Table of Contents

 

 

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 June 30, 2010

OR

 

¨	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.)

55 Second Street

San Francisco, California 94105

(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		¨
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 July 31, 2010, there were 17,171,448 shares of the registrant’s common stock outstanding, par value $0.001 per share.

 

 

 

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Table of Contents

TABLE OF CONTENTS

 

		PART I		3
ITEM 1.		FINANCIAL STATEMENTS		3
		UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS		3
		UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS		4
		UNAUDITED 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		23
ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		36
ITEM 4.		CONTROLS AND PROCEDURES		36
		PART II OTHER INFORMATION		37
ITEM 1.		LEGAL PROCEEDINGS		37
ITEM 1A.		RISK FACTORS		37
ITEM 2.		UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		46
ITEM 3.		DEFAULTS UPON SENIOR SECURITIES		46
ITEM 4.		REMOVED AND RESERVED		46
ITEM 5.		OTHER INFORMATION		46
ITEM 6.		EXHIBITS		46
SIGNATURE				47
EXHIBIT INDEX				48

 

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Table of Contents

PART I

 

ITEM 1.

FINANCIAL INFORMATION

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

		June 30, 2010				December 31, 2009
ASSETS
Current assets:
Cash and cash equivalents		$	24,457			$	22,933
Short-term investments			1,000				4,780
Total cash, cash equivalents and short-term investments			25,457				27,713
Trade accounts receivable, net			4,929				3,990
Prepaid expenses and other current assets			756				847
Total current assets			31,142				32,550
Property and equipment, net			3,873				3,717
Capitalized software and other assets, net			1,990				2,080
Total assets		$	37,005			$	38,347
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable		$	2,821			$	2,918
Accrued liabilities			4,088				5,477
Deferred revenue and customer deposits			1,022				1,113
Current portion of capital lease obligations			1,267				1,272
Total current liabilities			9,198				10,780
Capital lease and other obligations, net of current portion			1,398				1,646
Total liabilities			10,596				12,426
Commitment and contingencies
Stockholders’ equity:
Convertible preferred stock, $0.001 par value; Authorized: 5,000 shares at June 30, 2010 and December 31, 2009; Issued and Outstanding: none at June 30, 2010 and December 31, 2009			—				—
Common stock, $0.001 par value; Authorized: 200,000 shares at June 30, 2010 and December 31, 2009; Issued and Outstanding: 17,157 shares and 17,145 shares at June 30, 2010 and December 31, 2009, respectively			17				17
Additional paid-in capital			261,337				260,981
Accumulated other comprehensive gain			—				3
Accumulated deficit			(234,945	)			(235,080	)
Total stockholders’ equity			26,409				25,921
Total liabilities and stockholders’ equity		$	37,005			$	38,347

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

 

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Table of Contents

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

		Three Months ended June 30,								Six Months ended June 30,
		2010				2009				2010				2009
Revenue		$	13,017			$	13,223			$	26,303			$	26,477
Cost of revenue			7,525				7,990				16,561				16,092
Gross profit			5,492				5,233				9,742				10,385
Operating expenses:
Sales and marketing			1,275				1,474				2,429				2,839
Product development and technical operations			2,473				2,485				4,917				5,098
General and administrative			1,197				2,303				2,436				5,672
Restructuring charge			—				229				—				229
Impairment charge			—				180				—				180
Total operating expenses			4,945				6,671				9,782				14,018
Income (loss) from operations			547				(1,438	)			(40	)			(3,633	)
Non-operating income, net			19				22				2				76
Income (loss) from continuing operations before income taxes			566				(1,416	)			(38	)			(3,557	)
Income tax (benefit) expense			(1	)			—				5				8
Income (loss) from continuing operations			567				(1,416	)			(43	)			(3,565	)
Income from discontinued operations, net of tax			85				130				178				239
Net income (loss)		$	652			$	(1,286	)		$	135			$	(3,326	)
Net income (loss) per share - Basic
Income (loss) from continuing operations		$	0.04			$	(0.09	)		$	—			$	(0.20	)
Income from discontinued operations, net of tax			—				0.01				0.01				0.01
Net income (loss) per share		$	0.04			$	(0.08	)		$	0.01			$	(0.19	)
Net income (loss) per share - Diluted
Income (loss) from continuing operations		$	0.04			$	(0.09	)		$	—			$	(0.20	)
Income from discontinued operations, net of tax			—				0.01				0.01				0.01
Net income (loss) per share		$	0.04			$	(0.08	)		$	0.01			$	(0.19	)
Weighted average shares outstanding used in computing basic net loss per share			17,157				17,102				17,151				17,089
Weighted average shares outstanding used in computing diluted net loss per share			17,192				17,102				17,168				17,089

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

 

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LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

		Six Months Ended June 30,
		2010				2009
Cash flows from operating activities:
Net income (loss)		$	135			$	(3,326	)
Adjustment to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization			1,433				1,470
Share-based compensation			332				1,032
Restructuring charge			—				18
Impairment charge			—				180
Gain from sale of assets and other non-cash charges			(228	)			(254	)
Changes in operating assets and liabilities:
Trade accounts receivable, net			(939	)			2,115
Prepaid expenses and other current assets			(20	)			477
Trade accounts payable			(97	)			(1,197	)
Accrued liabilities			(531	)			(2,038	)
Deferred revenue and customer deposits			(91	)			128
Other long-term obligations			84				(588	)
Net cash provided by (used in) operating activities			78				(1,983	)
Cash flows from investing activities:
Purchase of short-term investments			(4,498	)			(5,334	)
Proceeds from sale of short-term investments			8,262				9,404
Proceeds from sale of equipment			67				—
Payments for property and equipment and capitalized software development			(1,863	)			(653	)
Proceeds from contingent purchase consideration of certain consumer assets			178				268
Net cash provided by investing activities			2,146				3,685
Cash flows from financing activities:
Principal payments of notes			—				(34	)
Principal payments of capital lease obligations			(700	)			(476	)
Proceeds from issuance of common stock			—				14
Net cash used in financing activities			(700	)			(496	)
Increase in cash and cash equivalents			1,524				1,206
Cash and cash equivalents, beginning of period			22,933				22,393
Cash and cash equivalents, end of period		$	24,457			$	23,599
Supplemental disclosure of noncash activities
Assets acquired through capital lease obligations		$	363			$	870
Property and equipment received and liability accrued		$	38			$	113

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

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

Nature of Business

LookSmart, Ltd. (“LookSmart” or the “Company”) 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 operates in a large online search advertising ecosystem serving ads that target user queries on partner sites. The Company operates in the middle of this ecosystem, acquiring search queries from a variety of sources and matching them with the keywords of its search advertising customers. The Company’s largest category of customers has been intermediaries, the majority of which purchase clicks to sell into the affiliate networks of the large search engine providers. Another category of customers are direct advertisers and their agencies, some of whom want conversions or sales from the clicks, while others want unique page views. The last category of customers is self-service advertisers that sign-up online and pay by credit card.

The Company offers search advertising customers targeted, pay-per-click (PPC) search via a monitored search advertising distribution network using the Company’s “AdCenter” platform technology. The Company’s search advertising network includes publishers and search advertising customers, including intermediaries and direct advertising customers and their agencies as well as self-service customers in the United States and certain other countries. The Company’s application programming interface (“API”) allows search advertising customers 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 Company 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 publishers and portals to manage their advertiser relationships, distribution channels and accounts.

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. The Furl assets were accounted for under the guidance of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 360-10-40, Impairment or Disposal of Long-Lived Assets (“ASC 360-10-40”) as “assets held for sale” and a full impairment of these assets was recorded at December 31, 2008. 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 2). At June 30, 2010, 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 June 30, 2010 and December 31, 2009, and for the three and six months ended June 30, 2010 and 2009, 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 June 30, 2010, and for the three and six months ended June 30, 2010 and 2009, 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 June 30, 2010 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, 2009 (“Annual Report”). The Unaudited Condensed Consolidated Balance Sheet as of December 31, 2009, 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 June 30, 2010, are not necessarily indicative of results to be expected for the full year.

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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.

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.

Fair Value of Financial Instruments

The Company’s estimate 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.

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 AdCenter Platform.

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 AdCenter platform technology. These license arrangements may include some or all of the following elements: revenue-sharing based on the publisher’s customer’s monthly revenue generated through the AdCenter application; upfront fees; monthly minimum 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.

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 at June 30, 2010 and December 31, 2009.

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 $0.1 million at June 30, 2010 and December 31, 2009, respectively. Bad debt expense (benefit) included in sales and marketing expense is insignificant for the three and six months ended June 30, 2010, and insignificant and ($0.1) million for the three and six months ended June 30, 2009, respectively.

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 June 30, 2010 and December 31, 2009, 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 exceed federally insured limits at June 30, 2010 and December 31, 2009. 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:

 

		June 30, 2010			December 31, 2009
Company 1		*	*		16	%
Company 2		17	%		*	*

 

**	Less than 10%

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Revenue Concentrations

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

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2010			2009			2010			2009
United States		59	%		89	%		62	%		87	%
Canada		12	%		*	*		13	%		*	*
United Kingdom		11	%		*	*		11	%		*	*

 

**	Less than 10%

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

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2010			2009			2010			2009
Advertiser Networks		93	%		91	%		93	%		91	%
Publisher Solutions		7	%		9	%		7	%		9	%

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

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2010			2009			2010			2009
Company 1		*	*		17	%		*	*		19	%
Company 2		*	*		11	%		*	*		10	%
Company 3		*	*		*	*		11	%		*	*
Company 4		11	%		*	*		11	%		*	*
Company 5		11	%		*	*		11	%		*	*

 

**	Less than 10%

For the three and six months ended June 30, 2010, IAC Search and Media (“IAC” or “Company 1”) accounted for 7% and 8%, respectively, of net revenue, and 69% and 71%, 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, was scheduled to expire by its terms on December 31, 2009. On December 22, 2009, the Company and IAC further amended the Agreement, effective December 1, 2009, to extend the term through March 31, 2010, and to allow IAC to extend the term in one-month intervals up to a maximum period of six months. On June 16, 2010, IAC notified the Company that, in accordance with the Sixth Addendum to the Agreement, it intends to extend the term of the Agreement on a monthly basis up to August 31, 2010.

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

 

Three Months Ended June 30,

Six Months Ended June 30,

2010

2009

2010

2009

Distribution Partner 1

*

*

*

*

*

*

15

%

Distribution Partner 2

*

*

10

%

*

*

12

%

Distribution Partner 3

*

*

*

*

*

*

11

%

Distribution Partner 4

*

*

11

%

*

*

10

%

Distribution Partner 5

26

%

*

*

17

%

*

*

 

**	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.

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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, which is generally 3 years. The Company expects to continue to invest in internally developed software and to capitalize such costs.

Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets as follows:

 

Computer equipment		3 to 4 years
Furniture and fixtures		5 to 7 years
Software		2 to 3 years

Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the lease term.

When assets are retired or otherwise disposed of, the cost and accumulated depreciation and amortization are removed from their respective accounts, and any gain or loss on such sale or disposal is reflected in operating expenses. Maintenance and repairs are charged to expense as incurred. Expenditures that substantially increase an asset’s useful life are capitalized.

Intangible Assets with Definite Lives

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 and capitalized software, 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 generate cash flows that are 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.

The Company tested its long-lived assets used in operations for impairment as of December 31, 2009, and determined they were not impaired.

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 records TAC expenses as cost of revenue 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

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Company’s Unaudited Condensed Consolidated Statements of Operations over the requisite service periods. Share-based compensation recognized for the three and six months ended June 30, 2010 were $0.2 million and $0.4 million, respectively, and $0.5 million and $1.1 million for the three and six months ended June 30, 2009, 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.

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 Unaudited Condensed 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

Other comprehensive gain as of December 31, 2009, consists of unrealized gains on marketable securities categorized as available-for-sale.

Net Income (Loss) per Common Share

Basic net income (loss) and diluted net income (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.

Segment Information

The Company has one operating segment, online advertising. While the Company operates under one operating segment, management reviews revenue under two product offerings—Advertiser Networks and Publisher Solutions.

As of June 30, 2010 and December 31, 2009, all of the Company’s accounts receivable, intangible assets and deferred revenue related to the online advertising segment. All long-lived assets are located in the United States.

Recent Accounting Pronouncements

With the exception of those stated below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the six months ended June 30, 2010, 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 January 1, 2010, the Company adopted the FASB’s updated guidance related to fair value measurements and disclosures, which requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and to describe the reasons for the transfers. In addition, in the reconciliation for fair value measurements using significant unobservable inputs, or Level 3, a reporting entity should disclose separately information about purchases, sales, issuances and settlements (that is, on a gross basis rather than one net number). The updated guidance also requires that an entity should provide fair value measurement disclosures for each class of assets and liabilities and disclosures about the valuation techniques and inputs used to measure fair value for both recurring and non-recurring fair value measurements for Level 2 and Level 3 fair value measurements. The guidance is effective for interim or annual financial reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. Therefore, the Company has not yet adopted the guidance with respect to the roll forward activity in Level 3 fair value measurements. The Company has updated its disclosures to comply with the updated guidance (see Note 12), however, adoption of the updated guidance did not have a material impact on the Company’s results of operations, financial position or liquidity.

 

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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. However, in February 2010, the FASB amended the guidance to remove the requirement for SEC filers to disclose the date through which an entity has evaluated subsequent events. Adoption of the updated guidance did not have a material impact on the Company’s results of operations, financial position or liquidity.

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 operations. The Company completed the dissolution of these entities in 2009. During the three and six months ended June 30, 2009, the loss related to the liquidation of the Company’s foreign legal entities was not significant. As of June 30, 2010 and December 31, 2009, there were no net assets related to the discontinued foreign legal entities.

Consumer Products

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 its remaining consumer assets. The various remaining related websites and assets associated with the consumer products activities 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 June 30, 2010 and December 31, 2009, 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 from discontinued operations for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

		Three Months Ended June 30,							Six Months Ended June 30,
		2010			2009				2010			2009
Revenue		$	—		$	—			$	—		$	8
Gross profit		$	—		$	—			$	—		$	8
Total operating expenses			—			(3	)			—			(39	)
Gain on disposal			85			133				178			270
Net income from discontinued operations		$	85		$	130			$	178		$	239

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 fully 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 Company determined the warrant received had no significant value and did not record a gain on the disposal. The Furl assets had no net book value. The warrant expired unexercised in February 2010.

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 and $0.2 million for the three and six months ended June 30, 2010, respectively, and $0.1 million and $0.3 million for the three and six months ended June 30, 2009, respectively. 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.

 

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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 June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010												December 31, 2009
		Amortized Cost			Unrealized Gains			Unrealized Losses			Estimated Fair Value			Amortized Cost			Unrealized Gains			Unrealized Losses			Estimated Fair Value
Cash and cash equivalents:
Cash		$	9,946		$	—		$	—		$	9,946		$	4,460		$	—		$	—		$	4,460
Cash equivalents
Money market mutual funds			14			—			—			14			10,074			—			—			10,074
Certificates of deposit			1,000			—			—			1,000			2,000			—			—			2,000
Commercial paper			13,497			—			—			13,497			6,399			—			—			6,399
Total cash equivalents			14,511			—			—			14,511			18,473			—			—			18,473
Total cash and cash equivalents			24,457			—			—			24,457			22,933			—			—			22,933
Short-term investments:
Corporate bonds			—			—			—			—			2,887			3			—			2,890
Certificates of deposit			1,000			—			—			1,000			490			—			—			490
Commercial paper			—			—			—			—			1,400			—			—			1,400
Total short-term investments			1,000			—			—			1,000			4,777			3			—			4,780
Total cash, cash equivalents and short-term investments		$	25,457		$	—		$	—		$	25,457		$	27,710		$	3		$	—		$	27,713

Realized gains and realized losses were not significant for either of the three and six months ended June 30, 2010 and 2009. As of June 30, 2010 and December 31, 2009, there were no unrealized losses on investments. The cost of all securities sold is based on the specific identification method.

The contractual maturities of cash equivalents and short-term investments at June 30, 2010 and December 31, 2009 were less than one year.

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 months and six months ended June 30, 2010 and 2009, the Company did not recognize any impairment charges on outstanding investments. As of June 30, 2010, 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 June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010			December 31, 2009
Other prepaid expenses		$	498		$	538
Income taxes receivable			172			172
Other current assets			86			137
Total		$	756		$	847

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

5. Property and Equipment

Property and equipment consisted of the following at June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010										December 31, 2009
		Cost			Accumulated Depreciation				Net Book Value			Cost			Accumulated Depreciation				Net Book Value
Computer equipment		$	11,530		$	(7,952	)		$	3,578		$	10,920		$	(7,516	)		$	3,404
Furniture and fixtures			74			(57	)			17			74			(55	)			19
Software			1,260			(1,250	)			10			1,260			(1,247	)			13
Leasehold improvements			308			(40	)			268			288			(7	)			281
Total		$	13,172		$	(9,299	)		$	3,873		$	12,542		$	(8,825	)		$	3,717

Depreciation expense on property and equipment for the three and six months ended June 30, 2010, including property and equipment under capital lease, was approximately $0.5 million and $0.9 million, respectively, and is recorded in operating expenses. Depreciation expense on property and equipment for the three and six months ended June 30, 2009, including property and equipment under capital lease, was approximately $0.5 million and $1.0 million, respectively. Equipment under capital lease totaled $4.5 million and $4.4 million as of June 30, 2010 and December 31, 2009, respectively. Depreciation expense on equipment under capital lease was $0.3 million and $0.7 million for the three and six months ended June 30, 2010, respectively, and was $0.3 million and $0.5 million for the three and six months ended June 30, 2009, respectively. Additionally, accumulated depreciation on equipment under capital lease was $2.1 million and $1.8 million as of June 30, 2010 and December 31, 2009, respectively.

6. Capitalized Software and Other Assets

The Company’s capitalized software and other assets are as follows at June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010										December 31, 2009
		Gross Amount			Accumulated Amortization				Net Book Value			Gross Amount			Accumulated Amortization				Net Book Value
Capitalized software		$	5,875		$	(4,026	)		$	1,848		$	5,499		$	(3,449	)		$	2,050
Amortizable purchased technology			78			(78	)			—			78			(78	)			—
Other assets			142			—				142			30			—				30
		$	6,095		$	(4,104	)		$	1,990		$	5,607		$	(3,527	)		$	2,080

Capitalized Software

Capitalized software consists of 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 and is amortized over three years. Amortization expense was $0.3 million and $0.6 million for the three and six months ended June 30, 2010, respectively, and $0.3 million and $0.5 million for the three and six months ended June 30, 2009.

Purchased Technology

Amortizable purchased technology had an estimated useful life of three years. Amortization expense related to purchased technology was not significant for the three and six months ended June 30, 2009, and has been classified as discontinued operations.

7. Accrued Liabilities

Accrued liabilities consisted of the following as of June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010			December 31, 2009
Accrued distribution and partner costs		$	2,102		$	2,957
Accrued compensation and related expenses			1,241			839
Accrued legal costs and other professional service fees			324			376
Accrued legal proceedings liability			339			339
Accrued equipment purchases			38			806
Other			44			160
Total accrued liabilities		$	4,088		$	5,477

See Note 10, Commitments and Contingencies, for complete discussion of the accrued legal proceedings liability.

 

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8. Lease Restructuring

Between 2003 and 2006, the Company vacated portions of its leased headquarter office facilities that expired in November 2009, incurring lease restructuring costs related to closing these facilities and entering into various subleases. During the three and six months ended June 30, 2009, the Company amortized $0.3 million and $0.6 million, respectively of accrued lease restructuring costs to operating expenses. The Company had no lease restructuring costs accrued at June 30, 2010 and December 31, 2009.

9. Capital Lease and Other Obligations

Capital lease and other obligations consist of the following at June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010				December 31, 2009
Capital lease obligations		$	2,502			$	2,838
Deferred rent			163				80
Total capital lease and other obligations			2,665				2,918
Less: current portion of capital lease obligations			(1,267	)			(1,272	)
Capital lease and other obligations, net of current portion		$	1,398			$	1,646

Capital Lease Obligations

City National Bank (CNB)

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. The lease expired on April 30, 2010, at which time the Company had drawn down approximately $4.9 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. 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 June 30, 2010.

The agreements with CNB, consisting of an outstanding standby letter of credit (“SBLC”) and a master equipment lease agreement, contain cross-default provisions, whereby a default under one is deemed a default for the other. As of June 30, 2010 and December 31, 2009, the Company was not in default on either agreement with CNB (see Note 10).

Cisco Systems Capital Corporation

In December 2009, the Company entered into an Agreement to Lease Equipment (“Lease Agreement”) with Cisco Systems Capital Corporation (“Cisco”), whereby the Company was to lease from Cisco certain hardware, software and maintenance services. The Lease Agreement provided for the lease of $0.8 million of hardware and software and $0.2 million of maintenance services over a period of three years. In connection with the Lease Agreement, the Company provided Cisco a SBLC for $0.2 million. As of December 31, 2009, $0.5 million of the equipment and software had been received and is included in property and equipment with an offsetting amount in accrued liabilities in the Condensed Consolidated Financial Statements. In March 2010, prior to the commencement of the lease, the Company and Cisco agreed to cancel the Lease Agreement, and the Company paid the vendor $1.0 million for the hardware, software and maintenance services. No additional costs will be incurred by the Company. The SBLC provided to Cisco for $0.2 million was released by Cisco and terminated in May 2010.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

10. Commitments and Contingencies

As of June 30, 2010, future minimum payments under all capital and operating leases are as follows (in thousands):

 

		CNB Capital Lease				Operating Leases			Total
Six months ending December 31, 2010		$	719			$	288		$	1,007
Years ending December 31,
2011			1,186				496			1,682
2012			617				517			1,134
2013			145				536			681
2014			—				557			557
Total minimum payments			2,667			$	2,394		$	5,061
Less: amount representing interest			(165	)
Present value of net minimum payments			2,502
Less: current portion			(1,267	)
Long-term portion of capital lease obligations		$	1,235

Operating Lease

On August 31, 2009, the Company entered into an agreement to sublease office space for its headquarters in San Francisco, California, under an operating lease that commenced in November 2009 and expires on December 30, 2014. In addition to scheduled base rent payments, the Company will also be responsible for varying amounts of operating and property tax expenses.

Letters of Credit

At June 30, 2010, the Company has an outstanding SBLC related to the security of a building lease for $0.3 million. At December 31, 2009, the Company had outstanding SBLCs related to the security of a building lease for $0.3 million and security on an equipment lease for $0.2 million. In March 2010, the equipment lease requiring the $0.2 million SBLC was cancelled and the SBLC was released by the vendor and terminated in May 2010. The remaining SBLC contains two financial covenants, with which the Company was in compliance as of June 30, 2010.

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 June 30, 2010 and December 31, 2009, the Company was not in default on either agreement with CNB (see Note 9).

Purchase Obligations

In October 2009, the Company entered into a Master Services Agreement and related Service Level Agreement for IT data center services for a two year term. The Company completed the transition to the new facility in May 2010. The contractual obligations under the agreement include non-recurring charges of $0.1 million and recurring charges of $0.9 million each year.

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.

Officer and Director Indemnification

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.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 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. 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. 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 remain as an accrued liability at June 30, 2010 and December 31, 2009. As of June 30, 2010, the Company has provided approximately $0.1 million of advertising credits to Class Members.

As of June 30, 2010 and December 31, 2009, the legal proceedings liability of $0.3 million is classified in accrued liabilities on the Company’s Unaudited Condensed Consolidated Balance Sheet (see Note 7).

 

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11. 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 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 seven or 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 4.6 million and 4.8 million shares of common stock at June 30, 2010 and December 31, 2009, respectively. There were 1.8 million shares available to be granted under the Plans at June 30, 2010.

Share-based compensation expense recorded during the three months ended June 30, 2010 and 2009 was included in the Company’s Unaudited Condensed Consolidated Statement of Operations as follows (in thousands):

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2010			2009			2010			2009
Sales and marketing		$	18		$	46		$	38		$	103
Product development and technical operations			77			137			183			271
General and administrative			68			332			111			658
Total share-based compensation expense			163			515			332			1,032
Amounts capitalized as software development costs			10			20			24			44
Total share-based compensation		$	173		$	535		$	356		$	1,076

Total unrecognized share-based compensation expense related to share-based compensation arrangements at June 30, 2010 was $1.0 million and is expected to be recognized over a weighted-average period of approximately 2.3 years. The total fair value of equity awards vested during the three and six months ended June 30, 2010 was $0.2 million and $0.4 million, respectively, and $0.5 million and $1.1 million during the three and six months ended June 30, 2009, respectively.

 

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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 six months ended June 30, 2010:

 

		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		328				1.22
Expired/forfeited		(937	)			3.55
Options outstanding at December 31, 2009		3,209				4.05
Granted		7				0.96
Expired/forfeited		(756	)			3.88
Options outstanding at March 31, 2010		2,460				3.90
Granted		512				0.96
Expired/forfeited		(176	)			4.58
Options outstanding at June 30, 2010		2,796			$	3.41		6.72		$	26
Vested and expected to vest at June 30, 2010		2,546			$	3.54		6.67		$	16
Exercisable at June 30, 2010		1,888			$	4.06		6.50		$	10

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 June 30, 2010:

 

		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)
$     0.91 - $     1.83		807		7.21		$1.67		213		$1.25
3.20 -         3.60		1,181		7.50		3.11		902		3.10
3.70 -         4.33		310		6.67		4.10		282		4.08
4.45 -       20.55		498		4.94		6.99		491		7.03
0.91 -       20.55		2,796		6.72		3.41		1,888		4.06

Stock Awards

No restricted stock was issued during the three months ended June 30, 2010. During the six months ended June 30, 2010, the Company issued 13 thousand shares of fully vested restricted stock, with a weighted average grant date fair value of $1.03 per share, under the Plan. During the three and six months ended June 30, 2009, the Company issued 10 thousand and 33 thousand shares, respectively, of fully vested restricted stock, with a weighted average grant date fair value of $1.33 and $1.11 per share, respectively, under the Plan.

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 six months ended June 30, 2009. As of June 8, 2009, when the 1999 ESPP expired, 490 thousand shares had been issued under the 1999 Plan.

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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, 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. Share-based compensation expense under the 2009 ESPP was not significant for the three and six months ended June 30, 2010. As of June 30, 2010, no shares have been issued under the 2009 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.

The assumptions used in the Black-Scholes option valuation model and the weighted average grant date fair value per share for employee stock options were as follows:

 

		Three Months Ended June 30,				Six Months Ended June 30,
		2010		2009		2010		2009
Volatility		63.8 - 66.0%		63.55%		61.9 - 66.0%		63.55% -65.03%
Risk-free interest rate		1.31 - 2.02%		2.31%		1.31 - 2.02%		1.55 - 2.31%
Expected term (years)		3.81 - 4.00		4.49		3.81 - 4.18		4.49 - 4.54
Expected dividend yield		—		—		—		—
Weighted average grant date fair value		$0.71		$0.78		$0.71		$0.73

As share-based compensation expense recognized in the Unaudited Condensed 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.

Exercise of Employee Stock Options and Purchase Plans

There were no options exercised in the three and six months ended June 30, 2010 and 2009. The Company issues new shares of common stock upon exercise of stock options. No income tax benefits have been realized from exercised stock options.

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

12. Fair Value Measurements

Fair Value of Financial Assets

The Company’s financial assets measured at fair value on a recurring basis subject to disclosure requirements at June 30, 2010 and December 31, 2009 were as follows (in thousands):

 

		Balance at June 30, 2010			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)
Cash equivalents:
Money market mutual funds		$	14		$	14		$	—
Certificates of deposit			1,000		$	1,000
Commercial paper			13,497			—			13,497
			14,511			1,014			13,497
Short-term investments:
Certificates of deposit			1,000			—			1,000
Total financial assets measured at fair value		$	15,511		$	1,014		$	14,497
		Balance at December 31, 2009			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)
Cash equivalents:
Money market mutual funds		$	10,074		$	10,074		$	—
Certificates of deposit			2,000			—			2,000
Commercial paper			6,399			—			6,399
			18,473			10,074			8,399
Short-term investments:
Corporate bonds			2,890			—			2,890
Certificates of deposit			490			—			490
Commercial paper			1,400						1,400
			4,780			—			4,780
Total financial assets measured at fair value		$	23,253		$	10,074		$	13,179

The Company had an insignificant level 3 investment at December 31, 2009. In February 2010, the level 3 investment, a warrant, expired unexercised.

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.

 

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LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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.

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 publicly 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 June 30, 2010 and December 31, 2009, 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

At June 30, 2010 and December 31, 2009, the Company had no non-financial assets to be measured at fair value on a non-recurring basis and subject to disclosure requirements.

13. Related Party Transactions

Jean-Yves Dexmier, as one of the Company’s Board of Directors members, was paid fees totaling $0.1 million and $0.2 million during the three and six month periods ended June 30, 2010, respectively, in connection with Dr. Dexmier’s services to the Company. In addition, the Company paid Dr. Dexmier $0.1 million and $0.2 million during the three and six months ended June 30, 2009, respectively, in connection with Dr. Dexmier’s services to the Company.

14. Net Income Per Share

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the periods presented (in thousands):

 

		Three Months Ended June 30,							Six Months Ended June 30,
		2010			2009				2010				2009
Numerator
Income (loss) from continuing operations		$	567		$	(1,416	)		$	(43	)		$	(3,565	)
Income from discontinued operations			85			130				178				239
Net income (loss)		$	652		$	(1,286	)		$	135			$	(3,326	)
Denominator
Weighted average shares used to compute basic EPS			17,157			17,102				17,151				17,089
Effect of dilutive securities:
Dilutive common stock equivalents			35			—				17				—
Weighted average shares used to compute diluted EPS			17,192			17,102				17,168				17,089
Net income per share - Basic
Income (loss) from continuing operations		$	0.04		$	(0.09	)		$	—			$	(0.20	)
Income from discontinued operations, net of tax		$	—		$	0.01			$	0.01			$	0.01
Net income (loss) per share		$	0.04		$	(0.08	)		$	0.01			$	(0.19	)
Net income per share - Diluted
Income (loss) from continuing operations		$	0.04		$	(0.09	)		$	—			$	(0.20	)
Income from discontinued operations, net of tax		$	—		$	0.01			$	0.01			$	0.01
Net income (loss) per share		$	0.04		$	(0.08	)		$	0.01			$	(0.19	)

For the three and six months ended June 30, 2010, potentially dilutive securities of approximately 2.5 million shares and 2.8 million shares, respectively, have not been considered in the computation of net income per share as the exercise prices of these options were greater than the average market price of common shares for the period.

15. Subsequent Events

On July 28, 2010, at the Annual Meeting of the Company, the shareholders approved a Board of Directors recommendation to amend the Company’s Certificate of Incorporation to reduce the authorized shares of common stock from 200,000,000 shares to 80,000,000 shares. The Company’s issued and outstanding shares will not be affected as a result of the decrease in authorized shares of Common Stock. The Certificate of Incorporation was amended on August 2, 2010.

 

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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, continued 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 maintain profitability, that we may be unable to 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 advertising customers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.

LookSmart operates in a large online search advertising ecosystem serving ads that target user queries on partner sites. We operate in the middle of this ecosystem, acquiring search queries from a variety of sources and matching them with the keywords of our search advertising customers. Our largest category of customers has been intermediaries, the majority of which purchase clicks to sell into the affiliate networks of the large search engine providers. Another category of customers are direct advertisers and their agencies whose objective is to obtain conversions or sales from the clicks, while others want unique page views. The last category of customers is self-service advertisers that sign-up online and pay by credit card.

LookSmart offers search advertising customers targeted, pay-per-click (PPC) search via a monitored search advertising distribution network using the Company’s “AdCenter” platform technology. The Company’s search advertising network includes publishers and search advertising customers, including intermediaries and direct advertising customers and their agencies as well as self-service customers in the United States and certain other countries. The Company’s application programming interface (“API”) allows search advertising customers 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.

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 publishers and portals to manage their advertiser relationships, distribution channels and accounts.

In the first quarter of 2008, 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. The Furl assets were accounted for under the guidance of Accounting Standards Codification (“ASC”) 360-10-40, Impairment or Disposal of Long-Lived Assets (“ASC 360-10-40”) as “assets held for sale” and a full impairment of these assets was recorded at December 31, 2008. In the first quarter of 2009, the Furl assets

 

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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 2). At June 30, 2010, 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 circumstance, 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 periods presented. Actual results may differ from those estimates.

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.

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. 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, and 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. Actual results could differ from those estimates.

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.

Fair Value of Financial Instruments

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.

 

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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 AdCenter Platform.

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 revenue. 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 platform technology. These license arrangements may include some or all of the following elements: revenue-sharing based on the publisher’s customers monthly revenue generated through the AdCenter application; upfront fees; minimum monthly 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 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. We will record an increase or reduction of the allowance for doubtful accounts if collection rates or economic conditions are more or less 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.

Concentrations, Credit Risk and Credit Risk Evaluation

Concentration of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash equivalents, investments, and accounts receivable. As of June 30, 2010 and December 31, 2009, we placed our cash equivalents and investments primarily through one financial institution, City National Bank, 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. We have not experienced any credit losses on these cash equivalents and investment accounts and do not believe we are 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. We perform ongoing credit evaluations of our customers and maintain allowances for estimated credit losses. We apply judgment as to our ability to collect outstanding receivables based primarily on our evaluation of the customer’s financial condition and past collection history and record a specific allowance. In addition, we record an allowance based on the length of time the receivables are past due. Historically, such losses have been within our expectations.

Revenue Concentrations

Our largest category of customers has been intermediaries, the majority of which purchase clicks to sell into the affiliate networks of the large search engine providers.

 

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We derive our revenue from two service offerings, or “products”: Advertiser Networks and Publisher Solutions. For the three and six months ended June 30, 2010, IAC Search and Media (“IAC”) accounted for 7% and 8%, respectively of net revenue, and 69% and 71%, respectively, of Publisher Solutions revenue. On May 19, 2009, Ask Sponsored Listings, a division of IAC, notified us that it did not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement (“the Agreement”), which provides for certain Publisher Solutions services, upon its expiration. The Agreement, as amended, was scheduled to expire by its terms on December 31, 2009. On December 22, 2009, we further amended the Agreement, effective December 1, 2009, to extend the term through March 31, 2010, and to allow IAC to extend the term in one-month intervals up to a maximum period of six months. On June 16, 2010, IAC notified us that, in accordance with the Sixth Addendum to the Agreement, it intends to extend the term of the Agreement on a monthly basis up to August 31, 2010.

Intangible Assets with Definite Lives

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 revenues 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 and internally developed software, 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 assets 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.

We tested our long-lived assets used in operations for impairment as of December 31, 2009 and determined they were not impaired.

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.

We exercise 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, which is generally 3 years. We expect to continue to invest in internally developed software and to capitalize such costs.

Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets as follows:

 

Computer equipment		3 to 4 years
Furniture and fixtures		5 to 7 years
Software		2 to 3 years

Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the lease term.

When assets are retired or otherwise disposed of, the cost and accumulated depreciation and amortization are removed from their respective accounts, and any gain or loss on such sale or disposal is reflected in operating expenses. Maintenance and repairs are charged to expense as incurred. Expenditures that substantially increase an asset’s useful life are capitalized.

Traffic Acquisition Costs

We enter into agreements of varying durations with our distribution network partners that display our listings ads on their sites in return for a percentage of the revenue-per-click that we receive when the ads are clicked on those partners’ sites.

We also enter 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 our revenue or based on a certain metric, such as number of searches or paid clicks, or a combination of the two.

 

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TAC expense is recorded in cost of revenue, and is based on a percentage of revenue.

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 in our Unaudited Condensed Consolidated Statement of Operations over the requisite service periods.

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.

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 the Unaudited Condensed Consolidated Statement of Cash Flows of the tax effects of employee share-based compensation awards.

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. 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.

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 Six Months Ended June 30, 2010

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

 

		Three Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change			% Change
Revenue		13,017			100.0	%		13,223			100.0	%		(206	)		(2	%)
Cost of revenue		7,525			57.8	%		7,990			60.4	%		(465	)		(6	%)
Gross profit		5,492			42.2	%		5,233			39.6	%		259			5	%
Operating expenses:
Sales and marketing		1,275			9.8	%		1,474			11.1	%		(199	)		(14	%)
Product development and technical operations		2,473			19.0	%		2,485			18.9	%		(12	)		(0	%)
General and administrative		1,197			9.2	%		2,303			17.4	%		(1,106	)		(48	%)
Restructuring charge		—			0.0	%		229			1.7	%		(229	)		(100	%)
Impairment charge		—			0.0	%		180			1.4	%		(180	)		(100	%)
Total operating expenses		4,945			38.0	%		6,671			50.5	%		(1,726	)		(26	%)
Income (loss) from operations		547			4.2	%		(1,438	)		(10.9	%)		1,985			(138	%)
Non-operating income, net		19			0.1	%		22			0.2	%		(3	)		(14	%)
Income (loss) from continuing operations before income taxes		566			4.3	%		(1,416	)		(10.7	%)		1,982			(140	%)
Income tax benefit		(1	)		0.0	%		—			0.0	%		(1	)		0	%
Income (loss) from continuing operations		567			4.3	%		(1,416	)		(10.7	%)		1,983			(140	%)
Income from discontinued operations, net of tax		85			0.7	%		130			1.0	%		(45	)		(35	%)
Net income (loss)		652			5.0	%		(1,286	)		(9.7	%)		1,938			(151	%)

 

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		Six Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change			% Change
Revenue		26,303			100.0	%		26,477			100.0	%		(174	)		(1	%)
Cost of revenue		16,561			63.0	%		16,092			60.8	%		469			3	%
Gross profit		9,742			37.0	%		10,385			39.2	%		(643	)		(6	%)
Operating expenses:
Sales and marketing		2,429			9.2	%		2,839			10.7	%		(410	)		(14	%)
Product development and technical operations		4,917			18.7	%		5,098			19.3	%		(181	)		(4	%)
General and administrative		2,436			9.3	%		5,672			21.4	%		(3,236	)		(57	%)
Restructuring charge		—			0.0	%		229			0.9	%		(229	)		(100	%)
Impairment charge		—			0.0	%		180			0.7	%		(180	)		(100	%)
Total operating expenses		9,782			37.2	%		14,018			53.0	%		(4,236	)		(30	%)
Loss from operations		(40	)		(0.2	%)		(3,633	)		(13.8	%)		3,593			(99	%)
Non-operating income, net		2			0.0	%		76			0.3	%		(74	)		(97	%)
Loss from continuing operations before income taxes		(38	)		(0.2	%)		(3,557	)		(13.5	%)		3,519			(99	%)
Income tax expense		5			0.0	%		8			0.0	%		(3	)		(38	%)
Loss from continuing operations		(43	)		(0.2	%)		(3,565	)		(13.5	%)		3,522			(99	%)
Income from discontinued operations, net of tax		178			0.7	%		239			0.9	%		(61	)		(26	%)
Net income (loss)		135			0.5	%		(3,326	)		(12.6	%)		3,461			(104	%)

Revenues

Revenue is derived from our two service offerings or “products”: Advertiser Networks and Publisher Solutions. Total revenue and revenue from Advertiser Networks and Publisher Solutions for the three and six months ended June 30, 2010 and 2009, were as follows (in thousands):

 

		Three Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Advertiser Networks		$	12,100		93	%		$	12,011		91	%		$	89			1	%
Publisher Solutions			917		7	%			1,212		9	%			(295	)		(24	%)
Total revenue		$	13,017		100	%		$	13,223		100	%		$	(206	)		(2	%)
		Six Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Advertiser Networks		$	24,533		93	%		$	24,026		91	%		$	507			2	%
Publisher Solutions			1,770		7	%			2,451		9	%			(681	)		(28	%)
Total revenue		$	26,303		100	%		$	26,477		100	%		$	(174	)		(1	%)

We recognized $13.0 million and $26.3 million of total revenue during the three and six months ended June 30, 2010, respectively. Total revenue for the three and six months ended June 30, 2010 was down 2% and 1%, respectively from the $13.2 million and $26.5 million recognized during the comparable three and six months ended June 30, 2009. Advertiser Network revenue increased 1% and 2%, to $12.1 million and $24.5 million, during the three and six months ended June 30, 2010, respectively, from the $12.0 million and $24.0 million recognized during the three and six months ended June 30, 2009, respectively. Revenue from Advertiser Networks increased by $0.1 million in the second quarter of 2010 and $0.5 million in the first half of 2010 compared to the same periods in 2009.

The Advertiser Networks saw a reduction in paid clicks for the three months and a growth for the six months ended June 30, 2010. Total paid clicks for the three months ended June 30, 2010 decreased 8% to 190 million compared to 207 million for the second quarter of 2009. During the same three month period, average RPC increased 10%, from $0.058 to $0.064. Total paid clicks increased 11% to 434 million, compared to 391 million for the six months ended June 30, 2009. The growth in the first half of 2010 was partially offset by a decrease in the average revenue-per-click (“RPC”) to $0.056 from $0.061 in the first half of 2009, an overall decrease of 9%.

We recognized Publisher Solutions revenue of $0.9 million during the three months ended June 30, 2010, a 24% decrease from the $1.2 million recognized during the three months ended June 30, 2009. For the six months ended June 30, 2010, we recognized $1.8 million of Publisher Solutions revenue, a decrease of 28%, or approximately $0.7 million, from the $2.5 million recognized during the

 

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six months ended June 30, 2009. The decrease in Publisher Solutions revenue for the second quarter and first half of 2010 as compared to the same periods in 2009 is attributed to reduced revenue from IAC Search and Media, Inc. (“IAC”). IAC represented $0.6 million, or 69% of Publisher Solutions revenue during the three months ended June 30, 2010, compared to the $1.0 million, or 79%, during the three months ended June 30, 2009. IAC represented $1.3 million, or 71%, of Publisher Solutions revenue during the first half of 2010 compared to $2.1 million, or 84%, during the first half of 2009.

We continue to be dependent upon a few customers for a significant percentage of our revenue. For the three months ended June 30, 2010 and 2009, two customers combined to account for 22% and 28% of revenue, respectively. For the six months ended June 30, 2010 and 2009, three and two customers accounted for a combined 33% and 29% of revenue, respectively. One of the two customers, IAC, notified us in May 2009 that it did not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services, upon expiration on December 31, 2009. On December 22, 2009, prior to the expiration date, IAC and the Company signed a Sixth Addendum (“Addendum”) to the May 2005 AdCenter License, Hosting and Support Agreement (the “Agreement”). The Addendum became effective December 1, 2009 and, among other things, extended the term of the Agreement through August 31, 2010. In addition, the Addendum allows IAC to extend the term in one-month intervals up to a maximum period of six months. On June 16, 2010, IAC notified the Company that, in accordance with the Addendum, it intends to extend the term of the Agreement on a monthly basis up to August 31, 2010.

Advertiser Network revenue derived from IAC, which is covered under separate distribution agreements, was $0.3 million and $0.8 million during the three and six months ended June 30, 2010, respectively, down 78% and 72% from the $1.3 million and $2.9 million recognized during the same period in 2009. IAC has not indicated to us intent to terminate these separate distribution agreements.

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 six months ended June 30, 2010 and 2009 (in thousands):

 

		Three Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Traffic acquisition costs		$	7,034		54	%		$	7,458		56	%		$	(424	)		(6	%)
Other costs			491		4	%			532		4	%			(41	)		(8	%)
Total cost of revenue		$	7,525		58	%		$	7,990		60	%		$	(465	)		(6	%)
Traffic acquisition costs as percentage of Advertiser Network revenue					58.1	%					62.1	%
		Six Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Traffic acquisition costs		$	15,424		59	%		$	15,045		57	%		$	379			3	%
Other costs			1,137		4	%			1,047		4	%			90			9	%
Total cost of revenue		$	16,561		63	%		$	16,092		61	%		$	469			3	%
Traffic acquisition costs as percentage of Advertiser Network revenue					62.9	%					62.6	%

Our total cost of revenue during the three months ended June 30, 2010 was $7.5 million, lower by $0.5 million, or 6% from the $8.0 million in the three months ended June 30, 2009. Total cost of revenue during the six months ended June 30, 2010 was $16.6 million, up $0.5 million, or 3% from the $16.1 million in the six months ended June 30, 2009.

Our TAC during the three months ended June 30, 2010 was $7.0 million, lower by $0.4 million, or 6% from the $7.5 million in the three months ended June 30, 2009. TAC for the first six months of 2010 was $15.4 million, up 3%, or $0.4 million, from the $15.0 million in the first six months of 2009. As a percentage of Advertising Network revenue, TAC for the three months ended June 30, 2010, was 58% compared to TAC of 62% during the same period in 2009. For the six months ended June 30, 2010 and 2009, TAC was at 63%. The increased TAC percentage during first half of 2010 was related to our continued focus on improving the quality of our traffic to better serve certain advertising customers on our Advertiser Network through optimizing bids/prices paid for different sources of traffic and keywords.

 

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

Our other costs of revenue, which consists primarily of co-location costs and credit card processing fees, increased 9% or $0.1 million in the six months ended June 30, 2010 in comparison to the same period of 2009, primarily due to duplicate costs incurred during our move of co-location facilities. The relocation to the new co-location facility was successfully completed in May 2010.

Gross profit for the three months ended June 30, 2010, increased 2 percentage points to 42% from the 40% achieved in the three months ended June 30, 2009. The gross profit of 37% for the six months ended June 30, 2010 declined 2 percentage points from the 39% achieved in the six months June 30, 2009. The increase in gross profit for the three months ended June 30, 2010 is primarily the result of decreasing TAC.

Operating Expenses

Operating expenses consist of the following (in thousands):

 

		Three Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Sales and marketing		$	1,275		10	%		$	1,474		11	%		$	(199	)		(14	%)
Product development and technical operations			2,473		19	%			2,485		19	%			(12	)		(0	%)
General and administrative			1,197		9	%			2,303		17	%			(1,106	)		(48	%)
Restructuring charge			—		0	%			229		2	%			(229	)		(100	%)
Impairment charge			—		0	%			180		1	%			(180	)		(100	%)
Total operating expenses		$	4,945		38	%		$	6,671		50	%		$	(1,726	)		(26	%)
		Six Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Sales and marketing		$	2,429		9	%		$	2,839		11	%		$	(410	)		(14	%)
Product development and technical operations			4,917		19	%			5,098		19	%			(181	)		(4	%)
General and administrative			2,436		9	%			5,672		21	%			(3,236	)		(57	%)
Restructuring charge			—		0	%			229		1	%			(229	)		(100	%)
Impairment charge			—		0	%			180		1	%			(180	)		(100	%)
Total operating expenses		$	9,782		37	%		$	14,018		53	%		$	(3,827	)		(27	%)

Share-based compensation expense was allocated as follows (in thousands):

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2010			2009			2010			2009
Sales and marketing		$	18		$	46		$	38		$	103
Product development and technical operations			77			137			183			271
General and administrative			68			332			111			658
Total share-based compensation expense			163			515			332			1,032
Amounts capitalized as software development costs			10			20			24			44
Total share-based compensation		$	173		$	535		$	356		$	1,076

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.

 

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Our sales and marketing expenses during the three months ended June 30, 2010, were $1.3 million, down 14% from $1.5 million in the same period of 2009. Sales and marketing expenses in the first half of 2010 decreased $0.4 million compared to the first half of 2009. The reduction in sales and marketing expenses for both the three and six month period ended June 30, 2010 is primarily due to lower compensation related expense associated with lower headcount and lower severance costs, together with lower facilities costs attributed to our new headquarters, which was partially offset by higher commissions paid to a third party sales representative in the United Kingdom. The agreement with the third party was terminated in May 2010.

Product Development and Technical Operations

Product development and technical operations expense includes all costs related to the continued operations, development and enhancement of 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 and technical operations functions are also included in product development and technical operations expense.

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

Product development and technical operations and capitalized software development costs were as follows for each of the three and six months ended June 30, 2010 and 2009 (in thousands):

 

		Three Months Ended June 30,
		2010				% of Revenue			2009				% of Revenue			Dollar Change				% Change
Product development and technical operations costs		$	2,660			20	%		$	2,794			21	%		$	(134	)		(5	%)
Capitalized software development costs			(187	)		(1	%)			(309	)		(2	%)			122			(39	%)
Total product development and technical operations expense		$	2,473			19	%		$	2,485			19	%		$	(12	)		(0	%)
		Six Months Ended June 30,
		2010				% of Revenue			2009				% of Revenue			Dollar Change				% Change
Product development and technical operations costs		$	5,293			20	%		$	5,781			22	%		$	(488	)		(8	%)
Capitalized software development costs			(376	)		(1	%)			(683	)		(3	%)			307			(45	%)
Total product development and technical operations expense		$	4,917			19	%		$	5,098			19	%		$	(181	)		(4	%)

Our product development and technical operations expense, net of capitalized software development costs, during the three months ended June 30, 2010, was $2.5 million, consistent with the $2.5 million for the three months ended June 30, 2009. Product development and technical operations expense, net of capitalized software development costs, for the first half of 2010 decreased $0.2 million compared to the comparable period in 2009 primarily due to lower facilities costs attributed to our new headquarters and lower compensation related expenses associated with lower headcount, which was primarily offset by lower capitalized software development and increased severance costs.

General and Administrative

General and administrative expenses include costs of executive management, human resources, finance, 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 June 30, 2010, were $1.2 million, down 48% from $2.3 million for the three months ended June 30, 2009. General and administrative expenses in first half of 2010 decreased $3.2 million to $2.4 million compared to $5.7 million in the first half of 2009. The reduction is due to lower staffing related and temporary help costs, including share-based compensation, of $1.6 million and $1.0 million of expenses in the first half of 2009 related to the evaluation of strategic growth alternatives that did not recur in the first half of 2010, combined with lower facilities costs attributed to our new headquarters and reduced legal and audit expenses.

 

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Income (Loss) from Operations

The table below sets forth income (loss) from operations for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

		Three Months Ended June 30,
		2010				% of Revenue			2009				% of Revenue			Dollar Change			% Change
Income (loss) from operations		$	547			4	%		$	(1,438	)		(11	%)		$	1,985		(138	%)
		Six Months Ended June 30,
		2010				% of Revenue			2009				% of Revenue			Dollar Change			% Change
Income (loss) from operations		$	(40	)		0	%		$	(3,633	)		(14	%)		$	3,593		(99	%)

Our income from operations for the three months ended June 30, 2010, was $0.5 million and our loss for the six months ended June 30, 2010 was $40 thousand, which represented an improvement of $2 million and $3.6 million from the respective losses of $1.4 million and $3.6 million for the three and six months ended June 30, 2009. Results of operations for the three and six months ended June 30, 2010, were due to the factors discussed above, including but not limited to, lower TAC and operating expenses in the first half of 2010, as compared to the first half of 2009.

Other Continuing Operations Items

The table below sets forth other continuing operations data for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

		Three Months Ended June 30,
		2010				% of Revenue			2009				% of Revenue			Dollar Change				% Change
Non-operating income, net
Interest income		$	16			0	%		$	63			0	%		$	(47	)		(75	%)
Interest expense			(41	)		0	%			(41	)		0	%			—			0	%
Other income, net			44			0	%			—			0	%			44			0	%
Total non-operating income, net		$	19			0	%		$	22			0	%		$	(3	)		(14	%)
Income tax expense		$	(1	)		0	%		$	—			0	%		$	(1	)		0	%
		Six Months Ended June 30,
		2010				% of Revenue			2009				% of Revenue			Dollar Change				% Change
Non-operating income, net
Interest income		$	33			0	%		$	155			1	%		$	(122	)		(79	%)
Interest expense			(83	)		0	%			(79	)		0	%			(4	)		5	%
Other income, net			52			0	%			—			0	%			52
Total non-operating income, net		$	2			0	%		$	76			1	%		$	(74	)		(97	%)
Income tax expense		$	5			0	%		$	8			0	%		$	(3	)		(38	%)

Interest Income and Expense

Interest income, which includes income from our cash, cash equivalents and investments, decreased an insignificant amount and $0.1 million in the three and six months ended June 30, 2010, respectively, compared to the three and six months ended June 30, 2009. This decrease was primarily driven by a decrease in average cash and investment balance during the same periods, combined with an insignificant increase in average yields earned on cash and investment balances for the three months ended June 30, 2010 and a decrease in average yields earned on cash and investment balances for the six months ended June 30, 2010.

Interest expense, primarily consisting of interest paid on capital leases, remained consistent during the second quarter of 2010, compared to the same period in 2009. Interest expense increased an insignificant amount in the six months ended June 30, 2010 from the six months ended June 30, 2009.

 

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Income Tax Expense

Due to our utilizable net operating losses and other tax attributes, our income tax expense primarily consists of minimum state taxes.

Income from Discontinued Operations, Net of Tax

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 its remaining consumer assets. The various remaining related websites and assets associated with the consumer products activities 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.

Income from discontinued operations, net of tax, for the three and six months ended June 30, 2010 and 2009 was as follows (in thousands):

 

		Three Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Income from discontinued operations, net of tax		$	85		1	%		$	130		1	%		$	(45	)		(35	%)
		Six Months Ended June 30,
		2010			% of Revenue			2009			% of Revenue			Dollar Change				% Change
Income from discontinued operations, net of tax		$	178		1	%		$	239		1	%		$	(61	)		(26	%)

The following table reflects revenue, gross profit, operating expenses, gain on disposal, and net income from discontinued operations for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2010			2009			2010			2009
Revenue		$	—		$	—		$	—		$	8
Gross profit		$	—		$	—		$	—		$	8
Total operating expenses:
Product development and technical operations expense			—			3			—			39
Gain on disposal			85			133			178			270
Net income from discontinued operations		$	85		$	130		$	178		$	239

As a result of our decision in early 2008 to dispose of its consumer assets, the Furl assets, consisting of property and equipment, capitalized software, goodwill and intangibles were accounted for as “assets held for sale.” Later in 2008, we determined that the Furl assets were impaired and recognized an impairment charge of $1.4 million. In February 2009, we 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). We determined the warrants received had no significant value and did not record a gain on the disposal. The warrant expired unexercised in February 2010.

In January 2007, we 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. We recorded contingent purchase consideration of $0.1 million for each of the three month periods ended June 30, 2010 and 2009 and $0.2 million and $0.3 million for the six months ended June 30, 2010 and 2009, respectively. Under the terms of the Content Watch agreement, the contingent purchase consideration will end in the fourth quarter of 2010. Contingent purchase consideration has been classified as gain on disposal.

During 2008, we sold the Wisenut trademark and related domain names. As of June 30, 2010 and December 31, 2009, we continue to own the Wisenut search engine technology and its intellectual property rights in such technology and other assets.

 

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Liquidity and Capital Resources

Cash flows were as follows (in thousands):

 

		Six Months Ended June 30,
		2010				2009				Change
Net cash provided by (used) in operating activities		$	78			$	(1,983	)		$	2,061
Net cash provided by investing activities			2,146				3,685				(1,539	)
Net cash used in financing activities			(700	)			(496	)			(204	)
Increase in cash and cash equivalents		$	1,524			$	1,206			$	318

Cash, cash equivalents and short-term investment balances were as follows as of June 30, 2010 and December 31, 2009 (in thousands):

 

		June 30, 2010				December 31, 2009				Change
Cash and cash equivalents		$	24,457			$	22,933			$	1,524
Short-term investments			1,000				4,780				(3,780	)
Total		$	25,457			$	27,713			$	(2,256	)
% of total assets			69	%			72	%
Total assets		$	37,005			$	38,347

At June 30, 2010, we had $25.4 million of cash, cash equivalents and short-term investments. Cash equivalents and short-term investments are comprised of 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 $2.3 million to $25.4 million at June 30, 2010, from $27.7 million at December 31, 2009, primarily due to the increased accounts receivable and payment of capital lease obligations.

Our primary sources of liquidity are our cash, cash equivalents and short-term investments, the cash flow that we generate from our operations. We believe that our existing cash, cash equivalents, short-term investments 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 a decrease in demand for our services beyond the current quarter if the IAC AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services, and changes in customer buying behavior is not renewed beyond August 2010. In addition, our liquidity could be negatively affected if we are in default under our credit facilities and are required to pay the lenders cash in an amount equal to the capital lease balance, or are required to identify restricted cash equal to the capital lease balance, plus an outstanding standby letter 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 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. Through December 31, 2009, this change resulted in a decrease in deferred revenue as those customers with prepaid balances used those funds in their account, and adversely affected our cash flow by $0.5 million as customer deferred balances were used up and new unpaid charges accumulated. The adverse cash flow affect of launching post-pay was substantially complete as of December 31, 2009.

Operating Activities

Cash provided by operating activities in the six months ended June 30, 2010, consisted of our net income adjusted for certain non-cash items, including depreciation, amortization, share-based compensation expense, as well as the effect of changes in working capital and other activities. Cash provided by operations in the first half of 2010 was $0.1 million and consisted of a net income of $0.1 million, adjustments for non-cash items of $1.5 million and cash used by working capital and other activities of $1.6 million. Adjustments for non-cash items primarily consisted of $1.4 million of depreciation and amortization expense on property and equipment and internally

 

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developed software and $0.3 million of share-based compensation expense, partially offset by a $0.2 million gain on sale of assets. In addition, changes in working capital activities primarily consisted of a net increase of $0.9 million in accounts receivable and a $0.6 million decrease in accounts payable and accrued liabilities. The increase in account receivable is primarily attributed to an increase in invoiced customer revenue. The decrease in accounts payable and accrued liabilities was primarily due to the timing of vendor payments.

Cash used by operating activities in the six months ended June 30, 2009, consisted of our net loss adjusted for certain non-cash items, including depreciation, amortization, share-based compensation expense, impairment charge, as well as the effect of changes in working capital and other activities. Cash used in operations in the first half of 2009 was $2.0 million and consisted of a net loss of $3.3 million, adjustments for non-cash items of $2.4 million and cash used by working capital and other activities of $1.1 million. Adjustments for non-cash items primarily consisted of $1.5 million of depreciation and amortization expense on property and equipment, intangible assets and internally developed software, $1.0 million of share-based compensation expense, and a $0.2 impairment charge. In addition, changes in working capital activities primarily consisted of a net decrease of $3.2 million in accounts payable and accrued and other current liabilities partially offset by a $2.1 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.

Investing Activities

Cash provided by investing activities in the first half of 2010 of $2.1 million was primarily attributed to $3.8 million of net proceeds from investments, partially offset by $1.9 of capital expenditures. Capital expenditures for the first half of 2010 consisted of $0.8 million for equipment received in 2009, for which a liability was accrued in 2009, $0.7 million for equipment acquired during the first half of 2010, and an investment of $0.4 million in internally developed software related to our AdCenter platform technology.

Cash provided by investing activities in the first half of 2009 of $3.7 million was attributed to net proceeds from investments of $4.1 million and $0.3 million of proceeds related to the sale of certain consumer assets, partially offset by $0.7 million for capital expenditures. Our first half of 2009 capital expenditures consisted of an investment of $0.6 million in internally developed software related to our AdCenter platform technology. During the six months ended June 30, 2009, most of our $0.6 million investment in computer equipment was financed with capital leases.

Financing Activities

Cash used by financing activities of $0.7 million and $0.5 million in the first half of 2010 and 2009, respectively, is attributed to scheduled capital lease and note payable payments.

Credit Arrangements

We have an outstanding standby letter of credit (“SBLC”) issued by City National Bank (“CNB”) of approximately $0.3 million at June 30, 2010, related to security of a building lease.

On April 30, 2010, our master equipment lease agreement with CNB of $5.0 million expired. As of June 30, 2010, we had drawn down approximately $4.9 million of the available lease line of credit. 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 June 30, 2010.

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 June 30, 2010, we are in compliance with both agreements with CNB.

In December 2009, we entered into an Agreement to Lease Equipment (“Lease Agreement”) with Cisco Systems Capital Corporation (“Cisco”), whereby we were to lease from Cisco certain hardware, software and maintenance services. The Lease Agreement provided for the lease of $0.8 million of hardware and software and $0.2 million of maintenance services over a period of three years. In connection with the Lease Agreement, we provided Cisco a SBLC for $0.2 million. As of December 31, 2009, $0.5 million of the equipment and software had been received and is included in property and equipment with an offsetting amount in accrued liabilities in the Condensed Consolidated Financial Statements. In March 2010, we decided, and Cisco agreed, to cancel the Lease Agreement, and we paid the vendor $1.0 million for the hardware, software and maintenance services. No additional costs will be incurred by the Company. The SBLC provided to Cisco for $0.2 million was released by Cisco and terminated in May 2010.

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.

 

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ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable for smaller reporting companies.

 

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 13a-15(e) and 15d-15(e) 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 June 30, 2010, there were no material weaknesses identified in the design and operation of our internal controls.

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.

 

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PART II

 

ITEM 1.

LEGAL PROCEEDINGS

None.

 

ITEM 1A.

RISK FACTORS

We have updated our risk factors regarding our revenue concentration, operating profitability/losses, concentrations of search advertisers and distribution network partners, downward pressure on our match rate and/or revenue-per-click, upgrading products and services and adapting to our rapidly changing environment, credit facilities, compliance with NASDAQ listing requirements, any failure in the performance of our key production systems, dependence on internet service providers and third party technology providers, and current economic conditions set forth below, and included a risk factor regarding international sales. 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, 2009.

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 advertising accounted for substantially all of our revenues for the year ended December 31, 2009 and six months ended June 30, 2010. Our success depends upon search advertising customers choosing to use, and distribution network partners choosing to distribute, our search advertising networks products. Search advertising customers 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 has been concentrated with one customer, IAC Search and Media (“IAC”), accounting for 16% of net revenue and 81% of Publisher Solutions revenue for the year ended December 31, 2009, and 8% of net revenue and 71% of Publisher Solutions revenue for the six months ended June 30, 2010. IAC notified us in May 2009 that it did not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement (the “Agreement”), which provides for certain Publisher Solutions services, upon expiration on December 31, 2009. On December 22, 2009, we amended the Agreement, effective December 1, 2009, to extend the term through March 31, 2010, and to allow IAC to extend the term in one-month intervals up to a maximum period of six months. On June 16, 2010, IAC notified the Company that, in accordance with the Sixth Addendum to the Agreement, it intends to extend the term of the Agreement on a monthly basis up to August 31, 2010. Advertiser Network revenue derived from IAC, which is covered under separate distribution agreements, totaled $4.9 million, or 10%, for the year ended December 31, 2009, and $0.8 million, or 3%, for the six months ended June 30, 2010. IAC has not indicated to us intent to terminate these separate distribution agreements. 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.

Our largest category of customers are intermediaries, the majority of whom purchase clicks to sell into the affiliate networks of large search engine providers; changes in the purchasing patterns of these search engine providers could adversely affect our business and results of operations

We operate in a large online search advertising ecosystem serving ads that target user queries on partner sites. We operate in the middle of this ecosystem, acquiring search queries from a variety of sources and matching them with the keywords of our search advertising customers. Our largest category of customers are intermediaries, the majority of which purchase clicks to sell into the affiliate networks of large search engine providers. If these large search engine providers cease purchasing clicks from these intermediary customers, the intermediary customers could reduce the amount of clicks they purchase from us, or cease altogether purchasing clicks from us, and that could have a material adverse effect on our business and results of operations.

Our Future Success Depends on Sales to, and the Management of International Customers

A growing portion of our revenue is derived from sales to international customers. Sales to non-U.S. customers accounted for approximately 38% of our revenue for the six months ended June 30, 2010, as compared to 13% in the six months ended June 30, 2009.

 

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Managing our growing group of customers outside the U.S. presents various challenges, including, but not limited to:

 

•

economic and political conditions;

 

•

longer payment cycles;

 

•

differences in the enforcement of intellectual property and contract rights in varying jurisdictions;

 

•

our ability to develop relationships with local accounts;

 

•

compliance with U.S. and international laws and regulations;

 

•

fluctuations in foreign currency exchange rates; and

 

•

our ability to secure and retain qualified people for the operation of our business.

To date, foreign exchange exposure from sales has not been material to our operations. Our activities with customers outside the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment, including the Foreign Corrupt Practices Act and local laws prohibiting corrupt payments. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States, which increases the risk of unauthorized use of our technologies. Our business could be materially adversely affected if foreign markets do not continue to develop, if we do not maintain the relationship with our third party representatives, if we do not receive additional traffic suitable for our foreign accounts or if regulations governing our international businesses change.

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 has been concentrated, with the one and four largest distribution network partners accounting for approximately 26% and 48% of our Advertiser Networks revenue for the six months ended June 30, 2010 and the year ended December 31, 2009, respectively. 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 an operating profit in the second quarter of 2010, but have generated significant losses in the past and may be unable to maintain operating profitability in the future. Failure to maintain operating profitability could result in a decline in our stock price

We had net income of approximately $0.7 million and $0.1 million for the three and six months ended June 30, 2010, respectively, and as of June 30, 2010, our accumulated deficit was approximately $234.9 million. We may be unable to 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 advertising customers spend on our advertising network, expand our advertiser base 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.

 

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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 may 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 a change in customer mix, the erosion of our advertiser base, the reduction in average advertiser spend, the reduction in the number of listings purchased by search advertising customers, the reduction of bids on keywords, 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 search advertising customer base; if our search advertising customer base and average search advertising customer spend falls, our financial results will suffer

Our growth depends on our ability to build a search advertising customer 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 advertising customers may view these changes to the distribution network negatively, and existing or potential search advertising customers 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 continues to evolve 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. For example, certain performance measurement tools for referring websites have recently been employed by a small group of our customers. These tools only count clicks from certain recognized referring sites and do not count clicks from some of our distribution partners, resulting in lower paid clicks. In addition, 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 advertising customers on the basis of the quality and composition of our network, the price-per-click (“PPC”) charged to search advertising customers, the volume of clicks that we can deliver to search advertising customers, 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 advertising customers. 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, may make acquisitions of or significant investments in, complementary companies or technologies to increase our technological capabilities expand our service offerings, or extend the operating scale of our network businesses. The pursuit of acquisitions, whether or not completed, as well as the completion of any 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.

 

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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. In recent years, we have experienced significant restructurings and turnover in our management team that has placed additional burdens on our remaining personnel. Over the past ten months, our General Counsel, Chief Executive Officer and Vice President and General Manager, Advertising Platforms have all left the Company. We cannot insure 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 service 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 obtain new credit facilities may adversely affect the way we conduct our business

On April 30, 2010, our bank lease line expired. We may need to enter into additional credit facilities in the future to operate the business. The recent global financial crisis, further financial institution failures, as well as our history of operating losses, may make it more difficult for us to 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 standby letter of credit (“SBLC”) 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.

 

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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. These and other economic factors could have a material adverse effect on demand for the Company’s products and services and on the Company’s financial condition and operating results.

Cyclical and seasonal fluctuations in the economy, in internet usage and in traditional retail shopping may have an effect on our business

Both cyclical and seasonal fluctuations in internet usage and traditional retail seasonality may 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 may 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 search advertising customers’ 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 search advertising customer 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 advertising customers may experience a reduced return on their investment in our online advertising because the invalid clicks will not lead to conversions for the search advertising customers. This could lead the search advertisers to become dissatisfied with our products, which could lead to loss of search advertising customers and revenue and could materially and adversely affect our financial results.

Any failure in the performance of our key production 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 data center 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 facilities for our San Francisco, California headquarters, where the majority of our employees reside. We completed the transition of our data center to a new location in Sacramento, California in May 2010. 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.

 

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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 distribution network partners and search advertising 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 currently have an agreement with Raging Wire Enterprise Solutions, Inc. (“Raging Wire”) to house equipment for web serving and networking and to provide network connectivity services. We terminated our relationship with Savvis and completed our relocation of equipment in May 2010. 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 Raging Wire to protect the systems in their data centers from system failures, earthquake, fire, power loss, water damage, telecommunications failure, hackers, vandalism and similar events. Raging Wire does not guarantee that our Internet access will be uninterrupted, error-free or secure. 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.

 

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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.

In addition, 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, along with some of our distribution network partners or search advertising customers 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 advertising customers 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

 

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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 advertising customers 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 securities may be delisted

The NASDAQ Stock Market requires us to satisfy certain continued listing requirements, including maintaining a minimum closing bid price for our common stock of at least $1.00 per share. On March 9, 2010, NASDAQ sent us a letter stating that we were out of compliance with that requirement and that we had until September 7, 2010, to regain compliance by having our common stock close at or above the $1.00 per share minimum closing bid price for 10 consecutive trading days. On April 26, 2010, we received a letter from NASDAQ stating that we had regained compliance with the minimum closing bid price requirement and that the matter was closed. However, should our stock price again close under the $1.00 per share minimum closing bid price for 30 consecutive days, we could again be deemed out of compliance with the minimum closing bid price requirement and be forced to consider various actions to regain compliance, including a reverse stock split of our common stock. No assurance can be given that we will remain in compliance with all of the NASDAQ Stock Market’s continued listing requirements. If delisting were to occur, our securities will not enjoy the same liquidity as shares that are traded on the NASDAQ Stock Market or a national U.S. securities exchange and investors may find that it is more difficult to obtain accurate and timely quotations. As a result, the price of our securities would likely decline.

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 advertising customers who do business with us, or the amount of spending per customer,

 

•

the revenue-per-click we receive from search advertising customers, 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.

 

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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 long-lived assets may be subject to greater risk of impairment if we undergo a change of control limiting the use of our net operating losses

As of December 31, 2009, we had net operating losses (NOLs) amounting to approximately $175 million for federal income tax purposes. We can utilize these NOLs in certain circumstances to offset future U.S. taxable income and reduce our U.S. federal income tax liability, which may arise even in periods when we incur an accounting loss for reporting purposes. We also include these NOL benefits in the calculation associated with testing for impairment of our long-lived assets. However, our ability to utilize our NOLs for these purposes would be substantially limited if there were an “ownership change” as defined under Section 382 of the Internal Revenue Code. In general, an ownership change would occur if certain ownership changes related to our stock held by 5% or greater shareholders exceeded 50%, measured over a rolling three year period beginning with the last ownership change. These provisions can be triggered not only by merger and acquisition activity, but also by stock repurchases and normal market trading of our common stock. While we have not undergone a change of control under Section 382 since 2003, we were close to the threshold in 2008 and 2009, and no assurance can be given that such a change of control will not occur in the future. Should we undergo such a change of control, our ability to utilize our NOLs to offset future U.S. taxable income and reduce our U.S. federal income tax liability may be limited in certain circumstances. This, in turn, would affect our ability to utilize the NOLs in the calculations associated with testing for impairment of our long-lived assets used in operations, which could result in an increased likelihood of such impairment.

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.

 

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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. Although we invest in short-term, highly liquid debt instruments of the U.S. government, commercial paper, time deposits, money market mutual funds and U.S. corporate securities, similar events in the future 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.

REMOVED AND RESERVED

 

ITEM 5.

OTHER INFORMATION

None.

 

ITEM 6.

EXHIBITS

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

 

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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: August 5, 2010

 

By:		/S/    STEPHEN C. MARKOWSKI
		Stephen C. Markowski
		Chief Financial Officer

 

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EXHIBIT INDEX

Exhibits

 

Number		Description of Document
3.1		Restated Certificate of Incorporation (Filed with the Company’s Quarterly Report on Form 10-Q (File No. 000-26357) filed with the SEC on November 14, 2005).
3.2		Bylaws (Filed with the Company’s Quarterly Report on Form 10-Q (File No. 000-26357) filed with the SEC on August 14, 2000).
4.1		Form of Specimen Stock Certificate (Filed with the Company’s Quarterly Report on Form 10-Q (File No. 000-26357) 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 (File No. 000-26357) 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 (File No. 000-26357) filed with the SEC on May 10, 2006).
4.4++		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 (File No. 000-26357) filed with the SEC on March 2, 2007).
10.47*		Paid Listings License Agreement between the Registrant and Kontera Technologies, Inc. dated July 17, 2006.
10.78*		Paid Listings Agreement between the Registrant and Parked.com dated March 13, 2008.
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

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

 

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