009, there were no significant deficiencies identified in the design and operation of our internal controls. For the year ended December 31, 2008, there were two significant deficiencies identified in the design and operation of our internal controls. During the nine months ended September 30, 2009, we remediated these significant deficiencies and will continue to work to reduce the occurrence of future significant deficiencies.

Limitations on the Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a Company have been detected. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the Chief Executive Officer and the Chief Financial Officer have concluded that these controls and procedures are effective at the “reasonable assurance” level.

PART II

ITEM 1.

LEGAL PROCEEDINGS

None.

ITEM 1A.

RISK FACTORS

We have updated our risk factors regarding our revenue concentration, net losses, concentrations of search advertisers and distribution network partners, credit facilities, any failure in the performance of our key operating systems, fluctuations in quarterly revenues and current economic conditions set forth below, removed the risk factor regarding our technology service offerings to online publishers, and included a risk factor regarding the financial covenants contained in our credit agreements. Other than the aforementioned changes, there have been no material changes to the risk factors that are included in our Annual Report on Form 10-K for the year ended December 31, 2008.

You should carefully consider the risks described below before making an investment decision regarding our common stock. If any of the following risks actually occur, our business, financial condition and results of operations could be harmed. In that case, the trading price of our common stock could decline and our investors could lose all or part of their investment. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.

Risks Related to our Business

Our financial results are highly concentrated in the online search advertising business; if we are unable to grow online search advertising revenues and find alternative sources of revenue, our financial results will suffer

Search advertisements accounted for substantially all of our revenues for the year ended December 31, 2008. Our success depends upon search advertisers choosing to use, and distribution network partners choosing to distribute, our search advertising networks products. Search advertisers and distribution network partners may not adopt our products at projected rates, or changes in market conditions, such as the current financial crisis, may adversely affect the use or distribution of search advertisements. Because of our revenue concentration in the online search advertising business, such shortfalls or changes could have a negative impact on our financial results. Also, many of our products are offered to website publishers who use them to display or generate revenue from their online advertisements. Our overall revenue is concentrated with three customers each accounting for more than 10% of net revenue and 35% in aggregate for the year ended December 31, 2008. In addition, two customers accounted for more than 10% of net revenue and 25% in aggregate for the nine months ended September 30, 2009. If we are unable to generate significant revenue from our online advertising business, or if market conditions adversely affect the use or distribution of online advertisements generally, or for some of our larger customers specifically, our results of operations, financial condition and/or liquidity will suffer.

One of our two customers that accounted for more than 10% of net revenue for the nine months ended September 30, 2009, IAC Search and Media (“IAC”), notified us in May 2009 that it does not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services, when it expires on December 31, 2009. For the three and nine months ended September 30, 2009, IAC accounted for $0.6 million and $2.6 million, or 74% and 82%, respectively, of Publisher Solutions Revenue. Advertiser Network revenue derived from IAC, which is covered under separate distribution agreements, totaled $1.3 million and $4.1 million, or 11% and 12%, respectively, for the three and nine months ended September 30, 2009. IAC has not indicated to us an intent to terminate these separate distribution agreements.

We rely primarily on our distribution network partners to generate quality search queries and display advertisements that generate paid clicks; if we are unable to maintain or expand the scope and quality of this network, our ability to generate revenue may be seriously harmed

The success of our online search advertisement products depends in large part on the size and quality of our distribution network of search queries. We may be unable to maintain or add distribution network partners of satisfactory quality in our distribution network at reasonable revenue-sharing rates, or at all. Our distribution network is concentrated, with the five largest distribution network partners accounting for approximately 56% of our Advertiser Networks revenue for the year ended December 31, 2008. Our three largest distribution network partners accounted for approximately 40% of our Advertiser Networks revenue for the nine months ended September 30, 2009. If we lose any significant portion of our distribution network, we would need to find alternative sources of quality click traffic to replace the lost paid clicks. In the past, we have lost portions of our distribution network and chose to remove those with poor quality. Although alternate sources of click traffic are currently available in the market, they may not be available at reasonable prices or may be of unacceptable quality. There is significant competition among advertising networks to sign agreements with traffic providers. We may be unable to negotiate and sign agreements with quality traffic providers on favorable terms, if at all. In order to attract higher quality traffic, we may have to pay high traffic acquisition costs which may adversely affect our gross margin and other financial results. If we are unable to attract higher quality traffic, or if we are otherwise unsuccessful in maintaining and expanding our distribution network, then our ability to generate revenue may be seriously harmed.

We have generated significant losses in the past and we may be unable to achieve operating profitability in the foreseeable future, and if we achieve profitability, we may be unable to maintain it, which could result in a decline in our stock price

We had net losses of approximately $5.3 million for the nine months ended September 30, 2009, and as of September 30, 2009 our accumulated deficit was approximately $234.1 million. We may be unable to achieve and maintain profitability in the foreseeable future. Our ability to achieve and maintain profitability will depend on our ability to generate additional revenue and contain our expenses. In order to generate additional revenue, we will need to expand our network of distribution network partners, increase the amount our search advertisers spend on our advertising network, expand our advertiser base, offer our publisher products to additional publisher customers and experience an increase in paid clicks across our network and publisher products. We may be unable to accomplish some or any of these goals because of the risks identified in this report or for unforeseen reasons. Also, we may be unable to contain our costs due to the need to make revenue sharing payments to our distribution network partners, to invest in product development, and market our products. Because of the foregoing factors, and others outlined in this report, we may be unable to achieve profitability in the future, which could result in a decline in our stock price.

If we experience downward pressure on our match rate and/or revenue-per-click, or we are unable to rebuild our match rate, and/or revenue-per-click, our financial results will suffer

We have experienced, and may in the future experience, downward pressure on our average revenue-per-click (“RPC”) and average match rate, which is the rate at which our paid listings are matched against search queries from distribution network partners, due to various market segment, customer, and channel factors. We may experience decreases in RPC or average match rate in the future for many reasons, including the erosion of our advertiser base, the reduction in average advertiser spend, the reduction in the number of listings purchased by search advertisers, changes in the composition of our distribution network or other reasons. If our RPC or average match rate falls for any reason, or if we are unable to grow our RPC and average match rate, then we may be unable to achieve our financial projections and our stock price would likely suffer.

Our growth depends on our ability to retain and grow our advertiser base; if our search advertiser base and average advertiser spend falls, our financial results will suffer

Our growth depends on our ability to build a search advertiser base that corresponds with the characteristics of our distribution network. Our distribution network, which currently consists of a diversified network of distribution sources, may change as new distribution sources are added and old distribution sources are removed. Search advertisers may view these changes to the distribution network negatively, and existing or potential search advertisers may elect to purchase fewer or no advertisements for display on our distribution network. If this occurs, it is likely that our average RPC and average match rate may decline and our stock price would likely suffer.

If we do not introduce new and upgraded products and services and successfully adapt to our rapidly changing industry, our financial condition may suffer

The online search advertising industry is rapidly evolving and very turbulent, and we will need to continue developing new and upgraded products and services, and adapt to new business environments and competition in order to maintain and grow revenue and reach our profitability goals. New search advertising technologies could emerge that make our services comparatively less useful or new business methods could emerge that divert web traffic away from our Advertising Network. Competition from other web businesses may prevent us from attracting substantial traffic to our services. Also, we may inaccurately predict the direction of the online search advertising market, which could lead us to make investments in technologies and products that do not generate sufficient returns. We may face platform and resource constraints that prevent us from developing upgraded products and services. We may fail to successfully identify new products or services, or fail to bring new products or services to market in a timely and efficient manner. Rapid industry change makes it difficult for us to accurately anticipate customer needs for our products, particularly over longer periods.

We face intense competitive pressures, which could materially and adversely affect our financial results

We compete in the relatively new and rapidly evolving online search advertising industry, which presents many uncertainties that could require us to further refine our business model. We compete with large companies that provide paid placement products, paid inclusion products, and other forms of search marketing as well as contextually-targeted advertising products and other types of online advertisements. We compete for search advertisers on the basis of the quality and composition of our network, the price-per-click (“PPC”) charged to search advertisers, the volume of clicks that we can deliver to search advertisers, tracking and reporting of campaign results, customer service and other factors. We also compete for distribution network partners and for ad placement on those partners’ sites on the basis of the relevance of our ads and the PPC charged to search advertisers. We also experience competition in offering our publisher products to website publishers. Some of our competitors have larger distribution networks and proprietary traffic bases, longer operating histories, greater brand recognition, higher RPC, better relevance and conversion rates, or better products and services than we have.

Our acquisition of businesses and technologies may be costly and time-consuming; acquisitions may also dilute our existing stockholders

From time to time we evaluate corporate development opportunities, and when appropriate, we intend to make acquisitions of or significant investments in, complementary companies or technologies to increase our technological capabilities to expand our service offerings, and to extend the operating scale of our network businesses. The pursuit of these acquisitions, whether or not completed, as well as the completion of these acquisitions and their integration may be expensive and may divert the attention of management from the day-to-day operations of LookSmart. It may be difficult to retain key management and technical personnel of the acquired company during the transition period following an acquisition. Acquisitions or other strategic transactions may also result in dilution to our existing stockholders if we issue additional equity securities and may increase our debt. We may also be required to amortize significant amounts of intangible assets, record impairment of goodwill in connection with future acquisitions, or divest non-performing assets at below-market prices, which would adversely affect our operating results. Integration of acquired companies and technologies into LookSmart is likely to be expensive, time-consuming and strain our managerial resources. We may not be successful in integrating any acquired businesses or technologies and these transactions may not achieve anticipated business benefits.

Our success depends on our ability to attract and retain key personnel; if we were unable to attract and retain key personnel in the future, our business could be materially and adversely impacted

Our success depends on our ability to identify, attract, retain and motivate highly skilled development, technical, sales, and

management personnel. We have a limited number of key development, technical, sales and management personnel performing critical company functions, and the loss of the services of any of our key employees, particularly any of our executive team members or key technical personnel, could adversely affect our business. The combination of depressed capital markets, stock volatility and small market capitalization may not allow us to offer competitive equity based compensation to attract and retain key personnel. Also, our June 2009, September 2008 and 2007 restructurings have placed additional burdens on all remaining personnel, including our remaining Finance staff. In recent years, we have experienced significant turnover in our management team. Our current Chief Financial Officer joined us in August 2008 and our Chief Executive Officer joined us in that role in August 2007, and the management team as a whole has had only a limited time to work together. Previously, both our Chief Executive Officer and Chief Technical Officer resigned in August 2007 and in September 2007 our Chief Financial and Operating Officer announced his resignation as of November 2007. The employment of a new Chief Financial Officer in December 2007 ended in January 2008. We cannot assure you that we will be able to retain our key employees or that we can identify, attract and retain highly skilled personnel in the future.

We face capacity constraints on our software and infrastructure systems that may be costly and time-consuming to resolve

We use proprietary and licensed software and databases to receive and analyze advertisements, campaigns and budgets, match search queries to advertising, analyze webpage information to match advertising to relevant content, integrate third-party ads, detect invalid clicks, serve ads in high volume, and track, analyze and report on advertising responses and campaigns. Any of these software systems may contain undetected errors, defects or bugs or may fail to operate with other software applications. The following developments may strain our capacity and result in technical difficulties with our website or the websites of our distribution network partners:

•

customization of our matching algorithms and ad serving technologies,

•

substantial increases in the number of queries to our database,

•

substantial increases in the number of searches in our advertising databases, or

•

the addition of new products or new features or changes to our products.

If we experience difficulties with our software and infrastructure systems or if we fail to address these difficulties in a timely manner, we may lose the confidence of search advertisers and distribution network partners, our revenue may decline and our business could suffer. In addition, as we expand our service offerings and enter into new business areas, we may be required to significantly modify and expand our software and infrastructure systems. If we fail to accomplish these tasks in a timely manner, our business will likely suffer.

Our ability to retain existing credit facilities or obtain new credit facilities may adversely affect the way we conduct our business

On April 30, 2009, we renewed our capital lease line which expires on April 30, 2010. We may need to renew this lease line or we may need to enter into additional credit facilities to operate the business. The recent global financial crisis, and further financial institution failures, may make it more difficult for us either to utilize our existing debt capacity or otherwise obtain additional financing for our operations, investing activities, or financing activities. This difficulty or inability could materially limit our business operations and adversely affect our business performance.

If we do not comply with the financial covenants in our credit agreements, our financial condition could be adversely affected.

Our credit facilities contain provisions that could limit our ability to, among other things, incur, create or assume additional debt, sell or otherwise dispose of our or any of our subsidiary’s assets, or consolidate or merge with or into, or acquire the obligations or stock of, or any other interest in, another person. In addition, our credit facilities contain financial covenants that require us to maintain specified levels of tangible net worth and liquid assets. Our ability to meet those financial covenants can be affected by events beyond our control, and we may be unable to satisfy these covenants. If we fail to comply with these covenants, we may be required to identify restricted cash equal to our outstanding capital lease balance plus our outstanding SBLCs or, in the event of default, we may be required to pay the lenders cash in an amount equal to the capital lease balance. Paying such cash balances could have a material adverse effect on the Company’s financial condition.

Risks Related to Operating in our Industry

Economic conditions, political events, and other circumstances could materially adversely affect the Company

The Company’s operations and performance depend significantly on worldwide economic conditions and their impact on levels of consumer spending, which have recently deteriorated significantly in many countries and regions, including without limitation the United States, and may remain depressed for some time. Some of the factors that could influence the levels of consumer spending and, in turn, online advertising, include continuing volatility in fuel and other energy costs, conditions in the residential real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other macroeconomic factors affecting consumer spending behavior and, in turn, online advertising. As evidenced by our recent financial results, these and other economic factors have had, and could in the future have, a material adverse effect on demand for the Company’s products and services and on the Company’s financial condition and operating results.

Additionally, like many other stocks, our stock price has been affected by global economic uncertainties and if investors have concerns that our business, operating results and financial condition will be negatively impacted by a worldwide economic downturn, our stock price could further decrease.

Cyclical and seasonal fluctuations in the economy, in internet usage and in traditional retail shopping have affected, and are likely to continue to affect, our business

Both cyclical and seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and may continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates.

If we fail to prevent, detect and remove invalid search queries and clicks, we could lose the confidence of our search advertisers, thereby causing our business to suffer

Invalid clicks are an ongoing problem for the Internet search advertising industry, and we are exposed to the risk of invalid clicks on our advertisers’ text advertisements coming from within our distribution network. Invalid clicks occur when a person or robotic software causes a click on a paid listing to occur for some reason other than to view the underlying content. Invalid clicks are commonly referred to as “click fraud.” We continue to invest significant time and resources in preventing, detecting and eliminating invalid traffic from our distribution network. However, the perpetrators of click fraud have developed sophisticated methods to evade detection, and we are unlikely to be able to completely detect and remove all invalid traffic from our search network.

We are subject to advertiser complaints and litigation regarding invalid clicks, and we may be subject to advertiser complaints, claims, litigation or inquiries in the future. For example, in March 2005, the Company was served with the second amended complaint in a class action lawsuit (Lane’s Gifts and Collectibles, L.L.C., v. Yahoo! Inc.) alleging that the Company engaged in click fraud and seeking damages as a result. We have from time to time credited invoices or refunded revenue to our customers due to invalid traffic, and we expect to continue to do so in the future. If our systems to detect invalid traffic are insufficient, or if we find new evidence of past invalid clicks, we may have to issue credits or refunds retroactively to our search advertisers, and we may still have to pay revenue share to our distribution network partners. This could negatively affect our profitability and hurt our brand. If traffic consisting of invalid clicks is not detected and removed from our advertising network, the affected search advertisers may experience a reduced return on their investment in our online advertising because the invalid clicks will not lead to actual sales for the search advertisers. This could lead the search advertisers to become dissatisfied with our products, which could lead to loss of search advertisers and revenue and could materially and adversely affect our financial results.

Any failure in the performance of our key operating systems could materially and adversely affect our revenues

Any system failure that interrupts our hosted products or services, whether caused by computer viruses, software failure, power interruptions, intruders and hackers, or other causes, could harm our financial results. For example, our system for tracking and invoicing clicks is dependent upon a proprietary software platform. If we lose key personnel or experience a failure of software, this system may fail. In such event, we may be unable to track paid clicks and invoice our customers, which would materially and adversely affect our financial results and business reputation. Moreover, our services are governed by Service Level Agreements that, if not met, require the payment of credits to our customers depending upon the level of service interruption.

The occurrence of a natural disaster or unanticipated problems at our principal headquarters or at a third-party facility could cause interruptions or delays in our business. A loss of data could render us unable to provide some services. Our California facilities exist on or near known earthquake fault zones and a significant earthquake could cause an interruption in our services. We do not have back-up sites for our main customer operations center, which is located at our San Francisco, California office. Additionally, we are moving our headquarters office in the fourth quarter of 2009, and we have scheduled a data center move in the first quarter of 2010. These moves could disrupt our operations. An interruption in our ability to serve advertisements, track paid clicks, bill and collect invoices, and provide customer support would materially and adversely affect our financial results.

Our business and operations depend on Internet service providers and third party technology providers, and any failure or system downtime experienced by these companies could materially and adversely affect our revenues

Our consumers, distribution network partners and customers depend on Internet service providers, online service providers and other third parties for access to our services. These service providers have experienced significant outages in the past and could experience outages, delays and other operating difficulties in the future. The occurrence of any or all of these events could adversely affect our reputation, brand and business, which could have a material adverse effect on our financial results.

We have an agreement with Savvis Communications, Inc. to house equipment for web serving and networking and to provide network connectivity services. We have an agreement with AboveNet Communications, Inc. to provide network connectivity services. We also have agreements with third-party click tracking and ad-serving technology providers. We do not presently maintain fully redundant click tracking, customer account and web serving systems at separate locations. Accordingly, our operations depend on Savvis and AboveNet to protect the systems in their data centers from system failures, earthquake, fire, power loss, water damage, telecommunications failure, hackers, vandalism and similar events. Neither Savvis nor AboveNet guarantees that our Internet access will be uninterrupted, error-free or secure. We have developed a 30-day disaster recovery plan to respond in the event of a catastrophic loss of

our critical, revenue-generating systems. We have an agreement with Raging Wire, Inc. in Sacramento, California to provide co-location and networking services for our critical systems in such an event. Although we maintain property insurance and business interruption insurance, such insurance may not protect against some risks and we cannot guarantee that our insurance will be adequate to compensate us for all losses that may occur as a result of a catastrophic system failure. Also, if our third-party click tracking or ad-serving technology providers experience service interruptions, errors or security breaches, our ability to track, realize and record revenue would suffer.

We may face liability for claims related to our products and services, and these claims may be costly to resolve

Internet users, search advertisers, other customers, and companies in the Internet, technology and media industries frequently enter into litigation based on allegations related to defamation, negligence, personal injury, breach of contract, unfair advertising, unfair competition, invasion of privacy or other claims. Lawsuits are filed against us from time to time. As we enter foreign markets, our potential liability could increase. In addition, we are obligated in some cases to indemnify our customers or distribution network partners in the event that they are subject to claims that our services infringe on the rights of others.

Litigating these claims could consume significant amounts of time and money, divert management’s attention and resources, cause delays in integrating acquired technology or releasing new products, or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on acceptable terms, if at all. Our insurance may not adequately cover claims of this type, if at all. If a court were to determine that some aspect of our services infringed upon or violated the rights of others, we could be prevented from offering some or all of our services, which would negatively impact our revenue and business. For any of the foregoing reasons, litigation involving our listings business and technology could have a material adverse effect on our business, operating results and financial condition.

We could be subject to infringement claims that may be costly to defend, result in the payment of settlements or damages or cause us to change the way we conduct our business

Internet, technology and media companies, as well as patent holding companies often possess a significant number of patents. Further, many of these companies and other parties are actively developing online advertising, search, indexing, electronic commerce and other Web-related technologies, as well as a variety of online business models and methods. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, we may face claims of infringement of patents and other intellectual property rights held by others. Also, as we expand our business, acquire and maintain our customer base, and develop new technologies, products and services, we may become increasingly subject to intellectual property infringement claims. In the event that there is a claim or determination that we infringe third-party proprietary rights such as patents, copyrights, trademark rights, trade secret rights or other third party rights such as publicity and privacy rights, we could incur substantial monetary liability, be required to enter into costly royalty or licensing agreements or be prevented from using the rights, which could require us to change our business practices in the future and limit our ability to compete effectively. We may also incur substantial expenses in defending against third-party infringement claims regardless of the merit of such claims. The occurrence of any of these results could harm our brand and negatively impact our operating results. In addition, many of our agreements with our customers, partners and affiliates require us to indemnify them for certain third-party intellectual property infringement claims or determinations, which could increase our costs in defending such claims and our damages. For example, in October 2008, we agreed to indemnify one of our Publisher Solutions customers relating to a patent infringement suit filed against it pursuant to an AdCenter for Publishers’ agreement between it and the Company. The resulting settlement agreement between the Company and the plaintiffs required us to pay the plaintiffs $0.6 million and the Publisher Solutions customer’s defense costs of $0.4 million.

Litigation, regulation, legislation or enforcement actions directed at or materially affecting us may adversely affect the commercial use of our products and services and our financial results

New lawsuits, laws, regulations and enforcement actions applicable to the online industry may limit the delivery, appearance and content of our advertising or our publisher customers’ advertisers or otherwise adversely affect our business. If such laws are enacted, or if existing laws are interpreted to restrict the types and placements of advertisements we or our publishers’ customers can carry, it could have a material and adverse effect on our financial results. For example, in 2002, the Federal Trade Commission, in response to a petition from a private organization, reviewed the way in which search engines disclose paid placement or paid inclusion practices to Internet consumers and issued guidance on what disclosures are necessary to avoid misleading consumers about the possible effects of paid placement or paid inclusion listings on the search results. In 2003, the United States Department of Justice issued statements indicating its belief that displaying advertisements for online gambling might be construed as aiding and abetting an illegal activity under federal law. In 2004, the United States Congress considered new laws regarding the sale of pharmaceutical products over the Internet and the use of adware to distribute advertisements on the Internet. In 2007, the Federal Trade Commission proposed new regulations relating to online behavioral targeting. Moreover, as we enter into foreign markets, we may become subject to additional regulation and legislation. If any new law or government agency were to require changes in the labeling, delivery or content of our advertisements, or if we are subject to legal proceedings regarding these issues, it may reduce the desirability of our services or the types of advertisements that we can run, and our business could be materially and adversely harmed. In addition, many of our agreements with our customers, partners and affiliates require us to indemnify them for certain claims related to online advertising laws, regulations and enforcement actions, which could increase our costs in defending such claims and our damages.

In addition, legislation or regulations, including compliance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”), present ongoing compliance risks, and a failure to comply with these new laws and regulations could materially harm our business. As

we continue our Section 404 compliance efforts we may identify significant deficiencies, or material weaknesses, in the design and operation of our internal control over financial reporting. We may be unable to remediate any of these matters in a timely fashion, and/or our independent registered public accounting firm may not agree with our remediation efforts in connection with its Section 404 attestation. Such failures could impact our ability to record, process, summarize and report financial information, and could impact market perception of the quality of our financial reporting, which could adversely affect our business and our stock price.

Privacy-related regulation of the Internet could limit the ways we currently collect and use personal information, which could decrease our advertising revenues or increase our costs

Internet user privacy has become an issue both in the United States and abroad. The United States Congress and Federal Trade Commission are considering new legislation and regulations to regulate Internet privacy. The Federal Trade Commission and government agencies in some states and countries have investigated some Internet companies, and lawsuits have been filed against some Internet companies, regarding their handling or use of personal information. Any laws imposed to protect the privacy of Internet consumers may affect the way in which we collect and use personal information. We could incur additional expenses if new laws or court judgments, in the United States or abroad, regarding the use of personal information are introduced or if any agency chooses to investigate our privacy practices.

Our search advertisers and partners may place information, known as cookies, on a user’s hard drive, generally without the user’s knowledge or consent. This technology enables web site operators to target specific consumers with a particular advertisement, to limit the number of times a user is shown a particular advertisement, and to track certain behavioral data.

Although some Internet browsers allow consumers to modify their browser settings to remove cookies at any time or to prevent cookies from being stored on their hard drives, many consumers are not aware of this option or are not knowledgeable enough to use this option. Some privacy advocates and governmental bodies have suggested limiting or eliminating the use of cookies. If this technology is reduced or limited, the Internet may become less attractive to search advertisers and sponsors, which could result in a decline in our revenue.

We and some of our distribution network partners or search advertisers retain information about our consumers. If others were able to penetrate the network security of these user databases and access or misappropriate this information, we and our distribution network partners or search advertisers could be subject to liability. These claims may result in litigation, our involvement in which, regardless of the outcome, could require us to expend significant time and financial resources. In addition, many of our agreements with our customers, partners and affiliates require us to indemnify them for certain claims related to privacy laws, regulations and enforcement actions which could increase our costs in defending such claims and damages.

Online commerce security risks, including security breaches, identity theft, service disrupting attacks and viruses, could harm our reputation and the conduct of our business, which could have a material adverse effect on our financial results

A fundamental requirement for online commerce and communications is the secure storage and transmission of confidential information over public networks. Although we have developed and use systems and processes that are designed to protect customer information and prevent fraudulent credit card transactions and other security breaches, our security measures may not prevent security breaches or identity theft that could harm our reputation and business. Currently, a significant number of our customers provide credit card and other financial information and authorize us to bill their credit card accounts directly for all transaction fees charged by us. We rely on encryption and authentication technology to provide the security and authentication to effect secure transmission of confidential information, including customer credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect transaction data. In addition, any party who is able to illicitly obtain a user’s password could access the user’s transaction data. An increasing number of websites have reported breaches of their security. Any compromise of our security could damage our reputation and expose us to a risk of litigation and possible liability. The coverage limits of our insurance policies may not be adequate to reimburse us for losses caused by security breaches.

Additionally, our servers are vulnerable to computer viruses, physical or electronic break-ins, and similar disruptions, and we have experienced “denial-of-service” type attacks on our system that have made all or portions of our websites unavailable for periods of time. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches. Disruptions in our services and damage caused by viruses and other attacks could cause a loss of user confidence in our systems and services, which could lead to reduced usage of our products and services and materially adversely affect our business and financial results.

New tax treatment of companies engaged in Internet commerce may adversely affect the commercial use of our search service and our financial results

Tax authorities at the international, federal, state and local levels are currently reviewing the appropriate tax treatment of companies engaged in Internet commerce. New or revised state tax regulations may subject us or our search advertisers to additional state sales, income and other taxes. We cannot predict the effect of current attempts to impose sales, income or other taxes on commerce over the Internet. New or revised taxes and, in particular, sales taxes, would likely increase the cost of doing business online and decrease the attractiveness of advertising and selling goods and services over the Internet. Any of these events could have an adverse effect on our business and results of operations.

Risks Related to the Capital Market

Our quarterly revenues and operating results may fluctuate for many reasons, each of which may negatively affect our stock price

Our revenues and operating results will likely fluctuate significantly from quarter to quarter as a result of a variety of factors, including without limitation:

•

change in the composition of our Advertiser Network customer base,

•

change in composition of our AdCenter customer base,

•

changes in our distribution network, particularly the gain or loss of key distribution network partners, or changes in the implementation of search results on partner websites,

•

changes in the number of search advertisers who do business with us, or the amount of spending per customer,

•

the revenue-per-click we receive from search advertisers, or other factors that affect the demand for, and prevailing prices of, Internet advertising and marketing services,

•

change in our traffic acquisition costs (TAC) related to our Advertiser Network,

•

systems downtime on our Advertiser Network, our website or the websites of our distribution network partners, or

•

the effect ASC 718, which became effective January 1, 2006, and requires that we account for the fair value of stock awards granted to employees as compensation expense.

Due to the above factors, we believe that period-to-period comparisons of our financial results are not necessarily meaningful, and you should not rely on past financial results as an indicator of our future performance. If our financial results in any future period fall below the expectations of securities analysts and investors, the market price of our securities would likely decline.

Our stock price is extremely volatile, and such volatility may hinder investors’ ability to resell their shares for a profit or avoid a loss

The stock market has experienced significant price and volume fluctuations in recent years, and the stock prices of Internet companies have been extremely volatile. The low trading volume of our common stock may adversely affect its liquidity and reduce the number of market makers and/or large investors willing to trade in our common stock, making wider fluctuations in the quoted price of our common stock more likely to occur. You should evaluate our business in light of the risks, uncertainties, expenses, delays and difficulties associated with managing and growing a business in a relatively new industry, many of which are beyond our control.

Our stock price may fluctuate, and you may not be able to sell your shares for a profit, as a result of a number of factors including without limitation:

•

changes in the market valuations of Internet companies in general and comparable companies in particular,

•

quarterly fluctuations in our operating results,

•

the termination or expiration of our distribution agreements,

•

our potential failure to meet our forecasts or analyst expectations on a quarterly basis,

•

the relatively thinly traded volume of our publicly traded shares, which means that small changes in the volume of trades may have a disproportionate impact on our stock price,

•

the loss of key personnel, or our inability to recruit experienced personnel to fill key positions,

•

changes in ratings or financial estimates by analysts or the inclusion/removal of our stock from certain stock market indices used to drive investment choices,

•

announcements of new distribution network partnerships, technological innovations, acquisitions or products or services by us or our competitors,

•

the sales of substantial amounts of our common stock in the public market by our stockholders, or the perception that such sales could occur, or

•

conditions or trends in the Internet that suggest a decline in rates of growth of advertising-based Internet companies.

In the past, securities class action litigation has often been instituted after periods of volatility in the market price of a Company’s securities. A securities class action suit against us could result in substantial costs and the diversion of management’s attention and resources, regardless of the merits or outcome of the case.

We may need additional capital in the future to support our operations and, if such additional financing is not available to us, on reasonable terms or at all, our liquidity and results of operations will be materially and adversely impacted

Although we believe that our working capital will provide adequate liquidity to fund our operations and meet our other cash requirements for the foreseeable future, unanticipated developments in the short term, such as the entry into agreements which require large cash payments or the acquisition of businesses with negative cash flows, may necessitate additional financing. We may seek to raise additional capital through public or private debt or equity financings in order to:

•

fund the additional operations and capital expenditures,

•

take advantage of favorable business opportunities, including geographic expansion or acquisitions of complementary businesses or technologies,

•

develop and upgrade our technology infrastructure beyond current plans,

•

develop new product and service offerings,

•

take advantage of favorable conditions in capital markets, or

•

respond to competitive pressures.

The capital markets, and in particular the public equity market for Internet companies, have historically been volatile. It is difficult to predict when, if at all, it will be possible for Internet companies to raise capital through these markets. We cannot assure you that the additional financing will be available on terms favorable to us, or at all. If we issue additional equity or convertible debt securities, our existing stockholders may experience substantial dilution.

A significant market downturn may lead to a decline in the value of securities we hold in our investment portfolio

Beginning in 2008, the global markets for fixed-income securities, particularly the markets for financial instruments collateralized by sub-prime mortgages, experienced significant disruption. This disruption affected the liquidity and pricing of securities traded in these markets, as well as the returns of, and levels of redemptions in, investment vehicles investing in those instruments. This downturn may adversely affect the value and liquidity of securities we hold in our investment portfolio.

Provisions of Delaware corporate law and provisions of our charter and bylaws may discourage a takeover attempt

Our charter and bylaws and provisions of Delaware law may deter or prevent a takeover attempt, including an attempt that might result in a premium over the market price for our common stock. Our board of directors has the authority to issue shares of preferred stock and to determine the price, rights, preferences and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, our charter and bylaws provide for a classified board of directors. These provisions, along with Section 203 of the Delaware General Corporation Law, prohibiting certain business combinations with an interested stockholder, could discourage potential acquisition proposals and could delay or prevent a change of control.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On July 14, 2009, we held our annual stockholder meeting, at which a quorum of our stockholders voted to re-elect Director Jean-Yves Dexmier to the Board of Directors, approve the 2009 Employee Stock Purchase Plan and ratify the Board’s selection of Moss Adams LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2009. Information regarding these matters voted on by our stockholders was reported in our Quarterly Report on Form 10-Q for the period ended June 30, 2009, filed with the SEC on August 4, 2009, and is incorporated herein by reference.

ITEM 5.

OTHER INFORMATION

On October 30, 2009, we and RagingWire Enterprise Solutions, Inc. entered into a Master Services Agreement for IT data center services (the “RagingWire Agreement”) for a two year term. Prior to the expiration on March 28, 2010 of the Company’s existing data center services agreement, the Company will move its data center to the new facility. During the first 3 months of service, the amount to be paid by the Company to RagingWire under the RagingWire Agreement will vary based on power usage. After the first three months, the minimum annual cost is approximately $0.9 million and will be reflected in cost of revenue.

ITEM 6.

EXHIBITS

Please see the exhibit index following the signature page of this report.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

LOOKSMART, LTD.

Dated: November 3, 2009

By:

/s/ STEPHEN C. MARKOWSKI

Stephen C. Markowski

Chief Financial Officer

EXHIBIT INDEX

Exhibits


Number		Description of Document

3.1		Restated Certificate of Incorporation (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 14, 2005).

3.2		Bylaws (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 14, 2000) (File No. 000-26357).

4.1		Form of Specimen Stock Certificate (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 14, 2005).

4.2++		Forms of Stock Option Agreement used by the Registrant in connection with grants of stock options to employees, directors and other service providers in connection with the Amended and Restated 1998 Stock Plan (Filed with the Company’s Current Report on Form 8-K filed with the SEC on October 22, 2004).

4.3++		Form of cover sheet for use with Stock Option Agreement for grants of stock options to executives in connection with the Company’s Executive Team Incentive Plan, Plan Year 2006 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).

4.4++		Form of Indemnification Agreement entered into between the Registrant and each of its directors and officers (Filed with the Company’s Registration Statement on Form S-1 (File No. 333-80581) filed with the SEC on September 14, 1999).

4.5++		Form of cover sheet for use with stock option agreement for grants of stock options to executives in connection with the Company’s Executive Team Incentive Plan, Plan Year 2007 (Filed with the Company’s Current Report on Form 8-K filed with the SEC on March 2, 2007).

10.1++		Form of Indemnification Agreement entered into between the Registrant and each of its directors and officers (Filed with the Company’s Registration Statement on Form S-1 (File No. 333-80581) filed with the SEC on September 14, 1999).

10.2		Amended and Restated 1998 Stock Plan (Filed with the Company’s Registration Statement on Form S-1 (File No. 333-80581) filed with the SEC on September 14, 1999).

10.3		1999 Employee Stock Purchase Plan as amended (Filed with the Company’s Registration Statement on Form S-8 (File No. 333-129987) filed with the SEC on November 29, 2005).

10.5++		LookSmart, Ltd. Executive Team Incentive Plan, Plan Year 2007 (Filed with the Company’s Current Report on Form 8-K filed with the SEC on March 2, 2007).

10.6++		LookSmart, Ltd. 2008 Executive Team Incentive Plan (Filed with the Company’s Current Report on Form 8-K filed with the SEC on February 19, 2008).

10.7		Zeal Media, Inc. 1999 Stock Plan (Filed with the Company’s Registration Statement on Form S-8 filed with the SEC on December 7, 2000).

10.8		Wisenut, Inc. 1999 Stock Incentive Plan (Filed with the Company’s Registration Statement on Form S-8 filed with the SEC on April 18, 2002).

10.9		LookSmart 2007 Equity Incentive Plan (Filed with the Company’s Definitive Proxy Statement and Amended Definitive Proxy Statement with the SEC on April 30 and September 11, 2007, respectively).

10.12		Lease Agreement with Rosenberg SOMA Investments III, LLC for property located at 625 Second Street, San Francisco, California, dated May 5, 1999 (Filed with the Company’s Registration Statement on Form S-1 (File No. 333-80581) filed with the SEC on September 14, 1999).

10.13++		LookSmart, Ltd. Form Change of Control/Severance Agreement (Filed with The Company’s Quarterly report on Form 10-Q filed with the SEC on November 9, 2007).

10.14++		Employment Offer Letter between the Company and its Chief Financial Officer dated November 15, 2007 (Filed with the Company’s Current Report on Form 8-K/A filed with the SEC on December 27, 2007).



10.15		Preferred Shares Rights Agreement dated November 15, 2007 between the Company and Mellon Investor Services LLC (Filed with the Company’s Current Report on Form 8-K with the SEC on November 21, 2007).

10.16		Asset Purchase Agreement between the Company and CNET Networks, Inc. dated November 5, 2007 (Filed with the Company’s Current Report on Form 8-K with the SEC on November 7, 2007).

10.17		Amendment to LookSmart Preferred Shares Rights Agreement dated July 8, 2008 (Filed with the Company’s Current Report on Form 8-K with the SEC on July 8, 2008).

10.18++		LookSmart, Ltd. Form Amended and Restated Change of Control/Severance Agreement (Filed with the Company’s Annual Report on Form 10-K filed with the SEC on March 16, 2009).

10.31		Fourth Addendum to AdCenter License, Hosting and Support Agreement between the Registrant and IAC Search & Media dated September 14, 2007 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2007).

10.32		Sponsored Links Master Terms and Conditions between the Registrant and eBay, Inc. dated March 12, 2007 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2007).

10.33+		LookSmart Reseller Terms and Conditions with MeziMedia dated September 7, 2005. (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2007).

10.34		Co-Location Services Agreement between the Registrant and Savvis Communications Corporation dated March 29, 2008 (Filed with the Company’s Quarterly Report on Form 10-Q with the SEC on May 12, 2008).

10.35+		Second Addendum to AdCenter License, Hosting and Support Agreement between the Registrant and IAC Search & Media dated May 16, 2006 (Filed with the Company’s Form 10-Q with the SEC on August 8, 2006).

10.36+		Third Addendum to AdCenter License, Hosting and Support Agreement between the Registrant and IAC Search & Media dated January 1, 2007. (Filed with the Company’s Annual Report on Form 10-K on March 16, 2007).

10.37+		AdCenter License, Hosting and Support Agreement between the Registrant and Ask Jeeves, Inc. dated May 16, 2005 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).

10.38+		Addendum to AdCenter License, Hosting and Support Agreement between the Registrant and Ask Jeeves, Inc. dated January 20, 2006 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).

10.39+		Paid Listings License Agreement between the Registrant and SearchFeed.com dated April 15, 2006 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).

10.40+		License Agreement between the Registrant and SearchFeed.com dated November 23, 2003, as Amended on March 29, 2004 and March 21, 2005 (Filed with the Company’s Annual Report on Form 10-K filed with the SEC on March 15, 2006).

10.41++		Promotion letter between the Company and its Vice-President, Technology dated September 7, 2007 (Filed with the Company’s Current Report on Form 8-K with the SEC on September 12, 2007).

10.42++		Amendment to employment offer between the Company and its Chief Financial Officer dated August 27, 2007 (Filed with the Company’s Current Report on Form 8-K with the SEC on September 4, 2007).

10.45++		Promotion letter between the Registrant and its Vice President, Finance and Principal Accounting Officer dated July 10, 2007. (Filed with the Company’s Current Report on Form 8-K filed with the SEC on July 16, 2007).

10.46++		Severance Agreement and General Release between the Company and Dave Hills dated August 2, 2007 (Filed with the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2007).

10.47+		Paid Listings License Agreement between the Registrant and Kontera Technologies, Inc. dated July 17, 2006. (Filed with the Company’s Quarterly Report on Form 10-Q with the SEC on November 9, 2007).

10.48+		License Agreement between the Registrant and Oversee.net dated April 1, 2004 (Filed with the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 9, 2007).

10.49		Letter from Oversee.net to the Registrant dated January 21, 2008 terminating Agreement between Registrant and Oversee.net dated April 1, 2004 effective September 30, 2008 (Filed with the Company’s Annual Report on Form 10-K filed with the SEC on March 17, 2008).



10.50+		Backfill Agreement between the Registrant and Internext Media Corp. dated February 8, 2008 (Filed with the Company’s Quarterly Report on Form 10-Q on May 12, 2008).

10.51+		Paid Listings License Agreement between the Registrant and PeakClick GMBH dated April 15, 2006 (Filed with the Company’s Amended Quarterly Report on Form 10-Q/A on February 9, 2009).

10.52+		Advertiser Terms and Conditions between the Registrant and MeziMedia dated September 26, 2008. (Filed with the Company’s Amended Quarterly Report on Form 10-Q/A on February 9, 2009).

10.53+		Paid Listings License Agreement between the Registrant and Wellbourne Limited dated March 15, 2006 (Filed with the Company’s Quarterly Report on Form 10Q on May 5, 2009.

10.54		Letter dated May 19, 2009 from IAC Search & Media (“IAC”) to the Registrant notifying the Registrant that IAC does not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement (Filed with the Company’s Current Report on Form 8-K filed with the SEC on May 21, 2009).

10.55++		July 13, 2009 Amendment to the Registrant’s Chief Financial Officer’s Offer Letter (Filed with the Company’s Current Report on Form 8-K filed with the SEC on July 13, 2009).

10.56++		Severance Agreement and General Release between the Registrant and its former Senior Vice President, Corporate Development (Filed with the Company’s Current Report on Form 8-K filed with the SEC on June 10, 2009).

10.59++		Employment offer letter between the Registrant and its General Counsel and Senior Vice President dated as of July 11, 2005 (Filed with the Company’s Current Report on Form 8-K filed with the SEC on July 14, 2005).

10.60++		Employment offer letter between the Registrant and its Chief Financial Officer dated August 1, 2008 (Filed with the Company’s Current Report on Form 8-K filed with the SEC on August 5, 2008).

10.61++		Board Services Agreement between the Registrant and its Director dated July 1, 2008 (filed with the Company’s Amended Annual Report on Form 10-K/A on April 30, 2009)

10.62++		Amendment to offer letter between Registrant and its Chief Financial Officer dated March 23, 2009 (filed with the Company’s Quarterly Report on Form 10Q on May 5, 2009).

10.63*		Sublease Agreement with KPMG, LLP for property located at 55 Second Street, San Francisco, California.

10.64++		Amendment to offer letter between the Registrant and its Chief Financial Officer dated July 13, 2009 (filed with the Company’s Current Report on Form 8-K filed with the SEC on July 13, 2008)

10.66*		Covenants Rider to the Master Lease Agreement between the Registrant and City National Bank dated September 30, 2009.

10.67*		Irrevocable Standby Letter of Credit Application and Letter of Credit Agreement between the Registrant and City National Bank dated August 14, 2009.

10.68*		First Amendment to Supplemental Terms and Conditions Letter between the Registrant and City National Bank dated October 16, 2009.

31.1*		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2*		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1*		Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(*)	Filed herewith

(+)	Confidential treatment has been granted with respect to portions of the exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission.

(++)	Management contract or compensatory plan or arrangement.

LOOKSMART LTD - FORM 10-Q - November 3, 2009

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