10-K 1 form10k.htm LOOKSMART LTD 10-K 12-31-2012 form10k.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-K
 

(Mark One)
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012
 
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.)
 
555 California Street, Suite 324
San Francisco, California 94104
(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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
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  ¨ (Do not check if a smaller reporting company)
Smaller Reporting Company  x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing price of common stock on the last business day of the most recently completed second fiscal quarter, June 30, 2012, was approximately $12,624,063. Shares of voting stock held by each executive officer and director have been excluded from this calculation. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of March 22, 2013, 17,308,059 shares of the registrant’s common stock were outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
None.
 


 
 

 
 

 
   
Page No.
     
 
PART I
 
     
ITEM 1.
4
     
ITEM 1A.
7
     
ITEM 1B.
15
     
ITEM 2.
15
     
ITEM 3.
15
     
ITEM 4.
15
     
 
PART II
 
     
ITEM 5.
15
     
ITEM 6.
17
     
ITEM 7.
17
     
ITEM 7A.
28
     
ITEM 8.
29
     
ITEM 9.
50
 
   
ITEM 9A
50
     
ITEM 9B.
51
     
 
PART III
 
     
ITEM 10.
51
     
ITEM 11.
51
     
ITEM 12.
51
     
ITEM 13.
51
     
ITEM 14.
52
     
 
PART IV
 
     
ITEM 15.
52
     
 
53-54
     
 
55
 
 
PART I
 
 
·
This Annual Report on Form 10-K 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 “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 “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other sections of the report.
 
 
·
All forward-looking statements, including but not limited to, projections, expectations or estimates concerning our business, including demand for our products and services, mix of revenue sources, ability to control and/or reduce operating expenses, anticipated gross margins and operating results, cost savings, product development efforts, general outlook of our business and industry, future profits or losses, competitive position, share-based compensation, and adequate liquidity to fund our operations and meet our other cash requirements, are inherently uncertain as they are based on our expectations and assumptions concerning future events.
 
 
·
These forward-looking statements are subject to numerous known and unknown risks and uncertainties.
 
 
·
You should not place undue reliance on these forward-looking statements.
 
 
·
Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including but not limited to,
 
 
o
the possibility that we may fail to preserve our expertise in search advertising network product development,
 
 
o
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,
 
 
o
that seasonal fluctuations in internet usage and traditional advertising seasonality are likely to affect our business,
 
 
o
that we may be unable to maintain or grow sources of revenue,
 
 
o
that changes in the distribution network composition may lead to decreases in query volumes,
 
 
o
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,
 
 
o
that we may be unable to attain and maintain profitability,
 
 
o
that we may be unable to attract and retain key personnel,
 
 
o
that we may not be able to effectively manage, or to increase, our relationships with international customers,
 
 
o
that we may have unexpected increases in costs and expenses, or
 
 
o
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.
 
 
ITEM 1.
 
Overview
 
LookSmart, Ltd. (“LookSmart” or the “Company”) is a search and display advertising network solutions company that provides relevant solutions for search and display advertising customers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.
 
LookSmart operates in a large online advertising ecosystem serving ads that target user queries on partner sites.
 
LookSmart offers search advertising customers targeted 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.
 
LookSmart also offers advertisers the ability to buy graphical display advertising. LookSmart’s trading desk personnel utilize DSP technology and licensed data from third party providers to buy targeted advertising on a real-time bidded basis. By leveraging our extensive historical search marketing network data along with performance data from a conversion pixel, LookSmart constructs models of the highest performing audiences, and targets them via exchange inventory. LookSmart offers its trading desk as a managed service.
 
Our largest category of customers are Intermediaries, the majority of which 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.
 
In 2012, revenue from Intermediaries decreased significantly compared to 2011. We experienced a reduction in Intermediary revenue throughout 2011 and a significant decrease in revenue from Intermediaries in the fourth quarter of 2011 due to revenue chargebacks to our customers by large search engine providers. This trend continued into 2012 as several Intermediary customers exited the market or ceased business with the Company. Intermediaries continue as our largest category of customer and we expect that to continue in the foreseeable future although we do not expect the number of customers to grow significantly.
 
In addition, LookSmart 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.
 
Products and Services
 
LookSmart’s revenue sources are divided into two categories:
 
 
1.
Advertiser Networks
 
2.
Publisher Solutions
 
Advertiser Networks
 
LookSmart develops, markets, and sells premium and performance search and display advertising products to advertising customers and related advertising agencies through a variety of pricing models tailored to customer requirements. These search advertising customers reach potential customers with our sponsored search products. Our sponsored search products give search advertising customers complete control of their campaigns with different keyword matching options (Smart, Broad, Negative) and targeting options (Keyword, Category, Geography, Day-parting, or “Run of Network”) to maximize advertiser Return on Investment (“ROI”). Ads are distributed through a network of syndication partners.
 
LookSmart actively pursues relationships with portals, internet service providers (“ISPs”), media companies, other ad networks, demand side platforms (DSP’s), search services and other websites to maintain and increase the distribution of our advertiser’s search advertisements.
 
These relationships are key drivers of our growth because more distribution typically results in more online advertising revenues. We derive the majority of our traffic from our pay-per-click (“PPC”) distribution network partners. Each click is verified through our proprietary network traffic monitoring and management process, as well as third-party technologies and tools.
 
Our largest category of customers are Intermediaries, Intermediaries purchase clicks to sell into the affiliate network of large search engine providers or retain us on a managed service profit sharing  basis to sell into the affiliate network of large search engine providers. In 2012, revenue from Intermediaries decreased significantly compared to 2011.  This decrease was the primary driver of the revenue drop and was a result of changes in the search ecosystem that had a severe impact on the Intermediary business models and consequently the business they conduct with us.  We ceased business with several Intermediaries as a result and we do not expect significant future growth in the Intermediary business. Intermediaries continue as our largest category of customer and we expect that to continue in the foreseeable future although we do not expect the number of customers to grow significantly.
 
 
Through a web interface or our proprietary API, LookSmart’s AdCenter allows multiple search advertising customers to upload keywords, manage daily budgets, set rates and view reports—including spend data that is updated hourly. Search advertising customers can also access keyword suggestions, price and traffic estimates, online help and frequently asked questions (“FAQ”). The AdCenter API is also available for search advertising customers and related agencies that use third-party or in-house systems to analyze and manage their search campaigns.
 
Publisher Solutions
 
LookSmart offers a suite of customizable search advertising management tools and solutions that help publishers grow their audience, control advertiser relationships, and enhance and optimize the monetization of their sites. Our Publisher Solutions can be branded and configured according to publishers’ needs. We offer publishers:
 
 
·
Command and control over revenue diversification and growth via the AdCenter for Publishers, a comprehensive private-labeled Application Service Provider (“ASP”) solution that provides publishers with the ability to own and grow their advertiser relationships, increase their distribution capacity, and diversify their revenue sources.
 
 
·
A customizable set of services and technology to integrate multiple sources of advertisers, including dominant third-party feeds, within a single auction-based platform for cost-per-click (“CPC”) text-based advertising.
 
 
·
Access to a “backfill” of advertisers so they can quickly ramp their online operations and not lose time or existing revenue sources while establishing their advertiser relationships. Connecting multiple installations of the AdCenter for Publishers together allows LookSmart to create an open marketplace environment that empowers publishers to share, leverage, and exchange their advertisers for expanded distribution.
 
Technology
 
We have developed a proprietary web-based advertising auction platform, the AdCenter, that allows us to create, track, analyze, report and optimize customers’ advertising campaigns. The AdCenter indexes ads, analyzes webpage information to match advertising to relevant content, matches search queries to advertising and utilizes advanced fraud detection techniques in a high-volume ad serving environment. The platform also collects impression and click data for each listing that we manage for our customers and provides us with billing information. In addition, we provide each of our advertising customers with a password-protected online account that enables them to track, analyze and optimize their search marketing campaigns using online reports. The platform also includes an interface for publishers to access ad syndication feed reports and revenue information.
 
We rely on a combination of patent, trade secret, copyright and trademark laws and contractual provisions to protect our intellectual property and proprietary rights. Our trademarks include LookSmart ®. We have an issued patent on our search engine technology and have patents on various aspects of our ad delivery and search technologies.
 
Competition
 
The online advertising industry is constantly evolving, changes rapidly and is highly competitive. One of the major factors contributing to this competitive environment is that providers of all online advertising formats compete for a share of the advertisers’ limited advertising budgets. The large search engines, such as Yahoo!, Google, and Bing often receive the biggest portion of the search marketing budget. In addition, social networks such as Facebook and LinkedIn are rapidly scaling their advertising capabilities. With greater capital and technical resources, and greater brand recognition, the larger brands are often first priority in the mind of the advertiser, agency or buyer.
 
We compete on two main fronts: 1) attracting and growing our base of advertising customers to purchase our online advertising products and to incorporate their key words into our search advertising network, and 2) attracting and maintaining distribution network partners to incorporate their search queries into our search advertising network. The basis on which we compete differs among the two fronts. In addition, while online advertising continues to grow year over year, customers’ online advertising budgets are in competition with advertising in other media such as television, radio and print.
 
Government Regulations
 
We are subject to a number of domestic state and federal laws that affect companies conducting business on the Internet. In addition, because of the increasing popularity of the Internet and the growth of online services, laws relating to user privacy, freedom of expression, content, advertising, information security and intellectual property rights are being debated and considered for adoption.
 
 
In the U.S., state and federal laws relating to the liability of providers of online services for activities of their consumers, and the liability of providers of online advertiser’s ads and activities, are currently being tested by a number of claims, which include actions for defamation, libel, invasion of privacy and other data protection claims, tort, unlawful activity, copyright or trademark infringement, or other theories based on the nature and content of the materials searched by consumers, the advertisements shown to consumers or the content generated by consumers. Likewise, other federal laws could have an impact on our business. For example, the Children’s Online Protection Act and the Children’s Online Privacy Protection Act restrict the distribution of materials considered harmful to children and impose additional restrictions on the ability of online services to collect information from minors. In addition, the Protection of Children from Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances.
 
In addition, the application of existing laws regulating or requiring licenses for certain businesses of our search advertising customers, including, for example, distribution of pharmaceuticals, adult content, online gambling, financial services, alcohol or firearms, can be unclear. Application of these laws in an unanticipated manner could expose us to substantial liability and restrict our ability to deliver services to our customers.
 
Marketing
 
We use both traditional and non-traditional means and media types to grow our business. We seek to retain customers through a mix of informative marketing communications, helpful account tools, continual customer support and an optimal user experience.
 
Employees
 
Our future success is substantially dependent on the performance of our senior management and key technical and sales personnel, and our continuing ability to attract and retain highly qualified technical and managerial staff. As of December 31, 2012 we had 38 employees.  Beginning in January 2013, the Company suffered significant employee departures across all functional areas, most notably in product development, technology operations and sales. Through March 2013, the Company has used contractors in certain critical functional areas while a comprehensive hiring plan is under development.
 
Customers
 
For the year ended December 31, 2012, our largest Intermediary customer accounted for 28% of our revenue. For the year ended December 31, 2011, each of two Intermediary customers accounted for more than 10% of our revenue, and in the aggregate, they accounted for 22% of our revenue.
 
Product Development and Technical Operations Expense
 
Product development and technical operations expense includes all costs related to the continued operation, development and enhancement of our core technology product, the AdCenter platform. Our product development and technical operations expense, net of capitalized software development costs, was approximately $6.0 million during the year ended December 31, 2012 and approximately $6.7 million during the year ended December 31, 2011.
 
Due to employee departures discussed above, the Company stopped making upgrades to the ad server and to the corresponding database and data warehouse. Also due to the key personnel losses, through March 2013, the Company has not started new development projects.
 
The Company reviews assets for evidence of impairment annually at year end and whenever events or changes in circumstances indicate the carrying values may not be recoverable. The impairment review requires the Company to make significant estimates about its future performance and cash flows, as well as other assumptions. These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in business operations and changes in competition.  At December 31, 2012, the Company determined that continuing losses associated with the use of long-lived assets and a projection of associated future cash flows required the adjustment of long-lived assets to fair market value at December 31, 2012.  The lower projected operating results reflect changes in assumptions related to revenue growth rates, market trends, business mix, cost structure, and other expectations about the anticipated short-term and long-term operating results.  Accordingly, long-lived assets including capitalized software, computer equipment, furniture and fixtures, software and leasehold improvements with a recorded net book value of $2.7 million were reduced to fair market value of $0.4 million at December 31, 2012.
 
The fair value of the long-lived assets was derived based on Level 3 inputs, which are based on significant inputs that are not observable.  The fair value of the capitalized software long-lived assets was determined using an income approach, based on expected future cash flows and market considerations.  The fair value of the computer equipment, furniture and fixtures, software and leasehold improvements long-lived assets was determined using a market approach, based on comparable fair values of similar assets.
 
However, the Company expects to continue to invest in internally developed software.
 
Available Information
 
Our website, www.looksmart.com, provides access, without charge, to our annual report on Form 10-K, quarterly reports on Form  10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (“SEC”). The information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is otherwise specifically referenced elsewhere in this report.
 
Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information regarding our company that we file electronically with the SEC.
 
 
ITEM 1A.
RISK FACTORS
 
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 years ended December 31, 2010 and 2011. 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, 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.  If we are unable to generate significant revenue from our online advertising business or related business models under development, 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 have historically been Intermediaries, the majority of whom purchase clicks to sell into the affiliate networks of large search engine providers. In 2011, we experienced a significant decrease in revenues largely due to loss of Intermediary business.
 
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 has historically been Intermediaries, the majority of which purchase clicks to sell into the affiliate networks of large search engine providers. The Intermediary business model experienced a significant change in the fourth quarter of 2011.  We have ceased business with several of our Intermediary customers and do not expect significant future revenue growth in this area.  If we are unable to identify and exploit alternative sources of profitable revenue, our results of operations, financial condition and/or liquidity will suffer.
 
Our future success depends on sales to, and the management of, international customers
 
A portion of our revenue is derived from sales to international customers who are headquartered internationally, however our business with them is primarily U.S. based and our transactions are primarily in U.S. dollars.
 
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 United States. 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 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. 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 generated net losses in 2012 and 2011, have had losses in the past, and may have further losses in the future.  Failure to maintain operating profitability could harm our business and result in a decline in our stock price.
 
We had a net loss of $11 million in 2012 and $2.5 million in 2011. As of December 31, 2012, our accumulated deficit was approximately $248 million. We may be unable to achieve 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, experience an increase in paid clicks across our network and publisher products and develop and implement successful new digital advertising revenue generating models. 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 maintain profitability in the future, which could result in a decline in our stock price.
 
If we experience downward pressure on our match rate and/or revenue-per-click, or we are unable to rebuild our match rate, and/or revenue-per-click, our financial results 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. 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 the company. 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 or 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 the company is likely to be expensive, time-consuming, and strain our managerial resources. We may not be successful in integrating any acquired businesses or technologies and these transactions may not achieve anticipated business benefits.
 
Our success depends on our ability to attract and retain key personnel; if we were unable to attract and retain key personnel in the future, our business could be materially and adversely impacted
 
Our success depends on our ability to identify, attract, retain and motivate highly skilled development, technical, sales, and management personnel. We have a limited number of key development, technical, sales and management personnel performing critical company functions, and the loss of the services of any of our key employees, particularly any of our executive team members or key technical personnel, could adversely affect our business. The combination of depressed capital markets, stock volatility, and small market capitalization may not allow us to offer competitive equity based compensation to attract and retain key personnel.
 
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
 
We may need to enter into additional credit facilities in the future to operate the business. 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.
 
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 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 have in the past been 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. 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. An interruption in our ability to serve advertisements, track paid clicks, bill and collect invoices, and provide customer support would materially and adversely affect our financial results.

Our business and operations depend on Internet service providers and third party technology providers, and any failure or system downtime experienced by these companies could materially and adversely affect our revenues
 
Our 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 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, patent infringement or other claims. Lawsuits are filed against us from time to time. As we enter foreign markets, our potential liability could increase. In addition, we are obligated in some cases to indemnify our customers or distribution network partners in the event that they are subject to claims that our services infringe on the rights of others.
 
Litigating these claims could consume significant amounts of time and money, divert management’s attention and resources, cause delays in integrating acquired technology or releasing new products, or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on acceptable terms, if at all. Our insurance may not adequately cover claims of this type, if at all. If a court were to determine that some aspect of our services infringed upon or violated the rights of others, we could be prevented from offering some or all of our services, which would negatively impact our revenue and business. For any of the foregoing reasons, litigation involving our listings business and technology could have a material adverse effect on our business, operating results and financial condition.
 
We could be subject to infringement claims that may be costly to defend, result in the payment of settlements or damages or cause us to change the way we conduct our business
 
Internet, technology and media companies, as well as patent holding companies often possess a significant number of patents. Further, many of these companies and other parties are actively developing online advertising, search, indexing, electronic commerce and other Web-related technologies, as well as a variety of online business models and methods. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, we may face claims of infringement of patents and other intellectual property rights held by others. Also, as we expand our business, acquire and maintain our customer base, and develop new technologies, products and services, we may become increasingly subject to intellectual property infringement claims. In the event that there is a claim or determination that we infringe third-party proprietary rights such as patents, copyrights, trademark rights, trade secret rights or other third party rights such as publicity and privacy rights, we could incur substantial monetary liability, be required to enter into costly royalty or licensing agreements or be prevented from using the rights, which could require us to change our business practices in the future and limit our ability to compete effectively. We may also incur substantial expenses in defending against third-party infringement claims regardless of the merit of such claims. The occurrence of any of these results could harm our brand and negatively impact our operating results. In addition, many of our agreements with our customers, partners and affiliates require us to indemnify them for certain third-party intellectual property infringement claims or determinations, which could increase our costs in defending such claims and our damages. For example, in October 2008, we agreed to indemnify one of our Publisher Solutions customers relating to a patent infringement suit filed against it pursuant to an AdCenter for Publishers’ agreement between it and the Company. The resulting settlement agreement between the Company and the plaintiffs required us to pay the plaintiffs $0.6 million and the Publisher Solutions customer’s defense costs of $0.4 million.
 
 
Litigation, regulation, legislation or enforcement actions directed at or materially affecting us may adversely affect the commercial use of our products and services and our financial results
 
New lawsuits, laws, regulations and enforcement actions applicable to the online industry may limit the delivery, appearance and content of our advertising or our publisher customers’ advertisers or otherwise adversely affect our business. If such laws are enacted, or if existing laws are interpreted to restrict the types and placements of advertisements we or our publishers’ customers can carry, it could have a material and adverse effect on our financial results. For example, in 2002, the Federal Trade Commission, in response to a petition from a private organization, reviewed the way in which search engines disclose paid placement or paid inclusion practices to Internet consumers and issued guidance on what disclosures are necessary to avoid misleading consumers about the possible effects of paid placement or paid inclusion listings on the search results. In 2003, the United States Department of Justice issued statements indicating its belief that displaying advertisements for online gambling might be construed as aiding and abetting an illegal activity under federal law. In 2004, the United States Congress considered new laws regarding the sale of pharmaceutical products over the Internet and the use of adware to distribute advertisements on the Internet. In 2007, the Federal Trade Commission proposed new regulations relating to online behavioral targeting. Moreover, as we enter into foreign markets, we may become subject to additional regulation and legislation. If any new law or government agency were to require changes in the labeling, delivery or content of our advertisements, or if we are subject to legal proceedings regarding these issues, it may reduce the desirability of our services or the types of advertisements that we can run, and our business could be materially and adversely harmed. In addition, many of our agreements with our customers, partners and affiliates require us to indemnify them for certain claims related to online advertising laws, regulations and enforcement actions, which could increase our costs in defending such claims and our damages.
 
In addition, legislation or regulations, including compliance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”), present ongoing compliance risks, and a failure to comply with these new laws and regulations could materially harm our business. As we continue our Section 404 compliance efforts we may identify significant deficiencies, or material weaknesses, in the design and operation of our internal control over financial reporting. We may be unable to remediate any of these matters in a timely fashion, and/or our independent registered public accounting firm may not agree with our remediation efforts. 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 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. 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 intermediary business model which affect the entire online search advertising ecosystem,
 
·
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, or
 
·
systems downtime on our Advertiser Network, our website or the websites of our distribution network partners.
 
Due to the above factors, we believe that period-to-period comparisons of our financial results are not necessarily meaningful, and you should not rely on past financial results as an indicator of our future performance. If our financial results in any future period fall below the expectations of securities analysts and investors, the market price of our securities would likely decline.
 
Our stock price is extremely volatile, and such volatility may hinder investors’ ability to resell their shares for a profit or avoid a loss
 
The stock market has experienced significant price and volume fluctuations in recent years, and the stock prices of Internet companies have been extremely volatile. The low trading volume of our common stock may adversely affect its liquidity and reduce the number of market makers and/or large investors willing to trade in our common stock, making wider fluctuations in the quoted price of our common stock more likely to occur. You should evaluate our business in light of the risks, uncertainties, expenses, delays and difficulties associated with managing and growing a business in a relatively new industry, many of which are beyond our control.
 
Our stock price may fluctuate, and you may not be able to sell your shares for a profit, as a result of a number of factors including without limitation:
 
 
·
changes in the market valuations of Internet companies in general and comparable companies in particular,
 
·
quarterly fluctuations in our operating results,
 
·
the termination or expiration of our distribution agreements,
 
·
our potential failure to meet our forecasts or analyst expectations on a quarterly basis,
 
·
the relatively thinly traded volume of our publicly traded shares, which means that small changes in the volume of trades may have a disproportionate impact on our stock price,
 
·
the loss of key personnel, or our inability to recruit experienced personnel to fill key positions,
 
·
changes in ratings or financial estimates by analysts or the inclusion/removal of our stock from certain stock market indices used to drive investment choices,
 
·
announcements of new distribution network partnerships, technological innovations, acquisitions or products or services by us or our competitors,
 
·
the sales of substantial amounts of our common stock in the public market by our stockholders, or the perception that such sales could occur, or
 
·
conditions or trends in the Internet that suggest a decline in rates of growth of advertising-based Internet companies.
 
In the past, securities class action litigation has often been instituted after periods of volatility in the market price of a Company’s securities. A securities class action suit against us could result in substantial costs and the diversion of management’s attention and resources, regardless of the merits or outcome of the case.
 
We may need additional capital in the future to support our operations and, if such additional financing is not available to us, on reasonable terms or at all, our liquidity and results of operations will be materially and adversely impacted
 
Although we believe that our working capital will provide adequate liquidity to fund our operations and meet our other cash requirements for the foreseeable future, unanticipated developments in the short term, such as the entry into agreements which require large cash payments or the acquisition of businesses with negative cash flows, may necessitate additional financing. We may seek to raise additional capital through public or private debt or equity financings in order to:
 
 
·
fund the additional operations and capital expenditures,
 
·
take advantage of favorable business opportunities, including geographic expansion or acquisitions of complementary businesses or technologies,
 
·
develop and upgrade our technology infrastructure beyond current plans,
 
·
develop new product and service offerings,
 
·
take advantage of favorable conditions in capital markets, or
 
·
respond to competitive pressures.
 
The capital markets, and in particular the public equity market for Internet companies, have historically been volatile. It is difficult to predict when, if at all, it will be possible for Internet companies to raise capital through these markets. We cannot assure you that the additional financing will be available on terms favorable to us, or at all. If we issue additional equity or convertible debt securities, our existing stockholders may experience substantial dilution.
 
 
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.
 
 
None.
 
ITEM 2.
 
In August 2009, the Company entered into an agreement to sublease 19,997 square feet of 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 July 2012, the Company entered into an agreement to sublease this subleased office space under terms generally equivalent to its existing commitment for a term that commenced in August 2012 and expires in December 2014. Beginning in August 2012, the Company has utilized a smaller space for its corporate office in San Francisco, California under a six month sublease which was renewed in February 2013 for an additional six months.
 
The Company leases office space in Kitchener, Canada of approximately of 5,222 square feet that houses our Engineering and Support teams. The lease has a constant term of six months.
 
The Company leases office space in Los Angeles, California of approximately of 4,803 square feet. The lease expires in July 2015.
 
The Company leased a sales office in New York, New York on a month to month basis as of December 31, 2012. The lease was terminated on February 1, 2013.
 
The Company maintains a data center in Sacramento, California, under a Master Service Agreement and related Service Level Agreement on a month to month basis.
 
We believe our existing facilities are suitable for Company operations.
 
ITEM 3. 
                     
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, we do not expect resolution of these matters to have a material adverse impact on our consolidated results of operations, cash flows or financial position. However, an unfavorable resolution of a matter could, depending on its amount and timing, materially affect our future results of operations, cash flows or financial position in a future period. Regardless of the outcome, litigation can have an adverse impact on us because of defense costs, diversion of management resources and other factors.
 
                     
Not Applicable.
 
PART II
 
 
On July 20, 2012, PEEK Investments LLC, a Delaware limited liability company (“PEEK”) commenced the unsolicited tender offer to purchase all outstanding shares of LookSmart, Ltd., a Delaware corporation (“LookSmart” or the “Company”) for $1.00 per share, net to the seller in cash, without interest and less any applicable withholding taxes, upon the terms and subject to the conditions set forth in the Schedule TO filed jointly with the Securities and Exchange Commission (the “SEC”) by and on behalf of PEEK and the following persons: (a) Snowy August Fund I LP, a Delaware limited partnership; (b) Snowy August Management LLC, a Delaware limited liability company; (c) Michael Onghai, a United States citizen; (d) Platinum Partners Value Arbitrage Fund L.P., a Cayman Islands exempted limited partnership; (e) Platinum Management (NY) LLC, a Delaware limited liability company; (f) Mark Nordlicht, a United States citizen; and (g) Uri Landesman, a United States citizen (such tender offer, on the price, terms and conditions described in such Schedule TO, as amended, the “Offer”).
 
 
On January 14, 2013, PEEK consummated the Offer by purchasing 8,447,647 shares of the Company (the “Shares”), which, together with the 836,312 shares owned by PEEK's affiliates as of such date, represented approximately 54% of the total outstanding shares of the Company. As a result of the consummation of the Offer, a change in control of the Company occurred and PEEK became the largest stockholder of the Company.
 
LookSmart, Ltd. common stock was quoted on the NASDAQ Global Market through December 2, 2012 and on the NASDAQ Capital Market subsequent to December 2, 2012.  The Company trades under the symbol “LOOK”. The following table sets forth the range of high and low sales prices of the common stock on the NASDAQ Global Market for each period indicated:
 
 
 
HIGH
   
LOW
 
2012
 
 
   
 
 
First quarter
  $ 1.50     $ 1.10  
Second quarter
  $ 1.13     $ 0.72  
Third quarter
  $ 1.00     $ 0.80  
Fourth quarter
  $ 0.96     $ 0.75  
2011
               
First quarter
  $ 2.26     $ 1.47  
Second quarter
  $ 2.23     $ 1.39  
Third quarter
  $ 1.67     $ 1.30  
Fourth quarter
  $ 1.42     $ 1.17  
 
LookSmart had approximately 1,349 holders of record of common stock as of March 22, 2013. We have not declared or paid any cash dividends on the common stock and presently intend to retain our future earnings, if any, to fund the development and growth of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future.
 
Recent Sales of Unregistered Securities; Uses of Proceeds from Registered Securities
 
Repurchase of Equity Securities by the Company

In May 2012, the Company's Board of Directors authorized the repurchase of up to $1 million of the Company's common shares. Under the program, the Company may purchase its common shares from time to time in the open market or in privately negotiated transactions.
 
Approximately 56 thousand shares were purchased at approximately $0.85 per share under the program in the year ended December 31, 2012, and recorded as Treasury Stock at cost totaling approximately $48 thousand dollars.
 
Period
 
Total Number of
Shares Purchased
Under Publically
Announced
Programs
   
Average Price
Paid per Share
   
Approximate Dollar
Value of Shares that
May Yet Be Purchased
Under the Plans or
Programs
 
July 1, 2012 - July 31, 2012
    -     $ -     $ 1,000,000  
August 1, 2012 - August 31, 2012
    10,800       0.87     $ 990,604  
September 1, 2012 - September 30, 2012
    28,891       0.86     $ 965,758  
October 1, 2012- December 31, 2012
    16,784       0.82     $ 951,849  
Total
    56,475     $ 0.85     $ 951,849  
 
The Company had no sales of unregistered securities in 2012.
 
 
 
As a smaller reporting company, as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), we are not required to provide the information required by this item.
 
 
 
·
The following discussion should be read in conjunction with the Consolidated Financial Statements and the Notes to those statements that appear elsewhere in this Annual Report on Form 10-K.
 
 
·
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 “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 “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other sections of this report.
 
 
·
All forward-looking statements, including, but not limited to, projections, expectations or estimates concerning our business, including demand for our products and services, mix of revenue sources, ability to control and/or reduce operating expenses, anticipated gross margins and operating results, cost savings, product development efforts, general outlook of our business and industry, future profits or losses, competitive position, share-based compensation, and adequate liquidity to fund our operations and meet our other cash requirements, are inherently uncertain as they are based on our expectations and assumptions concerning future events.
 
 
·
These forward-looking statements are subject to numerous known and unknown risks and uncertainties.
 
 
·
You should not place undue reliance on these forward-looking statements.
 
 
·
Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including but not limited to,
 
 
o
the possibility that we may fail to preserve our expertise in online advertising,
 
 
o
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,
 
 
o
that we may be unable to maintain or grow sources of revenue,
 
 
o
that seasonal fluctuations in internet usage and traditional advertising seasonality are likely to affect our business,
 
 
o
that changes in the distribution network composition may lead to decreases in traffic volumes,
 
 
o
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,
 
 
o
that we may be unable to maintain profitability,
 
 
o
that we may be unable to attract and retain key personnel,
 
 
o
that we may not be able to effectively manage, or to increase, our relationships with international customers,
 
 
o
that we may have unexpected increases in costs and expenses, or
 
 
o
that one or more of the other risks described above in the section entitled “Risk Factors” (Item 1A of this Annual Report on Form 10-K) 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.
 
OVERVIEW
 
LookSmart, Ltd. (“LookSmart” or the “Company”) is a search and display advertising network solutions company that provides relevant solutions for search and display advertising customers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.
 
 
LookSmart operates in a large online advertising ecosystem serving ads that target user queries on partner sites.
 
LookSmart offers search advertising customers targeted 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.
 
 LookSmart also offers advertisers the ability to buy graphical display advertising. LookSmart’s trading desk personnel utilize DSP technology and licensed data from third party providers to buy targeted advertising on a real-time bidded basis. By leveraging our extensive historical search marketing network data along with performance data from a conversion pixel, LookSmart constructs models of the highest performing audiences, and targets them via exchange inventory. LookSmart offers its trading desk as a managed service.
 
Our largest category of customers is Intermediaries, the majority of which 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.
 
In addition, LookSmart 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.
 
On July 20, 2012, PEEK Investments LLC, a Delaware limited liability company (“PEEK”) commenced the unsolicited tender offer to purchase all outstanding shares of the Company.  On January 14, 2013, PEEK consummated the Offer by purchasing 8,447,647 shares of the Company (the “Shares”), which, together with the shares owned by PEEK's affiliates as of such date, represented approximately 54% of the total outstanding shares of the Company. As a result of the consummation of the Offer, a change in control of the Company occurred and PEEK became the largest stockholder of the Company.
 
The following developments, explained in greater detail in Results of Operations, had a significant impact on our business and economic performance in 2012:
 
 
·
Decrease in revenue across all categories of customers, most notably Intermediary.
 
·
Increased product development efforts resulting in nominal upgrade of existing technology and no technology advances.
 
·
Increased and ultimately unsuccessful investment in sales and sales support.
 
·
Cost of defense of the unsolicited tender offer by PEEK Investments.
 
·
Impairment of assets at December 31, 2012, based on a projection of future cash flows.
 
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 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 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.
 
Revenue Recognition
 
Our online search advertising revenue is composed of per-click fees that we charge customers and profit sharing arrangements we enter with Intermediaries. 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. The Company has profit-sharing agreements with several customers that call for the sharing of profits and losses. Profit sharing arrangements are governed by contractual agreement. Revenue from these profit-sharing agreements is reported net of the customer’s share of profit.
 
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 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 customer’s 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.
 
The Company evaluates individual arrangements with customers to make a determination under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605-45 Revenue Recognition. We test and record revenue accordingly.
 
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 and adjusted on a periodic basis. The review is based on factors including the application of historical collection rates to current receivables and economic conditions. Additional allowances for doubtful accounts are considered and recorded 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 December 31, 2012 and December 31, 2011, we placed our cash equivalents and investments through one financial institution, City National Bank (“CNB”), and mitigated the concentration of credit risk by placing percentage limits on the maximum portion of the investment portfolio which may be invested in any one investment instrument. These amounts at times may exceed federally insured limits. 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 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 is, and is expected to continue to be, Intermediaries. Revenue from Intermediary business declined approximately 58% in the year ended December 31, 2012, as compared to the same period in 2011, and has continued to decline in the first quarter of 2013.
 
Property and Equipment
 
Property and equipment are stated at cost, except when an impairment analysis requires use of fair value, 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.
 
At December 31, 2012, the Company determined that continuing losses associated with the use of long-lived assets and a projection of associated future cash flows required the adjustment of long-lived assets to fair market value at December 31, 2012.  Accordingly, long-lived assets including capitalized software, computer equipment, furniture and fixtures, software and leasehold improvements with a recorded net book value of $2.7 million were reduced to fair market value of $0.4 million at December 31, 2012.
 
 
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.
 
Restructuring Charges
 
In August 2012, the Company entered into an agreement to sublease its office space in San Francisco under terms generally equivalent to its existing commitment. The Company had $0.2 million in restructuring costs associated with the sub-lease of the San Francisco headquarters in the year ended December 31, 2012.
 
In January 2011, our Board of Directors approved a plan of termination that resulted in a reduction of the workforce of approximately 20 full-time positions, or approximately 35%. In the year ended December 31, 2011 the Company recorded $0.9 million in pre-tax restructuring charges associated with this action. All restructuring charges have been classified as such on the Consolidated Statement of Operations.
 
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. These affiliate agreements provide for variable payments based on a percentage of our revenue or based on a certain metric, such as number of searches or paid clicks.
 
TAC expense is recorded in cost of revenue.
 
Advertising Costs are charged to sales and marketing expenses as incurred.
 
Product Development Costs of new product ideas and enhancements to existing products are charged to expense as incurred.
 
Share-Based Compensation
 
We recognize share-based compensation costs for all share-based payment transactions, including grants of 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 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 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 to our Consolidated Financial Statements below.
 
 
RESULTS OF OPERATIONS
 
Overview of 2012
 
The following table sets forth selected information concerning our results of operations as a percentage of consolidated net revenue for the years ended December 31, 2012 and 2011 (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
% of
Revenue
   
2011
   
% of
Revenue
   
Dollar
Change
   
%
Change
 
Revenue
  $ 15,691       100.0 %   $ 27,634       100.0 %   $ (11,943 )     (43 %)
Cost of revenue
    10,163       64.8 %     15,195       55.0 %     (5,032 )     (33 %)
Gross profit
    5,528       35.2 %     12,439       45.0 %     (6,911 )     (56 %)
Operating expenses:
                                               
Sales and marketing
    2,527       16.1 %     2,332       8.4 %     195       8 %
Product development and technical operations
    6,036       38.4 %     6,742       24.4 %     (706 )     (10 %)
General and administrative
    5,579       35.6 %     5,312       19.2 %     267       5 %
Asset impairment charge
    2,303       14.7 %     -       0.0 %     2,303       100 %
Restructuring charge
    169       1.1 %     889       3.2 %     (720 )     (81 %)
Total operating expenses
    16,614       105.9 %     15,275       55.2 %     1,339       9 %
Loss from operations
    (11,086 )     (70.7 %)     (2,836 )     (10.2 %)     (8,250 )     291 %
Non-operating income (expense), net
    45       0.3 %     331       1.2 %     (286 )     (86 %)
Loss from continuing operations before income taxes
    (11,041 )     (70.4 %)     (2,505 )     (9.0 %)     (8,536 )     341 %
Income tax expense
    (6 )     (0.0 %)     (3 )     0.0 %     (3 )     100 %
Net loss
  $ (11,047 )     (70.4 %)   $ (2,508 )     (9.0 %)   $ (8,539 )     340 %
 
Revenue
 
Total revenue and revenue from Advertiser Networks and Publisher Solutions for the years ended December 31, 2012 and 2011, were as follows (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
% of
Revenue
   
2011
   
% of
Revenue
   
Dollar
Change
   
%
Change
 
Advertiser Networks
  $ 14,523       93 %   $ 26,388       95 %   $ (11,865 )     (45 %)
Publisher Solutions
    1,168       7 %     1,246       5 %     (78 )     (6 %)
Total revenue
  $ 15,691       100 %   $ 27,634       100 %   $ (11,943 )     (43 %)
 
Advertiser Networks
 
In 2012, revenue from Intermediaries decreased significantly compared to 2011.  We experienced a reduction in Intermediary revenue throughout 2011 and a significant decrease in revenue from Intermediaries in the fourth quarter of 2011 due to revenue chargebacks to our customers by large search engine providers. This trend continued into 2012 as several Intermediary customers exited the market or ceased business with the Company.  Intermediaries continue as our largest category of customer and we expect that to continue in the foreseeable future although we do not expect the number of customers to grow significantly.
 
In 2012, revenue from Direct Advertisers decreased from 2011.  This decrease was most notable in the second half of 2012.  The Company invested in sales and delivery resources to drive revenue growth but the effort did not meet our expectations primarily due to difficulties encountered in matching new customer requirements with availability of key words in our network.  The Company views Direct Advertisers as a strong potential source for revenue growth and plans to refocus in this area in the future.
 
In 2012, revenue from Self Service Advertisers decreased.  We did not invest significant resources to expand this business.  The Company views Self Service Advertisers as a source for modest potential growth and plans to invest accordingly in the future.
 
Publisher Solutions
 
In 2012, Publisher Solutions revenue remained relatively consistent with the prior year.  The Company did not invest and does not plan to invest significant resources to grow this business in the future.
 
 
Cost of Revenue and Gross Profit
 
Cost of revenue is primarily TAC (costs paid to our distribution network partners).  Other costs include data center rent and power usage, commissions paid to advertising agencies, and credit card fees.
 
Cost of revenue for the years ended December 31, 2012 and 2011 were as follows (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
% of
Revenue
   
2011
   
% of
Revenue
   
Dollar
Change
   
%
 Change
 
Traffic acquisition costs
  $ 8,726       56 %   $ 13,640       49 %   $ (4,914 )     (36 %)
Other costs
    1,437       9 %     1,555       6 %     (118 )     (8 %)
Total cost of revenue
  $ 10,163       65 %   $ 15,195       55 %   $ (5,032 )     (33 %)
                                                 
Traffic acquisition costs as percentage of Advertiser Network revenue
            60.1 %             51.7 %                
 
TAC as a percent of Advertisers Network revenue increased in 2012, our Intermediary category of revenue generally has lower margins than Direct and Self-Service and the change in revenue mix from 2011 drove the margin decrease.
 
Data center rent and power usage are generally fixed costs. Other costs decreased due to the decrease in revenue.
 
Operating Expenses
 
Operating costs for the years ended December 31, 2012 and 2011 were as follows (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
% of
Revenue
   
2011
   
% of
Revenue
   
Dollar
 Change
   
%
Change
 
Sales and marketing
  $ 2,527       16 %   $ 2,332       8 %   $ 195       8 %
Product development and technical operations
    6,036       38 %     6,742       25 %     (706 )     (10 %)
General and administrative
    5,579       36 %     5,312       19 %     267       5 %
Asset impairment charge
    2,303       15 %     -       0 %     2,303       100 %
Restructuring charge
    169       1 %     889       3 %     (720 )     (81 %)
Total operating expenses
  $ 16,614       106 %   $ 15,275       55 %   $ 1,339       9 %
 
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 and allocation of depreciation. Sales and marketing expenses also include the costs of advertising, trade shows, public relations activities and various other activities supporting our customer acquisition effort.
 
The increase in sales and marketing expenses for the year ended December 31, 2012, is primarily due to efforts to expand our Direct Advertiser business. During 2012, the Company hired a Chief Revenue Officer and increased the sales force across the United States in an effort to gain new business.  This effort was largely unsuccessful primarily due to difficulties encountered in matching new customer requirements with availability of key words in our network.  On January 18, 2013, the Company announced the resignation of the Chief Revenue Officer.  Effective with his resignation, the Company had no remaining sales personnel.
 
The Company views Direct Advertisers as a strong potential source for revenue growth and plans to refocus in this area in the future.
 
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 for the years ended December 31, 2012 and 2011 were as follows (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
% of
Revenue
   
2011
   
% of
Revenue
   
Dollar
Change
   
%
 Change
 
Product development and technical operations costs
  $ 7,250       46 %   $ 7,224       26 %   $ 26       0 %
Capitalized software development costs
    (1,214 )     (8 %)     (482 )     (2 %)     (732 )     152 %
Total product development and technical operations expense
  $ 6,036       38 %   $ 6,742       24 %   $ (706 )     (10 %)
 
Product development and technical operations headcount remained relatively constant for most of 2012 compared to 2011.  The Company completed an important upgrade in click server technology in the third quarter of 2012 but made no progress on aggressive plans to revamp and upgrade its ad serving technology.  Towards the end of 2012, the Company began to lose key members of its product development team and by January 2013, product development and technical operation staff were at critically low levels. A concentrated effort is underway to rebuild product and technical human resources.
 
General and Administrative
 
General and administrative expenses include personnel cost, legal, insurance, tax and accounting, consulting, professional services fees and the provision for, and reductions of, the allowance for doubtful trade receivables.
 
During 2012, the Company incurred $0.7 million of costs associated with the unsolicited tender offer by PEEK.  Excluding these PEEK related costs, General and Administrative costs decreased $0.4 in the year ended December 31, 2012, as compared to 2011.
 
Share Based Compensation
 
Share-based compensation expense for the years ended December 31, 2012 and 2011 was allocated as follows (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Sales and marketing
  $ 29     $ 19  
Product development and technical operations
    56       150  
General and administrative
    142       192  
Total share-based compensation expense
    227       361  
Amounts capitalized as software development costs
    18       20  
Total share-based compensation
  $ 245     $ 381  
 
Asset Impairment Charge
 
The Company reviews assets for evidence of impairment annually at year end and whenever events or changes in circumstances indicate the carrying values may not be recoverable. The impairment review requires the Company to make significant estimates about its future performance and cash flows, as well as other assumptions. These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in business operations and changes in competition.  At December 31, 2012, the Company determined that continuing losses associated with the use of long-lived assets and a projection of associated future cash flows required the adjustment of long-lived assets to fair market value at December 31, 2012.  The lower projected operating results reflect changes in assumptions related to revenue growth rates, market trends, business mix, cost structure, and other expectations about the anticipated short-term and long-term operating results.  Accordingly, long-lived assets including capitalized software, computer equipment, furniture and fixtures, software and leasehold improvements with a recorded net book value of $2.7 million were reduced to fair market value of $0.4 million at December 31, 2012.
 
The fair value of the long-lived assets was derived based on Level 3 inputs, which are based on significant inputs that are not observable.  The fair value of the capitalized software long-lived assets was determined using an income approach, based on expected future cash flows and market considerations.  The fair value of the computer equipment, furniture and fixtures, software and leasehold improvements long-lived assets was determined using a market approach, based on comparable fair values of similar assets.
 
Restructuring Charges
 
In August 2012, the Company entered into an agreement to sublease its office space in San Francisco under terms generally equivalent to its existing commitment. The Company had $0.2 million in restructuring costs associated with the sub-lease of the San Francisco headquarters in the year ended December 31, 2012.
 
 
In January 2011, our Board of Directors approved a plan of termination that resulted in a reduction of the workforce of approximately 20 full-positions, or approximately 35%. In the year ended December 31, 2011 the Company recorded $0.9 million in pre-tax restructuring charges associated with this action.
 
Other items
 
The table below sets forth other continuing operations data for the years ended December 31, 2012 and 2011 (in thousands):
 
 
 
Year Ended December 31,
 
 
 
2012
   
% of
Revenue
   
2011
   
% of
 Revenue
   
Dollar
 Change
   
%
 Change
 
Non-operating income (expense), net
 
 
   
 
   
 
   
 
   
 
   
 
 
Interest income
  $ 78       0 %   $ 89       0 %   $ (11 )     (12 %)
Interest expense
    (26 )     0 %     (81 )     0 %     55       (68 %)
Other income (expense), net
    (7 )     0 %     323       1 %     (330 )     (102 %)
Total non-operating income (expense), net
  $ 45       0 %   $ 331       1 %   $ (286 )     (86 %)
                                                 
Income tax expense
  $ (6 )     0 %   $ (3 )     0 %   $ (3 )     100 %
 
Interest Income and Expense
 
Interest income, decreased 12% in the year ended December 31, 2012 from the year ended December 31, 2011. This decrease was primarily due to a reduction in investment balances.
 
Interest expense, which primarily consists of interest paid on capital leases, decreased $55 thousand in 2012, as compared to 2011, primarily due to a reduction in capital lease obligations.
 
Income Tax Expense
 
Due to our net operating losses, our income tax expense in the U.S. consists of minimum state taxes.
 
Other Income, Net
 
In 2008, the Company established a Settlement Fund related to a class action lawsuit in which the Company was named as a defendant, Lane’s Gifts and Collectibles, L.L.C., v. Yahoo! Inc (the “Fund”). In the second quarter of 2011, the Company determined that all settlements related to the Fund had been paid. The Fund was closed on June 30, 2011 and the Company recorded $0.3 million in non-operating income related to the closure.
 
Liquidity and Capital Resources
 
Cash flows were as follows (in thousands):

 
 
Year Ended December 31,
 
 
 
2012
   
2011
   
Change
 
Net cash used in operating activities
  $ (6,568 )   $ (42 )   $ (6,526 )
Net cash used in investing activities
    (4,405 )     (3,080 )     (1,325 )
Net cash used in financing activities
    (578 )     (1,047 )     469  
Effect of exchange rate changes on cash and cash equivalents
    (47 )     -       (47 )
Decrease in cash and cash equivalents
  $ (11,598 )   $ (4,169 )   $ (7,429 )
 
 
Cash, cash equivalents and short-term marketable investment balances were as follows as of December 31, 2012 and 2011 (in thousands):

 
 
Year Ended December 31,
 
 
 
2012
   
2011
   
Change
 
Cash and cash equivalents
  $ 6,352     $ 17,950     $ (11,598 )
Short-term investments
    9,506       6,809       2,697  
Total
  $ 15,858     $ 24,759     $ (8,901 )
% of total assets
    84 %     82 %        
Total assets
  $ 18,865     $ 30,112          

At December 31, 2012, we had $15.9 million in cash, cash equivalents and short-term marketable investments. Cash equivalents and short-term marketable investments are comprised of highly liquid debt instruments of the U.S. government, commercial paper, time deposits, money market mutual funds and U.S. corporate securities. We actively monitor the depository institutions that hold our cash and cash equivalents and the institutions of whose debt instruments we hold. Our investment policy, which is reviewed annually by our Board of Directors, primarily emphasizes safety of principal while secondarily maximizing yield on those funds. We can provide no assurances that access to our invested cash and cash equivalents will not be impacted by adverse conditions in the financial markets.  These balances may exceed the Federal Deposit Insurance Corporation insurance limits. While we monitor the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail or could be subject to other adverse conditions in the financial markets. Note 2 to our Consolidated Financial Statements below, further describes the composition of our cash, cash equivalents and short- and long-term investments.
 
Cash, cash equivalents and short-term investments decreased $8.9 million in 2012 primarily due to operating losses, the purchase of property and equipment, and payments of capital lease obligations and increased accounts receivable.
 
Our primary source of liquidity is our cash, cash equivalents, short-term investments, and cash flow from operations. We believe that our existing cash, cash equivalents, short-term investments and cash 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, and changes in customer buying behavior. 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.
 
Operating Activities
 
Cash used in operating activities in the year ended December 31, 2012 consisted of our net loss adjusted for certain non-cash items, including depreciation, amortization, provision for doubtful accounts, share-based compensation expense, and loss on impairment of assets, as well as the effect of changes in working capital and other activities. Cash used in operations in the year ended December 31, 2012 was $6.6 million and consisted of a net loss of $11.0 million, adjustments for non-cash items of $5.0 million in cash used in working capital and other activities of $0.6 million. Adjustments for non-cash items primarily consisted of $2.3 million in impairment of property and equipment and internally developed software, $2.0 million of depreciation and amortization expense on property and equipment and internally developed software, $0.3 million of bad debt expense, $0.1 million of restructuring charge expense and $0.2 million of share-based compensation expense. In addition, changes in working capital activities primarily consisted of $0.8 million increase in accounts receivable. The increase in accounts receivable is primarily attributed slower paying customers in anticipation of the impending tender offer.
 
Cash used in operating activities in the year ended December 31, 2011 consisted of our net loss adjusted for certain non-cash items, including depreciation, amortization, share-based compensation expense, and loss on disposition of assets, as well as the effect of changes in working capital and other activities. Cash used in operations in the year ended December 31, 2011 was $0.04 million and consisted of a net loss of $2.5 million, adjustments for non-cash items of $3.3 million and cash used by working capital and other activities of $0.8 million. Adjustments for non-cash items primarily consisted of $2.7 million of depreciation and amortization expense on property and equipment and internally developed software, $0.5 million of bad debt expense and $0.4 million of share-based compensation expense, partially offset by a $0.3 million gain on the closure of a settlement fund. In addition, changes in working capital activities primarily consisted of a $2.1 million decrease in accounts payable and accrued liabilities, partially offset by a net decrease of $1.1 million in accounts receivable. The decrease in accounts payable and accrued liabilities was primarily due to reduced TAC and operating expenses. The decrease in account receivable is primarily attributed to a decrease in invoiced customer revenue.
 
 
Investing Activities
 
Cash used in investing activities during the year ended December 31, 2012 of $4.4 million was primarily attributed to $2.7 million net purchase of investments. Capital expenditures for the year ended December 31, 2012 consisted of $0.5 million for equipment acquired during 2012 and an investment of $1.2 million in internally developed software related to our AdCenter platform technology.
 
Cash used in investing activities during the year ended December 31, 2011 of $3.1 million was primarily attributed to $2.1 million net purchase of investments. Capital expenditures for the year ended December 31, 2011 consisted of $0.6 million for equipment acquired during 2011 and an investment of $0.5 million in internally developed software related to our AdCenter platform technology.
 
Financing Activities
 
Cash used in financing activities in the year ended December 31, 2012 of $0.6 million is primarily attributed to $0.5 million in scheduled capital lease payments.
 
Cash used by financing activities in the year ended December 31, 2011 of $1.0 million is primarily attributed to $1.1 million in scheduled capital lease payments, partially offset by $0.1 million in proceeds from the issuance of common stock.
 
Credit Arrangements
 
We have an outstanding standby letter of credit (“SBLC”) issued by City National Bank (“CNB”) of approximately $0.2 million at December 31, 2012, related to security of the subleased corporate office lease.
 
We have 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. As of December 31, 2012, our outstanding balance was $0.1 million.
 
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, and are secured by a general lien on all assets of the Company. As of December 31, 2012, and December 31, 2011 we are in compliance with both agreements with CNB.
 
Off-Balance Sheet Arrangements
 
We do not have any off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4), investments in special-purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.
 
Contractual Obligations and Commercial Commitments
 
We incur various contractual obligations and commercial commitments in our normal course of business. The following table summarizes our significant contractual obligations, net of related subleases, and commercial commitments as of December 31, 2012, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands):
 
 
 
Total
   
Less than
1 year
   
1-3 years
   
3-5 years
   
Thereafter
 
Operating lease obligations
  $ 342     $ 201     $ 141     $ -     $ -  
Capital lease obligations (principal and interest)
    110       110       -       -       -  
 
  $ 452     $ 311     $ 141     $ -     $ -  
 
 
Operating Leases
 
In August 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 July 2012, the Company entered into an agreement to sublease this subleased office space under terms generally equivalent to its existing commitment for a term that commenced in August 2012 and expires in December 2014. Beginning in August 2012, the Company has utilized a smaller space for its corporate office in San Francisco, California under a six month sublease which was renewed in February 2013 for an additional six months.
 
The Company leases office space in Kitchener, Canada of approximately of 5,222 square feet. The lease has a constant term of six months.
 
The Company leases office space in Los Angeles, California of approximately of 4,803 square feet. The lease expires in July 2015.
 
The Company leased a sales office in New York, New York on a month to month basis as of December 31, 2012. The lease was terminated on February 1, 2013.
 
Capital Leases
 
We have acquired various network operating equipment under capital leases with remaining terms up to 3 months as of December 31, 2012.
 
Purchase Obligations
 
The Company had no outstanding purchase obligations as of December 31, 2012. The Company had outstanding purchase obligations of an insignificant amount relating to an open purchase order for which the Company had not received the related services or goods.
 
Indemnification
 
We have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is or was serving, at our request, in such capacity, to the maximum extent permitted under the laws of the State of Delaware. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, we maintain 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. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal. Historically, we have not incurred any losses or recorded any liabilities related to performance under these types of indemnities.
 
Additionally, in the normal course of business, we have made certain guarantees, indemnities and commitments under which we may be required to make payments in relation to certain transactions. These indemnities include intellectual property and other indemnities to our customers and distribution network partners in connection with the sales of our products, and indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease. It is not possible to determine the maximum potential loss under these guarantees, indemnities and commitment due to our limited history of prior indemnification claims and the unique facts and circumstances involved in each particular provision.
 
 
Not Applicable.
 
 
 
INDEX TO THE FINANCIAL STATEMENTS
 
LOOKSMART, LTD.
 

 
 
To the Stockholders and Board of Directors of
LookSmart, Ltd.

We have audited the accompanying consolidated balance sheets of LookSmart, Ltd. (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of LookSmart, Ltd. as of December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
 
/s/ Moss Adams LLP

San Francisco, California
April 1, 2013
 
 
LOOKSMART, LTD.
 
(In thousands, except par value)

 
 
December 31,
 
 
 
2012
   
2011
 
ASSETS
 
 
   
 
 
Current assets:
 
 
   
 
 
Cash and cash equivalents
  $ 6,352     $ 17,950  
Short-term investments
    9,506       6,809  
Total cash, cash equivalents and short-term investments
    15,858       24,759  
Trade accounts receivable, net
    2,055       1,588  
Prepaid expenses and other current assets
    452       604  
Total current assets
    18,365       26,951  
Property and equipment, net
    378       1,941  
Capitalized software and other assets, net
    122       1,220  
Total assets
  $ 18,865     $ 30,112  
LIABILITIES & STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Trade accounts payable
  $ 1,427     $ 1,682  
Accrued liabilities
    1,278       895  
Deferred revenue and customer deposits
    1,147       1,143  
Current portion of capital lease obligations
    110       515  
Total current liabilities
    3,962       4,235  
Capital lease and other obligations, net of current portion
    177       296  
Total liabilities
    4,139       4,531  
Stockholders' equity:
               
Convertible preferred stock, $0.001 par value; Authorized: 5,000 shares at December 31, 2012 and 2011; Issued and Outstanding: none at December 31, 2012 and 2011
    -       -  
Common stock, $0.001 par value; Authorized: 80,000 shares; Issued and Outstanding: 17,305 shares and 17,288 shares at December 31, 2012 and 2011, respectively
    17       17  
Additional paid-in capital
    262,463       262,201  
Accumulated other comprehensive loss
    (46 )     (24 )
Accumulated deficit
    (247,660 )     (236,613 )
Treasury stock at cost:  56 shares at December 31, 2012
    (48 )     -  
Total stockholders' equity
    14,726       25,581  
Total liabilities and stockholders' equity
  $ 18,865     $ 30,112  

The accompanying notes are an integral part of these Consolidated Financial Statements.
 
 
LOOKSMART, LTD.
 
(In thousands, except per share data)

 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Revenue
  $ 15,691     $ 27,634  
Cost of revenue
    10,163       15,195  
Gross profit
    5,528       12,439  
Operating expenses:
               
Sales and marketing
    2,527       2,332  
Product development and technical operations
    6,036       6,742  
General and administrative
    5,579       5,312  
Asset impairment charge
    2,303       -  
Restructuring charge
    169       889  
Total operating expenses
    16,614       15,275  
Loss from operations
    (11,086 )     (2,836 )
Non-operating income (expense), net
               
Interest income
    78       89  
Interest expense
    (26 )     (81 )
Other income (expense), net
    (7 )     323  
Loss from operations before income taxes
    (11,041 )     (2,505 )
Income tax expense
    (6 )     (3 )
Net loss
  $ (11,047 )   $ (2,508 )
Net loss per share - Basic and Diluted
  $ (0.64 )   $ (0.15 )
Weighted average shares outstanding used in computing basic and diluted net loss per share
    17,253       17,287  

The accompanying notes are an integral part of these Consolidated Financial Statements.
 
 
LOOKSMART, LTD.
 
(In thousands)

 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Net loss
  $ (11,047 )   $ (2,508 )
Other comprehensive income (loss):
               
Foreign currency translation adjustments
    (47 )     -  
Unrealized gain (loss) on investments
    25       (25 )
Change in accumulated other comprehensive loss
    (22 )     (25 )
Comprehensive loss
  $ (11,069 )   $ (2,533 )
 
The accompanying notes are an integral part of these Consolidated Financial Statements.
 
 
LOOKSMART, LTD.
 
(In thousands)

   
Common Stock
   
Additional
Paid-in
   
Accumulated Other
Comprehensive
     
Accumulated
   
Treasury Stock
   
Total
Stockholders'
 
   
Shares
   
Amount
   
Capital
    Gain (Loss)    
Deficit
   
Shares
   
Amount
   
Equity
 
Balance at December 31, 2010
    17,222     $ 17     $ 261,740     $ 1     $ (234,105 )     -     $ -     $ 27,653  
Common stock issued upon exercise of stock option
    42       -       49       -       -       -       -       49  
Common stock issued for employee stock purchase plan
    24       -       31       -       -       -       -       31  
Stock-based compensation
    -       -       381       -       -       -       -       381  
Changes in accumulated other comprehensive loss
    -       -       -       (25 )     -       -       -       (25 )
Net loss
    -       -       -       -       (2,508 )     -       -       (2,508 )
Balance at December 31, 2011
    17,288     $ 17     $ 262,201     $ (24 )   $ (236,613 )     -     $ -     $ 25,581  
Common stock issued upon exercise of stock option
    2       -       3       -       -       -       -       3  
Common stock issued for employee stock purchase plan
    16       -       14       -       -       -       -       14  
Stock-based compensation
    -       -       245       -       -       -       -       245  
Treasury stock at cost
    -       -       -       -       -       (56 )     (48 )     (48 )
Changes in accumulated other comprehensive loss
    -       -       -       (22 )     -       -       -       (22 )
Net loss
    -       -       -       -       (11,047 )     -       -       (11,047 )
Balance at December 31, 2012
    17,305     $ 17     $ 262,463     $ (46 )   $ (247,660 )     (56 )   $ (48 )   $ 14,726  


The accompanying notes are an integral part of these Consolidated Financial Statements.
 
 
LOOKSMART, LTD.
 
(In thousands)

 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Cash flows from operating activities:
 
 
   
 
 
Net loss
  $ (11,047 )   $ (2,508 )
Adjustment to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    1,988       2,656  
Provision for doubtful accounts
    316       521  
Share-based compensation
    227       361  
Other non-cash charges
    71       91  
Deferred rent
    23       (12 )
Restructuring charge
    137       -  
Deferred lease incentive     28       -  
Asset impairment charge
    2,303       -  
Gain on closure of settlement fund
    -       (339 )
Changes in operating assets and liabilities:
               
Trade accounts receivable
    (783 )     1,067  
Prepaid expenses and other current assets
    37       130  
Trade accounts payable
    (255 )     (767 )
Accrued liabilities
    383       (1,381 )
Deferred revenue and customer deposits
    4       139  
Net cash used in operating activities
    (6,568 )     (42 )
Cash flows from investing activities:
               
Purchase of investments
    (20,305 )     (18,921 )
Proceeds from sale of investments
    17,566       16,839  
Payments for property, equipment, and capitalized software
    (1,666 )     (1,089 )
Proceeds from contingent purchase consideration of certain consumer assets
    -       91  
Net cash used in investing activities
    (4,405 )     (3,080 )
Cash flows from financing activities:
               
Principal payments of capital lease obligations
    (547 )     (1,127 )
Proceeds from issuance of common stock
    17       80  
Payments for repurchase of common stock
    (48 )     -  
Net cash used in financing activities
    (578 )     (1,047 )
Effect of exchange rate changes on cash and cash equivalents
    (47 )     -  
Decrease in cash and cash equivalents
    (11,598 )     (4,169 )
Cash and cash equivalents, beginning of period
    17,950       22,119  
Cash and cash equivalents, end of period
  $ 6,352     $ 17,950  
Supplemental disclosure of cash flow information:
               
Interest paid
  $ 26     $ 81  
Income taxes paid
  $ 6     $ 4  
Supplemental disclosure of noncash activities:
               
Change in unrealized gain (loss) on investments
  $ 25     $ (25 )
Share-based compensation capitalized as software development costs
  $ 18     $ 20  
 
The accompanying notes are an integral part of these Consolidated Financial Statements.
 
 
LOOKSMART, LTD.
 
 
1.
Summary of Significant Accounting Policies
 
Nature of Business
 
LookSmart, Ltd. (“LookSmart” or the “Company”) is a search and display advertising network solutions company that provides relevant solutions for search and display advertising customers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.
 
LookSmart operates in a large online advertising ecosystem serving ads that target user queries on partner sites.
 
LookSmart offers search advertising customers targeted 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.
 
 LookSmart also offers advertisers the ability to buy graphical display advertising. LookSmart’s trading desk personnel utilize DSP technology and licensed data from third party providers to buy targeted advertising on a real-time bidded basis. By leveraging our extensive historical search marketing network data along with performance data from a conversion pixel, LookSmart constructs models of the highest performing audiences, and targets them via exchange inventory. LookSmart offers its trading desk as a managed service.
 
Our largest category of customers are Intermediaries, the majority of which 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.
 
In addition, LookSmart 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.
 
Principles of Consolidation
 
The Consolidated Financial Statements include the accounts of the Company and its Subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.
 
Use of Estimates and Assumptions
 
The 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 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
 
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 in the Consolidated Statements of Comprehensive Loss. 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
 
Our online search advertising revenue is composed of per-click fees that we charge customers and profit sharing arrangements we enter with Intermediaries. 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. The Company has profit-sharing agreements with several customers that call for the sharing of profits and losses.  Profit sharing arrangements are governed by contractual agreements. Revenue from these profit-sharing agreements is reported net of the customer’s share of profit.
 
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 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 customer’s 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. The allowance included in trade receivables, net is insignificant and $0.3 million at December 31, 2012 and 2011, respectively.
 
Deferred revenue is recorded when payments are received in advance of performance in underlying agreements. Customer deposits are recorded when customers make prepayments for online advertising.
 
The Company evaluates individual arrangements with customers to make a determination under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605-45 Revenue Recognition. We test and record revenue accordingly.
 
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. The review is based on factors including the application of historical collection rates to current receivables and economic conditions. Additional allowances for doubtful accounts are considered and recorded 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. The allowance for doubtful accounts included in trade accounts receivable, net is $0.7 million and $0.6 million for each of the years ended December 31, 2012 and 2011. Bad debt expense included in general and administrative expense is $0.3 million and $0.5 million for each of the years ended December 31, 2012 and 2011.
 
 
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 and cash equivalents, investments, and accounts receivable. As of December 31, 2012 and 2011, 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 December 31, 2012 and 2011. 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 net accounts receivable:
 
 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Company 1
    54 %     12 %
 
Revenue and Cost Concentrations
 
The following table reflects the concentration of revenue by geographic locations that accounted for more than 10% of net revenue:
 
 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
United States
    49 %     70 %
Europe, Middle East and Africa
    46 %     21 %
 
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:
 
 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Advertiser Networks
    93 %     95 %
Publisher Solutions
    7 %     5 %

 
The following table reflects the percentage of revenue attributed to customers who accounted for 10% or more of net revenue, all of which are Intermediaries:
 
 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Company 1
    28 %     **  
Company 2
    **       11 %
Company 3
    **       11 %


** Less than 10%
 
The Company derives its revenue primarily from its relationships with significant distribution network partners. The following table reflects the distribution partners that accounted for more than 10% of the total TAC:
 
 
 
Year Ended December 31,
 
 
 
2012
   
2011
 
Distribution Partner 1
    29 %     **  
Distribution Partner 2
    11 %     **  
Distribution Partner 3
    10 %     **  
 

** Less than 10%

Property and Equipment
 
Property and equipment are stated at cost, except when an impairment analysis requires use of fair value, 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.
 
At December 31, 2012, the Company determined that continuing losses associated with the use of long-lived assets and a projection of associated future cash flows required the adjustment of long-lived assets to fair value at December 31, 2012.  Accordingly, long-lived assets including capitalized software, computer equipment, furniture and fixtures, software and leasehold improvements with a recorded net value of $2.7 million were reduced to fair value of $0.4 million at December 31, 2012.
 
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.  These costs are capitalized after certain milestones have been achieved and generally amortized over a three year period once the project is placed in service.
 
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 three years. The Company expects to continue to invest in internally developed software.
 
Restructuring Charges
 
In August 2012, the Company entered into an agreement to sublease its office space in San Francisco under terms generally equivalent to its existing commitment. The Company had $0.2 million in restructuring costs associated with the sub-lease of the San Francisco headquarters in the year ended December 31, 2012.
 
In January 2011, our Board of Directors approved a plan of termination that resulted in a reduction of the workforce of approximately 20 full-positions, or approximately 35%. In the year ended December 31, 2011, the Company recorded $0.9 million in pre-tax restructuring charges associated with this action. All restructuring charges have been classified as such on the Consolidated Statement of Operations.
 
 
Impairment of Long-Lived Assets
 
The Company reviews long-lived assets held or used in operations, including property and equipment and internally developed software, for impairment in accordance with ASC 360-10 “Impairment and Disposal of Long-Lived Assets”
 
The Company reviews assets for evidence of impairment annually at year end and whenever events or changes in circumstances indicate the carrying values may not be recoverable. The impairment review requires the Company to make significant estimates about its future performance and cash flows, as well as other assumptions. These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in business operations and changes in competition.  At December 31, 2012, the Company determined that continuing losses associated with the use of long-lived assets and a projection of associated future cash flows required the adjustment of long-lived assets to fair market value at December 31, 2012.  The lower projected operating results reflect changes in assumptions related to revenue growth rates, market trends, business mix, cost structure, and other expectations about the anticipated short-term and long-term operating results.  Accordingly, long-lived assets including capitalized software, computer equipment, furniture and fixtures, software and leasehold improvements with a recorded net book value of $2.7 million were reduced to fair market value of $0.4 million at December 31, 2012.
 
The fair value of the long-lived assets was derived based on Level 3 inputs, which are based on significant inputs that are not observable.  The fair value of the capitalized software long-lived assets was determined using an income approach, based on expected future cash flows and market considerations.  The fair value of the computer equipment, furniture and fixtures, software and leasehold improvements long-lived assets was determined using a market approach, based on comparable fair values of similar assets.
 
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. These affiliate agreements provide for 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.
 
TAC expense is recorded in cost of revenue.
 
Share-Based Compensation
 
The Company recognizes share-based compensation costs for all share-based payment transactions with employees, including grants of employee stock options, restricted stock awards, 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 each option award on the date of grant using the Black-Scholes option valuation model. Our assumptions about stock-price volatility are based on the actual volatility of our publically traded stock.  The risk-free interest rate for periods within the contractual life of the award is based on the U.S. Treasury yield curve in effect at the time of the grant.  We estimate the expected term based upon the historical exercise activity. The value of the portion of the award that is ultimately expected to vest is recognized as expense in the Company’s Consolidated Statements of Operations over the requisite service periods. Share-based compensation expense recognized for the years ended December 31, 2012 and 2011, was $0.2 million and $0.4 million, 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 Consolidated Statements of Cash Flows of the tax effects of employee share-based compensation awards.
 
Advertising Costs
 
Advertising costs are charged to sales and marketing expenses as incurred and were insignificant in 2012 and 2011.
 
Product Development Costs
 
Research of new product ideas and enhancements to existing products are charged to expense as incurred.
 
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 Loss
 
Other comprehensive loss as of December 31, 2012 and 2011 consists of unrealized gains and losses on marketable securities categorized as available-for-sale and foreign currency translation adjustments.
 
 
Net Loss per Common Share
 
Basic net loss per share is calculated using the weighted average shares of common stock outstanding. Diluted net loss 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.  As a result of the Company’s net loss position at December 31, 2012 and 2011, there is no dilution.
 
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 December 31, 2012 and 2011, all of the Company’s accounts receivable, intangible assets, and deferred revenue are related to the online advertising segment. All long-lived assets are located in the United States and Canada.
 
Recent Accounting Pronouncements
 
In July 2012, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2012-02, "Testing Indefinite-Lived Intangible Assets for Impairment" or ASU 2012-02. ASU 2012-02 simplifies the requirements for testing for indefinite-lived intangible assets other than goodwill and permits an entity to first assess qualitative factors to determine whether it is necessary to perform a quantitative fair value test. This new guidance is effective for us beginning in the first quarter of 2013 and will be applied prospectively. We anticipate that the adoption of this standard will not have a material impact on us or our consolidated financial statements.
 
In June 2011, the FASB issued an amendment to an existing accounting standard which requires companies to present net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. The Company was required to adopt this standard as of the beginning of 2012.  This guidance did not have an impact on the Company’s results of operations, financial position or cash flows as it is related only to the presentation of consolidated comprehensive loss.
 
2. 
Cash and Available for Sale Securities
 
The following table summarizes the Company’s cash and available-for-sale securities’ amortized cost and estimated fair value by significant investment category as of December 31, 2012 and 2011 (in thousands):
 
 
 
Amortized Cost and Estimated Fair Value
 
 
 
December 31,
 
 
 
2012
   
2011
 
Cash and cash equivalents:
 
 
   
 
 
Cash
  $ 1,203     $ 7,205  
Cash equivalents
               
Money market mutual funds
    249       1,045  
Certificates of deposit
    500       3,100  
Commercial paper
    4,400       6,600  
Total cash equivalents
    5,149       10,745  
Total cash and cash equivalents
    6,352       17,950  
Short-term investments:
               
Corporate bonds
    1,258       2,031  
Certificates of deposit
    3,301       3,278  
Commercial paper
    4,947       1,500  
Total short-term investments
    9,506       6,809  
Total cash, and cash equivalents, and short-term investments
  $ 15,858     $ 24,759  
 
Realized gains and realized losses were not significant for either of the years ended December 31, 2012 or 2011. As of December 31, 2012 and 2011, there were no significant unrealized losses on investments. The cost of all securities sold is based on the specific identification method.